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J. Bradford DeLong
1
W
Seven Sects of Macroeconomic
Error
:
Wrong Models of the Great Recession
J. Bradford DeLong
U.C. Berkeley
March
14
, 2011
<
https://www.icloud.com/pages/0zwSkfmRDPILOSmiq0_91g5nw
>
<
https://github.com/braddelong/public-fi les/blob/master/seven-sects-of-
macroeconomic-error-2011-03-14.pdf
>
The Right Model of the Great Recession
e have spent a lot of time talking about the right model of the fi nancial
crisis that we went through in 2007-2009,
and the Great Recession that
started in 2008.
We have discussed the sources of the downturn:
irrational exuberance, overleverage, and
misregulation. Those left us at the end of
2007 with a situation in which we had built fi ve million houses extra houses—
largely in the swamps of
Florida and in the desert between Los Angeles and
Albuquerque—that simply should not have been built. On average the purchaser
took out US
$100,000 in mortgage debt that simply will never be repaid: the
buyer cannot afford it, and the house is not worth it. The end of 2007 saw $500
billion of fi nancial losses to be allocated.
In a global economy with $80 trillion worth of fi nancial wealth, a $500 billion
loss due to irrational exuberance and malinvestment should not be a big problem.
Modern, sophisticated, highly liquid fi nancial markets and originate-and-
distribute securitization to slice, dice, and spread risks means that nobody
systemically important should be ruined by an idiosyncratic risk like mortgage
defaults in the desert between Los Angeles and Albuquerque going bad. The
losses from the collapse of the dot-com communications-and-computers bubble
were an order of magnitude larger. Yet they did not create anything like our
current problem.
But irrational exuberance in the dot-com boom was not accompanied by
overleverage. The venture capital fi rms that created and issued the securities of
J. Bradford DeLong
2
the dot-com boom sold them off to unleveraged primary investors, rather than
leveraging up and holding on to them by fi nancing their positions with borrowed
money. When the dot-com crash came, high- net-worth individuals lost their
wealth. But there were no large money-2center banks whose solvency was thrown
into doubt by the crash.
Things were different with the subprime crash. The large money-center
investment and commercial banks found, after the crash, that the losses on their
subprime mortgage holdings were of the same order of magnitude as and might
exceed their capital cushion. Their other liabilities were thus no longer beyond
question—perhaps the money-center banks were not good to pay back all their
creditors and make good on all of the deposits they had accepted. This was, in
large part, the result of the third factor: misregulation—the government had failed
to impose and maintain prope
r
capital adequacy standards of those banks that
were indeed "too big to fail"; the government had failed to use its regulatory
hammer to check whether the large money-center banks possessed the proper risk
controls. It turned out that they did not: that the top managements of the money
center banks had no idea of the risks that their subordinates were running on their
shareholders' behalf.
The trap was set by what we politely call regulatory “forebearance” and what we
politely call a “lack of suffi cient risk controls” on the part of the top management
of highly-leveraged fi nancial institutions. The consequence was to transform the
liabilities of all of America's and most of Europe’s major money center banks
from safe, secure, and liquid high- quality assets to unsafe, insecure, and illiquid
low-quality assets. The result was an enormous worldwide flight to quality. A
$500 billion fundamental loss triggered a $20 trillion decline in global fi nancial
asset values as everybody dumped their risky and build up the safe assets in their
portfolios.
As John Stuart Mill knew back in 1829, whenever you have a large excess
demand in fi nance it will be mirrored by a large defi ciency in demand for
currently-produced goods and services and labor: a "general glut"—unsold
commodities in pretty much every branch of distribution and unemployed workers
in pretty much every branch of production.
That is the chain of causation that led to the great recession: a shortfall of
aggregate demand generated by a flight to quality and a shortage of high- quality
assets which itself flowed from irrational exuberance on the part of the world’s
investors, misregulation on the part of the world’s governments, and overleverage
in the world’s major banks.
J. Bradford DeLong
3
T
The point most worth making right now is this: you do not need to deal with the
deep causes in order to deal with the major problem. You do not need to eliminate
the cholera bacterium from somebody’s body in order to
keep them from dying of
cholera: what you need to do is to keep them hydrated and keep their electrolytes
in balance. Similarly, the key treatment needed for an economy in a fi nancial
crisis-caused
grand mal
seizure of unemployment is not to reform fi nance to
prevent future episodes of irrational exuberance but rather to do something to
pump up aggregate demand now.
The Right Cure for the
Great Recession
hus we have discussed the right cure for the Great Recession. One part of it,
of course, is regulatory reform. Irrational exuberance, misregulation, and
overleverage are bad things. And systems need to be designed and redesigned to
deal with them and try to prevent future episodes. But that is only one of the three
prongs that policy should pursue.
The fi rst other prong is that the government should boost its spending in order to
boost aggregate demand. It is the proper role of the government to stand up via
more spending when private sector lies down and spends less.
The second other prong is that the government should also undertake the
appropriate strategic interventions in fi nancial markets in order to boost aggregate
demand as well. If the government can provide the private sector with the
fi nancial assets it wants, then there will be no excess demand for fi nancial assets
and hence no defi ciency of demand for currently-produced goods and services and
for labor. We talked about shortages of liquid cash, of “money” (as happened in
1982 in the Volcker
disinflation, of shortages of savings vehicles, of “bonds” (as
happened in 2001 after the collapse of the dot-com bubble), and of shortages of
high- quality assets (as happened in 2008). We talked about how shortages can
arise from either a fall in supply or a rise in demand. And we talked about Say’s
(true) Law: when there is no excess demand at full employment for fi nancial
assets—whether bonds, money, or quality—there will be neither upward nor
downward pressure on production and employment.
These strategic interventions in fi nancial markets can be carried out through any
of a large number of possible mechanisms. Milton Friedman was certain that the
only mechanism you needed was standard open- market operations—purchases
and sales of short-term Treasury bonds for cash—and that the right policy to
J. Bradford DeLong
4
follow was one that kept the economy- wide money stock on a smooth growth
path. We are not no certain.
One strategic intervention is to create more savings vehicles, either by creating
more government bond directly via additional defi cit spending or through
inducing the creation of more private bonds. Defi cit spending by government—
and subsidization policies like investment tax credits to encourage private
investment by businesses, or even jawboning to create expectations of a little
more inflation in order to boost private bond
issues—create more savings
vehicles, more places for people to park their money if they want to move it from
the present into the future. To the extent that the excess demand in fi nancial
markets is an excess demand for duration, the creation of more such savings
vehicles is exactly the right thing to do.
A second strategic intervention is that the Federal Reserve can buy back bonds
from the private sector for cash, and so increase the amount of liquid cash money
in the economy. If the excess demand in fi nancial markets is an excess demand for
liquid cash money, this is exactly the right thing to do.
A third set of strategic interventions is more mushy and diffuse. The Federal
Reserve and bank regulators together can guarantee bank debt. They can take risk
onto their own books by a whole host of what we now call "quantitative easing"
measures—the purchase not just of short-term safe nominal assets but risky
assets. They can boost not the supply of savings vehicles or the supply of liquidity
but rather act to reduce the demand for and increase the supply of safety in
fi nancial markets. And since the principal origin of our problem was in the flight
to quality and the resulting excess demand for safety, it would be appropriate to
take this as the principal focus of policy right now.
In any event, when there is no excess demand at full employment for fi nancial
assets, there won’t be any downward pressure on production and employment.
That stopped the downturn. To generate a recovery we need to do a little bit more:
create an excess supply of fi nancial assets in order to generate an excess demand
for currently-produced goods, services, and labor. But we have not advanced far
along that road yet.
In the income-expenditure framework, all three of these excess demands for
fi nancial assets show up as a level of spending less than that needed to maintain
full employment.
Putting regulatory reform to one side, the needed cure can
be
accomplished via fi scal policy: ΔG. It can be accomplished via monetary and
banking policies to try to rebalance fi nancial markets.
J. Bradford DeLong
5
O
Thus we have covered, at exhaustive length, the right model of the Great
Recession.
It is true that the root problem was a derangement in the subprime
mortgage market resulting from irrational exuberance which then
triggered a
derangement in fi nancial markets more generally due to overleverage and
misregulation.
But we could fi x mass unemployment without tackling the fundamental roots of
the downturn. We just have to pull the fi scal, monetary, and banking policy levers
in such a way as to get aggregate demand back to where it should be. We can then
clean up the fi nancial mess later on. Job number one, after all, is to cure mass
unemployment rather than to fi x the fundamentals of the fi nancial system.
This is the right model for the cause and cure of the Great Recession.
Wrong Models of the Great Recession
: Why?
ur problem is that a lot of
economists claim that people like me have
gotten it wrong—that the Great Recession has another, a different cause.
I
f you go outside of this classroom out there into the great political-
economical
debate, into the scrum, you will fi nd that this position that I have been
pushing in this course—while it is certainly the dominant position, the plurality
position, the position held by the overwhelming majority of most qualifi ed experts
—it is by no means the only position out there. I say that our problem is that
misregulation, excess of leverage and irrational exuberance produced the fi nancial
crisis which then led to an aggregate
demand shortfall that we should repair as
fast as possible by properly- stimulative fi scal, monetary, and banking policies.
But there are
others whom you will fi nd saying at least seven different
things.
Four wrong “how we got here” models are currently live—or perhaps, as my
friend John Quiggin would say, undead: models that ought to have been buried
long ago, but that still shamble forward wreaking havoc.
There are those who blame our current downturn on the presence of low marginal
product workers, on the existence of structural unemployment, on the
overaccumulation of too much capital, and on uncertainty caused by government
defi cits and overregulation. And there are three more strands of thought that,
while more-or-less agnostic on the causes of the downturn, are certain that
stimulative banking and fi scal policies have no proper role to play in getting us
J. Bradford DeLong
6
out of this mess: theorists who say that fi rst priority has to go to avoiding inflation
or to avoiding the crowding- out of productive private investment, theorists who
are certain that banking and fi scal policy are never needed, and theorists who are
certain that banking and fi scal policy are never effective.
So in the rest of this lecture section, let me run through the wrong models of the
current downturn and what we should be doing about it—and let me explain why
all of these alternative positions are wrong.
Let me note that I fi nd this to be a very awkward position to be in. There is my
karass of economists—sensible, reality-based, empirically-oriented,
understanding reality. And there are seven other factions and schools of
economists out there saying very different things—things very different from
what I am saying and from what all the other economists who I believe are
carrying out sensible analyses are saying.
I fi rmly believe that I am right.
I fi rmly believe that I am right almost as fi rmly as I believe that the
sun will rise in
the east
tomorrow.
Of course, there was the
day...
I was flying back from Europe during northern hemisphere winter. We came out
of the earth's shadow into the sun somewhere north of Manitoba at local noon—so
the sun was due south of the plane as we flew into daylight. From the plane, on
that day the sun rose in front of us directly to the south.
Thus it is not certain that the sun is always going to rise in the east. In fact, I have
seen it do otherwise. Admittedly, I have seen it only in very special
circumstances: 30,000 feet up, flying due south out of the earth's shadow during
northern hemisphere winter, and at local noon.
That is an important lesson: no matter how certain you are that you are right, you
could be wrong.
Nevertheless, I will proceed...
I think that there are clear and obvious fallacies in all seven of the approaches that
I have lumped into “wrong models.”
J. Bradford DeLong
7
T
I Blame Milton Friedman
his then raises the question of why do people claim to believe in them. I am
not sure that I have the right answer. But I do have what I think is a pretty
good and likely answer. You see, I blame Milton Friedman. Why do I think it is
Milton Friedman’s fault? Because he made things much, much too simple.
Simply stabilize the money stock via open market operations, and everything will
be fi ne: there will then be no shortage of aggregate demand.
Milton Friedman thought that it was suffi cient simply to keep the money stock on
a stable growth path—that that was the only set of strategic interventions in
fi nancial markets necessary to ensure constant full employment. Why did he think
this? I believe that there are two reasons. The fi rst was that if you look from say
1980 or so back into the past, the times when the money stock is unstable are the
times when there are depressions. The times when the money stock is stable are
times when there are no depressions. You could argue whether instability in the
money stock was cause or effect of depressions. Milton Friedman thought that
instability in the money stock was cause. Others thought it was the effect. They
argued back and both. It was not clear. Of course, it is clear now: because the
Federal Reserve tried successfully to prevent a decline in the money stock in
2008, it is now clear to us that much of past money- demand correlations arose
because when demand fell the banking system came under pressure to shrink the
money stock
.
If there were good arguments on both sides, what made Friedman so
certain that instability that the money stock was the cause and not the effect? I
think the answer is that he was a committed libertarian. He was not just an
economic libertarian—not just a believer that the government shouldn’t be
interfering in the marketplace in prices and quantities and property rights. He was
a social libertarian. He was a believer that the government should not be sticking
its nose into people’s bedrooms, or into their ideas about how to pursue better
living through chemistry. He wanted to say that that government is best that
governs least: establish property rights, set up some courts to decide things if
people dispute, otherwise just get out of the way—don't interfere with market
prices or market quantities or property rights or social mores, but get out of the
way in order to maximize individual liberty.
The problem is that this does not fi t with macroeconomics. We have this circular-
flow income-expenditure system in which there are always these excess demands
for and excess supplies of fi nancial assets emerging. They carry with them either
J. Bradford DeLong
8
high unemployment or inflation. And so the government is always having to
intervene to rebalance fi nancial markets to avoid mass unemployment or inflation.
Now that is not a terribly terribly comfortable position for a libertarian to be in.
The government is constantly intervening in the money market: buying and
selling bonds and cash in order to soak up whatever excess demand or excess
supply exists in fi nancial markets. How is this a hands- off, libertarian, laissez-
faire policy?
At this point Friedman could have done either of two things. He could have said:
libertarianism is true always and everywhere except for monetary economics,
where the rules are different. He could have found a way to make his preferred
government monetary policy sound like laissez faire.
He chose the second. He said that the right monetary policy is for the government
to keep its hands off of the money stock—for the government to follow a non-
interventionist policy of letting the money stock grow at a constant rate and not
intervene in fi nancial markets to push the money stock up or down. It is a bright-
line rule. It should be easy to
follow.
I would say that it is not "non-
interventionist": whenever something happens to the banking system to make
banks want to diminish their ratio of deposits to reserves, the Friedman rule
requires that the Federal
Reserve not keep its hands off the economy but rather
that it go into the market and buy a huge amount of bonds. Why is a constant
money growth rate rule a "laissez faire" "non-interventionist" policy? It isn't—any
more than a constant kwh growth rate rule or a constant steel production growth
rate rule is a "laissez-faire" "non-interventionist"
policy.
But these are not
questions Milton Friedman wanted to answer, or even wanted to hear asked.
Instead, Friedman said: keeping the money stock growing at a constant rate is a
neutral, non-interventionist, laissez-faire policy. Forget about what all the
Keynesians over there are saying about more complicated strategic interventions.
Constant M growth is the rule.
And so Milton Friedman acquired a lot of followers behind this constant money
stock growth rule. But starting in the 1980 it becomes apparent that it’s simply not
true. Central bankers tried to follow Milton Friedman prescriptions. And they
found themselves getting into trouble. And lo and behold in 2008 they got into big
trouble, when extraordinary increases in the monetary base did not keep
unemployment from rising and kissing 10
%
.
So when it turned out that Friedman’s model was wrong, a lot of economists
J. Bradford DeLong
9
found themselves trying to think complicated issues through on the fly from
scratch.
Stabilizing the money stock via open market operations is not enough.
What happens if there is a shortage of aggregate demand due to an excess demand
for high quality assets and so i has hit zero?
People will then be holding money as
a high-quality asset rather than as a liquid asset.
And so the economy will be short
of money for transactions. Further open- market operations don’t raise the amount
of high-quality assets: they just swap one HQA for another
What happens if there is a shortage of aggregate demand due to a shortage of
savings vehicles? People will then be holding money as a savings vehicle rather
than as a liquid asset. And so the economy will be short of money for transactions.
And further open-market operations won’t raise the supply of savings vehicles
either.
Here Friedman's followers and their intellectual descendants found themselves
trapped by the rhetorical strategy Friedman had adopted in the 1950s and 1960s
and 1970s. Friedman believed that macroeconomic stabilization required that the
central bank be always in the market, buying and selling government bonds in
order to match the supply of liquid cash money to the demand, and so make Say's
Law true in practice even
though it was false in
theory.
And Friedman tried to
maximize the rhetorical distance between his position—which was merely the
"neutral," passive policy of maintaining the money stock growth rate at a constant
—and the position of other macroeconomists, which was an "activist,"
interventionist policy of having the government disturb the natural workings of
the free market. Something went wrong, Friedman
claimed,
only when a
government stepped away from the "neutral" monetary policy of the constant
growth rate rule and did something else.
It was, I think, that description of optimal monetary policy—not "the central bank
has to be constantly intervening in order to offset shocks to cash demand by
households and businesses, shocks to desired reserves on the part of banks, and
shocks to the fi nancial depth of the banking system" but "the central bank needs to
keep its nose out of the economy, sit on its hands, and do nothing but maintain a
constant growth rate for the money stock"—that set the stage for what was to
follow, and for what we see now among the seven sects of macroeconomic error
that I am taking an unconscionably long time in getting to.
Friedman's rhetorical doctrine was successful in eliminating the perception of
cognitive dissonance between normal laissez-faire policies and optimal macro
policy: both were "neutral" in the sense of the government "not interfering" with
the natural equilibrium of the market. But it did so at the cost of eliminating all
J. Bradford DeLong
10
interesting macroeconomic questions: if the government followed the proper
"neutral" policy, then there could be no macroeconomic problems. And it left his
intellectual descendants with no way to think about these issues: generations of
Chicago that had been weaned on this diet turned out to know nothing about
macro and monetary issues when they became important again.
It is in this sense, I think, that I blame Milton Friedman: he sold the Chicago
School an interventionist, technocratic, managerial optimal monetary policy under
the pretense that it was something—laissez-faire— that it was not.
And then it turned out at the end of 2008 that it simply did not work.
Now at this point the seven sects of macroeconomic error could have done either
of two things. They could have chosen wisely. They could have
said: "Oops we’ve
been followers of Milton Friedman for 50 years and we were wrong, his
intellectual opponents were right.
We
have to go back and listen to them and learn
what they had to say and change our minds.
We
need to sit at the feet of Bagehot
and Wicksell and Minsky and Keynes and Hicks and
Tobin
for a while and think
through the issues of the determinants of aggregate demand.
They chose not wisely. They chose to say: "Milton Friedman taught us that the
Keynesian version of the income-expenditure approach was wrong.
There is something wrong with Friedman's theory. But we need to develop it and
add something new rather than return to something old and discredited."
It turned out an awful lot of economists decided to follow the second road—that
of becoming Ptolemaic astronomers, of trying to add epicycle after epicycle,
adding eqants and deferents, and so forth to try to save the phenomena. And they
did so even though the standard story of demand shortfall-driven recessions that
dated back to 1829 and that in fact underpinned Friedman's version of monetarism
was still in good shape, and still perfectly adequate.
That story leaves me highly confi dent that all seven of the alternative models are
wrong. I understand how it is that people—smart people, even if not wise people
—arrived at them. And I also understand why they are wrong.
Seven Wrong Models
1.
Low Marginal Product Workers
