July 23, 2008
Cherished myths fall victim to economic reality
By Paul De Grauwe
The financial crisis continues to create victims. Not only people but also some of our most cherished ideas risk falling by the wayside. Take the hugely influential idea that financial markets are efficient. Its proponents told us that when financial markets were left free, they would work miracles. Savings would be channelled to the most promising investment projects, thereby boosting economic growth and welfare. In addition, these financial markets would spread risk around over a large number of participants, thereby lowering the risk of doing business, again boosting growth and welfare. In order to achieve these wonders, financial markets had to be freed from the shackles of government control.
The country that embodied these principles most was the US. Helped by the missionary zeal of successive American administrations and pushed by international financial institutions, country after country freed their financial markets from pernicious government controls, hoping to share in these economic wonders.
The remainder of this column can be read here. Debate from our panel of economists appears below.
The recent financial crisis in the U.S. cannot discredit free financial markets as no such market exists in the U.S.
The main “product” of financial markets is money, in this case, the U.S. dollar. However, the Federal Reserve sets the price of dollars via interest rates - more specifically, the cost to “buy dollars” via loans. Such price setting is the antithesis of a free market. Hence, while you state that financial markets do not efficiently distribute capital, the fact is that interest rate controls by the Federal Reserve distort market signals, thus making efficient allocation impossible.
This is not to say that markets are always perfectly efficient, that humans always act as rational economic agents, or that financial models can accurately capture the workings of something as complex as a national economy. However, how do you not expect the government through tighter regulations to do much worse? Politicians and bureaucrats are also fallible humans subject to lapses in economic rationality, and policy advisors rely on the same complex economic models and antiquated economic theories that you question. Indeed, the quest for political power and misaligned financial incentives fraught in government spending add to the difficulties of devising any type of useful government regulation of markets.
I also do not claim that banks, mortgage brokers, et. al. acted with the appropriate fiduciary responsibility due to their clients. However, criminal laws against fraud cover such malfeasance without the introduction of market-interfering regulations.
Justin Rietz
Posted by: Justin Rietz | July 23rd, 2008 at 6:18 am | Report this commentBA Economics, Stanford University
MBA, Haas School of Business, UC Berkeley
Martin Weale: Mr de Grauwe’s critique of economic models used by central banks rather missed their point- at least if they are sued well. Models of how people would behave if they were rational are extremely valuable as tools for identifying when something is going wrong. This is one of their main purposes. Another one is surely to prevent the implementation of policies which work only if they are mis-understood.
Thus with models which assume rational behaviour, a modeller can say, for example, that savings levels are much too low- even if it is not possible to explain exactly the time-scale over which the problem will be resolved. No coherent model would suggest that the United States could sustain the behaviour of the last few years.
Posted by: Martin Weale | July 24th, 2008 at 10:57 am | Report this commentPaul De Grauwe:
Dear Martin,
I do not dispute the need to assume that individuals are rational in the sense that they maximize their utility (profits). My critique is about the informational assumption of DSGE-models. These models assume that individuals understand the underlying model (rational expectations) and that they all understand the same model. This assumption has far-reaching implications. One of these is that individuals do not make systematic mistakes. As a result, the DSGE-models also deny the existence of bubbles and crashes. It follows that there is no need for the monetary authorities to do much more than to stabilize prices.
When I argue that we have to develop models that makes less strong assumptions about the cognitive abilities of agents, I am not saying that these agents are irrational. They continue to be rational, but the information they have is limited. It is in such a context that optimal monetary policies should be analyzed.
The source of the confusion is that the “rational expectations” school lays an unjustified claim on the term “rational”, implying that if one departs from rational expectations one assumes that agents are irrational. This is not the case. One can certainly make less extreme assumptions about the capacity of agents to process information without assuming that these agents are irrational.
Best regards
Paul
Posted by: Paul De Grauwe | July 24th, 2008 at 8:14 pm | Report this commentMartin Wolf: Two comments on the above discussion seem in order.
First, Mr Rietz is aiming at the wrong target. Under a fiat money system (government-made money) the government (or its agent, the central bank) must set the price or the quantity of the money it creates. The only way to change this is to abandon fiat money altogether. That would involve either going back to commodity-based money or moving to a free market in money. So if someone wants to abolish the role of the central bank in determining the price of money, he or she needs to specify the alternative monetary arrangement.
Second, I agree with Paul that the present crisis has killed off much recent macroeconomic theorising: markets are not perfectly efficient; everybody does not understand the same, correct model of the economy; and so forth. All this is clearly correct.
What Paul has not done, however, is draw the implications. Obviously, he is not arguing that we should have no financial markets and no monetary policy. So how should the former be structured and regulated and the latter be run?
Is he really implying, at the end, that inflation does not matter very much? But does it not still make sense for monetary policy to aim at inflation, while other policies (regulatory, fiscal support and liquidity provision) deal with financial distress?
While I agree with much of what Paul says, does he think that a really big bout of inflation would now help, other than being a politically convenient way of bailing out profligate borrowers? Quite a few people did not think house prices would rise forever and so did not borrow up to the hilt. Are we suggesting that these people should be punished for their good sense?
In other words, I do not think the fundamentals of decent and sensible monetary policy have changed so much, just because some economists have been too clever by half.
Posted by: Martin Wolf | July 27th, 2008 at 4:41 pm | Report this commentPaul De Grauwe: I am not implying that inflation does not matter much anymore; rather that the trade-off between inflation and financial stability is quite painful today. The fight against inflation requires central banks to raise interest rates and limit credit creation. This is bound to increase the risk of a financial meltdown both directly and indirectly (the latter because it increases the likelihood of a recession, which will hurt banks even further).
So central banks must make a choice, i.e. they have to give a weight to inflation and financial stability. My criticism was that the models central bankers use today biases them towards giving a strong weight to inflation fighting, for the simple reason that these models only recognize inflation as a threat. Financial instability is not a threat in these models because agents with perfect information cannot produce financial crises.
I tend to think that central banks today should give a greater weight to financial stability than to inflation. I know that this can increase inflation, but it seems to me that the risk of a deepening financial crisis is now greater. I realize that Martin may disagree with this conclusion, and there is very little in terms of overwhelming evidence that I can give here.
Two more points I want to make in this connection. First, I have the feeling that inflation is likely to be temporary mainly because of a looming recession. This will dampen aggregate demand and bring down commodity prices (including oil prices). Second, central banks have set their inflation targets so low that it is not really surprising that once in a while inflation exceeds this target. Let’s not forget that the average inflation in Germany during the postwar period was about the level of inflation we observe today in the eurozone. Now people claim that this rate of inflation is excessively high. Yet the Bundesbank got its reputation from a rate of inflation that on average was close to this excessively hight present level.
Thanks for your comments, Martin
Posted by: Paul De Grauwe | July 29th, 2008 at 11:05 pm | Report this commentMartin Wolf: Paul’s comments raise two different questions: what are the long-term lessons of the crisis? And what should central banks do now?
On the first of these, I do not think we disagree profoundly. It is obvious that policy now needs to take account of the erratic behaviour of the financial system, though I am not convinced that monetary policy alone can do much to prevent financial bubbles.
On the second, however, we disagree rather more. I accept that trying to eliminate inflation too brutally might aggravate the financial crisis. For this reason, returning to the target should be a medium-term objective. It would certainly be foolish to wring out the immediate impact of higher commodity prices. Nevertheless, it would be disastrous if inflation expectations were to become unanchored. It would also be wrong for inflation to be deliberately used to tax the prudent for the benefit of the profligate. If governments do decide to rescue the financial system, let them do so openly and honestly, via taxation and public spending.
Posted by: Martin Wolf | July 30th, 2008 at 6:04 pm | Report this comment