I have been travelling for most of today so I have to keep this post…
It is unsurprising that my profession has suddenly became enamoured with studies of financial cycles. Up until the GFC mainstream macroeconomics (theories and models) mostly ignored financial markets and banking, thinking that they were largely peripheral to understanding the business cycle. The only linkage between the financial sector and the real economy that was considered was via interest rates – the impact on investment spending and the demand for loanable funds to fund investment impacting back onto interest rates. Even within this limited context, the theories developed were hopelessly deficient and incapable of explaining anything that relates to the real economy. But now – more brash than ever – my profession is busily conjuring up financial markets to fit into their Dynamic Stochastic General Equilibrium (DSGE) models, despite these models being next to useless. In March 2009, Willem Buiter said that DSGE models “excludes everything relevant to the pursuit of financial stability.” More recent research from the BIS (link below in the text) has highlighted some salient facts about the relationship between financial cycles and business cycles. What that research implies is that push for fiscal austerity is without foundation and will not only damage the real economy but will, in the process, prolong the financial downturn and prevent a resolution that could provide the springboard for sustainable growth.
Willem Buiter also noted in the same article (March 9, 2009) The unfortunate uselessness of most ‘state of the art’ academic monetary economics – that:
The common practice of solving a dynamic general equilibrium model of a(n) (often competitive) market economy by solving an associated programming problem, that is, an optimisation problem, is evidence of the fatal confusion in the minds of much of the economics profession between shadow prices and market prices and between transversality conditions that are an integral part of the solution to an optimisation problem and the long-term expectations that characterise the behaviour of decentralised asset markets. The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time – a God-like father figure – who makes sure that nothing untoward happens with long-term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.
I realise that won’t mean much to non-economists (and even many economists) but the message is clear – DSGE models combined with the Efficient Market Hypothesis are about fantasy land and have nothing meaningful to say about the actual monetary system.
The Bank of International Settlements has just published a new working paper (BIS Working Papers No 380) – Characterising the financial cycle: don’t lose sight of the medium term! – which provides some interesting insights into how we might judge the current policy framework around the world. It is a technical paper but I can summarise it quite simply for a lay audience.
In that paper the BIS comments on the disregard by the mainstream of my profession for financial markets that:
… they could not account for financial crises. A rapidly growing literature is now seeking to remedy these shortcomings.
But the developments are all within a deeply flawed narrative about how the monetary system operates. Ad-hoc additions to an already terminally flawed approach don’t make the approach any the more relevant than it was prior to the crisis.
The models will become more elaborate and include various stylised observations about financial markets (for example, non-linear feedbacks between asset prices and funding in different states of liquidity where financial institutions mark-to-market and impose margin calls etc). But they will forever remain deficient and should be disregarded.
A whole generation of new PhD students is about to embark on programs embracing these “developments” and like the previous generation that ignored them they will finish their programs basically illiterate with respect to the way the real world operates although they will arrogantly strut around within the large institutions like the IMF etc solving complex (linear) models eventually, as their seniority progresses, they will tell governments what to do.
The advice given will be exactly what governments should not do.
Anyway, for now there is a lot of work being done on financial cycles and at the empirical level there are some interesting results being produced even though these results were known by those who have read and not disregarded (as the mainstream largely did before the crisis) authors such as Hyman Minsky.
In April 2011, there was an IMF Working Paper released – Financial Cycles: What? How? When? – which undertook a “detailed provides a “comprehensive analysis of financial cycles using a large database covering 21 advanced countries over the period 1960:1-2007:4”.
Their results showed that:
1. “financial cycles tend to be long and severe, especially those in housing and equity markets.”
2. “they are highly synchronized within countries, particularly credit and house price cycles.”
3. “The extent of synchronization of financial cycles across countries is high as well, mainly for credit and equity cycles, and has been increasing over time.”
4. “financial cycles accentuate each other and become magnified, especially during coincident downturns in credit and housing markets.”
All these results were well-known prior to the study, especially to those who have been studying Japan since their real estate meltdown in the early 1990s.
The IMF paper produced some interesting graphs which I reproduce here. The graph provides some calibration to the summary findings above.
What does this mean for policy (especially in the current period)? All the IMF paper offers is a concluding paragraph:
… our analysis provides much input for current policy debate, in particular regarding the role of financial markets in the real economy, including the need for and design of macro- prudential approaches. Specifically, it presents much needed data to analyze a number of issues relevant to long-standing policy debates on cycles in credit and asset markets.
Which doesn’t advance us very far, does it?
In the last few days, the Bank of International Settlements has just published a new working paper (BIS Working Papers No 380) – Characterising the financial cycle: don’t lose sight of the medium term! – which provides some interesting insights into how we might judge the current policy framework around the world. It is a technical paper but I can summarise it quite simply for a lay audience.
The UK Guardian article (June 19, 2012) – Bank for International Settlements warns against short-term fixes – said this of the article:
Firstly, it notes that financial cycles are linked to trends in credit and property prices. The ups and down of stock markets are of far less importance when it comes to defining a financial cycle.
Secondly, … the duration and amplitude of financial cycles has increased since the financial liberalisation of the 1980s. Cycles now tend to last for 20 years rather than the average of 11 years previously.
Thirdly, the peaks in financial crises are closely linked to banking crises.
Finally, financial cycles and business cycles are different. The latter are shorter, and the contraction phase does not usually exceed a year, whereas the downturn triggered by a financial crisis lasts for several years and results in a much bigger hit to growth.
That provides a fair summary of what the BIS authors found.
So what does that all mean?
The first interesting observation in the BIS paper is that “the medium-term financial cycle is a different phenomenon from the business cycle that is generally discussed in the macroeconomic literature”.
When we talk of the business cycle we are talking about the fluctuations in real GDP growth (and the accompanying real aggregates – employment, income etc). The BIS analysis clearly shows that this cycle is shorter than the typical financial cycle.
They produce an interesting graph (Graph 3) which I reproduce below which shows the two types of cycles for the US from the early 1970s to 2011. The BIS describe the graph in this way:
… the medium-term financial cycle (orange and green lines: peaks and troughs identified by the turning- point method; blue line: frequency-based filters), NBER recessions (grey bars), and the cycle in real GDP identified by the short-term frequency based filter (red line).
The length of the financial cycle is longer and the amplitude (depth of fluctuation) larger, particularly “after financial liberalisation”. Recall that after the 1990s, the mainstream macroeconomists were claiming that the “business cycle was dead”. Please read my blog – The Great Moderation myth – for more discussion on this point.
The reality was that while the mainstream economists were waxing lyrical about the success of inflation targetting and claiming that the only thing governments should be doing was – in the words of the Chicago economist Robert E. Lucas at his 2003 presidential address to the American Economic Association:
… providing people with better incentives to work and to save, not from better fine tuning of spending flows. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management.
That is, more deregulation and hollowing out of the state. For Lucas and the majority of my profession “macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes”.
Meanwhile, the financial cycle heading towards the credit-fuelled boom as they were congratulating themselves and reinforcing the financial cycle by pressuring governments to deregulate even further, particularly in financial markets.
Modern Monetary Theory (MMT) writing at the time was predicting a major collapse of the financial markets based on our analysis of the sectoral balances and the growing precariousness of household and corporate balance sheets. For those who cared to include the financial markets in their analytical vision, it was obvious that the fluctuations in the financial cycle were becoming larger which meant that the crash would be that much bigger.
Stock-flow macroeconomics provided a framework for understanding those dynamics. But sadly, the mainstream models were not stock-flow consistent. Please read my blog – Stock-flow consistent macro models – for more discussion on this point.
The other points the BIS make is that “not all recessions coincide with troughs in the financial cycle” and “that business cycle recessions are also much shorter than contraction phases in the financial cycle”.
The link between the behaviour of the financial cycle and the policy context is not coincidental. The BIS say that
… the length and amplitude of the financial cycle (and the associated medium-term business cycle), have increased since the early 1980s … a key factor behind this development is the conjunction of changes in the financial and monetary regimes … The wave of financial liberalisation that took place in the early-mid 1980s allowed financial forces to have full play, reinforcing the procyclicality of the financial system. At the same time, more subdued inflation progressively removed the need to tighten monetary policy as the economy expanded. The stop-go policies of the 1960s-early 1970s naturally prevented financial cycles from gaining strength; the change in regimes in effect loosened the anchors of the financial system, increasing its “elasticity”.
They fail to mention that the financial liberalisation meant that policy makers (central banks, prudential regulators) lost oversight of financial markets and allowed a plethora of questionable practices, which extended to outright frauds to proliferate.
Anyone who questioned what was going on at the time were brutally put down within the academy, the public policy processes and/or the wider public debate.
Remember the case of one Brooksley Born, who became the head of the US federal Commodity Futures Trading Commission, in relation to her dealings witht he so-called “Committee that Saved the World” (Alan Greenspan, Robert Rubin and Larry Summers). It was documented on the US PBS Frontline program The Warning which went to air in the US on October 20, 2009.
There was a segment which described Born’s first lunch with Greenspan after she was appointed as Head of the Commodity Futures Trading Commission. Apparently, Greenspan expressed a “disdain for regulation” and when she raised the issue of the problem of financial fraud Greenspan said that “the market would take care of the fraudsters by self-regulating itself”.
Born had wanted to regulate the growing and secretive Over the Counter (OTC) derivatives market and met with great resistance from Rubin, Greenspan and Summers. She told the program that “Alan Greenspan at one point in the late ’90s said that the most important development in the financial markets in the ’90s was the development of over-the-counter derivatives”.
When asked if Greenspan knew what he was talking about, Born replied “Well, he has said recently that there was a flaw in his understanding”. The last comment is in relation to testimony that Greenspan gave to the US Congress in October 2008 which I discussed in detail in this blog – Being shamed and disgraced is not enough.
Born got involved in the law suit filed by filed by Procter & Gamble against Bankers Trust. It is clear that BT were screwing Procter by selling them derivatives that were too complicated for them to understand the risk. The program reveals audio-tapes of Bankers Trust brokers talking about their deliberate “intention to fleece the company” (Procter). One said “This is a wet dream” while there was a lot of laughing about how smart BT was in “setting up” Procter as a pigeon (victim).
At that stage Born saw the need for government regulation of the financial sector (particularly the banks) but she met incredible resistance from the Adminstration and Greenspan. She sought to develop a “concept release” – a plan for regulation within the legal jurisdiction of the CFTC.
The Committee to Save the World came out publicly on May 7, 1998 with this Press Release from Rubin, Greenspan and Levitt (SEC Chair) issued by the US Treasury:
JOINT STATEMENT BY TREASURY SECRETARY ROBERT E. RUBIN, FEDERAL RESERVE BOARD CHAIRMAN ALAN GREENSPAN AND SECURITIES AND EXCHANGE COMMISSION CHAIRMAN ARTHUR LEVITT
On May 7, the Commodity Futures Trading Commission (“CFTC”) issued a concept release on over-the-counter derivatives. We have grave concerns about this action and its possible consequences. The OTC derivatives market is a large and important global market. We seriously question the scope of the CFTC’s jurisdiction in this area, and we are very concerned about reports that the CFTC’s action may increase the legal uncertainty concerning certain types of OTC derivatives.
The concept release raises important public policy issues that should be dealt with by the entire regulatory community working with Congress, and we are prepared to pursue, as appropriate, legislation that would provide greater certainty concerning the legal status of OTC derivatives.
This New York Times article from last year – Taking Hard New Look at a Greenspan Legacy provides a good summary of the events. It documents the fierce opposition that Greenspan, Rubin and Summers put up against any notion of regulation of the financial markets.
The PBS program shows us that Rubin set his attack dog … Deputy (Summers) onto Born. Summers made the incredible statement (that should have disqualified him from any further office given the developments that were to follow). In a phone conversation where he claimed there were 13 angry bankers in his office berating him, Summers shouted at Born:
You’re going to cause the worst financial crisis since the end of World War II.
He now cannot recall that conversation or ever making the statement.
Soon after, in the US summer of 1998 and unbeknown to the government, Long-term capital management collapses. Born captured her feelings when she found out:
… None of us, none of the regulators had known until Long-Term Capital Management phoned the Federal Reserve Bank of New York to say they were on the verge of collapse.
Why? Because we didn’t have any information about the market. They had enormous leverage. Four billion dollars supporting $1.25 trillion in derivatives? Excessive leverage was clearly a big problem in the market. Speculation? I mean, this was speculation, gambling on prices, on interest rates and foreign exchange rates of a colossal nature. Prudential controls? I mean, all these big banks had in essence … extended unlimited loans to LTCM, and they hadn’t done their homework. They didn’t even know the extent of LTCM’s exposures in the market or the fact that the other OTC derivatives dealers had been lending to them as well.
This was massaged away by the neo-liberals as nothing to worry about and they continued to resist regulation. By 2000, the Commodity Futures Modernization Act [CFMA] that took away all regulative jurisdiction for over-the-counter derivatives from the CFTC.
The behaviour of the financial cycles shown in the graph above were thus not “developments”. They were the result of a blind ideology that deployed erroneous macroeconomic models to justify policy changes which led, unambiguously to the malaise the world is now in. The blind arrogance of my profession has caused millions of people to become unemployed and impoverished. It has led to huge write-offs in wealth for many people and cruelled the hopes of a reasonable retirement for many.
I am sure the Committee to Save the World have not been equally as damaged.
The behaviour of the financial cycle depicted in the graph above is unsustainable and requires a large shift in regulatory thinking to ensure that the financial markets are on a tight leash and work only to the benefit of the real economy. Please read the following blogs – Operational design arising from modern monetary theory and Asset bubbles and the conduct of banks for further discussion.
The other important lesson for policy arising from the BIS results is that it is imperative to understand the nature of any real downturn because when they are linked to financial downturns the consequences for the economy and the correct policy response is different to situations when the real cycle is self-promoting.
Please read my blog – Balance sheet recessions and democracy – for more discussion on this point.
Most recessions begin and end in the real economy and are caused by a growing pessimism among firms (who invest) in the future state of aggregate demand. They respond to the downgrading of their revenue forecasts by slowing the growth of investment spending (capacity building) and laying off workers. The multiplier effects spread throughout the economy – one person’s spending is another person’s income – and a recession become inevitable if there is no other intervention (for example, government stimulus).
While these events can be very severe – they are generally relatively short and recovery is generally driven by renewed optimism as new investment seeks to expand market share at the expense of firms that went broke in the downturn or who have older vintages of technology (and hence higher costs).
This is the traditional V-shape business cycle. As you can see, from the graph above (for the US, which is not a special case) these real fluctuations can be occurring even during an upwsing in the financial cycle.
However, when the real economy gets caught up in financial cycle downturn then the situation is different.
The sequence of events might be something like this:
- The private sector builds up massive debt levels to buy property and speculative assets.
- The asset prices rise as demand rises but then eventually the bubble bursts and the private sector is left with declining wealth but huge debt.
- The private sector then start restructuring their balance sheets – and stop borrowing – no matter how low interest rates go.
- All effort is devoted to paying back debt (de-leveraging) and households increase their saving and reduced spending because they become pessimistic about the future.
- A credit crunch emerges – not because there is enough funds but because banks cannot find credit-worthy borrowers to lend to.
- Attempts at pumping liquidity into the banks will fail because they are not reserve-constrained. They are not lending because no-one worthy wants to borrow.
- The faltering spending causes the macroeconomy to go into recession.
- With this private contraction (reducing debt, saving) the only way out of the “balance sheet recession” is via public sector deficit spending.
The other relevance of the BIS research is that the fiscal stimulus efforts can quickly restore real GDP growth so the business cycle starts to improve. But these balance sheet adjustment processes are very long and so even though the real economy is growing again, the financial cycle is still in the downturn phase and will remain that way for some years.
What does that mean?
First, the real cycle helps the financial cycle to resolve itself. How? If the government deficits support real GDP growth, national incomes start to rise again and, given saving is a positive function of income, households are able to continue de-leveraging while enjoying some capacity to resume consumption spending without borrowing.
Firms are also given an incentive to renew capacity building (investment) as consumers signal they are able to spend more freely again (without recourse to the credit binges that created the problem in the first place).
Second, given that the balance sheet adjustments take a long time to work their way through (reducing debt is a slow process), policy makers have to understand that fiscal stimulus should not be withdrawn at the first sign of real GDP growth. For many years after the trough, private spending will remain subdued (relative to the pre-crisis behaviour) and aggregate demand will require on-going support from budget deficits.
This is why the current austerity push is so damaging. It is not only directly undermining real GDP growth at at time when the non-government sector is unable to pick up the gap (and is more intent on reducing their debt exposure), but also prolonging the financial cycle downturn – because it is thwarting attempts by households and firms to stabilise their balance sheets.
The fundamental point is that during a balance sheet recession the problem is too much non-government debt. But somehow the neo-liberals (who caused the crisis) have reconstructed the problem as too much sovereign debt.
This logic is just plainly false. The debt that a household, which uses the currency, carries is a burden on its future capacity to consume because it has to be funded in some manner. The debt that a government holds does not constrain its capacity to spend in the future. There is never a solvency issue with sovereign government debt.
The problem though is that by reconstructing the problem as a sovereign debt issue – the logic that follows merely prolongs the agony.
What the BIS analysis provides is an empirical basis for understanding why the current policy framework which is focusing on austerity is wrong-headed.
Governments will have to commit to large deficits for years to come to allow the financial cycle to resolve itself.
While committing to supporting aggregate demand growth, the governments should also be putting in place a robust regulatory framework that reduces the amplitude of the financial cycles and ensures they are relatively short, especially in the periods of euphoria (that is, prevent asset bubbles).
That is enough for today!
(c) Copyright 2012 Bill Mitchell. All Rights Reserved.