Monday, November 24, 2014

The Perils of Prophecy

BERKELEY – We economists who are steeped in economic and financial history – and aware of the history of economic thought concerning financial crises and their effects – have reason to be proud of our analyses over the past five years. We understood where we were heading, because we knew where we had been.

In particular, we understood that the rapid run-up of house prices, coupled with the extension of leverage, posed macroeconomic dangers. We recognized that large bubble-driven losses in assets held by leveraged financial institutions would cause a panicked flight to safety, and that preventing a deep depression required active official intervention as a lender of last resort.

Indeed, we understood that monetarist cures were likely to prove insufficient; that sovereigns need to guarantee each others’ solvency; and that withdrawing support too soon implied enormous dangers. We knew that premature attempts to achieve long-term fiscal balance would worsen the short-term crisis – and thus be counterproductive in the long-run. And we understood that we faced the threat of a jobless recovery, owing to cyclical factors, rather than to structural changes.

On all of these issues, historically-minded economists were right. Those who said that there would be no downturn, or that recovery would be rapid, or that the economy’s real problems were structural, or that supporting the economy would produce inflation (or high short-term interest rates), or that immediate fiscal austerity would be expansionary were wrong. Not just a little wrong. Completely wrong.

Of course, we historically-minded economists are not surprised that they were wrong. We are, however, surprised at how few of them have marked their beliefs to market in any sense. On the contrary, many of them, their reputations under water, have doubled down on those beliefs, apparently in the hope that events will, for once, break their way, and that people might thus be induced to forget their abysmal forecasting track record.

So the big lesson is simple: trust those who work in the tradition of Walter Bagehot, Hyman Minsky, and Charles Kindleberger. That means trusting economists like Paul Krugman, Paul Romer, Gary Gorton, Carmen Reinhart, Ken Rogoff, Raghuram Rajan, Larry Summers, Barry Eichengreen, Olivier Blanchard, and their peers. Just as they got the recent past right, so they are the ones most likely to get the distribution of possible futures right.

But we – or at least I – have gotten significant components of the last four years wrong. Three things surprised me (and still do). The first is the failure of central banks to adopt a rule like nominal GDP targeting or its equivalent. Second, I expected wage inflation in the North Atlantic to fall even farther than it has – toward, even if not to, zero. Finally, the yield curve did not steepen sharply for the United States: federal funds rates at zero I expected, but 30-Year US Treasury bonds at a nominal rate of 2.7% I did not.

The failure of central banks to target nominal GDP growth remains incomprehensible to me, and I will not write about it until I think that I have understood the reasons. As for wages, even with one-third of the US labor force changing jobs every year, sociological factors and human-network ties appear to exercise an even stronger influence on the level and rate of change – at the expense of balancing supply and demand – than I would have expected.

The third surprise, however, may be the most interesting. Back in March 2009, the Nobel laureate Robert Lucas confidently predicted that the US economy would be back to normal within three years. A normal US economy has a short-term nominal interest rate of 4%. Since the ten-year US Treasury bond rate tends to be one percentage point above the average of expected future short-term interest rates over the next decade, even the expectation of five years of deep depression and near-zero short-term interest rates should not push the 10-Year Treasury rate below 3%.

Indeed, the Treasury rate mostly fluctuated between 3% and 3.5% from late 2008 through mid-2011. But, in July 2011, the ten-year US Treasury bond rate crashed to 2%, and it was below 1.5% at the start of June. The normal rules of thumb would say that the market is now expecting 8.75 years of near-zero short-term interest rates before the economy returns to normal. And similar calculations for the 30-year Treasury bond show even longer and more anomalous expectations of continued depression.

The possible conclusions are stark. One possibility is that those investing in financial markets expect economic policy to be so dysfunctional that the global economy will remain more or less in its current depressed state for perhaps a decade, or more. The only other explanation is that even now, more than three years after the US financial crisis erupted, financial markets’ ability to price relative risks and returns sensibly has been broken at a deep level, leaving them incapable of doing their job: bearing and managing risk in order to channel savings to entrepreneurial ventures.

Neither alternative is something that I would have predicted – or even imagined.

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    1. CommentedXuan Han

      There seem to be many critical comments addressed towards this paragraph. Yet, upon closer examination, most of the aggressive, critical comments does not even have the slightest clue of who some of these economists are and their academic beliefs.

      Many readers have their eyes completely fixated on the mention of Mr. Krugman. Many seem to perceive his name as being the representative agent for the rest of the mentioned economists. This perception is erroneous and mis-lead.

      Although most of Mr. De Long's list of good blogging friends are pro-stimulus, pro-monetary expansion, many of them are incredibly pragmatic in their economic work. Two names worth highlighting are Kenneth Rogoff and Carmen Reinhart, who happens to be leading authors in the study of debt. A publication written by the two authors, "debt overhang:past and present" (, offers a clean and pragmatic view of high deficit spending. Their hardly coincides with the view-point of Mr. Krugman; if anything, Rogoff's work on debt goes directly against some of Mr. Krugman's short-run perceptions.

    2. Commentedprashanth kamath

      "trust those who work in the tradition of Walter Bagehot, Hyman Minsky, and Charles Kindleberger. That means trusting economists like Paul Krugman, Paul Romer, Gary Gorton, Carmen Reinhart, Ken Rogoff, Raghuram Rajan, Larry Summers, Barry Eichengreen, Olivier Blanchard, and their peers. Just as they got the recent past right, so they are the ones most likely to get the distribution of possible futures right."

      - So what are you now, Gangs of New York?

      Let me get you a view from the street. We are better off approaching an astrologer with a macroeconomic problem than one of so called economists.

      You chaps remind me of my high school kids cricket match. Both the opposing teams keep score, fudge them and declare that they have won!

      Hmm. I think I have a better solution. Why don't we put some money and efforts on our police force and clear our macroeconomic streets of gangs that prowl them?

    3. CommentedZsolt Hermann

      It is a positive article considering its honesty at the end.
      On the other hand unfortunately it is totally irrelevant if an economist, financial analyst, politician or any present day leader is well rooted in history, or previous and present methods, or not.
      One of the greatest problem those who try to find a solution face today is that our global situation is unprecedented. We have no historical experience for it, and we definitely have no methods that can handle it.
      Among the multiple reasons why we have no historical experience and any foundation to rely, on here are the two main ones:
      1. We never had a completely interconnected and interdependent human system, where it is impossible to disconnect even the action of the smallest faraway country, market or even individual from the fate of any other part of the network. The whole network moves, works in unison as a single living organism. All previous methods based on competition, fragmentation, polarized worldview have become obsolete.
      2. The whole economic model the western world, and as a result all other emerging market areas (regardless of governing structure) based their lives on, was built on an illusion. There is no long term possibility for constant quantitative growth in a closed finite system. It is unsustainable and as we reached the boundaries of our closed finite system our whole structure has turned destructive. We have been living way beyond our necessities and our resources, brainwashing each other into chasing artificially generated desires, useless, excessive and harmless products which in turn made us unhappier and emptier than we have ever been.
      Thus the first step towards any resolution is throwing away all our historical knowledge and experience and a completely new start. But this time not one based on dreams and illusions, but on the exact, scientific research of our global, integral, interdependent system.

    4. CommentedAnthony Banks

      A few years back, a handful of people surveyed the state of the US housing market, consulted freely available government statistics, got out their calculators, and drew what were to them stunningly obvious conclusions: house prices had diverged from their fundamental long-term trends, leading to massive overbuilding and housing-wealth overspending; in short, a housing bubble had inflated and was due, with catastrophic consequences, to burst. It is telling that none of the people listed by Mr. DeLong as trustworthy prophets--including, of course, Mr. DeLong--were amongst that group with working calculators.

      Mr. DeLong, of course, is being ironic--working economists do not trade in prophecies; they leave that to the investment gurus hawking their pet theories through late-night infomercials. But economists can be blind to--or be blinded by--the nature of the problem.

      Marc Laventurier brought Wittgenstein to the debate, and so will I: The gifted economist will attempt to get a clear view of the state of affairs, to "look and see" if there is a fundamental misunderstanding that has led to a fundamental distortion. Dean Baker and Steve Keen approach economics like this, and so were clear-headed enough to warn of the coming disaster. A merely competent economist, like Brad DeLong, will helpfully explain how the fire got started but will not sound the alarm.

    5. CommentedMarc Laventurier

      In a note to his wife, Keynes once referred to Wittgenstein as 'God', possibly with some irony since Mr. K was involved in academically promoting and funding one of the most penetrating & richest men in Europe. This doesn't make Mr. K anybody's prophet, an often pejorative mantle Marx seems to have uniquely earned among the avatars of economics.

      As Mr. W had 'shown the way out of the fly-bottle' to the conceptual descendants of those who had argued about the angelic demographics of pin heads, Maybe Mr. M has something deep, humane and ultimately pragmatic to say to those who he predicted would serve as the conceptual clerks and apologists for the status quo.

    6. CommentedGary Marshall

      Hello Again Mr. DeLong,

      And the little proof below, part of a powerful argument for the abolition of Taxation, should point you in the right direction. The abolition of Taxation may be absurd on the face of it, but not so when examined.

      Below is the very simple proof for this measure.

      If you or anyone can find the flaw in this proof, I shall be more than happy to give the reward of $50,000. None have yet been successful. Perhaps because so few have tried.

      Its not the end of the world, but a new beginning.



      The costs of borrowing for a nation to fund public expenditures, if it borrows solely from its resident citizens and in the nation's currency, is nil.

      Why? Because if, in adding a financial debt to a community, one adds an equivalent financial asset, the aggregate finances of the community will not in any way be altered. This is simple reasoning confirmed by simple arithmetic.

      The community is the source of the government's funds. The government taxes the community to pay for public services provided by the government.

      Cost of public services is $10 million.

      Scenario 1: The government taxes $10 million.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      No community government debt, no community
      government IOU.

      Scenario 2: The government borrows $10 million from solely community lenders at a certain interest rate.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      Community government debt: $10 million;
      Community government bond: $10 million.

      At x years in the future: the asset held by the community (lenders) will be $10 million + y interest. The deferred liability claimed against the community (taxpayers) will be $10 million + y interest.

      The value of all community government debts when combined with all community government IOUs or bonds is zero for the community. It is the same $0 combined worth whether the community pays its taxes immediately or never pays them at all.

      So if a community borrows from its own citizens to fund worthy public expenditures rather than taxes those citizens, it will not alter the aggregate finances of the community or the wealth of the community any more than taxation would have. Adding a financial debt and an equivalent financial asset to a community will cause the elimination of both when summed.

      Whatever financial benefit taxation possesses is nullified by the fact that borrowing instead of taxation places no greater financial burden on the community.

      However, the costs of Taxation are immense. By ridding the nation of Taxation and instituting borrowing to fund public expenditures, the nation will shed all those costs of Taxation for the negligible fee of borrowing in the financial markets and the administration of public

      Gary Marshall

    7. CommentedGary Marshall

      Hello Mr. Delong,

      I do not argue that Krugman is wrong. I argue that he is reckless, as are those who will advocate for increases in government expenditure without heed to the financial costs and benefits for the nation of those increased public expenditures.

      My reasons as to why are as follows:

      The Keynesian prescription has always been to engineer an increase in aggregate demand for an ailing economy. The flaw in this reasoning is not found in aggregate demand, which can be easily manipulated by the dearth or superfluity of money. The flaw is found in aggregate supply.

      In economic hardship, Keynesians inevitably select their preferred remedial lever: augmented government expenditure to utilize idle resources.

      Suppose the government requires $1 billion for some public venture: a job creation project consisting of workers digging holes in the morning and filling them in during the afternoon: an undertaking of overtly little worth. The government borrows $1 billion on the markets for the diggers’ project. There is an effect upon interest rates, but it is negligible given the size of the economy. And there is a borrowing rate.

      At the end of the project, idle people were paid to produce nothing for the $1 billion received. They did not build any houses. They did not build cars. They did not enforce the law. They did not create any saleable or valued product. If none had bothered to show up while still receiving pay, the result would have been the same.

      The flaw in Keynesian reasoning is located within production, and specifically diminished production. When a nation's individuals earn $1 billion, value is given for the income received. The worthy employees gave the economy $1.0 billion worth of production. They built, designed, engineered, insured, piloted, manufactured, performing a variety of economically worthy pursuits and supplying goods that the markets demanded. The earners produced valued goods and services and were rewarded for their efforts. With the earnings, they retired debt, consumed, invested, saved.

      The $1 billion Dig certainly commandeered labour and consumed materials, equipment, and domestic goods. But the good offered by the project no one needs, no one values. The entire project yielded nothing of value, nothing for consumption or service. The effort’s value comes to naught.

      If the Dig funds were taxed, it is now $1 billion dollars stripped from productive people and squandered. If the Dig funds were borrowed, as I said they were, it is $1 billion dollars with accruing interest, interest that will fall upon future taxpayers to indefinitely satisfy for an enterprise of no value.

      The productive workers have supplied a certain amount of saleable goods. The unproductive workers have supplied no saleable goods. But both have the means of competing for a diminished supply of goods. With 90% of the nation employed in worthy pursuits and the idle remainder hired for the worthless Dig, 100% of the nation’s workers will compete in markets for only 90% of the goods, the other 10% being valueless. Too much money chasing to few goods, or by another name – Inflation.

      If the numbers of workers employed without purpose by government climbs because of the severity of the recession, the entire situation aggravates accordingly: less saleable goods available among consuming competitors. The problem in the Keynesian prescription is not a shortage of aggregate demand, but surprisingly a shortage of aggregate supply.

      A Keynesian would argue that with demand for goods soaring, companies should increase production. Unfortunately, the projects creating such unsaleable goods have utilized the idled capacity of the economy. Labourers, material, and equipment can be had at a premium, not a discount. For most firms there may be little profit in expanding production and great profit in simply raising prices.

      Keynesians would argue that most government expenditure yields some value for the nation. Certainly true. However, within public finance there is meager cost and benefit analysis. There is some accounting of the financial costs of public endeavours, often vague and erroneous and usually bearing many an upward adjustment. Yet, an honest accounting of the financial benefits of public enterprise is notoriously absent.
      There are always costs in the things that we do and there are always benefits. In every decision, we labour at making benefits exceed costs.

      Had the public expenditure lowered costs or increased revenues for business or diminished prices for the consumer or enlarged his income, by an amount exceeding the funds invested and capital charges, then one may declare the expenditure a success. Until the authorities and economists develop a system and its tools, returns on public expenditures must always be scant or negative.

      What course would best benefit a nation in recession knowing the present delinquencies and ruinous nature of public expenditure?

      In economic crisis Government should avoid the use of any resources in equipment, material, and labour unless an evaluation of costs and benefits justifies the undertaking.

      Put money into the hands of those that know best how to right their financial ship and expend on worthy goods. Put money into the hands of those persons and firms that know well and can produce the items valued by the markets Lower the taxes on many activities and objects, and the nation will thrive. Lower or abolish the income tax and corporate tax, and marginal endeavours shall become profitable, and profitable endeavours far more so. Let the government maintain their present spending and erase taxes.

      William Gladstone spoke of the reproductive effect of tax cuts on government revenues. He could never quite believe how fast subsequent tax revenues erased and surpassed the created deficiency. That was 150 years ago.

      Offer financial aid to the idle: A loan for living and schooling expenses to enhance education or a loan to cover the unemployed until the recovery begins. The individual will then be able to decide the best course given his circumstances. If the recovery provides a worthwhile position, the worker will have little reason to ignore it. The student as well.

      The problem is a lack of worthy production, not a lack of aggregate demand. By limiting saleable and desired production with harmful make work projects, the nation is poorer with the result. By encouraging worthy production and limiting harmful public expenditure, the nation is wealthier with less competition for desired production.

      Gary Marshall

    8. Portrait of Asgeir B. Torfason

      CommentedAsgeir B. Torfason

      Professor Steve Keen is not very happy about the list by Professor Brad DeLong of the economists to trust, see Keen's blog here:

        Portrait of J. Bradford DeLong

        CommentedJ. Bradford DeLong

        Professor Keen seems--as best I can tell--to be unhappy that he does not head my list of 12. My response is that if that makes him unhappy, he should write something that teaches me more than Bagehot, Eichengreen, or Reinhart have taught me...

    9. CommentedProcyon Mukherjee

      Brad Delong has raised an important point on the wage spiral and his belief is right that the downward movement could have been more pronounced, but it has not. This essentially means that in an environment where conditions for deflation is overwhelmingly high, we have Fed actions directed towards inflation targeting instead of the GDP or employment. There is no doubt that the bulk of the investment community have been searching for safe havens for parking their investments and this could be more than a short term view.

      The thinkers of our time, economists included, have been able to influence very little to what the polity has embarked on to procreate. Between events that have far reaching consequences and actions that are far too feeble to influence these events, we have intellectual discourses dedicated to passive observance; it is time that scientific thought that is guided by experimental proclivity replaces the dominant urge of theorizing that is inapplicable under uncertainty.

      Procyon Mukherjee

    10. CommentedWilliam Hampton

      You did not mention the prophecy of Ross Perot. In that what he predicted has come true and is probably the reason for the worlds economic problems, you would think that some one besides me noticed. I am starting to think that it is a secret that no one wants revealed. Ross Perot predicted that the free trade agreement would suck so many job of America that it would cause big economic problems. Is that not exactly what has happen? It not only happened here, it has happened every where. All of the problems that this has caused are being talked about, with out a mention of this being the cause. In that economists can not seem to agree on anything, I do not give much credence to most of what they say.

    11. CommentedBob Welling

      Re-examine your "job definition" premise in light of this recent NYFED paper.