Why economists failed to anticipate the financial crisis

About three months ago, Nobel Prize winning economist Paul Krugman took a stab at explaining why economists didn’t anticipate the worst financial crisis in three-quarters of a century. His was a long piece, taking up eight pages and 6,000 words at the New York Times website. His overview was certainly one of the best in explaining the running debates over stimulus and government intervention that have been raging for over two decades between economists of the Saltwater variety (i.e. from schools near the coasts) and those of the Freshwater variety (i.e. from the University of Chicago).  And for this reason alone, it should not be forgotten.

Crucially, Krugman said:

During a normal recession, the Fed responds by buying Treasury bills — short-term government debt — from banks. This drives interest rates on government debt down; investors seeking a higher rate of return move into other assets, driving other interest rates down as well; and normally these lower interest rates eventually lead to an economic bounceback. The Fed dealt with the recession that began in 1990 by driving short-term interest rates from 9 percent down to 3 percent. It dealt with the recession that began in 2001 by driving rates from 6.5 percent to 1 percent. And it tried to deal with the current recession by driving rates down from 5.25 percent to zero.

But zero, it turned out, isn’t low enough to end this recession. And the Fed can’t push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the “zero lower bound” even as the recession continued to deepen, conventional monetary policy had lost all traction.

Now what?

Paul Krugman is a Keynesian. So, his prescription is fiscal stimulus. Have the government pump money into the economy and it will alleviate some of the pressure for the private sector. There is some merit to this argument on stimulus. Many Freshwater economists say monetary stimulus is what is needed. If the Federal Reserve increases the supply of money, eventually the economy will respond. This is what Ben Bernanke was saying in his famous 2002 Helicopter speech at the National Economists Club.

Yet, I couldn’t help but notice that Krugman mentioned the word debt only twice in 6,000 words. In fact, it is in the very passage above where Krugman uses the term for the only time in the entire article. And here Krugman refers to government debt; no mention of private sector debt whatsoever.  I have a problem with that.

Let me fill in some of the pieces. In the run-up to the Holiday Season, I missed a good article by Derek Scott in last week’s Financial Times. Scott explains very lucidly why economists failed to anticipate the financial crisis. He starts out:

The current crisis reflects not the failure of capitalism, but the failure of the people running capitalism to understand how it works. This is bound to affect how we get out of the mess.

In simple terms, the prevailing consensus is to view the post-2007 crisis as the result of an external shock which could not have been anticipated. The remedy is to deal with the perceived cause (bankers or regulators) embarking on large-scale fiscal and monetary stimuli until the damaged “animal spirits” of households and business are restored. After this, things can get back to normal and stimuli be withdrawn.

I hope you recognize this argument because it is identical to the Keynesian and Monetarist arguments from Bernanke and Krugman above. But this misses the problem with debt caused in large part by artificially low interest rates.  Scott explains:

A series of monetary policy mistakes in the late 1990s meant that interest rates were too low, creating in several countries what Austrian economists such as Friedrich Hayek, called an “inter-temporal” problem. It is no coincidence that economists who did predict the crisis, notably in Britain the estimable Bernard Connolly, looked at economics in a similar way.

In essence what happens is that inappropriately low rates of interest bring forward investment spending by households and business (adding to demand when it takes place) from “tomorrow” to “today” so that when “tomorrow” arrives, budget constraints reduce spending at precisely the time when “yesterday’s” investment comes on stream, adding to supply. The only way to keep things going is even lower interest rates, bringing forward even more spending, so establishing the international Ponzi game that eventually burst in 2007.

This economic Ponzi scheme is what I have labeled the asset-based economy. As with all things Ponzi, it must come to a spectacularly bad end. One can only Inflate asset prices to perpetuate a debt-fuelled consumption binge so far. At some point, the Ponzi scheme collapses. And we are nearing that point.  We still have zero rates, massive amounts of liquidity, manipulation of short-term rates, manipulation of long-term rates, and bailouts galore a full 15 months after Lehman Brothers collapsed. This is pure insanity.

The reason economists failed to anticipate the crisis is because they were fixated on avoiding downturns and driving the economy to unsustainable growth rates by using debt to consume today what will be earned in the future. Debt is the central problem. When debt to income or debt to GDP doubles, triples and quadruples, it says you have doubled, tripled and quadrupled the amount of future earnings you are consuming in the present (see the charts here and here). That necessarily means you will have less to spend in the future. It’s not rocket science.

And let’s not forget that artificially low interest rates distort capital and investment allocation so that many of the so-called economic gains turn out to be illusory.

So, Mr. Krugman asks now what?

Now that we finally recognize that we are overindebted, I say we should move cautiously in a direction of less consumption, more savings and less debt – the key word being caution.

Update: if you want a more graphic and risqué version of this idea see How did economists get it so wrong (parody version)? (not a ‘work-friendly’ video, if you know what I mean).



Insight: More capitalism, less regulation – Derek Scott, FT

How Did Economists Get It So Wrong? – Paul Krugman, NY Times

Deflation: Making Sure "It" Doesn’t Happen Here – Ben Bernanke, Federal Reserve Board


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.