I found a flaw in the model that I perceived is the critical functioning structure that
defines how the world works —Alan Greenspan
Financial markets around the world may seem to have stabilized 18 months after the big crash, but don’t let that fool you into thinking it is back to business as usual. The crash of 2007-9 not only wiped out tens of trillions (US$) in asset values and brought the world economy to its knees, the resulting shock waves also led to intense soul-searching among mainstream economists and the policymakers influenced by them.
At stake are not only some arcane academic theories, but whether financial markets and the world economy should be run in much the same way as before, with governments keeping a hands-off approach, or a different arrangement needs to be set up.
The questions uppermost on the minds of orthodox economists are appropriate given the scale of the calamity: How did they get it so wrong and why didn’t they see it coming? Unfortunately, there is nothing in their worldview or models suggesting that a crash of the magnitude recorded and a full-blown recession are even remotely possible, let alone a prediction of these events.
Although a handful of academics did warn of an impending disaster they were lone voices largely ignored as cranky Cassandras. So when markets dived and the economy went into a freefall, economists were in a state of stunned disbelief.
Bubble in academia
It wasn’t always so bad. For a long time, orthodox economists were a happy bunch. They believed they had discovered the Holy Grail of economics. The contentious debates in past decades had been settled, or so they thought. With the Federal Reserve pursuing monetary policy in line—or at least not out of step—with their models, everything appeared to be under control. Inflation was largely tamed, the economy grew at a steady pace and recessions seemed to be a thing of the past.
While there were a few ‘hiccups’ in financial markets along the way these were seen as no more than a blip on the road to progress. Free market reigned supreme in the spheres that mattered and everything was well under heaven.
Life was good in the best of all possible worlds, and that called for a celebration. Thus, in his address to the American Economic Association in 2003, Nobel Prize winner Robert Lucas of the University of Chicago triumphantly declared: “the central problems of depression prevention have been solved.” The audience rapturously applauded. It seemed the golden age of economics had arrived.
The euphoric bubble in both academia and asset prices was ruthlessly pricked in the financial collapse. In its wake, economists began to question and even disparage the paradigm that previously went unchallenged. Bold headlines in articles published by newspapers such as The Financial Times and New York Times tell the story: ‘The Unfortunate Uselessness of Most State of the Art Academic Monetary Economics’, ‘How Did Economists Get It So Wrong?’ ‘Economics May Be Dismal, But It Is Not a Science’, ‘Did Economists Ever Get It Right?’, and ‘Needed: A New Paradigm Shift’.
Those articles aren’t puffy pieces written by hacks seeking sensational headlines. They come from respected scholars. Some, like Paul Krugman and Joseph Stiglitz, have won the Nobel Prize in economics. What the rebels are saying is that economists need to rethink much of their craft. Fundamental rupture of this kind hasn’t been seen in the past four decades, at least not in mainstream circles. We live in turbulent times indeed.
Bubble not possible?
So what is wrong with the models that are causing so much dismay and contention among the high priests of the profession? The first casualties of the shake-out are the efficient markets hypothesis (EMH) and the macroeconomic models known as dynamic stochastic general equilibrium (quite a mouthful huh?). At the heart of EMH is the idea that prices of securities or assets accurately reflect everything we know about their values (that’s the ‘strong’ version of the theory).
In that sense, markets are said to be efficient. Couple it with EMH’s sister, the idea of rational expectations among investors, and you end up with the notion that financial and property markets are basically self-regulating and inherently stable. Given that markets reflect fundamental value, asset-price bubbles can’t be entertained even as a possibility.
Widely accepted by economists and central bankers, such a view was never seriously questioned by its proponents till the financial earthquake brought down the house of cards. Its foundation is now revealed to be downright faulty. EMH, dreamed up by American academics to reduce the complexity of markets to something that can be handled in a simple model, is a blatant over-simplification of reality. It assumes away uncertainty, crowd manias and imperfect information.
Besides its disconnect from reality, EMH is riddled with internal inconsistencies. If market prices reflect fundamental values and investors are fully informed and rational, why is there so much trading between punters? If the theory holds true, there shouldn’t be any trade at all as market participants would share the same view about prices—asset markets have already priced in values—and markets would grind to a halt. Active trading in itself only implies that markets are inefficient.
Dissenting economists have also pointed to the mismatch of EMH with empirical data. Moreover, small changes in assumption would lead to wildly different conclusions. Even small information asymmetries, as Stiglitz has shown, would make markets inefficient. These findings, however, were simply brushed aside as no more than curious anomalies.
As late as 2007, Eugene Fama, the father of EMH, said “the word ‘bubble’ drives me nuts,” insisting that property prices couldn’t be over-inflated because rational house buyers are careful when it comes to a big investment. The same logic was behind policymaking at the Fed. Both Alan Greenspan and his successor, Ben Bernanke, have rejected calls to rein in US housing prices on the grounds that there was no bubble. Now they know better.
If EMH is a disaster, macroeconomics doesn’t fare much better. As Willem Buiter, professor at the LSE and a former member of the Bank of England’s Monetary Policy Committee, rightly points out, the neoclassical models imbued with the theory of rational expectations “have turned out to be self-referential, inward-looking distractions at best.” Research has been driven by the internal logic and aesthetic puzzles of established research programmes, rather than by a desire to understand how the real economy works—much less how it works during times of instability.
It may seem strange to outsiders, but in the ‘complete markets’ theories concocted by orthodox economists, intertemporal budget constraints, by assumption, don’t exist; nor do default and insolvency as a result. In this Alice-in-Wonderland world, questions about illiquidity and insolvency can’t even be posed.
That’s not all. It was clear that the dynamic stochastic general equilibrium (DSGE) macro models couldn’t accommodate non-linearity and uncertainty in the real world. To get round the deep conceptual and technical problems, economists stripped them of the pesky non-linearities so as to make them ‘work’. Buiter couldn’t put it better when he said, “They took these non-linear DSGE models into the basement and beat them with a rubber hose until they behaved.”
In doing so, they have turned their toolkits into eunuchs incapable of handling systemic shocks. It thus came as no surprise that no analysis was available of the systemic effects that would unroll after any significant defaults in financial markets. In short, DSGE is nothing more than a fancy math model because it excludes things that might undermine financial stability.
As if that isn’t unrealistic enough, the DSGE models used by the Fed, according to a Santa Fe Institute blog, left out banks and derivatives, much less sub-prime mortgages and housing. No wonder their predictions weren’t even good enough to be wrong. They were simply non-existent.
The central affliction of the neoclassical paradigm is clear: the fixation on smoothly functioning markets and equilibrium blinds its practitioners to what could happen when markets become dysfunctional; by ruling out that very possibility, they cannot conceive of any mishap. Put simply, orthodox economics is innately incapable of offering insights into crises because it precludes a theory of crisis.
Indeed, economists haven’t even bothered to seriously study financial meltdowns, the only notable exceptions being Hyman Minsky and, lately, Nouriel Roubini who called the collapse a couple of years before it occurred. The blatant neglect can only be explained by economists’ ideological blinkers and their blind faith in markets.
If macroeconomics can’t tell us about the possibility of crises, it also has nothing constructive to say about solutions to a recession. Casey Mulligan of the University of Chicago said: “Employees face financial incentives that encourage them not to work…..decreased employment is explained more by reductions in the supply of labour (the willingness of the people to work)…..and less by the demand for labour”.
In other words, millions of jobless workers in America (and elsewhere) are opting to take a long vacation from work right now. That is obviously an absurd conclusion, but it is inevitable once you take seriously the idea of perfectly functioning markets. Unemployment can only be voluntary if demand for labour is assumed to equal its supply.
Dazzled by math
You must be wondering how economics got into such a muddle. Indeed, how could those questionable notions gain popular acceptance in the first place? In the famous New York Times article entitled ‘How Did Economists Get It So Wrong?’ Krugman provided part of the answer: “As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”
Beauty, as we all know, is in the eye of the beholder. To most economists eager to prove themselves the intellectual equals of theoretical physicists, it is epitomized in simple axioms dolled up in equations. The mathematically elegant approach succeeds in quantum physics, allowing the likes of Stephen Hawking to unveil the mystery of the cosmos.
When attempted in economics, the results are far less assured because simple, universal models can only be pulled off if you sever such things as Wall Street greed, herd instinct, beliefs, perceptions and social norms that have a bearing on human behaviour, imperfections of markets and uncertainty.
That is precisely what economists did when they erected the EMH, DSGE and rational expectations trio. But no amount of math can hide the naiveté. As one scientist, who in his late 40’s studied an MBA, said of the economics courses he was taught, “The mathematics was used to dress up something very banal.”
Still, the paradigm enables its disciples to build careers in academia. Professors get tenure at prestigious universities by ‘proving’ theorems without having to shed light on the economy. The exercise becomes a self-contained intellectual game or jigsaw puzzle with the paradigm taken for granted, in much the same way ‘normal’ science is pursued, as described in Thomas Kuhn’s seminal work.
Generations of economists have been raised on the orthodox staple. As undergraduates, they sit in lecture halls, transfixed by what appears to be scientific inquiry on the whiteboards. Some are dazzled by the math, and certainly few feel able to object in the face of the formidable-looking calculus. The math overwhelms what resistance they have to the basic tenets. Those who go on to complete their PhDs take the tenets as articles of faith.
Not only are academics bewitched by the math, Wall Street also swears by quantitative methods, hiring a horde of PhDs in mathematics and physics—known quaintly as quants—whose job it is to build math models for financial engineering and trading purposes.
It is worth quoting the remarks of a quant on a FT blog: “Sitting in a portfolio theory class filled with other scientists…. we laughed it up, [but] we didn’t just walk out of the classroom assuming it was all complete hogwash. Most understood that economists could only develop these silly, simplified models because they simply had no choice….Provide quants with something they can use, and you have struck gold. I doubt if [critics are] rich yet.”
In other words, quants knew the models were deeply flawed, but they went ahead regardless, as it was the only way of making money. This mindset is a stark case of ‘enlightened’ self-interest arrogantly ignoring the risks that could bring the house down. Yet it is not uncommon among quants and other ‘masters of the universe’ working at investment banks and hedge funds. It serves as a reminder that math could be abused with disastrous consequences.
Prestige and power
Over the years, academics from different intellectual traditions have been gradually elbowed out until dissenters became nearly extinct. Keynesian economics, once the competing paradigm, was considered passé. According to Lucas, “at research seminars (even back in1980), people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another.” If anything, the sneering complacency only swelled over time.
Meanwhile, funding for both teaching and research purposes has been plentiful for the economics departments or faculties that bent with the prevailing winds. For recognition, orthodoxy was the only way to go. The fawning and showering of money by Wall Street—in the form of lucrative consulting and sponsored speeches—also made it hard to turn away from the crowd.
Of course, the resurgence of the neoclassical orthodoxy has been intricately bound up with shifting politics. Led by Margaret Thatcher and Ronald Reagan in the 1970’s, the swing to the right in the political spectrum has since gained ground and spread nearly everywhere. The creed that idolizes free market lends neoliberalism legitimacy, and it is, in turn, upheld as the only feasible economic philosophy. The invisible alliance has conferred prestige and authority on mainstream economics. (For an excellent account, read A Brief History of Neoliberalism by David Harvey.)
Economic orthodoxy, the Trojan horse deployed in the neoliberal onslaught, has been more than helpful to its ally in reshaping the world order. In this brave new world, free capital markets, for instance, are de rigueur, permitting financial corporations to profit handsomely, and impediments such as regulation must be removed.
So it came to pass that the Glas-Steagall Act, put in place in the wake of the 1929 crash to separate commercial and investment banking to prevent a bubble from recurring in the US, was scrapped 60 years later after sustained lobbying by Wall Street.
An important lesson from economic history was simply deleted. When regulators stopped regulating because conventional economic wisdom said that must be so, the result was an open invitation to an orgy in toxic sub-prime derivatives which eventually broke the financial system, exposing the fragility of free-market fundamentalism.
Now that orthodoxy is revealed to be the emperor without clothes, prominent economists are calling for a paradigm shift. A change in paradigm is, of course, never easy. It is a rarity that happens maybe once in a couple of centuries in the sciences, which should tell us something about how dominant worldviews are essentially static. In economics resistance to change is likely to be just as strong.
Thomas Kuhn, the philosopher of science who studied the rare occurrences, has mapped out in broad brush strokes an apparently clear-cut account of the milestones in physics. In his canvas of scientific revolutions, an existing paradigm periodically would be challenged by a new, competing paradigm. When the anomalies confronting the established model build up to a crisis, a tipping point occurs and the new paradigm would replace the old.
We can deduce from Kuhn’s exposition an important idea: crises bring about change. Often, fundamental upheaval only emerges from a crisis or catastrophe. History lends support to this thesis, whether in scientific paradigm shifts, political revolutions, or social and personal transformations.
Economics likewise has arrived at a crisis point. Existing models are riddled with anomalies. A paradigm shift seems almost inevitable. Don’t underestimate the resistance to change, however. In the current minefield where a potent web of professional opposition, vested interests and politics are intertwined, the process of change is going to be complex and the outcome far from certain. Powerful forces are already marshalling the troops for what is likely to be a long, drawn-out battle.
Within academia, the clash has begun in earnest. Their faith unshaken by the crisis, the defenders of orthodoxy are locking horns with a growing number of disbelievers. In a recent skirmish giving a taste of things to come, John Cochrane of the University of Chicago took aim at Krugman, the chief offender who earlier ruffled a few feathers with his barbs at the profession.
The empire strikes back
In a paper entitled How Did Paul Krugman Get It So Wrong?, Cochrane countered with considerable verve, arguing that the EMH remains intact despite the financial collapse: “It’s fun to say we didn’t see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going—neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences.”
The point, however, is not so much that economists couldn’t predict the collapse—though a few did using non-standard models. It is rather their staggering inability to take on board the idea of financial and economic crises, as noted earlier. And if mainstream economics offers no clue to instability, what good does it do? Cochrane is also disingenuous since finance professors undoubtedly had sold Wall Street and central banks on the notion that bubbles don’t exist and markets are inherently stable.
If he really believes everyone got it wrong about EMH, he and his colleagues could have warned others of the dire consequences. This they didn’t do. Maybe the EMH should now come with a warning label: use it at your own peril. But then if financial markets are not necessarily stable, as Cochrane now appears to be saying, they ought to be providing models of disequilibrium. Again, that would be welcome, but we haven’t seen anything of this ilk from the Chicago School. Nor are we likely to, given its ideological bent.
Cochrane also argues that contrary to Krugman’s view, macroeconomists have done a great deal of useful work to shed light on the economy: “Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviours and especially new models of risk, and comparing the resulting models, quantitatively, to data.”
He is probably right about the amount of work predicated on the existing paradigm. But Cochrane couldn’t claim that the effort had produced startling insights into the unfolding of a crisis or how it might be unleashed, despite all the “flaws and frictions” introduced. What’s more, the standard macro models favoured by economists, as pointed out earlier, largely ignore the possibilities of shocks from financial markets. Clearly, the work produced hasn’t been, for the most part, germane.
What really exasperates Cochrane is the charge that economists mistake beauty for truth or what he calls “Krugman’s Luddite attack on mathematics”. To him, math isn’t the issue. Rather, “the problem is that we don’t have enough math. Math in economics serves to keep the logic straight, to make sure that the ‘then’ really follows the ‘if’, which it frequently does not if you just write prose.”
The quest continues
So Cochrane still prefers the models that got us into trouble. He is also attacking a straw man. Nobody is against math per se. What we don’t need is the kind of math that reduces the economy to abstractions that are useless in making sense of market failures and their causes.
To take up his line of reasoning, the problem is that the ‘then’ only follows the ‘ifs’ which in existing models bear little relations to the real world. The ‘then’ is hence totally undependable. And no amount of math can disguise the poor ‘prose’ (underlying conjectures) behind it. That just won’t do anymore.
Yes, we still need math, but of the kind that helps elucidate the real economy. It won’t be easy because the models need to grapple with a host of complications and it certainly won’t give us the Theory of Everything. Instead, economists have to settle for an eclectic salad of partial theories and insights, empirical facts and hunches. This may be a let-down for some, but admitting you don’t know much is a good start. It may eventually generate some real knowledge.
Cochrane pours scorn on Krugman’s suggestion of revisiting Keynes for his insights into economic depressions. To him, that’s a step backward: “Science that moves forward almost never ends up with where it started. Einstein revises Newton, but does not send you back to Aristotle.”
Isn’t Cochrane flattering economists a little in comparing them to Einstein? Is economics a science in light of the mess we are in? The answers to those rhetorical questions needn’t be spelt out. In the dismal science, we may indeed need to look back for ideas deleted by economists who share a collective amnesia in recalling crises and recessions.
In his attempt to salvage a sinking ship, Cochrane defends his neoliberal bedrock by falling back on the familiar mantra: “The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse….Krugman at bottom is arguing that the government should massively intervene in financial markets”.
Cochrane obstinately insists that unregulated asset markets are the only option. But that is precisely the Pandora’s box that launched the freefall. To recap the events that unfolded, the financial storm began in the US property market, and it was fully unleashed in a run on the minimally regulated shadow banking system gorging on toxic, highly leveraged sub-prime securities and derivatives. That was the epicenter of the financial crisis before it spread to commercial banks.
In his version of the collapse, Cochrane prefers not to see it as a crisis of financial markets. That is an obvious obfuscation designed to paper over the cracks in free-market fundamentalism. If the crisis teaches us anything, it is that unfettered financial markets are a recipe for disaster. Regulation, rather than “massive intervention”—the bogeyman Cochrane conjures up to spook us—is indeed necessary to prevent a replay of the meltdown.
Cochrane’s defence of orthodoxy is indicative of what to expect in ongoing clashes which look likely to drag on. The faithful have one thing in their favour. Despite the growing defection from their camp, the rebels don’t have a complete and coherent competing paradigm to bring to the table. The search for a candidate will take time.
A paradigm shift, of course, is not simply about settling an economic argument. It has enormous economic and political ramifications for the beneficiaries of the current orthodoxy. Among them are major corporations, the rich and the powerful, as well as sympathetic politicians in the halls of power. Neoliberal orthodoxy legitimizes their mode of operation. Without it, their hold on the existing world order would be tenuous at best. In the struggle for supremacy, they will do everything in their power to defend the ideology that allows them to maintain their wealth and position.
The massive lobbying campaign earlier this year by Wall Street and its political allies aimed at watering down the regulations proposed by the Obama administration is just one instance of corporate maneuvers. Stiff resistance to change is only to be expected. Already, the fight has spilled into the political arena.