After the crisis, bashing the economists has become a fashionable sport. While some allegations can be dismissed as irrelevant or intellectually vulgar (that economists did not foresee the timing of the crisis or that their theories are too abstract), have there been more serious failures? Though some scholars have initiated thoughtful soul searching exercises, the prevailing mood seems to be that business as usual, as if nothing happened, is the best reply to criticisms. It is, however, undeniable that this crisis does raise serious issues for the profession. In CEPR Policy Insight No. 38, I attempt to summarily consider some of them.
First, were economists aware that the financial system was on an unsustainable path that would eventually lead to a crisis? Broadly speaking, they were not, as also shown by how long it took many to understand what was going on even after the crisis started. The financial consequences of the bursting of the housing bubble, long predicted by Robert Shiller, were never properly explored. Neither the literature on the 1997-98 crises, nor that on global imbalances, nor the recent generation of crisis models were particularly helpful in directing any attention to the growth of credit, leverage, and risk exposure that was nurturing the imminent crisis. The warnings of those who understood what was brewing (Raghuram Rajan in his 2005 Jackson Hole paper, the economists of the BIS, Nouriel Roubini) went unheeded; a strand of useful literature on banks’ balance sheets, leveraging cycles, market and funding liquidity did not find a place in macro policy modelling.
Second, can it be maintained (as some do) that the fault, if any, laid only with economists afflicted by “cognitive capture”, while economic theory had much to say on the pathologies of financial markets – from agency theory to the analysis of asymmetric information? But there does not exist a general framework where all these relevant bits of theory can be assembled to yield a plausible explanation of the crisis and of its dynamics. DSGE-type models neglect financial assets and intermediaries and cannot accommodate heterogeneous agents, asymmetric information, agency problems, coordination failures and so on – it has been said that there is nothing in those model that can be of interest to central bankers. There may be concurrent explanations for the lack of concern for financial variables in modern macro modelling: the acceptance of the efficient market hypothesis and of neutrality theorems; the illusion that the volatility of financial markets had come to an end with the Great Moderation; the practical problems arising from the need to keep models manageable and easy to handle.
My final issue is whether economists’ shortcomings also had a social cost, as would be the case if their doctrines and attitudes contributed to creating an environment congenial to the eruption of a crisis. Finance theory is the obvious suspect. But even leaving that aside, there is a way in which economists have helped create a zeitgeist inspiring the actions and omissions of policymakers and regulators and therefore bear some responsibility for what has happened. Not only were regulators caught by the crisis with their eyes wide shut, but they had resisted attempts to allow regulation to keep pace with financial innovations, as shown by many examples. This was coherent with the prevailing creeds: that markets were self-regulating and only required the lightest possible public touch; that self-interest would lead to proper risk assessment; that capital deepening was always good for growth, no matter how. Respectable economists would of course warn that these propositions depended on a large number of stringent conditions unlikely to hold in real life. Sometimes, however, this caution was lost in the process of translating rigorous research into a product for immediate consumption. More generally, few objected to the vulgate version of their doctrines requested by the congregation to which they preached, which included private sector agents as well as regulators.
Thinking afresh, with some humility and without defending past rent positions, will be good for the discipline. The younger and the brighter must understand that there have been problems – otherwise we would not have seen Hyman Minsky become a popular character in the letters of private sector sell-side analysts to their clients.
