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You may be familiar with the “Peter Schiff was right” Internet meme that’s been doing the rounds for a year or so. If you are not, the meme is a montage of Peter’s appearances on various business television shows between 2006 and 2007. In each clip he is alone in arguing that the US stands at the precipice of a collapse and is roundly derided by the other participants and the anchor. One such example is set out below:

Peter was indeed right about the ensuing collapse. What’s more, he was right for the right reasons, as opposed to the “permabears” who are right the way a stopped clock is right twice a day (ordinarily we’d include Nouriel Rubini in this club, but won’t do so on this occasion for reasons which will shortly become obvious). Is Peter clairvoyant? No. He’s a disciple of the Austrian School of Economics (about which we came out of the closet a few weeks back). Given Schiff’s prescience and well-known adherence to Austrian economics, one might think that the Austrian School deserves a second look, especially so given that the Keynesian orthodoxy completely missed the crash. One such paper seeks to do just that, but with a wider lense that doesn’t presuppose the conclusion.

In No One Saw This Coming: Understanding Financial Crisis Through Accounting Models (.pdf) Dirk J Bezemer of Groningen University takes a scholarly look at which macroeconomic models helped anticipate the credit crisis and economic recession and which did not. Says Bezemer:

The credit crisis and ensuing recession may be viewed as a ‘natural experiment’ in the validity of economic models. Those models that failed to foresee something this momentous may need changing in one way or another. And the change is likely to come from those models (if they exist) which did lead their users to anticipate instability. The plan of this paper, therefore, is to document such anticipations, to identify the underlying models, to compare them to models in use by official forecasters and policy makers, and to draw out the implications.

There are two broad ideas in the paper most interesting to us: The first is Bezemer’s documentation of the “sense of surprise at the credit crisis among academics and policymakers,” which gave rise to the erroneous view that “no one saw this coming”. The second “is a careful survey – applying a number of selection criteria – of those professional and academic analysts who did ‘see it coming’, and who issued public predictions of financial instability induced by falling real estate prices and leading to recession.”

“No-one saw this coming”

Bezemer makes the arguement that the view that it was impossible to know that a crash was imminent has gone unchallenged and unexamined by the mainstream press and academia:

The view that “[n]o one foresaw the volume of the current avalanche” appears justified by a lack of discussion, in the academic and policy press, of the possibility that financial globalization harboured significant risks, or that the US real estate market and its derivative products were in dangerous waters. Wellink (2009) quoted a 2006 IMF report on the global real estate boom asserting that there was “little evidence (..) to suggest that the expected or likely market corrections in the period ahead would lead to crises of systemic proportions”. On the contrary, those developments now seen as culprits of the crisis were until recently lauded by policy makers, academics, and the business community.

…

These assessments by the experts carried over to a popular view, enunciated in the mass media, that the recessionary impacts of the credit crisis came out of the blue. USA Today in December 2006 reported on the fall in house prices that had just started that summer, “the good news is that far more economists are in the optimist camp than the pessimist camp. Although a handful are predicting the economy will slide into a housing-led recession next year, the majority anticipate the economy will continue to grow” (Hagenbauch 2006). Kaletsky (2008) wrote in the Financial Times of “those who failed to foresee the gravity of this crisis – a group that includes Mr King, Mr Brown, Alistair Darling, Alan Greenspan and almost every leading economist and financier in the world.”

The surprise at this gravity was proportionate to the optimism beforehand. Greenspan (2008) in his October 2008 testimony before the Committee of Government Oversight and Reform professed to “shocked disbelief” while watching his “whole intellectual edifice collapse in the summer of [2007]”. Das (2008) conceded that contrary to his earlier view of financial globalization ‘eliminating’ credit risks, in fact “[p]artial blame for the fall 2008 meltdown of the global financial market does justly go to globalization.” The typical pattern was one of optimism shortly before and surprise shortly after the start of the crisis.

The common elements of the alternative view

Bezemer notes that, despite the foregoing, there was an “alternative, less sanguine interpretation of financial developments” and it was “not confined to the inevitable fringe of bearish financial commentators.” Bezemer is mindful that among those expressing the alternative view, the lucky guesses must be distinguished from the insightful predictions. Here he discusses the problem and his methodology for doing so:

A major concern in collecting these data must be the ‘stopped clock syndrome’. A stopped clock is correct twice a day, and the mere existence of predictions is not informative on the theoretical validity of such predictions since, in financial market parlance, ‘every bear has his day’. Elementary statistical reasoning suggests that given a large number of commentators with varying views on some topic, it will be possible to find any prediction on that topic, at any point in time. With a large number of bloggers and pundits continuously making random guesses, erroneous predictions will be made and quickly assigned to oblivion, while correct guesses will be magnified and repeated after the fact. This in itself is no indication of their validity, but only of confirmation bias.

In distinguishing the lucky shots from insightful predictions, the randomness of guesses is a feature to be exploited. Random guesses are supported by all sorts of reasoning (if at all), and will have little theory in common. Conversely, for a set of correct predictions to attain ex post credibility, it is additionally required that they are supported by a common theoretical framework. This study, then, looks to identify a set of predictions which are not only ex post correct but also rest on a common theoretical understanding. This will help identify the elements of a valid analytical approach to financial stability, and get into focus the contrast with conventional models.

In collecting these cases in an extensive search of the relevant literature, four selection criteria were applied. Only analysts were included who provide some account on how they arrived at their conclusions. Second, the analysts included went beyond predicting a real estate crisis, also making the link to real-sector recessionary implications, including an analytical account of those links. Third, the actual prediction must have been made by the analyst and available in the public domain, rather than being asserted by others. Finally, the prediction had to have some timing attached to it. Applying these criteria led to the exclusion of a number of (often high profile) candidates – as detailed in the Appendix – so that the final selection is truly the result of critical scrutiny.

The twelve analysts described there – the number is entirely an outcome of the selection criteria – commented on the US, UK, Australian, Danish and global conditions in housing, finance and the broader economy. All except one are (or were) analysts and commentators of global fame. They are a mixed company of academics, government advisers, consultants, investors, stock market commentators and one graduate student, often combining these roles. Already between 2000 and 2006 they warned specifically about a housingled recession within years, going against the general mood and official assessment, and well before most observers turned critical from late 2007. Together they belie the notion that ’no one saw this coming’, or that those who did were either professional doomsayers or lucky guessers.

So who were those analysts able to make an accurate and cogent prediction? Here’s the table:

What are the common elements of these analysts?

A broadly shared element of analysis is the distinction between financial wealth and real assets. Several of the commentators (Schiff and Richebächer) adhere to the ‘Austrian School’ in economics, which means that they emphasize savings, production (not consumption) and real capital formation as the basis of sustainable economic growth. Richebächer (2006a:4) warns against ““wealth creation” though soaring asset prices” and sharply distinguishes this from “saving and investment…” (where investment is in real-sector, not financial assets). Likewise Shiller (2003) warns that our infatuation with the stock market (financial wealth) is fuelling volatility and distracting us from more the durable economic prospect of building up real assets. Hudson (2006a) comments on the unsustainable “growth of net worth through capital gains”.

A concern with debt as the counterpart of financial wealth follows naturally. “The great trouble for the future is that the credit bubble has its other side in exponential debt growth” writes Richebächer (2006b:1). Madsen from 2003 worried that Danes were living on borrowed time because of the mortgage debt which “had never been greater in our economic history”. Godley in 2006 published a paper titled Debt and Lending: A Cri de Coeur where he demonstrated the US economy’s dependence on debt growth. He argued it would plunge the US into a “sustained growth recession … somewhere before 2010” (Godley and Zezza, 2006:3). Schiff points to the low savings rate of the United States as its worst malady, citing the transformation from being the world’s largest creditor nation in the 1970s to the largest debtor nation by the year 2000. Hudson (2006a) emphasized the same ambiguous potential of house price ‘wealth’ already in the title of his Saving, Asset-Price Inflation, and Debt-Induced Deflation, where he identified the ‘large debt overhead – and the savings that form the balance-sheet counterpart to it’ as the ‘anomaly of today’s [US] economy’. He warned that ‘[r]ising debt-service payments will further divert income from new consumer spending. Taken together, these factors will further shrink the “real” economy, drive down those already declining real wages, and push our debt-ridden economy into Japan-style stagnation or worse.” (Hudson 2006b). Janszen (2009) wrote that “US households and businesses, and the government itself, had since 1980 built up too much debt. The rate of increase in debt was unsustainable… Huge imbalances in the US and global economy developed for over 30 years. Now they are rebalancing, as many non-mainstream economists have warned was certain to happen sooner or later.” Keen (2006) wrote that the debt-to-GDP ratio in Australia (then 147 per cent) “will exceed 160 per cent of GDP by the end of 2007. We simply can’t keep borrowing at that rate. We have to not merely stop the rise in debt, but reverse it. Unfortunately, long before we manage to do so, the economy will be in a recession.”

Of the analysts holding the “alternative, less sanguine” view, most were from the Austrian School. It would be nice if a few more Keynesians had Greenspan’s “shocked disbelief” while watching his “whole intellectual edifice collapse in the summer of [2007]”. We’re not holding our breath. While we don’t necessarily agree with all of Bezemer’s conclusions, the paper is superbly written and an engaging read.

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