Economics making sense?

Why economists seems just as confused as me.

(A republication of a post first shown on the 8th August, 2009, still seems pretty relevant)

We live in a world where finance and money play a hugely more important role in our everyday lives than, say, 25 years ago.  Well that’s how it seems.  Our energy costs don’t seem to be connected to supply and demand but more in the hands of the speculators.  Our house values have been greatly influenced, perhaps misaligned is a better word, by the availability of too easy money, resulting from exotic financial leveraging. Commodities are, like energy, traded for their own sake rather than to provide an efficient process of linking the grower with the consumer.  And more.

So it comes as a bit of a shock to read in a recent copy of The Economist that most of the theories and economic models are being ‘re-examined’ in the light of the current global crisis.  These theories and models are not esoteric ideas kept

The Economist July 18th 2009
The Economist July 18th 2009

within the scholarly walls of universities but used by Governments, investment institutions and banks so they affect you and I in the real world, big time!

They ought to work a great deal better than they do because they have the capability to harm, as millions have found out in the last 2 years.

Anyway, The Economist, July 18th-July 24th has a lengthy briefing: The state of economics, comprised of two articles. To me it makes very sobering reading.  Unless you have a subscription there is no web access to the articles so here are a few extracts to give you a flavour.  The first article is about turmoil among macro-economists.

In the last of his Lionel Robbins lectures at the LSE on June 10th, Mr Krugman [Paul Krugman of Princeton and the New York Times] feared that most macroeconomics of the past 30 years was “spectacularly useless at best, and positively harmful at worst”.

These internal critics argue that economists missed the origins of the crisis; failed to appreciate its worst symptoms; and cannot now agree about the cure. In other words, economists misread the economy on the way up, misread it on the way down and now mistake the right way out.

Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same.

Towards the end of this first article in the Briefing, there is this:

In the first months of the crisis, macroeconomists reposed great faith in the powers of the Fed and other central banks. In the summer of 2007, a few weeks after the August liquidity crisis began, Frederic Mishkin, a distinguished academic economist and then a governor of the Fed, gave a reassuring talk at the

Frederick Mishkin
Frederick Mishkin

Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole, Wyoming. He presented the results of simulations from the Fed’s FRB/US model. Even if house prices fell by a fifth in the next two years, the slump would knock only 0.25% off GDP, according to his benchmark model, and add only a tenth of a percentage point to the unemployment rate. The reason was that the Fed would respond “aggressively”, by which he meant a cut in the federal funds rate of just one percentage point. He concluded that the central bank had the tools to contain the damage at a “manageable level”.

Since his presentation, the Fed has cut its key rate by five percentage points to a mere 0-0.25%. Its conventional weapons have proved insufficient to the task. This has shaken economists’ faith in monetary policy. Unfortunately, they are also horribly divided about what comes next.

The second article explores the way that the efficient-markets hypothesis has underpinned many of the financial industry models.

IN 1978 Michael Jensen, an American economist, boldly declared that “there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis”

Michael Jensen
Michael Jensen

(EMH).

Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.

Eugene Fama
Eugene Fama

Even as financial engineers were designing all sorts of clever products on the assumption that markets were efficient, academic economists were focusing more on how markets fall short. Even before the 1987 stockmarket crash gave them their first real-world reminder of markets’ capriciousness, some of them were examining the flaws in the theory.

However, a second branch of financial economics is far more sceptical about markets’ inherent rationality. Behavioural economics, which applies the insights of psychology to finance, has boomed in the past decade.

Behavioural economists were among the first to sound the alarm about trouble in the markets. Notably, Robert Shiller of Yale gave an early warning that America’s housing market was dangerously overvalued. This was his second prescient call. In the 1990s his concerns about the bubbliness of the stockmarket had prompted Alan Greenspan, then chairman of the Federal Reserve, to wonder if the heady share prices of the day were the result of investors’ “irrational exuberance”.

One task, also of interest to macroeconomists, is to work out what central bankers should do about bubbles—now that it is plain that they do occur and can cause great damage when they burst.

Another priority is to get a better understanding of systemic risk, which Messrs Scholes [Myron Scholes]

M Scoles
Myron Scholes
Richard Thaler
Richard Thaler

and Thaler [Richard Thaler of the University of Chicago] agree has been seriously underestimated.

Several countries now expect to introduce a systemic-risk regulator. Financial economists may have useful advice to offer.

Financial economists also need better theories of why liquid markets suddenly become illiquid and of how to manage the risk of “moral hazard”—the danger that the existence of government regulation and safety nets encourages market participants to take bigger risks than they might otherwise have done. The sorry consequences of letting Lehman Brothers fail, which was intended to discourage moral hazard, showed that the middle of a crisis is not the time to get tough. But when is?

Mr Lo [Andrew Lo of the Massachusetts Institute of Technology] has a novel idea for future crises: creating a financial equivalent of the National Transport Safety Board, which investigates every civil-aviation crash in America. He would like similar independent, after-the-fact scrutiny of every financial

Andew Lo
Andew Lo

failure, to see what caused it and what lessons could be learned. Not the least of the difficulties in the continuing crisis is working out exactly what went wrong and why—and who, including financial economists, should take the blame.

Mr Lo’s idea of treating financial failures in the same way as civil aviation accidents might be a brilliant idea.  After all economics is a behavioural science just like the ‘science’ of air traffic controllers and air crew.  Seems to me that keeping my money as safe as my body in a civil airliner isn’t a bad goal.

If you can, do get hold of a copy of the briefing, if only to arrive at the same conclusion as me.  In terms of future personal financial planning, a pair of dice may be just as accurate as economists.dice

6 thoughts on “Economics making sense?

  1. Thanks for re-posting this Paul (I hope the road trip is going well).

    Your introductory paragraph provides a useful working definition of money fetishism – the ultimate expression of which will paradoxically be a cashless society in which all transactions are done electronically (Visa and MasterCard are working on it).

    Clearly, these economists were all still licking wounds inflicted by the 2008 meltdown but none of them quite summons the courage to admit that belief in perpetual growth as the solution to all our problems was itself the ultimate problem. Here are 3 quotes from Herman E Daly’s (1992) Steady State Economics (2nd edition):
    “…a steady-state economy is a necessary and desirable future state of affairs… Once we have replaced the basic premise of ‘more is better’ with the much sounder axiom that ‘enough is best’, the social and technical problems of moving to a steady state become solvable, perhaps even trivial. But unless the underlying growth paradigm and its supporting values are altered, all the technical prowess and manipulative cleverness in the world will not solve our problems and, in fact, will make them worse.” (p.2)
    “Of all the fields of study, economics is the last one that should seek to be ‘value-free’, lest it deserve Oscar Wilde’s remark that an economist, ‘is a man that knows the price of everything and the value of nothing.’” (p.4)
    “Continuing to study economies only in terms of the [exchange value of money] is like studying organisms only in terms of the circulatory system, without ever mentioning the digestive tract.” (pp.185-186).

    Here is the 6 minute Post Carbon Institute video I re-posted on my blog (from last September) only yesterday:

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    1. Thanks Martin, Yes, we made good time yesterday spending the night at Santa Clarita in Northern California, some 488 miles from Payson. Dogs have shown what fun it is to wake us at 4am and want to go for a ‘walk’. Hence the earliness of this reply!

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      1. Hi Paul. I was confused by your describing Santa Clarita as being in Northern CA because – even though I did not know where it was – I could not see how you could already be 50 to 67% of the way to Oregon. However, having checked a map, Santa Clarita is just outside Los Angeles (isn’t it?) – very much in the southern half of CA – and on the same latitude as Payson. If so, enjoy the drive down the San Joaquin Valley to Sacramento!

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      2. You spotted the mistake! Yes, was still a way from Northern CA but clearly pretty brain-tired!

        Now we are, repeat ARE, in the Northern half of the State, staying in a motel in Redding, about 130 miles south of the CA-OR border. But just as brain-tired! P.

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  2. I wonder how many Nobel prize winning economists it will take to figure out that you cannot borrow and spend your way to prosperity. The only way to prosperity (and happiness for that matter) is through production and investment. But still the western world just ignores this fundamental truth completely.

    First we have tried to borrow our way to prosperity by artificially low interest rates. When that failed (obviously), we kept the interest rates near 0% (which is better than free money because of inflation) and started the quantitative easing and bailouts to try and spend our way to prosperity. That will not work either and, I’m sad to say, there is no further ways of kicking the can down the road. The day of reckoning is fast approaching…

    Personally, I’m buying precious metals right now because government bonds will soon lose their “save haven” status when the world realizes that it is physically impossible for many countries to every pay back their gigantic debt. Global credit market debt is now close to total global wealth (around $220 trillion). Add to that all the unfunded liabilities (social security and Medicare promises) which are much larger still and you will quickly see that this is a matter of complete impossibility. I’ve even heard people say that there is not enough oil left in the ground to fuel the production needed to pay off global sovereign debt.

    But politicians will keep on buying votes with further promises of further benefits and more spending with zero regard for future generations. Personally, I don’t really get why even the most selfish of politicians would do this. The last thing that I would want to be is president for the next five years. Having the global economy implode on your watch does not sound like a lot of fun…

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    1. Schalk, we spent an hour today listening to the first lecture of the 2012 BBC Reith series given by economic historian Professor Niall Ferguson, see here http://www.bbc.co.uk/podcasts/series/reith

      Strongly recommend you listening to it as Prof. Ferguson throws a very clear light on what he describes as a failure of institution as the cause of the mess and offers a very erudite solution.

      I’m going to write a LfD post on the series of lectures once I have listened to them all but if you do listen to that first one. Under the series title of The Rule of Law and its Enemies, this first lecture is described on the BBC Podcast website as:

      Institutions determine the success or failure of nations and a society governed by abstract, impersonal rules will become richer than one ruled by personal relationships, says the economic historian Prof Niall Ferguson. But, he asks, are the institutions of the West now degenerating, as young people confront the fact that they must live with the huge financial debt generated by the baby boomers? And is there a way of restoring the compact between the different generations?

      Thanks for leaving your own thoughts, Paul

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