Great piece by Peter Orszag here on one reason why macro-models failed to adequately forecast the Great Recession: they didn’t account for leverage and its impact on the depth and length of the downturn.
This has a strong ring of truth. The folks who saw this coming, like Dean Baker (and Jamie Galbraith, Roubini, Krugman, Shiller…me, after Dean convinced me) either didn’t depend on such models or gave a prominent role to the debt bubble in addition to the standard models.
Peter cites Bernanke, who points out that while the bursting of the dot.com bubble was of a similar magnitude in terms of lost wealth, “the housing crisis was much more damaging because the initial impact was concentrated in a highly leveraged financial sector and then substantially amplified as those losses cascaded.”
I’d add a related wrinkle: when a dot.com bubble bursts, it mops up more quickly because of the difference between “mark-to-market” in an equity bubble and “extend-and-pretend” in a debt-financed housing bubble. The fact that your pet rock shares go from valuations of $1,000 on Friday to $1 on Monday rips the bandaid off in a way you don’t get when banks can inflate for months on end their balance-sheet value of non-performing loans.
What should we do about this very salient limitation to economic forecasting? Over to Peter:
…here’s a rough rule of thumb: Whenever a reasonable financial-stress index…is particularly elevated, be very skeptical of economic forecasts from models that pay scant attention to the financial industry. They will be making the housing- meltdown-is-just-like-the-tech-one mistake all over again.
You’re probably wondering why economists would leave leverage out of our models. Good question. It’s because we’ve historically viewed financial markets as basically an intermediate input in the economic process, distributing savings to their most productive sources. Greenspan added the assumption the hyper-rationality would lead market participants to self-regulate.
Keynes and later Minsky recognized the folly of this shortsightedness. Minsky in particular saw how the inherent instability in financial markets has derailed economies for as long as there’s been credit and debt. Financial “innovations” have only added to this instability.
I’d like to cite the Who here…but I think I’d better not.