Arenas ekonomiska råd Rapport 2 Axel Leijonhufvud Economics of the Crisis and the Crisis of Economics Axel Leijonhufvud, professor emeritus UCLA and University of Trento Economics of the Crisis and the Crisis of Economics 2 Publicerat i oktober 2011 ©Författaren och Arena Idé Arena Idé är en del av Arenagruppen www.arenagruppen.se Arenagruppen Drottninggatan 83 111 60 Stockholm Tel (vx) 08‐789 11 60 Fax: 08‐411 42 42 Arenas ekonomiska råd är en verksamhet inom tankesmedjan Arena Idé. Syftet är att utifrån en radikal och progressiv utgångspunkt bredda den ekonomiska och politiska diskussionen i Sverige. Vi vill skapa en oberoende arena för kunskapsutveckling och förnyelse av den ekonomiska debatten. Arenas ekonomiska råd är ett samarbete mellan Arena Idé och Friedrich Ebert Stiftungs kontor i Stockholm. 3 Axel Leijonhufvud Economics of the Crisis and the Crisis of Economics1 Balance sheet troubles 5 Stability and Instability 5 Markets for produced goods 6 Financial markets 7 Leverage Dynamics: The build‐up 8 Instability and Economic Logic 9 Leverage Dynamics: Unravelling 10 Network structures and instability 11 Corridor stability and bifurcation 13 A Complex dynamical System 13 Financial bifurcation 15 Macroeconomics and Financial Economics: In Crisis? 16 ( 1 ) Unemployment in DSGE: An example 16 ( 2 ) Representative agent models, fallacies of composition and instabilities. 18 ( 3 ) Stable GE with “frictions” vs. instability. 18 ( 4 ) Violations of budget constraints and their consequences 20 ( 5 ) An external critique: Ontology 21 1 Lecture given at the Stockholm School of Economics, September 20, 2011 4 Balance sheet troubles This is not an ordinary recession. The problems unleashed by he financial crisis are far more serious and intractable than that. The United States and the Eurozone countries are in the midst of a balance sheet recession. The concept is due to Richard Koo2 who used the term to summarize his diagnosis of Japan’s economic troubles in the wake of its 1992‐93 crisis. A balance sheet recession is fundamentally different from the garden variety and the usual countercyclical policies are not adequate to cope with it. The questions I want to discuss in these lectures all pertain to the extra‐ordinary nature of balance sheet recessions in general and, of course, the present one in particular: What makes them different from ordinary cyclical recessions? How do they come about? What makes them peculiarly intractable? What policies are effective or less effective in dealing with them? Apart from these substantive questions, there is one further question worth considering, namely, what kind of economic theory helps us understand these matters better? And what kinds do not? Stability and Instability How did we end up in our present unpredicted predicament? A short answer would be: By not being alert to the symptoms of instability. Almost all bankers, regulators, policy‐ makers and (of course) economists disregarded the possibility of serious systemic instability. But the widespread assumption that a system of “free markets” is stable needs reexamination. 2 Richard C. Koo, Balance Sheet Recession: Japan’s Struggle with Unchartered Economics and Its Global Implications, Singapore: John Wiley & Sons, 2003 and idem, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, Rev. edn., Singapore: John Wiley & Sons, 2009. 5 Markets for produced goods The beginning student’s first introduction to economics tends to be the supply‐and‐ demand model for a produced good. Two negative feedback loops are supposed to guarantee that the equilibrium is reached (ceteris paribus). If supply exceeds demand, price will rise so as to reduce the discrepancy in quantities. If marginal cost exceeds the demand price, output will decline so as to decrease the discrepancy in values. Both feedbacks reduce the deviation from the market equilibrium which is why they are termed “negative feedbacks.” In principle, it is possible that the interaction between the two feedback controls will generate persistent fluctuations in both output and price but theoretical reasons and practical experience both tell us that this possibility can most often be disregarded. So the conclusion is that we are safe in presuming that the market for any particular produced good will home in towards its equilibrium neighborhood, which is to say, that the market is stable. This presumption has been carried over to general equilibrium systems with an arbitrarily large number of goods. This is the case even though theoretical proofs of the stability of general equilibrium exist only for some special cases of limited interest. But as far as I know – and my knowledge is limited – the economists who in the last 20 or so years have based their macroeconomics on GE constructions have shown little interest in investigating their stability properties. Stability has been taken “on faith.” This faith may have some merit as long as what is being discussed are ( 1 ) Non‐ monetary GE models lacking fractional reserve banks and in which lending and borrowing are intertemporal barter transactions; and ( 2 ) budget constraints are always binding and never violated. These conditions are assumed in Real Business Cycle theory, for example, which pretty much dominated high brow macrotheory just a few years ago. But obviously these assumptions remove us altogether from the world of our experience. 6 Suppose we take stability on faith and trust that “market forces” will always tend to make output and consumption move towards a coordinated equilibrium state. How then explain recessions? Well, there might be conditions that interfere with markets and prevent them from doing their beneficial work. The “wage rigidity” postulated in conventional Keynesian theory as an explanation of unemployment would be an example. The recently dominant DSGE (dynamic stochastic general equilibrium) theory has pursued this logic. But a single “rigidity” does not take us very far in making the models “fit” the data. So we now have large‐scale DSGE models with more than a dozen “frictions” and “market imperfections” – with more to be added, you can be sure, when the models do not fit outside the original sample. It is my belief that this stability‐with‐impediments approach is quite wrong, that it does not explain recent events, and that it fails to suggest the right policies. Financial markets For more than a hundred years the instability of fractional reserve banking was the dominant topic in what came later to be called macroeconomics. Traditional banks had (1) large liabilities in relation to own capital (high leverage) and (2) liabilities of very short maturities relative to their assets (maturity mismatch). High leverage and maturity mismatch remain the keys to financial instability today.3 The Great Depression of the 1930s provided the ultimate lesson that taught us how to control traditional banks. Deposit insurance removed the incentives for depositors to run on banks and thereby also the “contagion” that had characterized the banking panics of the past. Reserve requirements served to limit the leverage ratios of banks. 3 Many observers would add fraud to the causes of recent instability. They are not without reasons. Cf., for example, L. Randall Wray, “Lessons We Should Have Learned from the Global Financial Crisis but Didn’t,” Levy Economics Institute Working Paper, August 2011. 7 The limits on leverage meant that banks by and large were earning the same rate of return on own capital as other industries.4 Leverage Dynamics: The build‐up In the last twenty years, financial institutions have not been satisfied to earn a rate of return no higher than that of other industries. The big investment banks, in particular, have learned to set themselves rate of return targets two or three times what is earned in the “real economy” – and the markets have learned to expect that such returns are actually achieved. The only way in which such returns can be achieved is by operating at high leverage. In retrospect, the piling up of leverage not just by financial institutions but also by other firms and notably by households has been the key to American prosperity since the early 1990s. It was an oft‐repeated cliché among American economists that the American economy performed better than Europe in the 1990s because of its “flexibility.” The simpler truth is that when more or less everybody spends more than he earns this will keep the “good times rolling.” But it leaves a legacy of debt, The arithmetic of leverage is simple enough. A bank with a leverage ratio of 30, which can invest in assets earning just ½ of a percent more than its liabilities, will earn a rate of return of 15%.5 (And if the central bank supplies funds at a rate hardly different from zero, it might be able to do a lot better than that!) Such a handsome return, however, will attract competitors and competition will narrow the margin between rates earned on assets and rates paid on liabilities. To keep its rate of return up as the margin shrinks, the individual bank can pursue one or more of 4Note that this stands in dramatic contrast to recent years when large banks have aimed for – and often achieved – rates of return above 20% while returns in manufacturing, for example, have remained in the single digits. 5 A leverage ratio of 30 is quite high, of course, but in 2007 all the big American investment banks had ratios hovering around that number. Some European big banks have operated with higher ratios than that. 8 several strategies. First, it can increase its leverage further. Secondly, it can move parts of its portfolio into riskier asset‐classes where the rates earned are a bit higher. Third, it can acquire assets too risky for its own portfolio, securitize them in bundles, and sell them off to investors that know no better.