There is a fundamental question: Do our models represent the "real world" sufficiently so that any policy experiment on a model would actually work out there?
Having studied in Minnesota, taking classes with Sargent, Prescott, Wallace, Sims and Hurwicz, I came out convinced that DSGE models that *assume* linearity right at the outset (with quadratic utility function for all participants if not outright identical ones) is far far away from reality. Leo Hurwicz taught us (taking a cue from Koopmans) that utility function additive in time require absurd assumptions about the preferences of the participants.
All of this is shoved under the carpet in a Lucas island model.
For the economics profession, what it has done is to completely take over the macro research. IMHO, in the long run, it has done more damage than help.
Executive summary: In the even longer run, we know what will happen to us as Keynes noted.
As somebody who started grad school at Minnesota in 1991, taking courses from Wallace, Prescott, Hurwicz I found the disconnect between micro and macro puzzling. But to me it seemed a premium in macros was put on big fancy models, lots of complicated math, and just show the math for it ab own sake. I eventually gravitated toward IO and worked with what I thought was a simple model, but was also combinatorial optimization that simply blew people’s minds (what? Not twice continuously differentiable?) and found on my own interpretations of integer constraints and answered some basic policy questions through simulation modeling built from large data sets on power generation and emissions controls.
While Lucas started a revolution and introduced a more mathematical and modeling heavy discipline, reality suffered, I found on the job market what Econ Depts, Govt, private sector cared about most of the ability to communicate well (I had won multiple teaching awards) and to answer relevant policy questions. The tools were a means to get to those results. Unfortunately academic macro was the tool for its own sake and own ideological and methodological purity. Nobody cared about about being more “rigorously and mathematically imprecise”.
While I'm sure this is meant to be complimentary, this ultimately sounds like he posed some interesting research work that ended up being counterproductive and probably hurt the economy. In the end we ended up with the old Keynesian insights. The market monetarists and monetarists can pretend they have something altogether new but it all builds on Keynesianism in the end.
Why counterproductive? New Keynesian models (and there aren't any Old Keynesian models any more) incorporate expectations. Now maybe they still are not good enough but that would not be Lucas's fault.
Because they ended up using Lucas' critiques as an excuse not to stimulate the economy adequately. I think you can track a lot of economic and political angst since to the negative effects of that. Noah had a post going on about how millennials were actually ok now. The thing is, millennials came of working age more than ten years ago. It's not acceptable to say you'll be ok in ten years. That's a quarter of a working life. That's wealthbuilding derailed.
I'll point out that we did indeed know how to deal with the 2008 Great Recession, we just didn't do it. We did rescue the banks and bank-like institutions.
But we left fiscal policy mostly unused, and left homeowners saddled with the debt from underwater mortgages, rescuing only the banks.
Banks essentially refused to participate in any of the programs design to refinance homes with a more reasonable balance and instead foreclosed on houses, a failure of government oversight.
Annoyingly, bank stockholders were left whole, while every startup I've participated would have faced real share dilution had they f**ked up to the degree that the big banks did with their CDS-based synthetic bonds.
Pretty sure this is wrong. Citibank shareholders were 90% diluted (my stepfather, a retired Citibank exec, was one). Who got held harmless were depositors and repo holders, i.e. creditors. Also homeowners who lied about their income to buy their dream home, and then found themselves underwater when the crash came and had to hand over the keys. Don't remember any going to jail. What btw is wrong with a CDS-based synthetic bond? Are you opposed to credit markets finding cheaper ways to fund housing? I thought this was a Yimby site.
Here's how the synthetic bonds worked: let's say the 10 year T bill rate is 3% and there's an IBM bond you want that pays 7%. But bummer -- you can't buy enough of those bonds because they're all sold out. That 7% is basically the T bill rate + the extra 4% for default risk from IBM.
But AIG says, no problem, I'll sell you a synthetic $1M IBM bond: I'll sell credit default insurance to some rando for the amount of $1M for $40K/year. I'll take your $1M and put it in T bills, and pay you $70K from the insurance premiums + T bill dividends. Just like a real IBM bond, you get $70K/year. Just like an IBM bond, you get zilch if IBM fails, because your $1M is the insurance payout in that case.
You can create an infinite # of clones of any bond with this mechanism, as long as you have enough people who think the cloned bond is really worthless and will pay out. This allowed a laser-like amplification of bad mortgage bonds (that's what was insured, not IBM bonds, IRL).
Combined with a bad risk model, this allowed a lot of investment banks to speculate crazily and end up having to be bailed out, because even if there were only $X billion of bad mortgages, these derivatives could total far more than $X billion.
IOW, this wasn't just repackaging of what turned out to be bad mortgages, it was rampant gambling with clones of those bad mortgages to such a degree that the companies failed and needed a bailout.
No doubt there was some mis-pricing in the market, and the disappearance of AIG is evidence of it. The rampant gambling was mortgage markets (Countrywide, Freddie, Fannie) making their money from originations and selling the loans into the secondary market, while skimming 2% off the spread. Whatever synthetic bonds were created was a rational response to millions of Americans lying about their income, and the banking industry closing a blind eye to the gravy train. A robust banking industry is still important to the strength of the United States. I'd add that the notional value of a derivative isn't the same as its settlement value, why we get pundits throwing around trillions when the real value is millions.
The banks dropped all scrutiny and explicitly encouraged people to lie to get loans. It wasn't a bunch of prospective home owners who all decided to lie at once to the advantage of mortgage originators and derivative salesmen. It was the banks and other financial institutions that preyed on financially unsophisticated people and told them flat out to lie. It wasn't the banks exploiting some mass mania.
The derivatives were designed to hide the weakness of the underlying loan portfolios. We all learned about tranches and slicing and dicing, but the end result was to lie about the strength of the portfolio. The ratings agencies, who should have been doing their jobs, went along with the game and gave excellent ratings to complete garbage. Homeowners weren't the only ones encouraged to lie.
Then came the collateral damage of the inevitable crash. It wasn't just the folks who were told to lie on their loans. The collapsed economy knocked a lot of people off track, and many of them have yet to recover. There was plenty of fraud out there to prosecute, but the corrupt Obama administration decided to let the bad actors off the hook.
The banks were promoting 'liar loans'. People who might not have qualified for modest loans qualified for loans far beyond their ability to pay (barring hyperinflation that nobody could foresee in the Double-Zero decade or spectacular escalation of their career prospects).
In the 1950's, the assumption was that banks would lose some money on defaulted loans, that they were not to gain from inflation or lose from deflation, and that in essence housing payments would be recycled into more housing loans. What changed? Around 2000 mortgage lenders could make money on a borrower's default. The borrower would pay exorbitant interest and the bank would have a claim against property of rising value. If someone had a mortgage loan for $500K on a house worth $800K on the open market, then the lender could make a profit on the resale. Great business model,huh?
Around 2005 that carousel stopped, and some mortgage holders got caught in the collapse of that corrupt scheme. By then, mortgage lenders were making huge volumes of fecal loans sure to go bust.
Don't blame Obama. Like FDR he had to rescue the banks to keep things from going worse. Maybe we would have otherwise had an honest-to-Hoover depression. Yes, it would have been fitting to see a cadre of corrupt people in the financial industry commit seppuku, but that would have done nothing to solve the problem. We'd simply have a boom for undertakers.
The perfect solution would have been to require that investments have deposits behind them. Then again, we go back to the Reagan era in which Reagan decided that the best way to solve inflation was to ensure that young Americans could work only for very low wages that, among other consequences, ensued that they could never save money for anything. So the government had to print money to allow investment.
It's hard to see any benefit to synthetic bonds -- it was pure gambling. Remember, the actual mortgage backed bonds were already sold out. There was no need to clone more of them, since the clones weren't providing funds for mortgages, they were pure speculation, which essentially bankrupted those investment banks.
And those losses were real transfers of money, since they were insurance payouts.
Gambling on interest rates is what bond traders do, and whether it was trading a mortgage-backed bond or a derivative, their gambling was providing liquidity to the mortgage market, to the benefit of us all.
That's part of the problem. Whenever they lose, they come whining to Uncle Sam for a bailout, and they usually get it. I'm surprised the guys who run Los Vegas haven't caught on with a government program to protect the gambling industry. We'd have done better to have bailed out the homeowners and let the banks rot. It takes many six or eight hours to build a new bank. We'd have a new banking industry in a week or two.
Citibank shares lost 90% of their value, but I don't think that was all because of dilution; some was due to Citibank being insolvent after their losses in bonds and/or derivatives.
But you're right that there was some dilution, since the Feds put in $45B, and got some preferred shares for that money, which they later sold at a profit. Citi's market cap is $88B now and the graphs I saw made it look like they were even a little lower in 2008, so it at a gross level looks like some significant dilution.
As for homeowners, yes, some of them had mortgages that they shouldn't have gotten, but that's not everyone by any stretch. Furthermore, the bankers knew that the mortgages were being written to people with insufficient income. The bankers just had a bad risk model that said that the top 90% of the mortgages were safe, and they were wrong.
I'll end this here but will respond separately to the CDS-based synthetic bond.
But is that a flaw in economists' theories, or a flaw in the US political system? (And even more so the EU's?)
Even under presidentialism, which is a terrible setup, we'd have been much better off with a unitary legislature making fiscal policy (and health policy, foreign policy...) under Obama.
I think the bicameral system exists in most democracies but in almost every case the "senate" is much less powerful than the main house. People complain that the British House of Lords is undemocratic because of its hereditary/appointed status, but over centuries it's been made so weak that the UK is closer to the unicameral-parliamentary ideal than most countries.
Apart from the United States, I think the only major democracy where the two legislative chambers have equal power is Italy. Those are two poor advertisements for bicameralism.
My argument, which apparently could have been clearer, is that the economic theories were good, but we just didn't follow them. IOW, 2008 was a political failure. And at the time, it was pretty clear that Republicans simply didn't want Obama to succeed -- McConnell said as much when he said his primary goal was to make Obama a one term president.
Krugman and many others wrote barrels of e-ink talking about the futility of pushing on a string, that is, providing cheap money but no additional demand. The Federal government, of course, could have provided as much demand as necessary.
And Obama did put into place debt forgiveness programs, but sorta seemed to lose interest in making sure that they actually were up and running. Again, mostly a political failure.
The recession ended in Q2 2009, just months after Obama’s inauguration. Given leads and lags, O had nothing at all to do with ending the recession - he simply presided over the weakest recovery in history and his admins theories about the fiscal multiplier proved false. Spending even more to get fractional results would not have been wise. And who would have guessed that soaking big banks for $100billion+ vis lawsuits and raising taxes might have made the recovery slower?
On giving haircuts to bank shareholders: is there any reason at all that the government can't just demand a new share issue and take 90 percent of the equity whenever it bails out an insolvent institution?
For that matter, why don't they do this with ordinary fines/settlements? I've read about cases in which banks were hit with multibillion-dollar penalties for breaking one rule or another, and then had the amount reduced because they were "systemically important" and paying the full sum would have created solvency risk.
Good grief, just collect the fine as a share dilution. Am I missing something?
I think a lot of people don’t like the government owning private industries. I don’t know that there are specific legal problems with it, but there is something awkward about it, when the government is supposed to be setting neutral rules for the market, rather than picking winners and losers, or participating. Maybe the growth of industrial policy will make people more comfortable with this.
But the government can take the shares and then immediately sell them. The point is that you can punish a bank's shareholders financially without damaging its balance sheet.
Not that I can see. Like I said, VCs are big fans of share dilution -- you screw up, and you lose X% of your company. Happens all the time, and for much more minor transgressions than investing in synthetic CDOs linked to fatally compromised bond issues.
If the Feds bail you out, taking board seats, and issuing shares should all be on the table. With the right legislation, you might even be able to force a 'light bankruptcy' procedure where you could claw back promises to executives for bonuses without triggering bond defaults, credit default swaps and the like.
Given the United States present love affair with extremism, a unicameral legislature would lead to intolerable “mood swings” in our governance. Just what we don't need!
That was basically the Founding Fathers' argument. When you build in checks and balances you promote moderation.
But we don't seem to be getting much moderation, do we? I really think the Founders got it backwards, mainly because they disapproved of political parties and tried to write the Constitution in a way that would prevent them from forming.
What actually happens, I think, is that when political parties campaign on a platform and then can't implement it after winning the most recent election, a large bloc of voters don't understand why their preferences weren't enacted. That may be what's really fueling extremism: you pump the gas and the car doesn't respond, so you end up flooring the pedal.
I think an overview of our history shows that voters are basically indifferent to politics until there is a time of real crisis, such as the 10 years before the Civil War or the progressive era of the 1910s, or the present day, when the dynamic of intense voter frustration you describe comes into play.
One of these crises was resolved by fighting a civil war, and the other by progressive hopes being frustrated until the New Deal Era.
So, the go-slow government bequeathed by our founders has worked well for 90% of our nation's history. I'll take that.
It's hard to build a constitutional framework in advance to deal with intense national disagreements, because each is so unique. I'd rather wait until a national consensus emerges rather than be ruled by a majority of 51%.
Incidentally, the US was in profound disagreement over WW II, and the government was paralyzed in consequence, until the nation was brought into unity by the attack on Pearl Harbor.
Relative to what it could have done, "we" left _monetary_ policy mostly unused. The Fed might have reminded market participants that it had a Congressional mandate to maintain stable prices (which it interpreted as 2% PCE inflation) and high employment and that it would do what it takes to achieve that mandate i.e. the beating will continue until morale improves. Anyone who is prepared to speculate that the Fed cannot produce inflation can place their bets accordingly.
Even the Great Depression didn't matter much in the long run. But, as Keynes said, in the long run we are all dead.
If you look at the remarkable divergence between Australia and New Zealand since 1980s, the most plausible explanation is that NZ has had more and deeper recessions and has never recovered the lost ground.
Ironically, the inflation targeting regime now taken to be sacrosanct is based on that adopted, disastrously, by NZ in the early 1990s. It's been tweaked, but it should have been abandoned long ago.
I suppose it depends what you mean by "matter". Ultimately we muddled through and things got better again, but that was hardly a certainty. The Great Depression helped create fascism in Europe. The more recent Great Recession helped produce a fascist movement in America. If the world truly goes off the rails in a way that prevents us from dealing with climate change, or leads to a nuclear exchange, it will not be unreasonable to say that macro-economic mis-management helped to make that happen.
While I largely agree with you, one other factor could be immigration. We had quite a bit more, I believe, and skilled too. Given younger average ages and higher skill levels, you'd expect this to increase average incomes over time.
The big relative decline happened in the 1980s and 1990s, well before our minerals boom. And I think they had a nice terms of trade shift for dairy products.
There’s a classic Keating press club address from just before the 93 election where he’s asked a question about NZ Labour and he says something like ‘yeah every now and then they come across trying to sell us on their tired creed’ before reminding them that the constitution contains conventions that will ‘allow us to come together’ to much amusement from the Press Gallery
I’ve always had a problem with ‘rational expectations’ stuff as if ppl are walking around all day thinking if price inflation & grown rates when making decisions considering 80% of ppl couldn’t tell you the right number for either in a spot quiz and spend way more of their time thinking about their kids soccer game or the TV show they watched last night
I guess a partial rebuttal would be that the most important economic decisions are made by corporations, commercial banks and investment banks, not individuals.
But when I see the number of investment bankers who seem implicitly committed to various crank libertarian theories about how the economy works, I think you're still more or less correct.
Plus rational expectations assumes large groups, like the population at large making rational decisions with their money based on knowing these things, it’s like they’ve never met a normal everyday person before
Like the papers like pretend in Australia at the moment that new homeowners are angry at the Reserve Bank here for having a comment 3 years ago after one board meeting that they expected interest rates to stay low and they find Vox pops saying ‘oh this is so so unfair’ but no way these ppl were thinking ‘maybe we should buy a house, but before we bid let’s go and read clause 4 on page 2 of the Reserve Bank notes after their April 2021 decision to keep rates flat’
The assumption of rationality isn't just a problem for expectations theory. It's a problem for neoclassical economics in general. You assume rational behavior because it's (a) sometimes roughly true and (b) mathematically tractable.
Stephen Hawking has a wonderful passage in his book "The Grand Design", in which he explains the concept of an "effective theory": one that doesn't rely directly on fundamental laws of nature but uses "chunked", macroscopic concepts to make the world more amenable to theorization:
==
In physics, an effective theory is a framework created to model certain observed phenomena without describing in detail all of the underlying processes. For example, we cannot solve exactly the equations governing the gravitational interactions of every atom in a person’s body with every atom in the earth. But for all practical purposes the gravitational force between a person and the earth can be described in terms of just a few numbers, such as the person’s total mass.
Similarly, we cannot solve the equations governing the behavior of complex atoms and molecules, but we have developed an effective theory called chemistry that provides an adequate explanation of how atoms and molecules behave in chemical reactions without accounting for every detail of the interactions.
In the case of people, since we cannot solve the equations that determine our behavior, we use the effective theory that people have free will. The study of our will, and of the behavior that arises from it, is the science of psychology.
Economics is also an effective theory, based on the notion of free will plus the assumption that people evaluate their possible alternative courses of action and choose the best. That effective theory is only moderately successful in predicting behavior because, as we all know, decisions are often not rational or are based on a defective analysis of the consequences of the choice. That is why the world is in such a mess.
All that was fine until the last sentence, the world really isn’t in such a mess, the average person in the west is more free and more prosperous than anyone in history, the main problem at the moment is ppl on the extremes of right and left (but let’s be honest, mostly the right as the right wing Party’s have embraced their cranks) who want to ‘tear the system down’
The perfect example is my (ex) friend, didn’t even graduate high school, is honestly really quite dumb but is good at sales and earns $300k a year and owns his home 2 investment properties, $100k company car, regular overseas holidays and married with kids but spends all his time talking about how ‘politicians have screwed up the world and we need a revolution’ (a right wing fascist revolution, hence the ‘ex’) when it’s those ‘stupid politicians’ who’ve built the society where a moron like him can live a life of unimaginable luxury to 99% of the ppl who have lived in the history of humanity
Rationality and economics are the least of it. Some people are 'live for the moment' types and some 'squirrel away nuts until they can kick up their heels at 70' types. The former will enjoy their twenties and not their seventies, and the latter will enjoy their seventies (assuming they make it there) a lot more than those who partied hard in their twenties. I would guess the former will have about 3x the divorces of the latter, an economic bummer to be sure. I doubt Bob Lucas knew a single human being who wasn't doing differential equations in his head at the bar before walking home by himself. If Lucas were rational, he'd have purged himself of everything he'd learned about economics.
Banks are pro-cyclical entities. They buy high and sell low (expand and lend into booms and downsize at the bottom) for a number of obvious reasons related to human nature and incentives (and nothing at all related to “crank libertarian theories”), and we are seeing this behavior played out before us today.
Policy makers have learned how to restrain their impulses at the bottom of cycles - recently adding massive and ridiculous fiscal over- stimulus to the standard irresponsible monetary stimulus so that inequality increases in wealth and income are exacerbated by declining purchasing power of consumers in real terms.
What they haven’t figured out is how to restrain them at the top of cycles (see GFC, Minsky etc). Why, it is almost as if pols and policymakers love a boom. Hey, why not let a bank buy 100 bio of 15 year MBS paying 1.75 pct when the economic recovery is going strong (after all the Fed is still buying that amount in bonds every month) and why shouldn’t the bank fund them overnight?
People don’t necessarily know what the normal rate of inflation is or the current one, and they don’t necessarily know the normal rate of unemployment or the current one. But they can often enough be aware of the fact that the current rate is *different* to react to it. That’s how rational expectations can get some sort of grip even when people don’t explicitly know much of this.
Rational Expectations work because they have always been a Platonic Ideal. We always miss the mark in our less-then-ideal world, but we always strive for the Ideal. In doing so, we improve both our outcomes and the predictive power of the models.
Some people buy information regarding a future decision. Others buy insurance. Some prefer to spend their time and money on other things and accept a greater variance of outcomes. All of them subsume a probability distribution of outcomes - implicitly or explicitly. And all of this is rational
"That said, I think that macroeconomics is a very very hard subject, given the complexity of the phenomena involved and the paucity of good empirical data. "
Exactly why you can't just create some neat little model and assume you've got it all figured out.
I can't find it at the moment, but I know there's a wonkish post from Krugman where he lays out that _even if you accept Lucas' model_ of how consumers rationally update behavior in response to stimulus, that doesn't mean stimulus won't work, because if consumers expect higher taxes _over the long term_, that means they will lower their consumption _in out-years_, whereas the stimulus is concentrated in the present. So while the multiplier will be lower than you might expect, you still can boost GDP and escape the liquidity trap via fiscal policy. If anything, the Lucas-ian theory here improves the argument for stimulus because it implies you'll get a counter-cyclical pullback in consumption spending in future good years, exactly when you want it!
I think you are mistaken when you say Lucas used simple math and simple logic.His business cycle models used sophisticated signal extraction mathematics and he published in the Journal of Economic Theory. In fact, the high powered math helped to obscure the simple logic that his results about policy irrelevance depended on perfect competition. Perhaps you had to be there…
Very interested in the idea that Lucas' simple logical intelligence was inherently destructive. I'd be interested in hearing more about the roles of different types of intelligence in economics if you have anything on that
There is a fundamental question: Do our models represent the "real world" sufficiently so that any policy experiment on a model would actually work out there?
Having studied in Minnesota, taking classes with Sargent, Prescott, Wallace, Sims and Hurwicz, I came out convinced that DSGE models that *assume* linearity right at the outset (with quadratic utility function for all participants if not outright identical ones) is far far away from reality. Leo Hurwicz taught us (taking a cue from Koopmans) that utility function additive in time require absurd assumptions about the preferences of the participants.
All of this is shoved under the carpet in a Lucas island model.
For the economics profession, what it has done is to completely take over the macro research. IMHO, in the long run, it has done more damage than help.
Executive summary: In the even longer run, we know what will happen to us as Keynes noted.
As somebody who started grad school at Minnesota in 1991, taking courses from Wallace, Prescott, Hurwicz I found the disconnect between micro and macro puzzling. But to me it seemed a premium in macros was put on big fancy models, lots of complicated math, and just show the math for it ab own sake. I eventually gravitated toward IO and worked with what I thought was a simple model, but was also combinatorial optimization that simply blew people’s minds (what? Not twice continuously differentiable?) and found on my own interpretations of integer constraints and answered some basic policy questions through simulation modeling built from large data sets on power generation and emissions controls.
While Lucas started a revolution and introduced a more mathematical and modeling heavy discipline, reality suffered, I found on the job market what Econ Depts, Govt, private sector cared about most of the ability to communicate well (I had won multiple teaching awards) and to answer relevant policy questions. The tools were a means to get to those results. Unfortunately academic macro was the tool for its own sake and own ideological and methodological purity. Nobody cared about about being more “rigorously and mathematically imprecise”.
While I'm sure this is meant to be complimentary, this ultimately sounds like he posed some interesting research work that ended up being counterproductive and probably hurt the economy. In the end we ended up with the old Keynesian insights. The market monetarists and monetarists can pretend they have something altogether new but it all builds on Keynesianism in the end.
Why counterproductive? New Keynesian models (and there aren't any Old Keynesian models any more) incorporate expectations. Now maybe they still are not good enough but that would not be Lucas's fault.
Because they ended up using Lucas' critiques as an excuse not to stimulate the economy adequately. I think you can track a lot of economic and political angst since to the negative effects of that. Noah had a post going on about how millennials were actually ok now. The thing is, millennials came of working age more than ten years ago. It's not acceptable to say you'll be ok in ten years. That's a quarter of a working life. That's wealthbuilding derailed.
And in any case, I'm fairly sure he was talking about American millennials. I'm not sure you could say the same about say, Spanish millennials.
Animal spirits. If you want to kill them, let loose a bunch of economists.
I'll point out that we did indeed know how to deal with the 2008 Great Recession, we just didn't do it. We did rescue the banks and bank-like institutions.
But we left fiscal policy mostly unused, and left homeowners saddled with the debt from underwater mortgages, rescuing only the banks.
Banks essentially refused to participate in any of the programs design to refinance homes with a more reasonable balance and instead foreclosed on houses, a failure of government oversight.
Annoyingly, bank stockholders were left whole, while every startup I've participated would have faced real share dilution had they f**ked up to the degree that the big banks did with their CDS-based synthetic bonds.
Pretty sure this is wrong. Citibank shareholders were 90% diluted (my stepfather, a retired Citibank exec, was one). Who got held harmless were depositors and repo holders, i.e. creditors. Also homeowners who lied about their income to buy their dream home, and then found themselves underwater when the crash came and had to hand over the keys. Don't remember any going to jail. What btw is wrong with a CDS-based synthetic bond? Are you opposed to credit markets finding cheaper ways to fund housing? I thought this was a Yimby site.
Here's how the synthetic bonds worked: let's say the 10 year T bill rate is 3% and there's an IBM bond you want that pays 7%. But bummer -- you can't buy enough of those bonds because they're all sold out. That 7% is basically the T bill rate + the extra 4% for default risk from IBM.
But AIG says, no problem, I'll sell you a synthetic $1M IBM bond: I'll sell credit default insurance to some rando for the amount of $1M for $40K/year. I'll take your $1M and put it in T bills, and pay you $70K from the insurance premiums + T bill dividends. Just like a real IBM bond, you get $70K/year. Just like an IBM bond, you get zilch if IBM fails, because your $1M is the insurance payout in that case.
You can create an infinite # of clones of any bond with this mechanism, as long as you have enough people who think the cloned bond is really worthless and will pay out. This allowed a laser-like amplification of bad mortgage bonds (that's what was insured, not IBM bonds, IRL).
Combined with a bad risk model, this allowed a lot of investment banks to speculate crazily and end up having to be bailed out, because even if there were only $X billion of bad mortgages, these derivatives could total far more than $X billion.
IOW, this wasn't just repackaging of what turned out to be bad mortgages, it was rampant gambling with clones of those bad mortgages to such a degree that the companies failed and needed a bailout.
No doubt there was some mis-pricing in the market, and the disappearance of AIG is evidence of it. The rampant gambling was mortgage markets (Countrywide, Freddie, Fannie) making their money from originations and selling the loans into the secondary market, while skimming 2% off the spread. Whatever synthetic bonds were created was a rational response to millions of Americans lying about their income, and the banking industry closing a blind eye to the gravy train. A robust banking industry is still important to the strength of the United States. I'd add that the notional value of a derivative isn't the same as its settlement value, why we get pundits throwing around trillions when the real value is millions.
The banks dropped all scrutiny and explicitly encouraged people to lie to get loans. It wasn't a bunch of prospective home owners who all decided to lie at once to the advantage of mortgage originators and derivative salesmen. It was the banks and other financial institutions that preyed on financially unsophisticated people and told them flat out to lie. It wasn't the banks exploiting some mass mania.
The derivatives were designed to hide the weakness of the underlying loan portfolios. We all learned about tranches and slicing and dicing, but the end result was to lie about the strength of the portfolio. The ratings agencies, who should have been doing their jobs, went along with the game and gave excellent ratings to complete garbage. Homeowners weren't the only ones encouraged to lie.
Then came the collateral damage of the inevitable crash. It wasn't just the folks who were told to lie on their loans. The collapsed economy knocked a lot of people off track, and many of them have yet to recover. There was plenty of fraud out there to prosecute, but the corrupt Obama administration decided to let the bad actors off the hook.
The banks were promoting 'liar loans'. People who might not have qualified for modest loans qualified for loans far beyond their ability to pay (barring hyperinflation that nobody could foresee in the Double-Zero decade or spectacular escalation of their career prospects).
In the 1950's, the assumption was that banks would lose some money on defaulted loans, that they were not to gain from inflation or lose from deflation, and that in essence housing payments would be recycled into more housing loans. What changed? Around 2000 mortgage lenders could make money on a borrower's default. The borrower would pay exorbitant interest and the bank would have a claim against property of rising value. If someone had a mortgage loan for $500K on a house worth $800K on the open market, then the lender could make a profit on the resale. Great business model,huh?
Around 2005 that carousel stopped, and some mortgage holders got caught in the collapse of that corrupt scheme. By then, mortgage lenders were making huge volumes of fecal loans sure to go bust.
Don't blame Obama. Like FDR he had to rescue the banks to keep things from going worse. Maybe we would have otherwise had an honest-to-Hoover depression. Yes, it would have been fitting to see a cadre of corrupt people in the financial industry commit seppuku, but that would have done nothing to solve the problem. We'd simply have a boom for undertakers.
The perfect solution would have been to require that investments have deposits behind them. Then again, we go back to the Reagan era in which Reagan decided that the best way to solve inflation was to ensure that young Americans could work only for very low wages that, among other consequences, ensued that they could never save money for anything. So the government had to print money to allow investment.
It's hard to see any benefit to synthetic bonds -- it was pure gambling. Remember, the actual mortgage backed bonds were already sold out. There was no need to clone more of them, since the clones weren't providing funds for mortgages, they were pure speculation, which essentially bankrupted those investment banks.
And those losses were real transfers of money, since they were insurance payouts.
Gambling on interest rates is what bond traders do, and whether it was trading a mortgage-backed bond or a derivative, their gambling was providing liquidity to the mortgage market, to the benefit of us all.
That's part of the problem. Whenever they lose, they come whining to Uncle Sam for a bailout, and they usually get it. I'm surprised the guys who run Los Vegas haven't caught on with a government program to protect the gambling industry. We'd have done better to have bailed out the homeowners and let the banks rot. It takes many six or eight hours to build a new bank. We'd have a new banking industry in a week or two.
Citibank shares lost 90% of their value, but I don't think that was all because of dilution; some was due to Citibank being insolvent after their losses in bonds and/or derivatives.
But you're right that there was some dilution, since the Feds put in $45B, and got some preferred shares for that money, which they later sold at a profit. Citi's market cap is $88B now and the graphs I saw made it look like they were even a little lower in 2008, so it at a gross level looks like some significant dilution.
As for homeowners, yes, some of them had mortgages that they shouldn't have gotten, but that's not everyone by any stretch. Furthermore, the bankers knew that the mortgages were being written to people with insufficient income. The bankers just had a bad risk model that said that the top 90% of the mortgages were safe, and they were wrong.
I'll end this here but will respond separately to the CDS-based synthetic bond.
Most of those homeowners had a good detrimental reliance claim.
But is that a flaw in economists' theories, or a flaw in the US political system? (And even more so the EU's?)
Even under presidentialism, which is a terrible setup, we'd have been much better off with a unitary legislature making fiscal policy (and health policy, foreign policy...) under Obama.
I think the bicameral system exists in most democracies but in almost every case the "senate" is much less powerful than the main house. People complain that the British House of Lords is undemocratic because of its hereditary/appointed status, but over centuries it's been made so weak that the UK is closer to the unicameral-parliamentary ideal than most countries.
Apart from the United States, I think the only major democracy where the two legislative chambers have equal power is Italy. Those are two poor advertisements for bicameralism.
My argument, which apparently could have been clearer, is that the economic theories were good, but we just didn't follow them. IOW, 2008 was a political failure. And at the time, it was pretty clear that Republicans simply didn't want Obama to succeed -- McConnell said as much when he said his primary goal was to make Obama a one term president.
Krugman and many others wrote barrels of e-ink talking about the futility of pushing on a string, that is, providing cheap money but no additional demand. The Federal government, of course, could have provided as much demand as necessary.
And Obama did put into place debt forgiveness programs, but sorta seemed to lose interest in making sure that they actually were up and running. Again, mostly a political failure.
The recession ended in Q2 2009, just months after Obama’s inauguration. Given leads and lags, O had nothing at all to do with ending the recession - he simply presided over the weakest recovery in history and his admins theories about the fiscal multiplier proved false. Spending even more to get fractional results would not have been wise. And who would have guessed that soaking big banks for $100billion+ vis lawsuits and raising taxes might have made the recovery slower?
The slow recovery was manufactures at Constitution Ave and 20th St, not 1600 Pennsylvania Avenue
On giving haircuts to bank shareholders: is there any reason at all that the government can't just demand a new share issue and take 90 percent of the equity whenever it bails out an insolvent institution?
For that matter, why don't they do this with ordinary fines/settlements? I've read about cases in which banks were hit with multibillion-dollar penalties for breaking one rule or another, and then had the amount reduced because they were "systemically important" and paying the full sum would have created solvency risk.
Good grief, just collect the fine as a share dilution. Am I missing something?
I think a lot of people don’t like the government owning private industries. I don’t know that there are specific legal problems with it, but there is something awkward about it, when the government is supposed to be setting neutral rules for the market, rather than picking winners and losers, or participating. Maybe the growth of industrial policy will make people more comfortable with this.
But the government can take the shares and then immediately sell them. The point is that you can punish a bank's shareholders financially without damaging its balance sheet.
Exactly and with the Fed flooding the market with liquidity to maintain inflation, other buyers can easily finance the purchase.
Not that I can see. Like I said, VCs are big fans of share dilution -- you screw up, and you lose X% of your company. Happens all the time, and for much more minor transgressions than investing in synthetic CDOs linked to fatally compromised bond issues.
If the Feds bail you out, taking board seats, and issuing shares should all be on the table. With the right legislation, you might even be able to force a 'light bankruptcy' procedure where you could claw back promises to executives for bonuses without triggering bond defaults, credit default swaps and the like.
Given the United States present love affair with extremism, a unicameral legislature would lead to intolerable “mood swings” in our governance. Just what we don't need!
That was basically the Founding Fathers' argument. When you build in checks and balances you promote moderation.
But we don't seem to be getting much moderation, do we? I really think the Founders got it backwards, mainly because they disapproved of political parties and tried to write the Constitution in a way that would prevent them from forming.
What actually happens, I think, is that when political parties campaign on a platform and then can't implement it after winning the most recent election, a large bloc of voters don't understand why their preferences weren't enacted. That may be what's really fueling extremism: you pump the gas and the car doesn't respond, so you end up flooring the pedal.
I think an overview of our history shows that voters are basically indifferent to politics until there is a time of real crisis, such as the 10 years before the Civil War or the progressive era of the 1910s, or the present day, when the dynamic of intense voter frustration you describe comes into play.
One of these crises was resolved by fighting a civil war, and the other by progressive hopes being frustrated until the New Deal Era.
So, the go-slow government bequeathed by our founders has worked well for 90% of our nation's history. I'll take that.
It's hard to build a constitutional framework in advance to deal with intense national disagreements, because each is so unique. I'd rather wait until a national consensus emerges rather than be ruled by a majority of 51%.
Incidentally, the US was in profound disagreement over WW II, and the government was paralyzed in consequence, until the nation was brought into unity by the attack on Pearl Harbor.
It’s almost as if a bunch of cronies and their friends did what they wanted. Imagine that.
Relative to what it could have done, "we" left _monetary_ policy mostly unused. The Fed might have reminded market participants that it had a Congressional mandate to maintain stable prices (which it interpreted as 2% PCE inflation) and high employment and that it would do what it takes to achieve that mandate i.e. the beating will continue until morale improves. Anyone who is prepared to speculate that the Fed cannot produce inflation can place their bets accordingly.
Even the Great Depression didn't matter much in the long run. But, as Keynes said, in the long run we are all dead.
If you look at the remarkable divergence between Australia and New Zealand since 1980s, the most plausible explanation is that NZ has had more and deeper recessions and has never recovered the lost ground.
Ironically, the inflation targeting regime now taken to be sacrosanct is based on that adopted, disastrously, by NZ in the early 1990s. It's been tweaked, but it should have been abandoned long ago.
They have recessions without going below the 2% target?
I suppose it depends what you mean by "matter". Ultimately we muddled through and things got better again, but that was hardly a certainty. The Great Depression helped create fascism in Europe. The more recent Great Recession helped produce a fascist movement in America. If the world truly goes off the rails in a way that prevents us from dealing with climate change, or leads to a nuclear exchange, it will not be unreasonable to say that macro-economic mis-management helped to make that happen.
Its very weird that NZ cant capitalise on catch up growth to start outpacing us
While I largely agree with you, one other factor could be immigration. We had quite a bit more, I believe, and skilled too. Given younger average ages and higher skill levels, you'd expect this to increase average incomes over time.
We had Hawke/Keating and NZ didn’t
They had Roger Douglas and Don Brash, which is probably more important
Another factor perhaps is that we have iron ore and they do not.
With apologies to Hillaire Belloc
The big relative decline happened in the 1980s and 1990s, well before our minerals boom. And I think they had a nice terms of trade shift for dairy products.
There’s a classic Keating press club address from just before the 93 election where he’s asked a question about NZ Labour and he says something like ‘yeah every now and then they come across trying to sell us on their tired creed’ before reminding them that the constitution contains conventions that will ‘allow us to come together’ to much amusement from the Press Gallery
I’ve always had a problem with ‘rational expectations’ stuff as if ppl are walking around all day thinking if price inflation & grown rates when making decisions considering 80% of ppl couldn’t tell you the right number for either in a spot quiz and spend way more of their time thinking about their kids soccer game or the TV show they watched last night
I guess a partial rebuttal would be that the most important economic decisions are made by corporations, commercial banks and investment banks, not individuals.
But when I see the number of investment bankers who seem implicitly committed to various crank libertarian theories about how the economy works, I think you're still more or less correct.
Plus rational expectations assumes large groups, like the population at large making rational decisions with their money based on knowing these things, it’s like they’ve never met a normal everyday person before
Like the papers like pretend in Australia at the moment that new homeowners are angry at the Reserve Bank here for having a comment 3 years ago after one board meeting that they expected interest rates to stay low and they find Vox pops saying ‘oh this is so so unfair’ but no way these ppl were thinking ‘maybe we should buy a house, but before we bid let’s go and read clause 4 on page 2 of the Reserve Bank notes after their April 2021 decision to keep rates flat’
That’s just not how ppl live their lives
The assumption of rationality isn't just a problem for expectations theory. It's a problem for neoclassical economics in general. You assume rational behavior because it's (a) sometimes roughly true and (b) mathematically tractable.
Stephen Hawking has a wonderful passage in his book "The Grand Design", in which he explains the concept of an "effective theory": one that doesn't rely directly on fundamental laws of nature but uses "chunked", macroscopic concepts to make the world more amenable to theorization:
==
In physics, an effective theory is a framework created to model certain observed phenomena without describing in detail all of the underlying processes. For example, we cannot solve exactly the equations governing the gravitational interactions of every atom in a person’s body with every atom in the earth. But for all practical purposes the gravitational force between a person and the earth can be described in terms of just a few numbers, such as the person’s total mass.
Similarly, we cannot solve the equations governing the behavior of complex atoms and molecules, but we have developed an effective theory called chemistry that provides an adequate explanation of how atoms and molecules behave in chemical reactions without accounting for every detail of the interactions.
In the case of people, since we cannot solve the equations that determine our behavior, we use the effective theory that people have free will. The study of our will, and of the behavior that arises from it, is the science of psychology.
Economics is also an effective theory, based on the notion of free will plus the assumption that people evaluate their possible alternative courses of action and choose the best. That effective theory is only moderately successful in predicting behavior because, as we all know, decisions are often not rational or are based on a defective analysis of the consequences of the choice. That is why the world is in such a mess.
All that was fine until the last sentence, the world really isn’t in such a mess, the average person in the west is more free and more prosperous than anyone in history, the main problem at the moment is ppl on the extremes of right and left (but let’s be honest, mostly the right as the right wing Party’s have embraced their cranks) who want to ‘tear the system down’
The perfect example is my (ex) friend, didn’t even graduate high school, is honestly really quite dumb but is good at sales and earns $300k a year and owns his home 2 investment properties, $100k company car, regular overseas holidays and married with kids but spends all his time talking about how ‘politicians have screwed up the world and we need a revolution’ (a right wing fascist revolution, hence the ‘ex’) when it’s those ‘stupid politicians’ who’ve built the society where a moron like him can live a life of unimaginable luxury to 99% of the ppl who have lived in the history of humanity
Rationality and economics are the least of it. Some people are 'live for the moment' types and some 'squirrel away nuts until they can kick up their heels at 70' types. The former will enjoy their twenties and not their seventies, and the latter will enjoy their seventies (assuming they make it there) a lot more than those who partied hard in their twenties. I would guess the former will have about 3x the divorces of the latter, an economic bummer to be sure. I doubt Bob Lucas knew a single human being who wasn't doing differential equations in his head at the bar before walking home by himself. If Lucas were rational, he'd have purged himself of everything he'd learned about economics.
Banks are pro-cyclical entities. They buy high and sell low (expand and lend into booms and downsize at the bottom) for a number of obvious reasons related to human nature and incentives (and nothing at all related to “crank libertarian theories”), and we are seeing this behavior played out before us today.
Policy makers have learned how to restrain their impulses at the bottom of cycles - recently adding massive and ridiculous fiscal over- stimulus to the standard irresponsible monetary stimulus so that inequality increases in wealth and income are exacerbated by declining purchasing power of consumers in real terms.
What they haven’t figured out is how to restrain them at the top of cycles (see GFC, Minsky etc). Why, it is almost as if pols and policymakers love a boom. Hey, why not let a bank buy 100 bio of 15 year MBS paying 1.75 pct when the economic recovery is going strong (after all the Fed is still buying that amount in bonds every month) and why shouldn’t the bank fund them overnight?
People don’t necessarily know what the normal rate of inflation is or the current one, and they don’t necessarily know the normal rate of unemployment or the current one. But they can often enough be aware of the fact that the current rate is *different* to react to it. That’s how rational expectations can get some sort of grip even when people don’t explicitly know much of this.
Models are models. Not exact representations.
Rational Expectations work because they have always been a Platonic Ideal. We always miss the mark in our less-then-ideal world, but we always strive for the Ideal. In doing so, we improve both our outcomes and the predictive power of the models.
Some people buy information regarding a future decision. Others buy insurance. Some prefer to spend their time and money on other things and accept a greater variance of outcomes. All of them subsume a probability distribution of outcomes - implicitly or explicitly. And all of this is rational
I do admire your ability to take a fair and measured perspective, even if your subject, in this case Lucas, didn’t always.
"That said, I think that macroeconomics is a very very hard subject, given the complexity of the phenomena involved and the paucity of good empirical data. "
Exactly why you can't just create some neat little model and assume you've got it all figured out.
But what if the alternative is some politician saying "we just have to tighten our belts." That is a model, too, just a worse one
It seems a shame Lucas never could update his views to recognize where he was wrong.
https://archive.nytimes.com/krugman.blogs.nytimes.com/2011/09/26/lucas-in-context-wonkish/
I can't find it at the moment, but I know there's a wonkish post from Krugman where he lays out that _even if you accept Lucas' model_ of how consumers rationally update behavior in response to stimulus, that doesn't mean stimulus won't work, because if consumers expect higher taxes _over the long term_, that means they will lower their consumption _in out-years_, whereas the stimulus is concentrated in the present. So while the multiplier will be lower than you might expect, you still can boost GDP and escape the liquidity trap via fiscal policy. If anything, the Lucas-ian theory here improves the argument for stimulus because it implies you'll get a counter-cyclical pullback in consumption spending in future good years, exactly when you want it!
Ah, here we go:
https://archive.nytimes.com/krugman.blogs.nytimes.com/2011/12/26/a-note-on-the-ricardian-equivalence-argument-against-stimulus-slightly-wonkish/
Excellent history lesson combined with a valuable insight: our ignorance of causes always stretches farther than we can see
Really, really nice summary for me. Thank you.
I think you are mistaken when you say Lucas used simple math and simple logic.His business cycle models used sophisticated signal extraction mathematics and he published in the Journal of Economic Theory. In fact, the high powered math helped to obscure the simple logic that his results about policy irrelevance depended on perfect competition. Perhaps you had to be there…
I highly doubt the Lucas Islands model would have made much of a lasting change on the profession (and in fact it did not)... 😉
Thanks Noah!
Of course, I didn't get it all, but Noahpinion has the best chance of 'splaining it to me.
Best economics course since my sophomore year in college.
Good overview, thanks.
Very interested in the idea that Lucas' simple logical intelligence was inherently destructive. I'd be interested in hearing more about the roles of different types of intelligence in economics if you have anything on that
Thank you in particular not just for your insight, but for your concluding sentence!
Nice one