Wednesday, October 10, 2012

Economists tainted by intellectual failure

In his Guardian column, Simon Jenkins makes a compelling case for the intellectual failure of economists while he tries to show why Adair Turner would be the best choice to become the next governor of the Bank of England.

Turner has been a banker and an economist, two professions most tainted by the past five years. Bankers are tainted by venality, economists by intellectual failure. No one involved is free of guilt. No one has gone to jail, and only a few high-profile bankers have even suffered. What matters is have they learned?
This is a great question.  What have economists learned?
Today the IMF predicted that Britain has relapsed into recession and should "smooth its planning adjustment over 2013 and beyond", jargon for "let up on austerity". Whether such IMF forecasts merit more credibility than the wildly over-optimistic ones last year, I cannot tell. Certainly the blunders have been serious. A cut of £1 in public spending apparently does not lead to 50p less economic activity but at least £1.30p less. The "multiplier effect" of deficit reduction is thus a downward deflationary spiral. This is not ideology, but the mathematics of catastrophe.
Did economists learn that the models they rely on don't work?

Based on what the IMF said the answer is:  Not for five years and even then they are unsure why the models don't work.

Yves Smith succinctly discussed the implication of the higher multiplier on her blog, Naked Capitalism,

In case you missed it, this is an admission [by the IMF specifically, but the economics profession generally] of complete and utter incompetence. 
The IMF was relying on assumptions by the folks forced to put together austerity budgets that austerity worked, specifically, that cutting government deficits by $1 would only reduce GDP by 50 cents. 
In what will be no surprise to any reader of this blog, they’ve finally been forced to see that isn’t working, that cutting deficits are at best barely productive in lowering debt to GDP ratios ($1 of deficit reduction lowers GDP by 90 cents) to pretty counterproductive ($1 of deficit reduction leads GDP to fall by anywhere from 90 cents to $1.70).
Who could imagine that the economics profession, with the exception of a handful of individuals, which utterly failed to predict the financial crisis would be unable to accurately forecast the damage caused by austerity in the middle of that solvency crisis?

Those who warned three years ago that the risk of double-dip recession was so high as to require a plan B were right. The Treasury, the Bank of England and the IMF were wrong. 
The fact that the Treasury has had to propose six ineffective business lending packages in a row, and the Bank has had to pretend to pump £375bn "into the economy" is proof of that failure. 
I do not believe for a minute that George Osborne and his advisers, had they correctly predicted the recession, would be following the present policy. At least the IMF is now admitting its mistake....
Please re-read the highlight text and Mr. Jenkins observation that had you correctly predicted the recession/financial crisis, you would not be following the present policy.

Regular readers know that your humble blogger correctly predicted the financial crisis/recession.  They also know that I am clearly advocating a much different policy.  Specifically, I recommend adoption of the Swedish Model.

By requiring the banks to absorb upfront the losses on the excesses in the financial system, society and the real economy are protected.
Economists are like physicians in the days when they believed in leeches. They take no responsibility for gross errors that would get doctors struck off, and even transport officials suspended....
Intellectual failure is the direct result of not taking responsibility.

If you take responsibility, you start asking questions like 'what assumptions were I making leading up to the financial crisis' and 'which of these assumptions was wrong'.

Without responsibility, economists are free to argue for bailing out the banks even though the modern financial system is designed explicitly so that banks do not need to have sovereign bailouts.

Without responsibility, economists are free to argue that bank capital requirements need to be raised at a time when bank book capital is completely meaningless due to regulatory forbearance and banks engaging in 'extend and pretend' with bad debt to create 'zombie' loans.

Without responsibility, economists are free to argue that artificially setting interest rates below Walter Bagehot's 2% minimum is a good idea despite the fact that it triggers a host of unintended consequences like the Retirement Fund Death Spiral under which the lacking of earnings on assets in both pension plans and individual retirement accounts diverts current consumption to cover the earnings shortfall.
To adapt Ruskin, a hundred economists may look, but few can see....
This is an incredible observation.

Part of the reason for this is the absolute lack of standards in the economics and finance peer review journals.  My favorite example of the absence of any standards in peer review journals was the publication of an article on informationally insensitive debt and the use of demand deposits as an example of this type of debt.

Apparently, the authors and the reviewers were not familiar with the idea of deposit insurance.  If they were, they would have immediately realized the existence of deposit insurance is information and that demand deposits are highly sensitive to this information.  Just ask any 6-year old opening up a bank account to see how sensitive.
His most celebrated soundbite, in 2009, was that British banking is over-large, and much of it is overpaid and "socially useless". As free markets mature, he says, insiders merely collude to "proliferate rent-extracting opportunities" – that is, make huge sums of money. They should be curbed....
A great observation, but completely lacking in what has to be done to curb collusion, shrink the size of banks, reduce bonuses and end socially useless activity.

Regular readers know that this can be easily accomplished by bringing transparency to all the opaque corners of the financial system.

For banks, this means requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants can assess the risk of each bank and exert discipline on their behavior.

Sunlight is the best disinfectant, but where are the economists championing this solution?

Where is the profession that touts the benefits of the invisible hand?

Is it possible that economists are so poorly trained that they do not know that the necessary and sufficient condition for the invisible hand to work properly is that the buyer has access to all the useful, relevant information in an appropriate, timely manner so they can independently assess what they are buying?

Is it possible that economists are so poorly trained that they do not know that monopolies and information asymmetries are simply examples of market imperfections from this necessary and sufficient condition?
Turner maintains that economics has blown too much with the political wind. ...
This does not seem leftwing – rather pragmatic. ... Market forces do not correctly price risk, as we have just seen in spades, but can spin off into an instability. The task of regulation, says Turner, is to curb upturns and minimise downturns, as Keynes ordered. It should have warned politicians against the debt bubbles and housing hysteria of the last decade....
Hello, but the reason that the market did not correctly price risk has to do with the vast quantities of opacity in the financial market.

Hello, but the reason that the market did not correctly price risk was that regulators were saying that 'black box' banks were less risky than they really were.

Hello, but if the economists had focused on market imperfections, they would have been warning about opacity long before the debt bubble and housing hysteria.
As for present policy, Turner seems to agree with the IMF that Britain has over-deflated its economy. In July he told the Bank's monetary policy committee that it faced a liquidity trap in which quantitative easing "was proving to have little impact on behaviour and on demand". Using the banks to stimulate the economy – the core of Treasury and Bank policy – was "ineffective". This amounted to saying that recession was now government-induced.
Fascinating, had he read this blog, he would have known that the recession was government-induced a year and a half earlier.
Turner's more private view is that Britain should consider whether debt should now be "monetised", financed by blatantly printing money rather than buying bank bonds and hoping this boosts demand.
Of course, this never considers the Iceland experience with making the banks absorb the losses.

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