Jean Tirole and the Silent Revision
By Arnold Kling
Jean Tirole writes,
Economic theory stresses the necessity for the state to boost industrial and financial sectors during periods of liquidity shortage. [here a footnote reads, “This is an old theme, dating back at least to Keynes and Hicks. For microfoundations, see, e.g., Homlstrom and Tirole (1998).] “Outside liquidity” [liquidity that comes from outside the private sector] is created through the government’s injection of funds into the economy, especially in times of recession. This involves bailing out economic agents, using forbearance in the implementation of capital requirements, following countercyclical monetary policy, providing deposit insurance and unemployment payments indexed over the cycle, implementing countercyclical fiscal policy, and so on…All of these practices share an explicit or implicit transfer of resources from households to industrial and (more often) financial sectors in periods of recession. But they also share the unintended consequence of bailing out those who have taken big risks.
That is from p. 36-37 of Balancing the Banks, by Tirole, Mathias Dewatripont, and Jean-Charles Rochet. I have just started the book, so it is too early to render my assessment of it. Some remarks about the quoted paragraph.
1. This relates to the issue of the “silent shift” (I prefer the phrase “silent revision”) of macro that Nick Rowe raised. I submit that if the above paragraph had been written in 2006, the phrase “bailing out economic agents” would not have been included in such a paragraph, much less been listed first. The consensus would have been that countercyclical monetary policy should be sufficient. Maybe with countercyclical fiscal policy tossed in if interest rates got close to zero. To me, the construction in this paragraph plainly illustrates the silent revision.
Scott Sumner may protest that “I [Scott] am still in the mainstream group of economists,” but I predict that the silent revision will cast him out. The need to justify what was done in 2008 will drive the new consensus. Thus, the mainstream view to which Sumner seeks to attach himself will be airbrushed out of history.
2. Capital forbearance, mentioned second, was my preferred approach at the peak of the crisis in September-October of 2008. Not that I align myself with either the pre-2008 or post-2008 macro consensus. As I recall, my thinking was that insolvent financial institutions should go out of business, but there might be a group of financial institutions that suffered from temporary asset price declines due to illiquidity. To test their soundness, institutions in this latter group could have been given capital forbearance but kept on a tight regulatory leash.
3. I disagree with Tirole on the transfer of resources to the financial sector. It is not just bad from a moral hazard perspective. In 2008, it strikes me that it was exactly the wrong thing to do from the standpoint of ending the recession. During the housing boom, our financial sector far outgrew the rest of the economy. The subsequent Recalculation requires moving resources out of the financial sector into something else. The recession will not be over until the economy has settled into a more natural balance that presumably will shrink the size of housing and finance relative to what they were in 2006. From my perspective, the bailouts were harmful rather than helpful.
4. I also disagree that the transfer to undeserving risk-takers was an “unintended consequence” of the policy. Instead, I think that the transfer to undeserving risk-takers was the primary intention of Henry Paulson and other key decisionmakers. They never conceived of the issue any other way. That is, consider two ways of looking at the issue as of September of 2008.:
a) Our bloated financial sector is in trouble. What options do we have to mitigate the effects on the rest of the economy of the adjustment to a smaller financial sector?
b) The failure of certain well-known financial institutions (except Lehman, given their management’s bad attitude) is unthinkable. What are all of our options for saving them?
Policy makers should have been in mindset (a). Instead, they were in mindset (b).