Michael Meeropol: An Economic Model That “Predicts” Events Like The Financial Crisis of 2008
Have you ever heard of Wynne Godley? Those who read the front page of the Business section of the NY Times on Wednesday, September 11, might have seen the picture and noted the name. For others, he will be an unknown.
[The article can be found here “Embracing Economist Who Modeled the Crisis” NYT, 9/11/13 Jonathan Schlefer B-1-2. All quotes that follow are from that article.]
The reason the NY Times featured Godley is because his approach to understanding economic processes or how the world works is in marked contrast to that of most economists.
To most economists, even macroeconomists who study the entire economy rather than just pieces of it, there are three crucial words that describe most economic processes – supply, demand and equilibrium.
At the macroeconomic level, supply refers to the size of the labor force, the state of technology, and the nation’s capital stock. Obviously total supply (or potential output) grows every year as the labor force grows, as knowledge increases and as last year’s investments become this year’s capital goods. (There is also growth in potential output if more land is brought into production or if new sources of natural resources are discovered.) Demand for the economy as a whole is just the sum of consumer, investment, government (and foreign) decisions to buy goods and services produced within a particular country.
The important word for this discussion, however, is EQUILIBRIUM. As the NY Times piece noted:
“Mainstream models assume that as individuals maximize their self-interest, markets move the economy to equilibrium. Booms and busts come from outside forces. Banks are an afterthought.”
[The word “model” here refers to a simplified picture of how the economy “works” – though some “simplifications” can be represented by 200 separate equations!]
Godley, on the other hand developed a model of the economy which predicts the kind of events that occurred during the economic crisis of 2008 –
The Godley model (according to the Times)
“…sees banks as central, promoting growth but also posing threats. Households and firms take out loans to build homes or invest in production. But their expectations can go awry. They wind up with excessive debt and they cut back. Markets themselves drive booms and busts.”
This is a nutshell is the difference between what my co-author Howard Sherman and I have called Conservative economics and Progressive economics. Conservative economics creates simplified models of the economy by assuming that people can predict (or at least estimate) the impact of the decisions they make. Such economic theorizing led more than one economist to declare that NO ONE could have predicted the financial meltdown of 2008. It is true that the economists who believe economies tend to such equilibrium could not predict the financial meltdown.
Progressive economics, of which Mr. Godley’s model is an example, does predict such a result. Now it cannot, of course, predict when such a result will actually occur. But the main point is that the Godley model demonstrates the possibility and under certain circumstances the strong likelihood of such an event. Godley’s model starts from the proposition that in the real world, people who make decisions do NOT have a well thought out way to predict the future based on the present.
[This issue actually turns on an issue that Keynes in his book The General Theory of Employment Interest and Money developed – the difference between risk (which can be modeled using probability --- this is how expert “card counters” at Blackjack win) and “fundamental uncertainty” about the future. In a situation of such fundamental uncertainty, there is no way to “scientifically” predict the future. All you can do is “predict” the path of current trends – which may or may not continue!]
Godley and his colleagues argued that because of this fundamental uncertainty, people operate using crude rules of thumb (no matter how sophisticated the “planning” departments of large businesses claim to be). Because of these rules of thumb, instead of the economy settling to a new equilibrium when there is a disruption, in the Godley world, “adjustments can be abrupt.” . He not only warned about the bubble and its inevitable consequences but he developed a formal model to demonstrate why that would occur.
In April of 2007, before the crisis had hit but after the housing bubble had started to deflate, Godley and his colleagues tried to see what the optimistic Congressional Budget Office projections would look like in his model. They discovered that for the optimistic projections to work out, household borrowing would have to reach 14 percent of GDP. They dismissed this as wildly implausible and predicted that borrowing would stop and GDP would stop growing.
The reason they saw this as wildly implausible is because according to data from the Federal Reserve’s flow of funds account, new household borrowing as a percentage of GDP rose from 3.7% in 1997 to a high of 9.4% in 2005 (at the height of the housing bubble when there was a stampede to buy houses on credit – many purchases done for speculative reasons). As the housing bubble began to deflate, new borrowing by households as a percentage of GDP started to fall. In 2007, when Godley and his colleagues ran the numbers, the ratio was down to 6.1%. The next year (the year of the financial crisis), borrowing started to fall.
[SOURCE: Household savings --- Federal Reserve System Flow of Funds Accounts: Z1/Z1/FA 154104005A. To get the percentages, just divide that number by GDP. I am indebted to Professor Martin Wolfson of Notre Dame University (who had previously worked for the Federal Reserve Board in Washington) for finding this data for me.]
In predicting that savings would stop growing, Godley and his colleagues actually underestimated the extent of the crisis.
Contrary to the idea that NO ONE could have predicted the financial crisis, people who have listened to my commentaries know that I was quoting people like Dean Baker about the housing bubble long before the crash of 2008. The NY Times article noted there were at least a dozen experts (including Baker) who warned about the housing bubble and the dangers it posed in the mid 00’s.
These are the people that Sherman and I describe in our book as PROFESSIVE in large part because they reject the idea that the economy has the strong self-correcting mechanisms that the conservatives rely on when they develop their “models” of how the economy works.
IF you haven’t read the NY Times article, check it out on line ---
For those interested in an introductory approach, the Sherman Meeropol Principles of Macroeconomics textbook is a good starting point.
[Principles of Macroeconomis: Activist vs. Austerity Policies by Howard J. Sherman and Michael A. Meeropol with Paul Sherman – Armonk, NY M.E. Sharpe 2013]
Michael Meeropol is visiting professor of Economics at John Jay College of Criminal Justice of the City University of New York. He is the author of Surrender, How the Clinton Administration Completed the Reagan Revolution.
The views expressed by commentators are solely those of the authors. They do not necessarily reflect the views of this station or its management.