The Rudd Essay & the Global Financial Crisis
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I appreciate the opportunity to comment on Prime Minister Kevin Rudd's recent essay. I find myself in virtually complete agreement with his analysis of the origins of the current economic crisis, its historic importance and the nature of the response that governments will be required to make. My comments will focus on some of the unique features of this crisis, those that may make it especially resistant to policy interventions.
Given the scale of the crisis, it is striking how little it was anticipated by mainstream economists. The Wall Street Journal recently published a ranking of the leading American economic forecasters on the accuracy of their 2008 economic predictions. The two key data points were the 2007-08 fourth-quarter to fourth-quarter real growth in GDP and the 2008 end-of-year unemployment rate. There were 51 economists in the sample, from all the major financial institutions and forecasting firms. Of the 102 forecasts, all were wrong in the same direction. Only one economist had the correct sign of the quarter-to-quarter change in GDP. Almost all the others thought that, while 2008 would see some disruption, it would be on the whole rather a decent year.
It is worth noting that all the predictions were made early in 2008, when the credit crunch was well underway and the American government had already resorted to extraordinary interventions. And the forecasters were not alone. In February 2007, only months before the first seismic tremors hit American banks, Federal Reserve Chairman Ben Bernanke, a fine economist, described to a congressional panel what the New York Times called a "Goldilocks" economy - neither too hot nor too cold. The weakness in housing, he told them, had stabilised and had not spilled over into the rest of the economy.
In other words, the professional mainstream, with a very small number of notable exceptions, did not have a clue. And look at the violent zigzags in official appraisals of the dangers of deflation or inflation over the past year: from a deflation alert to an inflationary near-panic, and back to deflation fears. In all, it is scarily reminiscent of the stunned incomprehension of leading economists at the outset of the Great Depression.
The harsh truth is that for the foreseeable future, governments will be flying blind. There are no economic models for, or precise historical analogies to, the present circumstances. Lessons from crises in other eras and in other nations are interesting, and possibly enlightening; but none of those crises was quite like this one - in breadth, in means of transmission, in the complexity and opacity of the financial instruments involved. The relative scale of the current collapse is now exceeded only by that of the Great Depression. But that occurred in such a different era, with such a different economic and financial infrastructure, that only the grossest of policy lessons can be drawn, and then only with great uncertainty. (After some three-quarters of a century, arguing over what did and did not work during the 1930s is still a minor academic industry.)
The political leadership, in other words, is on its own. Economists of all persuasions will readily offer advice - confidently, eloquently and with panache. But they will be just opinions, for macroeconomics is not a science. Its methods are primarily analogical and metaphorical. Its data are gross and error-prone, and its models of economic interactions bear only a distant relationship to those in the real world. The theoretical apparatus of economics - its ‘laws' - are mostly imaginative constructs that can rarely be confirmed with any precision, and stem more often from ideologies than from careful observation.
With the collapse of private credit, common sense says that governments have to step in with major stimulus programs, as most are now proceeding to do. And the financial sector must be firmly reined in - you're allowed to blow up the world only once in a career.
But the industrial economies have been badly weakened, and will be poised for some time on a knife edge between inflation and deflation, between fragile stability and sudden collapse. Large-scale public interventions are the bluntest of tools. Policymakers will inevitably make major mistakes, and the public will have to expect them to do so. The test will be not whether they get it right the first time, but whether they recognise problems and make adjustments.
Good leadership will require both boldness and alertness to missteps, as well as firmness and flexibility, courage and humility. It is nothing less than the policy challenge of a lifetime.
© Charles Morris 2009.