Sustainable global economic recovery will occur when pessimism fades – however, it is proving difficult to shift
The fifth anniversary of the start of the financial crisis is approaching and is being marked by concerted action to prevent a fresh downward lurch in the global economy. Interest rates have been cut in the eurozone and in China; the Bank of England has announced it will pump another £50bn into the UK economy; America’s central bank, the Federal Reserve, is trying to generate lower long-term borrowing costs, and will probably not leave the stimulus measures at that.
It seems like a good time to take stock of where things stand, and how events might unfold over the coming months.
The first thing to say, perhaps surprisingly, is that things could have turned out a lot worse. To be sure, this has been a long, drawn-out crisis. Output has fallen and unemployment has risen.
Most certainly, it has taken much longer than was envisaged to repair the damage to the financial system. But there has not been a second Great Depression or anything like it. Between the Wall Street Crash and the bottom of the slump in 1933, the US economy contracted by 27% and the jobless total rose above 25%. Nothing remotely comparable has happened this time.
A second conclusion is that the outcome could – and almost certainly would – have been a lot worse had it not been for the decisive action by policymakers. There has been a lot of debate in the past couple of weeks about the manipulation of market interest rates by Barclays and other UK banks, and what Gordon Brown’s government did or didn’t do to encourage this practice in the autumn of 2008.
Most of this discussion has taken place without reference to the financial and economic conditions of the time, which were chaotic and scary. So bad were things on the weekend that the UK government put public money behind RBS and Lloyds that the country was within hours of shutting down its cash machines.
Paul Ormerod, in his fascinating new book, Positive Linking, gives a good and fair description of how policymakers in the US responded to the crisis. The first thing they did was realise that all the ideas peddled by mainstream economics were utterly useless and had to be junked.
What had happened over the previous 30 years was that the economics profession had created models of the world based on the assumption that people made rational decisions after sifting through all the options available. At the big picture, or macroeconomic level, every central bank worth its salt had a model of the economy that only worked if one representative agent could be deemed to represent every individual, firm, government, or international body operating in the economy.
But in the last few months of 2008, policymakers started making decisions based on what the world was actually like, rather than they way it should be according to their dynamic stochastic general equilibrium models – the official name for the computer programmes used by central banks to make their forecasts.
Ormerod argues that it was the American authorities who saved the world, and they did so by trial and error and by relying on knowledge of how policy failures in the 1930s had led to the Great Depression. “They knew it was impossible to work out the optimal strategy” he says. “So they tried things which seemed reasonable and, quite literally, hoped for the best.”
One such experiment, the decision to allow Lehman Brothers to collapse, was a disaster that threatened to bring down the entire western banking system, so, without pause for thought, the US authorities discarded laissez-faire in favour of intervention. They nationalised the mortgage companies Fannie Mae and Freddie Mac, effectively nationalised the giant insurance provider AIG; eliminated investment banks; forced mergers of giant retail banks; and guaranteed money market funds.
Ormerod says: “It was not a grand plan, nor did one ever exist. This was a process of people responding to events on the basis of imperfect knowledge and experimenting to discover what did and didn’t work, desperately trying to restore confidence across financial networks.”
The point of Ormerod’s book is to show how such networks matter. When a video goes viral on YouTube or a book flies off the shelves it is not because each of us has come to a rational decision after weighing up all the alternatives. Instead, we copy what other people are doing. In the context of economic policy, Ormerod says the key is to create network effects that provide confidence that the sky is not about to fall. The Americans achieved this in 2008-09; the Europeans have never managed to pull off the same trick during the sovereign debt crisis.
“Confidence across networks was key”, Ormerod says of the US action. “Confidence across networks of financial institutions that the monies owed to them by others would be paid. Confidence across networks of commercial companies that output was not about to collapse like it did in the 1930s, so that they would not then act in ways which made this a self-fulfilling prophecy. And confidence across networks of individuals that their worlds were not about to fall apart.”
Unfortunately, a third thing we have learned in the past five years is that averting disaster is not the same as guaranteeing a return to business as usual. British companies are sitting on a cash pile of £700bn – equivalent to half the economy’s national output – but they are reluctant to spend it on new investment. They might no longer be fearful about a return to the 1930s, but equally they are not sure that demand will pick up soon.
That explains why the Bank of England is continuing to experiment with ideas such as funding for lending, under which banks will be offered lower cost finance provided they pass the benefits on to their personal and business customers. As in 2008, policy is being governed by rule of thumb, and if funding for lending doesn’t work the Bank will have to try something else.
Optimism is the default setting for western capitalism. As Daniel Kahneman notes in his book Thinking, Fast and Slow, we have an inbuilt optimism bias that makes us view the world as more benign than it actually is. Optimism is normal and healthy, he says, but can be a risk as well as a blessing because it tends to lead us to exaggerate our ability to predict the future. “The evidence suggests that an optimistic bias plays a role – sometimes the dominant role – whenever individuals or institutions voluntarily take on significant risks.”
Clearly, this was what happened in the years leading up to the crisis, but the optimism bias has now been replaced by a pronounced pessimism bias. Lasting recovery will only come when that pessimism bias is eradicated, and it is proving tough to shift. But a change in mood could happen at any time, in which case activity will pick up far more quickly than anybody currently expects. But that could be my optimism bias talking.
Positive Linking by Paul Ormerod is published by Faber and Faber.