Reposted from Forbes

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How Economists Contributed to the Financial Crisis

John T. Harvey | February 6, 2012 | Forbes

A lot of blame has been spread around regarding the financial collapse and the onset of the Great Recession. Greedy speculators, big banks, Wall Street executives, and Fannie Mae and Freddie Mac have all taken turns as whipping boys. But one group has largely avoided their fair share of attention: economists. They were the ones who provided the intellectual justification for the transformation of our economy over the past thirty years. They stood idly by as jobs went overseas, demand was sapped by increasingly uneven distributions of income, competition was destroyed by lax attitudes towards antitrust laws, and safeguards were discarded in the financial sector. More than that, many actually praised these events. This is not insignificant. Much of the financialization of the U.S. economy (the shift from producing goods and services to managing financial wealth that played such a central role in our collapse) could not have occurred without economists offering their tacit and open approval. Opposition would have slowed, if not stopped, these trends.

There was actually a poll among economists to determine which of their brethren they thought most responsible for our current debacle. The “winners” were as follows:

Alan Greenspan (5,061 votes): As Chairman of the Federal Reserve System from 1987 to 2006, Alan Greenspan both led the over expansion of money and credit that created the bubble that burst and aggressively promoted the view that financial markets are naturally efficient and in no need of regulation.

Milton Friedman (3,349 votes): Friedman propagated the delusion, through his misunderstanding of the scientific method, that an economy can be accurately modeled using counterfactual propositions about its nature. This, together with his simplistic model of money, encouraged the development of fantasy-based theories of economics and finance that facilitated the Global Financial Collapse.

Larry Summers (3,023 votes): As US Secretary of the Treasury (formerly an economist at Harvard and the World Bank), Summers worked successfully for the repeal of the Glass-Steagall Act, which since the Great Crash of 1929 had kept deposit banking separate from casino banking. He also helped Greenspan and Wall Street torpedo efforts to regulate derivatives.

One might wonder how there could be such a disconnect between the theories employed by these economists and the real world. But, to those of us in the profession, it comes as no surprise. Some of us have been worried to death about it for years.

The short answer is, the incentive structure in mainstream (or Neoclassical) economics is skewed towards rewarding people for building complex mathematical models, not for explaining how the actual economy works. You might assume those two things are connected in some tangible way, but that’s not necessarily the case. I think the non-economist would be absolutely shocked by some of the things we learn in graduate school. For example, I wonder how many people know the formal Monetarist (Milton Friedman’s school of thought) explanation of how the Great Depression occurred? Their analysis depends on the existence of something called money illusion on the part of workers. The idea is that laborers are never quite certain what the current cost of living is since they do not keep a careful accounting of their expenditures. Meanwhile, firms are pretty darn sure what prices are because it is so important to their livelihood to pay close attention. Now imagine the following. Let’s say there is a massive collapse in the supply of money, leading to a fall in prices (which is, as I have pointed out elsewhere (albeit, in terms of the opposite direction), based on a very poor understanding of the modern financial system; but, in the interest of keeping things simple, I’ll concede the point here). The fall in prices, because it means they are earning lower profits, leads firms offer lower wages to their employees. But–and here’s what they say happened in the Great Depression–workers, not realizing because of money illusion that the cost of living has declined (and that firms’ offer is therefore not unreasonable), quit their jobs. And that, apparently, is how unemployment rose to 25% in the 1930s: the money supply fell, lowering prices, leading firms to offer lower wages, and causing workers to VOLUNTARILY QUIT THEIR JOBS! I don’t know about you, but that’s one of the most ridiculous explanations I have ever heard in my entire life. It also puts into perspective the above quote criticizing Friedman’s approach.

This is not completely atypical. It is a function of the fact that economists spend too much time developing complex thought experiments and clever stories and not working to understand the complexities of the real-world economy. A famous book published in 1990 showed evidence of this in the top graduate programs in our discipline (The Making of an Economist by Arjo Klamer and David Colander, Westview Press). When asked what was most important to success as an economist, students ranked these skills in this order (page 18):

1. Being smart in the sense of being good at problem solving.
2. Excellence in mathematics.
3. Being very knowledgeable about one particular field.
4. Ability to make connections with prominent professors.
5. Being interested in, and being good at, empirical research.
6. Having a broad knowledge of the economics literature.
7. Having a thorough knowledge of the economy.

No, I did not accidentally type the list backwards! And, if anything, the relegation of “knowledge of the economy” to dead last has become worse. Courses that would have provided context and empirical grounding to theory have been slowly replaced over the past thirty years by those teaching more mathematical methods. Today, students learn more about set theory than they do about the merger movements of the late 19th and early 20th centuries–if they hear about the latter at all, which is increasingly unlikely. Moreover, winning the publishing game means writing articles that are more general, theoretical, and mathematical. The author of a piece on the evolution of the specific institutional structure of the financial sector in the United States from 1980 to 1990, for example, even if well-written and firmly grounded in theory, would find it difficult to publish in any of the “top” journals. This would hurt the career advancement of a middle- to senior-level economics professor and could be a death sentence for the junior one, needing, as they do, to earn tenure in order to keep their job.

Not that I have anything against mathematics. My first college major was physics and I have always enjoyed the subject. I was one of those strange kids who loved word problems and derived great joy from figuring out the underlying logic of mathematical relationships (no, I didn’t date very much!). But for economists, math should be no more than a tool, not the end in itself. I’m afraid that’s not the case, so much so that today a common pattern is for a student to earn a math degree as an undergraduate and then pursue an economics PhD. Are they really interested in understanding unemployment, inflation, poverty, pricing, consumer choice, etc., or have they found a place where doing what they do best is rewarded?

This doesn’t mean that nothing useful gets done, but there are built-in incentives against it. Nor do I mean to implicate all of economists. Many DID raise the alarm and tried very hard to get the attention of the powers that be. But, they were in the minority and members of schools of thought largely dismissed by mainstream economics (e.g., Institutionalism, Post Keynesianism, and Modern Monetary Theory). Their graduate programs DO force students to learn about the structure of the actual economy (although still with plenty of math, but this time as the means rather than the end) and their journals DO reward authors who tackle the extremely complex and much messier task of figuring out what caused real-world economic disasters and successes. This is the sort of work that needs to be encouraged.

There was, incidentally, a second poll asking who most accurately forecast the financial crisis. The winner was, by a wide margin, Professor Steve Keen of the University of Western Sydney. The page announcing the award says this about Professor Keen’s work:

In December 2005, drawing heavily on his 1995 theoretical paper and convinced that a financial crisis was fast approaching, Keen went high-profile public with his analysis and predictions. He registered the webpage www.debtdeflation.com dedicated to analyzing the “global debt bubble”, which soon attracted a large international audience. At the same time he began appearing on Australian radio and television with his message of approaching financial collapse and how to avoid it. In November 2006 he began publishing his monthly DebtWatch Reports (33 in total). These were substantial papers (upwards of 20 pages on average) that applied his previously developed analytical framework to large amounts of empirical data. Initially these papers analyzed the Global Financial Collapse that he was predicting and then its realization.

In the 1995 article referenced above, Keen takes pains to model explicitly the features of a modern financial system (see Steve Keen, “Finance and Economic Breakdown: Modeling Minsky’s ‘Financial Instability Hypothesis,’” Journal of Post Keynesian Economics, vol.17, no.4, Summer 1995, pp.607-635). For him, there are no helicopters increasing the money supply by dropping cash, no households with perfect working models of the economy in the backs of their heads, no depressions caused by the fact that workers suddenly and voluntarily quit their jobs en masse, no speculators who know the future (all of these are actually features of popular mainstream economic approaches). His paper contains a great deal of math, but as a tool rather than an end. Among his key conclusions are:

• “…capitalist expectations of profit during booms can lead them to incur more debt than the system is capable of financing” (p.633).
• a breakdown results when there is a debt-induced recession, leading some capitalists to go bankrupt and lenders to “write off bad debts and suffer capital losses” (p.633).
• “…a rise in income inequality (between workers and capitalists) leads to a period of instability and then collapse” (p.633).
• “…a long period of apparent stability is in fact illusory, and the crisis, when it hits, is sudden–occurring too quickly to be reversible by changes to discretionary policy at the time” (p.633).
• the weight of the collapse may be so great that monetary (he specifically mentions lowering interest rates) and fiscal policy are powerless to reverse the trend.

All this was written in the midst of the longest peacetime expansion in US economic history, a period when some mainstream economists were declaring it a “New Economy” where recession had been banished forever. His predictions–and this is just a small subset of his work–were eerily accurate and based on work well outside of what is recognized as worthwhile in mainstream economics. He has continued to constantly update his work in his blog: http://www.debtdeflation.com/blogs/.

If you have never heard of him, that’s not surprising. You probably don’t read too many academic journals. The real problem is, most economists have never heard of him either. If we are to truly recover and put ourselves back on the track to prosperity, that has to change. It is vital that our profession revise its incentive structure such that models that more closely reflect the complex institutional structures and behaviors in the real world are valued above those that look pretty, but tell us nothing.