Some note on Dean Baker's "False Profits"

Recently, in response a request for "resources for understanding the economy", I recommended a few books. The request was as follows:

The actually existing one I mean, the global economy and the US economy, not like general principles such as surplus value and exploitation, but what's really been going on recently-ish.... I feel really under-equipped in terms of knowledge about the economy and about how to find out more about the economy - from basic stuff like where do most people work, up to things that feel more confusing like what's a derivative, how does currency trading work, etc. Can folks recommend me like 1-3 good sources for getting a grasp on some of this? The shorter the better.

And my response was:

1-3 good sources is pretty difficulty because you've cast a very wide net. As a rule of are much better off reading economics that does not come from the far left. But after thinking about this while i cook lunch I think I am actually going to recommend you some left wing books.

So two books by Dean Baker The United States Since 1980 and False Profits: Recovering from the Bubble Economy (Haven't actually read this yet though)

One by Andrew Glyn Capitalism Unleashed

And one by Paul Krugman's The Return of Depression Economics and the Crisis of 2008

i.e. basically books by social democrats. The far left is shit at economics. (Although Glyn was on the far left, but exceptions rules all that.)

A lot of people have asked me for recommended reading on the economy recently and I think my above recommendations are pretty good. Dean Baker's books are quite US-centric but still well worth a look considering a) the central role the US plays in the world economy and b) very little is being written about the EU/Irish/Western economy.

However, as I said in my response, I hadn't actually read Baker's book "False Profits" so I perhaps shouldn't have recommended it. But I read it this morning and am now pretty happy recommending it. Anyway, the point of this blog post is basically to note down some issues with the book while its still fresh in my head.

As is my wont, I'm going to begin polemically by responding to Brad DeLong's blog post I Need to Review Dean Baker's "False Profits". DeLong writes:

 I really need to get started on this...


The first two paragraphs:

Dean Baker is one of the very few economists to have gotten things right in the mid-2000: to have not only recognized the housing bubble, but to have predicted that it would produce big trouble for the economy as a whole. Now he has produced his book on the financial crisis, False Profits. Given the sales of all the books by all the people who did not predict that the housing bubble would have big bad consequences for the economy as a whole, everybody who has bought even one of those other books is under a strong moral obligation to buy Dean Baker's book and to read it was very close attention. And they will all profit substantially from doing so.

But let me start by saying how I disagree with the book. I think that its story of the linkages between our current crisis and Federal Reserve policy is significantly overstated. Its argument about how excessively-low interest rates caused the housing bubble is exaggerated. I think that its belief that the Federal Reserve could have taken much more action to curb the housing bubble while is underway is also exaggerated, and does not recognize the very real constraints that the Federal Reserve works under and all but ignores the costs of austerity. And it overstates the strength of the links between the housing bubble and the housing crash on the one hand and our current situation of macroeconomic despair on the other.

I'm pretty much onside with DeLong here. I don't think that you can reduce the crisis to failings by the Fed to the extent that Baker does. Baker writes in paragraph 1, page 1: "The basic story of this economic collapse is very simple. The Federal Reserve Board, guided by its revered chairman, Alan Greenspan, allowed an $8 trillion housing bubble to grow unchecked." I don't think it is that simple. Paul Krugman lists six possible explanations of the crisis in his Minsky Lecture "Six Doctrines in Search of a Policy Regime"

- Size: Our largest financial institutions have just gotten too big - Shadows: The rise of shadow banking, institutions that fulfill banking functions but evade the regulatory regime, has undermined stability - Opacity: We’ve come to rely on complex financial instruments that neither regulators nor the private sector - Predation: Financial firms deliberately misled consumers and investors - Government intervention: Public policy pushed lenders into making bad loans, especially to the poor - Monetary mismanagement: The Fed did it by keeping interest rates too low for too long, and/or policymakers panicked in 2008 and spooked the markets

While, I don't find Krugman's dismissal of reason 1, 5 and 6, I also think that Baker basing his entire explanation on reason 6 'Monetary mismanagement' is too much. However, DeLong isn't being fair to Baker is saying that he reduces it to not increasing the interest rate in time. If that was Baker's argument both DeLong and Krugman would have a point. Neither the argument that interest rates were too low before the crisis, nor that increasing interest rates more in 2004/2005 would have prevented the crisis are arguments I find persuasive.But Baker doesn't argue that, rather he argues that "the Fed could have issued clear warnings about the existence and danger of the bubble." (p.36) He argues the Fed should have pressed "the case everywhere for the existence of a housing bubble". Along with that he says that "the Fed could also have used its regulatory authority to crack down on the proliferation of bad loans" by for example issuing mortgage guidelines (p.37) that were promised since the 1990s but weren't finalized until 2008. He argues that if that doesn't work, the fact that the Fed is pursuing a clear and committed strategy to burst the housing bubble would mean that if it came to increasing the interest rate, any increase would have an amplified effect. (p.38) This is a much stronger argument than simply saying that the Fed should have increased the interest rate; the opinion that DeLong attributes to Baker.

However, Baker's take on the effect of interest rates on the housing bubble is kind of confused/confusing. He actually explicitly rejects the argument that the housing bubble was fuelled by low interest rates (pp.25-26). He says that "Historically, housing prices have not been that sensitive to interest rates" (p.25). But later he argues that there was a surge in housing demand after the 1981-82 recession caused by the Fed cutting interest rates. He writes: "the Fed held the key to reviving the economy. When it did so, by lowering interest rates, it kicked off a huge surge in car purchases and home buying because substantial demand had built up during the recession." (p.40) The is a bit of a contradiction here. If lower interest rates increase the demand for houses then, ceteris paribus, the price of houses should increase i.e. housing prices should be sensitive to interest rates. There is a way to square this circle which is to argue that interest rates cause a rise in the supply of housing equivalent to the rise in demand. I can think of some reasons that that might be the case and Baker does have a strong argument that an increase in demand relative to the supply of housing was not the cause for rising house prices. He points out that neither income nor population were growing sufficiently to fuel the growth in demand, nor was supply constrained. The 2002-2006 building rate was at a record rate, rental vacancies were increasing throughout the period and ownership unit vacancies increased towards the end of the period. However, I'm filling in the blanks here. It would have been better if he had explained how and why low interest rates increase housing demand but not house prices.

Moving on from chapters 1 and 2, to chapter 3 "The Terrible Tale of the TARP". In this he argues strongly that the TARP was a bad policy. The TARP, I thought until reading this, was basically like a better designed NAMA. My thinking here was that NAMA agreed to purchase bad assets above their market value in order to recapitalise the banks, whereas the TARP planned to buy bad assets at market value. However, as Baker points out, there was no point to purchasing assets at market value. Doing this did not recapitalise the banks it merely changed the composition of its assets. He says that what Paulson ended up doing then was simple giving capital to the banks and not purchasing the 'bad assets' at all. To be honest I hadn't come across this argument before. I found it really interesting and its something I'm going to follow up on.

In chapter 4 he argues that the housing bubble is still being propped up. In chapter 5 and 6 he discusses the financial stimulus. In chapter 5 he argues that the stimulus was necessary and too small. This includes a humorous analogy, he writes: "the last senators who were pulled on board behind the stimulus were proud of the fact that they had reduced its size. The whole point of stimulus is to spend lots of money; reducing the size of a stimulus package is a bit like finding a shortcut on your jogging route. It might be possible, but whats the point? Instead of expressing ridicule, many in the media applauded these senators for being fiscally responsible." (p.109) Chapter 6 describes other possible expenditures that could be included in a further stimulus. This is probably the least interesting chapter. I'm sure we can all think of useful things the government could spend money on.

Chapter 7 is on reforming the financial system. In it he argues for two reforms. Firstly, he argues for restructuring the Federal Reserve system to take it out of the control of private finance and put it more under public control.This issue is what I'm doing my PhD on and it is not as simple as Baker suggests it is. Yes changing the appointment system of the federal reserve so as to make it so as that private banks aren't electing their regulators is obviously a good idea, but... placing the federal reserve under more public scrutiny and control is difficult. Democratising capitalism destabilizes capitalism. I don't want to pull the revolution rabbit out of the economics hat here, but there is a fundamental incompatibility of a publicly controlled economy and a free market economy.

His second proposal is to introduce a financial transaction tax, this is similar to the idea of a Tobin tax or more recently and more idiotically named the 'Robin Hood Tax'. However, his discussion of this raises two very interesting points that I didn't know. 1.) The UK has a financial transaction tax on London Stock Exchange. 2.) The LSE tax raises £4 billion pounds annually. I thought that any tax on financial transactions would not really raise all that much. I viewed the tax as basically being a disincentive to speculation not as a realistic revenue raiser. It would seem that it is!

Baker also argues for some other financial reforms. He argues for dealing with derivatives by making all derivatives exchange traded, regulated by the exchange and that any customized derivative would have to go through the bother of getting the customized derivative on the exchange before it could be sold.This he argues would result in the standardisation of derivatives and thereby in their decreased opacity. He also argues for ratings agencies being employed by exchanges and not by firms. This would change the incentive structure for ratings agencies and would stop them giving large firms the ratings they want, because they would no longer be directly employed by those firms. Apart from sounding like a pretty good idea, this is interesting because 1. I didn't know that rating agencies were directly employed by firms 2. Baker doesn't even bother arguing that ratings agencies were giving firms the ratings they wanted, he just takes it as a given. If ratings agencies were doing this is is serious, I imagine illegal and if so people should go to jail over it.

The book ends with chapter 8 appealing to reader to remember that the people arguing that workers should pay with unemployment for the crisis are the people who created the crisis. (How true that is I'm not really too sure.)