The Queen’s Question

Print/Save PDF

Queen Elizabeth, appearing at the London School of Economics during the Great Recession, famously asked a question along the lines of: Why didn’t anybody see this coming? That was the question I got, over and over again, from friends, acquaintances, and people I barely knew during the 2008-9 macro crisis. Why didn’t anybody see this coming?

With apologies to the Queen, it is the wrong question. Economists have long understood that highly specialized economies are vulnerable to macro shocks (notably including financial crises) that, if powerfully propagated by contracting total spending, produce huge losses in employment, output, income, and wealth. Prior to the Great Recession, many observers saw the surge of securitized subprime mortgage lending and concluded that substantial losses were likely sometime in the future. JP Morgan Chase, for example, decided that subprime mortgages had become too risky and, prior to the crash, exited the business – an insightful strategic choice that hurt its bottom line up to the 2007-09 Great Recession. More generally, no market participant who matters thought losses in a fairly minor pocket of the residential mortgage market would induce a collapse in total spending. The evidence indicates (i) that periodic financial crises are inherent to specialized economies and (ii) those which ones turn out to widespread disasters cannot be confidently identified in advance.

In that context, a more useful question is: What can we do to stop a macro shock, from whatever source, from producing disastrous extreme instability? We know enough about broad market failure to further refine the central question. What can be done to stop macro shocks from being propagated by a collapse in aggregate nominal demand? That is the right question. It is the response, from investors, lenders, firms, and households, to contracting total spending – not the losses from a Lehman bankruptcy – that is capable of generating the sort of damage that was occurring in late 2008 and 2009. It is the most predictable part of the extreme-instability story and most critical to the recurrent mechanics that are most vulnerable to effective stabilization policy.

Extreme Instability Mechanics

Understanding extreme instability. In order to get a handle on the 2008-09 Great Recession, three facts of must be kept in mind. First, in modern, specialized economies, many wages and prices adjust slowly to market disruptions. Consequently, contractions in total nominal spending generate involuntary job loss and underutilized capital. Adverse demand movements are always at the heart of recessions and depressions.

Second, in the wake of the 2008 bankruptcy of Lehman Brothers, it was readily observable that many investors/lenders, uncertain about the nation’s ability to avoid a near-term depression, became inactive, delaying acquisition of financial assets until the market disturbance is resolved. Financial markets quickly reacted to the absence of buyers, and asset prices began a frightening collapse. Recall that the S&P 500 equity index lost nearly a third of its value in the month following the Lehman failure. Sidelined buyers were particularly, and rationally, waiting for a halt to the contraction of total spending and the emergence of credible asset-market bottoms.

Third is the destabilizing feedback between cumulative damage to the financial system’s capacity to recycle saving into investment/consumption and collapsing aggregate demand. A lesson of both history and logic is that unchecked contractions in nominal spending in highly specialized economies result in depression. The destruction in living standards, massive permanent job loss, huge private/public debt default, and other predictable costs of a 21st century depression would make its famous 1930s predecessor look like a walk in the park. In one of its relatively minor outcomes, government debt would quickly swell by many, many trillions of dollars, saddling taxpayers with an unmanageable increase in liabilities.

The 2008-09 collapse in asset prices and the damage to business and household creditworthiness quickly ate up (mark-to-market) bank capital. Facing industry-wide capital inadequacy, bank managements rationally sought to reduce assets, cutting back sharply on lending and substantially aggravating the on-going contraction in total spending. Moreover, as increasingly inactive lenders to the banks themselves cut back on short-term funding to banks, even more financial-institution asset fire sales were needed to balance their books.

Inactive investor/lenders had set off a phenomenon that economists have named “contagion”. At its heart is an indiscriminate reluctance to provide short-term funding to financial institutions, forcing the sale of assets at depressed prices. Today’s policy consensus in correctly attributes the solvency threat to a different phenomenon named “connectedness”, in which banks and nonbanks were so overextended to each other that one failure directly caused others to fail. Hal Scott (2016) has closely studied both phenomenon and concluded that contagion, not connectedness, was the true engine of the 2008 financial crisis. The generalized-exchange macroeconomics featured in the GEM Project explains why.

Discretionary Management of Aggregate Demand

Here, it suffices to understand the following. Financial institutions exist to channel saving into spending on investment and, to a lesser extent, consumption. A widespread persisting breakdown in financial markets assures an unchecked collapse in total nominal demand. Here is the crux of the destructive macrodynamic process. Investor/lender uncertainty with respect to the credibility of stabilization authorities’ trend full-employment objective motivates (i) rational asset-acquisition inaction and (ii) consequent debilitating feedback between financial-sector disruption and collapsing total spending.

Building on those facts, GEM analysis provides a compelling alternative to the current consensus approach to extreme instability that concentrates on preventing, via ever-higher capital requirements and restrictions on market activities, banking disruptions. The focus shifts to concerted government action – on all fronts, in size and with speed – to halt and reverse collapsing nominal demand. An explicit objective must be to maintain (or restore), especially for investors and lenders, the credibility of the trend real-side (full-employment) objective of stabilization authorities. Such credibility is the antidote to macro uncertainty and extreme instability. Effective strategy crucially features rapid, large-scale actions to unfreeze financial markets. The GEM approach describes, in a nutshell, Ben Bernanke’s successful policymaking in 2008-09.

Blog Type: Policy/Topical Chicago, Illinois

Write a Comment

Your email address will not be published.