Some lessons from the sub-prime crisis responses

There are very few counterfactuals in social sciences. The closest to such a counterfactual are the contrasting responses of US and Europe to resolving their respective financial market crises. Though in recent months, Europe has taken steps to emulate the US, the initial responses across both sides of the Atlantic bear a striking contrast.

In the US, at the first signs of the sub-prime crisis bursting, the Treasury and the Federal Reserve aggressively intervened to contain the damage. The Treasury came forward with its Troubled Assets Relief Program (TARP) to directly assist the beleaguered banks and other financial institutions with equity injections. The Federal Reserve expanded its balance sheet many times and initiated quantitative easing programs to emerge as the lender, insurer, and buyer of last resort for the financial markets.

However, across the Atlantic, driven both by lack of similar political resolve and strong ideological predilections, the Eurozone governments and the European Central Bank refrained from aggressive intervention. They let events take their own course in the hope that markets would soon resolve the issue. Credit markets froze, driving up sovereign debt yields and nearly shutting off the peripheral economies. Banks, saddled with massive sovereign debt exposures, stumbled to the brink. The ECB refused to lend either to the banks or the battered sovereigns. It stepped in finally only when the situation had worsened considerably.

The contrasting fortunes of both economies, atleast their respective financial sectors, is a clear verdict on the policy courses followed on both sides of the Atlantic. Europe stares at a potential Japan like financial dystopia, whereas American financial institutions have recovered smartly and are back to doing all those things that caused the sub-prime crisis! However, there are a few quick learnings from the situations across both sides,

1. The loudest message from the two different courses of action is that markets do not repair themselves and when faced with such deep financial market crises, governments and central banks have to step in with aggressive policies.This becomes all the more important as the complexity of our banking systems increase and the too-big-to-fail syndrome become entrenched.

2. Related to this is the central and disproportionate importance that financial markets have come to assume in determing the economic fortunes of a country. Despite the fact that the financial sector occupies a far less share of both the economy and the working population, its good health is critical to the fortunes of any modern economy.

3. Similar to the stark contrast between the US and European responses is the difference between the responses by the US Government and the Fed to the condition of over-leveraged financial institutions and debt-ridden individual households. The latter received nothing like the unlimited and cheap liquidity injections, debt rescheduling at very favorable terms, and sweeping credit guarantees offered to the financial institutions. Household foreclosures, even when it happened in a massive scale, became a source of concern only when it threatened to affect an exposed financial institution.

In other words, the disciplining elements of the free-markets are reserved for individual households and small business firms, while the financial sector behemoths, the much trumpeted success stories of deregulated free-market capitalism, face no such constraints. The negative externalities created by financial institutions do not get internalized.

4. All this highlights the increasingly sharp cleavage between the real economy and the financial markets. Are the gains of the financial markets, especially their outsized wins, coming at the expense of the real economy? Is there a recession or even a depression lurking at the end of a sustained period of financial market boom? The financial markets, especially in their current avatar, appear to have become too big a systemic risk to be left as it is.

Graphic linkfest from 2011

Excellent graphics from the Wonkblog, BBC, and the Atlantic. All graphics below highlight important economic and social trends in a most striking manner.

It is no secret that any meaningful attempt to rein in America's debts has to involve addressing the burgeoning public health care expenditure. The graphic below makes this clear. Relentlessly rising health care costs coupled with demographic changes are driving the growth of these programs, while the open-ended structure of these programs is responsible for much of the increase in health care costs.



This graphic captures the extent of political polarization in the US. In the late 1960s, the most conservative Democrats in the House and the most liberal Republicans voted together frequently enough (as shown by the overlap between the two distributions) to make centrist legislating successful. By the late 1980s, that overlap was dwindling and today, it is largely gone.



Inequality is already one of the most important concerns for the US economy. As the graphic shows, corporate profits have not only recovered their post-recession highs, they’ve surpassed it and are growing, even as workers compensation as a share of the economy is declining continuously.



Thomas Gallagher of Scowcroft Group points out from the graphic below that the steep bull market since the early 1980s and the fact that previous such bull markets were preceded by pretty severe bear markets, is reason enough to be minimize expectations for overall stock market gains over the next several years.



Given the extent of job losses during the Great Recession, this Hamilton Project graphic shows that it may be years before the US economy regains the pre-recession level of jobs. If the economy adds about 208,000 jobs per month, which was the average monthly rate for the best year of job creation in the 2000s, then it will take until February 2024 — over 12 years — to close the jobs gap.



The chart below shows the real GDP in the US and the level of total civilian employment from 2002-2011. Its trends are an indicator of the gravity of labour market problem facing the US economy. While the total output has regained the pre-crisis level, the labour market is stuck way below. In other words, the US economy is producing the same output as in Q4 2007 with 6.6 million fewer workers. This jobless recovery points to a combination of increased productivity and labour market shifts (towards jobs which employ fewer jobs).



The graphic below captures the true magnitude of the global macroeconomic imbalance. It highlights the explosion of current account surpluses and official investments of delveloping economies in foreign financial assets, especially US Treasury Bonds. The mirro image of this is the rise in current account deficits in the developed economies.



Tyler Cowen's book, The Great Stagnation, has drawn attention to the stagnation in the Total Factor Productivity (TFP) of the US economy since the early 1970s. TFP is a measure of how much the economy is receiving a boost from innovation and new ideas, as opposed to, say, people working longer hours or taking a second job.



The graphic below highlights the power of the Fed's monetary policy announcements. On August 9, 2011, the FOMC meeting minutes announced that the economic conditions were 'likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013'. The market reaction was impressive.



One of the most powerful measures of the depth of the Great Recession is the output gaps that have emerged in both sides of the Atlantic. Bridging them could take years.




The two illuminating graphics ought to clarify the source of America's current debt crisis. It clearly points to the Bush legacy - tax cuts and Iraq-Afghan wars - as the main drivers of the ballooning deficit. Further, the much maligned stimulus spending and bailout policies have contributed only marginally to the debt stock and deficit. However, the loss of revenues due to the economic downturn has had a very significant effect.

More on the Dark Age - overcoming the obsession with mathematical models?

John Kay argues that the fundamental challenge for economics profession today is to abandon its exclusive focus on deductive model-based approach with its focus on rigour and consistency (and expressed exclusively with the tools of mathematics) and embrace elements of real-world observations based inductivism which also draws heavily from cross-disciplinary research (which are not exactly amenable to being reduced to mathematical models). He writes,

"Consistency and rigour are features of a deductive approach, which draws conclusions from a group of axioms – and whose empirical relevance depends entirely on the universal validity of the axioms. The only descriptions that fully meet the requirements of consistency and rigour are completely artificial worlds... deductive reasoning is the mark of science: induction – in which the argument is derived from the subject matter – is the characteristic method of history or literary criticism.



But this is an artificial, exaggerated distinction. Scientific progress – not just in applied subjects such as engineering and medicine but also in more theoretical subjects including physics – is frequently the result of observation that something does work, which runs far ahead of any understanding of why it works. Not within the economics profession.



There, deductive reasoning based on logical inference from a specific set of a priori deductions is 'exactly the right way to do things'. What is absurd is not the use of the deductive method but the claim to exclusivity made for it. This debate is not simply about mathematics versus poetry. Deductive reasoning necessarily draws on mathematics and formal logic: inductive reasoning, based on experience and above all careful observation, will often make use of statistics and mathematics.



Economics is not a technique in search of problems but a set of problems in need of solution. Such problems are varied and the solutions will inevitably be eclectic. Such pragmatic thinking requires not just deductive logic but an understanding of the processes of belief formation, of anthropology, psychology and organisational behaviour, and meticulous observation of what people, businesses and governments do.



The belief that models are not just useful tools but are capable of yielding comprehensive and universal descriptions of the world blinded proponents to realities that had been staring them in the face. That blindness made a big contribution to our present crisis, and conditions our confused responses to it."

The central challenge as the mainstream in the profession see it is to develop a model (preferably one that can be simulated on a computer) of the economy which is not only able to explain why events happen as they do but also make reasonably accurate predictions of them. Kay explores the various possible interpretations that have sought to correct the obvious flaws in the standard DSGE models, consequent to the soul-searching that followed the sub-prime crisis and its aftermath.



In response to the crititicism of the Lucasian DSGE model, its Chicago supporters have sought to make it even more complex in order for it to be more realistic! They have introduced more parameters to represent the complex problems that abound in the real world, which takes into account market frictions and transaction costs. Another response has come from those like Joe Stiglitz who while retaining many of Lucas assumptions have introduced greater importance to information imperfections (for example, Ricardian equivalence's assumptions of households having information about future budgetary problems is now questioned).



Some others, from the complexity economics school, have put forward agent-based modelling solutions, based on specific behavioural and other heuristics generally observed in the real-world. All these solutions satisfy the "requirement" of being mathematical and computer simulatable. However, questions about their real-world effectiveness remain.



Without offering any specific model, John Kay argues in favor of a less mathematics based approach. He writes,

"Another line of attack would discard altogether the idea that the economic world can be described by any universal model in which all key relationships are predetermined. Economic behaviour is influenced by technologies and cultures, which evolve in ways that are certainly not random but that cannot be fully, or perhaps at all, described by the kinds of variables and equations with which economists are familiar. The future is radically uncertain and models, when employed, must be context specific."

The crux of the debate is that all conventional approaches to explaining and forecasting macroeconomic phenomena assume that it has to be contained in a logically consistent and theoretically sound model. It assumes that it is possible to collapse all the different (and there are a maddening array of them) scenarios into this one comprehensive model.



Therefore, the supporters of the Lucasian school try to formulate a single model that can satisfactorily explain all the different types of economic recessions. Accordingly, it seeks to use the same model, with its standard set of assumptions, to explain aggregate demand slumps caused by as widely varying factors as the routine ones (say, monetary policy induced) to those spawned by banking crisis and resultant balance sheet damages.



The result is a failure to satisfactorily explain the present balance sheet recession, especially in conditions of persistent high unemployment rates and zero nominal interest rates. In response, the freshwater economists have either adopted a postion of ostrich like denial or have tried to tinker with the existing models, introducing newer parameters and assumptions to explain market frictions, and in the process drawing them further away from reality.



What if there is no such magic model that can be formulated? Is it possible to forecast macroeconomic outcomes with any great degree of accuracy, beyond estimating the broad trends? What if the degree of relevance of each assumption varies widely across different contexts, to be so irrelevant at certain times as they are relevant at other times, and in which case the model itself should assume a completely different character? More importantly, is there really a need to have a universal, one-size-fits-all model?

On changing human behaviour

Changing human behaviour, so as to get people to act in a manner that increases the likelihood of achieving certain social or environmental goals, is one of the most challenging areas of public policy. Standard approaches involving regulation and incentives (taxes, rewards, and penalties), while effective to certain extent, are increasingly becoming blunt instruments, especially on the more universal of social and civic problems.

In this context, Richard Thaler and Cass Sunstein's path-breaking book, Nudge offers several interesting insights into how human beings can be subtly nudged into performing specific tasks. And a series of small nudges could go a long way towards meeting important public policy goals.

An excellent summary of these techniques comes from Oliver Payne with his 19 ways to "ask" for sustainable change in human behaviour. He has three presentations (Summary, Part I, Part II, and Part III, this, this) form an excellent resource.

1. Simply Ask - eg. when asked nothing in a food Que, only 40% of students took a serving of fruit, but when specifically asked whether they will have fruit, nearly 70% took fruit; voters who were asked a few days before voting whether they will vote were more likely to turn up and vote etc. The "exposure effect" increases the likelihood of the desired outcome.

2. Ask using the right words - eg. carbon offsets are more acceptable than carbon tax; user charges are easier to push through than taxes (framing of the issue); nudge to prevent people from stealing wood from Arizona's Petrified Forest National Park ("Many past visitors have removed petrified wood from the Park changing the natural state of the Park" Vs "Please don't remove the petrified wood from the Park in order to preserve...", the latter was more effective) (reinforcement of social norms); describe carrots as "X-ray vision carrots" (to pre-schoolers) or soup as "Rich Vegetable medley Soup" increases uptake considerably (selective perception) etc.

3. Ask using the right images - eg. the dual image of a littered environment being changed to a clean one reinforces social norms and is more effective in driving home the message on littering than just a littered environment image (it ends up reinforcing the damaging message that many people do litter).

4. Ask using the right authority - eg. Don't Mess With Texas campaign (which did not work with fines) reduced roadside littering by over 70% over 5 years through a campaign with sporting and country-music heroes imploring people to not litter. Ads avoided the negatives of shame and guilt in favor of the positives of pride and group identity (reinforcement of social norms).

5. Ask using the right fake authority - eg. An office tea and coffee "honour box" (into which people dropped the charges) was more effective at boosting honesty and collecting money when a pair of eyes (Big Brother Eyes) was displayed beside it (authority effect - sensitivity to our actions being observed by others); smiley and frowny faces about your driving speed on electronic signboards in South Lanarkshire Council roads (instead of numerical speed information) was more effective at reducing speeds (social approval - smile, you're on camera!); smiley and frowny faces to represent electricity usage on consumers' electricity bills by South California Edison electricity utility's OPower Home Energy Reporting System etc.

6. Ask in the right order - eg. listing disadvantages followed by advantages of carbon tax was found to be more effective in getting public approval than the other way round (framing and anchoring effects)

7. Ask at the right time - eg. traffic light synchronization program in Texas which informed drivers (through digital signboards) about their optimal traffic speeds lowered delays by 25% (self-serving bias)

8. Ask with the right incentive - eg. RecycleBank has a program in many US and UK cities that weighs the amount you re-cycle and converts it into points which can either be redeemed for shopping coupons at local stores or brand outlets (partnership with eBay and Marks & Spencers) or informs them the equivalent numbers of trees saved and oil barrels conserved.

9. Add options - eg. using decoys to help people make choices between various options (by say, adding an additional qualification to the item we want people to purchase or not purchase); keep a non-recyclables (or trash) bin beside the recyclables so as to ensure more effective sorting (framing effect); also small hole for recyclables bin and a larger hole for non-recyclables bin etc

10. Take away options - eg. default options in computer programs nudges data entry operators away from making mistakes; mandatory fields and server clock times too reduces the probability of errors in data capturing.

11. Ask, but have a default option - eg. have a default menu option in school restaurant or conferences which is vegetarian (or healthy food) and provide non-vegetarian (or junk food) when asked (dramatically increases uptake) (framing effect); California's Ready Return tax filling form is pre-filled with last year's data was widely welcomed by assessees etc.

12. Ask a completely different question - eg. Piano staircase and calorie counters on steps (Goodnight Hostel in Lisbon) encouraged people to use stairs over the escalators (framing effect); Bottle Bank Arcade bins placed at strategic locations in Swedish cities that asks people to deposit used bottles and cans.

13. Let the feedback ask the question - eg. Ambient Orb device nudges people to optimize their electricity usage. Cognitively salient information helps people overcome inertia.

14. Don't Ask, Tell - eg. Inform tax payers that evasion is the exception and most people pay or put cards in the toilet to inform guests that most other guests re-use their towels. In both these cases, there is a reinforcement of a social norm.

15. Ask nothing, other than simply to measure - eg. Drivers become more mileage conscious with merely owning a car (say, a hybrid car) whose USP is mileage.

16. Don't ask anything - other than they go public - eg. grading restaurants in Los Angeles (reinforce social norms); Wattson household energy monitor whose data is displayed on the owner's Facebook page (Social norms - peer pressure) etc

17. Ask for a commitment - in the future - eg. shower timer to control water flow (temporal discounting or time inconsistent preferences); commitment contracts on exercising and eating habits on StickK.com etc

18. Ask Kinetically - eg. automatic light and AC on and off when key is inserted or taken off the slot in hotel rooms; square peg, compared to round peg, to hold lavatory paper (each tug is met with a resistance, which encourages people to optimize on their toilet paper usage) etc.

19. Make the question irrelevant - eg. smaller plates to reduce over-eating (selective perception); moving the clock backwards and forwards to make more optimal use of sunlight.

As can be seen from all these, loss-aversion, framing, and social norms are the commonest cognitive biases that can be targeted to formulate policies. People draw different conclusions and act differently based on how the information/data is presented - people are context dependent. People are much more averse to losses than to similarly sized gains - pain of loss is twice the pleasure of gain! People prefer to follow the herd and their actions to reinforce the social norms.

Re-thinking macroeconomic policies - a graphical summary

The sub-prime mortgage crisis and the Great Recession have questioned several underlying assumptions of modern macroeconomics. Paul Krugman famously called it the "Dark Age of Macroeconomics" and many standard macroeconomics text books are currently undergoing wholesale revisions in the light to these experiences.

What should be the role of Central Banks, especially in ensuring financial stability? What are the policies and instruments that can be deployed by central banks? What should be the optimal inflation target? What are the exit routes available for central banks from extraordinary monetary accommodation? Do central banks have a role in stabilizing output, that goes beyond interest rate changes, especially when faced with deep recessions?

What regulations are required to ensure greater stability and improve the crisis-resilience of banks? What can be done to contain the build up of systemic risks and limit the contagion effects of deleveraging and resultant liquidity crisis? How do we mitigate the moral hazard concerns arising from financial bailouts? What type of financial market regulations are required to limit the possibility of asset bubbles?

What are the fiscal policy options for governments faced with an economic recession and zero-bound in interest rates? How should fiscal policy be organized during such recessions? Which policies deliver the greatest bang for the buck? How can we swiftly deploy stimulus measures in the face of political paralyses and gridlocks? Should governments restrain from stimulating the economy, when faced with zero-bound recessions, with short-term fiscal measures for fear of deficits and debts?

What is the role of global macoreconomic imbalances in causing and sustaining asset bubbles? What is required to prevent the build up of such imbalances? How should cross-border financial flows be regulated? What is the optimal capital account policy for emerging economies? What sort of international monetary system is required to satisfactorily resolve cross-national financial crises?

I have tried to consolidate the learnings from events of the last three years and the post-mortems and other research that has gone into more satisfactorily understanding and explaining macroeconomic policy making. The result is this graphic. While I must admit that it is highly simplified (all such beautiful flow-charts are meant to simplify complex policy eco-systems), it only seeks to broadly highlight all the different elements of a post-crisis macoreconomic policy framework.

It is clear that the mandate of central banks have to expand beyond inflation targeting and include financial market stability. And when faced with deep recessions, central banks have a credit policy role, whence it could become a lender, buyer, and insurer of last resort. Fiscal policy becomes critical when monetary policy loses traction and when interest rates are at the zero-bound. Its main instruments are automatic stabilizers and discretionary spending measures. The specific instruments of each policy, as indicated in the chart, are illustrative and is meant to merely guide discussion.



(Please click on the graphic to enlarge)

In fact, the IMF recently brought together some of the world's leading economists to a conference where the Fund and participants urged a wholesale re-examination of macroeconomic policy principles. See also this concise presentation by Olivier Blanchard.