The ivory tower economist syndrome

Here we go. Academic economists are lost. Lawrence Summers just made a striking announcement in a speech a few days ago: we are likely to be in a secularly stagnating economy that needs recurrent bubbles to achieve full employment, as its natural rate of interest has been constantly below zero for a while. Evidently, Krugman, Sumner, Cowen, Wolf and many other economists started to discuss the issue. Some agree, some don’t. However, most seem to miss the main problem. I call that the ivory tower economist syndrome. Abstractly thinking in terms of aggregated economic figures locked in a university or government office won’t be of much help. Zerohedge rightly makes fun of Summers and Krugman, as the satiric newspaper The Onion made the same economic advices a few years ago:

Congress is currently considering an emergency economic-stimulus measure, tentatively called the Bubble Act, which would order the Federal Reserve to† begin encouraging massive private investment in some fantastical financial scheme in order to get the nation’s false economy back on track.

Who said that was fiction?

Many of them are backing their ideas using wrong arguments. For instance, Summers and Krugman don’t believe interest rates were too low before the crisis as… there was no inflation! Sure, but, how do you know that? CPI? RPI? GDP deflator? There are many problems with inflation figures. Let’s list some of them:

• They don’t accurately reflect inflation. You can change the calculation and the result changes dramatically. Moreover, the goods picked to calculate them and the weights applied to them are quite arbitrary. This is supposed to reflect the ‘average’ household basket. Well, I am not the average household apparently as my own inflation rate has been way higher than headline inflation over the past few years.

• 0% CPI increase does not mean that there is no inflation. Productivity increase drives inflation down. As a result, reasoning in terms of headline inflation is a mistake. Real inflation is hidden. The fastest economic growth in the history of the Western world (late 19^th and early 20^th century) occurred during a long period of secular deflation…

• Most asset prices aren’t reflected in inflation figures. Newly created money now mostly go to investments, a lot of which being speculation. Most of banks’ lending is mortgage lending. So newly-created money goes to housing, pushing up prices… which aren’t reflected in inflation figures. Sure, one can argue that, at some point, there will be inflationary pressure on consumer goods. But productivity increases reducing the price of domestically-produced goods (IT revolution anyone?) and cheap goods from developing countries mask that process. Moreover, when asset bubbles burst (which they eventually do), the wealth effect from asset price increases that could lead to inflation all but disappears. Lending was also different 50 or 100 years ago: much lending did not go directly to investments in financial or real assets. Consequently consumer goods inflation appeared a lot faster after new monetary injection (considering stable productivity).

So justifying the fact that nominal interest rates defined by central banks were not low because there was no inflation is in itself wrong, or at best inaccurate. In reality, low interest rates are very likely to have caused, or at least participated, in the recent credit bubble. Regarding the so-called ‘savings glut’, Cowen agrees with Kling on the fact that, if we really had ‘too much’ savings chasing ‘too few’ investment opportunities, we would not need central banks’ actions to push interest rates lower. The supply and demand of loanable funds would automatically drive the interest rate to a very low level.

But, most importantly, all those economists forget a fundamental fact that I have been mentioning a hundred times recently: regime uncertainty (yes, again…). For economists to speak in terms of monetary and spending aggregates alone and to not pay attention to the broader context surrounding businesses is a major mistake. I’ve kept repeating and giving many evidences recently (like here, here, and here) that businesses currently delay investments due to the uncertain regulatory and economic decisions taken by governments and regulators all around the world. This is now the major issue for SMEs and banks at least. Again today, Euromoney published an interesting short article on ‘renewed regulatory uncertainty’ for banks:

For all the populist fervor then about perceived policy inaction to address systemic risk, many banks see it differently: investor flight from banks’ equity and bond products has taken root over the years, amid fears that new rules will render business models uneconomic.

Take a look at that SEB and Deloitte chart summarising current regulatory reforms. It looks slightly messy doesn’t it? And look how it is named…

A bank analyst told Euromoney that:

Changes in regulations, changes in what other stakeholders consider to be acceptable, the risk that the behaviours of certain employees become associated with the institution as a whole – those are indeed much more expensive for banks these days than credit [risk].

As I have already highlighted in an earlier post, more than the number of rules, it is the fact that rules change that is crucial to business planning. You can’t play a certain game if the rules of the game constantly change. Yet none of those ‘great’ economists ever mentioned regulation, uncertainty, rules or anything related. Looks like abstract economic aggregates are a lot more interesting to manipulate…

Get out of your tower guys!