Will economics change?

Zahid Hussain

Photo: Shubasish Barua/Driknews

THE global crisis has raised questions about whether the kind of economics taught to students in economics departments was responsible for the widespread failure to predict the timing and magnitude of the events that unfolded in 2008 and 2009. Critiques range from an absence of historical context in mainstream teaching of economics to excessive reliance on mathematical and econometric models. The economic and financial meltdown resulted in a host of casualties. Economics is one such casualty. Peter Coy of Bloomberg Businessweek stated it very bluntly in 2009: “Economists mostly failed to predict the worst economic crisis since the 1930s. Now they can't agree how to solve it. What good are economists, anyway?”

Crisis viewed from the prism of mainstream economics
Mainstream economics teaches us that market economies are fundamentally dynamic and evolving. Adjustments to market processes are often smooth. Given appropriate macroeconomic policies, market processes generate growth and employment. At times, expectations by consumers, firms and financiers get misaligned. Recessions follow. Fiscal and monetary interventions can put economies back on the path to recovery and prosperity.

What leads to formation of asset price bubbles? Note that the term bubble describes an asset price that has risen above the level warranted by economic fundamentals. There is no unique answer on what can cause this that can be generalized to explain all bubbles throughout history and across the globe. One popular explanation is that when asset prices start to rise, the success of some investors attracts public attention which in turn fuels the spread of enthusiasm for the market leading to entry of new investors and bid up the prices. This so called “irrational exuberance” heightens expectations of further price increases. Investors begin to extrapolate recent price action into the distant future. However, the bubble caries the seeds of its own destruction. Pessimism takes hold as prices begin to sag, causing some investors to offload their holdings, thus setting in motion expectations of further downward price movement.

It is virtually impossible to ascertain beforehand the exact circumstances, magnitude and timing of the reversal of the artificial expansion, ultimately setting off a crisis. However, asset markets, stock markets in particular, usually offer the first sign that the expansion is “feet of clay”. Then the slightest trigger sets off a stock market crash. This usually takes place as soon as economic agents begin to doubt the sustainability of the expansionary process and become convinced that a crisis and recession will appear in the near future.

The root causes of the recent global economic crisis, as in the past, are many: insufficient regulation of banking activities, complexity of certain financial products and a lack of transparency in the market about these products, serious errors in risk assessment, and the sub-prime crisis in the housing market, to name the most obvious. This set of causes led financial institutions to take undue risks. Many took huge risks to maximise their short-term remuneration. A classic case of the internalisation of benefits and the externalisation of costs and risks ensued.

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Most economists failed to foresee the crisis
This sounds easy from hindsight. It still begs the question why the world's top notch economics professors, Nobel Laureates and mainstream economic analysts did not foresee its arrival? Not a whisper came from the lips of any of them. This does not befit a discipline that aspires to be treated as a predictive science. The economic crisis has proved otherwise. Ben S. Bernanke, Chairman of the Board of Governors of the US Federal Reserve System, confessed on September 24th, 2010 that economists have failed to predict the nature, timing, or severity of the crisis. Those few who issued early warnings generally identified only isolated weaknesses in the system.

There were exceptions for sure. A few economists mustered courage when apparently everything was rosy in Washington. Professor Raghuram Rajan from the Chicago University presented a paper in 2005 in which he warned that financial system was taking on potentially dangerous levels of risks. He was frowned upon and dismissed by the academics and economists. Robert Shiller, another notable economist, identified the bubble and warned of the painful consequences if the bubble burst. He was simply ignored. Mainstream enthusiasts declared that home price increases largely reflect strong economic fundamentals.

A financial crisis of sorts had also been forecast by Nouriel Roubini of New York University and Stephen Roach of Morgan Stanley. Their predictions tended to focus more on macroeconomic imbalances such as the current account deficit or the federal government debt. They too were largely ignored by central bankers as they were often pitted against the views of then Federal Reserve Chairman Alan Greenspan. Greenspan was widely heralded for having managed a major shift in the mid-1990s, namely a sharp increase in economic productivity.

American billionaire Warren Buffett, who did warn in 2003 that the rapidly growing trade in derivatives poses a "mega-catastrophic risk" for the economy, explains: "The whole American public was caught up in a belief that American housing couldn't fall dramatically,….Very, very few people could appreciate the bubble. That's the nature of bubbles they're mass delusions…..Rising prices and discredited Cassandras from the past blunt sensitivities and judgment even of people who are very smart."

Where mainstream economics went out of kilter
Paul Krugman wrote in New York Times (September 6, 2009) that the contemporary economists suffered because of their wishful thinking regarding perfect markets, rationality of the decision-makers and the inspiration of mathematical models. These have proudly transformed economics from a social science and allegedly placed it in the pedestal of natural sciences. However, contrary to the expectations and beliefs, the much-trumpeted macroeconomic models neither helped in predicting the looming crisis nor incorporating the effects of it.

The belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. Efficient market theory also played a significant role in inflating the bubble in the first place, according to Krugman.

Where is the problem? Formal models are incapable of capturing human emotions. People sometimes make decisions which are highly influenced by the sentiments and passions despite being well informed of the core rational and economic facts. Nor are people always rational. The concept of rationality exaggerates the amount of information that people have about the future, including wizards and experts, and disregards economic factors that are intractable in a formal analytical framework.

What role did economics education play in this crisis? Some have argued that the study of economics makes people more selfish and greedy than they otherwise would have been. This view does not survive harder scrutiny. Today's managers are not, on the whole, greedier or more narrowly self-interested than their predecessors because of what they learned in economics. Think of the landowners in ancient Rome, of the bankers and traders in medieval times, the behavior of the East India Company in the 18th century, and of the industrial barons of the nineteenth century.

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Do not throw the baby with the bathwater
Naturally, those who think that economics education should fully stress the importance of socially responsible and honest conduct do have a point. Actually, this is the cornerstone of modern political philosophy and economics, as the works of Machiavelli and Smith make clear. The more fundamental lesson, however, is that one should not design institutions that require the highest moral qualities from all. We Bangladeshis hopefully have taken this lesson to our hearts based on our experience with institution building during the last forty years.

One should not hold it against economics that their teachings and models give a lot of attention to self-interest. Self interested behavior is inherent to human nature. Why that is so is beyond the realm of economics. Economics, as a positive science, cannot ignore this reality. But, economic analysis should also focus on the common good and the connections between the individuals, business, and society. Are the models that we find in economics lacking in this respect? The answer probably is yes.

Having said that, much of what students need to learn in economics courses is actually readily found in standard economic textbooks. These concepts include externalities, public goods, imperfect competition, and the absence of complete and symmetric information. All of these result in the failure of the market to work well.

Economists such as Milton Friedman from the public choice school have argued that market failure does not necessarily imply that government should attempt to solve market failures. The costs of government failure might be worse than those of the market failure it attempts to fix. This failure is seen as the result of the inherent problems of democracy and other forms of government and also of the power of special-interest groups (rent seekers) both in the private sector and in the bureaucracy. Beyond philosophical objections, a further issue is the practical difficulty that any single decision maker may face in trying to understand the numerous interactions that occur between producers and consumers in any market.

In his book “Freefall America”, Stiglitz traces the origins of the crisis to a deregulatory fervor fuelled by the “ideology” of free-market fundamentalism and Wall Street's political clout. The book provides an analysis of the failures of academic economics and a call for a more inclusive, less materialistic society. Stiglitz dwells on the market imperfections and misaligned incentives that distorted decisions made by everyone from mortgage originators to credit-rating agencies. Far less convincing are Stiglitz's sweeping criticisms of the policy response. These include an attack on the fiscal stimulus where, he says, the Obama team failed to draw on “theory, empirical evidence and common sense” and on the bank rescue plan, which he describes as “among the most costly mistakes of any government at any time”. “Freefall” is, in essence, a call for stronger government to combat all the market failures that Stiglitz sees in modern capitalism.

After condemning today's policymakers so strongly as not just incompetent but also beholden to special interests, that prescription, and his broader faith in government activism, sounds inconsistent. The critics ask if policymakers failed as miserably as Stiglitz believes, then should we not be far more worried about the potential for government failure in the future.

How will economics change?
While it is important not to get carried away in economics bashing, there is clearly an emerging consensus that financial economics has to change. While conventional academic finance emphasizes theories such as Modern Portfolio Theory and the Efficient Market Hypothesis, the emerging field of behavioral finance investigates the cognitive factors and emotional issues that impact the decision-making process of individuals, groups, and organizations. Economist Markus K. Brunnermeier predicts that “macroeconomics will change.” Macroeconomic models ignored the main components of the crisis. Macro will merge with the field of financial frictions, giving rise to a new economics.

Indeed, cutting edge mainstream economic research has begun to identify links between monetary policy and financial leverage. The so called “risk-taking channel” of monetary policy postulates that short-term interest rates are an important factor in influencing the amount of financial leverage taken on by financial intermediaries. The challenge that remains is the integration of micro, macro, and financial outcomes into a single coherent theory.

All high fly economists appear to have realized that something is wrong with the financial theories they have been professing for decades. Hence change within economics is inevitable, although such transformation is still unpredictable. Most economists were not trained to spot the dangers posed by lax mortgage lending, overleveraged financial institutions, and complex derivatives. The time is now right for new ideas to come in, much as they did in the 1930s and the 1970s.

The question is not whether economics will change. Question is how will it change? Why should we care? The answer came from none other than John Maynard Keynes long time ago: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else.”

The author is a Senior Economist, the World Bank, Dhaka. Views expressed are his own, not that of the Bank.