tisdag 22 mars 2011

Brad DeLong on causes and cures of the Great Recession

In our popular  Brad DeLong is a National Treasure series:

The Right Explanation for Our Great Recession

The right explanation of our Great Recession is that the downturn had three sources. First comes irrational exuberance in housing markets. Irrational exuberance in housing markets led to a substantial number of mortgage loans being made that should not have been made. These loans would not have been a problem if you had had capital market arrangements like we had in the late 1990s during the dot-com boom. The dot-com boom also saw irrational exuberance, much more irrational exuberance, in fact, than we saw in the subprime mortgage bubble.

But irrational exuberance in the dot-com boom was not accompanied by overleverage. The venture capital firms that created and issued the securities of the dot-com boom sold them off to unleveraged primary investors, rather than leveraging up and holding on to them by financing their positions with borrowed money. When the dot-com crash came, high-net-worth individuals lost their wealth. But there were no large money-center banks whose solvency was thrown into doubt by the crash.

Things were different with the subprime crash. The large money-center investment and commercial banks found, after the crash, that the losses on their subprime mortgage holdings were of the same order of magnitude as and might exceed their capital cushion. Their other liabilities were thus no longer beyond question--perhaps the money-center banks were not good to pay back all their creditors and make good on all of the deposits they had accepted. This was, in large part, the result of the third factor: misregulation--the government had failed to impose and maintain proper capital adequacy standards of those banks that were indeed "too big to fail"; the government had failed to use its regulatory hammer to check whether the large money-center banks possessed the proper risk controls. It turned out that they did not: that the top managements of the money center banks had no idea of the risks that their subordinates were running on their shareholders' behalf.

The consequence was panic and flight to quality. A huge tranche of financial assets that had been generally classified as safe turned out not to be so. These tranches had been places to put your money where you could sleep easy, confident it would still be there when you came back for it. That was the whole reason for you to invest in a AAA mortgage-backed security rather than in something riskier that offered a higher return.

So what happened when it became clear that the supply of high-quality financial assets was a lot lower than people had thought? What happened when it became clear that a larger value of assets labeled AAA were not so? What happened when all of those debts that were thought to be of high quality because those owing the debts owned AAA assets turned out to be not such high quality at all because the assets backing those debts were not AAA? And what happened when it became clear that the ability of financial professionals to properly understand their risks had been greatly oversold? A collapse in the supply of high-quality financial assets accompanied by a surge in demand.

This fall in the supply and rise in the demand for high-quality assets created an enormous financial market imbalance. The counterpart to this large excess demand for high quality assets was deficient demand for currently-produced goods and services and labor--a "general glut." People who felt that their portfolios were short of high-quality assets cut back on their spending to try to build up their high-quality asset stocks. But when they and everyone else cut back in spending, all they managed to do was to cut back on sales, employment, and income. They found that their cut back on spending was matched by a fall in their incomes so that they did not manage in fact to build up their stocks of high-quality assets. And as total spending fell short of the amount needed to provide full employment the economy headed into recession.

He goes on to outline the cure, and the reasons so many have gotten the Great Recession wrong (hint: Milton Friedman's name is mentioned once or twice). ...Oh heck, I'll quote some more:

It is in this sense, I think, that I blame Milton Friedman: he sold the Chicago School an interventionist, technocratic, managerial optimal monetary policy under the pretense that it was something--laissez-faire--that it was not.

And then it turned out at the end of 2008 that it simply did not work.

Now at this point the seven sects of macroeconomic error could have done either of two things. They could have chosen wisely. They could have said: "Oops we’ve been followers of Milton Friedman for 50 years and we were wrong, his intellectual opponents were right. We have to go back and listen to them and learn what they had to say and change our minds. We need to sit at the feet of Bagehot and Wicksell and Minsky and Keynes and Hicks and Tobin for a while and think through the issues of the determinants of aggregate demand.

They chose not wisely. They chose to say: "Milton Friedman taught us that the Keynesian version of the income-expenditure approach was wrong. There is something wrong with Friedman's theory. But we need to develop it and add something new rather than return to something old and discredited."

But I do recommend that you follow the link and read the whole piece. (And a bunch of other posts on his blog, of course – I did call him a national treasure...)

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