Monday, April 1, 2013

Olivier Blanchard: 5 lessons for economists from the financial crisis

As reported by the Wall Street Journal's David Wessel, Mr. Blanchard, the chief economist at the IMF, offered 5 lessons that economists should take away from the financial crisis.

Here are 4 of his lessons with a few comments inserted by your humble blogger who publicly predicted the financial crisis, publicly predicted what policy responses would not work to end the financial crisis and, more importantly, publicly predicted what policy response would end the financial crisis.

#1: Humility is in order. 
If there is any characteristic that is in short supply in the economics profession, it is humility.

It is one thing to consistently miss on forecasts of economic growth, it is entirely another for the profession to have effectively missed forecasting the financial crisis.

The Queen of England asked a simple question that the economics profession still has no answer to: how if everything was going so well did no-one see the financial crisis coming.

Yes, there were a handful of economists like William White, Dean Baker and Paul Krugman who argued that subprime mortgages could be a problem.  However, these economists were dismissed by the profession because, while their analysis was correct, it was not linked to any economic theory about how the financial system operates.

Regular readers know that your humble blogger developed the FDR Framework with its combination of the philosophy of disclosure with the principle of caveat emptor (buyer beware) to show the link between a series of predictions based on opacity and the invisible hand of economic theory which only operates properly in the presence of transparency.

Before turning to the second lesson, let me repeat that humility is in short supply in the economics profession.

Given my track record, one would expect the economics profession, including those in a regulatory or academic environment, to pay attention and embrace what I am saying.

Clearly, track records don't matter.  Numerous economists, including many Nobel prize winners and central bankers, continue to pound the table in what appears to be a defense of their PhD dissertations as they push solutions that will not end the financial crisis.
#2: The financial system matters — a lot. 
It’s not the first time that we¹re confronted with [former U.S. Defense Secretary Donald] Rumsfeld called “unknown unknowns,” things that happened that we hadn’t thought about.
Actually, there is no excuse for the economics profession not to have thought about transparency as it is the necessary condition for the invisible hand and the markets to operate properly.
There is another example in macro-economics: 
The oil shocks of the 1970s during which we were students and we hadn’t thought about it. It took a few years, more than a few years, for economists to understand what was going on....
Please re-read the highlighted text as Mr. Blanchard has suggested that it will take years for economists to understand what was going on that led to the financial crisis.  However, this has not stopped them from offering up their solutions to how to end the financial crisis.

What hubris!

If you did not predict the financial crisis, it is highly unlikely that you have any insights into what caused the problem and what it will take to fix.  Doesn't it make sense under this condition not to offer up an uninformed opinion or, at a minimum, to confess a lack of understanding?
This is different. 
What we have learned about the financial system is that the problem is in the plumbing and that we have to understand the plumbing....
The problem is not the plumbing!!!

The problem is opacity which has plugged up the plumbing.

Apparently the entire economics profession suffers from amnesia and has already forgotten the term "opaque toxic securities" or the Bank of England's Andrew Haldane calling banks "black boxes".
In the financial system, a myriad of distortions or small shocks build on each other. When there are enough small shocks, enough distortions, things can go very bad.
When there is enough opacity in the financial system, things can go very bad.
This has fundamental implications for macro-economics. We do macro on the assumption that we can look at aggregates in some way and then just have them interact in simple models. I still think that¹s the way to go, but this shows the limits of that approach. When it comes to the financial system, it¹s very clear that the details of the plumbing matter.
Actually, it is transparency alone that matters.

The only question that economists need to concern themselves with is do market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

If the answer is yes, then the plumbing in the financial system is operating properly.

If the answer is no, then the plumbing is plugged and economists need to call attention to the problem.
#3 Interconnectedness matters.
Interconnectedness does not matter unless you are a banker trying to preserve their bonus!!!

As I have written about numerous times, the global financial system is based on the FDR Framework and this framework makes each market participant responsible for the losses on all their exposures.

This responsibility causes market participants to do two things.

First, market participants have an incentive to use the information disclosed under transparency to independently assess the risk of each of their investments.

Second, investors have an incentive to limit each of their exposures to what they can afford to lose given the risk of the investment.  It is this activity that ends financial contagion and the threat of interconnectedness.
#4 We don’t know if macro-prudential tools work. 
It’s very clear that the traditional monetary and fiscal tools are just not good enough to deal with the very specific problems in the financial system. This has led to the development of macro-prudential tools, which what may or may not become the third leg of macroeconomic policies. 
[Macroprudential tools allow a central bank to restrain lending in specific sectors without raising interest rates for the whole economy, such as increasing the minimum down payment required to get a mortgage, which reduces the loan-to-value ratio.] 
In principle, they can address specific issues in the financial sector. If there is a problem somewhere you can target the tool at the problem and not use the policy interest rate, which basically is kind of an atomic bomb without any precision. 
The big question here is: How reliable are these tools? How much can they be used? The answer — from some experiments before the crisis with loan-to-value ratios and during crisis with variations in cyclical bank capital ratios or loan-to-value ratios or capital controls, such as in Brazil — is this: They work but they don’t work great. 
People and institutions find ways around them. In the process of reducing the problem somewhere you tend to create distortions elsewhere.
Macro-prudential tools are dangerous for another reason.  They represent the substitution of regulators for market discipline.

As Mr. Blanchard observes, macro-prudential tools are suppose to deal with problems in the financial system such as too high loan to value ratios for mortgages.

Since each market participant is responsible for the losses on their investments, it is their choice as to how much exposure they want to mortgages with high loan to value ratios.  Naturally, there is a limit to their appetite.

Macro-prudential regulation suggests that regulators know where to set the limit better than market participants.

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