Lesson One: Centrality of Finance

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Evolution or Revolution, the macro academy’s most recent  installment in its annual series on the lessons from the Great Recession, was just released. Edited by Olivier Blanchard and Lawrence Summers (hereafter B&S), the book illustrates the box in which mainstream theorists still find themselves a decade after the greatest market failure since the Great Depression.

In their Introduction, B&S outline the 2019 version of that box: “We focus on what we see as three main lessons from the last decade, namely, the centrality of finance, the more complex and problematic nature of fluctuations, and the implications of very low neutral interest rates.” They fail to mention the most consequential lesson, which is much more stark. The academy’s consensus market-centric general-equilibrium model, 10-years ago and today, is fundamentally stabilization-irrelevant and should not be used to advise policymakers. The message of Evolution or Revolution is that leading theorists continue to assign top priority to defending the evidence-deaf approach that has for decades misinformed mainstream research and instruction.

This post looks at the B&S first lesson, the centrality of finance. The following three weeks will consider the other two, with complexity getting more space. Taken together, it is an unhappy story.

Centrality of Finance

The content of Evolution or Revolution, as well as the earlier installments in the series, makes clear that New Keynesian agree on the most action-worthy lesson of the Great Recession: The financial sector of the market-centric general-equilibrium model must be substantially enriched. B&S make two noteworthy points here. First, “based on  recent experience, a large fraction of whatever consequential instability takes place in advanced economies over the next decades is likely to be associated with financial instability.” Second, the proper response to financial distress is some combination of “crisis prevention and crisis resolution.”

It is in assessing the relative merits of prevention and resolution that B&S (along with the other authors) go astray. Perhaps as a result of the academy’s embarrassingly weak modeling of extreme instability, Evolution or Revolution concentrates attention on designing regulation that will prevent of future financial crises. That choice has been fatal to mainstream stabilization-relevance.

Institutional dynamics. Sharply greater bank regulation, including substantial increases in federally-regulated bank capital/liquidity, product restrictions, penalties on bank size, and so on, are easily understood to be ineffective in preventing or reversing extreme instability of the sort that began organizing itself in 2008. A central part of the ineffectiveness results from the inherent migration of financial risk to the ever-evolving shadow-banking system. The shadow system largely exists as a home for activities seeking to operate more aggressively and at lower costs by avoiding regulation. The emergence of new business models, intrinsic (incomplete-contract) holes in legislation, and inherently weak alternatives to federal regulators limits government’s capacity and will of federal banking regulators to contain risk concentrations outside familiar, already closely supervised institutions. Here is an illustrative example that I witnessed. The Fed Board of Governors was made aware of the extensive fraudulent underwriting of state-regulated small mortgage brokers well in advance of the subprime crisis but concluded it was effectively powerless in such a fluid industry, despite Truth-in-Lending legislation, to stop the malpractice.

The message has long been clear. The effort to prevent future financial crises will not work. It is deeply cynical and self-serving to casually note, as do B&S, that the shadow banking system must also be effectively regulated when you know that is not going to happen. Despite Dodd-Frank and on-going admonishment by macroeconomists to sharply reduce existence of financial risk (tellingly with little consideration to efficiency and growth consequences), the hard fact is that financial crises in various forms will continue to occur. Moreover, relevant macro shocks outside the financial system can, with sufficiently powerful propagation by weakening aggregate demand, also morph into an extreme-instability crisis. The decade-long stagflation crisis, rooted in a dramatic shift in the terms of trade against labor, is exhibit A. (For elaboration, see the website’s e-book, chapter 4.)

If preventing future financial crises is a bad bet, it follows that the most crucial dimension of proper stabilization policy is containing their propagation. Moreover, it turns out to be a relatively easy task, as will be demonstrated next week.

Completing the argument. Before turning to propagation, however, there is more to consider in the mainstream analysis of the role of finance in the Great Recession. Within the federally regulated banking system, broad liquidity breakdowns and spiking incidence of mark-to-market insolvency must be understood inherent outcomes of extreme instability, a causal relation largely independent of the existing level of required capital. (For elaboration, see next week’s summary of the GEM Project’s extreme-instability model.) If stabilization authorities are successful in a timely reversal of contracting demand, the funding and solvency challenges facing banks quickly dissipate, implying no net recapitalization bill to taxpayers. (Instead, they can expect a tidy profit.) If the stabilization effort fails, the existential threat confronting banks (as well as other enterprises) becomes self-fulfilling as the economy gives way to product/asset price deflation, high unemployment, widespread private and public debt default, chronic depression, and the broad destruction of wealth and living standards.

In a related argument, highly capitalized banks or size/product restrictions damage stabilization-authority efforts to contain destabilizing feedback mechanisms that are the acute-instability engine of cumulative output, job, and income loss. (Again, see next week’s post two weeks.) Also troubling is the NK degrading of regulator concern for the efficiency as well as the international competitiveness of the federally regulated banking industry in their bewildering push for ineffective policy solutions.

In what may be the most important puzzle, B&S appear to understand that financial-crisis prevention will not work. “… while much attention is now paid to financial regulation and macroprudential policies, the task is far from finished. The very complexity of the financial system, our limited understanding of its workings, and the ability of financial players to adjust and engage in regulatory arbitrage are formidable obstacles.” Formidable enough to forego providing any roadmap to overcoming the obstacles.

Concluding Comment

The GEM Project reinforces what we already know: Financial crises are inherently idiosyncratic. Commonality is largely confined to their universal propagation by inertial demand disturbances. Welfare costs of the idiosyncratic and shared processes are analytically separable. Losses directly associated with source financial disruptions have proved to be a small fraction of those that result from their propagation. The overall case is strong that the most effective policy to ameliorate the welfare costs of future financial crises is to eliminate, or at least contain, its demand-propagation.

Blog Type: New Keynesians Saint Joseph, Michigan



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