Should economists have foreseen the credit crunch? A few were warning of an overheated world economy with excessive credit and risk taking. Most economists prior to 2007/8, however, were predicting a continuation of steady economic growth. Inflation targeting, fiscal rules and increasingly flexible markets were the ingredients of this continuing prosperity. And then the crash happened!
So why did so few people see the downturn coming? Were the models used by economists fundamentally flawed, or was it simply a question of poor assumptions or poor data? Do we need a new way of modelling the economy, or is it simply a question of updating theories from the past? Should, for example, models become much more Keynesian? Should we abandon the new classical approach of assuming that markets are essentially good at pricing in risk and that herd behaviour will not be seriously destabilising?
The following podcast looks at these issues. “Aditya Chakrabortty’s joined in the studio by the Guardian’s economics editor Larry Elliott, as well as Roger Bootle, the managing director of Capital Economics, and political economist and John Maynard Keynes biographer Robert Skidelsky. Also in the podcast, we hear from Nobel prize-winning economist, Elinor Ostrom, Freakonomics author Steven Levitt, and UN advisor and developmental economist Daniel Gay.”
The Business: A crisis of economics Guardian podcast (25/11/09)
See also the following news items from the Sloman Economics news site:
Keynes is dead; long live Keynes (3/10/09)
Learning from history (3/10/09)
Macroeconomics – Crisis or what? (6/8/09)
The changing battle grounds of economics (27/7/09)
Repeat of the Great Depression – or learning the lessons from the past? (23/6/09)
Animal spirits (30/4/09)
Keynes – do we need him more than ever? (26/10/08)
Questions
- Why did most economists fail to predict the credit crunch and subsequent recession? Was it a problem with the models that were used or the data that was put into these models, or both?
- What was the Washington consensus? To what extent did this consensus contribute to the current recession?
- What is meant by systemic risk? How does this influence the usefulness of ‘micro’ financial models?
- What particular market failures were responsible for the credit crunch?
- What is meant by ‘rational behaviour’? Is it reasonable to assume that people are rational?
- Is macroeconomics too theoretical or too mathematical (or both)? If you think it is, how can macroeconomics be reformed to improve its explanatory and predictive power?
- Does a ‘really good economist’ need to have a good grounding in a range of social sciences and in economic history?
This podcast is from the Library of Economics and Liberty’s EconTalk site. In it, Scott Sumner of Bentley University discusses with host Russ Roberts the role of monetary policy in the USA since 2007 and whether or not it was as expansionary as many people think.
In fact, Sumner argues that monetary policy was tight in late 2008 and that this precipitated the recession. He argues that the standard indicators of the tightness or ease of monetary policy, namely the rate of interest and the growth in the money supply, were misleading.
Sumner on Monetary Policy EconTalk podcast (9/11/09)
Questions
- Why is it important to look at the velocity of circulation of money when deciding the effect of interest rate changes or changes in the monetary base? Can the Fed’s failure to take velocity sufficiently into account be seen as a cause of the recession?
- Is there evidence of a liquidity trap operating in the USA in late 2008?
- How could the Fed have pursued a more expansionary policy, given that interest rates were eventually cut to virtually zero and the monetary base was expanded substantially?
- Why does Sumner argue that monetary policy should focus on influencing the growth in aggregate demand?
- How useful is the quantity equation, MV = PT (or MV = PY) in understanding the role and effectiveness of monetary policy?
- What is the Keynesian approach to monetary policy in a recession? How does this differ from the monetarist approach? Are both approaches focusing on the demand side and thus quite different from supply-side analysis of recession?
- Why is the consumer prices index (CPI) a poor indicator of a nominal shock to the economy? Should the central bank focus on nominal GDP, rather than CPI, as an indicator of the state of the economy and as a guide to the stance of monetary policy?
- What are the strengths and weaknesses of using a Taylor rule as a guide to monetary policy? Would nominal GDP futures be a better target for monetary policy?
The Bank of England’s latest quarterly Inflation Report was published on November 11. With all the gloomy news over the past few months the report is pleasantly up-beat – certainly for the longer term. As Mervyn King, Governor of the Bank of England, states in his opening remarks to the publication of the report, “The considerable stimulus from the past easing of monetary and fiscal policy and the depreciation of sterling should lead to a recovery in economic activity.”
Nevertheless, recovery will be slow, especially at first. This means that it will be some time before output returns to pre-recession levels. “Despite a recovery in economic growth, output is unlikely, at least for a considerable period, to return to a level consistent with a continuation of its pre-crisis trend. That is in large part because the impact of the downturn on the supply capacity of the economy is expected to persist. But it is also because there is likely to be sustained weakness of demand relative to that capacity.”
There is surprisingly good news too on employment and unemployment. Although unemployment has risen sharply in recent months, the rate of increase is slowing and “There was a small increase of 6000 in the number of people in employment to 28.93 million, the first quarterly increase since May–July 2008 (see Labour market statistics, November 2009).
So should we be putting out the flags? Can the Bank of England ease off on quantitative easing (see Easing up on quantitative easing)? Or does it still need to keep on increasing money supply, especially as fiscal policy will have to get a lot tighter? The following articles consider the issues.
Mervyn King: economy remains ‘uncertain’ (video) Channel 4 News, Faisal Islam (11/11/09)
Bank of England governor dampens hopes of swift UK recovery Guardian, Graeme Wearden (11/11/09)
Recovery has only just started, warns sombre King Guardian, Heather Stewart (11/11/09)
Cautious good cheer BBC News, Stephanomics (11/11/09)
Bank of England’s Mervyn King says UK only just started on recovery road Telegraph (11/11/09)
The Bank of England’s Inflation Report is useless. Here’s why. Telegraph, Edmund Conway (11/11/09)
Bank of England raises growth and inflation forecasts: economists react (includes video) Telegraph (11/11/09)
Bank of England talks up hopes of strong recovery Times Online, Robert Lindsay (11/11/09)
Bank of England cautions on economic recovery BusinessWeek, Jane Wardell(11/11/09)
Just who benefits from quantitative easing? WalesOnline (11/11/09)
Inflation Report: Forget the fan charts, what we need is a clear economic policy Telegraph, Jeremy Warner (11/11/09)
We’ve no choice but to keep inflating Independent, Hamish McRae (11/11/09)
Is there a break in the economic gloom? (video) BBC Newsnight, Paul Mason (12/11/09)
The Bank of England Inflation Report can be found at the following site, which contains links to the full report, the Governor’s opening remarks, charts, a podcast and a webcast:
Inflation Report November 2009 Bank of England
Questions
- Explain what the three fan charts, Charts 1, 2 and 3 on pages 6, 7 and 8 of the Inflation Report, show.
- Why is the Bank of England more optimistic than in its previous report (August 2009)?
- Why did the sterling exchange rate fall on the publication of the report?
- Has the policy of expansionary monetary policy proved to be beneficial and should the Bank of England continue to pursue an expansionary monetary policy?
- What determines the balance of effects of an expansionary monetary policy on (a) asset prices; (b) real output; and (c) inflation?
- How have relatively flexible labour markets affected the impact of recession on (a) wage rates; (b) unemployment?
Northern Rock seems to have had a fixed place in the news for the past year or so. Unfortunately, the advertising it’s been getting hasn’t been positive. The usual picture was one of a Northern Rock branch and a few hundred people queuing outside, ready to withdraw their savings.
In the financial crisis, the banking sector has been at the forefront of economic policy and billions of pounds of public money have been invested in banks simply to keep them afloat and encourage them to keep lending. But now the government, in a measure approved by the European Commission, is considering selliing part of Northern Rock, by splitting it into a ‘good bank’, which will be returned to the private sector, and a ‘bad bank’, which will have to remain nationalised. This bad bank would gradually run down its assets and eventually be liquidated. Similar plans are being considered for the part-nationalised Royal Bank of Scotland and Lloyds Banking Group.
Northern Rock’s loan book will be cut from £100bn pre-crisis to just £20bn to ensure that a bank which enjoyed state support should not have “an unfair competitive advantage”. Savers with Northern Rock will find themselves in the ‘good’ bank, while mortgage customers with arrears and those who are regarded as risky, will be seen as ‘bad’ bank clients.
The buyers of these banks remain unknown. Tesco was considered to be a possible buyer of Northern Rock but has pulled out, with plans to build a new full-service bank itself. Established banks, such as Barclays, will not be allowed to make a purchase and the FSA has stated that standards will not be dropped to allow new competitors to enter the market, especially given that much of the banking crisis is due to poor standards and insufficient regulation. National Australia Bank, the owners of Yorkshire and Clydesdale, is a possible buyer, as too is Virgin Money, even though it would require new finance and possibly new partners. Some potential bidders may be ruled out by competition considerations. So let the games begin!
The following articles look at the banking situation and the possible developments.
Where Gordon Brown feared to tread, Kroes is ready to trample Telegraph, Alistair Osborne (28/10/09)
Lloyds eyes capital raising plans BBC News (29/10/09)
Tesco rules out Northern Rock takeover Guardian, Julia Finch (28/10/09)
EU approves Northern Rock split BBC News (28/10/09)
The Business Podcast: The break-up of Northern Rock Guardian (28/10/09)
Lloyds Banking share price could scupper offer SME Web, Roberta Murray (29/10/09)
Roll up, roll up, for the great bank sell off Independent, Richard Northedge (8/11/09)
Treasury says Northern Rock may lose savers as Government pulls out The Times, Francis Elliott and Suzy Jagger (5/11/09)
Union fears for 25,000 jobs as EU insists Lloyds and RBS must shed branches Guardian, Jill Treanor (3/11/09)
Decision time for Lloyds shareholders BBC News, Money Talk, Justin Urquhart Stewart (11/11/09)
The Business podcast: The break-up of Northern Rock Guardian (28/10/09)
Details of the European Commission ruling on the restructuring of Northern Rock can be found at:
State aid: Commission approves restructuring package for Northern Rock
Questions
- What started all the trouble at Northern Rock?
- What are the arguments (a) for and (b) against the break up of Northern Rock and the other banks that received state aid? Do you think the right decision has been made?
- The BBC News article ‘Lloyds eyes capital raising plans’ refers to 43% of Lloyds being owned by the tax payer. What does this mean and how has it happened?
- Why do you think Tesco has decided not to put in a bid to take over Northern Rock?
- Consider the potential bidders for these new ‘good’ and ‘bad’ banks. In each case, consider the (a) advantages and (b) disadvantages. Then, explain the type of take-over or merger this would be and whether there could be any competition considerations.
- One of the aims of recent developments in the banking sector is to increase competition. Why is this so important and how will it affect consumers and businesses?
After the November 2009 meeting of the Monetary Policy Committee, the Bank of England announced that it would keep Bank Rate on hold at 0.5%, at which rate it has been since March. It also said that it would spend a further £25 billion over the next three months on asset purchases, primarily government bonds, thereby pumping additional money into the economy: the process known as “quantitative easing“. This would bring total asset purchases under the scheme to £200bn.
But although this represents a further increase in money supply, the rate of increase is slowing down. In the previous three months, £50 billion of assets had been purchased. So does this imply that the Bank of England sees a recovery around the corner? Will money supply have been expanded enough to finance the desired increase in spending – on both consumption and investment?
A problem so far is that most of the extra money has not been spent on goods and services. Banks have been building up their reserves, with much of the money simply being re-deposited in the Bank of England as reserve balances (see Table A1.1.1 in “Bankstats). At the same time, households have been taking on very little extra debt – indeed, In July, total household debt actually fell (see “Payback time) and consumer debt (i.e. excluding mortgages) has continued to fall. If quantitative easing is to work, the money must be spent!
But with the monetary base having expanded so much, is there a danger that, once the recovery gathers pace, spending growth will return with a vengeance? Will inflation rapidly become a problem again with an overheating economy? The following articles examine the issues.
Interest rates held at 0.5 per cent (includes video) Channel 4 News (5/11/09)
Bank of England extends quantitative easing to £200bn Guardian, Larry Elliott (5/11/09)
What the economists say: Quantitative easing £25bn boost Guardian (5/11/09)
Bank of England faced with its biggest split on policy in a decade Independent, Sean O’Grady (4/11/09)
Bank of England expands money-printing programme to £200bn to fight downturn (includes video) Telegraph (5/11/09)
The one thing worse than quantitative easing would be no QE at all Telegraph, Edmund Conway (5/11/09)
BoE: It ain’t over till it’s over Telegraph, Edmund Conway blog (5/11/09)
Bank raises stimulus to £200bn to end recession Times Online, Grainne Gilmore (5/11/09)
Bank of England to inject another £25bn of stimulus money Management Today (5/11/09)
Extra £25bn to stimulate economy BBC News (5/11/09)
Quantitative easing ‘not working’ (video of DeAnne Julius: former MPC member) BBC News (5/11/09)
Boxed in BBC Stephanomics (5/11/09)
The BoE’s £25bn gambit Financial Times, Chris Giles blog (5/11/09)
US to reduce Quantitative Easing as rates kept low Telegraph, James Quinn (4/11/09)
Quantitative easing ‘unpleasant’ BBC Today Programme, Stephen Bell and Wilem Buiter (7/11/09)
Experts debate whether quantitative easing is working (video) BBC Newsnight (6/11/09)
Questions
- What has been happening to the velocity of circulation of (narrow) money in the past few months? Explain the significance of this.
- What is likely to happen to the velocity of circulation in the coming months if (a) the economy recovers quite strongly; (b) recovery is modest?
- What is the relationship between quantitative easing and the growth in broad money (i.e. M4 in the UK)? How will banks’ desire to build up their reserves affect this relationship?
- Is the UK economy in a liquidity trap? Explain.
- Why is it likely that the Bank of England may well engage in more quantitative easing next March and beyond? How is the fiscal situation likely to affect Bank of England decisions?
- Examine the argument for the Bank of England buying more private-sector debt (virtually all of the asset purchases have been of public-sector debt)?