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At long last, economists appreciate that private debt was the catalyst for the crisis

At long last, economists appreciate that private debt was the catalyst for the crisis

This month saw the tenth anniversary of the collapse of Lehman Brothers, a collapse which precipitated one of the only two global financial crises of the past 150 years.

The late 2000s and early 1930s were the only periods in time when capitalism itself has trembled on the edge of the precipice.

It was in November 2008 that the Queen put her famous question about the crisis to the academics of the London School of Economics: “Why did nobody notice it?”

The answer is simple. In the models of the economy at the time, finance did not matter.

Mainstream economists did not notice the massive financial imbalances in the economy, because in their models, any problems that might link to these imbalances were assumed away.

To be of any use, all scientific models have to make simplifications of reality. But orthodox macroeconomics took a step too far. It assumed that the workings of the whole economy could be explained by analysing the theoretical behaviour of just a single decision maker. In the jargon, this is the “representative agent”.

The agent is a device which economists used to model the economy. It was extremely clever, and could solve hard mathematical problems – calculating how the decisions of average consumers and companies would affect the macroeconomy.

These kinds of models go by the splendid name of “dynamic stochastic general equilibrium models”, or just plain “DSGE” to their friends. But at its most basic, the problem with such economic models was that there was only one decision maker in them.

Having just two, a “creditor” and a “debtor” for example, would have helped a lot.

Over the past decade, economists have been scrambling to incorporate other financial factors into their models, such as household debt. Key contributions to this research are discussed in the latest issue of the Journal of Economic Perspectives.

Bizarre though they may seem, DSGE models now finally recognise the potential importance of household finance in causing crashes.

A particularly interesting paper in the journal is by Atif Mian of Princeton and Amir Sufi of Chicago. Their focus is considerably wider than the crisis of the late 2000s in the United States. They quote empirical studies across some 50 countries with data going back to the 1960s. They found that a rise in household debt relative to the size of the economy is a good predictor of whether GDP growth will slow down.

Rickard Nyman, a computer scientist at UCL, and I applied machine learning algorithms to data on both public and private (households and commercial companies) sector debt in both the UK and America. We find that the recession of 2008 could have been predicted in the middle of 2007.

Perhaps the most striking result is that public sector debt played little role in causing the crisis. The driving force was the very high levels of private sector debt.

A critic might say that this is simply a case of generals fighting the last war.

True, we don’t know whether a completely different nasty event lies around the corner. But at long last, economists appreciate the fundamental importance of debt and finance in Western economies.

As published in City AM Wednesday 26th September 2018

Image: Her Majesty The Queen by UK Home Office on Flickr licensed under CC-BY 2.0
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The Bank of England’s own data negates Carney’s overhyped house price warning

The Bank of England’s own data negates Carney’s overhyped house price warning

No one can tell them quite like Mark Carney, the governor of the Bank of England.

He appears to have briefed the cabinet last week that house prices could fall by 35 per cent in the event of a no-deal Brexit.

To be fair, the Bank did try to qualify this figure by saying that it was just the worst of several scenarios which analysts had produced in order to stress test the balance sheets of the commercial banks.

But the 35 per cent house price drop has now become embedded in the public narrative about Brexit.

Just how likely is such a massive drop to take place?

We do not know exactly how the Bank did its stress tests. But, typically, the worst-case scenario in such tests is either one which is judged to have a one in 20 chance of happening, or, if you are setting really demanding standards for the test, just a one in 100 chance.

When trying to assess these odds, an important input is what has happened in the past. The past may of course not be a reliable guide to the future, but it is all we have to go on.

An analogy from the sporting world might help. Every year, three clubs from the Championship are promoted to the Premier League. What are the chances of one of them being relegated after their first season in the top league?

We can look at the historical record since the Premier League began in 1992/93, which helps us form an initial view. We might then qualify it, and set the benchmark – a 44 per cent chance of relegation, since you ask.

With house prices, we can go much further back in time, as far back as 1845 to be exact. And the source of this information on nearly two centuries of house prices data is none other than the Bank of England itself.

Over all this time, there has never been a cumulative fall in the Bank’s house price series of as much as 35 per cent.

The closest we have seen was in the opening decade of the twentieth century in the run-up to the First World War. The UK economy was pretty much in the doldrums, and between 1902 and 1909, prices fell by a total of 33 per cent.

Nothing else remotely compares to this drop.

There have been two global financial crises over this period. In the 1930s, house prices fell by only seven per cent between 1929 and 1934.

And following the most recent crash, the reduction between 2007 and 2009 was 13 per cent.

In America, the Case Shiller house price index was 21 per cent lower in 2011 than it was in 2006, but this is the largest fall in that particular database.

The governor is therefore inviting us to believe that, in the event of a no-deal Brexit, house prices may fall by more than they have ever fallen since the Bank’s own data began in 1845.

How did the Bank arrive at this figure? I think we should be told.

As published in City AM Wednesday 19th September 2018

Image: Mark Carney by Bank of England on Flickr licensed under CC-BY-ND 2.0
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It’s time to question the macroeconomic orthodoxy on interest rates and inflation

It’s time to question the macroeconomic orthodoxy on interest rates and inflation

Mark Carney, governor of the Bank of England, is getting his retaliation in early.

Faced yet again with the Bank failing to deliver its designated target of a two per cent inflation rate, in a speech last week he suggested that his remit was broader.

“We face a tradeoff between having inflation above target and the need to support, or the desirability of supporting, jobs and activity”, the governor stated.

In other words, he claimed that the Monetary Policy Committee (MPC) of the Bank should be concerned not just with inflation, but with what economists describe as the “real” economy, output and jobs.

The Federal Reserve in the US is explicitly mandated to take account both inflation and the real economy when it sets interest rates. This is definitely not the case with the Bank of England. When Gordon Brown made it independent in 1997, its remit was unequivocal. It was to ensure that inflation was two per cent a year.

This time round, inflation is above the Bank’s target. The current level of some three per cent may even rise in the short term because the weakness of sterling is pushing up the cost of imports.

But in recent years, inflation has been below the two per cent desired rate, even falling to zero in 2015.

All this time, Bank rate has been essentially flat. The MPC cut it to just 0.5 per cent in March 2009, where it remained until the reduction to 0.25 per cent in August 2016.

To put this into perspective, when the rate fell to 1.5 per cent in January 2009, this was the first time it had been below two per cent since the Bank was created in 1694, well over 300 years ago.

So here is a puzzle for mainstream macroeconomists, whether in central banks or universities. Central banks are meant in theory to be able to control inflation by setting short term interest rates. Inflation has been low since 2009. But at the same time, the Bank rate has been at all-time record lows.

Perhaps more pertinently, inflation has fluctuated from year to year, even though interest rates have to all intents and purposes not changed. It was 4.5 per cent in 2011, and 0.7 per cent in 2016.

In short, inflation seems to lead a life of its own, independently of what the experts on the MPC either say or do.

Inflation really is a naughty boy all round. A central concept in orthodox economic thinking, encapsulated in the quote from Carney above, is that there is a tradeoff between inflation and jobs and output. The faster the economy grows and unemployment falls, the higher inflation will be.

But starting in the early 1990s, for around 15 years across the entire Western world, both inflation and unemployment experienced prolonged falls.

The idea that a central bank can control inflation by adjusting interest rates is shown by the evidence to be absurd.

It is yet another example of the limits to knowledge in orthodox macroeconomics.

As published in City AM Wednesday 25th October 2017

Image: Mark Carney by Bank of England is licensed under CC by 2.0
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