When will the liquidationists learn they only make the problem worse?

At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.

Probably the scariest thing about the current state of economics is that it just has not seen disasters coming.

Paul Krugman did, and he was far from being the only one:

Informative Times piece on the global savings glut, the housing bubble, and the sum of all fears. But I dont think the piece accurately conveys the state of the debate circa, say, the summer of 2005.

The piece says this:

In hindsight, many economists say, the United States should have recognized that borrowing from abroad for consumption and deficit spending at home was not a formula for economic success.

Actually, a number of economists said this, not in hindsight, but as it was happening: people like Dean Baker, Calculated Risk, and yes, yours truly (I was reading Dean and CR). These days, I wrote in August 2005, Americans make a living selling each other houses, paid for with money borrowed from the Chinese. Somehow, that doesnt seem like a sustainable lifestyle.

So it wasnt that people failed to notice the problem. Instead, what happened was active and often angry denial. Conservatives, who didnt want anything to interfere with their visions of a wonderful Bush Boom, denounced the likes of CR as bubbleheads. And Alan Greenspan, still viewed as a demigod and probably unwilling to admit that anything was going wrong during his last years in office declared that a national severe price distortion seems most unlikely.

The answer, in short, to the question of why key players didnt see the problem coming is that they didnt want to know.

‘LONDON (Reuters) – London-based CF Partners will launch early next year a new 50 million euro ($70.06 million) hedge fund aiming to profit from volatility in carbon markets……

“To date in the carbon space the majority of the players from a fund point of view have been long-only guys,” said Simon Glossop, one of CF’s founders. “That’s been a workable model up to this year, but carbon has now become an asset class in its own right instead of a compliance tool.”‘

Just pray there’s some carbon space between the cheeks of your asset classes for the vaseline before the usual palsy suspects get their compliance tools out.

A stitch in time saves nine but bailout fools and you fill the world with fools eh?

“THE financial crisis is a result of many bad decisions, but one of them hasnt received enough attention: the 1998 bailout of the Long-Term Capital Management hedge fund. If regulators had been less concerned with protecting the funds creditors, our current problems might not be quite so bad.”….

“The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.”

http://www.nytimes.com/2008/12/28/business/economy/28view.html?partner=permalink&exprod=permalink

Damien, get real! The outcome of the subprime loans meltdown was predicted in a piece in the New York Times in 1999!

As Nicholas, or someone pointed out, scientists are not supposed to make prophecies about the future course of history, they are supposed to make conditional predictions along the lines If…..THEN…….

Misplace faith in the iron laws of history came from celestial mechanics where future events could be predicted accurately because the solar system works like an isolated, clockwork model (like the mythical “evenly rotating economy”).

For example in 2003 the RBA (and Nicholas’ brother) did some serious work on incorporating fighting asset price bubbles into monetary policy
. There should be pressure to roll this work into action. More broadly there should be a lot of soul-searching going on about how we got here (again) and some serious revisions going on, but I have not really seen it so far.

Particularly disappointing is when we pretend, as with inflation targeting, that we know exactly what we are doing have reached the end of the line and are resistant to change. I think only when we have 60 years of sustainable growth that we should resist theoretically beneficial changes to monetary (and fiscal) policy.

F for failure to deliver steady growth, F for consistently getting policy settings wrong, F for having no idea when disaster is about to strike, F for not knowing what to do when we do have a disaster, and F for not having its fundamentals settled sorted after millennia of trying.

Damian, your grading would depend on what your expectations were. Are these expectations reasonable? Is it even possible for “economics” to deliver steady growth? Perhaps even just gradually learning is all that can be hoped for.

Agreed that The Economist has been on the money on the bubble like nature of housing. In my defence, I did quote them with approval 3 years ago when I wrote this article on house prices:
“The longer that prices are allowed to stay at unrealistic levels the more young families will find themselves risking negative equity when pricing reality eventually returns. Further, a delay will also increase the number of families who will be unable to cope with the inevitable upswing of interest rates at some point. If those who cannot cope become a significant percentage of the population this will be an economic and social disaster and could put the economy permanently on the precipice of recession and increase the volatility of the economic cycle.”
A bit of overstated hyperbole on my part at the end there, but you get the idea.

I am not sure The Economist has been making the right call on the need for greater regulation, they are even now pretty reluctant to admit the full extent of the failure of deregulation/lack of regulation of the CDO and CDS markets. At the end of that article they call the deregulation of the last 30 years benign(!) in contrast to the bogeyman of regulation that is coming.

You are definitely right though that asking for timing is impossible, I guess what surprised me, though, is how wrong many have been even when the writing was on the wall. There was a research note sent around mid this year at M bank saying that those who predicted a US recession had “Egg on their faces” as they still thought it would scrape through without one. I was amazed.

This is unkind. Some Economists have been warning about disaster for years, most notably, The Economist. Commentators who think that the economy is a synonym for the market, or those commentators who stand to gain if people believe their positive spin about markets are simply stupid and/or untrustworthy.

So, I’d award an “F” to most “economics” commentators, just like you, and give a B+ to the many economists who warned of the dangers and even pointed to the exact weaknesses that would lead inevitably to the current stuffup.

The problem is that predicting WHEN an economic meltdown will happen is as difficult as saying WHEN a cancer patient will die. The best is to express things as a probability in a given time frame, which is why doctors talk of 2, 5 and 10 year survival rates. That approach to communicating predictions is a little too difficult for the masses to parse, and therefore too rarely makes it into the MSM (and indeed many blog posts – I plead guilty myself).

Meteorology has failed too. It cant predict what the weather will be like on the first of July next year any better than this years July 1st paper.

Edward N. Lorentz (one of the people who discovered Chaos Theory) happened to be a Meteorologist. His discovery ultimately provided a mathematical basis explaining why Meteorology (oh, and Economics) has trouble predicting the weather 6 months in advance (Meteorologists can at least provide a statistical profile, which I believe is more that Economists can currently do). The Meteorologists took the new discovery onboard, pondered on their limitations, reviewed what they would need to improve their predictions (lots more input data and bigger computer models) and did the best they could with they hand they were dealt. Better than that, the Meteorologists can now provide a calculated confidence estimate on their predictions.

Plenty of Economists are still busy denying any of that actually happened.

when is the last time any economy based on economic principles has suffered from hyperinflation? None. Desease cured, medicine known.

The problem of debasement of currency has been pretty well understood since the second or third gold nugget was struck into a coin. The solution is obviously not to debase the currency, but that hides the real problem which is: who do we trust in a position of power, such that they will never be tempted to debase the currency? You might be comfortable seeing this as a solved problem but I still worry over it. I have a feeling that trillions of US dollars in bailouts created out of thin air are going to leave a lot of US citizens worrying more than me.

Taking this further, why should we have any inflation (hyper or otherwise)? All the economists have done is drawn a circle around the problem and quietly said “we will pretend it’s OK if you don’t step outside the circle”. Pragmatically, it’s a workable method, intellectually, it’s hollow and dissatisfying.

How fast did we apply the basic recipe to get out of recession this time round? Within weeks, in stead of years. Hospital close to patient.

In Australia, the patient was not particularly sick, and hasn’t fully recovered yet, but I agree that the symptoms have been attended to.

In the US, the patient is a lot further gone and I’m certainly predicting that those guys will see things get worse before they get better. Let me start by predicting that the Detroit auto industry will get their bailout and still not survive. A defibrillator is not particularly useful to a drowning man.

how many governments still pick industrial winners constantly? Virtually none, though the old reflex dies hard. Known to be a poisened plant.

Well there’s the obvious auto-industry bailout (both US and Aus), and I remember an airline industry bailout not so long ago, and it would be disrespectful not to give the banker’s bailout a mention here. Beyond that, the Australian government has been pumping the film industry for years (with eventual positive results, although hard to say whether the money couldn’t have been spent better somewhere else). We are about to see the latest Australian offering for the big broadband promise, which will no doubt involve picking a winner in the communications industry. Wasn’t there something about the biomedical industry and the Howard government’s handouts to try and get that off the ground (good honest drug-research of course, not cloning or anything satanic)? We could discuss the future of the Australian Wheat Board here, and whether it was a good idea in the first place… but that got soaked in political intrigue (as the picking of winners usually is). Look I’m going to have to stop now before I fill the entire blog and have Jacques demanding I deliver a bigger hard drive!

The thing is, some of these government schemes do really fly. For example, while Silicon Valley came together mostly by accident, the high-tech industry of Huston Texas was a product almost singularly of NASA and government decisions regarding the US aerospace industry — both have attracted their share of successful follow-on business. Many poisoned plants have their medicinal uses when used on the right occasion (when is “right occasion”, best ask a Meteorologist).

As for predicting forthcoming bust, a simple look at steadily declining ‘goods producing sector’ employment from Dec 2006 in the US, vis a vis rising overall employment until the latter fell off the hill recently would have been portending exactly what Austrian economics has always been banging on about. Those who can’t be trusted with the monopoly of the printing press certainly shouldn’t be entrusted with the Law of the Lever. As for those with an unhealthy addiction to Lever Lever Land, none demolishes them and their destructive fetishes better than Spengler-
http://www.atimes.com/atimes/Global_Economy/JL25Dj02.html

Is anyone? Crashes born of hubris and gullibility predate central banking by centuries. It’s in the nature of lucky people to assume the status quo will persist and in the nature of unfortunate people to believe things will get better. What can you do?

Very few people in the finance industry saw this coming because they didn’t want to see it coming.

How fast did we apply the basic recipe to get out of recession this time round? Within weeks, in stead of years. Hospital close to patient.

We got out of the recession? Um really? I don’t think so somehow. I think this is where the mass of the Oz populai is this Christmas.

I prefer the view that had Keynes been properly heeded, we might have done better.

None of these people is ever properly heeded. I’ve been paying attention to the Keynsian/Frediman dichotomy for a couple years now. Here we are in the middle of a reversal and I can see good sense in tactics like guaranteeing bank deposits of issuing rescue packages but it’s already getting out of control. It seems Kevin Rudd has got shopping fever and he’s hysterically throwing money at everything he can think of.

Meteorology makes an interesting comparison to economics. I actually had it in mind when writing the post and was considering a more detailed side-by-side.

The current state of economics in its predictive role reminds me of what my grandfather told me of weather forecasting way back when. The measurements were taken, someone with a lot of experience and a theory was consulted, and the notoriously inaccurate results published.

These days, of course, the computerised modeling in meteorology is incredibly detailed, taking in an enormous number of data points and pushing the already impressive limits of supercomputing before publishing slightly less notoriously inaccurate results.

I would like to think this should be the way economics in a predictive role is heading. You must admit they do seem to know where the hurricanes are heading…

Why a ‘pass” for classical economics? What has it done to help us recover?

I prefer the view that had Keynes been properly heeded, we might have done better. But not classical economics.

How fast did we apply the basic recipe to get out of recession this time round? Within weeks, in stead of years. Hospital close to patient.

how many governments still pick industrial winners constantly? Virtually none, though the old reflex dies hard. Known to be a poisened plant.

how many governments allow monopolies to go unchallenged and have not managed to get a decent amount of competition going? Only those that are part of the problem themselves. Difference between doctor and virus.

etc.

if you want to argue economics has failed, you at least have to be evenhanded in mentioning its many achievements. The physics-envy is misplaced. Our science is in a way far more succesful and far harder given our constraints. We have to figure out how it all works without being able to do experiments on the economy. Kind of like being asked to diagnose a patient with a telescope.

gallstones: unknown cause, invasive “cure” that doesn’t address the cause, no known prevention, almost no research into achieving anything better — much more money in expensive bogus cures than there is in discovering a simple prevention. Maybe an “E”.

Severe sepsis and overuse of antibiotics — quietly killing far more people than terrorism, but you will never hear a doctor tell you that else they get booted from the club for talking out of school. Certainly an “F”.

I’d go as far as to say that economics suffers from very similar problems of vested interests and unwillingness to apply scientific principles when careers are at stake. Are the Reserve Bank gurus ever going to caution the market that debt levels have become dangerously high and the currency is bordering on unstable? Would any investment adviser recommend that the best long term strategy for retirement is to have six kids and spend every available dollar on their education? The primary purpose of all economics is to convince the punters that the economy is under control and they should continue to confidently participate, any scientific investigation can stand in line behind that.

Yeah. get on feet, dazed stumble, walk, canter, sprint, fly, crash, fall, get on feet, dazed stumble… is life.

But I think modern medicine deserves a Pass. It does pick most diseases most of the time and has treatments the efficacy of which it has scientifically tested. It cannot treat all diseases but it is steadily chipping away at the known limits of its knowledge.

To over-extend the analogy, you would turn up with arthritis to your local economist-doctor, he would diagnose it as cancer based on his previous mis-diagnoses, give you something to make it worse, and not bother recording the experience in his notes, preferring to rely on his theory.

I reckon it is time to take a good look at how economics is delivering in the real world. If its results are as bad as I think they are, and you have to admit the last 10 years have been tres ordinaire then it is time for the subject to take a long hard look at itself. It’s not rocket-surgery after all…