No-Armed Economists?

One of the individuals I used to work with often joked about his never-ending search for a one-armed economist. He wasn't looking for a dismal science expert with a disability, of course. Rather, he was commenting on the fact that he had yet to identify an economist who could analyze a broad cross-section of data and come up with a definitive and straightforward assessment of where things were and where they were (likely) headed. Instead, the specialists he knew would generally qualify their views with weaselly expressions like "on the one hand...but, on the other" (that's two arms -- get it?).

Regular visitors to Financial Armageddon know that I have plenty of issues with those who call themselves economists. Among other things, most of these so-called experts seem to believe that people and markets are rarely other than rational. Hogwash. Anyone who has ever studied how the trading "crowd" acts (and reacts), for example, knows that people often get caught up in crazy, emotional behavior that goes against their interests and better judgments.

In addition, I find fault with those who don't seem to grasp that many of their theories, tools and models aren't of much practical use in the real world. How, for instance, did virtually every economist -- excluding individuals like Nouriel Roubini and Dean Baker -- fail to anticipate the worst financial crisis and most severe economic downturn in decades?

That being said, I have to admit that I do appreciate economists -- and other specialists, for that matter -- who acknowledge their own fallibility, the shortcomings of their chosen profession and its intellectual underpinnings, and the fact that extensive training, knowledge and experience doesn't necessarily mean they can solve whatever problems might be thrown their way. In a New York Times commentary, "But Have We Learned Enough?" N. Gregory Mankiw, a professor of economics at Harvard, fomer adviser to President Bush, and publisher of Greg Mankiw's Blog, offers up some refreshing acknowledgements.

LIKE most economists, those at the International Monetary Fund are lowering their growth forecasts. The financial turmoil gripping Wall Street will probably spill over onto every other street in America. Most likely, current job losses are only the tip of an ugly iceberg.

But when Olivier Blanchard, the I.M.F.’s chief economist, was asked about the possibility of the world sinking into another Great Depression, he reassuringly replied that the chance was “nearly nil.” He added, “We’ve learned a few things in 80 years.”

Yes, we have. But have we learned what caused the Depression of the 1930s? Most important, have we learned enough to avoid doing the same thing again?

The Depression began, to a large extent, as a garden-variety downturn. The 1920s were a boom decade, and as it came to a close the Federal Reserve tried to rein in what might have been called the irrational exuberance of the era.

In 1928, the Fed maneuvered to drive up interest rates. So interest-sensitive sectors like construction slowed.

But things took a bad turn after the crash of October 1929. Lower stock prices made households poorer and discouraged consumer spending, which then made up three-quarters of the economy. (Today it’s about two-thirds.)

According to the economic historian Christina D. Romer, a professor at the University of California, Berkeley, the great volatility of stock prices at the time also increased consumers’ feelings of uncertainty, inducing them to put off purchases until the uncertainty was resolved. Spending on consumer durable goods like autos dropped precipitously in 1930.

Next came a series of bank panics. From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today.

The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks.

As they withdrew their funds, the banking system’s normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households’ debts.

Second, the disappearance of so many banks made credit hard to come by. Small businesses often rely on established relationships with local bankers when they need loans, either to tide them over in tough times or for business expansion. With so many of those relationships interrupted at the same time, the economy’s ability to channel financial resources toward their best use was seriously impaired.

Together, these forces proved cataclysmic. Unemployment, which had been 3 percent in 1929, rose to 25 percent in 1933. Even during the worst recession since then, in 1982, the United States economy did not experience half that level of unemployment.

Policy makers in the 1930s responded vigorously as the situation deteriorated. But like a doctor facing a patient with a new disease and strange symptoms, they often acted in ways that, with the benefit of hindsight, appeared counterproductive.

Probably the most important source of recovery after 1933 was monetary expansion, eased by President Franklin D. Roosevelt’s decision to abandon the gold standard and devalue the dollar. From 1933 to 1937, the money supply rose, stopping the deflation. Production in the economy grew about 10 percent a year, three times its normal rate.

Less successful were various market interventions. According to a study by the economists Harold L. Cole and Lee E. Ohanian, both of the University of California, Los Angeles, and the Federal Reserve Bank of Minneapolis, President Roosevelt made things worse when he encouraged the formation of cartels through the National Industrial Recovery Act of 1933. Similarly, they argue, the National Labor Relations Act of 1935 strengthened organized labor but weakened the recovery by impeding market forces.

LOOKING back at these events, it’s hard to avoid seeing parallels to the current situation. Today, as then, uncertainty has consumers spooked. By some measures, stock market volatility in recent days has reached levels not seen since the 1930s. With volatility spiking, the University of Michigan’s survey reading of consumer sentiment has been plunging.

Deflation across the economy is not a problem (yet), but deflation in the housing market is the source of many of our present difficulties. With so many homeowners owing more on their mortgages than their houses are worth, default is an unfortunate but often rational choice. Widespread foreclosures, however, only perpetuate the downward spiral of housing prices, further defaults and additional losses at financial institutions.

The Fed and the Treasury Department, intent on avoiding the early policy inaction that let the Depression unfold, have been working hard to keep credit flowing. But the financial situation they face is, arguably, more difficult than that of the 1930s. Then, the problem was largely a crisis of confidence and a shortage of liquidity. Today, the problem may be more a shortage of solvency, which is harder to solve.

What’s next? Perhaps the most troubling study of the 1930s economy was written in 1988 by the economists Kathryn Dominguez, Ray Fair and Matthew Shapiro; it was called “Forecasting the Depression: Harvard Versus Yale.” (Mr. Fair is an economics professor at Yale; Ms. Dominguez and Mr. Shapiro are at the University of Michigan.)

The three researchers show that the leading economists at the time, at competing forecasting services run by Harvard and Yale, were caught completely by surprise by the severity and length of the Great Depression. What’s worse, despite many advances in the tools of economic analysis, modern economists armed with the data from the time would not have forecast much better. In other words, even if another Depression were around the corner, you shouldn’t expect much advance warning from the economics profession.

Let me be clear: Like Mr. Blanchard at the I.M.F., I am not predicting another Great Depression. We have indeed learned a lot over the last 80 years. But you should take that economic forecast, like all others, with more than a single grain of salt.

Comments

[Independent Accountant]

Mike P:
You need a laugh. Click on this link:
http://news-info.wustl.edu/tips/page/normal/3562.html for the source of the one-armed economist.

[Michael Panzner]

Good one! Thanks.

[roger]

If the quality of professional economist is less than desirable
maybe we should check on the standards of the schools them selves,
(Every school of thought is like a man who has talked to himself for a hundred years and is delighted with his own mind, however stupid it may be.
(J.W. Goethe, 1817).

[Jan Paul]

The cause of the great depression and the cause of whatever this will turn out to be is probably "attitude."

There can be several reasons for "a consumer" to change his habits and it won't matter much to the economy. But, when the majority change their attitude from spending to saving, no matter the reasons, it spells disaster for a consumption based economy. But, we made things worse this time by creating $49 Trillion in debt $111 Trillion with unfunded liabilities (City, state, personal and corporate added to federal debt). Now, the change in attitude may cause all that unwinding to create a cycle that can't be stopped.

The consumer spends less. Profits fall and cause layoffs like in any recession. But, this time, there is a much greater fall in tax revenues because much of the consumption was based on home equity. Both because you could borrow on it and because your "growing wealth," made you confident and willing to spend more, we splurged and now tax revenues are plunging in some areas. This is causing more cuts in spending by cities and states and layoffs both from government and the companies that sell things to government.

That in turn, causes more drops in spending and more declines in profits and tax revenues. If the government pushes trillions into the financial system it won't help until that money is reaching workers and they change their spending to a more positive number. Even if they get the money, like in a new stimulus check, it won't help if they don't spend it. If it is used to pay down debt, we are left in the same place we are before the stimulus hits them.

Human nature causes more booms and busts to last longer than government. We could easily have a 10-20 year downturn if the consumer decides to keep saving and not spending on many of the discretionary items he did before. Think of how long the "depression era" thinking lasted with those who lived through it. They passed some on to their children and grandchildren and only in the 80's and 90's did we really return to the 20's type spending spree.

The key is not what the government does but what the consumer does. The government can make it a lot worse and probably will.

This article by Karl Denninger says a lot about how we got so deep into this mess. Note the 1968 date in the article.

http://tinyurl.com/6r5q8d

[roger]

Paul: Rain is forecast,your attitude is to sport a rain coat,
your attitude is not the cause of the rain....is it???

[Fuddwhacher]

OK, so what I've gathered from this article is that the problem is either faulty economic thinking or attitude. It's laughable.

THE PROBLEM IS EXCESSIVE LEVERAGE!

The problem is that people borrowed on the come, assuming that prices would never fall. It's not a new story. It's the same old story. The only difference is that we now live in an age where people blame the news, or the economists, or attitude.

Baloney.

The problem is excessive leverage. The end.

[Elaine Meinel Supkis]

I read more vapid commentary about the Great Depression, it is depressing.

The Great Depression was NOT all about the US not spending money on domestic goods. It was all about the collapse of the British pound in the wake of WWI. And the collapse of Germany's ability to pay reparations. And both Germany AND Britain owed the US banking system record amounts of money!

And to shore up the German reparations payments, the US central bank loaned yet more money to Germany in 1928-1929. When Germany was unable to pay the interest on these loans, our entire banking system went down the creek.

The Fed raised interest rates because EUROPE was borrowing like crazy, not because US consumers were buying radios or cars!

The inability to understand international trade/war/banking is at the root of most economist's inability to understand how the US is now playing the role of Germany and Britain in the Great Depression collapse. We are the ones unable to pay for our military, our business or anything. So we are basically defaulting on our loans to Asia.

[Al]

Fuddwhacher,

I agree with your conclusion. Debt is the problem. But we shouldn't call it leverage. Leverage is what companies use, borrowing at low interest rates to increase their capital assets which can produce at a higher rate of return than the cost of the debt. People use debt to buy stuff with their future income which can sometimes be smart, but usually isn't.