Crashed by Adam Tooze

My review of Crash: How a Decade of Financial Crisis Changed the World is finally out at the London Review of Books (subscribers only I’m afraid). From what I’ve read it has received glowing reviews elsewhere, and mine is no exception. Reflecting its ambition it is no quick read (the main text is 600 pages). There is an introduction which does summarise some of the key ideas, but the triumph of the book is that it combines a detailed account of the events of the last ten years with an analytical overview which makes sense of the detail and which makes good sense. It has the additional advantage from my point of view that it is broadly consistent with many of the arguments made on this blog, although I don’t think I ever managed to match the quality of his prose.

The argument that binds the whole book together is that the crisis was not the result of the specific shocks of Subprime debt or the housing markets of Ireland and Spain, but an inevitable consequence of a global banking system that became chronically short of buffers to cushion against any kind of significant systemic shock. To use the technical term the system became over leveraged: lending too much in relation to the capital it had to cover loans going bad. This is the same theme as the book by Tam Bayoumi I discussed here, but in fact the two compliment each other: Bayoumi focuses on the regulatory changes that created global megabanks, while Tooze deals with the consequences of when these banks crashed.

Key to how the crisis played out was how different governments reacted to the crisis, and this is the central part of the book. After the mistake of Lehman, the US government took comprehensive action on a huge scale. To quote Tooze:

“It was a class logic, admittedly – ‘Protect Wall Street first, worry about Main Street later – but at least it had a rationale and one operating on a grand scale.”

The UK did the same, but because there were no widespread defaults in the UK there was no failure to help borrowers.

The contrast with the Eurozone is emphasised by Tooze. First Eurozone countries tried to suggest this was an anglo-saxon crisis, despite their own banks being deeply embedded in this global network, and was particularly rich as the Fed was (as Tooze shows) providing billions of dollars to European banks to keep them afloat. Germany with the help of the ECB refused to participate in a joint Eurozone response, and then later attempted the ‘bait and switch’ of blaming the Eurozone crisis on excessive government debt: bait and switch is the title of my review, and was originally used by Mark Blyth who in his book Austerity: the History of a Dangerous Idea saw earlier than most that the crisis was all about banks. Again to quote Tooze on the Eurozone response:

“‘It is a spectacle that ought to inspire outrage. Millions have suffered for no good reason.”

I have to add for those reading in the UK that this was about how individual Eurozone governments behaved within the Eurozone system, and has nothing to do with the trade relationships and regulation pooling that is the EU.

There is a lot more in my review (LRB gives you the luxury of over 3,000 words), and many important things in the book that I did not have space to comment on. For those into international relations as well as economists and historians this book is a goldmine.

On the subject of books, my own more modest effort is out shortly: it can be ordered at a 20% discount here, rising to 35% if you join the publisher’s mailing list.)

How to predict a crisis

I was sorting through some old papers over the weekend (don’t ask) and I found an article I wrote for the Financial Times on 19th October 1990, which is also the month we entered the European Exchange Rate Mechanism (ERM). The article, based on work I had done earlier with colleagues at the National Institute (final published version here), argues that we were entering at the wrong exchange rate. The final paragraph starts with

“The danger is that the government will attempt to defend the present exchange rate bands at all costs. As a result it may produce, or fail to prevent, a recession on the same scale as 1980-81.”

According the current data vintage, GDP was already falling at that point, yet interest rates were not reduced by enough to prevent a recession because of concerns about pressure on sterling. GDP continued to fall almost continuously until we were forced out of the ERM (Black Wednesday). Leaving the ERM allowed interest rates to be lower and produced a 10% depreciation in sterling, which helped ensure a strong recovery.

I’m sure I wasn’t alone in making this prediction, but we were in a minority and we did produce the best analysis. The Global Financial Crisis (GFC) was of course a much bigger event, and far fewer saw it coming, so quite rightly 10 years later those economists who predicted something like it are getting media attention. They were very different events, so can we draw any parallels between them, or more generally is there anything that links disasters of this kind?

One common factor is using the markets as an excuse to avoid economic analysis. One of the two main excuses to ignore our ERM analysis was to look at the exchange rate at the time as say ‘the market must know what it is doing’.Of course before the crisis too many people who saw the data thought the banks must know what they are doing as they pumped up leverage.

Perhaps another is never let new ideas crowd out the knowledge embodied in older ideas. The other excuse that particularly academics used to disregard our analysis about the ERM entry rate was that the models we were using were a little old fashioned. (I talk more about that here.) Bankers fooled themselves that they had new methods of evaluating risk that meant they could ignore systemic risks. If we think of the other two major UK macroeconomic crises, the same applies. The Treasury predicted the recession of 1980 pretty well, but the analysis was trashed as the work of old fashioned Keynesians by Lawson et al from the Thatcher government. Austerity of course also ignored basic Keynesian truths.

One obvious final question is whether we learn from crises of this kind. Ten years after we left the ERM the Treasury asked me to do their entry rate analysis for possibly joining the Euro, so that at least implies some learning, but maybe being a different government helped. Perhaps Black Wednesday created a general distrust of fixed exchange rate regimes in the UK that helped Gordon Brown argue against joining the Euro.

Have we learnt the lessons of the GFC? Some changes to the banking system have been made, but I think the general consensus is its is not enough, and there still seems to exist a large implicit public subsidy for the major banks. If for no other reason that is why you should take note of what those who predicted the GFC say. In terms of how you recover from a financial crisis we certainly had learnt some of the lessons of the 1930s, but not all. As I argue in my last post, we have hardly begun the process of creating a macroeconomic policy regime that can deal with a future recession, let alone a crisis.

Another lesson of the GFC unlearnt: the Consensus Assignment is dead

Martin Sandbu recently responded to critics of an earlier piece of his arguing that central bankers could and should have done more to tackle the aftermath of the Global Financial Crisis. I stress aftermath here, because I have no doubt that central banks (including the Bank of England) were culpable in both ignoring warning signs before the crisis, and in the UK and Eurozone not reacting quickly enough to the consequent recession. (It is extraordinary that on the MPC only Danny Blanchflower understood what was going on, and I would argue that part of the reason for this was the primacy of the inflation target.)

It is also obvious that the ECB were wrong to raise rates in 2011 and not to introduce QE much earlier. That the UK almost raised rates in 2011 is not reassuring, and suggests they did take their foot off the peddle over that period. I would also argue that the ECB were very wrong to wait until September 2012 to introduce OMT.

In the UK and US I do not buy the argument that no further stimulus was needed.

UK unemployment rose from around 5% to around 8% in 2008/9, and stayed at that level until it began coming down in 2013. US unemployment was also above 8% until 2013. Both economies needed more stimulus in 2009, and in its absence in 2010 and so on. To think otherwise means you are placing too high a weight on temporary changes in inflation and too low a weight on the costs of the recession. 

Where I think I might disagree with Martin is that this stimulus could have reliably come from monetary policy. A good policy instrument is one that has a reliable impact on demand, and the only reliable monetary policy instrument that fulfills that criteria is short interest rates. Central banks could have done more QE, or they could have reduced rates below the Effective Lower Bound (ELB), but they wouldn’t have known how much to do. They might have got there in the end, but extra years of unemployment and probably a permanent hit to output through hysteresis were an avoidable cost.

The biggest mistake central banks made was not to recognise this and be honest with the public. They should have said, clearly and repeatedly, that once rates hit the ELB monetary policy was no longer the most reliable instrument to stabilise the economy, and fiscal policy should be used. This does not break any implicit concordat about not commenting on fiscal policy (which most central banks break anyway), because the statement is about a delegated authority being honest with the public about whether it can reliably do its job..

The fact that central banks in the UK and Eurozone didn’t do that may reflect dishonesty or it may reflect negligent ignorance. The fact that options like QE existed may have allowed central banks to convince themselves that they could still do the job assigned to them, and it discouraged them from being honest with the public. I say negligent ignorance, because instrument reliability is pretty basic stuff.

Martin writes

“Besides, there was broadly shared understanding among macroeconomists and central bankers of the best division of labour. Fiscal and budgetary policy should be set to achieve microeconomic and distributive goals, and the desired share of the state in the economy; while monetary policy should take care of stabilising aggregate demand.”

This is what I call the Consensus Assignment, and as the name implies it was certainly the consensus among mainstream macroeconomists before the 1990s. But the experience of Japan’s lost decade where they also had interest rates stuck at the ELB began a process of rethinking. By the time the GFC came around many macroeconomists had realised that there was an Achilles Heel in the Consensus Assignment. Fiscal stabilisation was still required when interest rates hit their ELB. That is why we had fiscal stimulus in 2009.

The importance of this cannot be overstated. The policy consensus in 2009 was that fiscal stimulus was required, because monetary policy was not enough. This consensus didn’t evaporate in 2010. What overrode it was mainly politics - what I call deficit deceit. There was also a bit of panic in some quarters caused by the Eurozone crisis. However a majority of academic macroeconomists continued to believe that further fiscal stimulus was required, and that majority got steadily larger as time went on.

Which means that the Consensus Assignment that Martin talks about is dead, or at least dead until monetary policy makers can agree some form of fiscal delegation (e.g. helicopter money) with governments. As this paper from the Boston Fed points out, downturns where interest rates hit their ELB are likely to become the new normal, but policymakers have not adjusted to this. (The exception is Labour’s fiscal credibility rule.) Quite simply, most policymakers have not learnt a major lesson of the Global Financial Crisis.

How China beat the Global Financial Crisis

If you were hoping for something on yesterday’s interest rate rise, I can only direct you to the leader in the FT today which says: “There is no compelling reason to increase the cost of borrowing in the UK, but there is definitely good cause to wait.” On why nine intelligent people could all make the same mistake, you have to question their mandate, and move to something that focuses on having the right environment for growth, as I do here.

I recently finished reading the latest book by Adam Tooze (of which much more in a subsequent post), and it reminded me of a story that was not told enough in the early days of austerity. Everyone knows about how quickly the Chinese economy has grown over the last few decades, and how strong exports have been an important part of that. In dollar terms the value of Chinese exports more than quadrupled between 2000 and 2007. By 2007 Chinese exports represented 35% of GDP.

An important characteristic of the Global Financial Crisis (GFC) was how quickly world trade collapsed. If we compare the beginnings of Great Recession after the GFC with the start of the Great Depression, while world industrial production moved in a similar fashion, world trade collapsed by much more in the Great Recession than the Great Depression. Here is a chart from Barry Eichengreen and Kevin O'Rourke’s ‘A Tale of Two Depressions Redux’ VoxEU article.

Trade collapsed in the winter of 2008 around the globe, without exception. This was very bad news for China. Whereas exports had been around 35% of GDP in 2007, they fell to around 25% of GDP in 2009. That is a big hole to fill, and if it wasn’t filled, there was a chance that Chinese growth would collapse completely with damaging knock on (multiplier) effects to the rest of the economy. Above all else, China feared the political consequences of the unrest widespread unemployment would bring.

As Tooze recounts, China’s reaction was swift and bold. In November 2008 it announced a stimulus package of public spending worth 12.5% of GDP. (The Obama stimulus package, by comparison, was around 5% of GDP.) “Over the days that followed [the announcement], across China, provincial party meetings were hurriedly convened …” Within a year 50% of the stimulus projects were underway. Some of this stimulus paid for what Tooze describes as “perhaps the most spectacular infrastructure project of the last generation anywhere in the world”, the Chinese high speed rail network. Monetary policy was also relaxed.

In 2008 as a whole, before the stimulus and hardly touched by the collapse in world trade, Chinese GDP grew by 9.6%. In 2009, when GDP in the advanced countries fell by 3.4%, Chinese growth was 9.1%. The stimulus package had filled the whole left by collapsing Chinese exports. (Source)

Basic macroeconomic theory says that a negative shock to GDP, caused for example by falling exports, can be completely offset by a monetary and fiscal stimulus. China is a good example of that idea in action. What about all the naysayers who predicted financial disaster if this was done? Well there was a mini-crisis in China half a dozen years later, but it is hard to connect it back to stimulus spending and it had little impact on Chinese growth. What about the huge burden on future generations that such stimulus spending would create? Thanks to that programme, China now has a high speed rail network and is a global leader in railway construction.

Now of course people will say that China is not like an advanced democracy, and it was not part of the global banking network that caused the GFC. But the US and UK stimulus programmes could and should have been larger. Those close to the action tell me that the UK was running out of things to spend more money on in 2008/9, but I cannot help think this amounts to a failure of imagination: it is not as if UK infrastructure is great, there are no flood defence projects left to do etc. Above all else China’s example tells you what a huge mistake 2010 austerity was.