Back in 2008, it seems like everyone from the Queen of England on down was blaming economists for not predicting the financial crisis.  I seem to recall that Bob Lucas pointed out that economic theory explains why economists cannot predict financial crises, so our failure to do so was a feather in the cap of modern economic theory.  I also seem to recall that lots of people rolled their eyes at his seemingly too clever excuse.

In the past I’ve argued that Lucas was exactly right, but in this post I’ll assume he was wrong.  I’ll assume the EMH is wrong.  Even in that case I’m going to argue the complaints were silly, just a bunch of crybabies.

So how do I respond to those people who are moaning that we didn’t warn them that a crisis was coming?  One answer is that some economists, such as Nouriel Roubini, did issue warnings.  But then the crybabies might respond, “But most economists didn’t warn us.  How were we to know that he was the one to listen to? The economics profession as a whole should have issued a warning, so that it was unambiguously clear to the public that a financial crisis was coming.”

To summarize, a few economists did warn the public, so the crybabies’ lament only makes sense if you assume that these people wanted the profession as a whole to offer a clear credible warning to the public.  Something that would be believed.

Were you the sort of person who believed in Santa Claus, and thought he would bring you a fairytale castle floating on a cloud, with unicorns prancing about in front?  If not, why would you make such a patently unrealistic demand of the economics profession?

You wanted us to warn you that a big financial crisis was coming so that you could sell all your stocks before they went down?  I ask this because a prediction of a severe financial crisis is implicitly also a prediction of a massive asset price collapse.  So the people complaining that economists didn’t predict the financial crisis are (whether they know this or not) effectively complaining that economists didn’t warn them that their 401k plan was about to lose a few hundred thousand dollars.

Let’s suppose we have a time machine and economists from October 2008 can go back 6 months in time, to April 2008.  They are told to warn the public that a massive financial crisis is coming in the fall.  They warn the public that Lehman won’t be bailed out, and its failure will trigger a rush for liquidity and a Great Recession.  What exactly would that warning have done, other than move those events up 6 months in time?  Then the crybabies would have asked why we didn’t warn them in October 2007 (assuming they didn’t lynch the economists for causing the crash.)

And as for those stocks you were going to sell if economists had warned you of the crash—just who did you plan to sell them to?  And at what price?

A better argument is that the economics profession didn’t warn the public that public policy was creating excessive lending, as Fannie and Freddie and FDIC and TBTF were creating moral hazard.  In fact, I did warn people I met about this problem (but I completely failed to forecast the financial crisis.)  Some other economists also warned about moral hazard, but not all.  But no one wants to listen to a bunch of killjoy economists on public policy questions.  It would be like blaming economists for tariffs, or rent controls.

When I explain to non-economist commenters what economic theory tells us about some public policy, they almost universally blow off my advice, unless it coincides with their pre-existing view on that particular public policy.  No one cares what economists think, so don’t blame us for areas where we have no control.  (Monetary policy is a different case; there the economics profession actually deserves far more blame than it’s gotten from the public.)

PS.  I see that Trump threw a temper tantrum when his aides told him that Iran had been adhering to the nuclear agreement.  We now have an administration with no ability to negotiate because no one trusts them to keep their word.  The focus of his top aides is not dealing with foreign crises but rather managing unnecessary crises created by an out of control and mentally ill president.  North Korea knows we’ll renege on any agreement we sign with them, and so a nuclear deterrent is their only option.  Meanwhile they show their population images of Trump threatening to destroy their country.

Meanwhile Trump has abandoned the utilitarian approach of the Obama administration and the slaughter of innocent civilians has been skyrocketing:

Airwars reports that under Obama’s leadership, the fight against ISIS led to approximately 2,300 to 3,400 civilian deaths. Through the first seven months of the Trump administration, they estimate that coalition air strikes have killed between 2,800 and 4,500 civilians.

Trump seems like excellent black comedy to me, but unfortunately there are lots of dead women and children for whom he is no joke.

PPS:  New Flash:  Americans horrified to discover Hollywood producer behaving like a President of the United States.  Hillary and Fox News particularly disgusted by this behavior.

PPPS:  Another gem:

Speaking over the phone, Mr Reich said he asked his friend whether other Republican senators were preparing to follow Senator Bob Corker and “call it quits with Trump”.

His source told him: “Others are thinking about doing what Bob did. Sounding the alarm. They think Trump’s nuts. Unfit. Dangerous.” . . .

“Tillerson would leave tomorrow if he wasn’t so worried Trump would go nuclear, literally,” he added.

“Who knows what’s in his head? But I can tell you this. He’s not listening to anyone. Not a soul.

“He’s got the nuclear codes and, well, it scares the hell out of me. It’s starting to scare all of them. That’s really why Bob spoke up.”

Trump ran for President as a crazy man, and we are shocked to discover he is governing as a crazy man?

I’ve always thought that the 2008 financial crisis was basically tight money plus moral hazard, with the latter factor playing the biggest role.  I’m no expert on banking, but I’d guess that these three factors increased moral hazard (in order of importance):

1.  FDIC (deposit insurance)

2.  The GSEs (Fannie and Freddie)

3.  Too Big to Fail

I’ve already spent a lot of time discussing the role of tight money, but I also believe that deposit insurance is a massively underrated problem.

A new NBER working paper by Charles W. Calomiris and Matthew S. Jaremski relied on rich set of panel data for banks in states with and without deposit insurance. They found that states that created deposit insurance during the early 1900s tended to see faster than normal rates of deposit growth, and then higher than average levels of bank failures after WWI:

First, we are able to show that deposit insurance increased insured banks’ deposits and loans, and lowered their cash to asset ratios and capital to asset ratios. Second, we find that deposits flowed from relatively stable banks to risky banks. Deposit insurance increased risk by removing the market discipline in the deposit market that had been constraining erstwhile uninsured banks.  .  .  .  Deposit insurance encouraged banks to increase their insolvency risk because doing so did not prevent them from competing aggressively for the deposits of uninsured banks operating nearby. In fact, increasing risk was necessary to fund the higher interest payments that presumably attracted depositors.

The extent to which insured banks attracted deposits away from uninsured banks, and used those funds to expand their lending, depended on the risk opportunities available in their local economic environment. Variation across in counties in the extent to which they produced commodities that appreciated during the World War I agricultural price boom explains between one-third and two-thirds of the observed effects of deposit insurance on deposit growth, loan growth and increased risk taking by insured banks. The fact that a large part of the moral hazard associated with deposit insurance is dependent on the time-varying and location-specific opportunities for risk taking has important implications for empirical analysis of the consequences of deposit insurance in other contexts. The potential costs of deposit insurance may appear low in environments that are relatively lacking in risk-taking opportunities, but those costs can appear much higher when greater risk taking opportunities present themselves.  (Emphasis added)

That’s final sentence is a warning not to become complacent.  Just because deposit insurance didn’t cause many problems in the decades after WWII (when borrowers were bailed out by higher than expected inflation), doesn’t mean that it could not do so in the 1980s or 2000s.

They also show that voluntary insurance systems were less destabilizing than mandatory insurance systems, presumably because they created less moral hazard.

Their paper ends with a warning:

The history of deposit insurance in the United States and internationally has been a process of increasing systemic risk in the name of reducing systemic risk. 

Here’s Ben Bernanke on the idea of using monetary policy to address financial imbalances:

Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to “pop” an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability.

For these reasons, I have argued that it’s better to rely on targeted measures to promote financial stability, such as financial regulation and supervision, rather than on monetary policy.

One of the “unintended side effects” of the Fed’s 1928-29 attempt to pop the stock market bubble was the Great Contraction of 1929-33.  Another was Hitler taking power in Germany.  And another was WWII.  So if anything, Bernanke is being too polite to those who favor using monetary policy to prevent financial imbalances.

Now of course they’d insist that they also favored macroeconomic stabilization, and merely wish to use monetary policy at the margin.  But even those more reasonable proposals are highly questionable.  Bernanke cites one study (links further down) that does find that monetary policy might play a role, but not a very large one:

Although, in principle, the authors’ framework could justify giving a substantial role to monetary policy in fostering financial stability, they generally find that, when costs and benefits are fully taken into account, there is little case for doing so. In their baseline analysis, they find that incorporating financial stability concerns might justify the Fed holding the short-term interest rate 3 basis points higher than it otherwise would be, a tiny amount (a basis point is one-hundredth of a percentage point). They show that a larger response would not meet the cost-benefit test in their estimated model. The intuition is that, based on historical relationships, higher rates do not much reduce the already low probability of a financial crisis in the future, but they have considerable costs in terms of higher unemployment and dangerously low inflation in the near- to intermediate terms.

And even this is doubtful, as it depends on the very dubious assumption that low interest rates imply easier money:

A new paper by Andrea Ajello, Thomas Laubach, David López-Salido, and Taisuke Nakata, recently presented at a conference at the San Francisco Fed, is among the first to evaluate this policy tradeoff quantitatively. The paper makes use of a model of the economy similar to those regularly employed for policy analysis at the Fed. In this model, monetary policy not only influences near-term job creation and inflation, but it also affects the probability of a future, job-destroying financial crisis. (Specifically, in the model, low interest rates are assumed to stimulate rapid credit growth, which makes a crisis more likely.)

Indeed a tighter monetary policy during the famous housing bubble of 2005-06 would have probably been associated with lower interest rates, not higher.  Thus in a counterfactual where in 2001-03 the Fed had cut rates to 3%, not 1%, the level of interest rates in the 2005-06 bubble would have had to be lower than the actual path of rates, as the economy would have been in depression.

What most caught my attention is that Bernanke comes down strongly in support of his former colleague Lars Svensson, who quit the Riksbank in disgust over its tightening of monetary policy around 2010-11:

Lars Svensson, who discussed the paper at the conference, explained, based on his own experience, why cost-benefit analysis of monetary policy decisions is important. Lars (who was also my colleague for a time at Princeton) served as a deputy governor of the Swedish central bank, the Sveriges Riksbank. In that role, Lars dissented against the Riksbank’s decisions to raise its policy rate in 2010 and 2011, from 25 basis points ultimately to 2 percent, even though inflation was forecast to remain below the Riksbank’s target and unemployment was forecast to remain well above the bank’s estimate of its long-run sustainable rate. Supporters justified the interest-rate increases as a response to financial stability concerns, particularly increased household borrowing and rising house prices. Lars argued at the time that the likely benefits of such actions were far less than the costs. (More recently, using estimates of the effects of monetary policy on the economy published by the Riksbank itself, he showed that the expected benefits of the increases were less than 1 percent of the expected costs). But Lars found little support for his position at the Riksbank and ultimately resigned. In the event, however, the rate increases were followed by declines in inflation and growth in Sweden, as well as continued high unemployment, which forced the Riksbank to bring rates back down. Recently, deflationary pressures have led the Swedish central bank to cut its policy rate to minus 0.25 percent and to begin purchasing small amounts of securities (quantitative easing). Ironically, the policies of the Swedish central bank did not even achieve the goal of reducing real household debt burdens.

When someone leaves an important policy position, where a person is not really free to speak their mind, to blogging, which is all about speaking one’s mind, you quickly learn a great deal about their views on controversial issues. Anyone want to wager with me on what Bernanke and Svensson think of the ECB’s decision to twice raise rates in 2011?

I was only disappointed by one aspect of the post—Bernanke continues to (implicitly) use a conventional measure for the stance of monetary policy.

Despite the substantial improvement in the economy, the Fed’s easy-money policies have been controversial. Initially, detractors focused on the supposed inflation risks of such policies. As time has passed with no sign of inflation, that critique now looks rather threadbare. More recently, opposition to accommodative monetary policy has mostly coalesced around the argument that persistently low nominal interest rates create risks to financial stability, for example, by promoting bubbles in asset prices or stimulating excessive credit creation.  (emphasis added)

In 2003, Bernanke correctly pointed out that conventional measures such as interest rates are highly flawed:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov.

.  .  .

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.

Of course by that criterion (averaging inflation and NGDP growth), money was tighter in 2008-2013 than in any 5 year period since Herbert Hoover was president.

A commenter named Steve sent me this puzzling article on stress tests:

The Federal Reserve plans to stress test six large U.S. banks against a hypothetical market shock, including a deterioration of the European debt crisis, as part of an annual review of bank health.

The Fed said it will publish next year the results of the tests for six banks that have large trading operations: Bank of America (BAC.N), Citigroup (C.N), Goldman Sachs (GS.N), JPMorgan Chase (JPM.N), Morgan Stanley (MS.N) and Wells Fargo (WFC.N).

“They are clearly worried about the issue of Europe,” said Nancy Bush, a longtime bank analyst and contributing editor at SNL Financial. “In a time of risk aversion and concern, you need transparency.”

The Fed said its global market shock test for those banks will be generally based on price and rate movements that occurred in the second half of 2008, and also on “potential sharp market price movements in European sovereign and financial sectors.”

In the Fed’s hypothetical stress scenario, unemployment would spike as high as 13 percent while U.S. gross domestic product would fall by as much as 8 percent.

I’d rather the Fed stress test their own policies.  Can they keep US NGDP rising at a 5% rate as Europe goes to pieces?  If not, what sort of policy regime might be able to do that?

The recent crisis exposed a fundamental flaw with our banking system (actually it’s been there since 1934, but this was the worst manifestation of the problem.)  Because of various government backstops (FDIC, F&F, TBTF, etc) our financial system takes excessive risks.

Tim Congdon has an intriguing proposal to address this problem.  His plan would not eliminate moral hazard, but it just might reduce it:

Suppose that banks are short of capital because of bad asset selection and heavy losses, and that there is a risk of deposits not being covered by banks’ remaining assets-the situation allegedly facing Britain’s banks and economy in late 2008. Surely everyone ought to agree that, ideally, the job of replenishing banks’ capital should fall on the private sector, not the state, and that as far as possible accountability must lie in only one place. How might that be achieved?

I propose a structure which is almost the polar opposite of Buiter’s. In a 2009 monograph, Central Banking in a Free Society, I argued that the capital of the Bank of England should be provided by the leading banks, and that the functions of the central bank and deposit insurance agency should be amalgamated. Whereas Buiter wants, in effect, to nationalise the arrangements (and the costs) of cleaning up a banking system fiasco, I would privatise them.

My proposal is much less radical than it may seem. Recall that at present the banking industry as a whole can in fact be levied by the FSCS if its funds are exhausted as a result of losses at one or a handful of banks. So, making the commercial banks the shareholders in the central bank and giving the central bank an explicit responsibility to protect deposits, has two consequences. First, the central bank would extend loans only if confident they would be repaid. The well-behaved, risk-avoiding and profitable banks have a strong interest in preventing their risk-prone competitors from incurring losses and ruining the system. Secondly, if the system nevertheless ran into trouble, the first line of defence would lie in the private sector, via the capital-levying power of the Bank of England. If the government did have to come in, it would be only after the bankers had decided that they could not help themselves. It would indeed be a last resort.

I’d like to separate two questions:  Should there be a unified institution to handle deposit insurance and emergency capital provision, which is owned and financed by the banking sector?  And should this institution be the central bank?  I agree with Congdon on the first point, but don’t see the second as being essential, or even politically feasible (at least in the US.)  In America, banks already have partial ownership of the Fed (albeit less than people imagine) and that’s highly controversial.  So let’s look at the first question.

The beauty of Congdon’s idea is that decisions on bank rescue will be made by those with the right set of incentives.  Suppose a bank gets into trouble, but is not a systemic threat.  The socially optimal solution is bankruptcy, that’s how markets should work.  That sends a signal to the banks that they should take fewer risks.  It sends a signal to creditors that they should carefully monitor bank behavior.  It would be nice to send a signal to depositors, but that doesn’t seem politically feasible—at best we might be able to trim the maximum coverage a bit.

But what if the bank failure was a systemic threat?  In that case the institution would have an incentive to provide emergency capital injections–in order to prevent contagion that would threaten the rest of the banking system.  This institution basically internalizes externalities.  The money belongs to the banks, who would be shareholders (in some proportion to bank size.)  If funds were paid out, banks would have to chip in to re-capitalize the institution.

In once in 100 year disasters the Treasury might have to backstop the institution with Federal loans.  But as we saw with the TARP loans, the Treasury could simply require that these loans be repaid by the institution, once the banks got back on their feet.

In theory, taxpayers should monitor Washington regulators, so that they wouldn’t show favoritism to politically important special interests.  But we know from public choice theory that that doesn’t work very well.  The banks themselves are the best monitor, or perhaps a Board of Directors that is directly answerable to the banks.

Here’s another way of looking at the plan.  It’s politically difficult to get the big banks to hold enough capital to overcome the TBTF problem.  They’ll whine about picking up and leaving New York, London, or Zurich.  But it’s also unlikely that all big banks will get into trouble at exactly the same time.  This institution would pool capital in a way the could nip a potential financial panic in the bud, without requiring taxpayer money.

Of course the cost of this insurance fund will ultimately be borne by customers, so in that sense it is a tax.  But it has two advantages over a bailout using income taxes.  The tax reflects the external costs imposed by fractional reserve banking.  And second, the banks would have much more incentive than government bureaucrats to use the funds wisely.

OK, I’m not a banking expert—tell me what’s wrong with this plan?