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Economists might usefully desist

In November last year, during a visit to the LSE, the Queen of England (and Australia to our eternal shame) asked some pointy heads why “if these things were so large, how come everyone missed them?” in relation to the apparent inability of the mainstream economics profession to foresee the crisis. Apparently, the Royal Academy then called a special workshop to discuss this and came up with an answer which they then relayed post haste … as “Your Majesty’s most humble and obedient servants” to Liz. The whole affair represents the standard massive denial that defines mainstream macroeconomics. There are no saving graces. It would be useful if they just desisted for a while and went and played gin rummy.

The Royal Academy pointy heads – all senior economists in Universities and elsewhere with links to monetary policy etc sent the Queen this letter, explaining how all of us bright things (economists) were all so concentrated on making wealth for our various spheres of influences (firms, banks, financial houses etc) and providing policy advice to our governments that was making consumers wealthy and free and everyone was so feeling, well, so “feel-good” and benefiting from what they call the “light touch” of self regulation thoughout the system … that, unfortunately, amid all this goodness and charity … although

Everyone seemed to be doing their own job properly on its own merit. And according to standard measures of success, they were often doing it well. The failure was to see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction. This, combined with the psychology of herding and the mantra of financial and policy gurus, lead to a dangerous recipe. Individual risks may rightly have been viewed as small, but the risk to the system as a whole was vast.

So in summary, Your Majesty, the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.

Can you believe these guys? There was only one a female among them by the way – lots of Sirs, Rt Hons and Profs notwithstanding.

The failure goes back squarely to the theoretical structures that mainstream economics uses to determine whether a situation is sustainable or not. Nothing has been learned from this disaster as yet when you consider that these characters will be sipping on their tea in their tenured and very well paid jobs while unemployment and poverty sky-rockets and once growth returns they will emerge at various board meetings and government task forces working out how to cut more cake for themselves and their wealthy mates while admonishing the unemployed for not showing enough endeavour to dig themselves out of the poverty they are trapped in.

You could usefully trace the academic work of the signatories to the letter and the attendees at the conference in June this year to many statements that supported de-regulation of financial markets and labour markets; increased harshness of welfare systems; reduction of public sector involvement in the economy generally and more. You will struggle to find any statements from them advocating that the only sustainable growth path is for the government sector to run deficits of sufficient size to finance the non-government desire to save.

The general malaise of the profession is to be found in the text books that dominate and are insidiously imposed on the students.

In a recent edition of the Atlantic Magazine, veteran macroeconomist Paul Samuelson gave a two part interview – Part One and Part Two. Samuelson, for non-economists, is 94 years old and wrote one of the most influential macroeconomics textbooks in the 1950s and 1960s.

It was a Keynesian book but in the spirit of what became known as the neo-classical synthesis – a bastardised Keynesian approach that emerged in the 1940s as a result of poorly written sections of Keynes’ General Theory that gave scope for the mainstream to reinvent themselves within his framework but still recapture some of the ground that they should have rightly lost as a result of their dismal performance during the Great Depression. That is, they failed to understand it as a systemic failure of the macroeconomy and instead still considered it to be a problem of excessive real wages. It wasn’t and their policy prescriptions made things worse.

However, by comparison with today’s textbooks Samuelson was almost a reasonable depiction of the gold standard economy he wrote about. Anyway, Samuelson was asked in Part 1 of the interview – in the context of the current crisis revealing the failure of the dominant macroeconomic theories of today (which rejected Keynesian style fiscal policy intervention in favour of inflation-first monetary policy and passive fiscal policy (surpluses)) – whether “it time for the Keynesians to declare victory?”. He replied:

Well I don’t care very much for the People Magazine approach to applied economics, but let me put it this way. The 1980s trained macroeconomics — like Greg Mankiw and Ben Bernanke and so forth — became a very complacent group, very ill adapted to meet with a completely unpredictable and new situation, such as we’ve had. I looked up — and by the way, most of these guys are MIT trained; Princeton to MIT or Harvard to MIT — Mankiw’s bestseller, both the macro book and his introductory textbook, I went through the index to look for liquidity trap. It wasn’t there!

Mankiw’s text book in macroeconomics is one of the most popular among lecturers. It is an appalling rendition of how the macroeconomy works. You will find very little in it that will help you understand how a modern monetary system works despite its several versions (different levels and coverage). You will only learn that ultimately unemployment will converge on some natural rate as long as welfare payments are scrapped and unions butt out. You will learn that budget deficits are ultimately inflationary and drive up interest rates. You won’t gain any clue about the essential operations of the monetary system and the way the central banks interact with treasuries to facilitate net spending etc.

In the second part, apart from slamming the state of new-classical macroeconomics, Samuelson also takes aim again at Mankiw. He was asked and replied:

Are you happy with the way economics is being taught now? You’ve mentioned Greg Mankiw’s textbooks.

Well to say that I’ve read them would be an exaggeration. I looked into them, and I was disappointed that they were so bland. [Laughs] No, he’s a gifted writer. But an economist with a facile pen isn’t necessarily an overnight expert on the likelihoods in our inexact science.

Another macroeconomics text book writer, Bradley De Long at least had the wit to be honest about the state of play. He told a gathering in Singapore recently that:

This is also a bad time to be a macroeconomics theorist. Take any intermediate macroeconomics textbook – even mine and Marty Olney’s – try to use it to figure out what is happening to the world economy right now, and you come up dry. Take any introductory economics principles text: it is of no greater help. Perform the difficult and arcane task fo reading the technical papers that we make graduate students read in their first and second years of macroeconomics courses – you gain little if anything of use. The economic theories we professional economists typically teach do not do their job of helping us to understand the world in which we are now living.

Well the real problem is that mainstream macroeconomics is devoid of any real understanding of how the fiat monetary system operates. There is also a dangerous “sociology” within the economics profession.

It is well established that economists rarely refer to other social science research in their own work. This study provides an interesting (one of many) comparisons of cross-citations among sociologists, political scientists and economists. It concludes:

The most straightforward (sociological) interpretation of the above is the former: Economists ignore the other two disciplines because they regard them as lower in status, and they are able to get away with such attributions because the other disciplines implicitly accept their lower status (otherwise they would reciprocate by ignoring economics as well) … Another interpretation takes these data as evidence of the openness of a given discipline to intellectual exchange with other disciplines. Using this interpretation, both sociology and political science became much more open to other disciplines around mid-century, with the latter particularly notable for its openness to other influences. By contrast, economics has essentially been closed both to sociology and political science.

My profession is largely an arrogant and narrow-minded group. I recall when I was a graduate student that I was vilified for reading sociology and political philosophy. A well-known professor at the time (now dead) said to me once “you are very bright billy but why do you dabble in all this pop sociology?”.

There was intense pressure in university to toe the line presented. I never did but most do. There is a clear club that defines in the main progress – it is easier to publish, easier to get research grants and easier to get promotion. It is very hard for a non-orthodox economist to even get a tenured academic post.

The consensus permeates all the big international institutions like the IMF and the World Bank. I have written about this before – see my blog Bad luck if your poor.

The main policy advice given by economists is to promote fiscal surpluses supporting monetary policy centred on inflation control and then microeconomic policies such as deregulation and welfare stringency.

The policy framework has failed dramatically. Even in the growth period it failed to provide enough jobs or working hours to satisfy the preferences of the available labour. It also increased inequality in access to national income. The less developed countries have gone backwards over the neo-liberal period. In a world of plenty more people are poor now than before. And we have increasingly trashed our natural environment.

The fact is that modern monetary theorists have been writing about the coming crisis for years now – long before the debt explosion started to unwind. We developed our understandings from first principles about the relationship between the government and non-government sector and how net public spending supports high levels of private sector activity without forcing the private agents into increasing levels of indebtedness.

We predicted that once the private agents started to restructure their balance sheets to reduce their precariousness, then the fiscal drag in the system would drive it into a very deep recession.

So all you bright Royal Academy things seeking some “collective imagination” the first place to start is to go back to first principles and start understanding that a government surplus = a non-government deficit (and vice versa). Then start building from that beginning.

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    This Post Has 8 Comments
    1. Dear Bill,

      “My profession is largely an arrogant and narrow-minded group.”

      I’d replace arrogant with ignorant.

      Cheers Alan

    2. ” … You won’t gain any clue about the essential operations of the monetary system and the way the central banks interact with treasuries to facilitate net spending etc”

      Rothbard’s book “The Mystery of Banking” talks briefly of the government’s account. His accounting is correct all the way (though his attitude is awful) but he makes a big mistake (other than ‘mutlipliers’) – he mentions that the government has an account at the banks and doesnt mention about an account at the central bank. Its really surprising.

      Some writers in India (don’t want to name them) – consultants to public policy departments write in such a pseudo intellectual way that its really amusing. They write in editorials of leading newspapers asking the government to take care that investments do not fall because of fiscal policies. There is no mention of “crowding out” but the way it is written is that crowding out is a law of nature so obvious that it is not even worth the mention and that the reader should know about it and if he doesnt, he/she is not learned and the article they are writing is for elite only. That is, if you were to ask them “Why did you raise the question on investments”, they would laugh inside their heads. These people keep pushing down hi-fi people in the government who seem to vaguely have started understanding modern monetary economics.

      I used to work in Derivatives. My taste for Economics is newly acquired and thankfully, I came at the right place early but at any rate, I would have reached this blog sooner or later. Have asked myself before and would have asked myself again- “How is it that in the private sector, people keep paying each other plus interests on principals etc and in spite of that an economy keeps growing?”

      And yeh! I am reading Wynne Godley and Marc Lavoie’s text also now!

    3. Dear Bill

      I’m confused, the early response to this crisis was a call for keynesian style fiscal stimulus. This came from many govt administrations. The UK treasury was banging this drum and insistent on the need to run large budget deficits.

      We’ve also seen that the measures undertaken to recapitalise the banking system has averted a financial catastrophe. This surely leads us to give credit to experts on the great depression such as ben bernanke.

      Can they have done more ? Sure. But these members of the profession have averted financial disaster and a great depression. For that atleast the likes of bernanke should get credit, no ?

    4. @tricky … whether a depression has been averted is, of course, not yet established. After all, in the US the Great Depression consisted of over one full Business Cycle … from the Great Crash recession through the banking panics of 1930, 1931 and 1932, to the Roosevelt Recovery of 1933 to 1937, then the Roosevelt Recession of 37/38 (when Roosevelt agreed to balance the budget), then the second recovery after resumption of deficit spending merging into the US early armament sales for WWII and then entry into WWII.

      The US economy, for example, could recover sometime in Q4 this year and reach 2% growth in 2010 and 2011, without seeing any substantial declines in unemployment, and then be pushed back into recession by another oil price shock, to which the US is more exposed than even Australia, let alone Japan, the EU or China. That would be the U6 unemployment series topping 10% in the middle of 2008, and staying well above 10% over 2009, 2010, 2011, and into 2012 with no clear end in sight, barring adoption of real-world based fiscal policies. Surely that would be a Depression, even though by hypothesis the current recession ended in 2009.

      And based on the theory that the markets could not be so wrong for so long about the “fundamental” values of financial assets, Bernanke has been injecting liquidity by buying and lending against unsound private financial assets, rather than public bonds. Now, that may look like averting a financial crisis, but there is no telling what the balance sheet of the Fed will look like if it proceeds for another three or four years.

      Under normal central banking practice, a central bank buys sovereign debt denominated in the domestic currency, so that it can always sell that debt back again as a mechanism to drain reserves from the system. It is unclear, however, precisely what the position the Fed will be in if the current experiment with its balance sheets should go awry. And given a failure to bring a macroeconomic model to the table that would permit him to understand that much of this debt was indeed overvalued for quite a long period of time, if something does go badly awry, it will take the Fed by surprise, and that in itself will be very damaging to its reputation, and hence the position of the US$ in the global political economy.

    5. The only LSE economists I can think of that had any ability were Lerner, Kaldor, and Hayek. Hayek supervised / taught both Lerner and Kaldor. Several years down the track (Socialist Calculation Debate) the students had defected to the otherside of economics and the gloves were well and truly off.

      Hence, there is absolutely nothing in the spirit of Keynes to have come out of the LSE for a very very very long time.

    6. You do have to feel a little bit sorry for the right honourable sirs. After all, what else could they do? Certainly not teach English! In the section of their letter that you quote, Bill, they wrote:

      This, combined with the psychology of herding and the mantra of financial and policy gurus, lead to a dangerous recipe.

      A spelling mistake in a letter to the queen (“lead” instead of “led”)? Very embarrassing. Unless of course metallic poisoning is the real cause of their problem.

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