Finance in the 21st Century
A Crisis of Understanding
Robert J. Shiller
|
|
|
|
NEW HAVEN – Few economists predicted the current economic crisis, and there is little agreement among them about its ultimate causes. So, not surprisingly, economists are not in a good position to forecast how quickly it will end, either.
Of course, we all know the proximate causes of an economic crisis: people are not spending, because their incomes have fallen, their jobs are insecure, or both. But we can take it a step further back: people’s income is lower and their jobs are insecure because they were not spending a short time ago – and so on, backwards in time, in a repeating feedback loop.
It is a vicious circle, but where and why did it start? Why did it worsen? What will reverse it? It is to these questions that economists have been unable to offer clear answers.
The state of economic knowledge was just as bad in the Great Depression that followed the 1929 stock market crash. Economists did not predict that event, either. In the 1920’s, some warned about an overpriced stock market, but they did not predict a decade-long depression affecting the entire economy.
Late in the Great Depression, in August 1938, an article by Ralph M. Blagden in The Christian Science Monitor reported an informal set of interviews with US “professors, banking experts, union leaders, and representatives of business associations and political factions,” all of whom were given the same question: “What causes recessions?” The multiplicity of answers seemed bewildering, and did not inspire confidence that anyone knew what was causing the deepest crisis of capitalism.
The causes given were “distributed widely among government, labor, industry, international politics and policies.” They included misguided government interference with markets, high income and capital gains taxes, mistaken monetary policy, pressures towards high wages, monopoly, overstocked inventories, uncertainty caused by the reorganization plan for the Supreme Court, rearmament in Europe and fear of war, government encouragement of labor disputes, a savings glut because of population shrinkage, the passing of the frontier, and easy credit before the depression.
Although economic theory today is much improved, if we ask people about the cause of the current crisis, we will mostly get the same answers. We would certainly hear some new ones, too: unprecedented real-estate bubbles, a global savings glut, international trade imbalances, exotic financial contracts, sub-prime mortgages, unregulated over-the-counter markets, rating agencies’ errors, compromised real-estate appraisals, and complacency about counterparty risk.
More likely than not, many or most of these people would be mostly or partly right, for the economic crisis was caused by a confluence of many factors, the chance co-occurrence of a lot of bad things, which pushed the financial system beyond its breaking point. At that point, the trouble grabbed widespread attention, destroyed public confidence, and set in motion a negative feedback loop.
Our attention, after all, is naturally drawn to the worst events. Precisely because the worst events are statistical outliers, their causes are probably multiple.
Consider the question of predicting events like the January 2010 earthquake in Haiti, which killed more than 200,000 people. It captured our attention because it was so bad in terms of lives and property damage. But if one went beyond trying to predict the occurrence of earthquakes to predicting the extent of the damage, one could surely devise a long list of contributing factors – including even political, financial, and insurance factors – that resembles the list of factors that caused the global economic crisis.
Indeed, the crisis knows no end to the list of its causes. For, in a complicated economic system that feeds back on itself in many ways, events that start a vicious cycle might be as seemingly trivial as the proverbial butterfly in the Amazon, which, by flapping its wings, sets off a chain of events that eventually results in a far-away hurricane. Chaos theory in mathematics explains such dependency on remote and seemingly trivial initial conditions, and explains why even the extrapolation of apparently precise planetary motion becomes impossible when taken far enough into the future.
Weather forecasters cannot forecast far into the future, either, but at least they have precise mathematical models. Massive parallel computers are programmed to yield numerical solutions of differential equations derived from the theory of fluid dynamics and thermodynamics. Scientists appear to know the mechanism that generates weather, even if it is inherently difficult to extrapolate very far.
The problem for macroeconomics is that the types of causes mentioned for the current crisis are difficult to systematize. The mathematical models that macroeconomists have may resemble weather models in some respects, but their structural integrity is not guaranteed by anything like a solid, immutable theory.
The most important new book about the origins of the economic crisis, Carmen Reinhart’s and Kenneth Rogoff’s This Time Is Different , is essentially a summary of lessons learned from virtually every financial crisis in every country in recorded history. But the book is almost entirely non-theoretical. It merely documents recurrent patterns. Unfortunately, in 800 years of financial history, there is only one example of a really massive worldwide contraction, namely the Great Depression of the 1930’s. So it is hard to know exactly what to expect in the current contraction based on the Reinhart-Rogoff analysis.
This leaves us trying to use patterns from past, dissimilar crises to try to infer the likely prognosis for the current crisis. As a result, we simply do not know if the recovery will be solid or disappointing.
Robert Shiller, Professor of Economics at Yale University and Chief Economist at MacroMarkets LLC, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
You might also like to read more from Robert J. Shiller or return to our home page.
|
|
wauch 12:21 13 Mar 10
I find it amazing that all the theory and practice underlying capitalism and brought to us by idealogues - dressed as scientists - NOT scientists can fail so often, with such velocity and flair yet many who write on this site and elsewhere continue to support capitalism in all it's glory and across-the-board. Yet, one researcher (a true scientist) is over zealous with his predictions about the Himalayan glaciers and the whole world is ready to pillory the empirically-based concept of climate change.
The quote below is from a recent article in The Economist "An anthropologist on the run" January 28th, 2010. It basically summarizes what capitalism has done for society and what will happen to the have-nots if the haves continue to ignore the data with respect to climate change.
Thus Thomas Jefferson’s mandate to pursue happiness “falls like kerosene on the torch of liberty”, warming many but “scorching and blinding” countless others.
peterp 04:20 16 Mar 10
"The most important new book about the origins of the economic crisis . . . "
Actually, the two most important books for understanding the curent crisis are both old: Charles Kindleberger's Manias, Panics and Crashes, arnd Hyman Minsky's Stabilizing an Unstable Economy.
It's not actually rocket science.
,
superb 06:13 16 Mar 10
Macroeconomics’ problem might be “that the types of causes mentioned for the current crisis are difficult to systematize.” But there is one advantage that economists have over scientists. An economic forecast is in itself a force influencing the outcome and unlike weather forecasts, it can generate a full-blown domino effect.
Although economists could not, in their majority, predict how deep the crisis could become in the US, and how the rest of the world could be affected, a number economists had been (since January 2008) talking themselves into a self-fulfilling prophecy that was recession.
It is possibly a self-fulfilling prophecy just like the one mentioned in your book “Irrational Exuberance”: enough people believe in an idea and it becomes mainstream thinking (or conventional wisdom as you put it). It is based on similar hunches...reinforced by news media.
dhlii 02:58 17 Mar 10
The hard part is recognizing the causes of a future downturn before the downturn. the downturn itself as well as increased unemployment, decreased wages and prices, increased savings, ... are all symptoms not causes. Human systems fail catastrophically when external forces push people/markets to move unnaturally in a single direction. When the visible hand presses on the scales the invisible hand restores balance.
FFTMMFA 12:00 17 Mar 10
There is an interesting point here, on which it would be great to hear Shiller's further thoughts. He makes the interesting analysis of the recent earthquake in Haiti. As with earthquakes, our models do not yet allow us to predict when an economic crisis will occur. And even if we could, that would not be the most important information. The most important information is knowing how a country, region or city will handle the carastrophe when it does strike, which it inevitably will. The inference is thus that economics should be refocused on providing economic "health checks." As there systemic vulnerabilites in an economy's ability to weather a crisis may be similar to the same characteristics that bring on a crisis, this practice if rigorously carried out may prove preventitive too.
FFTMMFA 12:52 17 Mar 10
@dhlii:
There can be no invisible hand with government, they always create distortions. And at the same time, the market needs them too. Read Milton Friedman more closely and you'll see that the great free market economist himself calls on governments to correct disequilibrium situations.
dhlii 07:08 17 Mar 10
FTMMFA;
I have read Hayek rather than Friedman. My argument is that the recession/depression is the action of the invisible hand correction for the distortion of the invisible hand. I am not familiar with Friedman's arguments for government action but within the classical liberal tradition the rationale for government intervention must be non-economic - and must accept that the economic effects of government action will be net negative. Rather that correcting dis-equalibrium, government needs to pay more attention to not creating it.
Haiti and Chile should provide lessons. Disasters natural or otherwise can occur anywhere, and anytime. The impact of the disaster is more closely tied to the existance and strength of the institutions.
Evelyn 05:07 27 Mar 10
Here's my theory--I think that when a market is over-heated, what is ratinal for each individual is irrational for the group as a whole. It is like being in a crowded theatre that has caught on fire. For each individual, the best thing to do is to run to the exit as quickly as possible, but if everyone does that, it will ruin the chances of escape for everyone. When house prices were rising by the day, when banks could sell a mortgage on to someone else, when everyone was making money by doing thingts that they knew were crazy, there is no way a rational person, guided by the need to maximize her own profit, can sit it out. Any money manager who wasn't investing in crazy stuff was losing money for his clients. So everyone is somehow forced to act in a way that is ultimately destructive--unless there is a power higher than individual financial self-interest to stop them.
Does anyone remember the movie "They Shoot Horses Don't They?" IN that dance contest, held in the depression years, competitors were forced to dance faster and faster because everyone else had to because whoever danced fastest would win--although if everyone had slowed down it would have been better for all of them.
Without effective counter-pressure from something outside the market, every market will self-destruct.
dhlii 11:25 28 Mar 10
Evelyn;
I think you are looking at the wrong end of the problem. First there i increasing evidence that the majority of people do not panic nearly as often as we beleive, nor enmasse, under dire circumstances. Most tragic fires kill large numbers because - exiting is inaddequate or worse exits are locked, the fire spreads fast, and most people are killed by smoke long before the fire gets them.
What was the rational response to circumstances in early fall 2008 ? I wish I had been wise enough to sell all the stock I owned in a panic, and bought it back in January 2009.
Regardless, most of what home buyers, banks, markets, were doing throughout this was a rational response to circumstances.
The fundimental problem was not that risky mortgages were being written - both good and bad business decisions are made everyday, and the vast majority of businesses can survive a number of small mistakes.
The key issue was that everyone was moving in the same direction.
Government put its thumb lightly and deliberately on the scales. The result was exactly as desired, but the unintended consequence was a small shift in the distribution of risk. Compound something small over enough years and it becomes large. A separate but related unintended consequence increased the cost of housing a small amount more than would have occured otherwise. Again compounded over several years. The Feds monetary policies did not help. It is even possible that if the Fed had acted early to burst the housing bubble the carnage might have been reduced.
Further, business mostly responded rationally to all of this. Banks changed from writing and holding to writing and selling mortgages. Mortgages were "securitized" to distribute risk - though distributing was confused with reducing. Banking rules encouraged using securities for capitol, and compounded the error by misvaluing the securities. Banks did not actually become insolvent, they became illiquid.
Markets are people, and they make mistakes - everyday. sometimes ones that are individulally catastophic. But creating the amplifying feedback system that causes the artificial or exagerated booms that devestate when they burst requires the external force of government.
Evelyn 02:57 31 Mar 10
dhli: Markets are people, and they make mistakes - everyday. sometimes ones that are individulally catastophic. But creating the amplifying feedback system that causes the artificial or exagerated booms that devestate when they burst requires the external force of government.
Markets are people and poeople make mistakes--agreed. But the effect was not caused or exacerbated by government interference. On the contrary, if the government had played the role of grown-up in a room full of 3-year-olds, they could have prevented the worst effects of market forces. Evidence? Well, from 1932 to the 2000s, the government had controls that prevented serious crises. And when those controls were lifted, we are right back to the latter part of the 19th and early part of the 20th century--crisis and disaster.
georgeNaing 10:12 04 Apr 10
(1) Richard Feyman once remarked that if we can't make a topic understandable to freshmen, we don't really understand it.
(2) Software project managers have already given up "long term" estimation, planning etc.
(3) Once Konosuke Matsushita was asked how he predicted so well. He replied by noting this bservation: It was the oned with good eyse who fall badly, but the blind seldom fall so badly.
I hope this realization at least will keep the policy makers honest and humble.
george kyaw naing
dhlii 08:56 05 Apr 10
Evelyn;
Get beyond the fallacious grade school versions history. Capitolism has existed for 1/4 of a millenium. During that time humanity has improved more by every measure than during the entire rest of history. The only economic distinction of consequence between the 19th and early 20th centuries and 1932-2000, is the introduction of inflation - which can only be caused by governments. There is a great deal of disagreement on the causes and cures of the grat depression - but I am not aware of anyone credible who still attributes its causes to the market or its cure to the progressive policies of Hoover and FDR. Nor am I aware of anyone who does nto attribute the economic mess of the late 60's through the 70's solely to government.
Within the past thirty years the improvement in the standard of living worldwide has been phenominal. The greatest improvements have been in those countries with the greatest decrease in government economic control. followed by countries that have the least government economic control.
The capitolist world has great disparity, but solely measured by the state of the poor one would chose to eschew government.
Much of what Adam Smith told us 250 years ago is still true. The political and economic outcome of Free Markets are most pronounced and positive at the bottom. The real objective of government interference is supressing upward mobility and preserving the status quo.
But don't take my word for anything. Check out worldwide standards of living, how, when and where they have improved - rather than accept some doctrinaire version of history given to you by others.
Rather than persuing policies that make us feel good, maybe we should chose those that have actually worked.
utilitus 10:17 12 Mar 10
Good God, man, flee for sanctuary on the higher ground of the other social sciences & technologies. Real progress will be made when money and its' use are electronic and integrated with empirical models which provide an alternative to current concepts and the institutions they support. An information utility that optimizes social outcomes rather than gross production, consumption and profit may well disintermediate the actors central to both contemporary capitalism and its' instability.