I’m adding a little section to each of the chapters in my Zombie Economics book called “Reanimation”, about the attempts that are already under way to revive economic ideas killed (at least according to the standard rules of hypothesis refutation) by the global crisis. I wasn’t surprised to find plenty of examples for the efficient markets hypothesis (easy to render immune from any kind of refutation by an appropriate formulation) or for policy ideas that yield big benefits to the rich and powerful, such as privatisation and trickle-down economics. But I was surprised a little while ago to see the crisis described as a transitory blip in the continuing Great Moderation. Still that pales into insignificance compared to this piece by Casey Mulligan of Chicago (h/t commenter Daniel ), in which (I swear this is true!) the crisis is the result of financial markets correctly anticipating the adverse labour market impacts of possible legislation under Obama, such as a health plan that might include means tests.
ZombiesWalkMulligan
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The crucial point in a good zombie movie is the moment when zombies who seem to have been blasted into the next world by the hero’s shotgun, pull themselves up from the ground and come shambling forward. In the writing of this book, that moment came for me when I read Casey Mulligan’s paper ‘Aggregate Implications of Labor Market Distortions: The Recession of 2008-9 and Beyond’
Looking at the way real business cycles theorists have tried to write the Great Depression out of macroeconomic history, presenting instead as a government-induced dislocation of labour markets it was obvious that, sooner or later, something similar would be attempted with the Global Financial Crisis. But, Great Depression revisionism did not take hold until the Depression had faded out of living memory, to the point where hardly any economists who had actually experienced it were still active.
I thought a similar process of fading memory would be required for the GFC. As long as the subprime fiasco, and the chaos of late 2008 remained vivid memories, it would be impossible to deny that this was, indeed, a crisis made in the financial markets.
I underestimated the speed and power of Zombie ideas. As early as Sep 2009, Casey Mulligan was willing to claim that the entire crisis could be explained in terms of labor market interventions. According to Mulligan, financial markets anticipated a variety of measures from the Obama Administration, observing ‘Arguably, the 2008 election was associated with an increase in the power of unions to shape public policy, and thereby the labor market. Congress has considered various legislation that would raise marginal income tax rates, and would present Americans with new health benefits that would be phased out as a function of income.’
This is truly impressive. So perspicacious are the financial markets, that even the possibility that Congress might raise taxes, or incorporate a means test in health care legislation that might be passed some time in the future (at the time of writing this in Feb 2010, the bill was still tied up) was sufficient to bring down the entire global financial market. And, even though the McCain-Palin ticket was widely seen as having a good chance (at least before the September 2008), the markets didn’t wait for the election returns to come in. Applying some superstrong version of market efficiency, market participants predicted the election outcome, applied Mulligan’s neoclassical model to the predicted policies of the Obama Administration and (perfectly rationally) panicked.
There is one problem with Mulligan’s neat explanation. Writing in October 2008, when the crisis had already erupted and when Obama’s victory was virtually assured Mulligan had this to say about proposals for economic stimulus
So, if you are not employed by the financial industry (94 percent of you are not), don’t worry. The current unemployment rate of 6.1 percent is not alarming, and we should reconsider whether it is worth it to spend $700 billion to bring it down to 5.9 percent.
This piece, which got the endorsement of his Chicago colleague, Freakonomist Steven Levitt, doesn’t even mention the possibility that a Democratic Congress might raise taxes, or that the health plan that was a central plank of candidate Obama’s platform might include means test. Yet he now claims that these possibilities (still hypothetical as of 2010) caused a massive increase in unemployment, the anticipation of which caused the crash!
H/T Brad DeLong
John Quiggin 
Much of my working career has entailed working for startup companies. My first serious job was with Optus in the early 1990s long before they made any money. When you make a living from other peoples investments it is hard to deny that some form of trickle down occurs. I got paid years before the investors ever did. I’m glad they had sufficient incentives to invest. If they didn’t then less would have trickled my way.
So to sum up the theory. Investors believed that Democrats were likely to win big in 2008. Investors associated this with the likelihood of higher taxes, regulations and other interventions harmful to economic growth. They then acted accordingly.
Alternatively, the one sentence summary is: widespread expectations of a sharp shift to the left in America scared the horses.
I am not saying this is necessarily what happened, or that this was the main cause of the GFC. But the idea that this could have contributed is a perfectly reasonable theory, and is certainly not the kind of far-fetched bizarre hypothesis you claim it to be.
I see my incredulity meter needs adjusting. Do you want to extend this theory to the string of failures that started with Northern Rock in the UK in Sep 20007?
“This is truly impressive. So perspicacious are the financial markets, that even the possibility that Congress might raise taxes, or incorporate a means test in health care legislation that might be passed some time in the future (at the time of writing this in Feb 2010, the bill was still tied up) was sufficient to bring down the entire global financial market.”
It doesn’t require superhuman levels of psychic ability to look at opinion polls, betting markets, political futures markets, or to simply listen to the talk on the street, to see that America was shifting leftward for a while leading up to the 2008 elections, and to work out that this may have consequences for future economic policy.
Indeed, this doesn’t even require sohisticated reasoning on the part of market participants. All it requires is a certain Pavlovian reflex and associations between different phenomena.
i.e. liberal Democrats ascendent = higher taxes, regulations, union power etc = bad!
Even my dog knows how to make associations between different things to uncover threats or opportunities and act accordingly.
Are Zombie ideas examples of or drivers of agnotology or just another word for the same problem?
Casey Mulligan’s aggregate neoclassical growth model has no financial sector in it. This ensures (guarantees) that the “2008-2009” recession, cannot possibly be due to anything with the word financial attached to it. The method corresponds to assigning measurements in the area of climate science to a hypothetical earth without humans, hence ensuring that any changes in AGW cannot be possibly be attributed to human activity.
Why isn’t the word stupid sufficient?
Quick shoot again its still twitching
As I said in the other thread, Mulligan is insane.
In retrospect it is clear that in 2007 US investment banks switched from a strategy of originating bad mortgages and selling down the securitised paper to other market participants to that of retaining the bonds on their own balance sheets. This was done in anticipation of a change in the White House which would preserve the upward climb of US house prices.
Blaming the financial crash on anticipation of the election of Obama and of the passage of his policies would have to be called the Ultra or Clairvoyant Rational Expectations Hypothesis – the most extreme version of REH I’ve ever heard of. Although, maybe I am being unfair. Maybe they just simply factored in the likelihood of his success and that was enough.
Casey Mulligan has his own blog which can be found at http://www.stopthefiscalstimulus.com/ where all his posts explaining that “fiscal stimulus = waste of money” can be found.
Otherwise, his blog has the subheading “Supply and Demand (in that order)” and states:
“The basic tools of supply and demand help immensely to understand and predict everyday events in our world. These days, many of those events are related to the financial crisis — or the Panic of 2008 as I call it. But I also look at other issues related to fiscal policy, labor economics, and industrial organization.”
Clearly, he is on the way to a nobel prize.
And here’s me thinking it was good old fashioned financial instability, when it was really the prospect of an Obama victory all along. Doh.
JQ. You will never finish the book if you keep updating it with the latest idiocies. They are not going away any time soon because too many people have a vested interested (or should I say INvested interest?) in maintaining them. I admire your intellectual effort though.
The blame for the financial crisis is here and I agree
http://rwer.wordpress.com/2010/02/22/greenspan-friedman-and-summers-win-dynamite-prize-in-economics/#comment-757
And my post was to a comment – scroll up for the blame for the financial crisis. Its pretty well spot on as far as I can see
How much longer do we have to put up with idiot economists or self interested economists at the expense of genuine economics that does what it should do and allocate resources efficiently with economic welfare maximised?? The charlatan economists (who have always been with us and who we will never shake off) are maximising their own economic welfare, not the economic welfare of the majority. They do economics great damage as a science. They work against the fundamental goals of economics. They are the destroyers of the goals of the field – but they cannot be that way unless they personally chose to be (narcissism or an inflated sense of self importance or luxuriously remunerated to parrot, promote and espouse destructive visions of future utopias that do not exist and serve only current interests).
They are as great enemies to good economic policies as corrupt governments. The individually self interested that parade themselves as economists (concern economists?).
“Blaming the financial crash on anticipation of the election of Obama and of the passage of his policies would have to be called the Ultra or Clairvoyant Rational Expectations Hypothesis – the most extreme version of REH I’ve ever heard of.”
It is again one of these verbal theoretician macro-economic model thing. The story would correspond to two societies in one geo-graphically defined country. One society (group of people) votes for political representation, the other society (non-overlapping group of people) votes with dollars in financial markets. Interestingly, the equations in the model allow for neither of the two societies.
Credibility ranking [0,10]: 0
PS: The story doesn’t even overlap at the fringes with the theoretical models of ‘Fully Revealing Rational Expectations’ models. IMHO these theoretical models provide a fast way to debunk stories like the above. This theoretical reseach has resulted in the concusion that the idea of prices fully revealing private information is not tenable. (See an earlier thread.)
Apologies for all the typos which I discover regularly after submitting.
You and I both Ernestine!
@Ernestine Gross
Prices may fully reflect private expectations and thats all they reflect. Im not sure why we ever thought the mass of people have all infornation. They only have the quota of information relative to their trading size.
Isn’t this just another version of the rational expectations idea which, as I recall, posited that people will note that excessive government spending now will stimulate inflation at some later time and so, in anticipation, adjust their behaviour to nullify the intended effect?
I recall (possibly wrongly) reading that the economist who put forward this received a Nobel Prize.
Rational expectations suggests consumers will see the government support for the economy and spend in anticipation of higher disposable income. Inflation is the result of increased economic activity and is a valid concern. There is no data as far as I know that suggests Ricardian equivalence in any way holds true.
@Alice
My comments relate to the paper by Casey Mulligan in the context of this thread. I am not aware of any model which assumes that ‘the mass of people’ (ie everybody) have all information. At #5 I am saying Mulligan’s model is biased by construction. It is like examining the effect of cigarette smoking on the health of people by pulling a sample of non-smokers who have never been exposed to side-smoke. One may find that people die, not surprisingly, but for reasons other than cigarette smoking. This handwaving method then includes a story as to what these other reasons might be. When one then checks the method coming from the other end, so to speak, one ends up with observations as I’ve illustrated @14 with respect to the Mulligan story. All this reminds me of my youth when I went through many papers, scratching my head and getting nowehere. The stack of papers was at least 1 metre high. I gave the pile to my supervisor. He returned them saying I should read only those which are face up. There were 2 (about 2cm in height). This helped. JQ’s blog and his upcoming book might help current youth to save time.
obviously this is ridiculous. the financial industry was the Obama campaign’s #1 source of investment
@gerard
And the evidence for your statement?
I’ve been pondering the same question for many years. Given the enduring fixation many have with increasing aggregate command I expect that the next generation will get to ponder the same issue.
@TerjeP (say tay-a)
“Given the enduring fixation many have with increasing aggregate command”
I assume you are referring to rating agencies, such as S&P, as described in the SMH article
http://www.smh.com.au/business/councils-sue-after-185m-investment-imploded-20100226-p8zz.html
and, possible the Chicago School of economists.
I have a feeling that pointing at people who truly get everything wrong about the economy is meant to take away from those who still aren’t quite right about it. Pointing out the sun doesn’t revolve around the earth and ridiculing those that do is not proof that plate tectonics is wrong or right. Ridiculing the idea the crisis was started because everyone anticipated a coloured president which at the time was unlikely to introduce health chare “reform” which is still unlikely to pass does not take away from the fact that the crisis has since been exacerbated by the very man and while he may not have started it he still is the very reason it is never going to end until he has driven the US through chapter 11.
@Freelander
6 out of the top 20 donors were actual financial institutions. A further 5 appear to be Wall St legal firms. Source:http://www.opensecrets.org/pres08/contrib.php?cycle=2008&cid=N00009638
EG – nope.
Freelander I am technically wrong but you get the general idea. All donations of more than $200 have the donor’s employer recorded.