What does it all mean?
There’s been a bit of discussion about what Alan Greenspan really conceded in his recent testimony. Although Greenspan was less opaque than usual, I won’t try to second-guess him any further, and will instead ask again what the crisis means for the way we think about economics and the economy. There are two big economic ideas that look substantially less appealing in the light of the current crisis.
The first is the macroeconomic hypothesis, often called the Great Moderation which combines the empirical observation that the frequency and severity of recessions declined greatly from 1990 to the recent past with the explanation that “the deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle”.
The second is the microeconomic idea, central to much of modern finance theory called the Efficient Markets Hypothesis. In its most relevant form, the EMH states that prices observed in asset markets (for stocks, bonds, foreign exchange and so on), reflect all known information, and provide the best possible estimate of the value of earnings that assets will generate.
On the Great Moderation, it is worth citing Gerard Baker’s piece from January 2007 at greater length to show how rapidly things have changed. Baker says
[Financial deregulation] gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods.
In the City of London and New York, the creation of the secondary mortgage market, cushioned banks from the effect of a sharp downturn in their core business. The globalisation of finance meant that downturns in one market could be offset by strength overseas. The economies that took the most aggressive measures to free their markets reaped the biggest rewards.
The Great Moderation offers another precious lesson in an old truth of economics: the power of creative destruction. The turmoil of free markets is the surest way to economic stability and prosperity.
I’m not picking on Baker in particular when I observe that it now seems that all of these claims are the exact reverse of the truth. Consumers have built up unsustainable gaps between income and consumption, banks have amplified their risks rather than cushioning them and the economies that took the most aggressive steps (like Iceland) are now in the deepest strife.
Of course, we have yet to see how deep the recession arising from the current crisis will be, but it already seems clear that it will be among the worst since the Depression in many countries. Typical forecasts for the US project 8.5 per cent unemployment next year, not quite as bad as the early 80s and early 90s, but worse than any other post-war recession. And there’s no guarantee that 8.5 per cent will be the peak.
Going beyond this single episode, the failure of the Great Moderation undermines, perhaps fatally, the idea that highly developed financial markets are a stabilising force in macroeconomic terms. Indeed, it suggests a reappraisal of the two decades or so since the emergence of a fully globalised international financial market from the turmoil of the 1970s. Beginning with the global stock market crash of 1987 there have been a series of financial crises and associated recessions. The link from the 1987 crash via monetary policy reactions to the recession of 1990-91 is a bit tenuous admittedly, but many developing countries experienced recessions driven directly by financial crises in the 1990s, as of course did Japan. Then there was the dotcom boom and bust in the late 90s.
After this crisis, the Keynes-Minsky view of financial markets as inherently destabilising looks a lot more appealing than the opposing view, argued most prominently by Milton Friedman. In this context, it doesn’t matter whether the financial markets caused the crisis or merely facilitated and amplified the results of excessively lax monetary policy (Daniel Davies argues strongly that monetary policy is the primary cause of the crisis, but I don’t buy the claim that financial markets were merely passive transmitters of monetary impulses).
The failure of the Efficient Markets Hypothesis is, perhaps, an even more significant outcome of the crisis than the end of the Great Moderation.
The EMH implies that, provided governments get prices right (avoiding distorting taxes, internalising externalities and so on) it’s impossible to improve on the allocation of investment capital generated by private markets. The converse doesn’t hold automatically. Even granting that private markets are subject to bubbles and fads, and that their investment decisions may not make sense in the light of publicly available information, it doesn’t necessarily follow that governments can do better. Still, for large scale infrastructure systems, the case for leaving investment planning as, in Keynes words ‘the by-product of the activities of a casino’, looks a lot weaker now than in did before this crisis. Of course, for anyone who cared to look, the ludicrous investment decisions made during the dotcom boom had already undermined the EMH.
Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century. I’ve written a more detailed version of this argument here here
At a more trivial level, until the severity of the crisis became apparent, Eugene Fama, the leading proponent of the EMH, was the hot favourite for the Nobel Prize in Economics. I think it’s safe to say that Robert Shiller, author of Irrational Exuberance, is now a much stronger candidate to get the next Nobel to be awarded to a finance theories.