Keynes wrote "a sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way with his fellows, so that no-one can really blame him." Lest anyone doubt the insight of the observation, they need only acquaint themselves with the ill-advised (but wholly accurate) comments of Chuck Prince, former CEO of Citibank,on the eve of the financial crisis: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing." These two quotations nicely summarize the dangers of "group think" – the self-reinforcing properties of conventional wisdom.
I have been reminded of Keynes’ reference to conventional thinking and orthodoxy reading the ongoing debates over the role of monetary policy, fiscal stimulus and, more recently, lender of last resort facilities that have raged in recent months. Charles Plosser, the President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia, writing in the Financial Times, scores a perfect trifecta. It is not that what he says is wrong: central bank financing of excessive fiscal deficits is indeed a recipe for inflation – and, in the limit, hyperinflation; fiscal stimulus at full employment will not, by definition, lead to sustained increases in output and higher employment; and, lender of last resort facilities should certainly be off limits to insolvent institutions. But, remarkably, those repeating the palliatives of conventional thinking seem to ignore a fairly important fact: we are not in conventional times.
As a result, the policy prescriptions they prescribe and that are sensible, sound and prudent in normal conditions may not be so in current circumstances. (For the avoidance of doubt, I do not think that this applies to all: countries that prevented the worst of the financial excesses and thus escaped the subsequent deleveraging and financial market dysfunction, such as Canada, are fortunate in that they confront the merely conventional, rather than the extraordinary challenges faced by the less fortunate.) It was not always such. In the midst of the post-Lehman meltdown, G20 governments mobilized to adopt extraordinary measures in response to the extraordinary times. People recognized that "outside-the-box" thinking was required and, because all faced the same common threat, the response was timely and coordinated.
Yet, having averted a catastrophic collapse in economic activity, some seemingly think that it is time to revert to the policy rules appropriate for normal times. That response would be wholly justified if the economy was back at full employment with output once again at its "potential" level, as would be the case at this point in most typical recessions. But, for key advanced economies, which continue to battle the headwinds of financial deleveraging and dysfunctional financial markets, this is not the case. Moreover, the application of conventional thinking could have very different outcomes from what its proponents expect. Rather than move the economy out of the "bad" equilibrium of reduced output and higher unemployment, such policies could propagate the stagnation into which they have fallen.
What is going on here?
There are two effects that may be at work. The first is the status quo bias that results when policy makers protect their reputations and credibility. Building reputations is costly and takes considerable time; it takes only one bad decision to lose that credibility. From the perspective of the individual, therefore, it is better to stick with what others are doing, even if the results are less-than-fully promising, than to jump to a policy option of uncertain effects that could lead to the loss of a well-deserved, hard-earned reputation for sagacity. As Keynes argued, it is better to fail in a conventional way along with others so that blame is shared, than to try and fail unconventionally.
The second effect at work may be the nature of economic equilibrium. In the introductory lecture of the course on international macroeconomics I teach, I describe equilibrium in terms of a marble at the bottom of a bowl. "Shock" the marble by flicking it and it will oscillate up and down the sides until it once again comes to rest at the bottom of the bowl. Think of this stable equilibrium as the outcome in the economy when market forces are functioning as they should. Individual self-interest and the "invisible hand" operate to keep the economy converging towards equilibrium. Of course, the economy is not always in equilibrium, but just as the marble oscillates around the sides of the bowl, the departures from equilibrium diminish over time.
This is a powerful idea; one that, once accepted, is difficult to dislodge.
Consider what happens, however, if market forces have been impaired by financial dysfunction and expectations are formed in a cloud of uncertainty that creates an option value of waiting. Under these conditions, think of equilibrium as a marble resting on top of an overturned bowl: in this case, a "shock" to the marble will not lead to the restoration of equilibrium. Instead, the marble rolls off the inverted bowl, off the table and along the floor where it comes to rest; and absent some intervention that is exactly where it will remain.
Part of the problem may simply be that economics is not intuitively obvious. Individuals that have been trained to think of the economy as endowed with self-righting properties and a single unique equilibrium no doubt find it difficult to think in terms of a possible "bad" equilibrium that might require a "visible hand" to restore it to full employment. Unfortunately, in the wake of the worst global financial crisis since the Great Depression, some economies may be confronting that very challenge.