Thomas Mayer - The Challenges of Economic Thinking in Practice

Deutsche Bank
DB Research

The Challenges of Economic
Thinking in Practice

Dr. Thomas Mayer, CFA
Chief Economist of Deutsche Bank Group
tom.mayer@db.com
(+49) 69 910 30800

24 January 2012

My main points

 Conventional economics did not anticipate the financial crisis, cannot
explain it, and cannot make recommendations on how to overcome it,
because it does not understand the credit cycle.

 To understand the credit cycle practitioners had to study economic
history and dig up old economic theories long discarded by the
mainstream.

 „Rethinking economics“ requires that we shift the focus from
„deduction“ (like in natural sciences) to „induction“ (like in social or
historic sciences) for the development of economic theories.

Deutsche Bank Thomas Mayer
DB Research Chief Economist 1

The macroeconomic consequences of conventional
economics

•Theory of rational expectations

•Theory of efficient markets

Monetary policy should target inflation

Asset prices can be ignored

Regulation can be „light“


1. Control illusion

"If you want a simple model for predicting the unemployment
rate in the United States over the next few years, here it is: It
will be what Greenspan wants it to be, plus or minus a random
error reflecting the fact that he is not quite God.“
Paul Krugman in late 1990s


The financial market consequences of conventional
economics
•Theory of rational expectations
•Theory of efficient markets
•Probability distribution of financial market
prices known (and ideally normal)

Modern portfolio theory

Value-at-risk

Leverage


2. Control illusion

“At the beginning of 1998, the firm (Long-Term Capital Management) had
equity of $4.72 billion and had borrowed over $124.5 billion with assets of
around $129 billion, for a debt to equity ratio of over 25 to 1. It had off-
balance sheet derivative positions with a notional value of approximately
$1.25 trillion, most of which were in interest rate derivatives such as interest
rate swaps.”
Source: http://en.wikipedia.org/wiki/Long-Term_Capital_Management


But:
What if these theories do not appropriately describe the
behaviour of humans and markets?

The (probably) biggest credit bubble of all times


The burst of the credit bubble

•US sub-prime credit crisis (early 2007)

•Money market crisis (mid-2007)

•Banking crisis (2008-09)

•Public debt crisis (2009-?)

•Euro crisis (2010-?)

Next

•Monetary crisis?


Business cycle theories where credit plays a key
role

Post-Keynesian economics Austrian economics
(Minsky) (von Mises, Hayek, Schumpeter)

Hedge borrowing Credit expansion phase -
Speculative borrowing investment boom
Ponzi borrowing Credit contraction phase -
investment bust


Minsky‘s financial instability theory

Credit
Minsky moment

Speculative Ponzi
Hedge borrowing borrowing borrowing
t


Minsky‘s error

Financial regulation can help stabilise the economy
Fiscal and incomes policies can help stabilise the economy

But:
Regulation and economic policies have been
more often pro- than anticyclical


The Austrian business cycle

GDP market rate < market rate >
market rate = natural rate natural rate natural rate

t

The liquidationists‘ error

"…liquidate labor, liquidate stocks, liquidate farmers, liquidate
real estate… it will purge the rottenness out of the system.
High costs of living and high living will come down. People will
work harder, live a more moral life. Values will be adjusted,
and enterprising people will pick up from less competent
people."
Andrew Mellon, US Secretary of the Treasury, 1921-1932

But: What if rising risk aversion keeps the market rate above the
natural rate?

Economic policy needs to reopen the credit channel


Overcoming the “fear of fear itself“

c ha nge , % of Unite d Sta te s % yoy 15
8 GDP
10
4
5
0
0

-4
-5
Credit impulse, % of GDP
-8 -10
Real consumption + investment
-12 (rhs) -15
1928 1930 1932 1934 1936 1938 1940 1942
Source : US Fe de ral Re s e rve , DB Global Marke ts Re s e arch

Notes: Credit impulse := change in net lending flows from financial to private non-
financial sector in % of GDP; Real C+I := real private consumption + investment


The power of credit

c ha nge , % of GDP % yoy 12
Unite d Sta te s The goldilocks phase
8
8
4
4
0
0
-4

-8 -4
Credit impulse, % of GDP
-12 -8
Real consumption + investment (rhs)
-16 -12
1928 1938 1948 1958 1968 1978 1988 1998 2008

Source : US Fe de ral Re s e rve , DB Global Marke ts Re s e arch

Notes: Credit impulse := change in net lending flows from financial to private non-
financial sector in % of GDP; Real C+I := real private consumption + investment


Understanding the nature of credit

 Where there is trust economic relations are based on credit, where
there is no trust economic relations are based on the exchange of
money (David Graeber).

 Modern finance pretended that trust can be replaced by financial
engineering. Financial engineering has flopped, trust has disappeared,
and credit is being replaced by money.

 But will the replacement of credit by fiat money eventually lead to a
crisis of the fiat money system?


Forty years of flat money

1600.00 US$
1400.00
1200.00 15/8/1971 US$ pric e of gold
end of
1000.00 $/gold link

800.00

600.00
400.00
Financial
crisis
200.00 Carter
dollar
0.00
68 71 74 77 80 83 86 89 92 95 98 01 04 07 10


What are the new challenges for economists?

•We need a better understanding of the credit cycle and the
nature of credit in macroeconomics

•We need to develop modern finance for a world of „Knightian
uncertainty“ with lots of „unknown unknowns“

•We must become more inter-disciplinary with input from
history, psychology, sociology and anthropology

•We must rely less on developing theories by „deduction“ (like in
natural sciences) and apply more „induction“ (like in social and
historical sciences)


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