Economists Forgetting History, Repeating It

Economist Brad DeLong comments about how he saw something familiar at the beginning of the financial crisis in 2008, but couldn’t remember where until he recalled the writings of economist John Hicks regarding Depression-era economics. Hicks talked of a “liquidity trap” that predicted an extended period of low interest rates rather than a spike to recover losses, and is now watching as that same pattern with the Treasury is taking shape. DeLong’s concern is that perhaps economists have not learned from past errors, and that when (and if) a recovery begins it will only be forgotten to be repeated again. For more on this continue reading the following article from Economist’s View.

Brad DeLong:

Sorrow and Pity of Another Liquidity Trap, by Brad DeLong: ...At the end of 2008, as the economy collapsed and the pace of net Treasury debt increases quintupled,... I presumed we had a little time for expansionary fiscal policy to boost the economy -- a year, maybe 18 months -- before the bond-market vigilantes would arrive. They would demand higher interest rates on Treasury bonds, which would begin seriously crowding out the benefits of fiscal stimulus. ...

But it didn’t happen in 2009. It didn’t happen in 2010. And it isn’t happening in 2011. There are no signs from asset prices that the market is betting heavily that it will happen in 2012. Looking at the yield curve, it appears the market intends to swallow every single bond that the Treasury will issue in the foreseeable future...

Although I worked for three years in the Clinton Treasury Department, and am a card-carrying member of the economist guild, I predicted none of this. Like most of my peers, I was wrong. Yet the most interesting thing is that I could have -- should have -- been right. I had read economist John Hicks; I just didn’t quite believe him.

Hicks ... was responsible for the ... version of the IS-LM model that formalized and elevated a key insight: that interest rates paid by creditworthy governments would remain low after a financial crisis. ...

This is the liquidity trap. In this situation we need deficit spending. ...

I had read Hicks. I even knew Hicks. But I thought that his era, the Great Depression, had passed. Sitting in my first graduate economics class in 1980, I listened to Marty Feldstein and Olivier Blanchard -- two of the smartest humans I am ever likely to see -- assure me that Hicks’s liquidity trap was a very special case, into which the economy was unlikely to wedge itself again. Yet it did.

On my shelf is a slim, turn-of-the-millennium volume by Paul Krugman titled “The Return of Depression Economics.” In it he argued that we mainstream economists had been too quick to ditch the insights of Hicks -- and of economists Walter Bagehot and Hyman Minsky. Krugman warned that their analysis was still relevant, and that if we dismissed it we would be sorry.

I am sorry.

I remember feeling pretty lonely calling for aggressive fiscal policy very early in the crisis.

On the bigger issue, I've argued that we weren't asking the right questions prior to the crash. We were worried about how to conduct monetary and fiscal policy in an economy that is mildly fluctuating around its long-run optimal path due to price and wage rigidities, and we used DSGE models to answer that question (the answer was that monetary policy alone would suffice, so there was no need to even worry about fiscal policy and the political problems that come with it, and it was largely ignored). Though there were notable exceptions, e.g. the literature on financial frictions and financial accelerators, for the most part researchers did not build models that examined the question of what might happen, and how best to respond, if there was a financial panic and a break down in financial intermediation. That was becasue "Hicks’s liquidity trap was a very special case, into which the economy was unlikely to wedge itself again" -- and the "central problem of depression-prevention has been solved," as Robert Lucas told us.

There will be a frenzy of research on this issue, just as there was after the Great Depression, and we will come to conclusions about what went wrong and what we can do better next time. Then we will move on as other important questions come to the forefront.

The question is, will we forget again? Will we stop asking these questions as the crisis fades in our collective memories? When the next crisis hits, as it will someday, will economists who reach into their tool bag of macroeconomic models come up empty except for those decades old DSGE models (or whatever we come up with that explains our recent experience) and even older IS-LM formulations? Will they, once again, be forced to choose between modern models that were not built to answer the questions policymakers need answers to, and older models that, despite their limitations, were? I suspect that they will.

This article was republished with permission from The Economist's View.

One Economist's Argument For The Coming Great Depression

The mood on Wall Street and at the Fed are pretty optimistic that a recovery is ready to take place. However, Economist Thomas Palley argues that the massive deleveraging by consumers and government will soon lead to a double-dip recession which could possibly spiral into the Great Depression II. See the following post from Economist's View to learn more.

Let's hope Thomas Palley, who says "a second Great Depression remains a real possibility," is wrong. My best guess is that he is (though I don't expect a quick recovery, particularly for labor). But I suppose I "should never underestimate the destructive power of bad ideas":

A second Great Depression is still possible, by Thomas Palley, Commentary, Economists' Forum: Over the past year the global economy has experienced a massive contraction, the deepest since the Great Depression of the 1930s. But this spring, economists started talking of “green shoots” of recovery and that optimistic assessment quickly spread to Wall Street. More recently, on the anniversary of the Lehman Brothers crash, Ben Bernanke, Federal Reserve chairman, officially blessed this consensus by declaring the recession is “very likely over”.

The future is fundamentally uncertain, which always makes prediction a rash enterprise. That said there is a good chance the new consensus is wrong. Instead, there are solid grounds for believing the US economy will experience a second dip followed by extended stagnation that will qualify as the second Great Depression. ...

There is a simple logic to why the economy will experience a second dip. That logic rests on the economics of deleveraging which inevitably produces a two-step correction. The first step has been worked through, and it triggered a financial crisis that caused the worst recession since the Great Depression. The second step has only just begun.

Deleveraging can be understood through a metaphor in which a car symbolises the economy. Borrowing is like stepping on the gas and accelerates economic activity. When borrowing stops, the foot comes off the pedal and the car slows down. ...

With deleveraging, households increase saving and re-pay debt. This is the second step and it is like stepping on the brake, which causes the economy to slow further, in a motion akin to a double dip. Rapid deleveraging, as is happening now, is the equivalent of hitting the brakes hard. ...

The US economy has hit a debt iceberg. The resulting gash threatens to flood the economy’s stabilising mechanisms, which the economist Hyman Minsky termed “thwarting institutions”.

Unemployment insurance is not up to the scale of the problem and is expiring for many workers. That promises to further reduce spending and aggravate the foreclosure problem.

States are bound by balanced budget requirements and they are cutting spending and jobs. Consequently, the public sector is joining the private sector in contraction.

The destruction of household wealth means many households have near-zero or even negative net worth. That increases pressure to save and blocks access to borrowing that might jump-start a recovery. Moreover, both the household and business sector face extensive bankruptcies that amplify the downward multiplier shock and also limit future economic activity by destroying credit histories and access to credit.

Lastly, the US continues to bleed through the triple hemorrhage of the trade deficit that drains spending via imports, off-shoring of jobs, and off-shoring of new investment. This hemorrhage was evident in the cash-for-clunkers program in which eight of the top ten vehicles sold had foreign brands. Consequently, even enormous fiscal stimulus will be of diminished effect.

The financial crisis created an adverse feedback loop in financial markets. Unparalleled deleveraging and the multiplier process have created an adverse feedback loop in the real economy. That is a loop which is far harder to reverse, which is why a second Great Depression remains a real possibility.

This post has been republished from Mark Thoma's blog, Economist's View.