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What Went Wrong With Economics

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http://www.economist.com/opinion/displaySt...e=hptextfeature

And how the discipline should change to avoid the mistakes of the past

OF ALL the economic bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself. A few years ago, the dismal science was being acclaimed as a way of explaining ever more forms of human behaviour, from drug-dealing to sumo-wrestling. Wall Street ransacked the best universities for game theorists and options modellers. And on the public stage, economists were seen as far more trustworthy than politicians. John McCain joked that Alan Greenspan, then chairman of the Federal Reserve, was so indispensable that if he died, the president should “prop him up and put a pair of dark glasses on him.â€

In the wake of the biggest economic calamity in 80 years that reputation has taken a beating. In the public mind an arrogant profession has been humbled. Though economists are still at the centre of the policy debate—think of Ben Bernanke or Larry Summers in America or Mervyn King in Britain—their pronouncements are viewed with more scepticism than before. The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.†Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.â€

In its crudest form—the idea that economics as a whole is discredited—the current backlash has gone far too far. If ignorance allowed investors and politicians to exaggerate the virtues of economics, it now blinds them to its benefits. Economics is less a slavish creed than a prism through which to understand the world. It is a broad canon, stretching from theories to explain how prices are determined to how economies grow. Much of that body of knowledge has no link to the financial crisis and remains as useful as ever.

And if economics as a broad discipline deserves a robust defence, so does the free-market paradigm. Too many people, especially in Europe, equate mistakes made by economists with a failure of economic liberalism. Their logic seems to be that if economists got things wrong, then politicians will do better. That is a false—and dangerous—conclusion.

Rational fools

These important caveats, however, should not obscure the fact that two central parts of the discipline—macroeconomics and financial economics—are now, rightly, being severely re-examined (see article, article). There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it.

The first charge is half right. Macroeconomists, especially within central banks, were too fixated on taming inflation and too cavalier about asset bubbles. Financial economists, meanwhile, formalised theories of the efficiency of markets, fuelling the notion that markets would regulate themselves and financial innovation was always beneficial. Wall Street’s most esoteric instruments were built on these ideas.

But economists were hardly naive believers in market efficiency. Financial academics have spent much of the past 30 years poking holes in the “efficient market hypothesisâ€. A recent ranking of academic economists was topped by Joseph Stiglitz and Andrei Shleifer, two prominent hole-pokers. A newly prominent field, behavioural economics, concentrates on the consequences of irrational actions.

So there were caveats aplenty. But as insights from academia arrived in the rough and tumble of Wall Street, such delicacies were put aside. And absurd assumptions were added. No economic theory suggests you should value mortgage derivatives on the basis that house prices would always rise. Finance professors are not to blame for this, but they might have shouted more loudly that their insights were being misused. Instead many cheered the party along (often from within banks). Put that together with the complacency of the macroeconomists and there were too few voices shouting stop.

Blindsided and divided

The charge that most economists failed to see the crisis coming also has merit. To be sure, some warned of trouble. The likes of Robert Shiller of Yale, Nouriel Roubini of New York University and the team at the Bank for International Settlements are now famous for their prescience. But most were blindsided. And even worrywarts who felt something was amiss had no idea of how bad the consequences would be.

That was partly to do with professional silos, which limited both the tools available and the imaginations of the practitioners. Few financial economists thought much about illiquidity or counterparty risk, for instance, because their standard models ignore it; and few worried about the effect on the overall economy of the markets for all asset classes seizing up simultaneously, since few believed that was possible.

Macroeconomists also had a blindspot: their standard models assumed that capital markets work perfectly. Their framework reflected an uneasy truce between the intellectual heirs of Keynes, who accept that economies can fall short of their potential, and purists who hold that supply must always equal demand. The models that epitomise this synthesis—the sort used in many central banks—incorporate imperfections in labour markets (“sticky†wages, for instance, which allow unemployment to rise), but make no room for such blemishes in finance. By assuming that capital markets worked perfectly, macroeconomists were largely able to ignore the economy’s financial plumbing. But models that ignored finance had little chance of spotting a calamity that stemmed from it.

What about trying to fix it? Here the financial crisis has blown apart the fragile consensus between purists and Keynesians that monetary policy was the best way to smooth the business cycle. In many countries short-term interest rates are near zero and in a banking crisis monetary policy works less well. With their compromise tool useless, both sides have retreated to their roots, ignoring the other camp’s ideas. Keynesians, such as Mr Krugman, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, the cacophony underlines the profession’s uselessness.

Add these criticisms together and there is a clear case for reinvention, especially in macroeconomics. Just as the Depression spawned Keynesianism, and the 1970s stagflation fuelled a backlash, creative destruction is already under way. Central banks are busy bolting crude analyses of financial markets onto their workhorse models. Financial economists are studying the way that incentives can skew market efficiency. And today’s dilemmas are prompting new research: which form of fiscal stimulus is most effective? How do you best loosen monetary policy when interest rates are at zero? And so on.

But a broader change in mindset is still needed. Economists need to reach out from their specialised silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work. And everybody needs to work harder on understanding asset bubbles and what happens when they burst. For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world.

I have to agree with Krugman on that statement.

Modelists have got too arrogant about how things work, LTCM is a case in point they just used data to prove themselves correct and ignored previous data which may have made them more cautious.

Central banks do not model debt sustainability, this is incredible considering they are moving interest rates up and down, all what they are concerned with the idea that X increase in interest rates will produce a Y decrease in inflation. The idea that X increase in interest rates won't case too many people to default destabilising the entire financial system is conveniently ignored because it doesn't fix into the model.

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http://www.economist.com/opinion/displaySt...e=hptextfeature

I have to agree with Krugman on that statement.

Modelists have got too arrogant about how things work, LTCM is a case in point they just used data to prove themselves correct and ignored previous data which may have made them more cautious.

Central banks do not model debt sustainability, this is incredible considering they are moving interest rates up and down, all what they are concerned with the idea that X increase in interest rates will produce a Y decrease in inflation. The idea that X increase in interest rates won't case too many people to default destabilising the entire financial system is conveniently ignored because it doesn't fix into the model.

Markets work just fine - not liking the result is a lot different than it being wrong.

Ofc lots of people don't like the results, which is why they buy politicians instead of competing in the marketplace.

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Markets work just fine - not liking the result is a lot different than it being wrong.

Ofc lots of people don't like the results, which is why they buy politicians instead of competing in the marketplace.

How long before we see a futures market in politicians?

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What went wrong with economics was the assumption that individuals not only act rationally but act morally too.

Economics has never bothered itself with the vague concept of morality; in terms of rationally, is it better to assume that people act irrationally, i.e. they set out to harm themselves.

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The bankers became the government.

Agreed, Gordon really is a banker.

Oh, no hang on, I've mis-read that, Gordon really is a w.....

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I'm just wondering - given California is thinking of legalising marijuana, will there be a futures market in that too?

Marijuana Backed Securities - guaranteed to go up in smoke.

Crack Default Swaps, anyone?

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Economics never work when you spend more than you earn. Gordon knows this but hates it because NuWorld economic growth requires everyone to spend more than they earn.

A sh1t system run by old w4nkers. Get them all under the ground, that's what I say. Waste of air that they are. :rolleyes:

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Agreed, Gordon really is a banker.

Oh, no hang on, I've mis-read that, Gordon really is a w.....

Not just the UK. Everywhere. The takeover happened many moons ago............

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What Went Wrong With Economics, Reality came knocking?

but some economists predicted it

link

The Economic Meltdown: Its Cause and Cure

by Laurence M. Vance

Free-market capitalism has taken a beating of late, even by some who generally support the free market. We have been told that the economic meltdown is the fault of greed, speculation, unregulated markets, business cycles, and market failure – even capitalism itself. "We Are All Socialists Now" proclaimed a recent cover of Newsweek magazine.

These recent attacks on capitalism are not only wrong they are misdirected. One of the greatest myths about the free market in the United States is that we have one. The U.S. economy – after a hundred years of Progressive Era reforms, the Square Deal, the New Deal, the Great Society, and, most recently, government ownership stakes, rescue packages, stimulus packages, and bailouts – is a mixed market economy. Behind the façade of the free market is a myriad of government prohibitions, restrictions, and regulations.

So, if it is not the failure of the free market, then what is it that has caused the worst economic crisis in this country since the Great Depression? More importantly, what is the cure?

According to Thomas Woods, the author of the New York Times bestseller Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (Regnery, 2009), the current and former administrations, both parties in Congress, the mainstream media, and most economists have things backwards. Government intervention is the cause of the current economic meltdown, not the cure.

Woods’ diagnosis of our economic woes is a simple one, even as his prescription for a cure is a radical one. Woods writes, "The current crisis was caused not by the free market but by the government’s intervention in the market."

Woods considers the Federal Reserve’s previous interventions in the economy "to push interest rates lower than the market would have set them" to be "the single greatest contributor to the crisis." He equates the Fed’s money and interest rate planning to the now-discredited economic central planning of the Soviet Union. And even though government and Fed intervention is the cause of the crisis: "There is nothing the government or the Federal Reserve can do to improve the situation, and a great deal they can do to prolong it," he writes.

Woods holds degrees from both Harvard and Columbia, is a senior fellow at the Ludwig von Mises Institute in Auburn, Ala., and is also the author of the New York Times bestseller, The Politically Incorrect Guide to American History.

Although his most recent book contains many timeless truths about money and markets, it could not be more timely. Woods promises, and delivers, "a layman’s overview of where the economy is and what should be done next." An appendix giving books and online resources for further reading is provided to guide the reader on the path of economic self-education. The book contains no novel or earth-shattering pronouncements, since Woods considers his ideas to be "for the most part, old ones" that have "simply been neglected."

Woods also discusses the housing bubble. He believes that the standard account of the crisis neglects the ultimate cause: failed government policies. The culprits are all connected with the government: Fannie Mae, Freddie Mac, the Federal Housing Administration, the Community Reinvestment Act, affirmative action in lending, the political goal of increasing home ownership, the tax code, HUD, and as always the interest rates set by the Federal Reserve. The solution, then, is not more government oversight, but less, since "more and riskier loans are what the government wanted."

And then there is the great Wall Street bailout. American taxpayers know all too well about AIG, Bear Stearns, Fannie Mae, Freddie Mac, Citigroup, Bank of America, General Motors, Chrysler – all bailed out because they were deemed to big to fail. Woods stands this reasoning on its head: "These firms we’re told are too big to fail are in fact too big to be kept alive. The longer they are kept on life support, the more they drain capital and resources away from fundamentally sound firms."

The business boom-bust cycle is not "an inherent feature of the market economy," argues Woods. Following the Austrian economists Ludwig von Mises and F. A. Hayek, he singles out the central bank as the culprit – "the very institution that postures as the protector of the economy and the source of relief from business cycles." Additional government interference is then exactly when prolongs the bust and delays the recovery.

A historian by training, Woods is at his best when he debunks the great myths of the Great Depression. The Great Depression was not caused by the Hoover administration’s laissez-faire economic policies. To the contrary, Hoover’s "unprecedented interventions took the 1929 downturn and made it into the Great Depression." This was then prolonged by FDR’s New Deal.

Woods also discusses in depth the topic of money, covering clearly and succinctly the origin and nature of money, the gold standard, the money supply, inflation, deflation, the Federal Reserve, and how governments throughout history have monopolized the production and eventual destruction of the value of money.

Woods gives his perspective on some cures to restore the economy to health: let firms go bankrupt, abolish Fannie Mae and Freddie Mac, stop the bailouts, cut government spending, end government manipulation of and control over money, and put the actions of the Fed on the table for review – the institution "responsible for more economic instability than any other."

The message of Meltdown is clear: Government intervention in the economy is always part of the problem, but never part of the solution.

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