We have just witnessed them make a massive failure in diagnosis. Despite the fact that there was rampant evidence of trouble on various fronts – a housing bubble in many countries (the Economist had a major story on it in June 2005 and as readers well know, prices rose at an accelerating pace), rising levels of consumer debt, stagnant average worker wages, lack of corporate investment, a gaping US trade deficit, insanely low spreads for risky credits – the authorities took the “everything is for the best in this best of all possible worlds” posture until the wheels started coming off. And even when they did, the vast majority were constitutionally unable to call its trajectory.
Now of course, a lonely few did sound alarms. Nouriel Roubini and Robert Shiller both saw the danger of the housing/asset bubble; Jim Hamilton at the 2007 Jackson Hole conference said that the markets would test the implicit government guarantee of Fannie and Freddie; Henry Kaufman warned how consumer and companies were confusing access to credit (which could be cut off) with liquidity, and about how technology would amplify a financial crisis. Other names no doubt belong on this list, but the bigger point is that these warnings were often ignored.
Shiller has offered a not-very-convincing defense, claiming that economists were subject to “groupthink” and no one wanted to stick his neck out. That seems peculiar given that many prominent policy influencers are tenured. They would seem to have greater freedom than people in any other field to speak their mind. And one would imagine that being early to identify new developments or structural shifts would enhance one’s professional standing.
But if a doctor repeatedly deemed patients to be healthy that were soon found to have Stage Four cancer that was at least six years in the making, the doctor would be a likely candidate for a malpractice suit. Yet we have heard nary a peep about the almost willful blindiness of economists to the crisis-in-its-making, with the result that their central role in policy development remains beyond question.
Perhaps the conundrum results from the very fact that they are too close to the seat of power. Messengers that bear unpleasant news are generally not well received. And a government that wanted to engage in wishful, risky policies would want a document trail that said these moves were reasonable. “Whocouldanode” becomes a defense.
But how economists may be compromised by their policy role is way beyond the scope of a post. To return to the matter at hand: there appears to be an extraordinary lack of introspection within the discipline despite having presided over a Katrina-like failure. Jeff Madrik tells us:
At the annual meeting of American Economists, most everyone refused to admit their failures to prepare or warn about the second worst crisis of the century.
I could find no shame in the halls of the San Francisco Hilton, the location at the annual meeting of American economists that just finished. Mainstream economists from major universities dominate the meetings, and some of them are the anointed cream of the crop, including former Clinton, Bush and even Reagan advisers.
There was no session on the schedule about how the vast majority of economists should deal with their failure to anticipate or even seriously warn about the possibility that the second worst economic crisis of the last hundred years was imminent.
I heard no calls to reform educational curricula because of a crisis so threatening and surprising that it undermines, at least if the academicians were honest, the key assumptions of the economic theory currently being taught.
There were no sessions about why the profession was not up in arms about the deregulation of so sensitive a sector as finance. They are quick to oppose anything that undermines free trade, by contrast, and have had substantial influence doing just that. The sessions dedicated to what caused the crisis were filled, even those few sessions led by radical economists, who never saw turnouts for their events like the ones they just got. But no one was accepting any responsibility.
I found no one fundamentally changing his or her mind about the value of economics, economists, or their own work. No one questioned their contribution to the current frightening state of affairs, no one humbled by events.
Maybe I missed it all. There were hundreds of sessions. I asked others. They hadn’t heard any mea culpas, either.
Madrik goes on in the balance of his piece to offer a list of things economists got wrong. Unfortunately, it’s off the mark in that he contends that economists (in effect) had unified beliefs on a lot of fronts. It’s a bit more accurate to say that there was a policy consensus, and anyone who deviated from the major elements had a bloody hard time getting a hearing (Dean Baker regularly points out that the New York Times and Washington Post still keep quoting economists who got the crisis wrong). The particulars on his list need some work too, but at least it’s a start (reader comments and improvements on it would be very much appreciated).
But Madrik does seem spot on about the lack of needed navel-gazing. I looked at the AEA schedule and did not see anything that questioned existing paradigms. And one paper that did was released recently, “The Crisis of 2008: Structural Lessons for and from Economics,” fell so far short of asking tough questions that it proves Madrik’s point. The analysis is shallow and profession serving. And that is not to say the author, Daron Acemoglu, is writing in bad faith, but to indicate how deeply inculcated economists are.
For instance, one of the three (only three?) ways in which he says economists took too much comfort in the Great Moderation;
The seeds of the crisis were sown in the Great Moderation… Everyone who patted themselves or others on the back during that time was really missing the point… The same interconnections that reduced the effects of small shocks created vulnerability to massive system-wide domino effects. No one saw this clearly.
Huh? The problems with the Great Moderation were far more deeply rooted than this depiction suggests. Acemoglu’s take is that the economy became more susceptible to shocks (that is, absent the bad luck of a shock, things could have continued merrily along). Thomas Palley argues, persuasively, that it was destined to come a cropper:
The raised standing of central bankers rests on a phenomenon that economists have termed the “Great Moderation.” This phenomenon refers to the smoothing of the business cycle over the last two decades, during which expansions have become longer, recessions shorter, and inflation has fallen.
Many economists attribute this smoothing to improved monetary policy by central banks, and hence the boom in central banker reputations. This explanation is popular with economists since it implicitly applauds the economics profession by attributing improved policy to advances in economics and increased influence of economists within central banks. For instance, the Fed’s Chairman is a former academic economist, as are many of the Fed’s board of governors and many Presidents of the regional Federal Reserve banks.
That said, there are other less celebratory accounts of the Great Moderation that view it as a transitional phenomenon, and one that has also come at a high cost. One reason for the changed business cycle is retreat from policy commitment to full employment. The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages. That is what happened in the 1960s and 1970s. However, rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth.
Disinflation also lowered interest rates, particularly during downturns. This contributed to successive waves of mortgage refinancing and also reduced cash outflows on new mortgages. That improved household finances and supported consumer spending, thereby keeping recessions short and shallow.
With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending. Higher asset prices have provided collateral to borrow against, while financial innovation has increased the volume and ease of access to credit. Together, that created a dynamic in which rising asset prices have supported increased debt-financed spending, thereby making for longer expansions. This dynamic is exemplified by the housing bubble of the last eight years.
The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation.
Palley wrote this in April 2008, although he had touched on some of these issues earlier. Did this view reach a wide audience? No. Understanding why might help us understand better why the economics profession went astray.
Acemoglu’s paper had a couple of other eye-popping items: Even though he gives lip service to the idea that the economics was unduly infused with ideas from Ayn Rand, he then backtracks:
On the contrary, the recognition that markets live on foundations laid by institutions— that free markets are not the same as unregulated markets— enriches both theory and its practice.
“Free markets” is Newspeak, and the sooner we collectively start to object to the use of that phrase, the better. Because it is imprecise and undefined, advocates can use it to mean different things in different contexts. I cannot take any economist seriously who uses “free markets” in anything more rigorous than a newspaper column (and even there it would annoy me). It has NO place in an academic paper (save perhaps on the evolution of the concept).
We also have this:
A deep and important contribution of the discipline of economics is the insight that greed is neither good nor bad in the abstract.
This reveals that Acemoglu has been corrupted by Rand more than he seems willing to recognize. No one would have dared write anything like that even as recently as ten years ago. Let us consider the definition of greed, from Merriam Webster:
a selfish and excessive desire for more of something (as money) than is needed