Wednesday, August 27, 2014
36

Economics in Denial

PARIS – In an exasperated outburst, just before he left the presidency of the European Central Bank, Jean-Claude Trichet complained that, “as a policymaker during the crisis, I found the available [economic and financial] models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.”

Trichet went on to appeal for inspiration from other disciplines – physics, engineering, psychology, and biology – to help explain the phenomena he had experienced. It was a remarkable cry for help, and a serious indictment of the economics profession, not to mention all those extravagantly rewarded finance professors in business schools from Harvard to Hyderabad.

So far, relatively little help has been forthcoming from the engineers and physicists in whom Trichet placed his faith, though there has been some response. Robert May, an eminent climate change expert, has argued that techniques from his discipline may help explain financial-market developments. Epidemiologists have suggested that the study of how infectious diseases are propagated may illuminate the unusual patterns of financial contagion that we have seen in the last five years.

These are fertile fields for future study, but what of the core disciplines of economics and finance themselves? Can nothing be done to make them more useful in explaining the world as it is, rather than as it is assumed to be in their stylized models?

George Soros has put generous funding behind the Institute for New Economic Thinking (INET). The Bank of England has also tried to stimulate fresh ideas. The proceedings of a conference that it organized earlier this year have now been edited under the provocative title What’s the Use of Economics?

Some of the recommendations that emerged from that conference are straightforward and concrete. For example, there should be more teaching of economic history. We all have good reason to be grateful that US Federal Reserve Chairman Ben Bernanke is an expert on the Great Depression and the authorities’ flawed policy responses then, rather than in the finer points of dynamic stochastic general equilibrium theory. As a result, he was ready to adopt unconventional measures when the crisis erupted, and was persuasive in influencing his colleagues.

Many conference participants agreed that the study of economics should be set in a broader political context, with greater emphasis on the role of institutions. Students should also be taught some humility. The models to which they are still exposed have some explanatory value, but within constrained parameters. And painful experience tells us that economic agents may not behave as the models suppose they will.

But it is not clear that a majority of the profession yet accepts even these modest proposals. The so-called “Chicago School” has mounted a robust defense of its rational expectations-based approach, rejecting the notion that a rethink is required. The Nobel laureate economist Robert Lucas has argued that the crisis was not predicted because economic theory predicts that such events cannot be predicted. So all is well.

And there is disturbing evidence that news of the crisis has not yet reached some economics departments. Stephen King, Group Chief Economist of HSBC, notes that when he asks recent university graduates (and HSBC recruits a large number of them) how much time they spent in lectures and seminars on the financial crisis, “most admitted that the subject had not even been raised.” Indeed, according to King, “Young economists arrive in the financial world with little or no knowledge of how the financial system operates.”

I am sure they learn fast at HSBC. (In the future, one assumes, they will learn quickly about money laundering regulations as well.) But it is depressing to hear that many university departments are still in denial. That is not because students lack interest: I teach a course at Sciences Po in Paris on the consequences of the crisis for financial markets, and the demand is overwhelming.

We should not focus attention exclusively on economists, however. Arguably the elements of the conventional intellectual toolkit found most wanting are the capital asset pricing model and its close cousin, the efficient-market hypothesis. Yet their protagonists see no problems to address.

On the contrary, the University of Chicago’s Eugene Fama has described the notion that finance theory was at fault as “a fantasy,” and argues that “financial markets and financial institutions were casualties rather than causes of the recession.” And the efficient-market hypothesis that he championed cannot be blamed, because “most investing is done by active managers who don’t believe that markets are efficient.”

This amounts to what we might call an “irrelevance” defense: Finance theorists cannot be held responsible, since no one in the real world pays attention to them!

Fortunately, others in the profession do aspire to relevance, and they have been chastened by the events of the last five years, when price movements that the models predicted should occur once in a million years were observed several times a week. They are working hard to understand why, and to develop new approaches to measuring and monitoring risk, which is the main current concern of many banks.

These efforts are arguably as important as the specific and detailed regulatory changes about which we hear much more. Our approach to regulation in the past was based on the assumption that financial markets could to a large extent be left to themselves, and that financial institutions and their boards were best placed to control risk and defend their firms.

These assumptions took a hard hit in the crisis, causing an abrupt shift to far more intrusive regulation. Finding a new and stable relationship between the financial authorities and private firms will depend crucially on a reworking of our intellectual models. So the Bank of England is right to issue a call to arms. Economists would be right to heed it.

Read more from our "Dismal Soothsaying" Focal Point.

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  1. Commentedjack belck

    The fundamental problem of Economics as it remains isolated from life and finds refuge and status in elegant statistical models is that it should never have divorced itself from Political Economy. Not only has economics therefore been lobotomized, but the leftover portion of the title, Political, with great nerve and no basis labelled itself Political SCIENCE when it is now nothing more than another faction huddling around the claim of Social Science when only Social Studies would be accurate.

  2. CommentedKuruvilla Abraham

    Please do check at http://mumblingskeptic.blogspot.in/2013/02/normal-0-false-false-false-en-us-x-none.html and comments there under. An attempt has been made to explain the fallacies of financial markets using the laws of classical physics and quantum mechanics. In response it is argued by some that stock markets are modeled, in accordance with the Kelly criteria, as a game of repeated trials. Which in simple terms means that a young child has to repeatedly fall to learn what the safety limits of a garden swing are? Be that as it may, the young child is confident that the physical limits once learned cannot be easily tampered with. He or she and the nannies (market regulators) know in advance what the limits and restrictions are. The same cannot be said of the stock market for any rigging, which is generally transparent to the investor and its pernicious consequences are known to the investor only after the damage is done. What is worse is that the riggers know and they are the consistent gainers on the upside and the down side.

    Further, without any limit to the number of players (investors) in the ring (on the other hand trapeze rings have limits to the number of artists it can hold) and with one ring being linked to another and that to another across the world, across time zones, I wonder if any of them, Kelly, Soros, Bernanke, Hull or White will be able to rationalize and justify the legitimized but specious gambling dens that stock markets are. It is not just the laws of physics or quantum mechanics that do not apply; the guiding principles of ethics also do not seem to apply. And as Raghuram Rajan surmises, at the crunch the nannies and curators (Stock Market watchdogs) are easily distracted by their own chatter.

    It could have been so once, but in an allegedly civilized world 'All' is no longer Fair in Love and War. Going by the legal maxim, hundreds of the criminals may go unpunished but no innocent should be convicted. Considering the futility of war, the argument of sacrificing hundreds of foot soldiers or innocent jihadists for the larger good is no longer acceptable. The right of governments to wantonly take shelter under any eminent domain is being seriously questioned. Thus, theorists and modern day soothsayers need to factor in such maxims and tenets into their mathematical models if they are to be called civilized models and not necessary evils. It is thus not a question of romancing financial markets but that of civilizing them.

  3. Commentedniels kristian schmidt

    For macro economists to learn more, they must study micro economic actions in detail - ie, they must understand human feelings/incentives, reasoning and actions.

    Macro economics (ME) is an analysis of aggregated micro data. ME is detached from causality because that lies at the micro level. Using ME to make so-called macro economic policy, is like arranging more traffic accidents because growth correlates with transportation activity.

    Mainstream macro economics seems detached from incentives, personal reasoning and justice. They talk about aggregate demand and supply. But they have little clue what they are aggregating, nor what makes people demand and supply very specific goods and services at the micro level.

    The fabric of society can erode and macro economists would have no answer except 'stimulate', 'print', lower the interest rate, subsidize, tax and increase redistribution. They use a sledge hammer to repair a watch, instead of leaving it to the watch maker and his customer to decide what to do, at what price with what kind of money over how much time.

    Macro economists are political advisers and they are not popular with their piers if they say, it is better not to make some kind of high profile political intervention that brake all the clocks in the watch makers shop.

    Making IS-LM models is useless if you do not even understand what money is, where credit comes from or what happens at the micro level.

  4. Portrait of Sin-ming Shaw

    CommentedSin-ming Shaw

    Jean-Claude Tricket's complaint was odd. When he raised interest rates while European economies were tanking, the inevitable happened. They tanked more. He falsely believed he was fighting inflation when there was none. Instead of admitting his mistake (at least to himself privately) he claimed economic theories had failed him! But anyone who knows Eco 101 should know he was depressing aggregate demand that would result in slump which is where Eurozone is today.

  5. CommentedGerald Silverberg

    Most of the shortcomings of mainstream (rational expectations, general equilibrium) theory have been known for years: equilibrium rather than dynamics; lack of agent interaction (representative agent and perfect competition); perfect, self-consistent behavior rather than procedural ("bounded") rationality that is additionally heterogeneous and endogenous; unique stable equilibria vs. combinations of negative and positive feedbacks resulting in multiequilibria and more complex dynamic behaviors. Just go back to the work of Simon, Nelson and Winter, Day, the Santa Fe Institute, etc., now known as complexity theory and evolutionary economics.

    The inability of mainstream economics to exit from its Ptolemaic theoretical bubble is an example of an extreme intellectual schizophrenia. Eugene Fama is a prime case. His intellectual mentor Benoit Mandelbrot showed back in 1962 (!) that the large jumps in asset prices that should only occur once every million years according to the efficient markets hypothesis are in fact quite frequent (technically know as fat-tailed distributions). Yet like the Pope, Fama still refuses to look through Galileo's/Mandelbrot's telescope and accept the consequences for the efficient markets hypothesis, capital-asset pricing models, Black-Scholes, etc .

    This lock-in to the standard paradigm is more a matter of the sociology of US graduate education in economics than intellectual rigor or lack of empirical research. Perhaps we should simply abolish existing graduate departments and start over? Replace the DSGE's, EMH's and Real Business Cycles's ever more elaborate epicycles with Kepler's vastly simpler and elegant ellipses?

  6. CommentedAndrey Shvets

    Hello
    Intellectual new model and a new theory of value: http://andreyshvets100.blogspot.com/2012/08/i-know-how-to-stop-global-crisis.html

  7. CommentedGilles Raveaud

    Thank you very much for this brilliant piece. Could you please tell us how to have access to the BOE conference "What's the use of economics?".

    It does not appear on the BOE's webpage: http://www.bankofengland.co.uk/publications/Pages/events/default.aspx

    Thanks in advance.

  8. CommentedYoshimichi Moriyama

    As many commentators have already suggested explicitly or implicitly, economics as we have it today will benifit far more from studying history and sociology than from seeking inspiration from other diciplines such as physics, engineering, climate change and the like.

  9. CommentedApicelleria Filomato

    Monsieur Davies,

    Sans aucune précaution oratoire, je dénonce dans votre texte la pire et la plus dangereuse tartufferie intellectuelle qui effectivement pointe actuellement.

    Première (fausse) affirmation : les modèles de la théorie économique et financière auraient failli ce qui expliquerait en elles-mêmes les crises financières et bancaires que nous connaissons à répétition depuis bientôt cinq ans.
    Et en particulier les modèles d’évaluation des actifs financiers dont le postulat est celui de l’efficience des marchés … que les praticiens et certains enseignants visiblement se sont empressés d’ignorer. Il n’est pire sourd que celui qui ne veut pas entendre … et quand en plus il est de mauvaise foi … que n’a-t-on vu ces « vulgarisateurs en séminaires » (comme des pommes de terre en robe des champs) ânonner leurs formules avant de partir en gerbes d’étincelles sur des extrapolations que leurs ouailles n’étaient pas en mesure de comprendre ?
    Ils ont improvisé : en pensant faire du free-jazz, ils n’ont fait que de l’air-guitar, remué beaucoup d’air et bonimenté en jargonnant comme les médecins de Molière. Ce qui est plus grave c’est qu’ils ont donné leur imprimatur d’expert (parfois sous l’égide de leurs titres universitaires) aux pires élucubrations des « créateurs de valeur » … tout le monde connaît le résultat et personne ne peut plus le nier. Alors avec le même culot, les mêmes artistes braient aujourd’hui que la faute en incombe aux modèles ? Ah bon ? Aux modèles ou à ceux qui n’ont pas su les lire, les interpréter et ont dit et laissé faire n’importe quoi ?

    Corollaire (faux) à cette première (fausse) affirmation : la science économique est au mieux une fumisterie et doit être abandonnée au profit de n’importe quelle autre science qui fera tout aussi bien l’affaire. D’ailleurs ces sciences ont aussi des modèles (chic, chic …à que les mêmes bateleurs pourront appliquer à la diable une nouvelle fois … mais ils s’en fichent ! Ils vont pouvoir changer de registre et tarifer à nouveau au prix fort leurs brillants exposés.

    Deuxième(fausse) affirmation : puisque les modèles ont failli, la responsabilité de la crise est à rechercher auprès de ces auteurs arrogants desdits modèles qui ont eu l’impudence de se tromper et de refuser de porter le chapeau : bien sûr puisqu’ils sont dans le déni !
    Nos experts et consultants en économie nous avaient pourtant prévu : ils vont se lancer sur les grand’routes des autres sciences : ah, ici le déni ! Un joli concept de la psychanalyse qu’ils vont pouvoir torturer à loisir. Il faudrait arrêter d’enseigner aux étudiants les thèses défaillantes mais au contraire créer des chaires apocalyptiques de dénonciation des modèles erronés (il s’en crée bon nombre actuellement effectivement). Et pourquoi pas un service de l’Inquisition financière ? Pourquoi pas des autocritiques en public ? Pourquoi pas des anathèmes ou mieux des autodafé sur les campus ? De toute façon, on vous le dit, ces étudiants sont nuls et n’ont pas le niveau.

    Non, vraiment, il ne leur faut pas manquer d’air pour que les grands prêtres d’une croyance hier dévoyée s’érigent aujourd’hui en chantres d’une pensée magique, avançant par analogie et approximations, et préparant son climax dans des tribunaux populaires ?
    Appel aux armes ? Contre qui ? Pourquoi ?
    Non, décidément c’est trop facile. Que les économistes continuent à faire de l’économie, de la théorie et qu’ils laissent la pratique aux praticiens : on ne peut être aussi outrageusement juge et partie et surtout son propre juge après avoir perdu la partie !

  10. CommentedPierre ratcliffe

    I think we should visit or revisit Hayek's "individualism and economic order" and Albert Schatz's "l'individualisme économique et social". In their references both authors refer to the great authors of the past that forged many of the ideas of today; from these, ideas relevant to the present situation may emerge in continuation. Links are here:

    Hayek: http://safe.mn/5oDX

    Schatz: http://files.libertyfund.org/files/1069/0589_Bk.pdf

    Schatz: l'individualisme économique et social:
    http://files.libertyfund.org/files/1069/0589_Bk.pdf


    Both refer to authors of the past that have contributed to our ideas of today and to those can emerge in continuation...
    This has been enlightening for me.

  11. CommentedNicklas Sundström

    My own experiance is that many economists are masters of calculation, but often fail spectacular in understanding the underlying assumption that form the basis for the mathematics they use.

    Theoretical physicist in turn, understand the mathematics intimatly, but often fail to grasp the properties of the economic reality that differs radically from the neat realiable predictable uncertainty of quantum mechanics and gravity.

    And both seems to fail miserably to fully account for the fundamental biology of human nature, and the consequences this have on the theories and mathematical models they use.

    So maybe required studies in biology, biochemistry, evolution, cognitive psychology could be worthwhile for budding new economists? Together with the growing fields of behavioural economics and complexity theory.

    But an important first step could very well be to fully embrace the idea that human beeings are not born as blank slates, and begin to really strive to take into account the many human quirks and universals we now have very strong evidence for to exist.

      CommentedHarold Lloyd

      There is no doubt that the standard economic theory of human psychology is crude, even laughable. So much so that the real surprise is that it turns out to be as useful as it is! Maximising convex "utility functions" is not much to go on.

      So behavioural economics and the like are welcome developments. My own judgment is that, so far, it has not amounted to very much--certainly not the revolution some had hoped for. Still, it is early days and the live policy experiments implemented by the Obama administration should provide good grist for the analytical mill.

      From the point of view of Davies' column, I would say the most interesting areas of application would be in the investgation of organizations (How do banks work so that, collectively, highly skillied and talented people drive the bank off a cliiff? How can incentives or organizations be changed to stop this? How do supervisory institution managers convince themselves that, aginst all evidence, that things are fine, and how can their incentives be changed?), and how psychology affects or causes financial market bubbles.

  12. CommentedHarold Lloyd

    It is of course understandable that everyone is taking the opportunity of the greates economic crisis in 80 years to pile onto economics and economists. Still, the tone of Davies' effort is surprising, coming as it does from the former head of the FSA, an organization that more than most must shoulder the blame for the financial meltdown that triggered it. I would have expected something more along the lines of confession and abject apology for such now-infamous policies as "light-touch" banking supervision.

    As to the substance, three points. First, forecasting, and especially forecasting very unusual events, is very difficult--maybe impossible. As economists, or climate scientists (about, say, hurricanes), or geologists (about, say, earthquakes), or engineers (about, say, collapsing bridges). Of course, all these disciplines should try harder. But I, for one, am not holding my breath for significant improvements.

    Second, contrary to what Davies seems to believe, lots of people (even many economists) were increasingly worried about the debt and housing bubbles that built up on the 2000s. Many warned that US house prices were likely to fall. many warned of the weakness of mortgage underwriting. Many warned of rising household debt. Most, it is true, did not predict the greatest recession since 1929. And I suspect that most of those that did were more lucky, or just naturally pessimistic, than smart. Unfortunately, the policy-making apparatus, especially in the US but also in the UK (remember the light touch?), had been captured by those who thought markets could do no wrong, and who therefore chose to do nothing.

    Third, the policy response--which I think was the best that could be done once the crisis took hold--was textbook, mainstream macro. Basically, monetary and fiscal stimulus to raise demand, and support for the financial sector. 1929 did not happen. Not all policymakers were fully on board, mind you. Trichet, a holdover from the old regime, resisted both as much as he could, even disastrously raising interest rates at one point. King was also slow to pull the trigger. Now, they complain that they received no "help". In fact, the help was in front of their noses, but they need an excuse to explain away their bungling.

    Finally let me say that Davies is right. Economists have been faced with a near-unprecedented situation, and it should take it as an opportunity to learn and to expand their knowledge. How economics will move forward is anyone's guess. Appeal to hoary and discredited theories is a waste of time (Marxists and Austrian theorists, this means you). Obvious candidates: how financial amd real markets interact (the IS-LM model has a bit of this, but surely there is more); how stocks and flows interact (ditto); how generalized excess demand comes about; multiple equilibria (that is, non-linear economics).


    Third, on the policy front, standard macroeconomic principles

      CommentedGary Marshall

      Hello Harold,

      The lax lending mechanisms at banks wherein large numbers of unworthy customers were given the funds to buy homes were forced upon those banks by our dear governments alleging all sorts of racism, sexism, and incomism. Hey, its the Fannie Maes and Freddie Macs that hold most of the mortgages in the country.

      From what I do recall of government, it is these institutions that fail time and again to live within a budget. Yet they never fail to point their sordid and corrupt fingers at everyone else for financial blemishes and misdeeds.

      The banks took a severe financial hit. But our dear governments have not learned a thing and now continue on their merry way, borrowing and expending without purpose or reason, which is I believe what got the banks and their borrowers into trouble in the first place. And these policies, our economists, always inclined to support such absurd and inestimably stupid policies, applaud. And I believe you do as well.

      When governments and national economies collapse, give yourself a pat on the back for seeing everything and understanding nothing, just like all the others.

      GM

      Commentedjimmy rousseau

      truthfully, in 4-5 paragraphs this is a sidebar comment more worth reading than the article. Thank You Sir that was refreshing

  13. CommentedGeorge Hariton

    Perhaps one of the flaws is less with the structure of the models and more with the stochastic specifications used to give the models empirical content. Most of the models I have seen are fed shocks that follow a gaussian distribution. But we have known for half a century now (John Tukey, Benoit Mandelbrot) that real-life economic and financial shocks are fat-tailed. Extreme events will occur far more frequemtly than a gaussian distribution will predict.

    The primary problem in my view is not that economic models are flawed (although that too) but rather that the average economist has a rather poor mastery of statistics. That leads to serious underestimation of volatility and to parameter estimates that are very unstable.

  14. CommentedEustaquio Vera

    Concepts that might be taken into account when analysing current World Economics.
    UNSTABLE EQUILLIBRIUM Many usual assumptions are based on systems returning to equillibrium but I believe there are some unstable equillibrium (plural).
    China´s stockpiling of foreign currency.
    Credibility of the US´s and worse Europe´s currencies as value storage means.
    From psicology: It is rational to be a consumist when the World might go to hell (Climate Change) AND when there is less spiritual credibility and greater dependence on the governments because of inequality, partially due to Globalization.

      CommentedEustaquio Vera

      Of Course, self interest of financial agents is already recognized. They invent the "sure" thing like derivatives, and then run it and profit.
      Most also accept very high valuations of stock, that allow them to trade, but basically sell them to irrational investors.
      POLITICS: We know it is very hard and inconvenient to act like a pessimist when you are in government. Save for the future? (It will be a opposition party spending what we save, so let´s SPEND IT ALL)

  15. CommentedSonam Agrawal

    Half way through the article, I lost patience. It pains to know that people such as the author are themselves in denial while they continue to blame others. The Austrian school of economics perfectly explains the phenomenon, but people are hell bent on propagating the Keynesian belief system, which they least understand. People like Ron Paul and Peter Schiff have repeatedly predicted it and stand vindicated, yet most economists continue to be in denial. New thinking should always continue, but why do you ignore the wisdom of the past. This is intellectual dishonesty and utter nonsense.

  16. CommentedRay DAMANI

    " ... we felt abandoned by conventional tools.”

    How strange. Happens to everybody eventually if they spend more than they earn, and can't pay back what they owe!

    The model is quite simple really. It is the operators that are the problem.

    Not much seems to have been learned, so far. Many still want to create money out of thin air and pretend they can keep spending. For "growth" - naturally, whatever that means when one is not paying their bills!

      CommentedDavid Joseph Deutch

      The problem, as this article suggests, is the dogmatic adherence to models. Economics must realise that it is a social science and that attempts to mathematize it, while useful for analytical purposes, do not mean that it is a definitively stable area of study governed by mechanistic rules.

      The discipline must be self-reflexive regarding its desire to describe human behaviour in a such a way as humans are inherently un-mechanistic.

  17. CommentedPaul Doherty

    Trichet should have sought the advice of economists in the Modern Money Theory camp. By taking the unusual (for economists) step of actually including money and banks in their models, they predicted this crisis. They also have the remedies to end the entirely unnecessary recession in the real economy which has followed the shenanigans in the finance sector.

    He should have read Warren Mosler's "Seven Deadly Innocent Frauds of Economic Policy" (free online) - a fascinating layman's introduction. Then he could have listened to Wynne Godley, James Galbraith, Mosler, Randall Wray, Bill Mitchell, et al.

    (Also, for many years Steve Keen has been producing non-equilibrium Minsky models using engineering system-dynamics techniques.)

    Remember folks :

    decreasing government debt = decreasing private savings!







      CommentedGary Marshall

      Hello Paul,

      That is somewhat true. The real explanation is a little more lengthy.

      Taxes > gov. expenditures = decreasing private savings

      But a government will usually just increase expenditures to match the largesse.

      Taxes < gov. expenditures = increasing private savings

      Government will borrow the deficit or raise taxes.

      But what is the value of the government expenditures? Usually, they have little value in that they merely transfer the plundered wealth of one to the eager hands of another for work of dubious value.

      In debt to GDP ratios, why pay down government debt with increased revenues from taxation. Just cut taxes, the economy will grow all that more, and the stable debt to increasing GDP ratio will fall.

      And if gov. debt rises by a percentage inferior to that of a rising GDP or national wealth, then all are enriched.

      GM

  18. CommentedJeffrey Rous

    Microeconomics is easy. We look at individual markets or policies in isolation (ceteris paribus) and much of the time these markets behave the way the models say they will. Macroeconomics is hard (I sometimes refer to it as fiction) because the world economy is a chaotic system where billions of actors and institutions are anything but ceteris paribus and a butterfly can flap its wings and create problems.

    Perhaps Tolstoy can offer a summery: "Happy families are all alike; every unhappy family is unhappy in its own way." Understanding small changes in the economic performance of a healthy economy is what economic models are (relatively) good at. Since collapse can come from one of 1,000 sources, predicting it is difficult. But that gets me back to micro. Almost all of the issues that led to the collapse were micro issues. That mortgage brokers could create mortgages designed to fail because they got their commission no matter the outcome is a micro incentive problem. That investment bankers didn't case about the quality of debt because they got their cut no matter how investors fared later is a micro problem. That ratings agencies blindly rated junk as AAA because they would loose market share if they rated things appropriately is a micro problem. Now, that Greenspan ignored all the warning of a housing/debt bubble because his Randian view of economics led him to take it as an article of religious faith that free markets never fail is an ideological failure. That is,he ignored signs of micro failures.

    I taught for years in my Urban Economics class that a housing price growth curve steeper than the income growth curve is not sustainable. Sadly, unlike the subjects of "The Big Short" I had no idea how to make billions from this.

    So here is the crux. The macro models assume that the world economy has enough if its micro ducks in a row so that nothing gets too out of whack. That is probably the best we can do on the macro side. What we need to do is ensure that our micro policies are are good as they can be.

  19. CommentedMatt Russo

    @mark pitts:

    And the other ~4 billion? How are they making out under capitalism? Don't see how 25% makes a viable political base of support for capitalism over the long run.

    And what of the ~1 billion in the "advanced" countries, whose real incomes have been stagnant or declining since the 1970s, and have been in absolute decline since 2000? Doesn't that suggest that when a country reaches a certain level of development, capitalism outlives its usefulness? That sticking with it causes development to stall and stagnate?

    Wasn't that Karl Marx's essential point?

    As for mainstream economics, when it is not silent it claims that certain things are simply "unknowable". This is theology, not science. It is a confession of failure.

      CommentedMark Pitts

      Even a brief reading of history shows that neither capitalism nor socialism has helped everyone on the planet.

      However, starting about 30 years ago as developing countries abandoned socialism there has been an unprecedented creation of a prosperous middle class where almost all had been poor before.

      Consider the cases of China, Eastern Europe, India and nations of the former Soviet Union.

      No system is perfect, far from it, but let’s continue to do what works.

  20. CommentedWilliam Osterberg

    If you want to understand 'the failure of economics' you need to understand how economic insights are used (or ignored) in the world outside academia. It should not be a surprise to anyone that those who identified a bubble were ignored; it was in the self-interest of the financial institutions and their regulators to ignore such voices.
    Mr. Davies appears to want the economic profession to serve the greater good rather than to provide rationalizations for the actions of the powerful. While I am all for that, it is not clear to me who is going to pay for it. At least in the U.S. it is my understanding that funding for education is more driven by the needs of the private sector, not less. Social sciences are being cut not boosted. The problem is deeper than he acknowledges.

  21. Commentedpieter jongejan

    I agree that we need a greater emphasis on the role of institutions. The most powerful of all institutions are central banks. They have succeeded in overloading Western economies with debt by keeping real interest rates at a relatively low level. They refused to raise real interest rates when prices at stock markets went through the roof in the 1990s. After the dotcom crisis of 2000 they held real interest rates at an artificial low level for far too long; this resulted in a real estate boom that started to burst in 2007 and was followed by the credit crisis of 2008. Five years after 2007 real interest rates are still almost zero in the USA, the UK, Japan and Northern Europe. The big difference between the 1930s and the 2010s is that real interest rates were too high in the 1930s (due to the gold standard) and too low in the 2010s (due to the cheap money policy of central banks in present day's fiat system).
    Cheap money has resulted in lower profits, lower savings, lower investments and higher debts. So the question should not be what is the use of economics, but what is the use of central banks. Central banks have become cartel leaders by keeping real interest rates at an unhealthy low level for far too long. They do this in order to rescue criminal banks and criminal governments from bankruptcy. In this way they have become criminals too.

  22. CommentedMark Pitts

    As long as human beings think and learn, financial markets will be chaotic and highly unpredictable.
    Here’s why:

    If we succeed in creating the perfect theory to explain the recent financial crisis, people will read that theory and incorporate it into their thinking and financial decisions. Their actions will create new feedback mechanisms based on the theory itself - mechanisms not accounted for in the theory.

    So, the new feedback created by the new theory will lead to chaotic outcomes not predicted by the new theory – and we are back where we started.

  23. Commentedjames durante

    Mainstream economics of whatever stripe takes capitalism as a given. Capitalism is held up as a natural phenomenon like the weather or the solar system. Then they attempt to model the functioning of this allegedly natural phenomenon.

    But capitalism is no more "natural" than feudalism or the classical Greek or Roman Imperial systems. Economics is a subset of politics. The kind of economic system under which one must live, its basic purpose and functioning, is dependent on the political will of a particular group in society. Capitalism, like the previous systems, is designed to benefit a particular class of individuals, namely those who own and manage the fields and factories and services.

    Under capitalism, the basic purpose of the state is to enforce laws that transfer wealth created by labor to owners and managers. Financial crises occur when this wealth transfer process becomes so severe that workers are no longer able to purchase the commodities and services that they themselves create. Wages are driven down, and income and wealth become so unequally distributed that there is insufficient demand to sustain economic growth.

    The twist in this most recent crisis of capitalism involved a variety of complex, real-estate related derivatives (on the side of the ownership class) coupled with increasingly debt-laden middle and working class individuals and families (on the working class side). "Naturally," when the inevitable crisis occurred, the state (ally of the dominant class) bailed out the ownership class and has devised endless variations of austerity for the class that actually creates the valued goods.

    A certain German born economist who worked all his life in England laid all this out in plain language for anyone who wanted to to see it. But power and greed are powerful and sufficient to blur most anyone's vision. Where he erred was in assuming that technological changes and economic laws would drive a historical transition. No, politics is the master of history. Today there is an incipient political clash between an increasingly corrupt and venal ownership class (represented in the schools by an army of economists) and working class that is beginning to realize how extravagantly the cards are stacked against them. Let a few major Spanish or Italian banks fail, let the house of finance cards start to crash and this political clash will become decisive. At that point the various dogs of the state--the police and paramilitary forces--along with a paranoid, neo-fascist right wing of society will join the fray. At that point the dictum that "the future is unwritten" will become a living, breathing historical reality. And then the dice will be rolled again and the possibility of real freedom and equality will resent itself.

      CommentedGary Marshall

      Very good, Mark.

      Serfdom predominated because there was little money around save precious metals that could not be mined in any great quantity to transform a barter economy into one with banking and finance as its core.

      Along comes a printing press as well as currency and money derived from precious metals. Voila, one is able to borrow with ease.

      GM

      CommentedMark Pitts

      Throughout history the vast majority of people were poor. In other words, virtually everyone was poor “in the first place.”

      It was not until effective pooling of financial resources (via capitalism) starting in the late 19th century, that any society on earth saw a significant number of its citizens escape poverty.

      Advanced economies got the resources, human and natural, to advance through investing and saving – and that is done most effectively in capitalist societies.

      CommentedRay DAMANI

      Mark Pitts, have you ever wondered how and why the billions who have escaped poverty were poor in the first place?

      You can say they were "socialists" - but where and how did the "advanced economies" get the resources, human and natural, to advance in the first place?

      CommentedMark Pitts

      In the last 30 years almost a Billion people in the third world have escaped poverty and entered the middle class. Virtually all of them live in countries recently converted to capitalism.

      Historically, capitalism as practiced in advanced economies is the only system that has allowed majority of the citizens to escape poverty.

  24. CommentedManfred Dix

    I find this article astounding, especially coming from an ex-Director of the London School of Economics. Evidently, this gentleman never picked up a decent book on Economic Theory. Makes me wonder what he teaches in Paris, to his unsuspecting students. Davies makes no effort to explain the financial crisis, just badmouths people who made huge contributions to Econ and Finance; contributions that Mr. Davies does not come even close by a long shot of having made.
    Mr. Davies says nothing about the institutional framework in the US, the prevalent laws, Fannie and Freddie and their implicit government guarantee, the loose monetary policy of the early 2000s, etc etc all of which made the crisis possible. In other words, the story is much, much more complicated than Mr. Davies presents it. He being a former Director of the LSE should be able to do much better, especially if he teaches this stuff in Paris, but does not.
    Yes, Mr. Davies, there were people telling policymakers that the financial markets were heading to a crisis (Raghuram Rajan comes to mind). And yes, they were using conventional Economics models, those that are in the journals and textbooks.
    In summary, I expect much better from a former Director of the LSE; but who knows, maybe it is a sign of how Economics is unfortunately taught in the UK right now.

  25. CommentedStephen Stanley

    As an engineer, if I used models that resulted in weekly failure modes that should, according to the models, happen once in a million years, I'd likely be fired. On the other hand, if I had a hundred monkeys flipping coins, I guarantee one of them would handicap the next six presidential elections. A science whose models are that inaccurate is not a science. Economics as currently promulgated more closely resembles philosophy, it creates great models and tests the models rigorously, unfortunately, the models, while rigorous and ingenious, do not model reality.

      CommentedMark Pitts

      The author is apparently using a hyperbole when he says the financial crisis was a one in a million event according to the models. Most financial professions would decribe it as something more like a once in a hundred year event.

      Models of human behavior will never be as accurate as engineering models. Humans adapt, often as a result of the model itself; materials do not.

  26. CommentedStéphane Genilloud

    Neo-classical theories, those of Lucas and the Chicago School, predict that crises can't happen. You have to seriously depart from the model (introduce various market distortions) in order to generate cycles. And even so, free-market would be supposed to promptly restore equilibrium.
    This is why neo-classical theories may be of some interest, but they are not fully relevant. It becomes more and more obvious that the most influential proponents of neo-classical theories are driven by ideology, as shown by the controversial support statement of 5 Nobel Laureates (including Lucas) to Mitt Romney.
    Economists with a more balanced ideological approach need to remain aware of that. In this respect, thank you for that most useful article.

      CommentedGary Marshall

      Hello Alan,

      Well, the hardworking people that are genuinely wealthy and smart are the ones that repeatedly risk their own money successfully. That is they produce something of value that people eagerly wish to buy.

      Its when governments think they can duplicate this effort by stripping the people of their hard earned money, "investing" it in all sorts of supposedly beneficial public projects like worthless alternative energies s wind and solar power, driving the impoverished to greater anguish and moving the middle class into the lower class.

      Now you say that the financial problems of 2008 resulted from the follies in private markets. There is truth in that. However, the problem was by no means solely a private affair. Governments are everywhere increasing their share of the economies of the world. You can see their ridiculous policies at work in mortgage lending markets for many decades now. You can see them at work in the oil fields and in the energy business. You can see them at work in the crony capitalism so prevalent in the US and far worse elsewhere. You can see it in the corruption of our levers and administrators of government.

      These fatuous public policies designed to take money from the hands that ably earned it and place it in those that will do the government's bidding without reason or benefit are the great threat to the world and its people.

      If you don't believe me, then ask Europe! Is Apple rendering all these Europeans serfs? Is it Greek shop owners that force Greece into bankruptcy?

      And what does economics and economists have to add about the perils of big, rotten government? Government can increase the wealth of the land by spending without sense or reason! And what has all this exorbitant government involvement in the economy brought Europe, Spain, Japan, or the US, now India and China?

      Who's in denial?

      Having money doesn't imply genius. But for one to claim genius in monetary and financial prognostication, I would expect wealth as a proof.


      GM

      CommentedAlan Luchetti

      A note for Gary. "If you're so smart, why aren't you rich?" has no application to all the useful members of a grossly unequal society who make it function but can't spare extra dollars on the rigged casino that is today's caricature of capitalism, or who have surplus to invest but whose spare moments are not monopolised by strategies for financial aggrandisement. Some of the people Howard mentions would say that such people are not rational actors but for their insistence that an economics that is only about rational actors is not fantasy.

      Howard's point is that there are too many people who should be asked "If you're so rich why aren't you smart"; certainly the prominent dummies he names.

      A more general point about all the reflexive anti-government guff in these comments. The 2008 crisis was caused by private debt, not public debt. The only reason a country like Spain went into debt post-crisis was because its private tax base collapsed, its social security commitments to the newly unemployed skyrocketed and it bailed out the very private institutions that caused the crisis.

      CommentedGary Marshall

      Hello Stephane,

      I am glad that the rest would never betray a partiality to any economic beliefs like big and squandering government, for instance.

      There is no need for such contemptible bias when economics is in such a golden scientific state. Is there?

      GM

  27. CommentedProcyon Mukherjee

    Economic models and the theories, vindicated by experiments and coupled with support from the mathematical and other cognitive sciences, behavioral and psychological included, had done a world of good to make better understanding of markets and market participants possible; the two theories pointed in this article as Capital asset pricing and efficient market hypothesis have served to expand the use of capital on one hand bringing prosperity to more than one generation of people and widened the belief on the resilience and efficacy of markets to self-correct and self-regulate if some of the regulatory framework is allowed to function that does not limit competition or allows too much freedom or too less. Thus it is not models, theories, and the subject itself, together with the profession, that should be taken to task.

    The larger focus must be shifted in understanding how the incentives for doing business do not work at cross purpose for greater good to happen to the society at large and how these two objective functions could be brought within the ambit of equity and fairness, that allows sustainable progress to be made, not only for now, but for the longer term. The rising power of finance and financial markets should be able to widen the means through which greater prosperity for the larger society could be achieved. This makes Economics, one of the most challenging subjects of our times and the most interesting one.

    Innovation or rather the lack of it, too much capital following too few goods, demographics, rational inattention and ignorance to conditions of downside, while expecting too much from upsides, risk aversion to losses, while expanding pool risk, all play a role to influence any model. The effect of so many variables and the rising number of variables (together with their complex interactions) given the explosion in information network does not make the puzzle any simple.

    Procyon Mukherjee

  28. CommentedKarlheinz Ramm

    To my own limited knowledge of economics it sounds ridiculous that economists claim they can't understand or foresee such a crisis. Just remember the austrians or Minsky. History is full of them. The only thing that's surprising is that anyone is surprised at all.

    But maybe the issue they are after is less a desire for understanding but a recipe to manipulate societies to eternal prosperity or whatever the government or their paymasters deem appropriate.

  29. CommentedAlexandros Liakopoulos

    I would very much agree with Mr Davies and his analysis - and I do agree for whatsoever that economics need to step out from their "Operational Manual Approach" and their Dogmatic Nature, under which their "believers", "followers", "zealots" and "fighters of the cause" tend to be trained to handle the questions involved - if only I could oversee the very fact that currently we are not in an Era of Normal Politics (Economics is part of Politics, even if nowadays the situation seems to be reversed so that Politics become part of Economics). As Trichet puts it in an article the other day, here on this site, we live in an era of "politics with other means", we - in other words - live in an Era of War, where "crisis" is just an "operation" for those who control the financial means and the Institutional Power that would allow them to capitalize other people's losses in terms of economic and political power allocations, as their own profits. Mr Davies states out the very obvious for any scientist of International Politics, Economic History and/or Diplomatic History Faculty or Department: Theories and Ideologies, no matter how "stiff" they tend to appear and no matter the aims they try to fulfill, can never deliver their desired results if they are not willing to incorporate to their basic doctrines the human factor and its irrational behavior which tends to move in parallel with social and personal uncertainty.
    Throughout the centuries, from Ancient Greek Heraklitus who defined war as the continuation of politics with other means, till nowadays, all scholars have always defined war as a political instrument seeking to maximize one's territory, assets and populations, with means and instruments that only get the "physical form" of military power when all other have failed: therefor war is a clear manifestation of power allocations and can be delivered with a variety of "tools", with military imposition standing as the "last resort of the means". International Politics from the time of Bertrand Russell, differentiates the three dynamic manifestations of Power and adopted them as a main point of reference: the Power is divided to the Economic Power, Power to form (your constituency's or other people's constituencies') the Public Opinion and the Military Power.
    So, while Economic Power of certain groups (see: "banksters", "gunsters" and "poisson masters") got completely out of proportion, scale and reach; while in the same time the very same people or their friends ("World Media Emperors") maximized their Power to form the World Public Opinion towards promoting and defending their own agenda (which lack public support and democratic legitimization) of a New World "Corporatocracy" (as defined by prof. Sachs); and after a Bush Jr decade which transmitted to the world financial sector a world crisis that can fit in the Milton Friedman's Doctrinal Advice of "crisis exploitation towards the creation of a neoliberal world", I think that the best way Economists could serve the public nowadays is by stating out, loud and clear, that there is a world war "with other means" going on. Economists should - at last! - recognize the very fact there is a "counter-revolution of the 1%" is in operational deployment and that all economic "decisions" the world political and economic leaders need to adopt in order to deliver a positive service to their public - at least if we all agree that peace, prosperity and sustainable development is of major importance than financial gains of specific groupings - is in completely different direction from the one which is being imposed to all governments unwilling or unable to defend themselves from the "banksters' hits", from those same banksters who deliver the hits!
    Politicians should be re-invited to step in World Politics exactly as Obama did. Given that economists for quite five decades (exactly after Keynnes) were mainly advising politicians to step out from economic decisions and leave the "open market" regulate itself, - which mainly took us at the cliffs we stand today, at the very edge I would say - acknowledging the mistakes of the past would be a first step towards becoming relevant to the problem, helpful to the solutions and inspiring as a scientific faculty of human interactions with much to offer, rather than much to gain...
    Cause, despite what one thinks of politicians and economists nowadays and whether they manage to do profit or not due to the crisis (we should all bear in mind that some people's losses are other people's gains, even when infrastructure and concrete financial means geet destroyed - this is just an "investment" as far as it delivers maximized results in the future), which mainly depends on the interests each one defends and the capacities he maintain to defend and promote them, if we all, as people of the world and International Community do not learn from the lessons of the past - as the article here clearly proposes - we will not manage to avoid the pains of the past. History delivers it "summer school lessons" in a very violent manner, for those failing to "learn its lessons" in the first term. Currently, due to economists as well, the whole Humanity seems to have failed in the first term and gets its lessons violently, during summer, while the time "flies" very very rapidly. History is on the run, while the "summer" is ending. Should in the coming months we all fail to the "exams" (stabilizing world economy without killing each other), History will deliver our "grades" with a "Hammer", an "Axe" and some bombs. Afterwards, economists will start explaining what has happened and why it was impossible to predict a so absurd development. But this will only be their effort to justify their incompetence when their knowledge was mostly needed. Just like in the '30s, as History will remind them then.
    I really hope they (economists) prove me wrong and irrelevant with my analysis and they prove themselves more relevant to the subject, providing the necessary tools to overcome the current "acts of war" of other means' origin with their proposals. However, if they do not first recognize we are in an Era of Low Intensity War, till it gets to become a World War of All Intensities, I strongly argue they will not be in place to be of any relevance to our problems. Cause, as Howard Davies implies, History is hardly an economic preoccupation, even if it should be.

  30. CommentedMatt Stillerman

    My understanding is that New Keynsian models have done very well in analyzing and predicting economic conditions during our recent financial turmoil.

    This account is more of an indictment of Mr. Trichet, and more broadly, of the "Chicago school" economics that is favored by central bankers like him.

      CommentedGary Marshall

      Hello Matt,

      Well you must be a billionaire having seen what so few did.

      Congrats.

      GM

  31. CommentedMichael Finn

    I think we may be beyond hubris and humility at this point.

    As I write these words, my town that I grew up in suicide's rate has doubled in the last four years.

    Young men in their early 20's are committing suicide at a frightening rate, these people are in their prime and the community is going to miss them.

    When I was going to college to study Sociology I took a class in economic history for the fun of it. It was the most ridiculous class that I had ever seen. While sociology teaches you that every single you have ever seen is not only wrong but how you saw it was wrong, the business students took their lessons as faith. I was awestruck at the willfull blindness going on. You couldn't disprove anything to them because you were always lacking some piece of information or they didn't give you the entire story.

    Right now the school of economics is in a state of disaster. We are seeing arguements from different schools of thought about whether the government can create jobs. Of course the government creates jobs if nothing else other than work is being done. What needs to happen is a an entire top-down review of the profession.

    When crisis happens our bureaucrats needs tools at their disposal that can handle crisis' like the one we are having right now. They need honest and working opinions from economists. The question is whether or not you people can provide them.

    So far the answer is no.

  32. CommentedJohn Wiederspan

    Economics is a social science. Regardless of all the attempts to fit it into a draconian bed of formulas, theories, philosophies, and math; it is the study of humans and how they handle what they have. It has been, and is, all too often dominated by economists who dwell on theory as opposed to simple observation. No matter how complex, an economy (and how it functions) always boils down to: what have you got, what are you going to do with it, who decides these questions and who gets what as a result.

      CommentedPieter Keesen

      Well put. The study of human behavior is not science, only it's methods are scientific. I myself prefer the arts to study the human condition.

  33. CommentedZsolt Hermann

    No specific science, or some new economic theory, or an adjustment of resent economic theory can help us with the crisis.
    First of all we need a complete shift in our perception, how we investigate and relate to the world around us.
    Despite everybody talking about global economy, global crisis, we still examine everything in isolation, we still look at separate markets, separate national economies, budgets, unemployment figures, and even when we attempt to bring economies or finances under one umbrella like in Europe we do it in isolation, leaving all the foundations isolated, fragments, competing with each other and then we are surprised it is falling apart when the "years of famine" come.
    Top physicists, scientist have been been searching for the "theory/model of everything", uniting the natural forces around us, trying to unify them under one common law, quantum physics is inching ever closer to such revelation.
    But on the surface in our macroscopic life we still try to pretend each human being, each nation is a separate entity, disconnected from others with complete individual will and freedom.
    We will only find solution to the global crisis when we understand what it means to be "global, integral, and interdependent".
    When we start to see one, unified system we are all parts of, and as a result we have to function accordingly we will automatically find the answers, as we will go in harmony with the system, not against it.
    The scientific information, proof is already around us, we simply have to exit our subjective, denying bubbles and start seeing the real world around us.

      CommentedGary Marshall

      Sure Zolte,

      We can do nothing. There are no novelties to help us. We must sit and await the interminable conclusion to our present ills. Lower taxes, higher productivity, less government, will do nothing.

      Sounds like another big government advocate goes down in lamentable surrender to theories and policies that never fail to fail.

      Life is good!

      GM

  34. CommentedBen Schiller

    I thought this was terrific -- until the last para, when Mr Davies says:

    These assumptions took a hard hit in the crisis, causing an abrupt shift to far more intrusive regulation.

    Where is this "more intrusive regulation"? Could Mr Davies provide examples?

    Surely, the real story is the lack of regulatory follow-through, much like the lack of rethinking in economics.

  35. CommentedPaul A. Myers

    With regard to economics education, possibly economics could borrow the case method from the business schools. Present different historical situations and then approach analysis and solution using different theories, different schools of thought, different articles or books on the subject.

    In particular, the Great Depression era seems rich in lesson. Discussing what the problems were, solutions tried, from different intellectual frameworks would seem to be quite useful.

    All of that said, I think with regard to recent US recovery efforts:

    1. Not enough public works spending was put into the mix.

    2. Mortgage write-downs and refinance were not undertaken anywhere near the scale needed.

    Both of these measures were successfully implemented during the New Deal and had success.

    The other dimension of the US situation seems to diagnosis: the US was and is in a liquidity trap situation. If you accept the diagnosis, then solutions become readily apparent.

    So there seems to have been some replay of a very old argument between classical economics and Keynesian economics, between confidence fairies and aggregate demand management.

    In Europe, there seems to have been the hope that one universal tool, an economics Swiss army knife, all by itself, could be used to solve everything. The tool was monetary policy and government and supra-national government control over credit and monetary expansion. Why should it seem odd that an unbalanced approach might lead to unbalanced outcomes?

    So some sort of public policy case study approach should be very seriously considered.

      CommentedBertrand Groslambert

      fully agree with you. Old IS-LM approach works very for explaining the crisis and providing solutions.

  36. CommentedGary Marshall

    Its more like economists in denial about the abhorrent state of economics. When economic thinkers and practitioners encourage government to squander with impunity for the benefit of the economy, then its time to go back and reform at the rudiments.

    GM

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