Up to Speed, But Lagging Behind

Matías Vernengo

Gary Gorton and Andrew Metrick have just produced a survey on the vast literature on what happened during the last financial crisis (and to a lesser extent why it did) titled “Getting Up To Speed on the Financial Crisis,” to be published by the Journal of Economic Literature. They used only 16 documents, between papers from ‘top journals,’ reports and speeches and congressional testimonies. It must be noted that the objective of the review is to provide “a one-weekend-reader’s guide” to the crisis.

The biggest problem with their paper is not the limited number of documents reviewed, which seem to be fairly representative of conventional views on the financial crisis, but the limitations of what the mainstream of the profession knows about the crisis, and worse, what the profession clearly does not know it does not know, the unknown unknowns, so to speak. And that is why ignoring heterodox and progressive contributions has been very harmful for the profession. I will use three of their cited documents as an example of what I mean.

Take, for example, Ben Bernanke’s (2005) speech, in which he argues that a global savings glut has caused the global imbalances, i.e. the large US current account deficits. Lack of savings in the US was seen by him as a problem. Even if we go beyond the questions of causality, and Bernanke’s implicit acceptance of Say’s Law, and whether savings are actually relevant for growth, it must be noted that the problem of the US was not low savings, but the fact that private spending was based on unsustainable debt accumulation, a point raised by, for example, Wynne Godley long ago. Bernanke wanted fiscal adjustment, and had nothing to say about stagnating wages being the reason why families got indebted. Understanding effective demand, Godley (1999, p. 1) argued that if “private expenditure at some stage reverts to its normal relationship with income, there will be, given present fiscal plans, a severe and unusually protracted recession with a large rise in unemployment.” In other words, without debt a fall in private spending, caused in this case by the pricking of the dot-com bubble, not compensated by big fiscal deficits (he thought those would be necessary), would lead to where we ended, a big recession.

Of course the housing bubble prolonged the debt-led expansion. On the housing bubble the authors of the review refer to Case and Shiller (subscription required), which they call “a remarkably prescient paper.” If one goes to the paper, what Case and Shiller actually argue is that: “judging from the historical record, a nationwide drop in real housing prices is unlikely, and the drops in different cities are not likely to be synchronous: some will probably not occur for a number of years. Such a lack of synchrony would blunt the impact on the aggregate economy of the bursting of housing bubbles” (2003: p. 342). In other words, no there was no bubble, fundamentals could explain the home price increases observed in most of the United States and if prices fell a collapse of the economy could be avoided. Prescient indeed! They ignore the contributions by Dean Baker, which were truly prescient. For example, he already complained back in 2003 (same year of Case and Shiller) that “the vast majority of economic analysts have failed to recognize the [current] housing bubble.”

Finally, Gorton and Metrick (2012, p. 2) suggest that the main empirical fact about financial crisis comes from the work by Reinhart and Rogoff (2011), which shows that there is a “strong association between accelerations in economy-wide leverage and subsequent banking crises.” That is hardly new, and by no means the main empirical fact about this crisis. Worse, in a previous paper, Reinhart and Rogoff (2010) argued that public-debt-to-GDP ratio of an economy could not exceed 90% without negatively affecting growth rates, a proposition that suggests that public, not private debt is dangerous, which is the opposite of what they should have learned. Nersisyan and Wray (2010) completely debunked that proposition and found that out of 216 observations, only five revealed public-debt-to-GDP ratios that exceeded 90 per cent. Further, Reinhart and Rogoff (2011) have nothing to say on financial deregulation as one of the causes of the crisis, or the effects of worsening income distribution and wage stagnation in promoting economy-wide leverage, particularly in the private sector. For that, one would be better served by Barba and Pivetti (2009; subscription required).

So if you read all the 16 documents suggested by Gorton and Metrick you may truly be up to speed with what the mainstream of the profession knows about the financial crisis. But the orthodoxy of the profession is still lagging behind and has a lot of catching up to do with heterodox and progressive economists. They might at least acknowledge it, and try to incorporate heterodox insights (if not their methods) if they want the profession to remain relevant.

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7 Responses to “Up to Speed, But Lagging Behind”

  1. Janine Berg says:


    Have you shared your piece with the authors and the editor of JEL?


  2. Camden Chancellor says:

    Reinhart and Rogoff state in their 2010 article, “When gross external debt
    reaches 60 percent of GDP, annual growth declines by about two percent; for levels of
    external debt in excess of 90 percent of GDP, growth rates are roughly cut in half. We are not in a position to calculate separate total external debt thresholds (as opposed to public debt
    thresholds) for advanced countries. The available time-series is too recent, beginning only in
    2000. We do note, however, that external debt levels in advanced countries now average nearly 200 percent of GDP, with external debt levels being particularly high across Europe.”

    I would be interested in seeing the correlation between growth declines and total external debt, particularly the ratios of public to private external debt as a product of GDP.

    Great update.


  3. Matías Vernengo says:

    Hi Janine. I think it was sent to them for reply, and space will be provided by the blog if they choose to do it. Camden. I was referring more to R&R threshold levels of public debt [in their words: “median growth rates for countries with public debt over roughly 90 percent of GDP are about one percent lower than otherwise”, 2010, p. 573], not external debt. They, in fact, talk almost as if all debt (in domestic or foreign currency) would be equivalent. Foreign debt is considerably more problematic than debt in domestic currency (as the Greeks have found out recently). They have no discussion of how public debt in domestic currency is a debt that the country owes to itself, and on which no default is possible.

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  5. Arijit Banik says:

    This approach from the neoclassical establishment is consistent with Chomsky’s assertions in Necessary Illusions (Chapter 3) concerning the Bounds of the Expressible: “To escape the impact of a well-functioning system of propaganda that bars dissent and unwanted fact while fostering lively debate within the permitted bounds is remarkably difficult.”

    The well functioning system of propaganda is, of course, the orthodoxy and dissent –hailing from heterodox quarters– supposedly lacks theoretical rigour as espoused by the establishment.

    But in practice, the marginalised heterodoxy will be set to lap the establishment as the gains of tweaking DSGE models rapidly diminish and appear appallingly inadequate in the face of their failure prior to 2008 (notwithstanding Chris Sims’ defnece of them) and superior (stock-flow consistent) dynamic modeling which some new scholars are embarking upon in economics and that has been de rigueur in real applied sciences such as engineering.

  6. Chao Zhou says:

    I like the idea that “reoccurrence of normal relationship between private spending and family income at a late stage would lead to a recession without the compensation by fiscal deficits.” But there are two issues to consider in this perspective, or maybe more like two assumptions. If the normal relationship between private expenditure and income reverted at an earlier stage, to what extent can it decrease the possibility of financial crisis? Another issue (assumption) is that if a fall in private spending be compensated by fiscal deficits to avoid umemployment, will such policy further increases the current account deficit and leads to a potential crisis just through another approach?

    Chao Zhou