GFC and spiralling debt: Isn't it time economists learnt from their mistakes?

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Despite the GFC and ongoing ominous signs of financial doom, economists are eager to return to "business as usual", writes Dr Steven Hail.

IT WAS THURSDAY, 15 October, 1987, I lived in London and I had the flu. The weather outside was getting a bit windy.

I watched the weather forecast on BBC1.

Someone had rung the BBC and said she "had heard that there was a hurricane on the way". The senior forecaster, Michael Fish, told us all not to worry.

And, after all, he was the expert. You’ve got to trust the experts, haven’t you?

Overnight, there occurred the worst hurricane in England in more than 300 years.

By coincidence, on the following Monday, 19 October, there occurred what was, at the time, the greatest stock market crash since 1929. It appears that the crash was, in part, driven by derivatives and trading strategies that had developed since the early 1970s.

Nobel-prize winning economists had assured us that these contributed to a more efficient allocation of risk and added to both the stability of financial markets — and to wealth.

And after all, they were experts. You’ve got to trust the experts, haven’t you?

Meteorologists learned the lessons of 1987. They looked very carefully at their models. They checked whether those models fitted all that was known about the climate system. They respected the data.

Weather forecasts are demonstrably more reliable now than they were then.

Orthodox economists failed to learn from 1987, just as they had failed to learn the right lessons from a series of prior events and just as they were to continue to fail to learn from subsequent events. Twenty years later, even the Queen was amazed how little economists had apparently learned. 

But back in 1987, there was not yet a significant amount of household debt, the globalisation of finance was still at an early stage and, consequently, the financial system was far more robust than it was later to become. All it took was interest rate cuts to help shore up the system and then it was back to business as normal.

No significant lessons were learned at all. Economists didn’t go back and look critically at the realism of their models. In fact, they made those models even more abstract and unworldly than before.

They pushed for more deregulation, more globalisation, more privatisation, more financialisation, more reliance on market mechanisms. They didn’t stop and think. They pushed on regardless. This was true virtually everywhere – with America in the lead – and bodies like the International Monetary Fund (IMF) and the World Bank bullying others to follow that lead.

The high priests of what by now was more of a religion than a science became more and more triumphalist.

Chief among them was Nobel Laureate Robert Lucas, who said in 2003 that macroeconomics had succeeded and:

‘ ... its central problem of depression prevention has been solved.’

The following year, Ben Bernanke, later to be left "holding the baby" as the successor to Alan Greenspan as chairman of the U.S. Federal Reserve when crisis struck in 2008, referred to a "great moderation", which he suggested was due to the highly skilled management of central banks by economists steeped in orthodoxy.

In that very year, Olivier Blanchard, chief economist at the IMF, wrote that 'the state of macro is good'.

All over the world, economists talked about "optimal monetary policy", and advocated for minimal government intervention in economies and maximal laissez faire.

All over the world, regulations were relaxed and those automatic stabilisers, which had helped in the avoidance of a major global economic downturn for decades, were gradually diminished.

Even as these men – they were nearly all men – congratulated themselves on the new golden age, private debt and, especially, household debt was rising exponentially in many countries. By the early 2000s, the U.S. had virtually given up on financial regulation and it was (virtually) anything goes.

If you have never watched the documentary Inside Job, or the dramatic film, The Big Short, I recommend you to do so to properly understand what these men and their theories had created. And, of course, their views were entirely consistent with the interests of what became known as "the one per cent" and a growing inequality of income and wealth in many countries. Especially in the USA — whoever was president.

We know what happened next, don’t we? Inevitably, what goes up, up, up, will come crashing down, down, down. And by the U.S. and global property market crash of 2007-8, the household sector was up to its eyeballs in debt it should never have been allowed, encouraged or forced to take out — and the system was many times more fragile than it had been back in October 1987.

The world faced a "Minsky Moment".

A financial crisis in such a fragile financial system that cutting interest rates to zero and central bank quantitative easing on a huge scale could not restore prosperity. Only big government, and large scale and long term fiscal deficits could do that. But deficit spending by governments was against the orthodox religion of what, by now, had been misnamed "New Keynesian economics"  — misnamed, as it had nothing to do with Keynes.

And politicians who for years had obsessed about pointlessly ‘balancing the budget’ could not bring themselves to contradict what they had been saying for years.

In the U.S., they were forced to grit their teeth and allow some deficit spending for a while, because as Robert Lucas put it:

‘ ... everyone is a Keynesian in a fox-hole.'

But nothing fundamental had been learned and they couldn’t wait to get back to "business as usual".

Across most of Europe, orthodox economists tried austerity instead, in the forlorn hope that somehow by the government spending less, everyone else would spend more.

Where they would get the money, from when the private sector had too much debt and the government wasn’t spending money into existence, was a mystery. It was probably too much to hope that they would show signs of learning from experience. Those outside orthodoxy who understood money and finance had warned them that the institutions of the Eurozone were guaranteed to fail in a crisis years before. Of course, they didn’t listen.

Meteorologists practice an empirical science: orthodox economists, for the most part, do not.

However, there have been some signs of discontent in the economics profession. Not many have put their heads into the orthodox line of fire but some have — and they have been big names too.

Only last year, Paul Romer, chief economist at the World Bank, wrote a paper entitled ‘The Trouble with Macroeconomics’.

Willem Buiter, now chief economist at Citigroup and formerly of the Bank of England, has written of:

‘ ... the unfortunate uselessness of most “state of the art” academic monetary economics.’

Charles Goodhart, now at the London School of Economics and formerly of the Bank of England, has referred to 'a steadfast refusal to face facts' in orthodox macroeconomics.

Something is up with macroeconomics. You can still see it in Australia in the excessive optimism, at least in public, of the Australian Treasury and the Reserve Bank of Australia. And in the neglect of growing household debt, housing affordability, labour force under-utilisation, youth unemployment and growing inequality.

You can hear it, every time a politician or pundit talks foolishly about "budget repair", or "a budget black hole", or confuses the government with a household, or pushes for yet more destructive deregulation.

I will have to leave for another occasion a discussion of the many things orthodox economics continues to get badly wrong and lessons many (most?) economists persistently fail to learn. It turns out they are wrong about the nature of money, they are wrong about human nature, they are wrong about the complexity and uncertainty of our economic system, they are wrong about the government budget, and they are wrong about unemployment and inequality.

What is the alternative to continuing as we have been going for the past 40 years? The alternative involves modern monetary theory, which I have written about previously and which others have written about on the Independent Australia site.

I hope you will take a look — and especially if you are an orthodox economist.

The weather forecasters learned from their mistakes: don’t you think it is time for economists to do the same?

You can read more by Dr Steven Hail at erablogdotcom, follow him on Twitter @StevenHailAus, as well as on Facebook at the Green Modern Monetary Theory and Practice.

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