Time for economists to eat humble pie...again

Stein Ringen, a professor of sociology at Oxford's Green Templeton College, had an interesting Financial Times column in which he examines the behavior of economists.

Economists are no more likely always to agree than any other experts but there was a remarkable unanimity as the crisis unfolded: Europe was on the edge of the abyss; bold and rapid action was needed from strong governments.... 

Economists warned politicians not to dither. In the New York Times Paul Krugman poured scorn over Europe’s politicians, collectively, in terms that, had he used them about say, black people, he would have been all but up for incitement to racial hatred. What was needed, it was argued, was more “firepower”, higher “firewalls” and bigger “bazookas”, with no delay.... 

Had the balance of opinion among economists prevailed, private bondholders, who had lent recklessly, would have been let off scot-free at European taxpayers’ expense....

Actually, by dragging out the restructuring of Greece's debts, the banking sector was given time to reduce its exposure.

Rather than the banking sector acting as a safety valve and absorbing the losses on the excesses in the financial system related to Greek debt, these losses were transferred to the real economy.  After the debt restructuring, Greece has almost as much debt as before and its government is locked into austerity policies for the next several years.

So the economists got the timing for restructuring the debt right.  Had it occurred two years earlier, the level of Greek debt would be substantially lower and the need for austerity policies much less acute.

What economists got wrong was arguing for bailing out the banking system and transferring the losses to the real economy.

I have no problem with the “chief economists”, whose job is to protect the banking sector, but what about the independent academic economists? 

It should not be the job of any economist to protect the banking sector.

Bankers are fully capable of taking care of themselves.

Moreover, the institutions that they run are capable of operating for years with negative book capital.  So long as depositors believe the state's guarantee of their money and central banks are willing to provide liquidity, an insolvent bank can continue to operate and support the real economy.

They fell victim to an exaggerated confidence in themselves. Most of us in the social sciences are aware of our limitations. Economists, for their sins, have worked themselves into a frenzy about being “scientific”. Overconfidence leads to hubris. The economists let their guard down. 

First, they neglected careful description of the problem....

True.  Since August 9, 2007, we have been dealing with a bank solvency led financial crisis.  On that date, BNP Paribas said it could not value opaque structured finance securities.

Since the largest banks are also 'black boxes' that were holders of these opaque structured finance securities, this meant that banks could no longer assess the solvency of the other banks.  As a result, by September 2008, the interbank lending market froze.

Second, they neglected the need for precise language. 

“Firewalls”, “firepower” and “bazookas” are not terms of analysis. Contagion? What does that mean? 

Economists of all people should know that trust in our modern financial system is based on disclosure.  Having access to all the useful, relevant information in an appropriate, timely manner so that a buyer can know what they are buying is a necessary condition for the invisible hand to operate properly.

Economists should have been leading the discussion on the need for banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  After all, they know this is the data that is needed so that market participants can assess the risk of each bank and adjust their exposure to what they can afford to lose ... bringing an end to contagion.

Economists should have been leading the discussion on the need to make available on an observable event basis the current performance information on the underlying collateral for each structured finance security.  After all, they know that with this data the structured finance market would be restarted as market participants can independently value and based on this independent valuation trade the securities.

Economists should have been leading the discussion on the asymmetric information flow enjoyed by Wall Street and how they used it to bet against their clients.  After all, economists know that until the information flow is rebalanced, clients who have been burned will not return to the market.

Economists should have been leading the discussion on how pursuing the Japanese model for a bank solvency led financial crisis was going to dramatically increase the cost of dealing with the crisis without solving the underlying problem.  After all, economists know that the Swedish model of requiring the banks to absorb the losses on the excesses in the financial system today works.

And third, they indulged in predictions, the economist’s ultimate vanity, but their models are no more than equations with countless unknowns. 

The need to predict, a psychological urge in the economic tribe, led to the wildest warnings....  

One lesson is clear: beware the experts who come bearing advice and in particular economic experts.

Your humble blogger can forgive economists for making predictions.  After all, I predicted the financial crisis and what it would take to moderate its impact.