Why did no one see it coming?

Many leading economists have called for radical changes to bring economic theory into closer contact with reality


Dr Asad Zaman April 10, 2016
The writer is vice-chancellor of the Pakistan Institute of Development Economics. He holds a PhD in Economics from Stanford University

In the wake of the Global Financial Crisis (GFC) 2007, the Queen of England asked academics at the London School of Economics why no one saw it coming. The US Congress constituted a committee to investigate the failure of economic theory to predict the crisis. Unfortunately, economists remain unable to answer this critical question. Some say that crises are like earthquakes, impossible to forecast. Others take refuge behind technical aspects of complex mathematical models. With monotonous regularity, more than 200 monetary crises have occurred globally, ever since financial liberalisation started in the 1980s. The methodology currently in use in economics, systematically blinds economists to the root causes of these crises. Many leading economists have called for radical changes to bring economic theory into closer contact with reality.

Many who had hoped that the GFC would serve as a wake-up call for the profession, have been extremely disappointed by subsequent developments. Although there has been a flurry of papers on various aspects of the crisis, there has been no fundamental rethinking. Theories which assume free markets will create full employment and maximal growth, continue to be taught at universities. The rational expectations theory of Eugene Fama says that the stock market prices always correctly reflect the information available to the market, and there is no possibility of a bubble — a systematic over-valuation of all stock market prices. Under the influence of this theory, Robert Shiller’s demonstration that the stock market prices were over-inflated went unheeded. Similarly, warnings by many Cassandras, like Raghuram Rajan, Dean Baker, Nouriel Roubini, were ridiculed and ignored by senior level policymakers infatuated with free market dogma.

The last nail in the coffin of the US Economy was the repeal of the Glass-Steagall Act in 1999. The Great Depression of 1929 had been caused by irresponsible speculation by banks. In 1933, the Glass-Steagall Act prohibited banks from investing in stocks, in order to prevent recurrences of this disaster. This prevented system-wide banking crises for 50 years, until the era of financial de-regulation ushered in by Reagan and Thatcher. Repeal of the act, combined with a lax monetary policy, led to precisely what it was meant to prevent. Banks went on a wild orgy of credit creation, enabling stock purchases of trillions of dollars backed by defective mortgage-based securities. Banking crises like this routinely happen when banks are not strictly regulated, since they gamble with the depositors’ money. Financial moguls have created and popularised the misconception that banks are the backbone of the financial system, and must be supported regardless of misdeeds. Thus, big banks are routinely bailed out when they indulge in wild gambles. This incentivises banks to speculate: if they win, it is their personal gain. If they lose, someone else pays.

Even though economists blinded by free market ideologies could not predict it, the global financial crisis was very predictable. Giving permission to banks to gamble with other people’s money led to a financial crisis within the short span of eight years. However, what was surprising and perhaps unpredictable was the aftermath. Instead of being tarred and feathered, Eugene Fama went on to win a Nobel Prize in Economics. Nobel Laureate Robert Lucas, who confidently asserted that economists have learned how to prevent recessions, continues to enjoy the respect of the profession. Ben Bernanke, who presided over the Federal Reserve during the Global Financial Crisis, is being lauded as a hero. He has written a self-congratulatory book entitled The Courage to Act, in which he praises himself for taking the heroic actions necessary to save the world from the complete collapse of the financial system. As Princeton economists Atif Mian and Amir Sufi have shown in their celebrated book The House of Debt, these actions were wrong, and harmful to the economy. The trillion dollar bailout given to banks by Bernanke should have been given to the distressed homeowners with the defaulting mortgages. That would have been just, and would also have saved the economy from the Great Recession, by preventing the large-scale transfer of wealth from the impoverished mortgagers to the rich and criminal bankers.

Not only do the faulty theories which led to the crisis continue to be taught to unsuspecting students all over the world, but all efforts to reform the defective system have been blocked. In the US Congress, proposals to bring back the highly successful regulatory system which was created after the Great Depression, failed. A few bills which were passed, were quietly repealed later. There have been large numbers of seminars and conferences on the need for a new regulatory framework to protect the global financial system, but no action has been taken to create effective new regulations. Thus the system is ripe for another crisis, and there are many signs that another one is on the way.

The reader might wonder, like the author, why there has been no learning from experience. The answer lies in the statistics recently published by Oxfam. The number of people who own half of the wealth of the planet, shrank rapidly from 388 in 2010, to only 62 in 2015. The richest people benefit vastly from the financial crises which destroy the wealth of the middle class. This is because the middle class is forced to borrow at interest from those who have the money. This enables the already wealthy to get rich much faster than in normal conditions, where people have enough money for their own needs. To top it all, current economic theories make no mention of debt as an important economic factor. These seriously defective theories are of vital importance in concealing the workings of the mechanism which creates this massive concentration of wealth in the hands of a tiny minority. In subsequent articles, we will explore the large number of ways in which current economic theory is defective, and the radical reforms needed to create a better economic theory for the 21st century.

Published in The Express Tribune, April 11th,  2016.

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COMMENTS (1)

FN | 5 years ago | Reply for the writer, also ponder why we need to rediscover what we already know ( as human ) if this system hedges greed as competition, how is it going to solve problems when it doesn't address them rightly? or take it this way , economics is for the human i.e. something that human's employ not that governs humans , as long as it stays this way nothing is going to change
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