Economics of the downturn – thoughts for investing

Researchers are still trying to explain why we had a bubble that burst, or if we had a bubble at all….

The January 11, 2010 issue of the New Yorker has a great article on Posner, the Chicago School of Economics and other matters that have come from the sub-prime mortgage mess (a summary appears below).

Also, there is a humorous video on line, comparing Keynes and Hayek on their approaches in rap format at:

Let me know what you think



John Cassidy, Letter from Chicago, “After the Blowup,” The New Yorker, January 11, 2010, p. 28

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LETTER FROM CHICAGO about the state of the Chicago School of economics after the financial crash. Earlier this year, Judge Richard A. Posner published “A Failure of Capitalism,” in which he argues that lax monetary policy and deregulation helped bring on the current economic slump. Posner has been a leading figure in the conservative Chicago School of economics for decades. In September, he came out as a Keynesian. As acts of betrayal go, this was roughly akin to Johnny Damon’s forsaking the Red Sox Nation and joining the Yankees. Ever since Milton Friedman, George Stigler, and others founded the Chicago School, in the nineteen-forties and fifties, one of its goals has been to displace Keynesianism, and it had largely succeeded. In the areas of regulation, trade, anti-trust laws, taxes, interest rates, and welfare, Chicago thinking greatly influenced policymaking in the U.S. and many other parts of the world. But in the year after the crash Keynes’s name appeared to be everywhere. In “A Failure of Capitalism,” Posner singles out several economists, including Robert Lucas and John Cochrane, both of the Chicago School, for failing to appreciate the magnitude of the subprime crisis, and he questioned the entire methodology that Lucas and his colleagues pioneered. Its basic notions were the efficient-markets hypothesis and the rational-expectations theory. In Posner’s view, older, less dogmatic theories better explained how the problems in the financial sector dragged down the rest of the economy. In the course of a few days, the writer talked to economists from various branches of the subject. The over-all reaction he encountered put him in mind of what happened to cosmology after the astronomer Edwin Hubble discovered that the universe was expanding, and was much larger than scientists believed. The profession fell into turmoil, with some physicists sticking to existing theories, while others came up with the big-bang theory. Eugene Fama, of Chicago’s Booth School of Business, was firmly in the denial camp. He defended the efficient-markets hypothesis, which underpinned the deregulation of the banking system championed by Alan Greenspan and others. He insisted that the real culprit in the mortgage mess was the federal government. Mentions John Cochrane. Gary Becker, who won the Nobel in 1992, says that Posner and others raised fair critiques of Chicago economics. Mentions Robert Lucas and James Heckman. If the economic equivalent of a big-bang theory is to emerge, it will almost certainly come from scholars much less invested in the old doctrines than Fama and Lucas. Mentions Richard Thaler. Raghuram Rajan, an Indian-born Chicago professor, is one of the few economists who warned about the dangers of the financial crisis. In 2005, he said that deregulation, trading in complex financial products, and the proliferation of bonuses for traders had greatly increased the risk of a blowup. In a new book he’s working on, “Fault Lines,” Rajan argues that the initial causes of the breakdown were stagnant wages and rising inequality. With the purchasing power of many middle-class households lagging behind the cost of living, there was an urgent demand for credit. The side effects of unrestrained credit growth turned out to be devastating. The impact of the financial crisis shouldn’t be underestimated, especially for Chicago-style economics. “Keynes is back,” Posner said, “and behavioral finance is on the march.”

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