A hard look in the mirror

IF A company’s business model is found to be flawed, the finance director could reasonably expect to be out of a job. But despite the failure of economic theory to give any hint of what has turned out to be the worst crisis in 70 years, there has been little public acknowledgement of a malfunction. Until now.

Finally, some of the world’s most eminent economists are starting to address that issue and, in some cases, embark on some almost Maoist self-criticism.

At a little-known gathering of Nobel Prize winners – the Lindau Economic Meeting in Germany – some admitted the profession had not only failed to predict the crash but had contributed to it.

Joseph Stiglitz, a professor at Columbia University and former chief economist of the World Bank, said bluntly: “I think macroeconomic models are largely responsible for the economic crisis.”

According to Stiglitz, the models used by central banks and many in the private sector created a policy framework that was clearly at the centre of the crisis: “It said you don’t need regulation. It said all you need for monetary policy is low inflation and that would suffice to ensure stable growth. In retrospect, these ideas seem absurd.”

The models failed to see that bankers had mispriced the risk involved in the complex financial instruments they had created.

“The reason the invisible hand seems invisible is that it’s not there,” he added.

Pointing fingers

Stiglitz’s critique was echoed by Bill White, who, as chief economist at the Bank of International Settlements, was one of the few to warn of complacency among central bankers. White said models used by economists in the City and even watchdogs such as the International Monetary Fund to make their forecasts did not even include the possibility of a credit crisis.

“I think the policymakers have got a lot to answer for in this crisis,” he said. “The basic modelling framework that people are using – the analytical framework – had no room for problems of this sort.”

What he has in his sights is the awkwardly named dynamic stochastic general equilibrium model, which builds a macroeconomic model out of a host of microeconomic interactions.

Stiglitz said it is “amazing” that central bank models did not include a focus on the role of credit. “Most models assume that securitisation – a central part of what has happened to the financial sector in recent years – works to diversify risk,” he said.
White said central banks erred by believing that by keeping inflation low and stable they had ended the boom-bust cycle that has rocked the world since the 1970s.

“There was a sense that price stability was not only necessary for good economic performance but somehow sufficient and that things couldn’t go wrong,” he said.

Edmund Phelps of Columbia University said the profession needs to get “back on track” after two decades that has seen a decline in the quality of work produced by economists: “The profession made a serious wrong turn by embracing rational expectations, which set off a spate of highly mechanical models that have nothing to say about our present predicament.”

But some Nobel laureates rejected the self-criticism. Robert Aumann, of the Hebrew University of Jerusalem, said: “All this talk about economists having caused the current crisis is just nonsense. I think economic science has made a tremendous contribution to the prosperity we have witnessed – macroeconomic policies, countercyclical behaviour by central banks.”

A Beautiful Mind

Roger Myerson, a Chicago University professor, said Stiglitz’s criticism fails to account for the role economics played in tackling the crisis. “In the aftermath of the crisis in 2008, there was an aggressive response to provide banks with the liquidity they needed, and with a Keynesian fiscal stimulus. They are all responses that come out of Keynesian and Friedman-style thinking. That meant we didn’t go into a Great Depression,” he explained.

Myerson said it is a mistake to ignore all the benefits that economics has brought to human welfare and development: “The world is a better place today because of macroeconomics. The events of 2008 have shown we need to understand it better. This is one of the most important jobs we have.”

John Nash, the 1994 laureate and focus of the hit film A Beautiful Mind, took a more nuanced view. “The critics are right, but economic theory is easy to criticise,” he said. “Some of the foundation ideas are relatively good – Adam Smith, Ricardo, Giannini – but I don’t think Adam Smith would have said the invisible hand worked so simply. These ideas – like the efficient market hypothesis – have been seized upon by those who argue something that’s favourable to a particular interest.”

White said he is glad questions are being raised: “A debate has already begun about whether that framework is adequate. I think it’s a good idea to embark on a series of investigations, starting with self-doubt.”

Such a defence might not save an FD’s job but hopefully means businesses will not face another crisis in 70 years’ time.