Game of Theories: Putting it All Together

In the final video in our Game of Theories mini-class, Tyler puts all the theories together to examine the great recession.


A very good summation. Of course, this summation and Cowen's prior blog post together tell the story. The summation never mentions globalization, never mentions rising inequality; indeed, the depiction of four blind men each representing a theory hits the nail on the head. The practical way to view the great recession (and financial and economic instability generally) is to consider the two opposing approaches to globalization, the American approach and the Chinese approach, and ask yourself which has worked better. And then ask if the four blind men have learned anything about the global economy from their experience, or are they still just blind men groping the elephant.

The Chinese approach: Start with nothing and get something from globalization.
The US approach: Have something and get something from globalization.

They started in very different places and had very different goals. The net consumption is higher for both ends.

If zero is a baseline, China was at a negative value. That they benefited more from globalization is evidence of the lack of effectiveness of their previous approach, and nothing to do with the great recession, financial or economic instability.

I'm not interested in turning the US into a nation of substance farmers using hand tools just so we can have the 'China Globalization Experience'.

I think I've asked this before but have you and Tyler ever thought of doing ASMR versions of your Marginal RevU videos?

The great recession is very simple to understand. It has two components:
1. The underlying fiscal problem of taxing too much and spending even more thus the need to borrow massive amounts of money. Simple as that. No one can live without fiscal troubles if they continue to spend more than they earn and brrow to make up the difference. Sooner or later the piper must be paid.
2. The trigger event. Or in this case the bubble that burst, which was the credit crisis or the subprime mortgage crisis depending on which name you prefer. This was a direct result of congress in the late 90's forcing banks to loan to subprime borrowers in the Keynesian wet dream belief that you can somehow make unproductive spendthrift people prosperous by giving them other people's money. In the late 90's congress also dramatically expanded Fannie Mae and Freddy Mac to assist in this massive ill conceived plan to transfer wealth. Well as we all know the bubble burst and in congresses vain attempt to hide their misdeeds they put the blame on banks for making and selling the loans that congress had mandated years before (and even threatened bankers who were afraid to put their banks at risk making these bad loans).

The rest is history. The system crashed, the thieves and crooks in congress scurried to stay out of the sunshine and put the blame on others and a new crop of dishonest politicians took this opportunity to misappropriate trillions of borrowed and printing press money to reward their cronies and voting blocks (commonly referred to as QE).

The problem was not fixed but merely papered over. It is still their like a vulture in a tree waiting for the final death throes of the American economy. The crash will be deeper and longer when it comes because of the attempts by politicians and Keynesian economists to shovel money into the widening hole thinking that somehow borrowing and printing money can fix a money crisis. The piper must be paid.

Great video.

The Austrians seem to have a good grasp on the root cause of the Great Recession, the monetarists seem to have a solid prescription as to what should have been done in the immediate aftermath, and the RBC camp has insights into policy mistakes that followed.

The keynesian school, at least from this video, seems to have very little to say.

Tyler's explanation: 5% Keynesian, 30% (market) monetarist, 25% Austrian, 40% RBC.

Typical commenter's explanation: 0%, 0%, 100%, 0% (or some reordering of these).

I'm sure RBC matters enormously, in the sense of Random Bloody Cock-ups.

Great video.

I can't claim to be crazy about either the RBC video or this one.

I think the difference between a recession and a depression is that the former is an income statement event and the latter is a balance sheet event. That is, in a recession, you can stimulate growth by reducing interest rates because the problem is costs misaligned to revenues. This can be solved in a relatively short period of time, say, 12-24 months.

In a depression, by contrast, it's a balance sheet problem, that is, the value of liabilities is greater than the value of assets, either individually or in aggregate. In a depression, the interest rate mechanism is largely ineffective, and excluding TARP (which stabilized the banks), the QE's were in fact ineffective in aggregate. In a depression, you have to pay down the debt, and that takes time, as much as 7-9 years. The Great Recession, by this line of thinking, was a crypto-depression.

If recessions and depressions are about income statements v balance sheet, real business cycles are about fixed and variable cost. In a boom, liquidity accumulates faster than fixed assets, thereby leading to price bubbles. Over time, however, the supply of assets increases. This causes asset related revenues to fall, which leads asset orders to collapse, leading to layoffs, etc. Put another way, you can get boom-and-bust with nothing more than a fixed/variable cost model, ie, a lag between the demand for fixed assets and the ability of the market to deliver them. It doesn't really require a 'shock' as such, merely the inherent momentum of an economic expansion.

That's not to discount the impact of shocks like oil prices spikes, but you can generate a boom and bust cycle with nothing more than a lag in the delivery of fixed assets.

That's great-thanks for posting.

Seconded. A Depression sold by film-flam men as a mere Recession - sounds about right. But stay: "In a depression, you have to pay down the debt, and that takes time, as much as 7-9 years". I am ignorant on this point: has the excess debt been paid down this time?

See for example, consumer debt and home equity withdrawals over at Calculated Risk.

I think the Taylor Rule is also quite enlightening here. During a depression, the ZLB is binding for an extended period of time, ie, real interest rates are too high and investment is being 'crowded out' by the ZLB, and the interest rate transmission mechanism is ineffective. You can see a nice analysis by Gavyn Davies at this link:

Importantly, once the Taylor Rule rate is above the ZLB, and it is now, I think the risk of more traditional crowding out by government borrowing becomes much bigger. You can't just look back at the last ten years and see no govt crowding out and assume that's going to be the case when the TR takes you above the ZLB.

Finally, just to elaborate on the points above, to create a business cycle, all you need is for either operators or their financers (lenders, equity investors) to have either a historical or present-day bias, ie, all they have to be is conservative about predicting future demand based on recent prior or current market conditions. We see with oil rigs, for example, that they follow oil prices by about nine weeks. Thus, rig counts are driven principally by spot prices and they change with a lag -- not with anticipation. Now, for US land rigs, the lag is not that great.

But if we're talking offshore, the lag can be four years easily, and as much as seven, both on the upside and downside of the cycle. For example, the oil price crash of 2014 is expected to show up in offshore oil production declines in 2019--five years later. That's how you get a business cycle--even absent a visible shock: lags in fixed asset responses.

That lags can create cycles is a commonplace point in engineering control theory. In fact, it's a phenomenon I first noticed in the post-rugby showers at school.

And for the simple answer: Yes, the excess debt has been paid down. The global economy is ready to rock and roll.

And one additional thought. By this line of thinking, the depression ends when the Taylor Rule interest rates exceeds the Fed Funds Rate or the Euro Target Rate. Thus, depression dating accordingly is different from recession dating. Rather than peak to trough as recessions are measured, for depressions, we would use the metric that from the point that the Taylor Rule interest rate falls below the FFR until the TR exceeds the FFR (during a prolonged downturn).

Excellent video.

The Keynesian and Monetarist theories basically talk about how to solve the problem of recession. While the RBC and Austrian schools are more concerned in determining the root causes.

What the video didn't touch upon was - do Keynesians and Monetarists have anything to say at all about what causes recessions in the first place? If they do get around to talking about causes those are mainly very proximate causes. Eg : Government didn't spend enough. Banks didn't print enough money. That's OK. But why did people default all at once? Why was there a bubble in the first place?

I am not sure if the Keynesians and Monetarists have anything to say on the root causes.

At the end of the day, the answer to the cause of recessions does not lie in economics but in religion.

People shouldn't borrow when they cannot pay back. People shouldn't pay more than what an asset is worth. THey shouldn't speculate for a living.

These are religious problems which require development of a moral fibre. Virtue is primary. Economic policy is about helping people who are in trouble for not being virtuous.

No Price-Misperceptions theory?


I am extremely impressed along with your writing abilities, Thanks for this great share.

All four theories were developed before there was a shadow banking system. Structural problems within the financial system don't matter in these theories. Gary Gorton had it right - at it's root was a form of bank run within the non-regulated non-transparent part of the financial system. It took time for the effects to work themselves out.

Comments for this post are closed