September 19, 2018 / 3:04 PM / 3 months ago

Breakingviews - Hadas: Economists trapped in pre-crisis fogs

LONDON (Reuters Breakingviews) - The bankruptcy of Lehman Brothers 10 years ago justified one standard recommendation for economic policy: If a big financial institution collapses in a heap, be sure to keep money flowing through the economy.

The Brooklyn Bridge is seen partially in fog from in front of the Manhattan skyline in Brooklyn, New York, U.S., January 12, 2018. REUTERS/Shannon Stapleton

It might have been more sensible simply to avoid letting a very big financial institution fail over that September weekend. Lehman could have been fully or partly nationalised, as so many other financial firms were over the preceding and following few months.

At least the response to the Wall Street bank’s demise was good. Following the near-unanimous advice of economists, governments injected equity into banks and free cash into the financial system. The drastic action almost certainly kept the Great Recession from turning into another Great Depression.

So that is one thing economists understand. But there are still many areas of ignorance. Indeed, all the big disputed questions about macroeconomics from 2008 remain unanswered.

Start with the cause of the recession. It is clear that Lehman was wrecked by a popped bubble in the U.S. real-estate market. What is unclear are the causes of this bubble, and why its popping had such global consequences.

One theory, vigorously propounded by Breakingviews contributor Edward Chancellor, is that the original sin was central banks’ low interest rates. Other experts, though, have different views, lots of them.

The list of possible problem areas starts with undercapitalised or underregulated banks, reckless or greedy bankers and the unrestrained, opaque use of derivatives. It goes on to excessive national leverage levels and uninhibited cross-border and inter-institutional flows of capital. Fans of markets blame uneconomic demands from governments while fans of governments cite unrealistic expectations for financial market stability.

There is nothing like a consensus. As a result, there is no agreement on how crisis-prone the global economy is right now. Only one thing is certain. Whatever happens, there will be tribes of economists saying, “I told you so”.

In the early post-crisis days, one idea did seem to be generally accepted, that new-fangled finance had been a big contributor to the problem. It was true that hedge funds had not lived down to the dire expectations of their many critics. However, almost everything to do with probability distributions, risk tranches and derivative instruments was highly suspect.

If there ever was such a consensus, it did not last. While the wild days of CDOs squared and triple-A tranches of toxic subprime paper have not returned, derivative markets in general are still thriving. Total daily turnover in the latest triennial survey from the Bank for International Settlements, in 2016, was 52 percent higher than in 2007. Regulators seem relaxed about the growth. They are confident that the new central clearing facilities, mandated after the crash, has removed much of the risk.

Speaking of relaxed, in early 2008 few economists were actually worrying much about bubbles and leverage. Many more were concerned with the risk of rising inflation after the price of oil had increased almost tenfold in a decade. The gloomiest prognosticators argued that the cuts in policy interest rates which had started in 2007 to counter initial financial market stresses would lead to a reprise of the stagflation of the 1970s.

As it turned out, the 2008 peak annual inflation rate in the United States was 5 percent. That was in September, the same month that Lehman collapsed. It is impossible to know whether prices would have continued to accelerate if a recession had been avoided, because economists have no better understanding of how prices and wages work now than they did a decade ago.

Indeed, the lack of inflationary pressure in most Western countries is an embarrassment to the economics profession. The leading theories hold that labour shortages and money availability push up prices and wages; so it follows that there should now be much more inflationary pressure than can be found in any developed economy.

Another big deal for many economists back in 2008 was the size of the U.S. current-account deficit. It was declining from the 2006 peak level of 5.8 percent of GDP, but was still expected to be close to 5 percent that year. There was much talk of global imbalances and the dangers of a Chinese savings glut.

As it turned out, the U.S. deficit sank almost unnoticed during the recession and the early years of recovery, falling to 2.1 percent of GDP in 2013. The gap has risen since, but not by much. The International Monetary Fund expects the deficit to hit 3 percent of GDP this year. As to what, if anything, trade deficits mean for the economy or the financial system – well, President Donald Trump is confident that he knows, but most economists are baffled.

In contrast, many economists think they do know why the recovery after the crisis has been unusually slow. Unfortunately, they disagree. Too little fiscal stimulus, too cautious monetary policy, not enough bank restructuring, underlying institutional or demographic weaknesses, consumer fears, sociological factors – the list of proposed explanations is too long to inspire much confidence in any one of them.

In sum, few of the economic fogs of 2008 have lifted. From an academic perspective, such ignorance may provide a welcome opportunity to learn more. For the rest of the world, however, it is a cause for concern.

Breakingviews

Reuters Breakingviews is the world's leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.


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