"A Missing Macroeconomic Playbook?"

Brad DeLong gives an example of what economic historians and economic history has to contribute to the understanding of and response to financial crises:

A Missing Macroeconomic Playbook?, by Brad DeLong: I am reminded of the extraordinary gulf between economics as I see it and economics as at least some others see it when I read things like Narayana Kocherlakota's opening paragraph:

Modern Macroeconomic Models as Tools for Economic Policy: I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world. In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not. Of course, from a longer view, macroeconomists let policymakers down much earlier, because they did not provide policymakers with rules to avoid the circumstances that led to the global financial meltdown...

My reaction to this is the old one: "Huh?!"

For "macroeconomics" did and does have a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances. The playbook was first drafted back in 1825, during the bursting of Britain's canal bubble.

Let me briefly set out what the macro playbook is, and how it has been developed by economists and policymakers over the past 185 years. Start with Say's or Walras's Law: the circular flow principle that everybody's expenditure is someone else's income--ands everyone's income is somebody else's expenditure. It has to be that way...

How, then, can you have a depression--a "general glut," a situation in which there is excess supply of not one or a few but all commodity goods and services? How can you have a situation in which workers laid off from shrinking industries where demand is less than was expected and thus less than supply are not rapidly hired into industries where demand is more than was expected and hence more than supply?

Moral philosopher, libertarian, colonial bureaucrat, feminist, public intellectual, and economist John Stuart Mill put his finger on the answer in a piece he published in 1844:

[T]hose who have... affirmed that there was an excess of all commodities, never pretended that money was one of these commodities.... [P]ersons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute. In extreme cases, money is collected in masses, and hoarded; in the milder cases, people merely defer parting with their money, or coming under any new engagements to part with it. But the result is, that all commodities fall in price, or become unsaleable...

Mill was thus explicitly refuting the older French economist Jean-Baptiste Say. ... In 1821 Say published his Letters to Mr. Malthus, in which he argued that the very idea of a "general glut" was self-contradictory, for the very fact that commodities had been produced meant that there was sufficient demand in aggregate to buy them...

Say was thus the first of a long line of economists to argue that the fact that something that appeared to exist in reality could not really be there because it was inconsistent with his theory.

In a normal microeconomic case of market adjustment--excess supply of one good and excess demand for another--it is clear how adjustment proceeds. Those entrepreneurs making the good in excess supply find themselves selling for less than their costs and so losing money. They cut back on the wages they pay and dismiss workers. But this is not a tragedy, because the profits they have lost have gone into the pockets of entrepreneurs in expanding industries, who are eager to expand production, raise wages, and hire more workers. After a short time the structure of production is better-suited to make what people want, and wages and profits in total are higher than if the structure of production had remained frozen in its old pattern.

But what if there is a general glut of commodities? What if the excess supply is for pretty much all goods and services, and the excess demand is for liquid cash or for safe investments that will not lose their value no matter what? How do you expand labor employed in the liquid cash-creating or in the AAA asset-creating businesses to make more of such assets?

One possibility is to rely on the private sector, saying: risky assets are at a discount and safe assets a premium? Good!

Make the profits from creating safe assets large enough, and Goldman Sachs and company will find a way. ... They will hire people to shuffle the papers. They will finance enterprises, and then slice and dice the cash flows from those enterprises in order to create lots of AAA-rated securities. And when they do, the excess demand for safe assets will be satisfied...

Oh.

You say nobody trusts Goldman Sachs or Standard and Poor's when they say: "we know we lied last time when we warranted that the assets we were selling were AAA, but this time for sure!!"? Well, how about investing abroad? There are still lots of AAA assets out there in the wider world. Suppose everybody devalues, puts people to work in newly-competitive export industries, and thus runs an export surplus and, in exchange, imports AAA assets from abroad for our savers and investors to hold.

Oh.

I see. Everybody can't devalue at once. Greece can run an export surplus only if Germany is willing to run an import surplus. The United States can boost its net exports only if China shrinks its own.

Maybe we could ship millions of our citizens to South Africa equipped with picks and shovels and put them to work as gastarbeiteren mining the gold of the Witwatersrand?

I know! Let's cut the price of every good and service by 25%! Then our same stock of nominal AAA assets will meet a 33% larger demand for real AAA assets, and there will be no excess demand for safe assets, and thus no excess supply of goods and services! The problem with this "solution" is that "money" is not just a medium of exchange and a store of value, it is also a unit of account. ... A lot of people have debts denominated in money and were counting on selling their goods and their labor at something like their previous prices to pay off their mortgages, their loans, and their bonds. A whole bunch of assets that were AAA before the decline in the price level are no longer AAA. You haven't fixed the imbalance. Each nominal AAA asset does indeed satisfy a larger slice of demand for real AAA assets as a result of the price-level decline. But the price level decline has shrunk the (nominal) supply of AAA assets just as it has shrunk the (nominal) demand for them. And how have you managed to reduce nominal wages and prices? By years if not decades of idle capacity and high unemployment.

Oh.

So now--drumroll--it is time to pull the rabbit out of the hat. The solution is... the government! The government has the power to tax! And so the government can make AAA assets when nobody else can!

Or the government can until and unless the assets that it has created for others to hold--which are its debts--rise to the point where people begin to get nervous about whether the government's taxing power will actually be deployed in the end to repay those debts--and we in the United States are still very far from that point (although we in Greece are not).

The first and easiest way for the government to create more safe assets is for the central bank to create them by buying up risky assets for safe ones via open-market operations or lending cash and taking other, riskier assets as its sole security. As Walter Bagehot wrote about the Panic of 1825:

The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. 'We lent it,' said Mr. Harman... [one of the Directors] of the Bank of England:

by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power...

Since the fall of 2007 the central banks and the Treasuries of the world have been following this playbook. They have expanded the supply of safe assets via open-market operations... They have topped up bank capital. They have guaranteed private-sector loans. They have swapped in risky private-sector debt in exchange for government bonds. They have--via expansionary fiscal policy--printed up huge honking additional tranches of government bonds and used the money raised to pull forward government spending and push back taxes.

Now it may be that we are creeping up on the point at which government debts are rising to the limits of politically-limited debt capacity. But that does not mean that the playbook comes to an end. Indeed, Ricardo Caballero is writing a new chapter about how even now governments can go on:

expanding the real supply of AAA assets.... [So far] governments in safe-asset-producing countries [have] produce[d] a lot more of them.... [We could also] let the private sector create the AAA assets... [with] governments... absorb[ing]... risk the private sector cannot handle... Currently the focus (implicitly) is [still] on the former strategy. ... However... at some point it will make sense to decouple fiscal deficits from asset production.... The US Treasury... [could] start buying riskier private assets rather than running fiscal deficits as the counterpart for its supply of Treasuries to the market.... [A] sounder medium-term strategy than the purely public approach... [is to use] the securitisation industry... [I]f the government only provides an explicit insurance against systemic events to the micro-AAA assets produced by the private sector, we could have a significant expansion in the supply of safe assets without the corresponding expansion of public debt...

by formalizing and making explicit what Charles Kindleberger always called their commitment to act as lender of last resort when systemic risk came calling.

The playbook is old and well-established, and has been put to effective use.

That Narayana Kocherlakota and company did not know it existed--that he and his circle had never studied Kindleberger and Minsky, let alone Fisher and Bagehot and Mill, and knew Keynes and Hicks only as straw men to be ritually denounced as sources of error rather than smart people to be listened to--will doubtless appear to future generations as an interesting episode in the history of political economy. But nobody should confuse the failure of Kocherlakota's branch of macroeconomics with the failure of macroeconomics in general.

It's interesting that as we add the appropriate tweaks to modern models and then ask them these questions, in most cases the old wisdom emerges as the answer.

I'm not sure that, in general, people were as unaware of this work as Brad implies. In some cases that was true, certainly, particularly given the fading attention to economic history within economics programs. But some programs still emphasize economic history, e.g. Berkeley,, and I'd hope Brad's students have been made aware of this work.

So it wasn't complete ignorance. But those who did know about this work discounted it. They found a way to argue that we had moved on from old models for good reason, that taking such advice from the past would be a step backwards. It was the arrogance that the present had nothing to learn from the past as much as ignorance of what the past had to say that caused policymakers to respond to the crisis with a deer in the headlights, "oh no my models have nothing to say about this," manner. After all, if the proponents of modern macro had thought there was something to be learned from the Kindlebergers and Bagehots of the past, then those who were ignorant of what they had to say would have already read and absorbed this work. The fact that they didn't gives an indication of the value they thought it had. Hopefully that assessment has changed.