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This Time, It Is
Not
Different:
The Persistent Concerns of
Financial Macroeconomics
J. Bradford DeLong
U. C. Berkeley, NBER, and WCEG
April 2012
DRAFT 2.4:
Pages: http://tinyurl.com/dl20161223d
html:
http://tinyurl.com/dl20161223e
pdf: http://delong.typepad.com/not-different.pdf
11905 words
1
ABSTRACT
When the
Financial Times's
Martin Wolf asked former U.S. Treasury
Secretary Lawrence Summers what in economics had proved useful in
understanding the fi nancial crisis and the recession, Summers
answered: “There is a lot about the recent fi nancial crisis in Bagehot...”.
“Bagehot” here is Walter Bagehot’s 1873 book,
Lombard Street
. How is
it that a book written 150 years ago is still state-of-the-art in
economists’ analysis of episodes like the one that we hope is just about
to end?
There are three reasons. The fi rst is that modern academic economics
has long possessed drives toward analyzing empirical issues that can be
successfully treated statistically and theoretical issues that can be
successfully modeled on the foundation of individual rationality. But
those drives are disabilities in analyzing episodes like major fi nancial
crises that come too rarely for statistical tools to have much bite, and
for which a major
ex post
question asked of wealth holders and their
portfolios is: “just what were they thinking?”. The second is that even
though the causes of fi nancial collapses like the one we saw in 2007-9
are diverse, the transmission mechanism in the form of the flight to
liquidity and/or safety in asset holdings and the consequences for the
real economy in the freezing-up of the spending flow and its
implications have always been very similar since at least the fi rst
proper industrial business cycle in 1825. Thus a nineteenth-century
author like Walter Bagehot is in no wise at a disadvantage in analyzing
the downward fi nancial spiral.
The third is that the proposed cures for current fi nancial crises still bear
a remarkable family resemblance to those proposed by Walter Bagehot.
And so he is remarkably close to the best we can do, even today
.
2
I. Introduction
At the spring 2011 INET Conference in Bretton Woods,
New Hampshire,
Financial Times
correspondent and
columnist Martin Wolf asked:
[Doesn’t] what has happened in the past few years
simply suggest that [academic] economists did not
understand what was going on?...
Former U.S. Treasury Secretary Lawrence Summers, in the
course of his long answer, said:
There is a lot in [Walter] Bagehot that is about the
crisis we just went through. There is more in
[Hyman] Minsky, and perhaps more still in [Charles]
Kindleberger...
1
Walter Bagehot (1826-1877) refers to his
Lombard Street
,
published in 1873. Hyman Minsky (1919-1996) is a
twentieth-century observer and theorist of fi nancial crises
best approached not through his books or his collected
essay volume—
Can “It” Happen Again?
—but rather
through the use that economic historian Charles
Kindleberger (1910-2003) made of his work in
Kindleberger’s 1978
Manias, Panics, and Crashes: A
3
1
See “Larry Summers and Martin Wolf on New Economic
Thinking” (April 8, 2011 video) <
http://tinyurl.com/dl201108a
>.
History of Financial Crises
.
234
Asked to name where to turn in the works of economists to
understand what was going on in 2005-2011, Summers
cited three dead economists—one of them long dead.
Summers did then enlarge his answer to include living
economists, starting with the economic historian Barry
Eichengreen and then moving on to mention “[George]
Akerlof, [Robert] Shiller, many, many others...”. Summers
he stressed the success of empirical work in aiding
understanding, in contrast to the failure of modern
“macroeconomic [theory to] keep up with [the] revolution”
in fi nance “as it was realized that asset prices show large
volatility that does not reflect anything about
4
2
Walter Bagehot (1873),
Lombard Street: A Study of the Money Market
(London: Henry S. King) <
http://www.econlib.org/library/Bagehot/
bagLomCover.html
>.
3
Hyman Minsky (1986),
Stabilizing an Unstable Economy
(New York:
Twentieth Century Fund) <
http://books.google.com/books?
id=MD3zrAe5iOYC
>; Hyman Minsky (1982),
Can “It” Happen
Again?: Essays on Instability and Finance
(New York: M.E. Sharpe)
<
http://books.google.com/books?id=dNCZAAAAIAAJ
>; Janet Yellen
(2009), “A Minsky Meltdown: Lessons for Central Bankers” (San
Francisco, CA: Federal Reserve Bank of San Francisco) <
http://
www.frbsf.org/news/speeches/2009/0416.html
>.
4
Charles Kindleberger (1978),
Manias, Panics, and Crashes: A History
of Financial Crises
(New York: John Wiley) <
http://books.google.com/
books?id=nBb-xYi9O-sC
>.
fundamentals”.
5
How is it that Walter Bagehot (1873),
Lombard Street: A
Study of the Money Market
, a book written 150 years ago
is still state-of-the-art in economists’ analysis of episodes
like the one we hope will end next year, in 2013? And
what, exactly did Bagehot say that is still useful?
There are three reasons that Bagehot (1873) still has
considerable authority:
The fi rst reason is that modern academic macroeconomics
has long possessed two drives. It has possessed a drive
toward analyzing empirical issues that can be successfully
treated statistically. It has possessed a drive toward
analyzing theoretical issues that can be successfully
modeled on the foundation of a representative agent
possessing individual rationality. These drives are often
very useful: most of the successes of modern
macroeconomics as a policy science are built on top of
them. These drives, however, become positive disabilities
5
5
See Robert Shiller (1980), “Do Stock Prices Move too Much to Be
Justifi ed by Subsequent Movements in Dividends?” (Cambridge:
NBER Working Paper 456) <
http://www.nber.org/papers/w0456.pdf
>.
The conclusion of a very long subsequent literature was that Shiller
was right: assuming that standard tools for constructing estimates of
rational expectations apply, only a small part of aggregate equity price
variation comes from revisions of rational expectations of future
dividends and earnings flows.
in analyzing episodes like major fi nancial crises. Major
fi nancial crises come too rarely for statistical tools to have
much bite. Given that a major
ex post
question asked of
wealth holders and their portfolios after a crisis is “just
what were they thinking?”, a baseline assumption of
individual rationality forecloses too many issues—as does
any assumption of a representative agent.
The second reason is that, while the causes of fi nancial
collapses are diverse, the effects are pretty much constant
across time. Since 1825 we have seen a single mechanism
transmit fi nancial distress to the real economy of
production and employment. transmission mechanism, in
the form of the flight to liquidity and/or safety in asset
holdings, and the consequences for the real economy, in the
freezing-up of the spending flow and its implications for
employment and production, looks much the same in
episode after episode. The transmission mechanism and the
consequences have typically been very similar since at least
the fi rst proper industrial business cycle in 1825.
Thus a nineteenth-century author like Walter Bagehot is in
no wise at a disadvantage in analyzing the causes and
spread of the downward fi nancial spiral, or in analyzing its
consequences for the real economy.
The basic story is simple. Through the arrival of new
information, through sheer panic, or through the effects of
6
government policies, wealth-holders lose their confi dence
that a good chunk of the fi nancial assets that they had
thought were safe, liquid stores of value and potential
means of payment are in fact safe and liquid. Such assets
thus lose their attractiveness as safe stores of value and
liquid potential means of payment. This causes wealth-
holders to attempt to dump their holdings of such now-
impaired assets to try to rebalance their portfolios with
respect to safety and liquidity. But the dumping of the now-
impaired assets makes them even less safe and less liquid.
The recognition of reality (or the simple panic) triggers an
attempted shift of portfolios in the direction of holding
more safe, liquid stores of value just at the moment that the
value of assets that count as such declines. This was the
story in 2007-9. And this was also the story in 1825-6. Thus
it is not surprising that a good analysis of 1825-6 and like
fi nancial crisis-driven downturns like Bagehot (1873) is
still a (nearly) state-of-the-art analysis of 2007-9.
Bagehot’s (1873) key insight was that expansionary
policies affect both demand for and supply of safe, liquid
stores of value. When households and businesses are
convinced that they need to hold more safe, liquid stores of
value, they will try to push their spending on currently-
produced goods and services below their incomes. But
since economy-wide incomes are nothing but spending on
currently-produced goods and services, the net effect is
only to push incomes, production, and spending down until
7
households and businesses feel so poor they forget about
building up stocks of safe, liquid stores of value.
Thus brings us to the third reason, the additional feature of
the situation that Bagehot saw back in 1873. The natural
cure for the fi nancial system and for the real economy is for
something to lead households and businesses to lower their
demand for or something to expand the supply of safe,
liquid savings vehicles. If this is accomplished so that
desired safe and liquid asset holdings at full employment
are once again equal to asset supplies, the economy will
recover. Bagehot (1873) saw aggressive expansionary
policies as desirable both to increase the supplies of the
safe, liquid stores of value that households and businesses
wish to hold and to damp down demand for such assets by
demonstrating that risks will be managed and reduced. And
those are still the policies, in many different flavors it is
true, advocated today.
Thus Walter Bagehot (1873) is remarkably close to the best
we can do, even today.
II. Aggregate Supply and Aggregate
Demand
A. Say’s Law
At the beginning of economics, back at the very start of the
8
nineteenth century, Jean-Baptiste Say (1803) wrote that the
idea of a “general glut”—of economy-wide
“overproduction” and consequent mass unemployment—
was incoherent.
6
Nobody, Say argued, would ever produce
anything beyond what they expected to use themselves
unless they planned to sell it, and nobody would sell
anything unless they expected to use the money they earned
in order to buy something else.
Thus, “by a metaphysical necessity”
7
, as John Stuart Mill
put it back in 1829, there can be no imbalance between the
aggregate value of planned production-for-sale, the
aggregate value of planned sales, and the aggregate value
of planned purchases. This is what would become “Say’s
Law”. Say pointed out that producers could certainly guess
wrong about what consumers wanted—and thus produce an
excess of washing machines when what consumers really
wanted were more yoga lessons. But, Say argued, that
would produce a clear market signal in the form of an
excess demand for and high profi ts in making commodities
short supply and an excess supply of and losses in making
commodities in surplus. The market system had the
incentive and the power to quickly iron out such
imbalances. The fact remained that planned spending had
9
6
Jean-Baptiste Say (1803),
Treatise d’Economie Politique
(Paris); Eng.
trans. Biddle <
http://tinyurl.com/dl201108b
>.
7
John Stuart Mill (1844),
Essays on Some Unsettled Questions in
Political Economy
<
http://tinyurl.com/dl201108e
>.
to equal planned production. And, in reply to those who
claimed that general depression could be produced if the
economy’s money supply was too low, Say said that
producers could and would always give credit:
to say that sales are dull, owing to the scarcity of
money, is to mistake the means for the cause....
Should the increase of traffi c require more money to
facilitate it, the want is easily supplied... merchants
know well enough how to fi nd substitutes for the
product serving as the medium of exchange or
money...
8
Thomas Robert Malthus thought at the start of the 1820s
that there was something wrong with Say’s argument.
Malthus believed that he could see the excess supply, but
not the corresponding excess demand:
[W]e hear of glutted markets, falling prices, and
cotton goods selling at Kamschatka lower than the
costs of production. It may be said, perhaps, that the
cotton trade happens to be glutted; and it is a tenet of
[Say’s and Ricardo’s] new doctrine on profi ts and
demand that if one trade be overstocked with capital
it is a certain sign that some other trade is
understocked. But where, I would ask, is there any
considerable trade that is confessedly under-stocked,
and where high profi ts have been long pleading in
vain for additional capital? The [Napoleonic] war has
now been at an end above four years; and though the
removal of capital generally occasions some partial
10
8
Jean-Baptiste Say (1855),
A Treatise on Political Economy
, Eng.
trans. Biddle <
http://tinyurl.com/dl201108b
>.