The Great Economists

by Linda Yueh

  European banks were exposed to US sub-prime mortgages and some had also borrowed from US wholesale money markets. It meant that European bank lending became less reliant on deposits since they could access the same cheap money as the Americans. When Northern Rock failed in 2007, it was the first bank run in Britain in more than a century. The UK is closely linked to US financial markets and also faced the prospect of a systemic banking collapse during the 2008 crisis.

  So, did central banks act sufficiently to avoid repeating the mistakes of the 1929 crash? Have central banks learned the lessons from the Great Depression, including those set out by Milton Friedman, whose seminal research changed our view of the 1930s?

  Ben Bernanke, like Friedman, was also a scholar of the Great Depression. Therefore, when the global financial crisis struck in 2008, he was well placed as Fed chair to prevent the same mistakes from happening again.

  Like the Great Depression, the recent financial crisis was preceded by an asset price boom, but this time centred in the housing market rather than the stock exchange. According to the Case-Shiller repeat sales index, US house prices doubled between 1999 and 2007. This was largely due to a huge expansion in housing credit. The quasi-government enterprises Fannie Mae and Freddie Mac strongly supported government policy to extend home ownership to lower income households by effectively underwriting mortgages requiring smaller down payments and allowing higher price-to-income ratios. The result was an increase in mortgage lending to less financially secure households. NINJA (no income, no job, no assets) and NO-DOC (no documentations) were acronyms that became commonplace in the mortgage market. There was rapid growth in the two riskiest components of the market, sub-prime and Alt-A mortgages, which are both below ‘prime’ or the standard measure of creditworthiness.

  Despite this, the banking sector had, or so it thought, found a way to mitigate the increased riskiness of lending. Riskier mortgages could be repackaged with others into mortgage-backed securities (MBS) and given the highest (AAA) credit ratings for the creditworthiness of the debt, while still offering a higher rate of return than other safe assets such as Treasury bills. Credit default swaps (CDS) could be purchased to provide insurance against any losses should there be a default. Bankers created funds, such as special purpose vehicles (SPVs) and structured investment vehicles (SIVs), to hoover up these financially engineered securities offering better returns than safe assets like government debt, and sell the SPVs and SIVs to clients. These special funds often borrowed heavily in the money markets and, being based offshore, avoided the capital requirements and regulatory oversight of other financial institutions. Between 2001 and 2005 there was a lending boom in America like no other.

  The collapse in house prices in 2007 triggered massive defaults in the US mortgage market. Homeowners with negative equity walked away from their properties. It meant that the originators of mortgages, or those that had bought mortgage-backed securities, found themselves with assets worth less than their liabilities. The banks were in trouble.

  It is true that this financial crisis, though, differed from the Great Depression in several important ways, thus the lessons from the 1930s may not have carried over exactly, but it is still useful to compare the two. The Great Depression analysed by Friedman and Schwartz in A Monetary History was essentially a liquidity crisis. Banks facing runs on their deposits needed a forceful and competent lender of last resort to stem the flow. Here, the Federal Reserve failed.

  In the global financial crisis, the biggest problem was solvency rather than liquidity. It became difficult to price complicated and opaque securities backed by a pool of assets where the value, quality and riskiness of each were difficult to ascertain. So the credit market could not determine which firms were solvent and which were not. Naturally, lenders were unwilling to extend loans without being able to determine the creditworthiness of the borrower. Most of these problems lay with the investment banks.

  The Fed reacted quickly to the crisis. It cut interest rates sharply and extended discount window facilities. Learning the lessons from the previous crisis, the TAF (term auction facility) enabled banks to bid anonymously for funds from the Fed and avoid the stigma of being seen as an institution in trouble. Transparency in policymaking is usually considered preferable, but in crisis mode opacity might be the better option.

  The Federal Reserve also made a number of large-scale asset purchases in a process known as quantitative easing (QE). Between November 2008 and June 2010 it purchased around $175 billion of long-term securities, thus injecting that amount of cash into the economy. In November 2010, as the economy wobbled, it made further purchases of long-term Treasury bonds amounting to $600 billion in its QEII programme. Finally, a third dose of QE was initiated in September 2012 when the Fed announced the purchase of $40 billion in mortgage-backed securities each month for an indefinite period. This was dubbed ‘QE infinity’ by investors. The final QE programme was raised to $85 billion in December, before being tapered back to $65 billion per month in June 2013. By the time QE was halted in October 2014, the three QE programmes had seen the Federal Reserve accumulate a staggering $4.5 trillion in assets.

  As a result, the M2 measure of money supply, which had tanked during the Great Depression, had increased sharply in the global financial crisis following the large expansion of the Federal Reserve’s balance sheet. A repeat of the bank panics and runs seen between 1930 and 1933 was also avoided.

  Would Friedman have approved of the QE and other policies used in dealing with the 2008 crisis?

  In terms of purchasing government debt such as Treasury bonds in order to drive down long-term interest rates and inject liquidity into the banking system, he would have been undoubtedly in favour. However, the purchase of mortgage-backed securities in his mind might have been conceived as a bailout of a troubled asset. His prescription for the Great Depression was for the Fed to provide liquidity, not bailouts.

  The Fed’s response to the crisis also involved the direct rescue of certain financial institutions deemed too systemically important to fail. The investment bank Bear Stearns was particularly exposed to the US mortgage market and in 2008 was rescued by JPMorgan in a move strongly backed by the Federal Reserve. This was justified by the risk posed by Bear, the collapse of which could have brought down the entire banking system. In July 2008 the US Treasury bailed out and part-nationalized the government-supported enterprises at the heart of the crisis, Fannie Mae and Freddie Mac.

  However, a couple of months later, Lehman Brothers was allowed to go bust. The fallout was to turn a US mortgage market crisis into a global financial crisis. Bernanke was later to argue in a 2012 speech that because Lehman was insolvent and posed less of a systemic risk than Bear Stearns, the Federal Reserve had no legal standing to make a bailout using public funds. The next day, however, the giant insurance firm AIG was rescued as the Fed was concerned about the impact on the credit default swap market if it were allowed to fail.

  In the global financial crisis, the Federal Reserve provided direct credit to specific markets and businesses in need of liquidity. Friedman’s recommended approach in the Great Depression was simply to flood the economy with general liquidity and allow solvency issues to sort themselves out. He might have viewed the targeted interventions made by the Fed, i.e. to save Bear Stearns and AIG but allow Lehman Brothers to go under, as undermining its independence and credibility and getting involved in specific cases.

  However, the world in 2008 was different from 1929. There were now players in the financial sector that were literally too big to fail, in the sense that they might bring down the entire system with them. This was not such a problem in the Great Depression, when the systemic risks of any specific bank failure were quite low. With this in mind, Friedman might have grudgingly accepted Bernanke’s approach as the best way forward. Of course, he would have been against the involvement of government-supported enterprises in the US housing market in the first place, and would have viewed the crisis as largely a res
ult of the government’s unsuccessful intervention in the mortgage market.

  There is no doubt that Friedman’s scholarship changed perceptions of the Great Depression. By focusing on the role of monetary policy, it greatly aided the response to the more recent crisis. But what about the unconventional monetary policies used afterwards to support the recovery?

  The effectiveness of QE still relies to some extent on an ill-functioning banking system. It’s all very well to create money; but that money still has to get out into the economy so small firms in particular can borrow and invest. There has been some evidence of positive impact from these unconventional monetary policies along those lines, but some worry about the side effects of increasing the supply of money so dramatically, especially since some of the money has flowed into stock markets which had reached heady heights around the world. It’s fair to say the jury is largely still out.

  Milton Friedman, though, was generally supportive of QE, which he witnessed in action in Japan. Japan was the first country to adopt QE after its real-estate bubble burst in the early 1990s, so this policy was initially used nearly two decades before the global financial crisis. Friedman approved of what the Japanese central bank did, commenting on their policy: ‘The surest road to a healthy economic recovery is to increase the rate of monetary growth.’14 He argued that the Bank of Japan should undertake QE since interest rates had been cut to rock bottom and the economy was still in dire straits:

  Defenders of the Bank of Japan will say, ‘How? The bank has already cut its discount rate to 0.5 per cent. What more can it do to increase the quantity of money?’ The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase … There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so.15

  Since he supported QE in Japan, Friedman would have viewed the use of unconventional policies such as cash injections by the US, the UK, the euro area and elsewhere as just as necessary to get lending going in these economies. Central banks in Japan and Europe setting negative interest rates would fall under the same canopy of using a novel tool to try to increase the flow of money into the economy.

  But Friedman would have viewed more cautiously the grant of macroprudential policy which gives central banks more direct power to regulate markets to further their monetary policy aims. However, the financial system is much more complex and global today, so Friedmanites may well support the notion that targeting credit and debt levels has become an important area for central banks to manage as part of keeping the monetary system stable. Working out how these policies of targeting inflation and financial stability should work together would surely have been up Friedman’s street as economists are now devising a framework for a new monetary policy era.

  Finally, for those who question the effectiveness of unconventional tools, particularly QE, Friedman would probably point to the successful winding down of this policy as the American economy has recovered. Even if these policies generated some adverse consequences such as pushing up stock prices, the priority would be to keep monetary policies supportive until the economy was on a sound footing.

  Friedman would say that not acting to keep money flowing in the system was the reason why the Great Depression was ‘Great’. In response to critics of Japan’s loose money policy, Friedman wrote in the Wall Street Journal: ‘After the US experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.’16

  He warned that this mistake should not be repeated. After all, it was four years after the US economy was thought to have recovered in 1933 that the country was plunged back into recession in 1937. As policymakers contemplate potential parallels to the 1930s, Friedman would have urged them to heed this lesson and not rein back monetary policy prematurely.

  Two Lucky People

  Milton and Rose Friedman’s long marriage and partnership extended beyond family life. They formed a prolific pair, especially in their later years at the Hoover Institution, when Friedman had stepped back from academic economics to focus on his popular writing. It was during this collaborative time that they co-authored the best-selling Free to Choose in 1980 as well as Tyranny of the Status Quo, published in 1984. They also co-wrote Two Lucky People: Memoirs, published in 1998.

  Friedman himself regarded Capitalism and Freedom, published in 1962, to be ‘a better book’ than the very commercially successful Free to Choose, published two decades later.17 He thought it was ‘more philosophical and abstract, and hence more fundamental’.18 In his view, the latter book complements the former. Friedman even named his Vermont hilltop home, situated in 120 acres, ‘Capitaf’ after Capitalism and Freedom.19 However, most economists would regard his A Monetary History of the United States, 1867–1960, written with Anna Jacobson Schwartz, as his finest work.

  Rose outlived Friedman by three years, passing away at the ripe age of ninety-eight in 2009. She would have witnessed her husband’s work being invoked and applied to the first systemic banking crisis since the one of their formative years in the 1930s.

  Milton Friedman would have relished that his widow saw his research being applied: ‘The true test of any scholar’s work is not what his contemporaries say, but what happens to his work in the next twenty-five or fifty years. And the thing that I will really be proud of is if some of the work I have done is still cited in the textbooks long after I am gone.’20

  CHAPTER 11

  Douglass North: Why are so Few Countries Prosperous?

  It’s one of the enduring conundrums of our time: why so few countries are prosperous. But will it remain one? There has been tremendous progress, so much so that the World Bank has stopped categorizing countries as ‘developed’ or ‘developing’ and now uses regional classifications instead. Are we really about to witness the end of poverty and find the solution to the decades-old question of why so few countries are rich?

  How few is few? Well, of the just under two hundred countries in the world that produce economic data, only about fifty are classified as high income. It is a difficult club to join. The World Bank estimates that of the 101 countries that were classified as middle-income in 1960, just a baker’s dozen had become prosperous by 2008.1 Those whose per capita GDP or average income have approached the level of the United States are: Equatorial Guinea, Greece, Hong Kong SAR (China), Ireland, Israel, Japan, Mauritius, Portugal, Puerto Rico, Singapore, South Korea, Spain and Taiwan.

  The answer to why only thirteen countries have become rich in the past half-century should include an analysis of the types of institutions that underpin their economies. Possessing good institutions is what economists have come to focus on after standard economic factors, such as capital, labour (including human capital that accounts for education and skills) and technological progress specified in neoclassical growth models, have been unable to explain in full why some nations prosper while many do not.

  The seminal research on institutions and economic development was pioneered by Douglass North. He, and those who followed him, systematically analysed how some countries adopted good institutions and what might be done to reform the bad ones. North observed:

  The evolution of government from its medieval, mafia-like character to that embodying modern legal institutions and instruments is a major part of the history of freedom. It is a part that tends to be obscured or ignored because of the myopic vision of many economists, who persist in modeling government as nothing more than a gigantic form of theft and income redi
stribution.2

  In North’s view, the existing models were unable to answer the essential question as to why economic growth varies across nations:

  What accounts for their widely disparate performance characteristics? This divergence is even more perplexing in terms of standard neoclassical and international trade theory, which implies that over time economies, as they traded goods, services, and productive factors, would gradually converge. Although we do observe some convergence among leading industrial nations that trade with each other, an overwhelming feature of the last ten millennia is that we have evolved into radically different religious, ethnic, cultural, political, and economic societies, and the gap between rich and poor nations, between developed and undeveloped nations, is as wide today as it ever was and perhaps a great deal wider than ever before.3

  It seems hardly radical, but North took economics out of its comfort zone, which consisted of examining more easily measured inputs like labour and capital and instead brought in politics, sociology and history in order to understand why some countries succeed and others fail.

  North won the Nobel Prize in economics in 1993. Along with his fellow laureates Ronald Coase (who won in 1991) and Oliver Williamson (who won more than a decade later in 2009), North founded the field of New Institutional Economics. This work was later expanded upon by MIT economist Daron Acemoglu and University of Chicago political scientist James Robinson, notably in their book Why Nations Fail: The Origins of Power, Prosperity, and Poverty, and by many others who have built on North’s work on the role of institutions in economic development.