Managing Extreme Instability

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Ben Bernanke, Jean-Claude Trichet and other prominent central bankers have made clear their frustration with modern macro theory. They have complained that consensus modeling was not helpful in their efforts to combat the extreme global instability that began in 2007. Brushing off the criticism, most mainstream theorists have, after a spell of lying low, resumed simply asserting their policy relevance. Illustrative of that unhappy state of affairs is the 2013 Conference on the Great Recession hosted by the Brookings and Hoover Institutions. Largely relying on mainstream market-centric DSGE theory, contributors considered the nature and propagation of the recent extreme instability as well as the way ahead for policymakers. Papers were published in an eBook, Across the Great Divide (2014), hereafter AGD. Given the deep inadequacy of their consensus macroeconomics, it is not surprising that critical mistakes were made, six of which organize this review.

First mistake. Some AGD contributors, most aggressively John Taylor, blamed the Fed for the extreme instability. Taylor’s analysis is pushed far out of touch with the available evidence by his strict adherence to the mainstream DSGE model. Given that consensus theory cannot coherently motivate causality from nominal demand disturbances to recognizable involuntary job loss, active management of the brewing nonstationary demand disturbance (NDD) – the object of Fed interventions in 2008-09 – appears to Taylor only to distort proper market outcomes. He argues the Fed’s demand-management powers should be curtailed.

The first critical mistake is the Conference’s inattention to the effectiveness of the central bank’s 2008-09 demand-oriented stabilization policy. As a result, AGD contributes to today’s badly misleading atmosphere of putative Fed failure that abets powerful evidence-ignoring forces in Congress and the nation. Gathering strength in the aftermath of the crisis, those forces have been working to limit the Fed’s power to manage total spending. If other contributors strongly disagreed with Taylor, and only Alan Blinder was aggressively opposed, they had a responsibility to make that assessment clear.

Second mistake. Most AGD contributors ignore the fact that almost all of the Great Recession’s huge welfare costs did not result from the much discussed macro shock, i.e., the housing boom/bust facilitated by low interest rates, illegal practices by State-regulated mortgage brokers, and aggressive securitization. The great damage instead resulted from its propagation via contracting total spending and the feedback from the cumulating loss in employment, output, profits, wage income, investment, and wealth. Direct welfare loss from the housing turmoil and consequent insolvency of a few financial institutions was in comparison quite small. The clear, albeit disregarded, message is that, in the circumstances of extreme instability, policymaking must focus on halting and reversing the collapse in nominal demand. That was the Fed’s approach and it worked.

In the second critical mistake, Conference participants paid little attention to the design and execution of policies that target NDD propagation. Why did nobody tackle the problem of improving the Fed’s toolkit used in total-spending interventions? While ignoring demand management strips AGD of its credibility, it still is an unsurprising choice for theorists who cannot coherently model causation from NDD to involuntary job loss. Economists who neither teach or research demand propagation are poor champions of the Fed’s success in avoiding depression.

Third mistake. Some of the contributors mentioned the need to better incorporate confidence into the mainstream GR analysis. The third critical mistake is that they did not go far enough. Why was no serious attempt made to properly define confidence and identify its crucial analytical role in extreme instability? No one who was close to financial markets and corporate leadership could miss the criticality of investor/lender macro confidence in the 2008-09 spending collapse. Once again, mainstream theorists failed to grasp what was happening largely because of their reluctance to recognize the centrality of NDD in acute macro instability. Wanting to remain consistent with the substance of their careers, most persevere in looking for crisis propagation in search theory and variations in vacancy-applicant match efficiency, which is little more than a fool’s errand?

Fourth mistake. Given the mainstream inability to coherently model the nominal-demand propagation of the financial crisis, it is predictable that most AGD contributors agreed that the primary task of effective macro policy is to prevent future financial shocks. Manifestations of that consensus occupy the bulk of the Conference. The fourth critical mistake is believing, contrary to the evidence, that policies designed to prevent the GR financial crisis will also thwart future episodes of market breakdowns. History shows that financial crises mutate and occur relatively frequently. Altered crises require altered remedies. It is foolish to rely on Dodd-Frank to prevent the next financial breakdown, especially since the most problematic risks continue to migrate to the shadow-banking system in order to avoid regulation. (It reflects another class of difficult macroprudential problems that Dodd-Frank would not have prevented the 2008-09 financial-market breakdown.) When financial crises do occur, the only effective macro response is to aggressively manage their NDD propagation, a strategy that the GEM Project shows to centrally include close central-bank attention to the credibility of its real-side objective. In one of the most damaging outcomes of inadequate mainstream macroeconomics, theorists ubiquitously assign primacy, frequently amounting to exclusivity, to the central bank’s nominal objective.

Fifth mistake. Also indicative of inadequate macroeconomics is the number of AGD contributors who appeared most concerned about too-big-to-fail banks. Their poor understanding the Great Recession implies a threat to taxpayers from the largest banks – a concern leading to legislation restricting the use of public funds for bank capital infusions. More adequate macro theory, however, shows that a general ban on capital injections cannot rise above rank stupidity. It is the Conference’s fifth critical mistake. Two crucial facts are ignored.  First, as emphasized throughout this essay, NDD induces almost all the welfare loss in periods of extreme instability. Second, the banking system, in its role of transforming saving into investment/consumption spending, is crucial to demand macrodynamics and part of any effective policy to prevent unchecked collapse in aggregate spending. If stabilization authorities are successful in halting and reversing NDD, temporary capital injections will be repaid at a profit, not loss, to taxpayers. If stabilization fails, taxpayers will incur such huge losses in the ensuing depression that the now trivial capital injections will be simply swept up in the mass defaults. When did we stop knowing this?

Sixth mistake. Extreme instability is fundamentally associated with a breakdown in the credibility of the real-side objective of stabilization authorities, denoted in the GEM Project by Ƈ. Damaged Ƈ motivates rational investor/lender inaction, which delays the purchase of financial assets and investment in capital goods and services. (Chapter 6) Damaged Ƈ is the keystone of the feedback mechanics at the heart of macro-shock propagation that accounts for almost all the welfare costs of extreme instability. Not understanding the criticality of stabilization authorities’ real-side objective and, indeed, continuing to buy into the extraordinarily flawed primacy of inflation targeting is the Conference’s sixth, ultimately fatal, mistake. Lacking adequate macroeconomics, most AGD participants do not come close to identifying the most critical policy implications of the Great Recession. They should forbear advising on “the way forward”.

Blog Type: Policy/Topical Chicago, Illinois

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