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“No one saw this coming?" Balderdash

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The widespread statement that this financial crisis was a tsunami that no one saw coming has been given the lie to by an excellent survey of economic models by Dirk Bezemer, a Professor of Economics at the University of Groningen in the Netherlands.
Bezemer did an extensive survey of research by economists or financial market commentators, looking for papers that met four criteria:
“Only analysts were included who:
  1. provide some account on how they arrived at their conclusions.
  2. went beyond predicting a real estate crisis, also making the link to real-sector recessionary implications, including an analytical account of those links.
  3. the actual prediction must have been made by the analyst and available in the public domain, rather than being asserted by others.
  4. the prediction had to have some timing attached to it.”
On that basis, Bezemer found eleven researchers who qualified:  
Researcher: Dean Baker, US
Role: Co-director, Center for Economic and Policy Research
Forecast date: 2006
Researcher: Wynne Godley, US
Role: Distinguished scholar, Levy Economics Institute of Bard College
Forecast date: 2007
Researcher: Fred Harrison, UK
Role: Economic commentator
Forecast date: 2005
Researcher: Michael Hudson, US
Role: Professor, University of Missouri
Forecast date: 2006
Researcher: Eric Janszen, US
Role: Investor and iTulip commentator
Forecast date: 2007
Researcher: Stephen Keen, Australia
Role: Associate professor, University of Western Sydney
Forecast date: 2006
Researcher: Jakob Brøchner Madsen and Jens Kjaer Sørensen, Denmark
Role: Professor and graduate student (respectively), Copenhagen University
Forecast date: 2006
Researcher: Kurt Richebächer, US
Role: Private consultant and investment newsletter writer
Forecast date: 2006
Researcher: Nouriel Roubini, US
Role: Professor, New York University
Forecast date: 200
Researcher: Peter Schiff, US
Role: Stock broker, investment adviser and commentator
Forecast date: 2007
Researcher: Robert Shiller, US
Role: Professor, Yale University
Forecast date: 2006
Having identified eleven researchers who did “see it coming”, Bezemer then looked for the common elements in the way these researchers analysed the economy. He argued that if there were common elements—and if these differed from the approach taken by the overwhelming majority of economists, who didn’t have a clue that a crisis was approaching—then the only useful economic models would be ones that included these common elements.
He identified four common elements:
  1. “A concern with financial assets as distinct from real-sector assets,
  2. with the credit flows that finance both forms of wealth,
  3. with the debt growth accompanying growth in financial wealth, and
  4. with the accounting relation between the financial and real economy.”
A non-economist might look at these elements in puzzlement: surely all economic models include these factors?
Actually, no. Most macroeconomic models lack these features. Bezemer gives the topical example of the OECD’s “small global forecasting” model, which makes forecasts for the global economy that are then disaggregated to generate predictions for individual countries—like the ones touted recently as indicating that Australia will avoid a serious recession.
He notes that this OECD model includes monetary and financial variables, but these are not taken from data but instead derived from theoretical assumptions about the relationship between “real” variables—such as “the gap between actual output and potential output”—and financial variables. As Bezemer notes, in the OECD’s model:
“There are no credit flows, asset prices or increasing net worth driving a borrowing boom, nor interest payment indicating growing debt burdens, and no balance sheet stock and flow variables that would reflect all this.”
How come? Because standard “neoclassical” economic models assume that the financial system is like lubricating oil in an engine—it enables the “real economy” to work smoothly, but has no driving effect—and that the real economy is a miracle machine that always returns to a state of steady growth, and never generates any pollution—like a car engine that, once you take your foot off the accelerator or brake, always returns to a steady 3,000 revs per minute, and simply pumps pure water into the atmosphere.
The common elements in the models developed by the Gang of Eleven that Bezemer identified are that they see finance as more akin to petrol than oil—without it, your “real economy” engine revs not at 3,000 revs per minute, but zero—which can contain large doses of impurities as well as hydrocarbons. The engine itself is seen as a rather more typical gas-guzzler that pumps not merely water and carbon dioxide, but sometimes unhealthy amounts of carbon monoxide as well.
That’s encapsulated in the flowchart that Bezemer copied from a paper by Michael Hudson (shown below). Without credit from the finance sector, producer/employers don’t get the finance needed to run their factories and hire workers; but with credit they accumulate debt that has to be serviced from the cash flows those businesses generate.
The component left out of the above flowchart—but incorporated in all the models praised by Bezemer for seeing the crisis coming—is that the finance system can fund not merely “good” real economy action but “bad” speculation on financial assets and real estate as well. This also leads to debt, but unlike the lending to finance production, it doesn’t add to the economy’s capacity to service that debt.
The growth in thus unproductive debt was the common element identified by Bezemer’s Gang of Eleven, which was why we most definitely did see “It” coming.
I’ll finish this analogy-laden article with a sideswipe at an inappropriate analogy—that this crisis is “like a tsunami”. Though that image captures the suddenness and devastating nature of the crisis, it is wrong not merely once but twice.
Firstly, unlike a tsunami, this crisis was predictable by economists who take what Bezemer characterized as a “Flow-of-fund or accounting” approach. Secondly, a tsunami is actually caused by a huge shift in the planet’s tectonic plates, and the shift itself relieves the tension that caused the tsunami in the first place: in a sense, the tsunami resets the system.
This financial tsunami was caused by the bursting of asset price bubbles driven by excessive levels of debt, but the bursting of those asset bubbles hasn’t eliminated the debt—far from it. Instead, economic performance for the next decade or more will be driven by the private sector’s attempts to reduce its debt levels, and this will depress economic activity for years. Unlike a tsunami, a debt crisis is a wave of destruction that keeps on rolling unless the debt is deliberately eliminated.
Everything that is being done by policy makers around the world is instead trying to restart private borrowing. A better analogy is therefore not a tsunami but a drug overdose—and our economic doctors are attempting to bring the patient back to health by administering more of the same drug.

Published: Tuesday, July 14, 2009

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