What have the economists ever done for us?

In an article by this title on Vox EU, the Bank of England's Andrew Haldane actually answers the Queen's Question of 'why if everything was going so well, economists didn't see the financial crisis coming'.

Mr. Haldane asserts that the reason why economists didn't see the financial crisis coming is that the conventional economic models they use failed because financial factors like asset prices and credit had little or no role in the model.

His conclusion is that these models need to be rethought and rewritten to reflect the fact that the system is more complex.

What caught my attention in the article, was his discussion of the importance of financial history in economics and how it was neglected pre-financial crisis in favor of economic models.  It was neglected because the path to tenure for economists lays in developing and extending the conventional models.

Conventional models that were unable to predict the financial crisis (your humble blogger did) and are unable to generate a policy response that will successfully end the financial crisis (history shows that the Swedish Model is the appropriate policy response).

There is a long list of culprits when it comes to assigning blame for the financial crisis. At least in this instance, failure has just as many parents as success. But among the guilty parties, economists played a special role in contributing to the problem. 

We are duty bound to be part of the solution (see Coyle 2012).

Why are economists duty bound to be part of the solution?  If they didn't predict the financial crisis in the first place, why on earth do they have the hubris to think that they have anything to contribute to its solution?

Honestly, no one is asking them to open up their mouths and provide a solution like higher bank book capital levels, zero interest rates and quantitative easing that make the problem worse.

Our role in the crisis was, in a nutshell, the result of succumbing to an intellectual virus which took hold of the body financial from the 1990s onwards.

Excuse me, but the intellectual virus took hold a long time before that.  If it had not, economists would have been shouting from the rooftops that a financial crisis was coming.

This did not happen.

There were a handful of economists who saw subprime mortgage-backed bonds as a problem.  I might be wrong, but I don't think these few economists were in their mid- to late 70s.

One strain of this virus is an old one. Cycles in money and bank credit are familiar from centuries past. And yet, for perhaps a generation, the symptoms of this old virus were left untreated. That neglect allowed the infection to spread from the financial system to the real economy, with near-fatal consequences for both. 

In many ways, this was an odd disease to have contracted. The symptoms should have been all too obvious from history. The interplay of bank money and credit and the wider economy has been pivotal to the mandate of central banks for centuries. For at least a century, that was recognised in the design of public policy frameworks. The management of bank money and credit was a clear public policy prerequisite for maintaining broader macroeconomic and social stability. 

Two developments – one academic, one policy-related – appear to have been responsible for this surprising memory loss. 

The first was the emergence of micro-founded dynamic stochastic general equilibrium (DGSE) models in economics. Because these models were built on real-business-cycle foundations, financial factors (asset prices, money and credit) played distinctly second fiddle, if they played a role at all. 

The second was an accompaying neglect for aggregate money and credit conditions in the construction of public policy frameworks. Inflation targeting assumed primacy as a monetary policy framework, with little role for commercial banks' balance sheets as either an end or an intermediate objective. And regulation of financial firms was in many cases taken out of the hands of central banks and delegated to separate supervisory agencies with an institution-specific, non-monetary focus.

I realize this is an excuse for the Bank of England, but it is certainly not the case for the Federal Reserve.

Regular readers know that the reason monetary policy and regulation of financial firms don't mix is that to be good at one precludes being good at the other.  Monetary policy involves a comfort with theory.  Regulation of financial firms involves a comfort with minutia.  These are mutually exclusive.

The financial crisis that began in 2007 confirms that they are mutually exclusive as the Federal Reserve did not prevent the US from participating in the financial crisis even though it houses both monetary policy and regulation of financial firms.

Coincidentally or not, what happened next was extraordinary. Commercial banks' balance sheets grew by the largest amount in human history....

This balance sheet explosion was, in one sense, no one’s fault and no one’s responsibility. Not monetary policy authorities, whose focus was now inflation and whose models scarcely permitted bank balance sheets a walk-on role. And not financial regulators, whose focus was on the strength of individual financial institutions. 

Yet this policy neglect has since shown itself to be far from benign.

Actually, this policy neglect as it occurred at the Federal Reserve is confirmation that monetary policy and regulation of financial firms don't mix.

The lessons of financial history have been painfully re-taught since 2008. They need not be forgotten again. This has important implications for the economics profession and for the teaching of economics. 

Regular readers know that transparency so 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 the necessary condition for the invisible hand to work properly.

All other market imperfections, like the existence of a monopoly or accounting control fraud or information asymmetry, are examples of where the invisible hand does not work properly.

In theory, this should be taught in Economics 101.  In practice, it isn't.

For one, it underscores the importance of sub-disciplines such as economic and financial history. 

As Galbraith said,"There can be few fields of human endeavour in which history counts for so little as in the world of finance." Economics can ill afford to re-commit that crime....

This is a very important point.

In financial history, we learned that the Swedish Model successfully ends a bank solvency led financial crisis and the Japanese Model does not.

Under the Swedish Model, banks are required to recognize the all the losses on the excess debt in the financial system and society and the real economy are protected.  Under the Japanese Model, bank book capital and banker bonuses are protected at all costs and society and the real economy are severely damaged.

The second strain of intellectual virus is a new, more virulent one. This has been made dangerous by increased integration of markets of all types, economic, but especially financial and social. In a tightly woven financial and social web, the contagious consequences of a single event can thus bring the world to its knees. That was the Lehman Brothers story....

Regular readers know that applying the lessons of financial history inoculates against contagion.

When each market participants has access to all the useful, relevant information in an appropriate, timely manner, they are likely to use this information when they are held responsible under the principle of caveat emptor for any benefit or loss on their exposures.

What results from caveat emptor is that all participants adjust their exposures to what they can afford to lose.

As a result, even though the failure of one institution might cause losses throughout the global financial system, it does not result in a domino effect where other institutions also fail.

These dynamics do not emerge from most mainstream models of the financial system or real economy. The reason is simple. The majority of these models use the framework of a single representative agent (or a small number of them). That effectively neuters the possibility of complex actions and interactions between agents shaping system dynamics. 

The financial system is an archetypical complex, adaptive socioeconomic system – and has become more so over time....

Conventional models, based on the representative agent and with expectations mimicking fundamentals, had no hope of capturing these system dynamics. They are fundamentally ill-suited to capturing today’s networked world, in which social media shape expectations, shape behaviour and thus shape outcomes. 

This calls for an intellectual reinvestment in models of heterogeneous, interacting agents, an investment likely to be every bit as great as the one that economists have made in DGSE models over the past 20 years. Agent-based modelling is one, but only one, such avenue. The construction and simulation of highly non-linear dynamics in systems of multiple equilibria represents unfamiliar territory for most economists.