Have economists learnt nothing from the crash? Three fallacies that persist

It is approaching ten years since the collapse of Lehman Brothers. To most people this is when the great financial crash started, since it is from this point that the most serious repercussions started to take place. Personally I date it from the collapse of interbank markets more than a year before, but never mind. What was so shocking about the crash was that so few trained economists foresaw it. Or, lest anybody mistake that for mere criticism of forecasting skills, how so many economists aided and abetted the forces that destabilised the financial system, or at any rate, did nothing to head the crisis off. Ten years on and I am starting to wonder whether we are unlearning the lessons of the crash, and relearning the complacency that let it happen.

What shook me was an article in the Financial Times by long-standing correspondent Martin Sandhu - the devasting cost of central banks' caution. His suggestion is that central banks were too cautious in the aftermath of the crash, and as a result the recovery has been stunted. What struck me about this article is how heavily it is based on the economic conventional wisdom that helped cause the crash in the first place. It is as if economists like Mr Sandhu had learnt nothing at all. In particular it is based on three persistent fallacies that should by now be well and truly exposed.

Fallacy 1: the pre-crash trend growth rate was real and sustainable

Economics is a numerical discipline, and economists are more than usually susceptible to the delusion that numerical measures are more real than the complex world they describe. One case in point is something called the "trend growth rate". This is an average rate of growth taken over a long period of time. By its nature it does not vary much from year to year, but before 2008 it had been remarkably consistent in developed economies, at about 2% per annum. After the crash it fell, and a new, much lower trend has established itself. Mr Sandhu's contention is that the pre-crash trend was ordained by the laws of physics, and that the decline must represent a policy failure - which he lays at the door of central banks. The gap between where the economy is now, and where it would have been had the pre-crash trend persisted, is now very big - and it is the "devastating cost" of the article's title. This is a persistent idea, which I have heard from Mr Sandhu's FT colleague Martin Wolf too, though I suspect that he is starting to wake up to the truth. You also hear it from some left wing commentators who lay the blame at the door of "austerity" rather than central banks.

The persistence of the trend before 2008 is all the evidence that many macroeconomists need that it must represent some natural law: the steady advance of technological change on productivity. They did not think it was their job to ask more penetrating questions. But the cracks were showing well before 2008, and had economists spotted this, they would have seen that instead of the world continuing on its steady course, the risk of an economic crash was building up. The crash blew away froth that had been accumulating in the years before.

There are several aspects to this, and I will try to be brief. First is that the sort of productivity growth that economists fondly believed is happening everywhere, was always confined to fairly narrow sectors of the economy, and those sectors are themselves narrowing. In particular it applied to agriculture and manufacturing: industries where you produce stuff and ship it. And yet the importance of these industries to developed economies is steadily diminishing, in a phenomenon called the Baumol Effect that is taught in Economics undergraduate courses, and which should have been no surprise. The true drivers of a modern economy are in services such as healthcare, where technological advance does not tend to advance productivity in the sort of way that is captured by economic statistics.

Second, in the ten years up to 2008 much of the rate of growth depended on globalisation, and in particular the use of cheap labour in the developing world, notably China. This was strikingly evidenced in the fact that the prices of many manufactured goods actually fell in the period. This was not a case of advancing productivity: it was the exploitation of another basic economic idea whose implications few modern economists actually seem to understand: that of comparative advantage. The problem is that where this arises because the developing world is catching up with the developed world these gains are temporary and actually go into reverse eventually. That was what was starting to happen before 2008 as Chinese wage costs relative to American and European ones started to close. It was not sustainable.

And third, much of the growth, especially in Britain, depended on industries whose economic benefits were actually doubtful, and where productivity measures are similarly flawed. Two sectors stand out. One is finance; not only are the actual benefits to human well-being from its output hard to understand, but much of the reported income turned out to be downright false. That is the main reason why the crash had such a drastic effect on GDP figures in 2009, as bank bailouts were needed to replace non-existent assets created by this fictitious income. That should be reasonably obvious, though I'm surprised by how few commentators pick this up. More subtle is the problem with a second sector reporting productivity growth: business services. This is things like lawyers, accountants, consultants and architects - particularly important in Britain. The problem here is that these do not provide services to end users but to other businesses. Which leads to the question, how can you say that these industries were becoming more productive when there is so little evidence of productivity gains in the industries they were advising?

Fallacy 2: consumer price inflation is the main evidence of unsustainable growth

In the 1970s developed economies overheated, and this led to an inflation price spiral, as consumer prices and pay rates chased each other. This wasn't supposed to happen under the Keynesian economic regime that most of the world used at the time, because unemployment was increasing too. This was a huge shock to the economics profession (a much greater shock apparently than the 2008 crash), which led to a brand new policy framework. This led to an obsession with consumer price inflation. If you keep this at some Goldilocks level, of between 1% and 3% per annum, then nothing too much could be going wrong, people thought. This was made the sole performance target for many central banks, as it meant that economies were neither overheating nor underperforming. Other things, like the level of bank lending, asset prices and balance of payments imbalances didn't really matter. This was central to the neo-Keynesian consensus.

If this was ever valid, it was rendered obsolete by the advance of globalisation in the 1990s and 2000s. Wages became detached from consumer prices. Capital flowed freely between the world's economies. Especially in Europe the movement of labour from one country to another became freer. There were many ways an economy could overheat without consumer price inflation becoming affected. Asset prices (real estate, shares or even bonds) could inflate into bubbles; dangerous levels of unreal assets could build up within the financial system; a destabilising level of migrants could cross borders. All of these things happened in Britain in the run up to 2008, and yet because inflation remained in the Goldilocks position people thought everything was fine, and that all these other things would just sort themselves out. Many still believe this; it is one of the few things that unites all factions of the Labour party, which was in power at the time. Likewise Mr Sandhu persists in suggesting that consumer price inflation was all that central bankers needed to worry about after the crash - and because it has shown no sign of taking off, there has been plenty of scope to pump things up.

Fallacy 3: monetary policy is an effective way of regulating demand

This was another part of the neo-Keynesian consensus. Prior to this the conventional wisdom that fiscal policy (taxes and public spending) was the best way to help a flagging economy or cool an overheating one. But after the failures of the 1970s it was felt that this got too tangled up in politics to be effective, and would lead to an excessively big state. Instead the job could be given to central banks, through changes to interest rates and other things like Quantitative Easing. These things were referred to as monetary policy, conjuring up the quaint image (not discouraged by economists) that it was about the printing of banknotes.

And yet this idea has not stood up to the test of time. Quite apart from the fallacy of using inflation as the main performance indicator, monetary policy affects many other things than consumer demand, and in fact has led to a build up of dangerous levels of private debt. The political pressures to keep interest rates low, especially if inflation is low, quickly become unbearable. And not just political pressures. Increasing interest rates can destabilise the banking system. Such increases may have provoked the pre-crisis in 2007 that in turn led to the main crisis. Monetary policy has no brakes.

Here the left wing critics of economic policy, who think that fiscal policy should do more of the work of regulating demand, are on stronger ground. But would politicians have the guts to tighten fiscal policy when needed? The vehemence of left wing criticism of austerity, and their denial that the pre 2008 economy was overheating, suggest that fiscal policy too lacks effective brakes.

Are we heading for a new crash?

There are some worrying signs, with the build up of private debt, and with reckless fiscal policy in the US. But we are not seeing the same reckless advance of "financial innovation" that proved so devastating ten years ago. Not in the developed world anyway: China looks a bit different, though the awareness of the central authorities there is a strong contrast to the denial of many western leaders before 2007.

But some trouble is surely ahead. Perhaps then economists will start to break out of their bunker and start viewing the world as it really is, instead being a construction of outmoded statistical aggregates.


12 thoughts on “Have economists learnt nothing from the crash? Three fallacies that persist”

  1. If I might risk an amateur comment in what is a highly technical field, one comment on the UK’s weak productivity performance which has rung bells with me recently is that much of the (strong) increase in the UK’s employment over the past decade has been in low wage occupations. It seems to me that the most important industries influencing a country’s productivity are those (in both the goods and service sectors) which (a) enter international trade and (b) have big differences in value added per head between different countries. Without success in these industries a country will, over the longer term, experience a balance of payments deficit followed by a depreciating exchange rate, and a build up of debt due to Government and central bank policies aimed at maintaining full employment. Monetary measures to stimulate demand will tend to result in this debt being in the private section; fiscal policy to stimulate demand will tend to result in the debt being in the public sector. Capital flows can prevent the currency depreciation in the short term but not the longer term. So if we want full employment without incurring debt, better not to incur the balance of payments deficit in the first place!

    1. I think that’s what a lot of people think Hugh. My (minority) take is a bit different. Britain, for whatever reason, has missed the boat on highly productive export industries. But, to mix metaphors, that is water under the bridge. Productivity globally continues to advance in these industries which means that imports are destined to cost less and the problem become more manageable. In due course even high exporters like Germany will face pressure to create “low quality” service jobs. Instead of trying to emulate Germany we should reorient the welfare state, taxes and public services so that people in service jobs have better lives.

    2. “So if we want full employment without incurring debt, better not to incur the balance of payments deficit in the first place!”

      If the pound floats freely there can’t be a BOP deficit. Any deficit in the current account has to be compensated by a surplus in the capital account. Otherwise the pound will change in value to restore the equilibrium.

      So is a deficit in one caused by a surplus in the other? You can’t really say for sure. It could be either. But if overseas ‘investors’ are net buying up UK bonds, property, shares etc there has to to a deficit in the current account. Maybe we shouldn’t let them buy up half of London? I’d say we shouldn’t but that’s just my opinion.

      Another opinion is that the capital inflow is just overseas “investors” putting their money into the “Bank of The United Kingdom” and is nothing to worry about. OK. Maybe not, but why then worry about the mirror image of the capital account surplus? ie The current account deficit.

      1. Regrets, I should have made it clear that by balance of payments deficit I meant a balance of payments deficit on current account (the idea of a balance of payments deficit overall being, I would agree, meaningless). There seems to me good evidence from the Eurozone that countries which lose international competitiveness are liable to be in trouble; thus Italy has lost international competitiveness against Germany (and hence has a relatively low value added per head as compared with Germany); and it is duly in trouble with its debt levels. True, Britain has a floating exchange rate, and so can restore its competitiveness by the currency depreciating. But as we are discovering at the moment, this comes at the cost of stagnant living standards despite the UK economy being at nearly full employment.

        I suppose that areas of British high tech strength such as aerospace and pharmaceuticals are likely to decline over time as the international competition in them becomes greater and production costs decline – so the service sector is certainly not to be neglected, I would agree. One inbuilt advantage is that international traders like British law as a basis for contracts, thus assisting the growth in British legal services of late.

  2. @ Matthew,


    It depends what you mean. If you’re saying that the world can’t cope with everyone growing at 3% you could have a point. If you’re saying that the growth rate couldn’t be 3% given the prevailing neo- Keynesianism ( read NOT Keynesianism IMO) of the time then you’re right too. But if we had better economics we can have the same growth if we are careful with the environmental implications too.


    The problems is that Economists tend to lurch from one extreme to another on fiscal and monetary policy. Yes in the 70s there was a case for saying that there was too much reliance on fiscal policy but that shouldn’t have meant abandoning altogether. It don’t actually think it has been abandoned because it simply can’t be. Anyone running the economy has to at least notice that the fiscal control lever works just like it always did.

    It would have been better to acknowledge that. Instead we’ve had the central bank fighting against Government. The Government has over-tightened fiscal policy and the central bank has tried to keep the economy going by by having monetary policy too loose.

    “The vehemence of left wing criticism of austerity, and their denial that the pre 2008 economy was overheating, suggest that fiscal policy too lacks effective brakes.”

    The pre-2008 economy wasn’t overheating. But there was too much private debt. The BoE was worried about that so put up interest rates. A similar story in the USA. The crash followed. What do you expect?

    If monetary policy was too lax and it was deemed necessary to raise rates then fiscal policy should have been loosened, and not tightened, to prevent a stall. It’s rather like flying an aircraft. There are two way of gaining height. Rely on the ailerons and/or open the throttle. A pilot uses a combination of both. To prevent a stall the throttle has to be opened when the flaps are down.

    I don’t particularly like these kinds of analogies but this might be a useful one.

    1. It depends what you mean. If you’re saying that the world can’t cope with everyone growing at 3% you could have a point. If you’re saying that the growth rate couldn’t be 3% given the prevailing neo- Keynesianism ( read NOT Keynesianism IMO) of the time then you’re right too. But if we had better economics we can have the same growth if we are careful with the environmental implications too.

      Certainly neo-Keynesian (as we have to call it – I think Keynes would be appalled, though I don’t he would be a Keynesian these days either) is played out – though some people whom I respect (like my UCL tutor Wendy Karlin) seem to be saying that the models can be adjusted to fit reality. Personally I don’t think there is any system that will get growth up to 2% sustainably – but that is because GDP is measuring things that don’t matter that much. I think it is perfectly possible to advance human wellbeing in a low growth environment. We could try to monetise this advance in wellbeing, but I’m not sure that is the right way to go.

      The pre-2008 economy wasn’t overheating. But there was too much private debt. The BoE was worried about that so put up interest rates. A similar story in the USA. The crash followed. What do you expect?

      We differ on this (so far as Britain is concerned anyway). I think the asset price bubble and huge level of immigration (to say nothing of balance of payments deficit) point in the direction of overheating. I will accept that this was primarily down to excessive private debt (which in fact is the unifying theme of the article – all three fallacies pointed that way). The problem was, once you had dug that hole, how were you to get out of it? I take your point on the aeroplane analogy. Part of the aim of public policy at the time should have been to shift debt from the private to the public sector – as happened in an uncontrolled way during the crash itself. But I think that required rather more direct intervention in the banking system than spraying income tax cuts on the public at large, which is what Gordon Brown decided to do.

      There is clearly a role for monetary policy, and it should be about a lot more than interest rates. My instinct is that fiscal and monetary policy should usually point the same way – though the aeroplane analogy of creating a more controllable environment by creating a tension between the two is an interesting one. I think that discussion can be translated into one about the virtues of fixed and floating exchange rates – but I have not quite got the headspace to work out which way round it goes! I think it is that balancing fiscal and monetary policy is what fixed (or anyway managed) exchange rates are trying to do.

      1. If you have several interacting economies, it obviously isn’t possible for everyone to fix, or even manage, their exchange rate to suit themselves. Everyone has to agree on a fixed exchange rate system and furthermore agree what the exchange rates should be. This would seem to be unlikely for any length of time. The end result would almost certainly be that everyone will start to fight each other to get what they want.

        Say there were just two interacting economies. A couldn’t manage its currency to be the same as B’s. B might be trying to manage its currency to be 20% less than A’s. Something would have to give.

        The ideal way is for everyone to let their exchange rates freely float and I can’t see why this means that each individual economy can’t manage both their monetary and fiscal policy as they see fit. Sure, if they stuff it up they’ll end up with too much inflation or too much recession.

        As it is we have only a few large scale economies like the USA, the UK, Australia, Canada who genuinely let their currency float. So if everyone else is “managing” theirs downward to help their export industry, it’s really no surprise we end up with a current account deficit. That’s only to be expected and we can’t use that to draw any conclusions on whether or not the economy is overheating.

        1. Well yes there is something in that. At the time both China and the oil-exporting countries were running large surpluses as a matter of policy. Germany was still going through its “internal devaluation” following unification, so wasn’t running such a big surplus as now though. This was in fact a bit of an opportunity for countries like the US and the UK to hitch a free ride on these policies and run a deficit. But even allowing for this I think the pound was running a bit high and so the deficit was higher than it would have been if the government had been a counter-cyclical fiscal policy. But the fact that there is a deficit doesn’t prove very much by itself, I admit. We must also remember that Britain’s oil economy was also quite substantial at the time, and that, given the price of oil, this should have been pushing Britain’s current account in the surplus direction. That would have been one of the things pushing the pound up, of course, there does seem to be something a bit unbalanced about UK economic management at the time.

  3. Does “the asset price bubble and huge level of immigration” indicate we have overheating?

    The levels of net immigration merely show that the UK is relatively more attractive to those who have access than where they were originally. The net figures were pretty much the same for 2007 as 2014. The economy wasn’t in good shape in 2014. But it was worse elsewhere.

    The asset price bubble shows there was too much private sector borrowing. Borrowing is economically neutral, on a microeconomic scale, over the cycle of the borrowing. If I ‘save up’ to buy a car, my consumption initially falls while I’m saving. Then I buy the car and so it jumps up to make up for that. If I borrow to buy the car its the other way around.My consumption peaks early then falls as I have to make repayments. So, leaving aside interest payments and other fees it is the mirror image of the ‘saving up’ route to puchasing the car.

    So if some purchasers choose one and others choose another there is no problem. Or if everyone is borrowing and saving at random times there’s no problem. The problem arises when the Govt deliberately stokes up a credit boom which causes everyone in the economy to do similar things at the same time. Then we have a macroeconomic consideration. The initial splurge of lending causes a boom, and possible asset price bubble, and later on we get the debt deflation as described by Fisher. When we do get the debt deflation we can’t then say “ah- ah I knew the economy was overheating caused by the Govt running a deficit!” 🙂

    This is how so called ‘monetary policy’ should be viewed. All the stuff about quantity of money in the economy is largely nonsense IMO.

    1. Well may be our perspectives differ because I live in London. My memory was that by the early 2000s there were labour shortages everywhere, wages were rising steadily and the only thing keeping inflation in check was cheaper manufactured goods (largely Chinese imports) and an influx of mainly East European labour, conspicuously in the building industry and plumbers, electricians, etc. Even so the prices in many things were rising by about 4% or so (I remember pulling apart the inflation stats as part of my degree course, which started in 2005). And the immigrant surge was historically unprecedented and not matched by our European neighbours to the same extent (partly because they didn’t throw door open so widely). As a good liberal I should say that this surge of immigration was a good thing and made the whole economy stronger. But I think the pace of change was too fast, and we are paying the price. It seems clear to me that without it there would have been inflation or an economic slowdown – which surely amounts to overheating?

      Yes the asset price bubble was down to excessive private borrowing, and I have been careful to say that fiscal policy did not cause the bubble. But having let that situation develop it would have been sensible to dampen things down with taxes a bit, and reduce dependence on taxes like stamp duty and CGT which were being fuelled by the bubble and fell of a cliff when the crash arrived. Once the debt deflation showed signs of materialising, then would have been a good moment to loosen fiscal policy a bit. Better to do that from a stronger fiscal position. In fact Gordon Brown probably had it about right with his Golden Rule. The problem was when he started to fiddle the figures and deny signs that the business cycle was advanced as it was.

      It’s a variation on the Irish travel direction that says “I wouldn’t start from here”. The government was happy to let private borrowing rip, and claim economic growth as being from the steady advance in productivity in a well-functioning economy. They showed scant awareness about the mounting dangers, and made things worse by not tightening fiscal policy after the wobble at the start of the 2000s was over.

      And yes, all the talk of the quantity of money is nonsense. And I wish people wouldn’t talk about “printing money” when they don’t mean it.


    Possibly but my money would be on a long Japanese style period of ultra low growth and higher levels of unemployment and underemployment. For the Remain side it can all be blamed conveniently on Brexit. 🙂

    None of this is inevitable of course. If the aircraft needs to gain height the pilot needs to open the throttle (ie more Govt spending). At the same time the flaps need to go down (ie tighter monetary policy) to push down private debt levels. But then there will be howls of anguish about higher inflation and/or the levels of Govt debt. But there needs to be higher inflation to restore a more sensible ratio between property prices and wage levels. Alternatively we let house prices fall and leave millions in negative equity.

    It almost certainly won’t happen as I would suggest it should and “some trouble is surely ahead.” Probably lots of trouble. It’s not just the UK that is the problem of course. Even if we’re technically out of the EU we’ll likely still be a part of the same trading bloc and we can’t fix their problems as well as our own. There’s Buckley’s chance of their changing their approach any time soon.

    “Perhaps then economists will start to break out of their bunker and start viewing the world as it really is….”

    We can but hope!

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