This article is based on a speech given by the author on 12 September 2011 in
Munich.
— Failure of the ―liquidationists‖ to overcome the Great Depression of the early
1930s prepared the ground for an era of interventionist economic policies.
Modern macroeconomics and finance nourished the belief that we can
successfully plan for the future. But the present crisis teaches us that we live
in a world of Knightian uncertainty, where the ―unknown unknowns‖ dominate
and our plans for the future are regularly thwarted by unforeseen and
unforeseeable events.
— In a world of Knightian uncertainty, financial firms and investors need larger
buffers to cope with the unforeseen, i.e. more equity and less leverage.
— In a world, where markets are not always liquid but can seize up in a collective
fit of panic, financial firms and investors also need a greater reserve of liquidity.
— Regulation can help to achieve both objectives, but it needs to realize its limits.
First and foremost, firms should have the incentives to follow sound business
practices. The best incentive is to make failure possible. Hence, we need
resolution regimes for financial firms.
— In a world where people have imperfect foresight and do not always behave
rationally, and markets are not always efficient, we need to accept that
economic policy cannot fine-tune the cycle.
— For us economists, the lesson from recent events should be to rely less on the
development of theories by ―deduction‖ (like in natural sciences) and to apply
more ―induction‖ (like in social and historical sciences). Failure to study history
makes us repeat the mistakes of the past.
Introduction
The financial crisis has led many people to doubt the merits of free
markets and a liberal economic regime. They blame markets for the
financial and economic crisis and demand tighter regulation and, in
effect, more central planning by governments as a remedy. We shall
argue that both the analysis on which this view is based and the
policy recommendations are flawed. This crisis has been caused by
too much reliance on the effectiveness of economic and financial
planning. Failure of the "liquidationists" to overcome the Great
Depression of the early 1930s prepared the ground for an era of
interventionist economic policies. Modern macroeconomics and
finance nourished the belief that we can successfully plan for the
future. But the present crisis teaches us that we live in a world of
Knightian uncertainty, where the ―unknown unknowns‖ dominate and
our plans for the future are regularly thwarted by unforeseen and
unforeseeable events. We have suffered from ―control illusion‖. We
need to recognize the limits of planning for the future and the
superiority of a market-liberal economic order, where states, firms
and individuals can be held liable for the financial decisions they
have taken.
The predecessor of today’s crisis
To develop our point we first take a look at the historical
predecessor of today’s financial crisis, the depression of the 1930s.
During the 1920s easy monetary conditions and an exaggerated
appetite for risk, evidenced by extreme leverage in the popular
equity trusts, fuelled the build-up of a stock price bubble. When
monetary conditions were tightened eventually, the edifice of
leverage came down and the stock market crashed in October 1929.
At the time, the authorities took the crash in their stride. Many policy
makers felt that the crash and a possible recession afterwards were
needed to eliminate the excesses and imbalances that had built up
during the roaring twenties. Andrew Mellon, then US Secretary of
the Treasury, brought this view to the point when he said:
"…liquidate labor, liquidate stocks, liquidate farmers, liquidate real
estate… it will purge the rottenness out of the system. High costs of
living and high living will come down. People will work harder, live a
more moral life. Values will be adjusted, and enterprising people will
pick up from less competent people." (Hoover, Herbert (1952).
Memoirs. Hollis and Carter. p. 30). Inspired by Mellon’s attitude,
those sharing the idea that a recession was a ―cleansing event‖
were later dubbed ―liquidationists‖.
The ―liquidationists‖ could claim theoretical support for their view
from the Austrian school of economics around Joseph Schumpeter
and Friedrich von Hayek, which built its view of the business cycle
on the work of the Swedish economist Knut Wicksell. Wicksell
distinguished between a natural rate of interest, which reflects the
return on investment, and a market rate, which reflects the
borrowing costs of funds charged by the banks. When the market
rate is below the natural rate, companies borrow to invest and the
economy expands. In the opposite case, investment is reduced and
the economy contracts.
The Austrian school used this idea to develop a theory of the
business cycle that puts the credit cycle in the centre (see picture
left). Low interest rates stimulate borrowing from the banking
system. The expansion of credit induces an expansion of the supply
of money through the banking system. This in turn leads to an
unsustainable credit-fuelled investment boom during which the
―artificially stimulated‖ borrowing seeks out diminishing investment
opportunities. The boom results in widespread overinvestment,
causing capital resources to be misallocated into areas which would
not attract investment if the credit supply remained stable. The
expansion turns into bust when credit creation cannot be sustained
– perhaps because of an increase in the market rate or a fall in the
natural rate – and a ―credit crunch‖ sets in. Money supply suddenly
and sharply contracts when markets finally ―clear‖, causing
resources to be reallocated back toward more efficient uses.1
The liquidationist approach to economic policy in the aftermath of
the 1929 stock market crash – for which Mellon became the symbol
– accepted the downturn in the early 1930s as inevitable. What they
missed was that extreme risk aversion can keep the market rate
above the natural rate even after ―the rottenness‖ has been ―purged
out of the system‖. Franklin D. Roosevelt, who beat Hoover in the
1932 presidential elections, seems to have intuitively understood
this problem. Perhaps the most important action Roosevelt took
shortly after his inauguration in early 1933 was to guarantee bank
deposits. As a result, cash that people had hoarded under their
mattresses came back to the banks and improved their liquidity
situation. When the Roosevelt administration later in the year
recapitalized banks, credit extension picked up again and the
economy recovered. It is interesting that there was no big fiscal
policy stimulus in 1933 – the famous New Deal was felt only later.
Hence, contrary to conventional wisdom, the spark that ignited the
recovery of 1934 was the turn in the credit cycle (see chart).
The experience of the depression and the Roosevelt recovery
induced John Maynard Keynes to launch a heavy attack on the
Austrian school. In his General Theory, written in 1935, he made a
strong case for government intervention. Fiscal policy should come
to the rescue when the public feared deflation and hoarded money.
Many students of economics today believe that it was the
application of Keynes’ theory that ended the downturn of 1930-33.
We do not agree. In our reading of events it was the policy-induced
turn of the credit cycle that did the trick. Hence, the recovery of 1934
was more ―Austrian‖ than ―Keynesian‖. Let us be clear: The
liquidationists were wrong to allow the depression to happen as they
failed to recognize that fear can beget fear. Roosevelt recognized
this when in his inaugural speech he said ―the only thing we have to
fear is fear itself‖, and he was right to intervene and stabilize the
banks. But what he did – opening the credit markets – is what
follows from an Austrian reading of the business cycle.
The Austrians have warned that a policy-induced extension of the
credit cycle before all excesses have been eliminated in the
economy will only delay the day of reckoning. But also they would
have had to conclude that after the depression of 1930-33 one could
hardly still see ―excesses‖ in the economies of the western world.
Nevertheless, the economy tanked again in 1937 when the
monetary and later fiscal policy support was withdrawn. Most
economic historians argue that the period of economic instability in
the US only ended towards the end of the 1930s when the country
prepared for war. The British historian Niall Ferguson has even
argued, that Germany got out of the depression ahead of the US
because of its earlier and more aggressive preparations for war. It
1 Note that Hyman Minsky, who is generally associated with the Post-Keynesian
school of economics, described the credit cycle in a similar way.
seems that only in the anticipation of war the ―fear of fear itself‖
ceased to be a de-stabilising factor in economic developments.
The historical review of the Great Depression leaves us with a
disturbing conclusion: The Austrian credit cycle theory seems to
have a better fit to events than Keynes’ theory of the liquidity trap
and power of fiscal policy (see chart). What the Austrians seem to
have missed is that an economy paralyzed by extreme risk aversion
may need a jolt by confidence-building economic policy measures.
But this was not what most economists and policy makers concluded.
Lessons from the Great depression: “Over to
governments”…
At the end of WWII a number of western intellectuals and
economists flirted with Soviet-style central planning. After all, the
Soviet Union had prospered during the 1930s while the capitalist
countries had been in crisis. Did this not prove that their economic
model was superior?
Having lost the intellectual battle with Keynes and followers in the
1930s, the Austrians made a last stand against central economic
planning with Hayek’s powerful book ―The Road to Serfdom‖
published in 1946. They won the war of principles and the western
world did not subscribe to Soviet-style central planning, despite the
allure this model was exercising on many intellectuals after WWII.
Even Keynes sided with the Austrians as far as the high ground was
concerned and wrote to Hayek: ―In my opinion it is a grand book ...
Morally and philosophically I find myself in agreement with virtually
the whole of it: and not only in agreement with it, but in deeply
moved agreement.‖
Nevertheless, the Austrians lost the battle over economic policy in
the post-WWII western countries. Keynes’ idea of ―demand
management‖ through fiscal policy became the mantra there after
the war. Somewhat belatedly, in 1971 when he ended the link of the
US Dollar to Gold, even Richard Nixon is reported to have said ―I’m
now a Keynesian in economics‖.
From the 1950s to the end of the 1970s western economic policy
makers used and abused fiscal policy as an economic management
tool. Governments were quite happy to raise borrowing in economic
downturns, but generally reluctant to bring it down in upturns.
Towards the end of the 1960s, the use and abuse of fiscal policy
created strains on government finances that could only be eased by
the monetization of government debt. As a consequence, Richard
Nixon on August 15, 1971 suspended the link of the USD to gold,
and in effect launched the post-WWII system of fiat money.
During the post WWII period of the implicit gold standard under the
Bretton-Woods System (where the USD was supposedly as good as
gold), there was hardly any room for pro-active monetary policy
(which, however, did not prevent the US government to use the
money printing press as an auxiliary funding tool). This changed
drastically after Nixon’s decision of 1971. The result was a bout of
inflation as government debt and deficits were financed in part by
the money printing press. As both growth and inflation disappointed,
the word ―stagflation‖ was coined to describe the economic
conditions of the 1970s.
….“over to the central banks”
The failure of the young new fiat money regime was that it lacked a
monetary anchor. As a result, monetary policy ended up
accommodating fiscal policy and wage policy developments. This
was eventually recognized by policy makers in the early 1980s. In
the seventies, Milton Friedman had proposed limits on the
expansion of money supply and laid the ground for the introduction
of independent central banks. As Stagflation killed the idea that
there was a trade-off between inflation and unemployment, the time
of monetarism had arrived. Federal Reserve Chairman Volcker used
the monetarist demand to ―gain control over the money supply‖ as a
justification to engineer a deep recession that brought inflation
down. Hence, the early 1980s were a period of repentance for the
sins of Keynesianism committed in the late 1960s and 1970s. With
the development of the theory of rational expectations and efficient
financial markets, the pendulum seemed to swing back from the
constructivism of economic policy before to a more market liberal
regime.
But the straitjacket intended by Friedman for monetary policy did not
hold long. In the course of the 1980s monetary policy freed itself
from the Friedman straitjacket and turned pro-active. The great
champion of this approach to monetary policy was Alan Greenspan,
who followed Volcker in 1987.
The 1987 stock market crash was the first application of the proactive
use of monetary policy. To fend off recession risks, Greenspan
cut interest rates. The therapy worked and instead of
decelerating the economy accelerated during the late 1980s. The
next occasion to apply the Greenspan method came in the wake of
the savings-and-loans-crisis at the end of the 1980s, which
contributed to the recession of 1990-91. Again, the Greenspan Fed
cut interest rates to support the economy and again succeeded in
mitigating the downturn. In the following years, the Greenspan
method was applied again to fight the Asian emerging market and
LTCM crisis of 1998 and again when the dot.com bubble burst in
2000-2002. Until the great financial crisis that began in 2007, it
seemed that the Greenspan method, the pro-active use of monetary
policy to fine-tune economic developments, had succeeded in
abolishing the business cycle as we knew it. Thanks to the art of
central bankers, the age of the Great Moderation had arrived.
The great financial crisis that erupted in 2007 uncovered the Great
Moderation as a great illusion. Nevertheless, the old reflexes led to
the combined deployment of monetary and fiscal policy on a so far
unprecedented scale. As the excessive leverage built up in the
illusory age of the Great Moderation was unwound, the crisis moved
from the US sub-prime mortgage sector to the money markets, the
banking sector and more recently to the public sector (see chart).
The principle has been to shift the unbearable burden of debt from
weaker to stronger shoulders and lower debt service costs through
monetary policy induced interest rate cuts. But in this process the
previously strong shoulders have also been weakened. Somehow
the old tricks seem to have lost their magic, and the crisis triggered
by massive de-leveraging appears to be getting out of control.
The theory behind “Greenspanism”
What was the major flaw that led us into this crisis? The belief that
even in a world of uncertainty economic and financial outcomes
could be planned was in our view a major contributor. The
assumptions of rational expectations and efficient financial markets
laid the ground for overconfidence in the ability of policy makers,
firms and individuals to successfully plan for the future despite the
uncertainties surrounding us.
At the macro level, rational expectations and efficient markets theory
laid the ground for inflation targeting by major central banks, which
replaced the monetary targeting of the early 1980s. The economy
was expected to grow in a steady state, if only the central bank
ensured stable and low consumer price inflation. The overconfidence
in the power of the central bank led Paul Krugman to
claim in the late 1990s:
“If you want a simple model for predicting the unemployment rate in
the United States over the next few years, here it is: It will be what
Greenspan wants it to be, plus or minus a random error reflecting
the fact that he is not quite God.”
When individuals had rational expectations and markets were
efficient there was no need to worry about asset markets or regulate
financial markets. After all, how could central banks or regulators
know more than the market when market prices reflected all
available information about the future? Anyone questioning the
wisdom of the ruling paradigm was regarded as old-fashioned by the
academic cardinals of the Church of Anglo-Saxon economics, which
has reigned supreme. In retrospect, it seems a bit odd that
academics overlooked financial markets’ obsession with central
banks and the cult status they awarded central bankers. How could
financial market participants hang on the lips of central bankers,
when they so efficiently processed all available information in real
time? But economists were too enamored with their theories to dwell
much on such oddities.
At the micro level, rational expectations and efficient markets theory
laid the ground for many highly leveraged financial products and risk
management. Financial market participants saw only ―known
unknowns‖ that could be quantified with probability theory. In a world
of ―known unknowns‖ they felt that there was little need for
contingencies for the truly unforeseen, the ―unknown unknowns‖.2
Hence, it seemed fully appropriate to raise leverage to the extreme.
After all, risk managers could calculate continuously and real time
the value that could be lost when the unknown happened. The
feeling of being in control – of being able to plan ahead with good, if
not perfect, foresight – laid the ground for the extremely high
leverage that was built into financial products and the balance sheet
of financial firms.
After the burst of “control illusion”
The collapse of these theories enforces the radical reduction of
leverage. If we cannot anticipate the range of future outcomes with a
relatively high degree of certainty, we need more slack and buffers
in the system for unforeseen events, and hence cannot afford high
degrees of leverage.
The helplessness of the economic profession in the face of the
present crisis manifests itself by the recommendations of prominent
economists for ever-stronger incentives for a renewed increase of
leverage. They advise that fiscal policy turn expansionary again,
2 We owe this graphic classification of uncertainties to Donald Rumsfeld, the former
US Secretary of Defence, who also learned about the ―unknown unknowns‖ the
hard way.
central bank policy rates be kept at zero for a long time, and central
banks purchase financial assets.
At present the central banks fight the reduction in leverage with the
issuance of ever more central bank money. As outside money
implodes inside money explodes. For now, the aim to reduce
leverage depresses asset prices and leads to a flight into money.
But the more the central banks succeed to replace the reduction of
outside money through de-leveraging by an expansion of inside
money, the more likely becomes the monetization of outstanding
debt.
The desperate attempt to avoid an economic crisis caused by the
necessary de-leveraging could eventually lead to a crisis of the fiat
money system itself. On August 15 this year, the fiat money system
celebrated its 40th birthday. Since Nixon cut the dollar’s link to gold
on August 15, 1971, the dollar has depreciated by 98% against gold
(see chart). Depreciation came in two stages: First during the 1970s,
when the excess supply of US Dollars created towards the end of
the BW-System and at the beginning of the new fiat-money system
boosted consumer price inflation, and secondly after the implosion
of the credit-driven ―Great Moderation‖ as of 2007, when bad assets
started to move from private sector via public sector to central bank
balance sheets.
When fiat money fails it may well be replaced by money backed by
real assets that cannot be augmented with the stroke of the pen of
central bankers. How could this happen? One possibility – which at
present may sound a bit like science fiction – would be for China
and other big EM countries to peg the value of their currencies to a
basket of commodities. It would then be up to the industrial
countries to try to stabilize their currencies against the Yuan, or
accept the inflation that goes along with secular depreciation.
To conclude:
Modern macro- and financial economics are based on the belief that
economic agents always hold rational expectations and that markets
are always efficient, in other words, that the earth is flat. We now
find out that this is not true. There are elements of irrationality and
inefficiencies in the behavior of people and markets. Therefore we
need to dump the flat-earth theories promising that economic and
financial outcomes can be planned with a high degree of certainty
and need to look at other theories that accept the limits of our
knowledge about the future. A revival of Austrian economics could
be a good start for such a research programme.
Unfortunately, however, the battle cry of the public and politicians is
for more regulation: regulate banks, regulate markets, regulate
financial products! But those who push for blanket regulation suffer
from the same control-illusion that got us into this crisis. In our view,
instead of more regulation we need more intelligent regulation. At
the heart of such regulation must stand the simple recognition that
we can at best tentatively plan for the future and must feel our way
forward in a process of trial and error.
In a world where we need to reckon with ―unknown unknowns‖ – in a
world where Knightian uncertainty reigns – financial firms and
investors need larger buffers to cope with the unforeseen, i.e. more
equity and less leverage.
In a world, where markets are not always liquid but can seize up in a
collective fit of panic, financial firms and investors also need a
greater reserve of liquidity.
Regulation can help to achieve both objectives, but it needs to
realize its limits. Regulation will create a false sense of security,
unless firms and investors have the incentives to follow sound
business practices. The best incentive to do so is to make failure
possible. Hence, we need effective resolution regimes for financial
firms.
In a world where people have imperfect foresight and do not always
behave rationally, and markets are not always efficient, we need to
accept that economic policy cannot fine-tune the cycle. All that
policy can do is to lean against excessive exuberance and
depression during the credit cycle and help avoid the excessive
swings of risk appetite that we have seen over the last 10 years. It is
unhelpful to pro-actively manipulate the market rate to achieve
certain economic growth objectives. Instead we should try to create
the conditions for a steady development of credit by allowing the
market rate to closely follow the natural rate. When accidents
happen, we need to prevent that ―fear of fear itself‖ perpetuates
economic crises by ensuring that the banking system is capable to
satisfy the demand for credit.
Finally, economists should be more humble. For too long we have
tried to be like natural scientists. Like they we like to develop our
theories with the method of deduction – start from a few axioms and
describe the world in mathematical terms from there. This was a
little presumptuous, to say the least. We need to realize that we are
to a significant extent a social science. Social scientists, like
historians, use the method of induction. They observe, and then
develop tentative descriptions of the world from these observations.
Because we did not pay enough attention to economic history and
relied heavily on formal models of the economy we repeated a
number of the mistakes that caused the Great Depression.
Thomas Mayer (tom.mayer@db.com, +49 69 910-30800)
TRANSLATED INTO SPANISH
