Posted by: Dirk | November 15, 2010

Macroeconomics and the crisis: Caballero edition

There is a new paper by Ricardo Caballero which you can download here. It starts by claiming that economists cannot and should not predict crises:

The recent financial crisis has damaged the reputation of
macroeconomics, largely for its inability to predict the impending
financial and economic crisis. To be honest, this inability to
predict does not concern me much. It is almost tautological that
severe crises are essentially unpredictable, for otherwise they would
not cause such a high degree of distress. Of course, it is well-known
that certain elements can increase the fragility of a financial
system, such as high levels of leverage or mismatches between
short-term liabilities and long-term assets, and that these issues may
justify policy intervention. But knowing these mechanisms is quite
different from arguing that a severe crisis can be predicted. Modern
Cassandras will always claim to have seen the crisis coming. What they will not say is how many times they saw things coming that never
materialized, or how the specific mechanisms behind the crisis are
different from those on which their predictions were based. In my
view, the conviction that one can foretell a severe crisis in advance
is mostly a manifestation of pareidolia—the psychological phenomenon that makes people see faces and animals in clouds and the like.

Well, I find this a little bit harsh. The Spanish real estate bubble and the one in Ireland were quite obvious to the observer some years before the bubble burst. I saw it when flats in Valencia became as expensive as those of Hamburg, with Spanish wages being below half of German wages and Spanish households spending just below 50% of their disposable income on mortgage payments. Also, the shabby house in Dublin a friend of mine lived in was said to be worth 1.5 million euros – although it looked stone-agey!

Of course, if you sat in front of your computer with a real business cycle model, writing another paper on The Great Moderation you did not notice all this. If you thought that you can get the huge, complex inter-connected world economy into a tiny box which is mathematically well-behaved, then you were in for a surprise. These people Caballero calls the core as opposed to the periphery:

“This distinction between core and periphery is not a matter of
freshwater versus saltwater economics. Both the real business cycle
approach and its New Keynesian counterpart belong to the core.”

Not quite. Saltwater economics is economics based on Keynes, not New Keynesians. Paul Krugman would probably not agree on the label “New Keynesian” for his thought, nor would the Post-Keynesian stick to that label. Keynesian is everything that focusses on the real and financial economy being two sides of the same coin, on risk as a big problem, on debt-deflation and problems where monetary policy is useless. That’s just my loose definitions of what I would call “Old Keynesians”, since they build on the ideas of Keynes (which are very different from the IS/LM model, by the way). These people have done a better job at explaining the crisis, I’d say.

The people of the Bank for International Settlements warned on the catastrophe for years. Nouriel Roubini, formerly at the International Monetary Fund, warned for years of underlying problems like the carry trade and described how debt markets would collapse like dominos. Paul Krugman in 2004 wrote that Americans got richer by selling each other houses for higher and higher prices. Robert Shiller made a career out of this. Richard Koo figured out the Japanese balance sheet recession, an often neglected case, and Hyman Minsky’s insights into forms of finance have proven to be a very nice framework to think about leverage and risk. Gary Gorton has explained how a bank-run in the shadow banking sector caused the financial crisis. Caballero does not engage with any of these people’s theories. That is sad.

What is astonishing is that the paper’s name ends on Time to Deal with the Pretense-of-Knowledge Syndrome. Really? Are we done with the crisis yet? What about the wobble’s in Ireland’s banking system and looming collapse of its sovereign debt, what about the currency war and finding a place for China in the world economy? What about fixing finance? It seems to me that on all these topics, the core has not much to offer. I would be glad to stand corrected and see a paper from economists of the so-called core discuss the theories of the people I have named and compare them to their own set of theories. However, as it stands it hasn’t happened and that is perhaps more insightful than going through the whole Caballero paper. Maybe there has been some catastrophic restructuring and the region formerly known as the core is the periphery now? Paul Krugman’s model makes this kind of prediction.



  1. Steve Keen did very well in predicting the crisis by recognizing the dynamics of booming private debt. His follows on Minsky’s insights.

    I have heard others excuse the economics profession along these lines. Basically, “If crises were predictable, we would avoid them.”

    Minsky and Keynes and others have correctly shown that crises are endemic, are the order of the day, are inevitable. And in fact they have occurred regularly. This one, apparently, is too big to ignore.

    As Karl Popper said (ht George Soros), “Predictions and Explanations are symetrical and reversible.” If economists cannot predict economic events, they need to revise their explanations.

  2. […] this blog, I used to discuss his ideas (like here or here) but I’ve grown tired of it. If you are still arguing in 2013 that there is a limit to fiscal […]

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