The reason for ignoring the WSJ – or at least its opinion pages – is that they many are not reality-based. They are misleading and use misinformation to make you afraid of certain people, ideas, and other institutions. Mark Spitznagel in his article The Man Who Predicted the Depression – Ludwig von Mises explained how government-induced credit expansions led to imbalances in the economy offers a nice example. Before I start criticizing it, lead me offer you my take on things.

The Great Depression called for explanations. Apparently, markets were not coming back to equilibrium, resulting in persistent unemployment and economic slump. Two questions were to be tackled: 1) What caused the Great Depression?, and 2) How do we get out? Roughly, Ludwig von Mises tackled the first one successfully and fumbled the second, while John Maynard Keynes skipped the first question, focussed on the second and got it right. This was the more important accomplishment, so that is why Keynes made it to the economic hall of fame while Ludwig von Mises did not. That, however, is not to say that von Mises is wrong or that Keynes would not agree with the answer von Mises provides for question 1). Here is an extract from ch. 22: Notes on the trade cycle, III:

The preceding analysis may appear to be in conformity with the view of those who hold that over-investment is the characteristic of the boom, that the avoidance of this over-investment is the only possible remedy for the ensuing slump, and that, whilst for the reasons given above the slump cannot be prevented by a low rate of interest, nevertheless the boom can be avoided by a high rate of interest. There is, indeed, force in the argument that a high rate of interest is much more effective against a boom than a low rate of interest against a slump.

To infer these conclusions from the above would, however, misinterpret my analysis; and would, according to my way of thinking, involve serious error. For the term over-investment is ambiguous.

So, even Keynes did not say that economists like von Mises which believe over-investment would cause recession were wrong. I would also agree with von Mises that over-investment is the candidate for causing business cycles. However, I would not agree that it is wrong monetary policy that causes these business cycles. Remember that in the 19th century we had no (modern) central banks, and still we had a lot of financial crises. Clearly the government was not responsible because it did not set interest rates – banks did.

As for the policy solution, von Mises proposed to do nothing and wait until the over-investment has been wiped out. This kind of ‘hands off’ policy was tried by Herbert Hoover, and it failed spectacularly, bringing about misery on a level not see in the US since the Civil War (don’t pinpoint me on this, though).

According to Keynes, the problem was that people could not save anymore, since there was nobody to invest the money. People started hoarding the money, and that meant that the drop in investment was not compensated. That drop led to unemployment, therefore to less income, which led to less demand. Because of this, firms invested even less, and this is where the vicious circle starts. The system ends up in an under-employment situation where it stabilizes. So, how do we get out of the slump?

Here is Keynes, ch. 22, II, on the use of monetary policy (my highlighting):

It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and, probably, a necessary condition of it. But, for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough. If a reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority. But, in fact, this is not usually the case; and it is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world. It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a “purely monetary” remedy have underestimated.

Now Keynes says in his General Theory, ch. 18, II:

But an increase (or decrease) in the rate of investment will have to carry with it an increase (or decrease) in the rate of consumption; because the behaviour of the public is, in general, of such a character that they are only willing to widen (or narrow) the gap between their income and their consumption if their income is being increased (or diminished). That is to say, changes in the rate of consumption are, in general, in the same direction (though smaller in amount) as changes in the rate of income. The relation between the increment of consumption which has to accompany a given increment of saving is given by the marginal propensity to consume. The ratio, thus determined, between an increment of investment and the corresponding increment of aggregate income, both measured in wage-units, is given by the investment multiplier.

So, it is investment that has to be stabilized at a high level in order to lead to more (and finally to full) employment. If the private sector does not bring it about, the government should do so.

Now let’s get back to Mark Spitznagel’s article:

But then, just Mises’s bad luck, along came John Maynard Keynes’s tome “The General Theory of Employment, Interest and Money” in 1936. Keynes was dapper, fresh and sophisticated. He even wrote in English! And the guy had chutzpah, fearlessly fighting the battle against unemployment by running the currency printing press and draining the government’s coffers.

He was the anti-Mises. So what if Keynes had lost his shirt in the stock-market crash. His book was peppered with fancy math (even Greek letters) and that meant rigor, modernity. To add insult to injury, Mises wasn’t even refuted by Keynes and his ilk. He was ignored.

This is a misrepresentation of what Keynes had said. Besides that, the last paragraph is also non-sensical. Keynes was a speculator, and that meant he was rich. So, like every other wealthy man during that time, he lost money during the stock market crash. Also, the ‘fancy math (even Greek letters)’ will impress you only if you happen to be attending elementary school. Alfred Marshall in his Principles of Economics from 1890 had ‘fancy math’ in it. And ‘even Greek letters’? Spitznagel is a hedge fund manager, where they throw around with alphas and betas all the time. I guess he writes for the WSJ in order to promote the public good, not his hedge fund (or the next one).

Oh, and about the last issue of that short quote, that Keynes ignored von Mises: No, he did not. And I can prove it. (Being a scientist has its advantages.) See above.

There is a new piece by Sebastian Edwards titled ‘Latin America’s Decline – A long historical view‘. It is argued that the period of 1945-1980 was not of exceptional growth, that inward-oriented policies like import-substitution have failed. The style of the ‘paper’ at times reminds of me of the WSJ’s front page editorial. There are almost no statistics, there is no model, no theoretical thinking. Don’t get me wrong: I like and value economic history, but this reads like a newspaper article. On page 16, Edwards ends chapter III. in this way:

After the Pinochet coup d’etat, and the diaspora of the left in the 1970s and 1980s, Chile has been able to make major institutional changes that have allowed it to become Latin America’s undisputable super star.

Proving that growth picked up under Pinochet misses the point. The question is what growth rate would have been achieved in an alternative scenario. And just by the way, Chile grows faster since Pinochet stepped back as president in 1990, as I have argued elsewhere. More important is the cost on human life. According to Edwards, there was a ‘diaspora of the left in 1970s and 1980s’. According to the Valech Report, more than 30,000 people were tortured and more than 1,000 exiled. The Rettig Report finds that more than 2,000 people were killed for political reasons or as a result of political violence. What good is economic growth if people are killed? Was Hitler’s Nazi Germany the ‘undisputed superstar of Europe’, Stalin’s Soviet Union the ‘undisputed superstar of Asia’?

On p. 26 Edwards, who was born in Santiago de Chile, has the opportunity to put some distance between him and the Pinochet government:

Through time, different United States administrations supported a succession of despots, including Anastasio Somoza in Nicaragua, Marcos Pérez Jiménez in Venezuela, Leónidas Trujillo in the Dominican Republic, and a long list of generals in Argentina and Brazil.  It was president Franklin Delano Roosevelt who, referring to Somoza in 1939, supposedly said: “He may be a son of a bitch, but he is our son of a bitch.”

He fails to do so. I wonder how NBER thinks about these things. In their own words (and with my highlighting):

Founded in 1920, the National Bureau of Economic Research is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. The NBER is committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.

To conclude, I highly value NBER for its output of high quality papers that are well researched. I have referred to these papers on this blog to comment on quite often, and I think that NBER fulfills an important role in stimulating discussion in the world of (academic) economics. The article by Sebastian Edwards misses NBER standards as defined above by far. I think that it is not a scientific article but rather an opinion piece, and I sincerely hope that this is not a new development at NBER. I would be very sad if NBER degrades into ‘he said, she said’ journalism.

The KfW (Kreditanstalt für Wiederaufbau) has found something that they want to share:

Hohe Eigenkapitalrenditen von 25 % und mehr sind bei deutschen Unternehmen in Zeiten guter Konjunktur keine Seltenheit. So konnten beispielsweise in den Jahren 2006 und 2007 sowohl die börsennotierten großen Unternehmen aus DAX und MDAX als auch die mittelständischen Unternehmen in Deutschland im Durchschnitt eine Eigenkapitalrendite von mehr als 25 % erzielen. Unter den nicht börsennotierten Mittelständlern konnte 2007 mehr als die Hälfte eine Eigenkapitalrendite oberhalb von 25 % erzielen und dabei auch ihre Eigenkapitalausstattung spürbar verbessern. Dies zeigt eine aktuelle Analyse der KfW Bankengruppe.

In short: the companies listed in the Dax had a return on equity higher than 25% during 2006 and 2007. The finding comes out of an analysis of the KfW group.

Besonders in Krisenzeiten ist für Unternehmen ein ausreichendes Eigenkapitalpolster wichtig. Ohne die in der öffentlichen Diskussion so kontrovers diskutierten hohen Eigenkapitalrenditen, die eine Stärkung der Eigenkapitalbasis erst ermöglichen, hätte die Finanz- und Wirtschaftskrise viele Unternehmen, vor allem zahlreiche Mittelständler, noch härter getroffen, als dies ohnehin schon der Fall ist.

So, in times of crisis it is important to have equity. Without a high return on equity in good times, firms would have accumulated less profits and be in more danger during bad times. Uh-huh.

The more risk you are running, the higher should be your return. Well, this is news for nobody. No economist I know would be amazed by that. What the KfW fails to mention, however, is that behaving in a risky way (by loading up with debt) will increase the likeliness of financial crisis. The KfW does not see the correlation between market risk and return to capital. Any of you guys ever heard of Hyman Minsky?

The KfW is completely unaware of the arguments that speak against taking on risks in the financial sector. The main argument is: why let companies take on big risks, if that increases their returns but also the risks for crisis, in case of which the taxpayer would have to pay the bill? Why play a zero-sum game with warped incentives? This is the argument you have to tackle if you would be aware of the discussion.

The sheer scale of ignorance at the KfW is amazing.

Last weekend I spent at a conference titled The World Economy in Crisis – The Return of Keynesianism? with about 250 participants, most of them international guests. Since the media did not cover it, let me state what I think are the main conclusions.

1. Young economists are fed up with the macroeconomic textbooks and their theories. They do not consider themselves ‘Keynesians’, but they like to think of themselves as ’serious scientists without dogma’.
2. The ‘mainstream’ (which is represented by the theories in textbooks) cannot explain the crisis, and couldn’t even put the crisis into the models. Ever tried to get a New-Neoclassical Synthesis model to explain why banks in the US hold close to 1,000 billion dollars as excess reserves? You’ll know what I mean.
3. This crisis is not over. Some participant said that the US consumers need to get the debt off their backs. Well, fine then, let us relieve the US consumer. But what is debt to the consumer is wealth to somebody else. Somebody holds the financial asset based on that mortgage and will be disappointed after default. So defaulting would not really make things better: your mortgage is gone which makes you richer (or better, less burdened by debt), but it will turn out that your pension fund holds the corresponding asset – and that is gone, too! So, there will be no significant net change in private wealth if the debt burden is reduced through default. Debt and wealth are two sides of the same coin!
4. It does not matter whether in the end Keynesians are right, or post-Keynesians, or Austrians or even monetarists (by the way, this is what Heiner Flassbeck said in his keynote address). We need to deal with this crisis without falling back to the dogmatic positions that were established in the last 30 years. Edmund Phelps is an example for somebody who should not be heard – he’s living deep inside the ivory tower (via Paul Krugman). This is not a stupid intellectual game between the ‘mainstream’ and ‘Keynesians’ – this is about saving the world economy from repeating the great depression of the 1930s, which put hundreds of millions into unemployment and poverty and led to political polarization.

US president Barack Obama is thinking about a new model for the US economy. According to the NY Times, he wants to follow Germany’s:

“If Germany, a wealthy, highly unionized industrial nation, can generate 40 percent of its economy as export-based, then it seems to me that there is something we’re missing that they are doing right, and we have got to figure that out,” he told a meeting of his Economic Recovery Advisory Board.

Now some people (hopefully, no economists among them) will say: but Germany had dismal growth rates! To which a trained economist should answer: “Well then, follow the economic policies of the world’s leaders in growth”. The top-10 for 2008 are: Bhutan, Macao, Qatar, Angola, Timor-Leste, Ethiopia, Rwanda, Azerbaijan, Equatorial-Guinea and Turkmenistan.

The idea of export-led growth is that you create extra jobs by exporting more. Of course, this is a zero-sum game on the international scale. What I export somebody else must import. So a Germany with more exports than imports must mean some other countries with more imports than exports. By the way: if you export more than you import, the countries buying your goods must go into debt. They must borrow in order to finance those net imports, or sell some of their assets.

So, Germany has recently accumulated net wealth vis-a-vis the rest of the world. Sadly, part of that wealth was invested into sub-prime assets from the US. A very important question for net exporters is hence whether they can get quality assets or not. For the US, the answer would be easy. Instead of accumulating wealth, they would first repay debt. But what kind of debt should we think of at this point? Of course, the US should repay the debt with higher costs of servicing – high interest rates – first.

Probably this is not government debt. According to the Fed, interest rates on government debt are barely above zero. However, household and private sector debt has to be serviced with high interest rates. This situation is completely different from that in Germany, where households are not very deep in debt and also companies have relatively less debt. Whereas Germany used net exports to pile up net foreign wealth, the US will do so to decrease net foreign debt. And I would say that the US strategy is appropriate for its state of the economy and will result in relatively higher growth rates. However, I believe that German policy-makers made a mistake and – with the help of the ECB – produced the lost decade of 1999-2009 (source: Eurostat; 1999-2010, 2010 is an estimate):

When you present a paper in about a week, and then Paul Krugman writes his column in the NY Times on the same subject, this can be exciting. So, here is the main part:

Many economists, myself included, believe that China’s asset-buying spree helped inflate the housing bubble, setting the stage for the global financial crisis. But China’s insistence on keeping the yuan/dollar rate fixed, even when the dollar declines, may be doing even more harm now.

My co-author and I absolutely agree with that. This is exactly the topic of our talk. Here’s a link to our paper (first draft). Since we have recently updated our paper (second draft), the talk will also focus on possible exit strategies. If you really want to know, I see you in Berlin next week…

Back in 2005, just before the general elections, a group of economists drafted the Hamburger Appell (pdf). It was signed by more than 250 German economists, just prior to the general elections 2005 (which brought about the Große Koalition). Let’s have a look at the first sentences (my translation):

Die wirtschaftspolitische Debatte m Deutschland wird verstärkt von Vorstellungen geprägt, die einen erschreckenden Mangel an ökonomischem Sachverstand erkennen lassen. Dies ist um so besorgniserregender, als Deutschland sich in einer tiefen, strukturellen Krise befindet, die drastische und schmerzhafte Reformen verlangt.

The economic policy debate in Germany is dominated by a frame of reference that shows an alarming lack of understanding in economics. This is all the more cause for concern since Germany is in the middle of a deep structural crisis which demands drastic and hurtful reforms.

The Hamburger Appell continues (I use excerpts, which are out of context but represent the main ideas):

Die gesamtwirtschaftliche Nachfrage ist eine bedeutende und komplex strukturierte ökonomische Größe, die sich einer nachhaltigen Steuerung weitestgehend entzieht.

Aggregate demand is an important and complex determinant, which cannot be influenced in a sustainable way. (1)

Deshalb sind die Arbeitskosten ein Schlüssel zur Überwindung der deutschen Wachstumsschwäche.

Therefore the cost of labor is the key to overcoming the weak growth of the German economy. (2)

Die Konsolidierung der Staatsfinanzen erfordert weitreichende Einschnitte in allen Bereichen der öffentlichen Ausgaben.

The consolidation of public finances demand far-reaching cuts in all areas of public spending. (3)

Während im Rahmen des Strukturwandels notwendigerweise auftretende Arbeitsplatzverluste in den Medien sehr stark thematisiert werden, fehlen klare Aussagen zu den positiven Auswirkungen der Globalisierung.

While job losses related to structural change have been made a topic by the media, positive statements about the positive implications of globalization are lacking. (4)

The sub-prime crisis started in summer 2007, just 2 years later. Let me comment the main points of the Hamburger Appell as I put them above, statement by statement.

(1) The fiscal stimulus has by now shown that demand management can work, and that only it can do the job in times of dire crisis. Demand management has actually saved the day, and not once.

(2) Labor costs are not the key, but a key to growth. Falling real wages have led to German export growth. Since Germany exported more than it imported, it acquired foreign monies. These were invested in toxic waste assets by the dysfunctional financial system. Germany exported Mercedes-Benz cars, and got in return toxic waste in the form of non-performing US assets. Are Germans better off now? I would not think so.

(3) See point (1). Public spending, the supposed brake on growth and stability, has turned out to bring, well, growth and stability.

(4) The whining about the oh-so liberal media is all too familiar from the US, where the Bush administration and their cronies made millions while the common man suffered from a weak job market. The Handelsblatt reported that the German Keynes-Gesellschaft published a statement in spring that no media reported. So much for the liberal media hypothesis. (Why oh why can’t we have a better press corps?)

As the article continues to argue, it is hard to see how the economists who were wrong all the way about the economy would now concede their defeat and make way for more pragmatic economists who are not bound by dogma. And let me get that clear: contrary to the article, there were no Keynesian professors from the university of Oldenburg at the conference at Karlsruhe. Actually, I am a post-doc and my colleague is a PhD student, and we do not consider ourselves Keynesians. We like to think of ourselves as (macro)economists.

I have been busy/away recently, but since I am back at my office now, there will be more blogging in the next few months. 10 days ago I presented a paper on China’s fixed exchange rate system (and how it influences the US financial markets) at a conference at Karlsruhe (the paper is downloadable on that website). The topic is connected with the propsective yield, a concept invented by Keynes and buried deep in the General Theory.

However, this is what they showed us there for entertainment:

I have been in Spain last week, where the economic crisis is probably worst in the EU (except for Ireland). Back in 2003, 50% of the average wage was spent on home loans. This has fuelled an immense bubble in the real estate sector. Now the bubbles has burst, demand has decreased and the government went deep into the red. Last month, it decided to raise taxes. This will probably hurt demand even more, and could lead to even more unemployment and in the end less tax collection than before. This should be the lesson of 1937, and it is strange that Spanish economists are not aware of that. Probably the Spanish Civil War (1936-39) has disconnected Spanish economic history from that of the rest of the world during this period.

Anyway, I have seen many signs of a distressed economy in Valencia. Since I have studied and lived in Valencia in 1999 and returned to the city a dozen times I consider myself of sufficient experience to judge how the city has transformed. Tourists better watch their change closely, since you are very likely to get ripped of. Also, there are people – I heard they are from eastern Europe – who sleep in the public parks (which close at 21:30h). Then there is people going through the garbage containers, the big ones in the street, not the small ones put up by the municipal government. I haven’t seen that anywhere in Spain before.

Apart from the that, there are loads of signs “se vende”, and real estate agents complaining that there is no demand. A friend of mine suggested that they should consider to lower the price and there would be demand, to which some real estate agent replied that then the price would be below the value of the flat. The Spanish have a long way to learn about how the real estate market and markets in general work. Only since 1975 they have evolved from the infamous Franco dictatorship, and their economic catch-up was fast. People have preferred to look ahead instead of looking back. However, the ghosts of Spain might come back to haunt them.

Ralph Wrobel of the Westsächsische Hochschule Zwickau recently published an open letter on Ordnungspolitik (roughly regulatory policy). He discusses the ongoing fight between conservatives and progressives in German faculties of economics. In a nutshell, conservatives embrace mathematics and (partial) models in very specialized subfields which means that they care less about reality. Progressives’ knowledge is more broad, including psychology, economic history and thinking about interacting markets. Wrobel claims that the scientific system based on peer-reviewed publications leads to a monoculture, which robs economics of many discussions, since some opinions cannot be articulated.

While being sympathetic to the critique of economics, I think all this is still too early. We still don’t have a complete picture of what happened and how we can fix our economies. The models have failed and so far, there have been no replacements. This should be the first priority of economists right now. Which reminds me that Richard Koo’s latest book makes a lot of sense …

As an afterthought I would like to point out that once more the myth that all economists failed to predict the crisis has been voiced by Ralph Wrobel. This is plain wrong. There have been people (yes, also some Germans) which have warned and published research related to financial depression. I really think somebody should go on a field trip and try to find those people, talk to them and publish a book.