Lessons from the Crisis for Teaching Macro

The NY Times “Room for Debate” recently had a forum on “Rethinking How We Teach Economics”, with contributions by Blinder, Taleb and Skidelsky, among others. In my contribution, I focused on the importance of asymmetric information and self-reinforcing feedback loops:

In the typical introductory textbook, wages and prices adjust so that labor is fully employed and goods are sold at the right price. A more sophisticated treatment shows up in more advanced texts, but even in some graduate texts, there is an emphasis on the self-correcting aspects of the modern macroeconomy. Recessions are eventually overcome as prices adjust to the right levels, even in the absence of government policy.

 

…[E]ven when unconstrained, price movements are often insufficient to clear markets, as pointed out by George Akerlof, A. Michael Spence and Joseph Stiglitz in work that garnered them the Nobel Prize. This outcome is particularly likely in markets where both sides of an economic transaction have differing sets of information, like in the credit market. During the financial crisis of 2008, the asymmetry of information regarding each institution’s financial situation was so pronounced that lending fell precipitously as trust dissipated. These informational problems were only exacerbated as lending fell further. Eventually, no interest rate could induce lending and price failed to clear the credit market. Restoring the functioning of the credit markets required mitigating those information asymmetries, essentially by way of short-term government guarantees.

…The crisis highlighted the existence of these self-reinforcing feedback loops, and we ignore them at our peril.

Jeffry Frieden and I expand upon this theme in our book Lost Decades (p.89).

As prices dropped, the feedback loop that had fed the bubble took
hold in reverse, with a vengeance. Homeowners with mortgages
worth more—sometimes much more—than their homes had good
reasons simply to give up and turn the house over to the bank. As
foreclosures mounted and creditors tried to unload the houses they
had been stuck with, prices were forced down further. Even many
of those who wanted to try to keep up payments were done in by
the financial innovations that had previously made their mortgages
attractive. When home prices were rising, it was easy to refinance at
attractive rates; as they fell, it became impossible to refinance. …

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18 thoughts on “Lessons from the Crisis for Teaching Macro

  1. Bruce Hall

    So, to paraphrase, after a period of great excess there is likely to be a period of great correction.
    I wonder if that can apply to governments that spend money they don’t have? Well, maybe it won’t happen to the government. Maybe the correction will happen to the governed.
    Sort of like cooking with too much Greece?

  2. W.C. Varones

    The central takeaway from the crisis is that the central planners are all corrupt and/or incompetent: Greenspan, Bernanke, Geithner, Rubin, Dodd, Raines…
    … and yet Menzie’s takeaway is that we need more central planning.

  3. ppcm

    Naturally, an economist should be a philosopher but only after having tried the rigorous methods of applied statistics.When time comes to opt for a school of thoughts, stoicism is highly recommended.The principles of economics are not wrong by themselves but once approved they should be managed by accountants,but once accounts are approved, they should be told by politicians. In reality the chain of accomplishments are in reverse,the politicians tell the accounts,the accountants make them,the economists interpret them,the stoics go to sciences Po.

  4. Chris

    Menzie, I felt you and Alan Blinder (along with Mirion) were the only ones who made serious, level-headed statements rather than the hyperbolic, overblown junk promoted by the likes of Mona Chalabi. I really hope that they ask you back for even more guest spots and articles in the future– it would go a long way toward healing the image of economics as a field of study (which one needs to ask if the other contributors had such a goal in mind).
    W.C. Varones- you truly are hopeless if you really think you can legitimately boil down Menzie’s succinct contribution to some inflammatory, attention-craving nonsense so absurd and wrong. Perfect information is a staple of competitive markets and rational economic behavior, yet when Menzie proposes a real solution to the problems of imperfect information you call it central planning. You are not an individual who makes rational sense.

  5. Kevin Donoghue

    “In the typical introductory textbook, wages and prices adjust so that labor is fully employed and goods are sold at the right price.”
    Maybe things have changed since I was a student, but too often teachers seemed to want to convince us that their models were not only worth knowing, but right in some sense. Although Joan Robinson’s economics never made much sense to me, there is an awful lot to be said for her approach to orthodoxy: learn it well so that you won’t be fooled by it.

  6. reason

    A little anecdote,
    I worked in economics once, and was asked to analyse the eigenvectors and eigenvalues of a log linear model. Turns out one of the eigenvectory was explosive. Can’t be said the boss. He lost faith in this model (his baby) after that. Positive feedback is a dirty secret in economics.

  7. ppcm

    In light of recent information regarding the sudden death of the Science Po Director Mr Descoings( BLOOMBERG,Sciences-Po Head Descoings Found Dead in New York Hotel), information unknown by me at time of writing.My full comments are not suitable.
    May be this version would more balanced.
    Naturally an economist should be a philosopher but only after having tried the rigorous methods of applied statistics.When time comes to opt for a school of thoughts, stoicism is highly recommended.The principles of economics are not wrong by themselves but once approved they should be managed by accountants,but once accounts are approved, they should be told by politicians. In reality the chain of tasks are in reverse,the politicians tell the accounts,the accountants make them,the economists interpret them.

  8. dwb

    In retrospect I do not think economists in general appreciated:
    1. the degree to which nominal debt on houses (which fundamentally are 30 yr fixed-price contracts for housing goods) are just “sticky prices”. Sticky prices are what give money real effects when the Fed tightens and result in recessions. when you try to pop a “bubble” in a huge sector of the economy with trmendously sticky prices, guess what happens – its like prodding a bear.
    The workout process (foreclosure) is fundamentally just resetting debt contracts for housing at lower prices.
    2. The extent to which regulation (or lack therof) drive prices. By that I mean, the lack of regulation of subprime no-documentation mortgage (the failure by regulators to demand more capital be held against them, the failure to dig deeper into lending standards). The price of credit on owner occupied strucures was in a tremendous imbalance compared to rentals.
    And when the Fed tried to turn the wheel, see #1.
    3. two words: Continental Illinois. Go back and read a dissection of why they failed (reliance on originate to distribute model, low capital and poorly documented loans…). There is nothing new under the sun. You can read a report on CI and replace them with Lehman and its the same report 30 years later.
    regulators need to remember history.

  9. JLR

    I graduated from UW-Madison majoring in economics. Even with calculus, econometrics, and a couple of graduate level courses, I never thought that one could actually understand economics. I was gratified when someone quoted the old saw about driving by the rear view mirror.
    ***
    For a few years I worked in a software company which developed electronic trading software. The most important thing I learned there was, “No one knows the market price.” We could prove it. Hundreds of market professionals (all who claimed that since they had done this for years knew the price) The price volatility from hour to hour, day to day, week to week, and season to season ran huge. We had models. We had models with dynamic corrections. We had years of data. The cost of information was lowest for us. We still could not predict the market price of any given item at any given time.
    ***
    I think that economics should be taught like quantum physics. There is a lot of evidence that the (insert issue studied) is averaging right around here. However, since it is in constant flux the answer is not wholly accurate–just a better model to explain phenomenom than others.

  10. W.C. Varones

    Chris,
    The point is that economists find plenty of flaws in markets, and then assume a benevolent and omniscient policy-maker to remedy them.
    Economists ought to spend more time studying the flaws in policy-makers, their conflicts of interest and errors in judgment.
    It wasn’t a free market that kept interest rates artificially low and created the perception of a riskless world where banks could feel comfortable levering up 30-to-1.

  11. Buzzcut

    “regulators need to remember history.”
    Regulators need to learn the lessons of history, but no one can agree on what those lessons are.
    If there were no banking regulation whatsoever, would the crisis have occurred? To what extent did capital requirements themselves drive the crisis (the “Engineering the Financial Crisis” theory).

  12. dwb

    Regulators need to learn the lessons of history, but no one can agree on what those lessons are.
    no: google search Continential Illinois and find FDIC reports and case studies. cross out CI and Penn Square and substitute Lehman and Countrywide (or Golden West or…)
    “The aggressiveness and loan policies that had met with so much praise during the
    “go-go” years were now seen in a far more critical light. The financial press began to write
    about faults in the bank’s management, internal controls, and loan pricing.
    “The deterioration in Continental’s condition and earnings, coupled with its reliance on
    the Eurodollar market for funding, helped make the bank vulnerable to the high-speed electronic
    bank run that took place in May 1984. Among the factors that caused the run to start
    and made stopping it difficult, rumor was prominent. On May 9, Reuters asked Continental
    to comment on rumors that the bank was on the road to bankruptcy; the bank condemned
    the story as “totally preposterous.””
    “As the nation’s seventh-largest bank, Continental forced regulators to recognize not
    only that very large institutions could fail but also that bank regulators needed to find satisfactory
    ways to cope with such failures.”
    Seriously: NOTHING NEW UNDER THE SUN
    http://www.fdic.gov/bank/historical/history/235_258.pdf

  13. Anonymous

    W.C.;
    More ignorance demonstrated on your part. Economists spend the most time assuming markets are perfectly competitive, the only time spent on “flaws” arise explaining the huge gulf between this theory and observed reality.
    If you weren’t so bitter and uninformed you would know that more than plenty of economists spend time studying the “flaws” in policymakers. Maybe you have never heard of Public Choice Theory, or “Government Failure”; both of which pervade economics literature on the public sector.
    So once again we are left with the only sensible conclusion; that you are not an individual who makes rational or logical sense.

  14. W.C. Varones

    Anonymous,
    Please put “Public Choice Theory” or “Government Failure” in the little Econbrowser search box at the top right. How many hits do you get?
    Try the same with other prominent economics blogs and mainstream media sites like DeLong and Krugman.
    You’d think if Public Choice Theory were such a hotbed of research, there would be a lot more prominent discussion of it.
    It was wise to hide behind “Anonymous” for your off-base attack.

  15. Menzie Chinn

    W.C. Varones: That’s partly because “public choice” is a pretty old term for a school of thought. I wrote a paper in this vein in the early 1980′s; even then we used the term “capture” due to Joe Kalt, to describe this phenomenon (see this post). This is particularly true as the approaches have become more mathematical (the older versions were more descriptive/talky in nature). Consider the “Protection for sale” literature.

  16. Menzie Chinn

    W.C. Varones: Well, my reading of Simon Johnson and James Kwak’s Thirteen Bankers is a dissertation on the capture of government by finance.

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