There is a danger in this business. If you don’t mark your beliefs to market occasionally, and throw out worthless intellectual trash, you ossify–you become one of those demented old coots detached from reality ranting unintelligibly at the moon.
So what major analytical mistakes–errors of either theoretical analysis, of empirical description of reality, or of applying theory to reality–have I made in the past decade?
I can think of three offhand to start the ball rolling. I erred:
- In my belief that central banks had the tools, the skill, and the political will to stabilize economies at high levels of employment and low levels of inflation, and thus that fiscal policy and financial institutions policy no longer had any compelling stabilization policy role to play.
- In my belief that large, leveraged financial institutions had sufficient caution and sufficient control over their derivatives books that their derivative positions did not pose major systemic risk.
- In my belief that the principal threat to the world economy would come from the fact that in a crisis the shaky long-term finances of the U.S. social insurance state might provoke a collapse of confidence in the long-term value of the dollar.
These were three biggies. But surely there were others. What were they?
I shared in one and two, though not three. I’m starting to believe in #3 however.
(That said, I would word #1 differently; for instance, I have long believed in automatic stabilizers and still do and I remain more skeptical of “ramp-up” spending than Brad. I would phrase #2 to focus on the balance sheet more generally and not derivatives per se.)
I also take the data on slow median income growth more seriously than I used to. I no longer think those numbers are a mere statistical artifact.
What can you all cite as changed beliefs? Examples like “Person X or Policy X turned out to be even worse than I had thought” do not count.
It’s a Friday in August, with nothing to report but the dismal GDP figures we were all expecting. So I’ll start with the Iraq War:
1) I erroneously believed that I could interpret the actions of Saddam Hussein. He seemed to be acting like I’d act if I had WMD. Whoops! I wasn’t an Iraqi dictator, which left huge gaps in my mental model of Hussein.
2) I erroneously extrapolated the experience of World War II to Iraq. This took several forms:
a) I overlooked the fact that Japan and Germany were both stable bourgeois nations with solid industrial bases long before we got into the act.
b) I overlooked the fact that we completely destroyed this nations before occupying and reconstructing them.
3) I was insufficiently empathetic in imagining how Iraqis would feel about our invasion. We liked the French for giving us military help during the Revolution. Now imagine that France had invaded in order to liberate us from the British. Even if they really did eventually leave, this would have had much worse results. Looking back, my confidence in our liberatory powers seems terribly callous, and it doesn’t really do the dead Iraqis much good that I’m sorry for it.
These things led me to underestimate the time and expense of the war (both fiscal and in human lives), and underestimate the benefits. Maybe history will vindicate the invasion, but I can’t say this seems likely.
Onto the financial crisis, where my erroneous beliefs are probably pretty typical:
1) I recognized the housing bubble pretty early (the first mention I can find on my old blog is in 2002)–but I had no idea it would have these kinds of broad, devastating effects. If you had asked me in 2006 what would happen as a result, I would have pictured
a) a wealth-effect lead recession, as consumers realized they weren’t as rich as they thought
b) a decline in the construction industry
c) some bank failures.
I would not have pictured wholesale runs on the money markets, the collapse of the shadow banking system, and 10+% unemployment.
2) I believed in the “Great Moderation”. That is, I believed that the Fed and prudent fiscal policy had, to a large extent, tamed the business cycle. I did not believe that there was even a small risk of another Great Depression; I believed that the Fed could and would prevent the contagion from spreading. Arguably they (and the Treasury) did, but I did not imagine anything close to that level of intervention being necessary.
3) I believed regulators were smarter than they were. In 2004, when the SEC decided to let the investment banks lever up to 30-to-1 instead of 12-to-1, because after all, the SEC had the tools to quickly identify and stop any contagion, I would have said they were probably right. (I’m not sure I was aware of it).
4) I believed bankers were smarter than they were. Or rather, I believed the system was smarter than it was. Individual bankers making idiotic mistakes? Absolutely. The occasional bank being brought low? Sure–it happens pretty regularly, in fact. But the whole banking system taking its entire balance sheet to the roulette table and laying it all down on a single bet? Ridiculous.
5) I expected any crisis to come from America’s gaping current account balances and its long-term entitlement problems. Again, arguably this was true, if you believe the “Global Savings Glut” theory (I’m inclined to). But I expected the problems to come via a currency crisis, not a global meltdown touched off by crappy US mortgage bonds.
6) I believed that over reasonably long time-frames, modest investments in equities would allow you to retire in comfort.
7) I believed that securitization mitigated risk by spreading it around, rather than enhancing risk by reducing transparency.
8) As a corollary, I believed that on the whole, Fannie/Freddie were harmless–not a libertarian ideal, of course, but hardly the worst thing the US government was doing. I still don’t think they were the worst thing the US government was doing, but I think that their distortions of the market were toxic, and have been especially so in the wake of the crisis*.
9) I believed we knew a lot more about the Great Depression, and how to fix such a thing, then we turned out to. I don’t think we know much at all about the various roles of fiscal and monetary policy; I think the only lessons we know for certain are “don’t peg your currency”, and “don’t let the banking system collapse”.
10) I underestimated the danger that new financial instruments pose to a system in which neither the bankers nor the regulators understand their unexpected effects.
Random policy things I was wrong about:
1) The bankruptcy reform reduced bankruptcies more, and for longer, than I expected. Still don’t think it was on net good policy, but about this empirical effect Todd Zywicki was right, and I was wrong.
2) I think it’s possible the Medicare Prescription Drug benefit may actually be saving money in other parts of the system. (Sorry, George!)
3) I was too optimistic about Doha; I no longer expect any serious trade liberalization for at least the next decade, maybe more.
On the political side:
1) I would never have imagined the 21st century United States Government effectively nationalizing an automaker and an insurance company.
2) I was astonished that Democrats managed to hold their coalition together to pass an incredibly unpopular policy in the odd belief that it would somehow get more popular later. (Oops)
3) I would never have predicted the emergence of the Tea Parties as an important phenomenon.
1. My way of thinking about the price/rent ratio for housing (see this post from 2003) caused me to think in terms of values that might be reasonable, not historical norms. When the price/rent ratio went above historical norms, I did not consider this in and of itself as an alarming sign. If I had, I would have started worrying much sooner and much more about high house prices.
Until very late in the game, I thought that the biggest threat to the housing market was an increase in the real interest rate, as opposed to a purely internal bubble/collapse.
2. I was sure that the stress tests used by Freddie and Fannie and the capital regulations at bank were sufficient to keep those institutions from taking on excessive credit risk. I thought that the sub-prime crisis would only cause newer, peripheral institutions to go bankrupt.
Incidentally, the Report released yesterday by the regulator overseeing Freddie Mac and Fannie Mae was very disappointing to me in that it says nothing about stress tests. What I would like to know is this: as of December, 2007, how much capital should Freddie and Fannie have been holding in order to conform to the regulatory stress test requirements? Did they have enough? Too little? More than enough? Then, subsequently, how bad was the housing price outcome relative to the stress tests? And what do the stress tests say now?
I strongly suspect that the actual house price outcome was not dramatically worse than what is used in the stress testing methodology. Instead, I suspect that Freddie and Fannie were way under-capitalized all along based on the stress tests, and that the regulator was not aggressive in dealing with the problem. My guess is that the regulator is not terribly eager to bring this to our attention.
3. I thought that the economy had become less susceptible to cyclical downturns. In April of 2003, I wrote The Elastic Economy, which argued that “the private sector has become more chaotic but more robust.” Read the whole thing. I also believed that inventory corrections would be less of a problem, for two reasons. First, the share of GDP represented by automobiles and other durable goods is much lower. Second, computer systems have made inventory management less mistake-prone.
4. I’ll talk about derivatives, not because I was wrong but because Brad and Tyler bring them up. From the late 1990’s until 2008, I was not interested in financial markets, so derivatives were off my radar screen. Back in 1986, the Fed published a book-length staff study on “Financial Futures and Options in the Economy,” and I wrote a chapter called “Futures Markets and Transaction Costs.” My view was that derivatives markets on organized exchanges serve to reduce transaction costs. Then and now, my thinking tended to downplay the role of derivatives as hedging and risk-management tools. So I would probably not have drunk the Kool-Aid that said that these were making financial markets more able to handle risk.
Back in the 1980’s, I got the sense that a lot of financial executives who played around with derivatives had insufficient understanding of option-pricing models. (You should have seen some of the S&Ls that bought “CMO residuals” for yield back in the 1980’s. I had not yet coined the term “suits vs. geeks divide,” but the phenomenon certainly existed.) So the fact that some companies blew up because of derivatives is not a shock to me. And I don’t think that regulated exchanges are the answer. Google for “Arnold Kling credit default swaps exchange” to see why.
I first heard about credit derivatives when my former Freddie Mac colleague Frank Vetrano mentioned them during a break at one of our fantasy baseball auctions one year at Dave Andrukonis’ house. This was some time around 1999 or 2000, after I had left Freddie, and I did not think that credit derivatives made much sense or would amount to anything. Judging by subsequent market volume, I was clearly wrong in thinking they would not amount to anything. As to whether they make sense, I think one could say that is still an open issue.
5. I would say that I have become less of a Keynesian since the crisis took place. Before the crisis, I would have stuck up for Keynesian macro, with the proviso in (3) that I would have thought that Keynesian demand policies would be needed less going forward. I was always a skeptic on monetary policy, and I continue to have a lot of skepticism. But I developed the whole Recalculation Story and related ideas as kind of a delayed, semi-subliminal response to a Tyler Cowen blog post as well as thinking about various empirical phenomena, such as the JOLTS data. However, whether I was most wrong in believing in Keynesian economics before or whether I am most wrong now in believing the Recalculation Story is certainly an open issue.
Looking back on my eighth (!!) year of blogging, here are the big things I think I got wrong over the past year:
1) The Green Movement did not cause Iran’s regime to crack up. Score one for the Leveretts — Iran’s regime has effectively silenced the Green movement, without any visible internal cost. Indeed, the regime now seems entrenched enough so that the fundamentalists and conservatives can now ignore reformists and start turning on each other. I confess, I though the Ashura protests marked an inflection point on Iran. Nope. The regime has suffered some serious costs from its internal repression, but Khamenei ain’t going anywhere anytime soon.
2) Iceland was willing to pay the price of financial isolation. I knew that Icelanders were outraged at the notion that they had to help bail out Icesave depositors in England and the Netherlands. I also thought, however, that when the question was put to a referendum, Icelanders would pause for a moment and consider the ramifications of financial isolation. Um… whoops.
3) The G-20 was been far less useful than I anticipated. A year ago at this juncture I was pretty pessimistic about the prospects of G-20 macroeconomic policy coordination. I was hopeful, however, that the G-20 could function effectively as a mechanism to pressure China into revaluing the yuan.
And… things are worse on both fronts than I anticipated. At Toronto, the G-20 encouraged contractionary fiscal policies way too early, helping to push the global economy into double3-dip territory. On the yuan, China has niminally pledged to let the yuan float, but acual movement has been pretty meager.