Interestingly enough, economic historians and economists who did not have a blind spot for history were better in giving conditional forecasts and policy advice than macroeconomists who were only familiar with modern DSGE models, but did not know anything about the history of financial crises. Even though history does not repeat itself, it often does rhyme.
The economic historian Charles Kindleberger, for example, has documented in his book “Manias, Panics, and Crashes: A History of Financial Crises” a great many similarities between financial crises all around the world over the course of several centuries. Financial panics have been occurring on a more or less regular basis ever since the modern payment system was created. The modern banking system has its origins in medieval Italy. Pre-industrial Great Britain and the Netherlands already had a financial system in the 17th century that was remarkably similar to modern finance. Fractional reserve banking was already widespread and merchants and consumers relied on a variety of credit instruments to finance investments, trade, real estate, and consumption. It is in the nature of money and debt to create an inherently unstable system because credit expansions and asset price booms interact with each other, creating a boom and bust cycle unless sound economic policy produces counteracting forces. Banks, for example, were historically prone to bank runs because they only hold a small fraction of their deposits in reserves. This feature allows banks to exploit the law of large numbers. They can use their deposits and grant an equivalent amount of credit to their customers while relying on the fact that at any given point in time only a small amount of depositors will withdraw some of their money. This, however, means that even solvent banks can fail relatively easily in the offchance that a large amount of depositors are withdrawing their deposits all at once, which is precisely what happens in periods of panic and financial distress. Banking crises were thus relatively common in advanced economies before the 20th century. The introduction of deposit insurance by governments mostly eliminated old-fashioned bank runs. However, most governments did not in any way address in any way excessive credit creation coupled with speculative bubbles in specific asset classes, mostly real estate.
The financial crisis of 2008 made a lot of sense, at lest ex-post, to those who knew about the Dutch tulip bubble in the early 17th century or the British South Sea bubble of 1720, for example, while modern macroeconomic theory provided little guidance at best and spread misinformation at worst.
Economic history can thus help us in putting some contemporary issues into context. While events might not be strictly alike, there are certainly patterns that do repeat themselves. The current global stagnation, for example, bears a lot of resemblance to the Great Depression of the 1930s. Krugman was one of the first prominent economists who worried that the Japanese lost decades with interest rates being pinned down at zero for many years could equally apply to Western economies, and he was proven right.
1)Using economic history as a reference for current or future events
2)Using economic theory (models)
3) Looking at financial markets (asset prices):
While financial markets can be prone to inefficiencies, asset prices adjust almost instantaneously to new information. Price changes can thus tell us soemthing about the particular event in question.
4) Looking at betting markets/prediction markets:
It turns out that betting markets, just as financial markets, are important aggegators of information. Individuals have “skin in the game”, which leads to an important incentive effect. “Getting it right” is of importance because otherwise you lose money. Contrast that to academia where some people, especially those who have already built up a lot of reputation, can get away with saying almost anything. It turns out that reputation is very hard to destroy, which again has certain implications for incentives, but in this case undesirable ones.
1) Back in October of last year I expected the Fed funds rate to be around 0.75% by the end of this year. The Fed funds rate is currently at 50 basis points and the implied probability by financial markets that the Fed will hike another 25 basis points by the end of this year is roughly 80%. My prediction thus looks pretty good, especially since the Fed’s own forecast from last year was that interest rates would be around 1.5% right now. So they were flat out wrong and I was right, not because I am much smarter than those guys, but because I relied to a greater extent on financial market prices instead of “wrong” macro models as a guideline for my forecasts. Fed officials, on the other hand, have simply dismissed markets as being mispriced without providing a reasonable explanation for why that might be the case.
2) In the same blog post, I predicted that nominal GDP growth and inflation would remain sluggish over the next 5 years. I forecasted 3.5 - 4% growth for the former and about 1.5% growth for the latter for the time period in question. So how did these predictions turn out? Nominal GDP growth came in at about 3% over the last year, even more sluggish than I expected. Again, my forecast proved to be more accurate than the one by the Fed (they expected more than 4% growth). When it comes to the CPI, it’s year-to-year change has been around 1% for the better part of the year. As of September 2016 inflation is showing a slight upward trend with a year-to-year change of about 1.5%.
Now to some predictions that didn’t pan out exactly as planned. Back in June I suggested that Brexit is relatively unlikely: http://macrothoughts.weebly.com/blog/brexit Mea culpa! I relied on financial markets and betting markets, which suggested that the probability of staying in was higher than that of Brexit. Well, financial markets definitely got it wrong that time.
However, I also predicted that in the event of Brexit we will see a large depreciation of the pound of up to 10%. Furthermore, I suggested the Bank of England (BoE) would probably cut interest rates to offset the negative shock to the economy, which might lead to some further depreciation, which is exactly what happened. Brexit led to a sudden 10% depreciation of the pound over the course of just a a few weeks. In August, the BoE decided to cut interest rates, and the pound has depreciated by more than 5% since then.
British stock markets plunged quite significantly in the immediate aftermath of the Brexit vote, which was in line with my expectations. However, they also recovered quite quickly and are now higher than before. While the depreciation makes imports more costly, British goods are now much more competitive than before. Furthermore, one should note that many British firms are quite international. Their assets and earnings from abroad are now 20% higher as measured in pound sterling. This is a quite significant effect. The BoE did a very good job in managing Brexit, cutting interest rates and starting another round of QE, thus preventing the economy even from slowing down. I actually expected some economic slowdown to occur. I guess that I implicitly did not trust the BoE to do as well as they did in managing the economy over the last two quarters. Conditional on Central Bank performance, the story of Brexit would always be about long-run costs instead of an immediate economic recession. Some estimates suggest that Britain’s GDP might be 2% lower in perpetuity, but the effects will only become apparent in the long-run. Talk about shooting yourself in the foot.
In what follows I will leave aside the fact that he is a racist and sexist prick who also displays major fascist tendencies. I am also unwilling and unable to comment on his economic policy proposals since the candidate has failed so far to lay out a coherent economic program, which contains more than just cutting taxes for the rich. Because of all the inconsistencies in his speeches as well as the lack of a policy framework, it is not entirely clear how a Trump presidency would actually look like. I will thus only focus on the immediate shock that his election would entail.
Over the course of the last week, the probability of a Trump win has increased from a very low of about 15% last week to now 35%, according to Nate Silver at FiveThirtyEight (http://projects.fivethirtyeight.com/2016-election-forecast/?ex_cid=rrpromo) . American stocks (the Dow Jones and the S&P 500) have lost a little more than 2% since last week. There is some reason to believe that we can attribute most of this movement to Trump’s increasing chances of winning the presidency. If that is true, it follows that a 10% increase in his chances of winning leads to about a 1% decrease in U.S. stocks. Consequently, a Trump win might entail a further drop in the U.S. stock market of up to 6%. The U.S. stock market is worth a little more 22 trillion US-$. A Trump win could thus wipe out 1.3 trillion dollars in wealth just in U.S. stock markets, the global impact is likely to be bigger. Conversely, U.S. stocks might make up their previous losses and increase by up to 2% after a Clinton win. The U.S. economy and the global economy would thus face a significant adverse economic shock in the end of this year if Trump becomes president. The Fed would maybe even have to decrease interest rates back to the zero-lower bound and start another round of QE, making my previous prediction on interest rates redundant.
Unfortunately, I think that the Fed is not quite willing to do whatever it takes. They have talked about “normalizing” interest rates, whatever that means, for more than a year now despite extremely sluggish nominal GDP growth. It is not for sure that they are willing to immediately offset the ”Trump shock” if global stock markets start to tumble because he has been elected for president.
However, I do think that Clinton will win tomorrow. The probability that she takes one of the necessary swing states is relatively high. Furthermore, the fact that a lot of early votes have been already cast seems to have worked in her favor. Some analysts suggest that Trump is now unlikely to take Nevada, and this could turn out to be quite crucial.
Nevertheless, taking the estimates of 538 at face value, a 35% chance of winning is extremely high. It means that Trump would carry away every third election, and this could just be said third time. Furthermore, polls have recently underestimated in many countries how well extremist parties and candidates would do in major elections, which is an extremely scary thought. From an historic point of view, a Trump victory would certainly make some sense. The parallels between this decade and the 1930s are striking, which frightens me a lot. In both cases we have seen a major global financial crisis followed by a long-lasting period of slow economic growth around the world. Increasing inequality and stagnating wages among the middle class have led to major animosity against immigrants and minorities. Brexit is just the latest example which shows that there is now a significant backlash against globalization in advanced economies.
It is frightening to see that Europe, being one of the richest regions in the world, lets people drown in the Mediterranean Sea, that German politicians deem it ok to send those poor people who have made it back to their home countries, and that one of the two candidates in the U.S. election apparently believes in Jewish conspiracy theories (http://www.themoneyillusion.com/?p=32073). We have seen all these tendencies about 80 years ago and the world burnt as a result. So please let’s not do it again! For all voting Americans tomorrow, the choice should be obvious. Unfortunately, the same could be said for Brexit.
And to all those Europeans who think that America is just crazy, please have a look at your own country. Look at how well extremist parties are doing at home, look at what politicians have said about drowning refugees, and what has happened to the number of violent attacks on minorities over the last years, etc. The answers to those questions might be much scarier than what you previously imagined.
PS: I hope everybody understands that the whole point of this exercise is not to show how I outsmart the Fed or something like that, quite the contrary. It is extremely important to make economists accountable for their predictions, both when they are right as well as when they are wrong. I was totally surprised by the Brexit vote, for example, and as a result was forced to revise my beliefs about the accuracy of prediction markets/financial markets, which both suggested that “remain” is a little bit more likely.
I wrote this blog post this morning before financial markets were open, but did not have time to post it. Over the course of the day, global stock markets have increased by about 1.5 % as the FBI investigation stuck to its findings that Clinton’s handling of emails wasn’t a crime. With global stock markets being worth maybe about 70 trillion dollars, some 1 trillion dollars of additional wealth was created over the course of one day around the world as financial markets now believe that the probability of a Trump win is somewhat smaller than just a few days ago. This is good news, but it is also in strong contrast with the assessment of Nate Silver & Co. that Trump has roughly a 34.5% chance of winning. We’re not out of the woods yet and will know more by Tuesday night/Wednesday morning for those of us who reside on this side of the Atlantic.