Paul Krugman desperately tries to suggest that economists have the answers

Despite amble evidence to the contrary, in his NY Times column, Paul Krugman made yet another attempt at arguing that economists have the answers when it comes to dealing with our current financial crisis.

I admire the man for his efforts, but the economics profession has never been able to answer the Queen's question of 'why if everything was going so well did no-one see the crisis coming'.

When there are hundreds, if not thousands, of individuals with a PhD in Economics and Finance, trotting out a handful of individuals like Bill White and saying that they saw the crisis coming does not rescue the economics profession for its failure to see the crisis coming.

What would have rescued the economics profession from this failure is its membership pointing to the fundamental principles underlying economic theory and warning about the coming crisis.

In defending the economics profession, Professor Krugman inadvertently drives home this point by highlighting how its membership cannot even agree on the fundamental principles underlying economic theory that unite its response to the financial crisis.

Your humble blogger has a confession to make.  I don't have a PhD in Economics or Finance and I am on record for having warned about the financial crisis.

Furthermore, my warning was based on the observation that the necessary condition for the invisible hand to operate properly is that the buyers have access to all the useful, relevant information in an appropriate, timely manner so the buyer can assess and make a fully informed decision.

If transparency is the necessary condition, then by definition 'opacity', 'lemons' and 'information asymmetry' are simply examples of market imperfections that need government involvement to address.

What results from recognizing that transparency is the necessary condition is a simple model of our financial system:  the FDR Framework.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

The principle of caveat emptor is needed to ensure that investors recognize they are responsible for all gains and losses on their investments and, as such, they have an incentive to use the disclosed information.

The FDR Framework easily explains our financial crisis.  All the opaque corners of the financial system froze as investors realized they could not assess what they were buying.

Examples of the opaque corners of the financial system include banks (the inter-bank lending markets froze because banks are 'black boxes' and nobody could tell which banks were solvent and which were not) and structured finance securities (these opaque, toxic securities are 'brown paper bags' where the value of the contents can only be guessed at).

Since transparency is the necessary condition for the invisible hand to operate properly and vast swathes of the financial system are cloaked in opacity, the natural suggestion is that transparency be brought to all the opaque corners of the financial system.

I would think that the need for transparency is something that everyone in the economics profession could agree on (after all, the relevance of economics is greatly reduced without the invisible hand) .  My observation is if the economics profession agrees on the need for transparency, it certainly isn't telling anyone outside the profession.

That said, back to Professor Krugman's attempt to say that the economics profession has something to say about how to respond to the financial crisis.

It’s that time again: the annual meeting of the American Economic Association and affiliates... And this year, as in past meetings, there is one theme dominating discussion: the economic crisis. 

This isn’t how things were supposed to be.

True.  Had global policymakers followed your humble blogger's suggestion to restore transparency to the financial system, the financial crisis would be over.

If you had polled the economists attending this meeting three years ago, most of them would have predicted that by now we’d be talking about how the great slump ended, not why it still continues.

These same economists didn't see the financial crisis coming so why would anyone expect them to be accurate in their prediction of its coming to an end?

So what went wrong? The answer, mainly, is the triumph of bad ideas.

Yes, yes, yes.  Leading the bad idea parade was the notion of protecting bank book capital levels and banker bonuses at all costs.  This placed the burden on the real economy of servicing the excess debt in the financial system.  Doing so diverted funds needed for reinvestment and growth.  The result is a global Japan-style economic slump.

It’s tempting to argue that the economic failures of recent years prove that economists don’t have the answers. But the truth is actually worse: standard economics offered good answers but political leaders – and all too many economists – chose to forget or ignore what they should have known....

So Professor Krugman, when are you going to start arguing for bringing transparency to all the opaque corners of the financial system?

So what can be done? A smaller financial shock, like the dot-com bust at the end of the 1990s, can be met by cutting interest rates. But the crisis of 2008 was far bigger, and even cutting rates to zero wasn’t nearly enough.

Professor Krugman, the problem we have is a bank solvency led financial crisis.  Cutting interest rates does not solve this type of crisis.

At that point governments needed to step in, spending to support their economies while the private sector regained its balance. And to some extent that did happen. Revenue dropped sharply in the slump, but spending actually rose as programmes like unemployment insurance expanded and temporary economic stimulus went into effect. Budget deficits rose, but this was actually a good thing, probably the most important reason we didn’t have a full replay of the Great Depression.

I happen to agree with Professor Krugman that there is a role for government spending when dealing with a bank solvency led financial crisis.  The role is to kickstart the economy after the banks have absorb all the losses on the excess debt in the financial system.

Government spending before the losses on the excess debt have been realized is far less effective as it has to overcome the burden of the excess debt (this is what Japan has shown for over 2+ decades).

But it all went wrong in 2010.

Actually, it all went wrong in 2008/2009 with the decision to protect bank book capital levels and banker bonuses.

In 2010, the policymakers doubled down on their bad decisions by adopting austerity.

The crisis in Greece was taken, wrongly, as a sign that all governments had better slash spending and deficits right away. 

Austerity became the order of the day, and supposed experts who should have known better cheered the process on, while the warnings of some (but not enough) economists that austerity would derail recovery were ignored. 

For example, the president of the European Central Bank confidently asserted that “the idea that austerity measures could trigger stagnation is incorrect”. 

Well, someone was incorrect all right.

And that someone wasn't Professor Krugman or myself.

Of the papers presented at this meeting, probably the biggest flash came from one by Olivier Blanchard and Daniel Leigh of the International Monetary Fund. Formally, the paper only represents the views of the authors, but Blanchard, the IMF’s chief economist, isn’t an ordinary researcher...

For what the paper concludes is not just that austerity has a depressing effect on weak economies, but that the adverse effect is much stronger than previously believed. The premature turn to austerity, it turns out, was a terrible mistake. 

I’ve seen some reporting describing the paper as an admission from the IMF that it doesn’t know what it’s doing. 

That misses the point; the fund was actually less enthusiastic about austerity than other major players. To the extent that it says it was wrong, it’s also saying that everyone else (except those sceptical economists) was even more wrong....

Your humble blogger wasn't wrong nor was I skeptical that austerity would end badly.  In fact, I argued on this blog that the only entities that should experience austerity were the banks and banker bonuses.  I argued for protecting the real economy, the social contract and society.

[I]t deserves credit for being willing to rethink its position in the light of evidence. 

The really bad news is how few other players are doing the same.

This applies across the economics profession and the global policymakers.

European leaders, having created Depression-level suffering in debtor countries without restoring financial confidence, still insist that the answer is even more pain. 

The current British government, which killed a promising recovery by turning to austerity, completely refuses to consider the possibility that it made a mistake. 

And here in America Republicans insist they’ll use a confrontation over the debt ceiling – a deeply illegitimate action in itself – to demand spending cuts that would drive us back into recession. 

The truth is that we’ve just experienced a colossal failure of economic policy – and far too many of those responsible for that failure both retain power and refuse to learn from experience.

Austerity, like bailouts, is simply a policy that flows from the choice of protecting bank book capital levels and banker bonuses.

If we are to end this colossal failure of economic policy, it is important that leading economists learn from their mistakes and highlight that there is another policy choice that has been proven successfully for ending bank solvency related financial crises:  bring transparency back to all the opaque corners of the financial system.

When transparency is brought to banks by requiring them to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, it will trigger recognition of all the losses on the excess debt in the financial system.  Banks will respond to market discipline by ending the use of 'extend and pretend' to create 'zombie' loans.

Fortunately, as the banks are absorbing these losses, they can rely on the design of a modern banking system to continue operating and supporting the real economy.  By design, banks can operate with low or negative book capital levels because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers become the banks' silent equity partners when they have low or negative book capital levels.