Causes: Economics

We are not short of causes for our current economic crisis.  The basic machinery of capitalism, including the process of making loans, did not work as it was supposed to.  Capital flows around the world proved much more destabilizing than even before (and we’ve seen some damaging capital flows over the past 200 years.)  And there are plenty of distinguished individuals with something to answer for, including anyone who thought they understood risk and how to manage it.

But perhaps the real problem lies even deeper, for example, either with a natural human tendency towards bubbles  or with how we think about the world.  All of our thinking about the economy – a vast abstract concept – has to be in some form of model, with or without mathematics.  And we should listen when a leading expert on a large set of influential models says (1) they are broken, and (2) this helped cause the crisis and – unless fixed – will lead to further instability down the road.

This is an important part of what my colleague, Daron Acemoglu, is saying in a new essay, “The Crisis of 2008: Structural Lessons for and from Economics.”  (If you like to check intellectual credentials, start here and if you don’t understand what I mean about models, look at his new book.)  To me there are three major points in his essay.

1. The seeds of the crisis were sown in the Great Moderation (the low inflation, relatively stable last 20 years or so).  Everyone who patted themselves or others on the back during that time was really missing the point (p.3).  The same interconnections that reduced the effects of small shocks created vulnerability to massive system-wide domino effects.  No one saw this clearly.

2. The predominant view was that the US and other relatively rich countries had pretty good institutions (i.e., rules, laws and practices underpinning economic transactions) and that these institutions would prevent powerful people from the kind of abuse that endanger social systems in many parts of the world (pp.4-5).  That view was incorrect.  (Speaking personally, I had no illusions about the power of the strongest on Wall Street – particularly after my experience on the SEC’s Advisory Committee on Market Information in 2000-2001.  But I didn’t have the right mental model of how this power aggregated up, i.e., the way in which these people, and the firms they controlled, had created or recreated a deeply unstable system.)

3. The way we think about reputation, including how it is acquired and maintained, is way off base (pp.6-7).  This is fundamental for both formal economics and how you go shopping.  You walk into a grocery store with a mental model that is based on the premise that the individuals all through the production chain operate in a control structure designed to build brands and make you think their products are healthy and tasty.  Such reputations are costly to build and not readily squandered.  But, Daron points out, this is too simple.  In particular, we should no longer make the mistake of saying “the company” wants this or that.  There are no companies in any kind of behavioral sense.  There are people, struggling to get ahead, and it is their interactions that can lead – particularly in finance – to products that are really terrible for you and your neighbors (and even quite bad for themselves).

Daron also urges that we not lose track of longer term economic growth issues in the current policy debate.  If the bailout process – including the evergreening of credit by the Federal Reserve – slows down or even freezes the reallocation of resources out of the financial sector, we have a problem.  We need to move, at least somewhat, out of a bloated financial sector and back into the kind of nonfinancial technology-developing sectors that have primarily driven growth in the US since the 1840s.

This is not an argument against a comprehensive stimulus package.  But it recognizes the legitimacy of any backlash both against the models that brought us here and many of the sweet deals for leading financial figures (received so far and no doubt currently pencilled in).  Beginning with designing, arguing about, and implementing the stimulus, we need to think more clearly about the economics and politics of how we rebuild the financial system.  If we recreate something fundamentally unfair and unstable, that will also undermine growth.

Originally published at the Baseline Scenario and reproduced here with the author’s permission.