Despite the meltdown, economists cling to their models

With the Nobel Prize in Economics about to be announced, Heather Stewart used her Guardian column to look at how despite the meltdown economists are clinging to their mathematical models.

In the midst of the deepest and longest-lasting economic malaise since the Great Depression, you might expect practitioners of economics to be wracked with self-doubt, academic departments from California to Cambridge sweeping away the old thinking that gave intellectual heft to the claims of City investment firms to be spreading risk and making the financial world a safer place....

The lack of self-doubt in the economics profession is a direct result of the profession's complete lack of academic standards as highlighted by its peer reviewed articles and policy prescriptions.

For those who are not familiar with the lack of academic standards in peer reviewed articles I offer up as Exhibit A the articles on informationally insensitive debt.  According to the authors of these articles, informationally insensitive debt exists and demand deposits are an example.

With a nano-second of thought, any reader knows that demand deposits are not informationally insensitive.  In fact, they are very sensitive to one critical piece of information:  the existence of a government guarantee.  Without a government guarantee, no 6-year old would hand over their savings because they would not trust that they would get their money back (see Mary Poppins for the response of a 6-year old when a government guarantee doesn't exist).

Clearly, the authors confuse how much time needs to be spent independently assessing all the useful, relevant information to make a fully informed investment decision with this notion that somehow debt is not sensitive to information.  A confusion that should have consigned the article to the trash bin and not publication.

This lack of academic standards also impacts the economic professions' policy recommendations.  I give you the horde of economists banging the table saying we need to require the banks to hold a higher level of the accounting construct known as book capital.

The OECD eviscerated their argument by pointing out the simple fact that banks are hiding losses on and off their balance sheets and as a result bank book capital is meaningless.

The fact that bank capital is meaningless has not stopped the economists from banging on the table and publishing articles.

David Blanchflower, the US economist and former member of the Bank of England's monetary policy committee, says most people in the profession have sailed on unperturbed: "Economics proceeds as if nothing has happened since 2008. Everybody's going on doing exactly the same things they always did, teaching the same classes."

As for the forecasting record of many of the world's most eminent economic institutions, not least the Bank of England, he says, "In many ways, we would have been better off to hire a monkey to throw darts at a dartboard." 

The Bank, as well as the independent office for budget responsibility established by George Osborne, and the vast majority of think tanks and City forecasters, failed to anticipate the severity of the Great Recession, and the painstaking nature of the recovery.

There is no surprise that their forecasts have been bad.  If you didn't predict the financial crisis, there is no reason to believe that you have any insight into what is going on.

Regular readers know that between the FDR Framework and the approaches to handling a bank solvency led financial crisis (Swedish versus Japanese Model) your humble blogger has outperformed the economics industry in predicting the financial crisis, predicting the severity of the Great Recession, and predicting what policies won't work and laying out what policies will work.

Yet many economists persist in clinging to their cherished mathematical constructions of the world, simply postponing the upturn each quarter when confronted with the reality that it has failed to materialise. And few have conceded that some of the fundamental tenets of their work – that individuals are perfectly rational, or markets always clear at the right price – need to be junked.

There are islands of resistance. 

Two former winners of the economics Nobel, Paul Krugman and Joseph Stiglitz, have used their prominence as public intellectuals over the past five years to issue repeated rebukes to policymakers for failing to grasp the scale of the crisis, and take sufficiently radical action to protect the economy from the worst ravages of the downturn....

While I appreciate the efforts of Professors Krugman and Stiglitz, they have effectively been a bunch of sound and fury that has distracted attention away from a serious discussion of the underlying cause of the financial crisis:  opacity in wide swaths of the financial system.

The IMF's shift, from cheerleading for austerity to advocating a gentler approach, shows just how much old orthodoxies are crumbling in the face of the facts. Five years after the onset of the crisis, the eurozone is on the brink of collapse and the UK is mired in a double-dip recession, despite embracing drastic deficit cuts.

The evidence is pretty overwhelming that the Japanese Model does not work and it is time to adopt the Swedish model.

Eric Beinhocker is the executive director of Oxford's Institute for New Economic Thinking, part of a transatlantic effort to rethink the basic tenets taught to students over recent decades. He says: "The crisis has revealed enormous gaps in economists' understanding of the linkages between the financial system and the broader economy. 

Before the crisis, few economists would have predicted that trouble in an obscure corner of the US mortgage market could cascade into a global calamity."... 

Jonathan Portes, director of the National Institute for Economic and Social Research, falls into the latter camp. He's a fierce critic of the government's deficit-cutting strategy. But he says that in microeconomics – the bottom-up study of individual firms and markets – it would be wrong to throw the baby out with the bathwater. 

"I don't think the crisis tells us much about the fundamental underpinnings of microeconomics," he says. However, he believes where economists failed was in assuming that finance worked just like any other market: "When it came to financial companies, it turned out we needed to think about them completely differently. More markets are not necessarily better."

Excuse me, but the foundation block of microeconomics is the notion of the invisible hand.  The necessary and sufficient condition for the invisible hand to operate properly is that the buyer has all the useful, relevant information in an appropriate, timely manner so the buyer can independently assess what they are buying and make a fully informed decision.

Everything else is a market imperfection (examples include monopolies and information asymmetry).

If economists had simply focused on their most basic assumption, they would have seen that opacity was becoming commonplace in the financial system and they would have rung alarm bells to have transparency restored.

He adds that one lesson economists may need to learn is to be more humble about the predictive power of their economic models, however neat and precise the mathematics that underlies them. 

Complex mathematical equations have replaced what Blanchflower calls "the economics of walking about," as the foundation of the modern subject.

Walter Bagehot was a practitioner of the economics of walking about.  Not only did he develop the concept of a modern central bank, but he established why interest rates should never go below 2%.

Lord Skidelsky, economic historian and biographer of Keynes, agrees: "It may be that there's no perfect model, and that the quest for one is an error. Maybe we need different models, different theories, for different situations, and that's the best we can do. Keynes said economics was a moral science, not a natural science – by which I mean that it has to take into account the variability of human situations."...

Clearly, the Swedish and Japanese model describe the situation when faced with opacity in the financial system and a bank solvency led financial crisis.