Sharing Queen Elizabeth’s Deafness

Ever since Queen Elizabeth II asked in July why nobody had predicted the Great Recession, sundry economists have given an avalanche of weak explanations. Phooey. Actually, Queen Elizabeth herself exemplifies the problem. Contrary to her complaint, dozens of economists and journalists warned repeatedly that the world suffered from unsustainable asset bubbles, global imbalances, and high debt. But most people, including the Queen, were not interested in listening.

The Queen’s financial portfolio shot up in the boom, yet she never asked whether this was justified or sustainable. Only after her portfolio lost $ 135 million did she ask why nobody had predicted the downturn. She typifies the millions of suckers who asked no questions when blinded by euphoria in the boom, and then indignantly demanded explanations in the subsequent bust.

A group of British economists led by Tim Besley told the Queen it was “a failure of the collective imagination of many bright people.\” This failure, they explained, arose from “a psychology of denial.” While many experts were indeed in denial, others shouted the truth but were ignored.

In these columns, I repeatedly said that 9% GDP growth in India was an unsustainable by-product of the biggest global boom of my lifetime, and that the global tide would one day fall and lower all boats, including India’s. In September 2007, in a column titled “Recession is a probability now” I wrote, “Journalists do not have a good reputation for predicting recessions. Indeed, they are reputed to have predicted 10 of the last three recessions. A month ago, I wrote that the US had a 33% chance of going into recession next year. Events of the last month have, in my view, increased the chances to over 50%.”

Queen Elizabeth may not read The Economic Times. But she must have heard of two Chairmen of the US Federal Reserve Board, Alan Greenspan and Ben Bernanke. Both were fully aware of the housing bubble in the USA. Indeed, Greenspan warned US Congress that the dominance of Fannie Mae and Freddie Mac (government supported institutions) in the mortgage market posed a huge systemic risk, a warning all Congressman ignored.

Greenspan and Bernanke both opposed imposing high interest rates to check asset bubbles, since this might plunge the whole economy into recession. They said it was better to let bubbles burst and then clean up the mess. The Queen might disagree with their timing, but can hardly say they didn’t foreseeing the bursting of the bubble.

Many journalists and economists wrote about asset bubbles in housing, real estate and commodities. Many columns pointed out that market indices suggested that asset prices were too high. The riposte was to cite economist Paul Samuelson’s famous line, “Wall Street indices have predicted nine of the last five recessions.”

So, don’t accuse economists of not predicting the recession. Rather, some predicted it so often that they were dismissed as boys crying wolf. Nouri El-Roubini and Stephen Roach repeatedly predicted the bursting of the asset bubble, but since the bubble kept inflating nevertheless, they were dubbed failed prophets. Nissim Nicholas Taleb’s book “The Black Swan” lampooned fund managers for ignoring the improbable, thus exposing themselves to massive bankruptcy of the sort that actually happened. The book was a best seller, yet few readers acted on Taleb’s advice.

Former IMF chief economist Rahguram Rajan said, in lectures and articles from 2005 onwards, that financial institutions were taking on excessive risk. Nobody listened. Newspapers pointed out that the debt of individuals, corporations and the US government had reached historic highs. Savings as a proportion of disposable household income became negative in 2005, and the media pointed out that the last time this happened was in 1933, during the Great Depression. Very few drew the appropriate conclusion.

Yale economist Robert Shiller’s celebrated book “Irrational Exuberance” in 2000 highlighted the unsustainability of the bubble and predicted, correctly, that it would burst. Shiller’s second edition of the book in 2005 warned that US housing was another bubble ripe for bursting. His Case-Shiller index of housing prices showed how far housing prices were out of line with household incomes and rents. His book sold millions of copies, and many reviewers declared that Shiller was obviously right. Yet so entrenched was irrational exuberance that the housing bubble kept inflating, and burst only in 2007.

Several economists, notably Martin Wolf of the Financial Times, wrote of the unsustainability of global imbalances. All economic theory and history held that rich countries had plentiful savings while poor ones had little, and so capital flowed from the rich to the poor. But in the last decade poor China ran up enormous trade surpluses—reflecting enormous savings–which financed enormous overconsumption—reflected in trade deficits– in the richest economy in the world, the US. Obviously this inversion of economic logic and history could not last forever. Yet as the imbalances rose year after year, markets bubbled with delight instead of freezing with apprehension.

Wolf pointed out that US consumers simply had to stop living beyond their means at some point. One scenario could be a gradual adjustment by consumers year by year, providing a soft landing to the US economy. The second scenario could be a sharp fall in US consumption, causing a deep recession. We all know today which scenario came true. This should not have come as a surprise: the most cursory look at business cycle history shows that soft landings are rare, and hard landings common.

Why then did so few anticipate a hard landing? Sadly, human euphoria during a boom is hard to shake. All humans—householders, businessmen, politicians, financiers—love bubbles. They love to see their wealth skyrocketing, they love to see the proliferation of jobs and income. Barring a few naysayers, nobody wishes to focus on the inevitable downturn, let alone check the boom. This is why booms and busts are inevitable. They reflect the human condition. Most of us are so much like Queen Elizabeth.

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