Monday, October 29, 2012

Of Politics, Financial Crisis Recoveries and Complete Hacks

I've picked on John Taylor a great deal, largely because he continually compares this recovery to the 1980s recovery (see here and here).  This comparison is wrong.  It is 100% wrong.  The reason is simple.  The 1980s recession was inducted by the Fed increasing interest rates to a very high level in order to choke inflation out of the system.  This recession was induced by a financial crisis.  The last time we had something this severe was the Great Depression.  For a complete explanation of this scenario, read the Debt Deflation Theory of Great Depressions.

Now, I'm not the only one who has noticed this.  Krugman had this to say:

People have been asking me for a while to respond to John Taylor’s claim that financial-crisis-induced recessions aren’t characterized by slow recovery. It’s a very convenient claim for Romney/Ryan, of course, because if true it eliminates the best excuse for lackluster performance under Obama.

Well, Reinhart and Rogoff, who literally wrote the book on crises and their aftermath, have weighed in, and they’re not happy. They have two main complaints, both of which are completely valid.

The first is that looking at the rate of recovery from the trough is a very peculiar criterion — especially when, as Taylor does, you look only at the first year (!) of recovery. By this standard, the New Deal was a tremendous success story, because growth was fast in 1933-4. Never mind the fact that pre-crisis per capita GDP wasn’t restored for more than a decade. As R-R say, surely the relevant comparison is with the pre-crisis peak, especially given the fact that post-crisis economies often suffer periods of relapse (as is happening in Europe now).

The second is that Taylor is awfully free in designating recessions as the result of financial crisis. He counts 1973 and 1981 as financial crises, to which the only answer if you know your history is, what on earth is he talking about? These were both disinflation recessions, caused more or less deliberately by the Fed; the Fed pushed interest rates very high to calm prices, and a V-shaped recovery took place once the Fed decided we had suffered enough. This isn’t hindsight: the contrast between those kinds of recessions and the slump following the bursting of a housing bubble was the reason many of us predicted a long, slow recovery well in advance. (It’s been even slower than I predicted back then, but in early 2008 I didn’t realize how bad the debt overhang was).

(For more from RandR on this, see this link)

Then there is this observation from Martin Wolf at the Financial Times:

John Taylor, professor at Stanford University, a highly regarded macroeconomist, has no doubt of the answer. In a recent blog, he argues that strong growth normally follows US financial crises, the exception to this rule being the current recovery (see chart). Moreover, he argues, bad policy is to blame. True, Prof Taylor is a member of Mr Romney’s economic team. Yet the question remains: is he right? The answer is: no. But it is important to ask why.

The first question is whether Prof Taylor is comparing like with like. Against him is widespread agreement that the aftermaths of systemic financial crises are worse than those of more normal downturns. The seminal research of Carmen Reinhart and Kenneth Rogoff in their classic book, This Time is Different, has shaped this consensus. It is also supported by the work of the economic historian Alan Taylor, of the University of Virginia, included in a recent paper entitled The Great Leveraging .

Profs Reinhart and Rogoff distinguish a “systemic financial crisis” as one characterised by a real estate bubble and high levels of debt. Neither of these preceded the recessions of 1973 and 1981, which are included in Prof Taylor’s chart. Both the precursors and results of the recent crisis were quite different from the downturns in the mid-1970s, early 1980s and early 1990s. This is true of real house prices, inflation, interest rates and debt (see chart).

Now we see that this disease of financial crisis denialism is spreading (Krugman again):

I managed to avoid reading this Times profile of Glenn Hubbard until now. Wow. But let me leave the consulting stuff to others, and talk about the bad economics.
Hubbard repeats what has now become the party line — that all deep recessions are the same, and that we should have had a V-shaped recovery from the crisis of 2008-2009, so that it’s all Obama’s fault:
“It is absolutely possible, Ali, both in terms of models of policy effects on the recovery and historical experience,” he said, in a tone that was professorial but not patronizing, “If you look at the recovery from ’74, ’75, or ’81, ’82, you can easily get job growth in this range. We have the wrong policy mix. We’ve had a nasty shock, we’re in a different situation, but we could do a lot better.”
Words fail me. Well, actually they don’t. Here are a few: Right at the beginning of the crisis, long before the people now advising Romney were even willing to admit that there was a problem, there was a debate between two ideas: that deep recessions were always followed by fast, V-shaped recoveries, and that financial-crisis recessions — which pushed monetary policy up against the zero lower bound — were followed by slow, “jobless” recoveries. Here’s my entry, from January 2008.

This wasn’t just a political question: private-sector forecasters were divided, too. There were a number of people predicting the V. But they were wrong, and ended up either admitting that they were wrong or went silent.

The Reinhart-Rogoff data on aftermath of crises actually came well into this debate, but added to the conclusion that the recovery from 2008-2009 was likely to be nothing like the recovery from 81-82 or 74-75. And this was a view validated by theory, history, and, it turns out, by successful prediction in the current crisis.

So -- why is all of this important?

First, let's make two points: the argument that we should be recovering at a faster pace (like that experienced in the 1980s) is wrong -- as in 100% wrong.  The data does not in any way support that conclusion (as an FYI, here are my thoughts on the pace of this current recovery from 2008).  Second, the people that are spreading this tripe should know better.   These are highly educated and intelligent people.  Yet, they are subsuming with intelligence for the sake of their political party.  And that is a very concerning issue.  When the overwhelming conclusion of the data is not as important as fealty to a political lord, a very large problem exists.

But the bigger issue is the: the problem emerges that by sticking with this argument that we should be experiencing 1980s style growth, the proponents thereof would proscribe the exact wrong solution to the problem.  Regarding the 1980s, standard supply side ideas would be appropriate -- cut rates and taxes, propose investment policies and you'll get solid growth.  As one observer has noted:

Basically, supply-side policies work best when there is pent-up private sector demand. By lowering the cost of investment, you can unleash a self-reinforcing cycle. The bigger the pent-up demand, the bigger the payoff to an improvement in expectations. Without that pent-up demand, resources freed from supply-side measures and austerity get saved, not spent, and no self-reinforcing cycle is triggered.

But that's not what we're dealing with now.  In fact, we're dealing with the exact opposite -- weak demand at the macro level.  I explained the difference a few weeks ago:

Lack of demand means we have plenty of stuff, but not enough people are buying that stuff.  Returning to the computer example from above, suppose we had plenty of computers, but there was a big inventory overhang.  Let's assume this doesn't mean the industry has matured and is on the way out.  What this means is there is either insufficient income to purchase these computers or insufficient credit to be expanded.  That means that at the macro level we need to create income or increase the credit and or lending facility inherent in the overall system.  Hence, the policy prescriptions between lack of supply and lack of demand are entirely different.
The way out of the above scenario is stimulus -- enough to increase incomes and therefore overall demand.  This is what basic macro teaches (even Greg Mankiw's book advocates this policy, for God's sake).

So, let's assume Romney wins.  His advisers now start proposing the wrong policies to kick-start the economy.  What happens?  

"I think there's a real chance that he'll manage to pursue a policy in the first couple of years that simultaneously blows up the deficit and depresses the economy," the Nobel Prize-winning economist said on HuffPost Live Wednesday. "Tax cuts for the rich, who won't spend them, and slash spending for the poor and the middle class, who will be forced to cut back. And so we end up managing to have a simultaneous deficit explosion and double-dip recession."