Published in The Spectator Australia (Sydney), 2 October 2010
The inability to see beyond their own models left them unprepared when the global economy hit trouble
Many groups have had to share the blame for the financial crisis that gripped the world economy in 2007, including commercial banks for unsustainable lending practices, rating agencies for flawed assessments, and central banks for misguided monetary policies.
There is one group, however, whos reputation has perhaps suffered even more than those mentioned above: the economics profession. Few, if any, economists saw the crisis coming. Worse still, before the crisis many economists thought that their tools and methods made such a series of events almost impossible.
Looking back at the state of economics in the pre-crisis years, it is hard not to detect a sense of complacency. The Great Depression had become a distant memory, and the experience gained from handling comparatively minor economic setbacks such as the 1987 stock market crash, the 1997 Asian financial crisis, and the end of the dotcom boom only seemed to demonstrate that economists and policymakers had acquired the necessary knowledge to deal with such challenges in a way that would prevent such setbacks from becoming global catastrophes.
Former UK prime minister Gordon Brown has rightly received a great deal of ridicule for a promise he had made as Chancellor of the Exchequer. At the time, he had predicted an end to boom and bust cycles. Unfortunately for him, the British boom turned to bust almost immediately after Brown became prime minister.
It is unfair to blame Brown alone for his unjustified smugness. He could have lifted it straight from the economics textbooks of the time. It is almost embarrassing to read economists’ statements from the pre-crisis years now because, in hindsight, they look dangerously naïve. In January 2003, for example, economist and Nobel laureate Robert E. Lucas delivered the Presidential Address to the American Economic Association and began with this bold statement:
‘Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.’
The events of 2007 to 2010 are far from the steady-state that Lucas thought had been achieved. If anything was absent during the recent crisis years, it was the kind of stability that macroeconomists thought they had created.
Laypeople were shocked to discover that many economists were largely ignorant of the developments in financial markets that ultimately caused the greatest economic disruption in decades. To these economists, the crisis was an ‘exogenous shock’. Translated into ordinary English, this means an event which resulted from forces working outside the world of economists’ models.
Of course, there is nothing necessarily wrong with economic models or theoretical abstractions. However, it is vital that the economists who apply them are aware that they are dealing with models and that these models have limitations. They must be willing to subject their models to a reality check from time to time. In order to do this, economists need a sound historical knowledge of the economy. And this is where economics has gone wrong.
If economists believe they are engaged in some kind of social physics, then it is only too easy to understand why they are so strangely uninterested in fields that other social scientists regularly deal with. Physicists, for example, do not have to know the biographical details of Albert Einstein to deal with his theory of relativity. Nor do they need to know the historical context in which Isaac Newton developed his concept of gravity.
Economists often pretend that they can afford similar historical ignorance. Today’s economics students may know of Keynes, but only a few would be able to locate him in time and place. Fewer still would know who Keynes’s great contemporary rival was (Friedrich August von Hayek), and don’t bet on any of these students knowing that Keynes had developed his theories against the backdrop of the Great Depression.
Is this really an appropriate way to learn economics? How much richer would economics be (and how much more interesting) if students were introduced to the field’s history and its leading exponents, because only then would they see how few things in economics today are genuinely new. The current generation of economists were so stunned by the global financial crisis because they were not properly aware that such crises had been happening for centuries. Carmen Reinhardt and Kenneth Rogoff have presented details of past financial crises under the wonderfully ironic title This Time Is Different, and if there is one lesson to be learned from their examples then it is that (a knowledge of) economic history matters.
Economists enjoy a reputation as the most rigid, most precise and, therefore (they believe) most authoritative social scientists. Other social scientists such as lawyers or sociologists often complain about ‘economic imperialism’, which is based on the notion that economics possesses the sophisticated toolkit other disciplines lack. If economists suddenly admitted that some of their fancy models had been severely flawed, where would this leave economists’ authority to tell others what to think and do?
Such understandable fear should not stop economists from offering their mea culpa. There is no use denying the fact that economics has not been as successful as it hoped it could be. It was not as accurate, either. Economists are not the scientists of the new age!
The lesson economists should learn from the wake-up call that was the global financial crisis is that, 234 years after Adam Smith published The Wealth of Nations, economics as a discipline desperately needs an open and honest debate about its current state, its future and its methods: How much mathematics is appropriate? What are the limitations to model-building? Where are the blind spots of its theories? What are its relationships to neighbouring disciplines such as law, psychology, sociology, philosophy and history?
Economists should take the time to ask themselves what they can learn from the events of the past three years. If they were honest with themselves, they would conclude that many of them had been too optimistic about their ability to predict the future with certainty. They would have to confess that the world is too messy a place to be expressed in models of ‘general equilibrium’ or ‘perfect competition’.
And, hopefully, they would also conclude that you cannot be a good economist unless you actually show a great interest and curiosity in the chaotic and complex world in which we live. As Hayek said: ‘An economist who is only an economist cannot be a good economist.’
Oliver Marc Hartwich is a research fellow at the Centre for Independent Studies. This is extracted from the current issue of Policy magazine