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IMF seeks to define the lessons of the crash – part 2

Asset bubbles | IMF seeks to define the lessons of the crash – part 2 Anthony Harrington

Part one considered IMF Chief Economist Olivier Blanchard’s view that one of the central lessons from the global crash of 2008 was the complete discrediting of the idea that all central banks have to do to ensure economic stability is to target stable prices by focusing on a two percent inflation target. Blanchard was speaking at a high-powered two day conference in Washington, entitled “Macro and Growth Policies in the Wake of the Crisis".

In part two we look at Nobel Laureate Joseph Stiglitz’s presentation, which began from the standpoint that this was very much a man made crisis, with nothing inevitable about it. “The implication is that it was policies, and in particular monetary and regulatory policies, that created the crash,” he told delegates. The “sins of omission and commission” by central banks led to the crisis. For sins of omission, look at the way the Fed ignored bank leverage. For sins of commission, look at the repeal of Glass-Steagal.

Stiglitz acknowledged that central banks can claim credit for helping to bring the global economy back from the brink of disaster, but he noted that they have not so far managed to bring us back to robust health. In fact, he argued, some of the actions taken by central banks, particularly the Fed’s first and second round of quantitative easing, have created more instability in the global economy, including generating profound adverse effects on global financial integration (which is one way of summing up the current so-called competitive devaluation strategies or currency wars, that are still ongoing), and stirring up protectionist sentiment.

The root cause of the crisis, as is now plain, was easy credit flows, for which central banks in developed economies such as the US, the UK and Europe, have to take responsibility, along with the asset bubbles these flows generated.

Stiglitz pointed out that what was so astonishing about the build up to the crisis was the fact that this was not a unique event. As Reinhart and Rogoff demonstrated in their analysis of eight centuries of financial folly (This Time Is Different: Eight Centuries of Financial Folly), massive amounts of easy credit always lead to bubbles. Stiglitz cited the history of the last 200 years which shows that the bursting of these bubbles always leads to very severe recessions. Given all of this, why wasn’t the Fed alert this time round? The reason, he suggests, is that the economic models that the Fed was working off did not factor in the risk of disorderly credit expansion. “This is the central major failure of monetary economics in recent decades,” he says.

“In the aftermath of the new classical revolution (in economics) there was a consensus that you needed to put macro economic theory on solid micro economic foundations. Unfortunately, they (the economists) chose the wrong micro economic foundations. They based their thinking on efficient market theory. What we know is that markets are not efficient. In fact with imperfect information and an imperfect understanding of risk, they are almost never efficient and they (the markets) are not stable. What we saw with the crash was one of the worst manifestations of this…”

What is going to be needed, going forward, is a lot more scholarly work on models that bear a much tighter relationship with the real world and that do factor in disruptive events such as cascading bankruptcies, and the impact of a Lehman Brothers-style collapse. What is also needed, he suggested in passing, is more work on the links between what central banks do and the flow of credit. There is a lot of work out there on this in the Latin American economic tradition, in the economics of information and in Austrian school economics, but so far it has not been incorporated into macro economics as practiced by central bankers, he said. That has to change.

Further reading on asset bubbles:

Tags: asset management , asset price bubbles , crash , IMF , Jean-Claude Trichet , Joseph Stiglitz
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