By James H. Nolt
Economic crises always create both winners and losers, as I argued last week and throughout this blog series. This was particularly stark during the 2008 World Financial Crisis. Yet those trained in textbook economics are so unused to thinking in terms of winners and losers that such obvious facts are ignored while economists focus their attention on the dull gray averages that explain little.
A particularly pointed example of economistic blinders is the story of the 2008 crisis, as told in the otherwise useful book by Mark Blyth, Austerity: The History of a Bad Idea. The author gives a liberal economist’s version of the crisis that blames private sector “mistakes,” rather than merely blaming the government, as conservatives typically do. However, like nearly all economists, Blyth cannot locate private power or strategy. Bad results must be the result of bad ideas or mistakes, not strategic intent.
A striking example of this blindness is Blyth’s asymmetrical discussion of price changes on debts. He says “inflation . . . benefits debtors over creditors,” (p. 9) which is true. However, the reverse case is strangely invisible to him: “In contrast, deflation, what austerity demands . . . There are no winners, only losers.” He cannot imagine, and indeed never mentions, bears who profit from falling prices. He does not mention that deflation benefits creditors. Furthermore his introduction and general tenor throughout the book is that austerity benefits nobody—it is a “dangerous idea,” yet it keeps recurring. Why are elites so stupid? In fact, bears and creditors understand their interests much better than Blyth can.
In the details of his interesting historical review of past instances of austerity, he does occasionally note private support for deflation, but so subtly that a reader might never notice. For example, his two-page treatment (p. 189-191) of British interwar austerity was pushed by the Treasury and the City of London (the British equivalent of the phrase “Wall Street”), but he speaks of austerity as their “view” rather than their “interest.” He explains that massive sterling-denominated debts worldwide would earn less if the British pound sterling was devalued, and that “the City” (private British banks) therefore pushed for austerity to maintain the value of the pound. Austerity policies were rewarded, he notes, with new dollar loans from J.P. Morgan. He comes very close to identifying the powerful private interests favoring austerity, but he does not connect the dots.
Conservatives blame the government for the 2008 crash because of government-owned mortgage underwriters colloquially known as Fannie Mae and Freddie Mac. Liberals like Blyth are more willing to blame the private sector, but typically for making stupid “mistakes” rather than for self-interested duplicity. Discussing the 2008 crash specifically, he says, “no one, not even those at the top, benefits.” (p. 15) He does not take into account short positions richly rewarded during the crisis. Even more broadly, all creditors whose debtors do not default (and taxpayers stepped in to compensate banks even for many that did) also benefit from deflation, since it increases the relative value of their debt assets.
He cites seven possible explanations for the 2008 crisis: 1) increasing income inequality, 2) inadequate regulation of banks, 3) political power of finance, 4) excessive overnight borrowing by banks in short-term repo markets, 5) mortgage-backed securities, 6) correlated risk and “tail risk,” and 7) “a set of economic ideas that blinded actors—both bankers and regulators—to the risks building up in the system.” (p. 22-23) He then says the first three are not essential reasons and focuses on the last four. By doing so, he dismisses the power of finance, which in fact explains the other reasons, except for his last one, which is just wrong. The notion that bad ideas blinded everyone to the risks in the system leading up to 2008 is an essential element in the widespread but erroneous economistic conclusion, endorsed by Blyth, that nobody could see the crisis approaching. Certainly nobody who takes economic textbooks seriously could.
Obviously, all the shorts saw it coming, which is why they bet their own and their clients’ capital aggressively on falling mortgage values. These included not only some outsiders, portrayed in the excellent film, The Big Short, but also many of the bankers who themselves rigged the game to profit enormously from the downturn. This story is clearly told by many authors, though one of the clearest and most comprehensive is Yves Smith’s, Econned.
Presumably Blyth, like so many in the public, was bamboozled by banker testimony to Congress that professed surprise and ignorance. I am reminded of the classic scene from the film Casablanca when the French police inspector exclaims, “I’m shocked, shocked to find gambling” occurring in Rick’s Café, though he himself was a frequent player. I suppose Blyth too would be shocked to discover banks running rigged gambling games with other people’s money. Opposing interests cause the boom and bust business cycle. Bad ideas merely obfuscate this reality.
Looking closely at Blyth’s list of seven causes, we can see how each is accounted for by the third and quickly forgotten reason, financial power:
1) Increasing income inequality is largely a function of the growing financialization of economies worldwide. In other words, more and more of GDP is captured by finance, where relatively few people gain massive income and profits.
2) Weak regulation of banking is one of the major accomplishments of the political power of finance, so it is not really a separate reason, merely a consequence.
3) The political power of finance, as Blyth calls it, is not simply a product of lobbying or massive contributions to politicians, but also of the private pricing and credit power of finance, detailed in many of my previous blog articles.
4) Excessive short-term borrowing by banks to fund “loans” according to Blyth (following the textbook model of what banks are supposed to do) was used first to fund trading desks of banks, often using derivatives to create what are called “money machines” to generate leveraged profit flows and second, when approaching a culminating point, the leverage bets to profit from the imminent crash. Blyth treats this as an error, yet it is quite typical of bank behavior throughout history to borrow liquid or short-term assets to invest in higher-yielding positions, whether long-term bullish or short-term bearish bets, depending on bank strategy.
5) Mortgage-backed securities and their derivatives are nothing new, either. They figured prominently in the U.S. 1893 crash, for example. Indeed, nearly all the techniques used by bears during the 2008 crash have been in profitable use for centuries. Bears profit through every crisis in part because economists are so blind to their existence, and therefore so is the mis-educated public.
6) Blaming risk models shows a blindness to private power and strategy. The lesson of 2008 is not that statisticians need to adjust their models to account for “fat tails,” which means a higher risk of supposedly rare events. Many “rare” or “Black Swan” events are not random in the first place. Statistical models assume mechanical relationships disturbed by random error. They ignore and cannot account for deliberate strategic action, since it is intentional rather than random. This is why I insist on my strategic method. Correlations among seemingly independent asset values also occur because of strategic action of contending bears and bulls.
7) “A set of economic ideas” did blind most commentators who take textbook economics seriously, like Blyth, but these ideas did not blind the many bankers and investors who profited during 2008 by understanding the culminating bear-bull contest and at the highest levels rigging it in their favor.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Pixabay]