Tuesday, 17 September 2013

The Economic Crisis Within

On a visit to the London School of Economics in 2008, the Queen asked a simple question to all the economists gathered there; why did no one see the crisis coming? This question reflected a widely held view that economics as a subject had something to answer for. For a proportion of economists (and their models), the crisis struck out of a cloudless sky in a world that had grown to believe that such events were a thing of the past; that modern economics had finally rid the world of “boom and bust”, that we would never witness anything like the Great Depression ever again.

This complacency was borne out of models that were created without including the possibility of endogenous crises or for only including crisis that attributed purely to exogenous, unidentifiable shocks. The failure of these economics models and in particular in the under-pricing of risk was central to collapse of global financial system in 2007. These models have continued to under-perform post-crisis, consistently predicting strong and swift recoveries. The last five years have seen growth forecasts consistently revised and downgraded in-fact in line with current forecasts the EU will be almost 8% smaller in 2015 than was forecast just two years ago.

A central reason for the recent failures has been the misunderstanding of the two forms of response to the crisis widely used in the developed economies. The immediate response to the collapse of credit was for Central Banks around the world to flood money markets with liquidity, formally known as Quantitative easing (QE).  The effect of this policy was heavily diluted by the banking system thirsty for liquidity and eager to repair their own balance sheets before exposing themselves to more risk in such volatile conditions. This prevented the increased availability to credit from trickling down to the wider real economy. Analysis of QE shows that much has been spent on bond purchases, seen as a relatively safe investment. QE has thus inflated bond prices, maintained gains in stock markets and boosted the profits of financial institutions, but achieved little for the real economy. Moreover as Central Bank balance sheets reach all-time highs (as of last week the Fed’s balance sheet had reached $3.7tn, compared with about $1tn before the recession), the effectiveness of monetary policy alone to stimulate demand and growth effects has continually been questioned. While further unconventional ideas could potentially have positive growth effects, such as negative interest rates and “helicopter money” policies such as Overt Monetary Financing, the discussion within policy circles of these alternative ideas only demonstrates further the failure that previous models and policy has served policymakers.

While monetary policy was entering uncharted territory, fiscal policy was moving sharply into the other direction with policymakers having seemingly ‘forgotten’ the lessons learnt in the 1930s. A key result of the financial crisis was the transfer of debt from the private to public balance sheets. Sovereign debt sky-rocketed, creating a desire for policy makers to reduce public spending in an attempt to bring total public debt back to pre-crisis levels. The effect of this contractionary fiscal policy was again vastly misinterpreted due to the gross underestimation of the fiscal multiplier, a topic this blog has previously discussed. In short cutting government spending was far more damaging than estimated.

Looking specifically at the modelling techniques used, the emphasis on individual rationality, underpinning these models generally is something which has been increasingly questioned due to advancements in the field of behavioral economics, which has suggested that the assumption of rationally is grossly wrong. An example of this is the basis of modern financial theory, the Efficient Market Hypothesis (EMH). The theory which was adopted on the basis of analytical and ideological reasons, states that it is impossible to "beat the market" as shares prices reflect all relevant information and are therefore ‘efficient’. However events have proved that EMH does has not accurately reflected human decision making, due to irrational human behaviors such as our compulsive nature and herd mentality. Therefore these models, which are presented as scientific and accurate, are in fact fundamentally flawed as they ignore the available empirical evidence.  Unbelievably there have even been calls of frustration from some economists that if only agents had acted in rationally, like in their models, then there would have been shallower and less destructive crisis or even no crisis at all!

Despite the financial crisis drawing attention to these short comings in the subject, there has been little or no movement to adjust the way economics is taught in academia, an increasingly important issue which has not been addressed at all. A central reason behind this is the influence of all those who have vested interests in the current setting who have reaped the rewards and thus are incentivised to prevent the subject progressing. Indeed those who received the highest quality in economics teaching were those often found to be those most responsible for the crash.  There has been some calls albeit small from students themselves for change in the way the subject is taught, with dozens of Harvard University undergraduates walking out of the school’s famous introductory economics course, Economics 10, pointing at its failure to prevent the financial crisis and that it offered nothing to narrow the gap between rich and poor. They have since called for a more diverse introductory course that includes exposure to more progressive economic frameworks. For the credibility and usefulness of the social science itself, let us hope more of those within economics begin questioning and demanding more of models and theory before applying them to decide crucial policy decisions.

By Andrew Whitehead and Thomas Viegas