BERKELEY – We economists who are steeped in economic and financial history – and aware of the history of economic thought concerning financial crises and their effects – have reason to be proud of our analyses over the past five years. We understood where we were heading, because we knew where we had been.
In particular, we understood that the rapid run-up of house prices, coupled with the extension of leverage, posed macroeconomic dangers. We recognized that large bubble-driven losses in assets held by leveraged financial institutions would cause a panicked flight to safety, and that preventing a deep depression required active official intervention as a lender of last resort.
Indeed, we understood that monetarist cures were likely to prove insufficient; that sovereigns need to guarantee each others’ solvency; and that withdrawing support too soon implied enormous dangers. We knew that premature attempts to achieve long-term fiscal balance would worsen the short-term crisis – and thus be counterproductive in the long-run. And we understood that we faced the threat of a jobless recovery, owing to cyclical factors, rather than to structural changes.
On all of these issues, historically-minded economists were right. Those who said that there would be no downturn, or that recovery would be rapid, or that the economy’s real problems were structural, or that supporting the economy would produce inflation (or high short-term interest rates), or that immediate fiscal austerity would be expansionary were wrong. Not just a little wrong. Completely wrong.
Of course, we historically-minded economists are not surprised that they were wrong. We are, however, surprised at how few of them have marked their beliefs to market in any sense. On the contrary, many of them, their reputations under water, have doubled down on those beliefs, apparently in the hope that events will, for once, break their way, and that people might thus be induced to forget their abysmal forecasting track record.
So the big lesson is simple: trust those who work in the tradition of Walter Bagehot, Hyman Minsky, and Charles Kindleberger. That means trusting economists like Paul Krugman, Paul Romer, Gary Gorton, Carmen Reinhart, Ken Rogoff, Raghuram Rajan, Larry Summers, Barry Eichengreen, Olivier Blanchard, and their peers. Just as they got the recent past right, so they are the ones most likely to get the distribution of possible futures right.
But we – or at least I – have gotten significant components of the last four years wrong. Three things surprised me (and still do). The first is the failure of central banks to adopt a rule like nominal GDP targeting or its equivalent. Second, I expected wage inflation in the North Atlantic to fall even farther than it has – toward, even if not to, zero. Finally, the yield curve did not steepen sharply for the United States: federal funds rates at zero I expected, but 30-Year US Treasury bonds at a nominal rate of 2.7% I did not.
The failure of central banks to target nominal GDP growth remains incomprehensible to me, and I will not write about it until I think that I have understood the reasons. As for wages, even with one-third of the US labor force changing jobs every year, sociological factors and human-network ties appear to exercise an even stronger influence on the level and rate of change – at the expense of balancing supply and demand – than I would have expected.
The third surprise, however, may be the most interesting. Back in March 2009, the Nobel laureate Robert Lucas confidently predicted that the US economy would be back to normal within three years. A normal US economy has a short-term nominal interest rate of 4%. Since the ten-year US Treasury bond rate tends to be one percentage point above the average of expected future short-term interest rates over the next decade, even the expectation of five years of deep depression and near-zero short-term interest rates should not push the 10-Year Treasury rate below 3%.
Indeed, the Treasury rate mostly fluctuated between 3% and 3.5% from late 2008 through mid-2011. But, in July 2011, the ten-year US Treasury bond rate crashed to 2%, and it was below 1.5% at the start of June. The normal rules of thumb would say that the market is now expecting 8.75 years of near-zero short-term interest rates before the economy returns to normal. And similar calculations for the 30-year Treasury bond show even longer and more anomalous expectations of continued depression.
The possible conclusions are stark. One possibility is that those investing in financial markets expect economic policy to be so dysfunctional that the global economy will remain more or less in its current depressed state for perhaps a decade, or more. The only other explanation is that even now, more than three years after the US financial crisis erupted, financial markets’ ability to price relative risks and returns sensibly has been broken at a deep level, leaving them incapable of doing their job: bearing and managing risk in order to channel savings to entrepreneurial ventures.
Neither alternative is something that I would have predicted – or even imagined.