Opinion: Why so many economists got it so wrong: they ignored history

By Neville Bennett On a visit to the London School of Economics in November 2008, H.M. The Queen demanded to know why nobody had anticipated the credit crunch. Predictably the School set up a committee, even co-opting the Bank of England and arch conspirator Goldman Sachs. With lightning speed it replied  last week,  a mere eight months later. It blamed "financial wizards" who believed that their plans to protect the financial system were infallible. They were guilty of "wishful thinking combined with hubris". This is more charitable than the view put forward in this column recently that the wizards are corrupt. The letter says, moreover, that the crisis was "caused principally by a failure in the collective imagination of many bright people...to understand the risks to the system as a whole". As explained last week, this is also the view of Ben Bernanke who is "disgusted" because corporates took "wild bets that forced these companies close to bankruptcy". Nevertheless, at the same time I pointed out that the models used by the Bank of England were absurd in concentrating on price and labour cost movements but having no interest in credit. Lack of imagination in economics

That brings the discourse focus back to economics, and more discussion of why economists in general have been found wanting. The Economist summed up the charge.. "they helped cause the crisis, that they failed to spot it, and they have no idea how to fix it.". The charge is comprehensive, and untrue and unfair to all economics and economists, but it appears to have  a hard core of substance in the case of macro and financial economics. The critics have emphasized the flawed assumptions in models. Models assumed market efficiency: a firm could always get credit at the going rate and sell at the going rate. In the crunch the market for derivatives disappeared and many desperate firms could not get credit. Indeed, banks remain reluctant lenders, even to each other, and credit is tight in the US, UK and EU. I explained last week that the Bank of England model did not include banks, and the Fed assumed away asset bubbles. Both banks focused on price not credit. The Fed also assumed asset booms would be smoothed by efficient markets, but even if they did not, it was more efficient to let them run their course and clean up afterwards. "Efficient markets" doctrine clashed with stopping a bubble forming. Macroeconomists had imperceptible interests in financial markets. These enjoyed perfect information, competition, and always cleared. Their models assumed an asset would hold its price, even if everyone else was selling. They also though a few years data was enough: it established that house prices never fell and stock markets never lost more than 5%. They had no interest in fiscal policy because it had few effects, it could be left to others such as political scientists. Paul Krugman says that of the 7000 papers published by the US National Bureau of Economic Research (1985-2000) only five mentioned fiscal policy in the abstract or title. The Bureau is the central clearing-house for macroeconomic research;  it also dates recessions. Nastiness in common rooms Many economists are uninterested in the real economy, but they are capable of being perturbed when Paul Krugman dismisses their discipline as spectacularly useless and positively harmful. This could affect student numbers and cannot be ignored! Krugman compounds his insults by saying the masters should be re-read, especially Keynes in order to get back to a sound basis. Macro, he says is in a Dark Age having lost the wisdom of the ancients. Krugman's Keynesian call for massive spending is not universally supported in common rooms. One issue is the size of the multiplier. Keynesian's often argue that a dollar spent by government on public works (now called "infrastructure") resulted in more than a dollar's worth of stimulus.  Economic critics like Professors Lucas and Barro criticize the estimates of Barrack Obama's economic advisors as absurd, according to the Economist. Financial Economics Financial economics is also struggling to restore its reputation. One core doctrine is the efficient market hypothesis (EMH): that the price of a financial asset reflects all available information. It is assumed that if the price was too high, smart investors would make money by shorting it. If it was too low, investors would go long. This was the basis of much hedge fund arbitrage. It was the basis too of many derivatives. The meltdown by Long-Term Capital Management in 1998 made no discernible impact on derivative writers who continued to under-value systemic risk. Behavioral economists have been critical of financial economics for a long time. They insist that prices can get out of line for a long time, and emphasize that  investors get too exuberant in booms and too much given to despair in slumps. But although the EMH is dented, it has yet to be replaced. History Neglected I personally feel that the lack of imagination admitted by LSE's wise men owes a lot to the neglect of history, both of economic history and the history of economic ideas. Like Krugman, I have been re-reading classic writers and have found that crises have attracted much study in the past. I have read some great thinkers on a record of events, like Bagehot on the 1885 crisis and Lionel Robbins and J.K.Galbraith on the Great Depression. There have been so many crises in the past that boom and slump is obviously inherent in capitalism. I have half-written a book making boom and slump the central part of a new interpretation of NZ history but lack the funds to complete it. I have no doubt there is a need for such history. (Gillian Tett's "Fools Gold" helps explain the recent crisis) While history can result in convincing explanation, there is also a need for a theory of crises and explanations of their everlasting occurrence. At another time, I hope to show that ideas from Sismondi (died 1842) Aftalion, Speithoff, Cassel and Schumpeter have  relevant insights.