It is commonplace to suggest that economics, as taught in our schools and universities, badly failed prior to the great financial crisis of 2007/08. But beyond this, things get a lot less clear. People tend to pipe up and attack aspects of the discipline that they have never liked; in the circles I move this tends to be the “neoliberal” ideas of well-functioning markets. This does not seem to be based on any real analysis, though. And universities plough on teaching the same old stuff as if nothing had happened, no doubt because nothing particularly coherent has replaced the old models. It is worth looking at the substance behind the remarkable failure of this discipline, which attracts so much intellectual heft in our era.
The failure of economics, and the imperious discipline of macroeconomics in particular, has been described brilliantly by Adair Turner in a recent lecture. I have already referred to this in an earlier post, but now I have been able to lay my hands on a copy of the text. It’s a challenge to read the 38 pages if you don’t have an academic economics training; but it’s well worth a try if you are not too daunted by this.
My personal perspective comes from the fact that I was a mature student on the BSc undergraduate course in Economics at UCL in the years 2005-08, just as the boom years were coming to an end, and the crisis started to develop, though before the seminal bankruptcy of Lehman Brothers, and the full blown crisis that followed in its wake. We were taught the standard macroeconomic model, referred to as the neo-Keynesian model, which nearly comprised a consensus at the time, although our lecturers were not beyond a little healthy scepticism.
Three related failures stand out. The first was an indifference to the potential macroeconomic impact of finance, and debt in particular. The fact that debt levels were exploding did not affect the models at all. You may think that economists are obsessed with money, but they treat it as a veil, and they try to see through it to a “real” economy of people and things. Finance is just tactics; a means to and which should not bother the imperial-level grand strategists too much. Besides, debt is two sided; for every debtor there is a creditor, and it all cancels out. If Matthew lends Mark £100, who in turn lends it to Luke, who in his turn lends it to John, who actual invests it in something, what has happened? £100 of debt has turned into £300 but there is still only £100 of investment. The bottom line is that Matthew lent £100 and John spent it; Mark and Luke are where they were beforehand. Do the machinations of intermediaries really matter?
This was much too complacent. Suppose Matthew, Mark, Luke and John are financially stretched, and a £100 loss will push them over the edge. If John’s investment fails, and he goes bust; he can’t pay Luke, who can’t pay back Mark, who can’t pay back Matthew. All four go bust, whereas just two would have done if Matthew had lent directly to John. The more overall levels of debt ramp up, the more likely it is that such contagion effects occur. I remember British policymakers expressing disbelief that a little trouble in the U.S. subprime property market could possibly have such a big global impact. And it isn’t just bankruptcy that is the issue; financial difficulties could simply cause a reduction in consumption – which would cause excessive saving in the economy at large, with bad macroeconomic effects, which can be very widespread from a rather small proximate cause.
The second problem was the fact that so little of the borrowing was invested in new investment projects, as theory supposed, with the majority being directed towards buying existing assets, and some to support additional consumption based on increased asset values. Hyman Minsky long ago pointed out that this type of investment simply led to asset price bubbles. And even if it had been directed towards “proper” investment, a similar bubble effect can occur. The latter was a point made by Friedrich Hayek. In spite of these warnings, the possibility of asset price bubbles, and what to do about them, was widely ignored.
The third problem centred on monetary policy. Economists used a theory of money that had scarcely moved on from the use of notes and coins. They assumed that bank money works in an equivalent way; that banks only lend money that has already been deposited, and that the whole money creation process is controlled by the central bank. Over a century ago the Swedish economist, Knut Wicksell pointed out the absurdity of this. Commercial banks effectively have the power to create money out of nowhere. And in any case, it really isn’t possible to distinguish the “transaction money” on which the theory depends, from other sorts of money, for example that being held just for safekeeping. I have frequently blogged about this blindness of conventional economists, shown by their frequent references to non-existent printing presses, and talk of throwing bundles of banknotes out of helicopters. This is almost as nonsensical as a metaphor as it is literally, and shows an utter failure of imagination.
The outcome of these failures was that most economists thought that high levels of debt, and the possibility of asset price bubbles, were just details that should not detain the grand strategist, and that the main thing was for central banks to watch consumer price inflation, while finance ministers should simply keep budget deficits small.
So, as the world’s finance sector boomed, finding ever cleverer ways to hide slimmer margins by increasing leverage, and debt levels exploded in many developed economies, the world’s policymakers looked on without too much concern. Inflation and budget deficits looked fine; everything else would sort itself out in due course. Indeed, since the world economy was delivering steady growth, many thought they had found the answer to life, the world and everything. If it ain’t broke, don’t fix it. And many economists made a fortune from the finance boom. Most of the students on my course chose it as a path to get rich via investment banking or management consultancy.
It is, incidentally, easier to say that economists were wrong, than it is to say that the disaster was their fault. If more economists had piped up to sound warnings, the political pressures to ignore them would have been overwhelming. If they had been heeded, then maybe banking would have been a bit less out of control. But there were other factors driving the instability, including the huge export surpluses of China and oil exporters – which pumped money into the developed world financial system, creating near-on insoluble problems. The situation would have been a bit like global warming – strong awareness from the academic community quite unable to stop overwhelming global political forces and the power of sheer human greed.
Still, the discipline of economics has been left in a sorry state. As Lord Turner points out, in the 1950s they had all the knowledge and insights needed to take it in a less blinkered direction. Wicksell, Hayek and Minsky were all highly respected economists; Maynard Keynes highlighted all the issues lucidly in his General Theory. But instead economists went up a forty year blind alley, becoming more sophisticated with the detail even as the fundamentals became more and more unrealistic. East coast liberals were as badly off track as Chicago supply-siders. It’s no wonder that so many are still in denial and still teaching the discredited models, as if only a few details here and there need to fixed. How can you discard such a huge volume of thinking in one go?
But the economic disaster is too big to be glossed over. Whether or not economic theory has caught up, policymakers understand that the banking system is a major problem, and that you can have too much debt. The last time such a disaster hit economics was in the stagflation era of the 1970s; let’s hope economists’ response to this crisis is more robust than that one!