Are Ever Larger Global Booms and Busts Really Inevitable?

February 14th, 2014 at 5:33 pm

I’ve been meaning to respond to this piece by Eduardo Porter from a few days ago on both recent and historical stirrings in global financial markets.  I found it to be unduly depressing and defeatist.  At least, I think it’s “unduly” so—there’s a chance the Porter’s right.

The piece argues that the future holds bigger and badder bubbles and busts and there’s just not much that anyone can do about it.  What’s driving this unfortunate cycle is the interaction of savings imbalances, skittish global capital, and aggressive central banks.

The US housing bubble contains all the features of the story.  Trade surplus countries used massive foreign reserves to help finance an unregulated real estate bubble.  When the bubble burst, the central bank put the monetary pedal to the metal in order to offset the demand contraction, leading investors to trot the globe in search of higher returns.  As the central bank starts thinking about returning to more normal operations, the specter of higher rates leads to unpredictable and sudden shifts in the flows of global money.

Economists quoted in the piece point out that such booms and busts are “older than the hills” and are likely to get worse before they get better…actually, none of them said anything about getting better.  Economic officials in emerging markets hit by capital outflows are calling for international monetary coordination, but it’s unclear what that would look like and even more so, why the US Fed, for example, would hold rates down to protect, e.g., the Turkish currency (Chair Yellen recently said she wouldn’t, btw).

“It’s not even clear,” Porter argues, “what governments should do about presumed bubbles. Should they “lean against” them by raising interest rates as they emerge, potentially sacrificing investment and jobs along the way?”

In fact, the key word a few ‘grafs up is “unregulated.”  The problem with all of this is that it assumes that successful regulation of financial markets is beyond our capacity.  Again, I’m not sure that’s wrong, but I think it is.  And we won’t know if we don’t try.

Porter mentions that “macroprudential rules.”  These include capital reserves against overleveraging, strong underwriting and risk-retention principles to counteract the no-skin-in-the-game effect of securitization on loan quality, financial transaction taxes to internalize the externality costs of flash trading, and so on.  They also include more vigilance at central banks themselves—remember, both Greenspan and Bernanke claimed they could neither spot nor deflate bubbles.  Yellen, on the other hand, has said othewise (“I think it’s important for the Fed, as hard as it is, to attempt to detect asset bubbles when they are forming”).

Now, many economists, including most cited in the piece, do not believe we can get this right.  The innovators are always many steps ahead of the plodding regulators.  There’s a risk that we’ll push too far and kill the golden goose—I was debating a prominent conservative economist on this point the other day and his view was “sure, if I never leave my house, I’ll never get run over.”  And let’s not forget that the opponents of financial regulation are often the funders of the politicians making the rules, a pretty strong recipe for the economic shampoo cycle: bubble, bust, repeat.

Yet while the forces pushing the other way are surely mighty, we have no choice but to try to better regulate the financial sector.  To not do so is to accept the inevitability of ever frequent and larger bubbles and busts, to accept that central banks can’t ply stimulative monetary policy without inflating assert bubbles, and to accept taxpayer-funded bailouts that reward the very sector that caused the damage.

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14 comments in reply to "Are Ever Larger Global Booms and Busts Really Inevitable?"

  1. smith says:

    There is no golden goose except for the 1%, though the 10% and 20% do enjoy 3 to 4 times the earnings of the average household even though their income may be stagnating (silver goose).

    The way to protect the economy is obvious since we already had a prosperous system that worked, there is very little risk in going back to a smaller safer financial sector and more equality, except for the greedy aforementioned geese owners.

    Internationally, economists (e.g. Stiglitz) have argued for capital controls when necessary.

    Again, for over 200 years in America, states regulated maximum interest rates on consumer credit, usually to 13% to 15%. A 1978 Supreme Court ruling on national banks changed that, and a 2005 cap set a maximum of 30%/year. Where is the outrage? No transaction tax, no end to carried interest, banks still too big to fail, etc etc

    A huge bust followed this time (unlike 2007) by true reform and compensation of victims would be preferable to the slow agonizing erosion of the remaining equality and opportunity, better even than the continuation of the current state of affairs which we all too readily endure and seem destined to continue.

    Next time, tell that conservative economist to stay in his house, we don’t need him. Meanwhile, let’s be prepared for the day when everyone can feast:

  2. Dausuul says:

    We did it once before, in the wake of the Great Depression. Popular anger over the treatment of Wall Street in the 2008 crash has been simmering for the last six years. If there’s another crash on a similar scale, there will be a lot more pressure for real reform.

  3. wkj says:

    Jared–What you have to remember is that rarely, if ever, will a political figure have the clout (and courage) to slow down or deflate a bubble. When millions are (or think they are) getting rich, a bubble is politically bullet-proof. It is my understanding that in the late 90’s, Alan Greenspan (then at the peak of his power) floated the idea of having the Federal Reserve raise margin requirements to cool down the stock market. He was promptly slapped down by Hank Paulson and Wall St. and learned his lesson.

  4. cfaman says:

    It is tempting to blame the housing bubble on foreign markets, but it may not wash. The housing bubble got started in 95, so first check when these surplus countries were putting the dough into US housing.

    Bubbles do not happen without leverage. 95 was in a period of rapid financial products innovation through securitization. Having looked at a lot of those deals it is fair to say the buyers often did not know what they were buying, AND that the rating agencies did not know what they were rating, AND that the bond bankers knew fully well–well enough to take their fee and get out of the way. This was especially clear in the relatively small at that time sub-prime market. The old guys in that business also knew what was what. The leverage was enormous, and the conceit of the day was that housing prices only rise slowly or quickly but do not decline.

    So these things are not inevitable. Lack of leverage shuts down a bubble process. Having sufficient real investment opportunities and thus GDP growth reduces the urge to speculate financially. Regulation can help with half of the problem, but national financial management that leads to higher ROI in real projects is also necessary. Otherwise, yes, it is back to the casino.

  5. Kent Willard says:

    More economists need to educate the public, and shame those economists who are propagandists of moneyed interests. Most educated people should know that a trade deficit will create a corresponding foreign investment, but they don’t. Most people don’t know that large persistent trade deficits are usually created by government manipulation that interrupts the corrective price changes of floating currencies, and not by lazy overpaid workers. This is a failure not just of the media and education, but of the economic profession in particular.

    Trade imbalances are addictive. Trade deficits create cheap labor and cheap debt for US corporations. The Fed chair basks in both low interest rates and low inflation. The exporting nation has high employment and industrialization. But a billion foreign workers can’t rely on Americans to buy their goods at an ever increasing rate, and cheap debt in the US can’t find a productive outlet in an outsourced nation, so the boom leads to bust.

    We have to identify the addiction and wean ourselves. As developing nations mature, they should think of their population as consumers, not just laborers. The US needs to openly re-examine its trade and tax policies to determine if it was written for its citizens, or for multinational corporations. Our trade agreements should explicitly allow import tariffs on nations that do not allow their currencies to float, or whose governments actively buy and hold large foreign currency portfolios.

    We aren’t impotent to the boom/bust cycle. Large persistent trade surpluses should be an alarm. We should understand that the trade surplus, and not Fed policy, creates low inflation and low interest rates. We need to trace where the foreign investment is flowing, look for mal-investment, and tighten regulatory oversight in that area (the same goes for developing nations). We should push back on large trade surplus nations, and even impose tariffs to move trade into balance if necessary. It is for the benefit not only of ourselves, but also for the global economy in the long run.

    • Robert Buttons says:

      We should be thanking China for not allowing the renminbi to float. They are impoverishing their own people, and the consumers of their exports (ie. all of us) are taking advantage of the rock bottom prices. To suppress the renminbi , the Chinese central bank is buying dollars, limiting price inflation in the U.S.

      • Kent Willard says:

        The buying of dollars by the PBOC effectively exports both inflation and employment from the US to China, and it exports consumption from China to the US.

        If you are an employed consumer in the US, then the PBOC’s actions are good. If you are unemployed or underemployed then their actions are terrible for you. The latter have little representation in our republic. If you are a US investor while interest rates are falling, then the PBOC is good for you. Once the malinvestment bubble bursts, then everyone but a few vultures is hurt.

        As Michael Pettis has pointed out, China’s foreign bond holdings is a negative for them in the long run. The last countries with outsized foreign bond portfolios were Japan in the 80’s and the US in the 20’s. From a national perspective, real wealth is what you do for each other, not what you own.

        • Robert Buttons says:

          From a national perspective, it’s standard of living that matters most. If China is willing to impoverish their own people, so that we can live better, why not let them? What is putting us at risk is not China’s hoarding of dollars but the endless fed money printing that China’s hoarding of dollars abets. But the solution is not to blame China and slap on a tariff. The solution is to stop printing!

  6. Dave says:

    Everyone of any prominence in these discussions seems to accept that bailouts are inevitable, so the only thing missing is to put extreme pressure upon investors to get it right, to detect bubbles themselves and avoid them, not because it might necessitate a bailout and create unpredictable losses, but because it will create predictable losses for investors.

    Make the losses inevitable for investors. Make it law. Investing should be much harder than it currently is. Investors are just too lazy.

  7. Perplexed says:

    -“In fact, the key word a few ‘grafs up is “unregulated.” The problem with all of this is that it assumes that successful regulation of financial markets is beyond our capacity. Again, I’m not sure that’s wrong, but I think it is. And we won’t know if we don’t try.”

    Maybe a better word is “uninsured.” After all, what’s really the problem with “bursting bubbles” in an economy with a wealth GINI of .87? So few people are affected by the “price adjustments” of most of these assets that these “corrections” themselves should matter to relatively few. The housing “bubble” was a special case that was largely driven by a massive counterfeit fraud. (Where are the economic studies showing what the maximum size the bubble could have grown to without the counterfeit fraud?) More unenforced laws (you’d have to back a long way in history to find a time when counterfeit fraud has been legal) will have little effect on limiting the damages. When certain actors are above the law anyway, it really doesn’t matter what the laws are.

    The damage from these “bubbles” is a result of the risk that is shifted from these actors to all Americans. Why should the government be responsible for making sure it doesn’t happen when they can instead insist that these actors insure the public against the consequences of their actions. We require it with every other industry (although certainly not with high enough limits of liability in many instances). Corporate welfare generated by limited liability for Corporations and the public bearing the risks of damages inflicted by the financial sector is what exposes the public to these massive losses. Requiring these “takers” to reimburse the public for the free insurance they are given will protect the public interest from these catastrophes much more than any more unenforced laws and impotent regulations. It would also allow the government to establish funds sufficient to aid the victims of these catastrophes when they do occur. The rationale for establishing the corporate form of organization was that is was thought (or sold) to be “in the public interest.” Free insurance for “investors” that covers the damage they might reek on the public has worked out only for the private interests that benefit, and at a tremendous cost to the public. When the premiums paid reflect the expected value of the risk transferred, the behavior will change, and not one minute before then.

  8. Robert Buttons says:

    I’m not an economist, but it seems the Boom-Bust cycle has been explained quite elegantly in “The Theory of Money and Credit”(Mises, Lv; 1953). Basically the boom is caused by an expansion of money or credit. (by definition, INFLATION)

    One VERY intelligent economist saw the problem with artificial expansion of money or credit:

    “[Failed investment firm MF Global] was leveraged 44 to 1 [..] (leverage ratios below 20 used to be the norm).

    If financial institutions have enough of a capital cushion to absorb such losses, it serves as built in insurance against the next new form of “innovative” finance that gets ahead of the regulators.

    Second, there’s interesting moral hazard in the MF case. The firm, and its benighted chief, former Gov. Corzine, appears to have been betting on a bailout.[..]

    The firm surmised that the banks exposed to troubled sovereign debt would get bailed out, and thus leveraged up to buy a lot of that debt at a steep discount. Had the bailout come sooner, MF and their investors would have made a lot of money — at the expense of European taxpayers. A classic case of socializing losses and privatizing gains.”–Jared Bernstein 2011

    So MF Global took advantage of the artificial expansion of credit (Aside: Currently the Fed is leveraged 72:1, which dwarfs the MF Global 44:1 ratio) and the moral hazard of a (perceived) govt backstop. It’s easy to end the boom-bust cycle: End artificial expansion of credit (no more fed fixing of interest rates and no more open market operations) and end the moral hazard of backstops provided by government.

    Further reading on boom-bust cycles:
    French, DE “Early Speculative Bubbles and Increases in the Money Supply” 1992.

  9. Taryn Hart says:

    My question is this: Would we have booms and bust if the key post-WWII Keynesian reforms were more permanent? In other words, my question is: Is this a political rather than an economic problem?

    • Jared Bernstein says:

      Very briefly answering a complicated question, I’d say if we seriously implemented the reforms in the piece, we be less prone to financial booms and busts–there’s some historical evidence for that argument. And the constraint there is political.

      However, capitalist economies clearly have cycles and that’s not going away.

    • smith says:

      What made the 2007 bust notable was it depth and longevity and distributional effects.
      Biggest since 1929 (or 1937 if you count Great Depression’s double dip as separate events).
      Biggest drop in GDP since Great Depression
      Longest effect on unemployment since Great Depression
      Really great graphics here:

      It is the severity of the recession that is troubling. Was the severity like a once in a century weather event and earthquake, impossible to forecast? Or was it actually very easy to predict to anyone not buying the soft landing scenario of 2007, and noticed every other business opening on main street the past few years had been a real estate office or bank branch?
      Moreover, the trend in inequality seems unrelated to the business cycle, it went up during the last boom, it went up following the bust. A lot of rich people made out like bandits.

      Also the key Keynesian reforms were pre-WWII, not post, right? After the threat of WWII defeat ended, conservative forces began a long counter offensive and war of attrition against the New Deal.