How the Entire Economics Profession Failed
I could find no shame in the halls of the San Francisco Hilton, the location at the annual meeting of American economists. Mainstream economists from major universities dominate the meetings, and some of them are the anointed cream of the crop, including former Clinton, Bush and even Reagan advisers.
There was no session on the schedule about how the vast majority of economists should deal with their failure to anticipate or even seriously warn about the possibility that the second worst economic crisis of the last hundred years was imminent.
“No one questioned their contribution to the current frightening state of affairs, no one humbled by events.”
I heard no calls to reform educational curricula because of a crisis so threatening and surprising that it undermines, at least if the academicians were honest, the key assumptions of the economic theory currently being taught.
There were no sessions about why the profession was not up in arms about the deregulation of so sensitive a sector as finance. They are quick to oppose anything that undermines free trade, by contrast, and have had substantial influence doing just that.
The sessions dedicated to what caused the crisis were filled, even those few sessions led by radical economists, who never saw turnouts for their events like the ones they just got. But no one was accepting any responsibility.
I found no one fundamentally changing his or her mind about the value of economics, economists, or their own work. No one questioned their contribution to the current frightening state of affairs, no one humbled by events.
Maybe I missed it all. There were hundreds of sessions. I asked others. They hadn’t heard any mea culpas, either.
Here’s what mainstream economists overwhelmingly—with only a few exceptions—ignored or believed was acceptable and even healthy economic behavior that contributed rather than detracted from prosperity:
• Wall Streeters paid themselves enormous bonuses based on rising market values of investments, not on revenues actually made. The bonus system has been based on the preposterous assumption that the value of an investment set by traders in financial markets rationally reflects the true future value of that asset almost all the time.
• Investment banks took on $25 to $40 of debt for every dollar of capital in order to maximize their returns. It was assumed that these smart people wouldn’t do this if they didn’t know how to manage their risk.
• Financial firms that were not regulated or overseen by the Federal Reserve or any other Washington watchdog agency lent four out of five dollars of lending to business and consumers. Economists as a group raised no concern and in truth went along without serious questioning.
• Average Americans took on record amounts of debt compared to incomes, which was said to be just fine because it was supported by high stock prices and, when that bubble burst, by high house prices.
• The earnings of financial institutions rose to more than one-third of all American profits. This only proved how valuable finance was to the economy and that manufacturing was simply old hat.
• Hedge funds could justifiably charge two percent of assets each year and take 10 to 20 percent of profits because they were excellent at finding anomalies in the otherwise efficient market. Meanwhile, economists assumed there was no manipulation or inside information involved, of course—or undue risk taking. Furthermore, economists believed this sector required no special regulation because it only had sophisticated and rich people as investors like those who participated in Bernard Madoff’s funds.
• House prices reached record levels compared to incomes. But this was because of innovations in finance that reduced interest rates substantially. That, after all, is why the Wall Street MBAs who made these innovations, like complex mortgage-backed obligations and credit default swaps, supposedly deserved all that money.
• Financial deregulation freed MBAs to make the brilliant technical innovations. I could find no single mainstream academic economist who criticized financial deregulation in a systematic way since the 1990s until only very recently. Two veteran Wall Street economists, Henry Kaufman and Al Wojnilower, were partial exceptions.
• A key economic price like the oil price, which rose to $145 a barrel in August and has reached about $40 today, was supposedly not unduly influenced by speculators. Markets are usually fair and, to repeat, correctly anticipate the future, right?
• A high dollar, as long as it is set freely in the currency markets, is just fine. It merely reflects the strength of the U.S. economy. No mere human mechanism could set a more economically efficient price.
• The record trade deficit, caused by the high dollar, was tolerable because overseas investors invested in America with their excess funds. Their confidence in America was again further indication the economy was strong, despite the ever-shrinking manufacturing sector.
• Low rates of unemployment were proof the American economic model was working. In light of this, stagnant or falling wages in the 2000s was not an indication of economic failure—just a reflection of American competitiveness.
• The Federal Reserve can always save the day, as Milton Friedman taught us. Just add more reserves and believe in Ben Bernanke, whose mentor was Friedman. So now Bernanke is adding reserves far beyond anyone’s imagination, just like Friedman said he should do, and the economy is in ever-deeper trouble.
Of course, there were objections to these trends by some academic economists. Robert Shiller of Yale was upset both about high stock prices and then high housing prices. Dean Baker, co-director of the Center for Economic and Policy Research in Washington, was long vociferous about over-speculation in housing. Nouriel Roubini of the NYU Business School warned about financial collapse, as did Jim Crotty of the University of Massachusetts at Amherst, who insisted, correctly, that Wall Street traders and bankers mispriced risk. There were a handful of Wall Street analysts who were concerned and some made money by betting the other way.
But the exceptions were partial at best, and they prove the rule. What most economists can't seem to acknowledge is that they have been overcome by free market ideology over the past thirty years. Such ideology is especially beneficial to wealthy vested interests. But economists are purportedly dedicated to objective empirical and statistical analysis. Ideology has little part in the work of these serious empiricists, but surely there was no buttering up of the rich and powerful that provide jobs and grants.
Only with the near collapse of the economy are economists changing their tunes slightly, accepting the need for regulation and Keynesian stimulus. But they will probably not change their deepest assumptions about how markets work, or about when they should and should not be given free reign. They will make no bigger place for government than to adjust a little more for “market failures.” They will go back to tinkering with those models, not transforming them, and even make them fit the current crisis without blinking an eye.
As I say, at least they now believe in Keynesian stimulus and are a little more skeptical of Friedmanism. Be thankful for small changes, I suppose. A few will fight for a larger shift. Among mainstreamers Shiller and George Akerlof at Berkeley are leading the charge. A lot of pertinent and important ideas are percolating among the liberal fringe. If there were some humility at the San Francisco gathering I’d be more optimistic these voices could prevail. Government has a central place in the economy, after all, as the Obama administration is about to demonstrate. It is not merely an option of last resort. In general—and I think the above examples of dereliction of duty make it just fine to generalize—mainstream economists are a long way from getting that fundamental idea.
Jeff Madrick is a contributor to The New York Review of Books and a former economics columnist for The New York Times. He is editor of Challenge Magazine, visiting professor of humanities at The Cooper Union, and senior fellow at the Schwartz Center for Economic Policy Analysis, The New School. He is the author of several books including Taking America (Bantam), and The End of Affluence (Random House). His latest book is The Case for Big Government (Princeton University Press).