Thomas Mayer - The Challenges of Economic Thinking in Practice

DB Research Deutsche Bank

The Challenges of Economic Thinking in Practice

Dr. Thomas Mayer, CFA Chief Economist of Deutsche Bank Group [email protected] (+49) 69 910 30800

24 January 2012

Thomas Mayer Chief Economist DB Research

Deutsche Bank

Conventional economics did not anticipate the financial crisis, cannot explain it, and cannot make recommendations on how to overcome it, because it does not understand the credit cycle. To understand the credit cycle practitioners had to study economic history and dig up old economic theories long discarded by the mainstream. „Rethinking economics“ requires that we shift the focus from „deduction“ (like in natural sciences) to „induction“ (like in social or historic sciences) for the development of economic theories.

My main points

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The macroeconomic consequences of conventional economics

•Theory of rational expectations

•Theory of efficient markets

Monetary policy should target inflation

Asset prices can be ignored

Regulation can be „light“

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Chief Economist

"If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.“ Paul Krugman in late 1990s

1. Control illusion

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The financial market consequences of conventional economics

•Theory of rational expectations

•Theory of efficient markets •Probability distribution of financial market prices known (and ideally normal)

Modern portfolio theory

Value-at-risk

Leverage


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“At the beginning of 1998, the firm (Long-Term Capital Management) had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt to equity ratio of over 25 to 1. It had off-balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps.”

2. Control illusion

Source: http://en.wikipedia.org/wiki/Long-Term_Capital_Management

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But: What if these theories do not appropriately describe the behaviour of humans and markets?

The (probably) biggest credit bubble of all times


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•US sub-prime credit crisis (early 2007)

•Money market crisis (mid-2007)

•Banking crisis (2008-09)

•Public debt crisis (2009-?)

•Euro crisis (2010-?)

Next

•Monetary crisis?

The burst of the credit bubble


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Business cycle theories where credit plays a key role

Hedge borrowing Speculative borrowing Ponzi borrowing

Credit expansion phase - investment boom Credit contraction phase - investment bust

Post-Keynesian economics (Minsky)

Austrian economics (von Mises, Hayek, Schumpeter)

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t

Credit

Hedge borrowing Speculative borrowing

Ponzi borrowing

Minsky moment

Minsky‘s financial instability theory


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Financial regulation can help stabilise the economy Fiscal and incomes policies can help stabilise the economy

Minsky‘s error

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But: Regulation and economic policies have been more often pro- than anticyclical


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The Austrian business cycle

t

market rate = natural rate market rate < natural rate

GDP market rate > natural rate


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The liquidationists‘ error

"…liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people." Andrew Mellon, US Secretary of the Treasury, 1921-1932

But: What if rising risk aversion keeps the market rate above the natural rate?

Economic policy needs to reopen the credit channel


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Overcoming the “fear of fear itself“

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1928 1930 1932 1934 1936 1938 1940 1942-15

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10

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Credit impulse, % of GDP

Real consumption + investment(rhs)

% yoychange, % of GDP

United States

Notes: Credit impulse := change in net lending flows from financial to private non-financial sector in % of GDP; Real C+I := real private consumption + investment

Source : US Federal Reserve , DB Global Markets Research


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The power of credit

Source : US Federal Reserve , DB Global Markets Research

Notes: Credit impulse := change in net lending flows from financial to private non-financial sector in % of GDP; Real C+I := real private consumption + investment

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1928 1938 1948 1958 1968 1978 1988 1998 2008-12

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Credit impulse, % of GDP

Real consumption + investment (rhs)

% yoychange, % of GDPUnited States The goldilocks phase


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Where there is trust economic relations are based on credit, where there is no trust economic relations are based on the exchange of money (David Graeber). Modern finance pretended that trust can be replaced by financial engineering. Financial engineering has flopped, trust has disappeared, and credit is being replaced by money. But will the replacement of credit by fiat money eventually lead to a crisis of the fiat money system?

Understanding the nature of credit

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Forty years of flat money

0.00

200.00

400.00

600.00

800.00

1000.00

1200.00

1400.00

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68 71 74 77 80 83 86 89 92 95 98 01 04 07 10

US$ price of gold

US$

15/8/1971 end of $/gold link

Carter dollar

Financial crisis


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What are the new challenges for economists?

•We need a better understanding of the credit cycle and the nature of credit in macroeconomics

•We need to develop modern finance for a world of „Knightian uncertainty“ with lots of „unknown unknowns“

•We must become more inter-disciplinary with input from history, psychology, sociology and anthropology

•We must rely less on developing theories by „deduction“ (like in natural sciences) and apply more „induction“ (like in social and historical sciences)


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Thomas Mayer - The Challenges of Economic Thinking in Practice