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Structural lessons for and from economics

The global crisis is a challenge to and an opportunity for the economics profession. Here one of the profession’s most innovative thinkers reflects on how and why economists failed to see the crisis coming, what they should tell governments to do about it, and what young economists should be working on to help us avoid future crises.

The global crisis is also a critical opportunity for the discipline of economics – an opportunity to disabuse ourselves of notions we should not have so gullibly accepted. Notions such as the unqualified support for market deregulation or the dismissal of aggregate volatility now come through as frivolous fads, while abstractions from the institutional foundations of markets seem naïve. These limitations call for self-analysis and reflection, and hopefully new research by young economists. The crisis is also an opportunity to identify the most important lessons that remain untarnished by recent events, and to ask whether these lessons provide guidance in current policy debates.

In CEPR Policy Insight No. 28 posted today, I present my views on what intellectual errors have been made and what lessons to draw from them in terms of new theoretical work that is needed. I also suggest that important lessons from growth and political economy for the current crisis-fighting policy have been underappreciated.

Lessons from our intellectual complaisance

Many of the roots of the crisis are apparent today, but most of us did not recognize them before the crisis. Three too-quickly-accepted notions impelled us to ignore these impeding problems.

  • Astute policy and new technologies had ended the era of aggregate volatility.

While the data robustly show a marked decline in aggregate volatility since the 1950s, it is now clear that the end of the business cycle was a myth. Indeed, the policy and technologies that made the economy more robust against small shocks also made the economy more vulnerable to low-probability "tail" events. Diversification of idiosyncratic risks creates a multitude of counter-party relationships. This new and dense pattern of interconnections created potential domino effects among financial institutions, companies, and households.

Massive drops in asset values and the simultaneous insolvencies of many companies highlight that aggregate volatility is part and parcel of the market system. It is also part of the creative destruction process. Understanding that such volatility will be with us should redirect our attention towards models that help us interpret the various sources of volatility and delineate which components are associated with the efficient working of markets and which result from avoidable market failures.

  • The capitalist economy lives in an institutional-less vacuum where markets miraculously monitor opportunistic behaviour.

Free markets are not unregulated markets. Well-designed institutions and regulation are necessary for the proper functioning of markets. Institutions have received more attention over the past 15 years, but focus was on understanding why poor nations were poor – not on understanding which institutions are necessary as the basis of markets and for continued prosperity in advanced economies.

  • We could trust the long-lived large firms to monitor themselves because they had sufficient “reputational capital”.

This belief turned out to be false due to two critical difficulties – monitoring must be done by individuals, and reputational monitoring requires that ex post punishment is credible. Both turned out false. Individuals may not care about the firm’s reputational capital, and the scarcity of specific capital and know-how means that the necessary punishments were non-credible.

On the bright side

We can blame ourselves for missing important economic insights and not being more farsighted than policymakers. We can even blame ourselves for being complicit in the intellectual atmosphere leading up to the current disaster. But this crisis is also an opportunity. It has increased the vitality of economics and highlighted several challenging, relevant, and exciting questions. Bright young economists are unlikely to worry about finding new and relevant questions to work on in the coming decade.

Things we should be telling policymakers

The three mistaken notions do not touch on economic principles that related to long-run growth and political economy. These principles have played little role in recent academic debates and have been entirely absent in policy debates. As academic economists, we should remind policymakers of the implications these principles have for current policies.

The first point is that fixing the short-run problem with policies that harm long-run growth is a bad option from a policy and welfare perspective. Innovation and reallocation are the keys to long-run growth, but potentially powerful groups tend to resist such changes. In developing nations, it is easy for impoverished populations suffering from adverse shocks and economic crises to turn against the market system and support populist, anti-growth policies. These threats are as important for advanced economies, particularly in the midst of the current economic crisis.

Stimulus plans that bailout the financial and auto sector will influence innovation and reallocation. Reallocation may particularly suffer if the stimulus plans lock in factors in low-productivity sectors and activities. Market signals suggest that labour and capital should be reallocated away from, for example, the Detroit Big Three and highly skilled labour should be reallocated away from the financial industry towards more innovative sectors. Halted reallocation will also mean halted innovation.

Avoiding the backlash

These concerns are not a sufficient reason for rejecting the stimulus plan, but rather a call to consider its implications for long-run growth. Decisive action on the crisis is necessary; not just soften the blow of the recession but also to avoid a backlash that could be deeply harmful to long-run growth. A deep and long recession raises the risk that consumers and policymakers start believing that free markets are responsible for the economic ills of today. If so, we could see a move away from the market economy. The pendulum could swing too far, bypassing properly-regulated free markets, towards heavy government involvement that could threaten future growth prospects of the global economy.

A comprehensive stimulus plan, even with all of its imperfections, is probably the best way of fighting these dangers. Nevertheless, the details of the stimulus plan should be designed so as to cause minimal disruption to the process of reallocation and innovation. Sacrificing growth out of our fear of the present would be as severe a mistake as inaction. The risk that the belief in the capitalist system may collapse should not be dismissed.

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