Reading all of these again made me think of three ways in which minds work. You see the macroeconomist is the alchemist. They do not deal with real things, such as aggregate demand, or even the GDP. They are massaged aggregates which are at best aggregates of aggregates. They are the alchemists bottles, handed down generation after generation, with secret names, and formulae that only those properly trained will ever have any understanding of, a priesthood whose admission is near the occult. You see the alchemist just mixes things from their esoterically labelled jars and tell the watcher what they are to see, it is interpreted.
Then I see Rajan and the finance people, they are the chemists. They can measure, name, perform experiments, and sometimes the lab blows up. They then go back to the drawing board and refine their theory. They are always looking at pushing the boundary of finance, or "chemistry" to keep the metaphor straight.
Then there are Chemical Engineers, and like engineers everywhere they are conservative, add extra margin, build pilot plants and then scale up, add more margin, and repeat. Unless over ridden by management, a good engineered structure will last a long time, just look at the Romans. Over engineering is the code of the engineer. Why, because the engineer always knows that they do not know everything and they need to be careful.
Krugman and his co-author (collectively Krugman) make an interesting observation:
Historically, developing countries have run trade deficits with advanced countries as they buy machinery and other capital goods in order to raise their level of economic development. In the wake of the financial crisis that struck Asia in 1997–1998, this usual practice was turned on its head: developing economies in Asia and the Middle East ran large trade surpluses with advanced countries in order to accumulate large hoards of foreign assets as insurance against another financial crisis. ...
For the trade deficit countries like the United States, Spain, and Britain, the flip side of the trade imbalance is large inflows of capital as countries with surpluses bought vast quantities of American, Spanish, and British bonds and other assets. These capital inflows also drove down interest rates—not the short-term rates set by central bank policy, but longer-term rates, which are the ones that matter for spending and for housing prices and are set by the bond markets.
So Krugman seems to say the problem was:
1. Large trade deficits
2. Developing countries were having a positive gain
3. They needed to invest somewhere, namely in "paper" assets
4. They drove demand up
5. Greenspan kept rates low
6. Housing went into a bubble
7. Rest is history
Krugman then recounts why in his view the reason for the collapse was NOT the complex securities developed by Wall Street. He argues as follows:
Three points seem relevant.
First, the usual version of the story conveys the impression that Wall Street had no incentive to worry about the risks of subprime lending, because it was able to unload the toxic waste on unsuspecting investors throughout the world. But this claim appears to be mostly although not entirely wrong: while there were plenty of naive investors buying complex securities without understanding the risks, the Wall Street firms issuing these securities kept the riskiest assets on their own books.
Second, the comparison between Europe and America is instructive. Europe managed to inflate giant housing bubbles without turning to American-style complex financial schemes.
A third strike against the argument that complex finance played an essential role is the fact that the housing bubble was matched by a simultaneous bubble in commercial real estate, which continued to be financed primarily by old-fashioned bank lending.
Rajan does explain these factors and in my review I try to explain how he does so with great clarity and elegance, the creation of tranches, and the balancing of risk, yet at the same time the explanation for their failure is also simply explained. Krugman then drops bomb number one on Rajan:
The idea that the government did it—that government-sponsored loans, government mandates, and explicit or implicit government guarantees led to irresponsible home purchases—is an article of faith on the political right. It’s also a central theme, though not the only one, of Raghuram Rajan’s Fault Lines. In the world according to Rajan, ...the roots of the financial crisis lie in rising income inequality in the United States, and the political reaction to that inequality: lawmakers, wanting to curry favor with voters and mitigate the consequences of rising inequality, funneled funds to low-income families who wanted to buy homes. Fannie Mae and Freddie Mac, ... made mortgage credit easy; the Community Reinvestment Act, which encouraged banks to meet the credit needs of the communities in which they operated, forced them to lend to low-income borrowers regardless of risk...
This is Krugman trying to mover any blame from Government to someone else, anyone else.
Rajan starts his response with:
First, Krugman starts with a diatribe on why so many economists are “asking how we got into this mess rather than telling us how to get out of it.” Krugman apparently believes that his standard response of more stimulus applies regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates.
Yes, Krugman delivers a diatribe, and he tries to explain away the problems with the alchemists formulary. Krugman continues:
Rajan claims that the Troubled Asset Relief Program (TARP), signed into law by President Bush on October 3, 2008, validated the belief of banks that they wouldn’t have to pay any price for going wild. Although Rajan is careful not to name names and attributes the blame to generic “politicians,” it is clear that Democrats are largely to blame in his worldview. By and large, those claiming that the government has been responsible tend to focus their ire on Bill Clinton and Barney Frank, who were allegedly behind the big push to make loans to the poor.
While it’s a story that ties everything up in one neat package, however, it’s strongly at odds with the evidence. And it’s disappointing to see Rajan, a widely respected economist who was among the first to warn about a runaway Wall Street, buy into what is mainly a politically motivated myth. Rajan’s book relies heavily on studies from the American Enterprise Institute, a right-wing think tank; he doesn’t mention any of the many studies and commentaries debunking the government-did-it thesis...Rajan replies:
In absolving Fannie and Freddie, Krugman has been consistent over time, though his explanations as to why Fannie and Freddie are not partially to blame have morphed as his errors have been pointed out. First, he argued that Fannie and Freddie could not participate in sub-prime financing. Then he argued that their share of financing was falling in the years mortgage loan quality deteriorated the most. Now he claims that if they indeed did it (and they did not), it was because of the profit motive and not to fulfill a social objective.
Rajan approaches this as one trained in Finance, the Chemists, he can do experiments, measure effects, create and validate models. He deals with things measurable.
The two talk past each other.
Yet where is the Chemical Engineer, who is going to build this plant, not anyone on Wall Street, all they do is turn the knobs and hope it works and pumps out money. The role of the Chemical Engineer is missing. That may be the reason these conversations occur. Is Ms. Warren to be that person, hardly, just try and find one.
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