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albert edwards central banks Markets

10 Years After Lehman: Hubris

Pride and fall.

Albert Edwards is back and it probably won’t surprise you to learn that he’s got some thoughts on central bank hubris on the tenth anniversary of the financial crisis.

The financial media has been awash this week in retrospectives on Lehman’s collapse and we’ve heard from some of the policymakers who in 2008 found themselves in the rather awkward position of having to rescue the world from a bubble that formed right under their noses and, arguably, with their consent (see the Op-Ed by Bernanke, Geithner and Paulson in the New York Times, for instance).

One of the points I try to drive home when it comes to assigning blame for burst bubbles in a world governed by an inherently “soft” science (economics), is that economists aren’t as oblivious to the shortcomings of their methods as critics often insist. Or at least the economists I know aren’t.

To be clear, my defense of economics (and of “soft” sciences and “pseudo-experts”, to quote the insufferable Nassim Taleb) isn’t based on extensive personal interactions with the economists who are actually in charge of making policy at the highest levels. As with any other profession, it’s unquestionably true that the higher one climbs on the ladder, the more arrogant one gets, and that arrogance undoubtedly served to blind the likes of Bernanke to what was happening in the lead up to the crisis.

But what I lack in face-to-face interactions with the handful of high-level policymakers who run the show, I like to think I make up for by the extensive personal interactions I’ve had over the years with dozens upon dozens of people you’ve never heard of but who practice the same “science” (or non-science, if you like) as that espoused by the Greenspans and Draghis and Bernankes and Yellens of the world. Believe it or not, these aren’t evil people and in my extensive experience, the “average” university-trained economist is acutely aware that he/she is not a physicist or a dentist (to use one of Taleb’s examples). I don’t know what Ben Bernanke would say after three beers, but I know what “regular” economists say when tipsy, and my experience isn’t that they think they’re masters of the universe with a complete command of the business cycle (even when inebriated to the point where most people think they can fly).

Ok, so with that obligatory defense of academia out of the way, let me excerpt Albert’s latest note because as ever, it’s worth highlighting. Here’s Edwards on Lehman and the extent to which things were already deteriorating prior to its collapse:

Without doubt, Lehman’s bankruptcy caused the financial system to seize up and for many this was the cause of the ensuing deep downturn and hence the focus on this one high profile event. But I have always found this explanation disingenuous and often an expost justification for those who had drunk the kool-aid and never foresaw the financial crisis and economic slump and that includes policymakers.

For even before the Sept 15 Lehman bankruptcy, the US economy had already collapsed into deep recession. In September 2008 we now know US payrolls declined 443,000 after a fall of 277,000 in August, and an average 190,000 decline in Q2. Although these numbers have been revised down, even at that time the Sept 2008 was reported as a fall of 159,000 having already lost 600,000 jobs that year (September’s 2008 survey was taken the week before the Lehman’s bankruptcy, so was unaffected by the fallout).

And here he is on central banker hubris:

I was amused to read the NY Times op-ed, co-authored by the three leading US policy makers at the time of the crisis (Ben Bernanke, Tim Geithner and Henry Paulson). In a piece entitled “What We Need to Fight the Next Financial Crisis” they lament the fact that Congress has taken away some of the tools that were crucial to us during the 2008 panic. It’s time to bring them back.

Tools! Apparently, they always need more tools. Rubbish, they had all the tools necessary. They just never recognised beforehand that the economy was a massive credit bubble just like it is now. It was worse than that. In 2005 Bernanke had even derided an interviewer who asked him about the possibility that the housing bubble could burst. And I also remember Shelia Bair, who headed up the FDIC (the Federal bank liquidator) at the time, and had successfully seized and closed many banks during that period, including the massive Washington Mutual, lamenting that she had not even been consulted about Lehman’.

He also cites comments from Peter Fisher, delivered last year at a conference held by Jim Grant. The full comments are embedded below, but this is the passage that Edwards alludes to:

Let’s agree that in the desperate conditions in which we found ourselves ten years ago, the Fed had a duty to be effective – to do no harm and preferably to do some good. How do we know that an action is reasonably likely to produce good outcomes? The second claim, that the central banks had a duty to experiment, is a stronger one and suggests a way of knowing whether an action may produce good outcomes. But simply invoking the scientific method is not enough. A duty to experiment, particularly when making guinea pigs of the rest of us, presumably carried with it a corresponding duty to scrutinize rigorously the results of their experiments – to apply what the late, great physicist Richard Feynman called “scientific integrity” requiring “a kind of utter honesty” – so as to learn from their failures and shortcomings.

Curiously, the Fed has acknowledged no failures. All the experiments have been successful, every one: no failures, no negative side effects, no perverse consequences, only diminishing returns.

Peter is in a far better position to make that latter claim than I’ll ever be, but do note that it is almost by definition a bit disingenuous. Implicit (and very nearly explicit) there, is the notion that no Fed officials have ever, in any context, admitted to screwing up at anything, ever.

Obviously, that’s not true. In fact, Peter is himself proof that it isn’t true because he’s a former Fed official.

In any event, Albert’s points excerpted above are duly noted. In fact, they’ve been duly noted by all kinds of people (economists included) since the crisis. There is no question that central banks, in their efforts to tame the business cycle, have created a kind of rolling, boom-bust dynamic. We’ve written voluminously about this. Here are two examples for anyone interested in exploring further:

The Spiral: ‘History Repeats Itself And The Price Is Higher Each Time’

I’m Out Of Bullets, How About You?

Ultimately, though, it’s important to remember that hubris isn’t the sole purview of economists and central bankers.

The idea that excessive pride comes before an inevitable humbling fall is a concept as old as Ovid and everyone would do well to bear it in mind – not just economists.

Undoing Extraordinary Monetary Policy, Remarks of Peter R. Fisher Tuck School of Business at Dartmouth Grant’s Interest Rate Observer Spring 2017 Conference New York, New York, March 15, 2017

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6 comments on “10 Years After Lehman: Hubris

  1. The failures of modern economics and banking policy are the failures to slay dogma. The present dogma has all manner of fancy mathematical formulae but there are akin to using dinosaur bones to prove dragons exist. Start from the premise there are dragons then assemble the bones to look like dragons… ergo dragons. Rather than starting from neuroscience and physics and building up from those cornerstones. We will continue to be stupefied when policy fails just as the men jumping from cliffs with wings strapped to their arms could not grasp why the birds flew but they plummet, until such time as we begin to examine the actual science of supply, demand, production and consumption and rebuild economics as a scientific field instead of a cult.

    • well, see, that’s the thing. there is no hard “science” of supply, demand, production and consumption. It makes no sense to talk about those things in terms of hard sciences. Economists are doing the best they can do. There will never, ever, ever, ever be a time when economics is a “hard” science. Because as soon as, for instance, you think you’ve discovered the foundational building blocks and physics of my demand function and consumption habits on the way to predicting I’m going to buy peanut butter today, I may decide to go to the strip club on a whim instead.

      • Haha, yes of course but then you cannot predict the explicit location of an electron only the probability distribution of it’s locations but the probability distribution is reflective of observed reality. I cannot tell you whether your next dollar will go to peanut butter or a strip club but I suspect neuroscience can build a predictive algorithm with high fidelity that tells the probability you do either at any given time. Meteorology is not as precise as 2+2 is four but it is highly science based and the predictive power grows with time and rarely does a storm predicted to have strong winds in summer instead produce sunshine and a light breeze. It is ultimately the unwillingness to be forthright and examine the experiments that limits its development.

  2. Our entire monetary system is a construct imposed onto us via force. On top of that the construct is run with the idea that those running it can model macro behavior. Reality is they cannot model macro behavior (because… humans) and no one asked for this construct to begin with. This means the construct is inherently going to fail as it already has multiple times in the past.

  3. Thomas Higgins

    How do we know if something is a hard science? First, it employs the scientific method: observation, theorization, experimentation, and formulation of the laws that govern a particular field of study. Second, practitioners of that field should be able to apply those laws to predict the outcome of a particular set of circumstances. Finally, if that field does have laws and if the practitioners do indeed understand what they are, it should be possible to use those laws to create a desired outcome. To borrow an example from the field of chemistry, Carrier used his knowledge of how gases operate to invent the air conditioner.

    Assuming that economies do indeed operate in accordance with certain laws and that economists have a thorough knowledge of what those laws are, one would imagine that these economic engineers would be able to create desired outcomes, that they would be able to counter the effects of economic crises. Has this been our experience?

    Did they, for example, immediately apply the lever necessary to end the GFC? In fact, despite protestations to the contrary, the crisis never ended. Not immediately nor even now, though ten years have passed. Otherwise, the markets wouldn’t threaten to have a heart attack at the mere suggestion that rates might rise above historically low levels.

    What actually happened was an exercise in trial and error. In an attempt to find some measure to deal with the crisis, the FED tried the Twist, numerous rounds of QE, near-zero interest rates, buying at par “assets” that could not otherwise be sold except at a steep discount, and various other stratagems.

    Nor is it just our economists who are not up to the challenge. For about 20 years the Bank of Japan has employed similar measures in an unsuccessful attempt to solve the crisis in their country. The record of the ECB of Europe since the GFC is no better.

    In short, economies do not operate in accordance with what a scientist would call laws, or if they do those laws are not discoverable through the scientific method. (An economy has so many inputs, many of which are unknown and possibly unknowable, that it would be impossible to control for all variables except for the one being tested.) Not surprisingly, economists lack the understanding necessary to bring about a desired economic outcome.

    As you rightly observed, Mr. Heisenberg, economists realize the limitations of their field of study. (If they hadn’t before, the unsuccessful decade-long attempt to bridle market forces has certainly taught them that fact.) This explains current Fed policy, but an elaboration on that theme is peripheral to the question at hand: Whether economics is a hard science with laws that economists might have used to predict and prevent the GFC.

    We know what Bernanke would have us believe: that the GFC was a bolt out of the blue, that neither the Fed nor anyone else could have seen it coming.

    There is a sense in which that is true. Economics is not a hard science, and it does not in the strict sense of the word have laws that economists might have used to anticipate the GFC. Just as economists are limited in their ability to positively affect an economy, their ability to make accurate predictions regarding the future of the economy is also severely constrained.

    Nevertheless, anyone with even a moderate amount of common sense could anticipate that trouble was brewing. Recall that the Fed had slashed rates in an attempt to limit the fallout from the implosion of the dot.com bubble some years earlier. The resulting flood of liquidity inflated a new bubble, this time in housing.

    One characteristic of bubbles is that they must either grow or die. And so it was here. The time came when pretty much everyone who could buy a house had already done so. In the natural course of things, the housing bubble would have collapsed.

    Obviously, that would never do. Various banks (Washington Mutual most prominently, though there were many others) decided to give house loans to “subprime borrowers,” the elderly (some more than 100 years old), illegal aliens, people without jobs or assets — all of the types of people who for legitimate reasons had been denied loans up until that time. To enable the borrowers to make the payments, banks issued “exploding ARM loans.” The payments would be small at first but within a few years they would rise as much as three times.

    “Of course,” the bankers said to themselves, “when the payments increase the borrowers will default and we will be left holding the bag. That would never do. Ah, I know! I’ll just ship the loans off to the big Wall Street houses. They will package them up as mortgage-backed securities and sell them to unwitting dupes. I’ll collect the origination fees, and when the borrowers default the MBS buyers — not my bank — will take the fall.”

    It should have been obvious to everyone with even a remote understanding of how the financial system works (and that certainly includes the Fed) that this would not end well. The subprime borrowers would default, and the owners of the mortgage-backed securities would go down (pension funds, chiefly, but a number of investment banks also).

    It should have been equally obvious that the fallout would not end there. Fannie Mae and Freddie Mac had insured a great many of these subprime loans. If, as proved to be the case, the defaults were sufficiently widespread, those institutions might well buckle under the financial strain. The mortgage-backed securities had also been insured with credit default swaps, and the issuers of these CDS’s (chiefly, the giant insurer AIG) would experience a great deal of pain. Widespread defaults would lower the value of real estate, harming real estate investment entities (not just REITs but also the large investment banking house Lehman Brothers, which had effectively transformed itself into a real estate hedge fund).

    There is much more on the subject that I might say, but this response is already overly long. The point is that the danger was quite obvious, even to those without a background in economics. And, indeed, during the three years preceding the crisis Shiller, Roubini, Taleb and a great many others warned of the danger resulting from an imminent real estate collapse.

    Yet, Bernanke claims that the GFC came as a total surprise. Let’s just say that I find that excuse less than compelling.

  4. One big difference between meteorology and economics is clear. If you predict rain, and people change their plans accordingly, the validity of the weather prediction remains unchanged. With economics, a prediction can have behavioral consequences that can change the economy and skew reality away from the prediction.

    Nevertheless, I do think economic science could make better predictions if its practice were not affected by the dogma of economic religion. For example, I remember arguing with a business prof who strenuously but not convincingly argued for the complete efficiency of the stock market. Such assumptions make for well-behaved models and may provide an interesting comparison, but are completely untenable for predicting reality. (One of H’s favorite themes is the lack of price discovery in modern markets, intimately relared to market inefficiency.)

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