“The Economics Profession Bears Some Responsibility for the Current Crisis”

As I have previously pointed out, most economists understand neither the cause of, nor the solution to, the economic crisis.

A new paper by an international group of economics professors now says the same thing.

The paper shows that the what the economics profession has adopted as gospel – that the economy is inherently stable – is utterly false.

The paper also says that mainstream economics has missed the fact that speculative bubbles lead to inevitable crashes, and that such popped-bubble-crashes can bring down the whole economy.

And the paper lambasts the risk models used to justify the casual buying and selling many trillions of dollars worth of credit default swaps and CDOs.

Why Did They Get It So Wrong?

Why did they get it so wrong? Why did mainstream economists stick to such faulty models and ignore basic truths about how the economy really works?

Certainly part of it is arrogance and ignorance.

But perhaps it is also because the wealthy make a lot of money in boom times, and in busts – as they understand that busts follow booms and invest appropriately ahead of time. By following the commonly-accepted dogma, the public is none-the-wise, and the elites can make a killing on both the boom and bust.

Mainstream economists have lapped up the theories of Keynes and Friedman as if they were proven beyond a shadow of a doubt. But Keynes and Friedman both conveniently ignored the fact that if the bubble is big enough, the resulting crash will take out the economy (like it is currently doing). Indeed, both Keynes and Friedman were faithful servants of those in power (that may, in fact, be one of the main reasons they were promoted to such an exulted status as the two leading economists of the twentieth century).

And both provided the illusion that problems can easily be fixed, without addressing the real, core problems:

  • Keynesian economics implies that you can keep on blowing endless speculative bubbles so long as the government is willing to “stimulate” the economy when things crash
  • Likewise, Friedman teaches that if you just increase the money supply enough, you can let business go wild and leverage itself into all the speculative bubbles it wants. That’s why – even a couple of years ago – the economic big-wigs said that they had everything figured out, and everyone could go hog wild and the system would still remain stable

The powers-that-be do not like economists who say “Boys, if you don’t slow down, that bubble is going to get too big and pop right in your face”. They don’t want to hear that they can’t make endless money using crazy levels of leverage and 30-to-1 levels of fractional reserve banking, and credit derivatives. And of course, they don’t want to hear that the Federal Reserve is a big part of the problem.

So Keynes and Friedman were elevated to the status of prophets, and those economists asking hard questions – like those in the Austrian school of economics – were ignored and sidelined. Likewise, those pushing voodoo theories justifying the tremendous increase in leverage and in the use of credit derivatives were lionized, while those questioning such nonsense were ridiculed.

Here are some excerpts to give the flavor of the paper:

The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession. … It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, “systemic crisis” appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory. …

The implicit view behind standard models is that markets and economies are inherently stable and that they only temporarily get off track. The majority of economists thus failed to warn policy makers about the threatening system crisis and ignored the work of those who did. …

The confinement of macroeconomics to models of stable states that are perturbed by limited external shocks and that neglect the intrinsic recurrent boom-and-bust dynamics of our economic system is remarkable. After all, worldwide financial and economic crises are hardly new and they have had a tremendous impact beyond the immediate economic consequences of mass unemployment and hyper inflation. This is even more surprising, given the long academic legacy of earlier economists’ study of crisis phenomena … This tradition, however, has been neglected and even suppressed. …

Many of the financial economists who developed the theoretical models upon which the modern financial structure is built were well aware of the strong and highly unrealistic restrictions imposed on their models to assure stability. Yet, financial economists gave little warning to the public about the fragility of their models . . .

Much of its research efforts are not directed towards the most prevalent needs of society. [There is now a] dominance of a paradigm that has no solid methodological basis and whose empirical performance is, to say the least, modest. … The economics profession bears some responsibility for the current crisis. It has failed in its duty to society to provide as much insight as possible into the workings of the economy and in providing warnings about the tools it created. It has also been reluctant to emphasize the limitations of its analysis. We believe that the failure to even envisage the current problems of the worldwide financial system and the inability of standard macro and finance models to provide any insight into ongoing events make a strong case for a major reorientation in these areas and a reconsideration of their basic premises.

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  • Good synopsis of Keynes and Friedman.

  • I fail to see how the Austrian School would have prevented the current crisis. It’s my understanding they like Libertarians would do away with all government regulations. I believe that’s exactly what got us here to day, the removal of regulation and guidelines for mortgages and the combining of banks and investment houses would have been the same under Austrian School logic. If you can show me where I’m wrong in this please send explanation.

  • i believe in the free flow of money and i believe that what the government needs to do is put the economic decisions in the hands of smaller corporations and businesses and that open-ended exchange is vital to keeping this economy alive instead of backing it up with fake or unavailable credithttp://americandream456.blogspot.com/

  • The field of economics is subject to the influence of what it studies. It is the corrupting influence of money that also sways medical science and agricultural science et al.Those with the money reward those with the words to justify their success and/or help them to acquire more money.

  • To better understand the mind of an economist, one needs to look at neural networks and how people learn things. Smart people with good verbal or math skills learn something quickly where one event gets burnt into their synods. Less smart people are required to learn the same things over repeated times, which give them a broader understanding of what is happening and their synods are not programmed with dogma.A good example is look at the so called "economists" at the University of Chicago. They are arrogant, opinionated and mostly wrong. They have bought off on supply economics, which cannot be academically substantiated.They also rely on SAS and looking at coefficients of correlation between two trend lines. The real world requires neural network algorithms, fuzzy logic, etc. It is absurd they get Nobel peace prizes for writing little equations when they should be required to program a more massive computer application taking in hundreds of variables that includes rule breaking.

  • Grey Tiger: We had a housing bubble because the Federal Reserve, after the dotcom crash, set the interest rates it charged the banks so low that after inflation they were effectively negative. It was paying banks to take as much money as possible. They had to put it somewhere. Since Austrians would do away with the Fed, this couldn't have happened. Neither would the big players have been able to recklessly invest with quite such confidence, in the absence of a government with printing power.

  • In the world of economics, to use Keynes and Freeman in the same sentence is blasphemy. The author neglects the fact that under his Ludwig Van Misses analyses, government would be powerless over regulatory oversight of banks. He/she claims they do not believe in efficient markets, but puts faith that it will be if government is dissolved. In another blog, the author claims Hayek warned of these bubbles. I cannot argue with him because I am not schooled in Austrian economics nor do I believe in there radical ideas. What I do know is that Milton Freedman was spurn form the sperm of Hayek. Unfettered free markets and efficiency of markets as a main stable of growth. It now seems after 30 years of New-Classical School polices, with the George Mason Grads cheerleading behind them the whole time, the Austrian School has walked away from the dismal result claiming to have clean hands from the whole affair and disingenuously denounce the side line economic policies that have given power to the renter and landlords of this nation, leaving the common man in debt and insecure. Hindsight is truly 20/20. The author cannot put the blood in the hands of Keynesian, for the policies have brought prosperity to so many of the proletarian class for 40 years. Allen Greenspan is a self proclaimed Liberian, even though schooled in the Chicago School fashion of New-Classical, nuanced in distinction to the Austrian school. It is his policies that the author now decries as unjust and the root of speculation, not Keynesian thought. It was Hyman P. Minsky that warned of these bubbles, not Hayek. It is confounding how Keynesian economics has been marginalized for over 30 years, controlled by Libertarians, as when their policies come crashing down, they blame Keynesian for all the problems, proclaiming, see we told you fiscal and monetary policy intervention will not work. It is as if government mandates foxes to watch the hen house, but then blame the farmer for the demise of live stock. I have one question for the author, if “End the Fed” comes to pass, and money is pegged to gold, what is stopping the speculative renters and landlords from driving up and down the currency at their whim. I could only imaging proprietary trading and carrier trading to dominate the landscape, causing turmoil throughout global markets. Anthony G Malin netprowlerp@hotmail.com

  • Great post Anthony and I agree 100%. The Austrian is no different than Freeman's practices why they fail to see this is beyond me. To think doing away with the FED and pegging the dollar to gold will work is to ignore the real world of Hedge funds and derivatives. Those days are long gone. I think folks like Elizabeth Warren and Ellen Brown have the economics we need. One more thing I fail to see how lowering the interest by the FED causes banks to make bad loans they knew were bad.