What does it tell you — particularly about the gross misallocation (and mis-remuneration) of human intellectual resources — when the New York Times declares the most powerful central banker on the planet, US Federal Reserve chairman Ben Bernanke, to be fundamentally wrong, and a humble Aussie economist, (now unemployed) Associate Professor Steve Keen, to be fundamentally right:
For a time, the period before the collapse was known as the “Great Moderation,” a term that Mr. Bernanke helped to publicize in a 2004 speech. Low levels of inflation, long periods of economic growth and low levels of employment volatility were viewed as unquestioned proof of success.
And what brought on that success? In 2004, Mr. Bernanke, then a Fed governor, conceded good luck might have helped, but his view was that “improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation.”
In 2005, three Fed economists, Karen E. Dynan, Douglas W. Elmendorf and Daniel E. Sichel, proposed an additional explanation for the Great Moderation: the success of financial innovation.
“Improved assessment and pricing of risk, expanded lending to households without strong collateral, more widespread securitization of loans, and the development of markets for riskier corporate debt have enhanced the ability of households and businesses to borrow funds,” they wrote. “Greater use of credit could foster a reduction in economic volatility by lessening the sensitivity of household and business spending to downturns in income and cash flow.”
At least Mr. Bernanke’s hubris was not as great as that of Robert E. Lucas Jr., the Nobel Prize-winning University of Chicago economist. In 2003, he began his presidential address to the American Economic Association by proclaiming that macroeconomics “has succeeded: Its central problem of depression prevention has been solved.”
In his speech last week, Mr. Bernanke cited several assessments of the Great Moderation, including the one by the Fed economists. None questioned that it was wonderful.
The Fed chairman conceded that “one cannot look back at the Great Moderation today without asking whether the sustained economic stability of the period somehow promoted the excessive risk-taking that followed. The idea that this long period of calm lulled investors, financial firms and financial regulators into paying insufficient attention to building risks must have some truth in it.”
One economist who would have expected that development was Hyman Minsky. In 1995, the year before Minsky died, Steve Keen, an Australian economist, used his ideas to set forth a possibility that now seems prescient. It was published in The Journal of Post Keynesian Economics.
He suggested that lending standards would be gradually reduced, and asset prices would rise, as confidence grew that “the future is assured, and therefore that most investments will succeed.” Eventually, the income-earning ability of an asset would seem less important than the expected capital gains. Buyers would pay high prices and finance their purchases with ever-rising amounts of debt.
When something went wrong, an immediate need for liquidity would cause financiers to try to sell assets immediately. “The asset market becomes flooded,” Mr. Keen wrote, “and the euphoria becomes a panic, the boom becomes a slump.” Minsky argued that could end without disaster, if inflation bailed everyone out. But if it happened in a period of low inflation, it could feed upon itself and lead to depression.
“The chaotic dynamics explored in this paper,” Mr. Keen concluded, “should warn us against accepting a period of relative tranquillity in a capitalist economy as anything other than a lull before the storm.”
When I talked to Mr. Keen this week, he called my attention to the fact that Mr. Bernanke, in his 2000 book “Essays on the Great Depression,” briefly mentioned, and dismissed, both Minsky and Charles Kindleberger, author of the classic “Manias, Panics and Crashes.”
They had, Mr. Bernanke wrote, “argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behavior.” In a footnote, he added, “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.”
It seems to me that he had both Minsky and Kindleberger wrong. Their insight was that behavior that seems perfectly rational at the time can turn out to be destructive.