great moderation

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Minsky, the Lucas Critique, & the Great Moderation

Last week, I noted that the post-2008 world had provided an astonishingly good test for Milton Friedman’s notion that stabilising M2 growth was an effective antidote for economic depressions. Bernanke stabilised M2 growth, yet the depressive effects such as elevated unemployment, elevated long-term unemployment, and depressed growth still appeared, although not to such a great extent as was experienced in the 1930s. Friedman-style macro-stabilisation may have succeeded in reducing the damage, but in terms of preventing the onset of a depression Friedman’s ideas failed.

Of course, the onset of the post-2008 era was in many ways also a failure of the previous regime, and its so-called Great Moderation. Ben Bernanke in 2004 famously noted that “one of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility”.  Bernanke saw successful monetary policy as a significant reason for this stabilisation:

The historical pattern of changes in the volatilities of output growth and inflation gives some credence to the idea that better monetary policy may have been a major contributor to increased economic stability. As Blanchard and Simon (2001) show, output volatility and inflation volatility have had a strong tendency to move together, both in the United States and other industrial countries. In particular, output volatility in the United States, at a high level in the immediate postwar era, declined significantly between 1955 and 1970, a period in which inflation volatility was low. Both output volatility and inflation volatility rose significantly in the 1970s and early 1980s and, as I have noted, both fell sharply after about 1984. Economists generally agree that the 1970s, the period of highest volatility in both output and inflation, was also a period in which monetary policy performed quite poorly, relative to both earlier and later periods (Romer and Romer, 2002). Few disagree that monetary policy has played a large part in stabilizing inflation, and so the fact that output volatility has declined in parallel with inflation volatility, both in the United States and abroad, suggests that monetary policy may have helped moderate the variability of output as well.

Bernanke’s presumptive successor, Janet Yellen explained in 2009 that from a Minskian perspective, this drop in visible volatility was itself symptomatic of underlying troubles beneath the surface:

One of the critical features of Minsky’s world view is that borrowers, lenders, and regulators are lulled into complacency as asset prices rise.It was not so long ago — though it seems like a lifetime — that many of us were trying to figure out why investors were demanding so little compensation for risk. For example, long-term interest rates were well below what appeared consistent with the expected future path of short-term rates. This phenomenon, which ended abruptly in mid-2007, was famously characterized by then-Chairman Greenspan as a “conundrum.” Credit spreads too were razor thin. But for Minsky, this behavior of interest rates and loan pricing might not have been so puzzling. He might have pointed out that such a sense of safety on the part of investors is characteristic of financial booms. The incaution that reigned by the middle of this decade had been fed by roughly twenty years of the so-called “great moderation,” when most industrialized economies experienced steady growth and low and stable inflation.

Minsky’s financial instability hypothesis can be thought of as an instance of the Lucas Critique applied to macro-stabilisation. Lucas’ contribution — earlier stated by Keynes — is that agents alter their behaviour and expectations in response to policy.  By enacting stabilisation policies, policy makers change the expectations and behaviour of economic agents. In the Minskian world, the promise and application of macro-stabilisation policies can lead to economic agents engaging in increasingly risky behaviour. A moderation is calm on the surface — strong growth, low inflation — but turbulent in the ocean deep where economic agents believing the hype of the moderation take risks they would otherwise not. In a Minskian world, these two things are not separate facts but deeply and intimately interconnected. Whichever way monetary policy swings, there will still be a business cycle. Only fiscal policy — direct spending on job creation that is not dependent on market mood swings — can bring down unemployment in such a context while the market recovers its lost panache.

The march of monetarists — following the lead of Scott Sumner — toward nominal GDP targeting, under which the central bank would target a level of nominal GDP, is a symptom of Friedman’s and the Great Moderation’s failure. If stabilising M2 growth had worked, nobody would be calling for stabilising other monetary aggregates like M4 growth, or stabilising the nominal level of economic activity in the economy. Sumner believes by definition, I think, that the policies enacted by Bernanke following 2008 were “too tight”, and that much more was needed.

Of course, what the NGDP targeters seem to believe is that they can have their Great Moderation after all if only they are targeting the right variable. This view is shared by other groups, with varying clinical pathways. Followers of von Mises’ business cycle theory believe that an uninhibited market will not exhibit a business cycle, as they believe that the business cycle is a product of government artificially suppressing interest rates. Minsky’s financial instability hypothesis and its notion that stability is destabilising is a slap in the face to all such moderation hypotheses. The more successful the moderation, the more economic agents will gradually change their behaviour to engage in increasingly risky activities, and the more bubbles will form, eventually destabilising the system once again. Markets are inherently tempestuous.

Or at least that is the theory. It would be nice to see empirical confirmation that the moderation produced by Sumnerian NGDP targeting is just as fragile and breakable as the Great Moderation. Which, of course, requires some monetary regimes somewhere to practice NGDP targeting.

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Abstraction & Reality

Brad DeLong alleges that critics of fractional reserve banking and fiat money suffer from (at best) a mental disorder (or, at worst, anti-semitism).

From Brad DeLong:

I think that the deep point of view underlying von Mises’s — and von Hayek, and Marx, and Ron Paul — complaint against fiat money in general and monetary management of the business cycle in particular is this: that value comes from human sweat and toil, not from being clever. Thus it is fine for money to have value if it is 100% backed by gold dug from the earth by sweat and machines and muscles (even if there is no state of the possible future world in which people actually want to exchange their pieces of paper for the gold that supposedly backs it). But it is not fine for money to have value simply because it is useful for buying things. There is, von Mises — and Marx, and von Hayek, and Ron Paul — think, something profoundly wrong on an economic and on a moral level with procedures that create value that is not backed by, in Marx’s case, human labor, and in von Mises’s and von Hayek’s case human entrepreneurial ingenuity. And in its scarier moments some of the trains of thought emanating from this deep point of view slide over to: “good German engineers (and workers); bad Jewish financiers” (and “good Russian Stakhanovites, bad Jewish Trotskyite intellectuals”).

Now I cannot speak for any of those named, but I am a critic of aspects of fractional reserve banking, and monetary management of the business cycle.

As I wrote last month:

Fractional reserve banking… means that the money supply is not in fact determined by the central bank (or by gold miners, politicians or economists, etc) but mostly by lenders. The problem is the fragility of any such a system to liquidity crises. If 10% of investors decide to withdraw funds at the same time, banks will quickly be illiquid. If 20% of investors do, bank failures will usually pile up. The system’s stability is contingent on society’s ability to not panic.

It is my belief that this fragility has been totally overlooked. Many have fallen into the lulling notion that the only thing we have to fear is fear itself — and that that fear can be conquered by rationality. This is to ignore man’s animal nature: the unforeseen, the unexpected, and the wild (all of which occur very, very frequently in nature and markets) make humans fearful, and panicky — not by choice, but by impulse. This is the culmination of millions of years of evolution — primeval reality is unconquerable, immutable and obvious. More than half a century after Roosevelt and Keynes markets still crash, fortunes are lost, and millions of grown men and women still tremble in irrational, primitive fear.

The textbook answer to this is that a lender of last resort should fix this problem by ensuring that enough new money is disbursed into the system for it to remain liquid, and confidence regained. The recent reality, though, has been that rather than fixing the problems, policy  — both in Japan in the 1990s, and now in the West — has resulted in zombification. Governments chose to keep bad banks going. Almost all the new money the government created has gone to shore up the balance sheets of irresponsible bankers. Now those banks sit on piles of idle cash while other businesses starve or cannot get started for want of credit.

As I noted earlier:

Vast sums spent on rescue packages to keep the zombie system alive might have been available to the market to increase the intellectual capabilities of the youth, or to support basic research and development, or to build better physical infrastructure, or to create new and innovative companies and products.

Zombification kills competition, too: when companies fail, it leaves a gap in the market that has to be filled, either by an expanding competitor, or by a new business. With failures now being kept on life-support, gaps in the market are fewer.

In other words, fractional reserve banking seems to lead to fragile systems that are hard to fix when they go awry. Now, I will readily admit that perhaps I am railing against a system that I can’t change or ban. Banning fractional reserve banking, or shadow banking or the various forms exogenous money creation will probably just drive it underground. Certainly, a pure gold standard has never prevented it. Perhaps full-reserve banking or the Chicago Plan may be some kind of panacea, but these ideas remain untested.

So — for me at least — the problem is not where money comes from, or whether it is backed by gold, or backed by labour, or entrepreneurship, or the Flying Spaghetti Monster. It is the managerialists’ mundane and matter-of-fact ignorance of the depth, the richness, the randomness, and the texture of reality – not captured by models that focus solely on money. The problem for me is that I see a fragile system and I want to fix it. But I am not sure I have the tools…

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Empiricism in Economics

It has long been held that there are two kinds of economics:

  1. Rationalist economics: starting out with theses about philosophy, money and reality (etc) and using logic and reason to reach conclusions about the present and predictions about the future.
  2. Empiricist economics: starting out with data and creating mathematical models representing these data, and using these models to reach conclusions about the present, and predictions about the future.

In traditional circles, the first class tends to include the various schools of Austrian and Marxian economics, and the second class tends to include the various schools of Keynesian and Monetarist economics.

Today, I want to put an entirely new spin on empiricism in economics, by focussing away from modelling. The process of mathematical modelling is just as rationalist as using logic and reason.

Why?

Economies are nonlinear systems.

From Wikipedia:

In mathematics, a nonlinear system is a system which is not linear, that is, a system which does not satisfy the superposition principle, or whose output is not directly proportional to its input. 

Effectively, a nonlinear system is one in which mathematical modelling mostly does not work. This, in a nutshell, is the reason why professional economists within the academic system, at the Federal Reserve, and within the IMF and the World Bank are often so desperately incorrect with their predictions, as we have seen so many times in the last few years. 

This is because nonlinearity is a direct result of incomplete information. Any map or model built will not be an exact replica of reality, and as Benoit Mandelbrot showed tiny divergences in an unmodelled (or unknown) variable can result in a humungous variation in the output of the system (i.e., the economy).

So in dealing with nonlinearity the model always fails — sometimes by a fraction, and sometimes by a huge amount.  The notion of accurate modelling was famously taken to a logical conclusion by the writer Jorge Luis Borges in On Exactitude in Science:

In that Empire, the Art of Cartography attained such Perfection that the map of a single Province occupied the entirety of a City, and the map of the Empire, the entirety of a Province. In time, those Unconscionable Maps no longer satisfied, and the Cartographers Guilds struck a Map of the Empire whose size was that of the Empire, and which coin- cided point for point with it. The following Generations, who were not so fond of the Study of Cartography as their Forebears had been, saw that that vast Map was Useless, and not without some Pitilessness was it, that they delivered it up to the Inclemencies of Sun and Winters. In the Deserts of the West, still today, there are Tattered Ruins of that Map, inhabited by Animals and Beggars; in all the Land there is no other Relic of the Disciplines of Geography.

So if accurate modelling in complex dynamical systems such as economies is effectively impossible without mapping every input what hope can there be for empiricism in economics?

We have to approach it from another angle: if it is impossible to model economies in a laboratory, through equations, or in a supercomputer, the real world must be the testing-ground for ideas.

Actors in economies should be free to experiment. Good ideas should be free to succeed, and bad ones to fail. The role of the government should be to provide a level playing field for experimentalism (and enough of a safety net for when experiments go wrong) — not pick winners or “manage the economy”. People with ideas must be able to access capital so that those ideas can be tested in the market place. If experiments go badly, that is no bad thing: it just means that another idea, or system, or structure needs to be tested. People should be free to go bankrupt and start all over again with a different mindset and different idea.

The corporatist model that most nations around the world have adopted, or fallen into (i.e. “capitalism” led by governments and large corporations) is nothing like this. Small businesses struggle to access capital. Young men and women are thrown onto the scrapheap of unemployment without a chance to develop skills, or entrepreneurial ideas, or even sell their labour, and pushed into leeching off the wealth of the nation through welfare. Large banks and corporations whose business models have failed are routinely declared “infrastructurally important” or “too big to fail” and bailed out to leech off the nation.

This is not empiricism. This is a disaster. To restore society, we must restore empiricism into economies.