Warped Perspective

Professor Black claims that “Rome is burning,” which I take to mean that we are in the midst of an economic disaster, and claims that I ignore it because of a theoretical bias.

2008 has been a disaster for Wall Street.  A couple of years of steeply rising oil prices has been bad for the automobile industry, and a disaster for the makers of gas guzzlers — namely, GM, Chrysler, and Ford.  However, I admit — proclaim — that I do not see 2008 as an economic disaster for the average American.  We will see what 2009 will bring, but my characterization of 2008 is largely based on data.

First let’s look at the employment data through November.  Employment is down about 2 million, which undoubtably creates stress for a couple of million families.  But is that a disaster?  Robert Hall and Susan Woodward have a chart comparing the employment dynamics today to the 1982 recession, and find that, in percentage terms, employment declined more rapidly in 1982.

By 1982 Q1, productivity had fallen 3 of 4 quarters for a cumulative decline of 2.3 percent.  Through 2008 Q3, productivity had risen six consecutive quarters, with an increase of 2.1 percent over the past four.  It is very likely that the U.S. will have the most real GDP per capita in its history in 2008, despite the fact that the entire year will be spent in recession (by the employment definition). [1]

Even the more gloomy forecasts for the next year do not portend disaster.  At quarterly rates, GDP growth, Goldman Sachs says, will fall 5/4 percent, 3/4 percent, and 1/4 percent from 2008Q3-Q4, 2008Q4-2009Q1, and 2009Q2. That’s a cumulative decline of 2.3 percent 2008Q3 – 2009Q2, or $200 billion, or about $700 per person.  Is that a disaster?


[1] Through Q3, 2008 GDP was $8,771 billion (seasonally adjusted by the BEA). 2008 population (July) was 303,824,640, so 2008 produced $28,870 per person already through Q3. That means only $9,338 per capita ($2,837 billion in aggregate) needs to be produced in Q4 to break the 2007 record. In other words, if Q4 is within 3 percent of Q3, we break the record. Even the most pessimistic forecasters admit that Q4 real GDP will be greater than that.

Also from this issue

Lead Essay

  • In the first of this month’s four accounts of the causes of the financial crisis, Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis, makes his case. White argues that the housing boom and bust, and the resulting meltdown of financial markets, cannot have been the result of a laissez-faire monetary and financial system, since we never had one. Nor can deregulation have been the cause, since the most recent relevant deregulation has probably helped contain the turmoil. While admitting that “private miscalculation and imprudence made matters worse,” White argues that “to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects.” He points to two such distorting sets of policies: the overexpansion of the money supply by the Fed, and government mandates and subsidies to write riskier mortgages.

Response Essays

  • In our second anatomy of the financial crisis, William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, says that key to the crisis was perverse compensation schemes that put the incentives of executives at odds with the interests of creditors and shareholders. Drawing on his concept of “control fraud,” Black argues that a failure of regulation encouraged executives to meet short-term earnings goals and to capture large bonuses by encouraging fraudulent mortgages — even when it could be foreseen that this might lead to the destruction of the firm. “When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud — and control fraud causes greater financial losses than all other forms of property crime combined,” Black writes. Fannie and Freddie cannot have been the culprits, Black argues, because they were guilty of less mortgage control fraud than their fully private counterparts. “ ‘Modern finance’ has failed the market test,” Black concludes. “Its policies optimize the environment for control fraud and create perverse dynamics that create recurrent financial crises.”

  • The housing boom and bust stands behind the financial turmoil of 2008. Therefore, in our third analysis of the financial crisis, University of Chicago economist Casey B. Mulligan explores various hypotheses about its underlying causes. Was it changes in tastes and technology? Public policy? Investor “exuberance”? Mulligan describes some of the empirical tests that would be needed to settle the question, and argues that at least part of the answer is already clear. Most of the housing boom, Mulligan finds, was based in expectations about the future, rather than in demand, supply, or subsidies during the boom. Mulligan says that additional empirical tests — especially about the aggregate wealth effects of the boom and bust — would help us form a more educated guess about whether boom expectations were based more to changes in tastes, changes in technology, or exuberance. But those tests have not been done, and therefore, Mulligan concludes we cannot yet reliably predict the future economic damage from the housing boom and bust, or formulate beneficial financial industry regulation.

  • Our fourth and final anatomist, J. Bradford DeLong, notes that “in the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion,” and lays out five reasons why this value might fluctuate. “Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements.” Therefore, DeLong says, we’re left with changes in the discounts for liquidity, default, and risk. The housing crash has increased default risk significantly, but central banks have actually pumped up liquidity. Almost the entire drop of the value of global capital, DeLong argues, comes from an “increase in the perceived riskiness … of income from capital.” The problem, DeLong says, is that “our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.” However, DeLong is confident that Larry White’s story — focusing on the money supply and government policy to encourage bad home loans — cannot be the right one.