Note to “The Economist” – your solution is the very problem itself

economics whats wrong

I’ve just been reminded of an article from The Economist published 16 July 2009 titled, What went wrong with economics. Note that it is not a question but a statement. The Economist naturally has no clue being an ultra-Keynesian rag but this, at least, can be dredged from its commentary:

And if economics as a broad discipline deserves a robust defence, so does the free-market paradigm. Too many people, especially in Europe, equate mistakes made by economists with a failure of economic liberalism. Their logic seems to be that if economists got things wrong, then politicians will do better. That is a false—and dangerous—conclusion.

What’s missing apparently is a more sophisticated financial model to graft onto the Keynesian core of what The Economist thinks of as good economics:

Central banks are busy bolting crude analyses of financial markets onto their workhorse models. Financial economists are studying the way that incentives can skew market efficiency. And today’s dilemmas are prompting new research: which form of fiscal stimulus is most effective? How do you best loosen monetary policy when interest rates are at zero? And so on.

As early as July 2009 they could see that the fiscal stimulus hadn’t worked. They just do not see that trying to drive an economy along using either monetary or fiscal policies is the problem. Public spending and near-zero interest rates leave an economy dead in the water but they cannot see that their solution is the very problem itself.

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14 Responses to Note to “The Economist” – your solution is the very problem itself

  1. Nothing went wrong with macroeconomics because of the 2008 GFC, which ended 5-years ago.

    Moral hazard, adverse selection, costly state verification, a Fed Funds rate of 1% and a long deviation from the Taylor rule on both sides of the North Atlantic are less tempting arguments than ‘round up the usual suspects – republicans all’.

    Many of the key issues about what modern macroeconomics has to say on financial crises are discussed at http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4526 Interview with Thomas Sargent where he says that:
    1. It is just wrong to say that this financial crisis caught modern macroeconomists by surprise: Allen and Gale’s 2007 book Understanding Financial Crises collects many of the dynamic models of the causes of financial crises and government policies that can arrest them or ignite them.

    2. Stern and Feldman’s Too Big to Fail doesn’t have an equation in it, but wisely uses insights gleaned from the formal literature to frame warnings in 2004 about the time bomb for a financial crisis set by regulations and government promises.

    3. Two polar models of bank crises and what government lender-of-last-resort and deposit insurance do to arrest them or promote them? In the Diamond-Dybvig and Bryant model, deposit insurance is purely a good thing, while in the Kareken and Wallace model, it is purely bad.

    4. Bryant-Diamond-Dybvig model has been very influential generally, and in particular that it was very influential in 2008 among policymakers. Many policy authorities correctly noticed that a Bryant-Diamond-Dybvig bank is not just something that has “B A N K” written on its front door. It’s any institution that executes liquidity transformation and maturity transformation.

    5. Policy makers saw Bryant-Diamond-Dybvig bank runs all over the place. The logic of the Bryant-Diamond-Dybvig model persuaded them that if they could arrest runs by convincing creditors that their loans to these “banks” were insured, that could be done at little or no eventual cost to the taxpayers.

    6. The Diamond-Dybvig and Bryant model makes you very sensitive to runs and very optimistic about the ability of insurance to cure them.

    7. The Kareken and Wallace model’s prediction is that if a government sets up deposit insurance and doesn’t regulate bank portfolios to prevent them from taking too much risk, the government is setting the stage for a financial crisis.

    8. The Kareken-Wallace model makes you very cautious about lender-of-last-resort facilities and very sensitive to the risk-taking activities of banks.

    As for the gambling for redemption crisis in Euroland, Milton Friedman predicted in the 1990s that the euro would not survive its first major recession. The UK stayed out of the Euro because Euroland was not an optimal currency area.

  2. entropy

    Their logic seems to be that if economists got things wrong, then politicians will do better. That is a false—and dangerous—conclusion.

    Also need to be wary of technocrats that automatically think that even though they make mistakes they are better than democratically elected politicians. In fact the power of the technorati might also be a reason for the problems of Europe, particularly in a regulatory sense.

  3. entropy, Stigler contended that economists exert a minor and scarcely detectable influence on the societies in which they live.

    As is well know, Stigler in the 1970s toasted Milton Friedman at a dinner in his honour by saying: “Milton, if you hadn’t been born, it wouldn’t have made any difference.”

    Stigler argued that if Richard Cobden had spoken only Yiddish, and with a stammer, and Robert Peel had been a narrow, stupid man, England would have repealed the corn laws to allow free trade in grain as its agricultural classes declined and its manufacturing and commercial classes grew in the 1840s,

    As Stigler frequently noted,
    • the ideas behind reform had been around for a long time.
    • To affect public policy, ideas must find a market among the groups influencing change.
    • when their day comes, economists seem to be leaders of public opinion.
    • But when the views of economists are not so congenial to the current requirements of interest groups and median voter, these economists are left to be the writers of letters to the editor in provincial newspapers. These days they would run an angry blog.

    Can you think of any significant public expenditure, regulation, subsidy and welfare benefit that is not supported by the median voter? Interest groups fight for scraps from the median voters’ table.

    Were the monetary and fiscal policies behind the great deviation from 2001 to 2007 unpopular with the median voter?

  4. The Pugilist

    Some excellent comments Jim Rose. Particularly about Diamond-Dybvig vs Karekan-Wallace conceptions of the world. You know your shit sir! Bravo…

  5. The Pugilist

    Here’s a discussion of the two opposing views in the Australian context.
    Swanny made the Australian financial system more vulnerable. I’m hoping this gets discussed by David Murray and his taskforce in ‘Son of Wallis’…
    Still. How do you unscramble the egg of deposit insurance in Australia now?

  6. The Pugilist

    On the key point about modern macro, it is flawed in it’s methods and theoretical underpinnings. Bolting on some models from financial economics is entirely the wrong way to proceed. There must be a complete reworking from the ground up. And there needs to be far more humility amongst economists about their pretensions of being ‘social physicists’…

  7. Bruce of Newcastle

    I suspect the Economist is suffering from the great migration of journalism training pathways to the universities, which are very lefty. TE used to be quite sceptical of everything maybe 20 years ago. But now it has bought all the lefty fads. I gave up my subscription last year with some sadness.

    As for the ‘bolting on of crude analyses of financial markets onto their workhorse models’ the track record of central banks’ predictions has been woeful since 2008. Likewise the IMF. From the look of those graphs I would think all that stimulus predicted to bootstrap the economies has actually done SFA.

    But stimulus is a wonderful excuse for governments, especially lefty ones, to avoid reform and removal of barriers and stupid rules drowning businesses and taxpayers. Keynes should be exhumed and then hung just for providing them with this cop out.

  8. The Pugilist

    Bruce, don’t you remember Kevin Rudd handing a signed copy of Keynes’ General Theory to the wombat whisperer? If you needed evidence that governments love Keynesianism as you rightly describe, that’s your proof right there. Always remember, Henry Simons, an early Chicago school economist and a contemporary of Keynes referred to the general theory as the bible of fascist economics. He was right!

  9. The Pugilist

    The Nazis lapped up the general theory too, whether or not that was Keynes’ intention is another matter.

  10. Pyrmonter

    @ Pugilist – that view of the Nazis is common, and echoes the infamous preface to the translation of the General Theory. The problem is, it probably isn’t right. The National Socialists lived up to their name (and were socialists in the sense of Hayek’s dedication of the Road to Serfdom), interfered widely in labour and capital markets, introduced near autarky and retarded growth in most sectors other than armaments.

  11. The Pugilist

    Pyrmonter, Mises fled the Nazis, while Keynes’ General Theory was one book the Nazis didn’t burn. For me, that’s enough said. I’m not saying Keynes was a Nazi sympathiser at all, but it is no surprise they liked his book. Lerner’s interpretation of Keynes was called the theory of control (and from what I can tell he was talking in terms of economic/political control). Kevin Rudd, with his predilection for micromanaging everything wholeheartedly embraced Keynes too. Join the dots. Fascist, socialist, communist, social democrat…all strains of the same breed.

  12. trax

    Not only is the Keynesian demand driven concept wrong, they aren’t even doing that properly in the US (sounds a lot like Say’s Law this quote):

    In an economy that is nearly 70% driven by consumption, production comes first in the economic order. Without a job, through which an individual produces a good or service in exchange for payment, there is no income to consume with. While income can come from social welfare, as seen in the latest personal income data, these dollars are derived from the production of others through taxation.

    Poll Shows Why QE Has Been Ineffective

  13. .

    Jim these are your best comments yet. You need to guest post.

    I know why the crisis happened, I think you can shed light on why policymakers made some dumb decisions at the time.

  14. thanks dot, I have a blog now but it would be spam to mention its name

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