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From The Times
February 5, 2009
Economists are the forgotten guilty men
Academics - and their mad theories -
are to blame for the financial
crisis. They too deserve to be hauled into the dock
Anatole Kaletsky
In the search
for the "guilty men" responsible for the near-collapse
of the global economy, one obvious group of scapegoats has escaped
blame:
the economists.
By "economists" I do not mean the talking heads (myself included)
employed by the media and financial
institutions to "explain", usually
after the event, why share prices or currencies have gone up or down.
Nor do I mean
the forecasters whose computers churn out
scientific-looking numbers about what will happen to growth or
inflation,
but whose figures are revised so drastically whenever
something "unexpected" happens - as it always does - that their
forecasts
are really nothing more than backward-looking descriptions
of recent events.
What I mean by "economists" are the
academic theorists who win Nobel
prizes, or dream of winning them.
To see why these seemingly obscure academics
deserve to be hauled out
of their ivory towers and put in the dock of public opinion, consider
why the bankers, politicians,
accountants and regulators behaved in
the egregious ways that they have. It may be true that all bankers are
greedy,
all politicians venal, all regulators blind and all
accountants stupid. But such personal failings do not explain their
behaviour
in the past few years. After all, bankers do not like losing
money and politicians do not like losing power. All these
"guilty men"
behaved as they did because they thought it made sense.
And why did these greedy bankers and stupid
politicians hold beliefs
that, in hindsight, seem so ludicrous and self-destructive? Why, for
example, did they think
it reasonable for a bank with just $1billion
of capital to borrow an extra $99 billion and then buy $100 billion of
speculative
investments?
The answer was beautifully expressed two generations ago by John
Maynard Keynes: "Practical men, who
believe themselves to be quite
exempt from any intellectual influence, are usually the slaves of some
defunct economist.
Madmen in authority, who hear voices in the air,
are distilling their frenzy from some academic scribbler of a few
years
back."
What the "madmen in authority" were hearing this time was the echo of
a debate that consumed academic economists
in the 1960s and 1970s - a
debate won by the side whose theories turned out to be wrong. This
debate was about the "efficiency"
of markets and the "rationality" of
the investors, consumers and businesses who inhabit them.
On those two dubious
adjectives "rational" and "efficient" an enormous
theoretical superstructure of models, regulatory prescriptions and
computer
simulations was built. And without this intellectual
framework, the bankers and politicians would never have built the
towers
of bad debt and bad policy that have come crashing down.
I am not suggesting that the bankers who borrowed 50 times
their
capital to gamble on mortgage bonds or the regulators who allowed them
to do it were consciously following academic
theories. As Keynes said,
these practical men had no interest in theories, which was why they
left so many technical
judgments to supposedly expert economists and
consultants. What the practical men didn't realise, however, was that
the
risk management consultants who told them their banks would face
no solvency problems and the economists who advised them
that
financial markets were always right were basing their analyses on two
theories that were catastrophically wrong.
These
two theories - called "rational expectations" and "the efficient
market hypothesis" - essentially assume that the economy
is a
predictable, comprehensible machine with a defined set of
instructions. That in itself may seem preposterous, but
the theory
goes farther and assumes that every "rational" participant in economic
life knows these instructions and
assumes that everyone else knows
them too. To make matters worse, it is then applied to financial
markets so that any
economically inexplicable gyrations that do occur
are explained a way as purely random, like tossing a coin. This leads
to
the conclusion that financial prices, although they may fluctuate
randomly in the short term, are highly predictable in
the long term,
in the same way that the takings of a casino are.
Why did these implausible theories defeat more
realistic ones? Partly
it was the ideological mood of the 1980s and partly the ease with
which rational expectations
theories could be turned into mathematical
models. By using these models, bankers and policymakers could be
"blinded
with science" - and even better from the standpoint of
academic economists, their discipline could be elevated to the
scientific
status of physics.
The impact on both economics and public policy has been dire. The
obvious effect has been the
reckless behaviour of bankers and
regulators, who were told by reputable-sounding economists that the
bankruptcy of
Lehman Brothers could be expected only once every
billion years or so even though similarly "impossible" events - such
as
the collapse of the LTCM hedge fund and the 1987 stock market crash
- had occurred twice in the previous 15 years.
Equally
pernicious has been the stifling of intellectual debate among
academic economists, who have spent the past 20 years arguing
about
the properties of their imaginary mathematical models rather than the
behaviour of the real economy these models
were supposed to describe.
The question, not only for professional economists but for all those
in politics and
business who have relied on these ideas, is what will
happen to economics now that its fundamental assumptions and
mathematical
models have been totally discredited by events.
There seem to be only two options. Either the subject has to be
abandoned
as an academic discipline and becomes a mere appendage of
the collection and analysis of statistics. Or it must undergo
an
intellectual revolution.
The prevailing academic orthodoxy has to be recognised as a blind
alley. Economics
will have to revert to a genuine competition between
diverse intellectual approaches - such as behavioural psychology,
sociology,
control engineering and the mathematics of chaos theory.
So economics is on the brink of a paradigm shift. We are where
astronomy
was when Copernicus realised that the Earth revolves around
the Sun. The academic economics of the past 20 years is comparable
to
pre-Copernican astronomy, with its mysterious heavenly cogs, epicycles
and wheels within wheels or maybe even astrology,
with its faith in
star signs.
The academic Establishment will resist such a shift, as it always
does. But luckily
economists understand incentives. They should now be
given a clear choice: embrace new ideas or return their public funding
and
Nobel prizes, alongside the bankers' bonuses they justified and
inspired.
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