ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Why economists failed to predict 2007/08 meltdown
, April 12, 2014
The 2007/08 global financial crisis (GFC), which almost demolished the world’s financial system, must sooner or later reshape the way we should evaluate politics and economics.
William R. White
Finance and the real economy — the latter being that part of the economy that actually produces goods and services — will eventually “recover” in some way; but it won’t be a return to the kind of economics and politics which existed before 2007.
However diligently we might search, the future never fully discloses its intentions in advance; but we can be certain that recovery won’t take us back to “normal”. That “normal” has been destroyed by what happened in 2007/08.
Those economists most closely associated with policy-making in the run-up to the crash are still smarting over the fact that they were taken completely by surprise. They are still struggling to make their flawed models fit with what happened. Trapped inside that type of thinking, they certainly can’t help when it comes to finding a way out of the mess.
In 2008, the British monarch asked economists at the London School of Economics why no-one, particularly economists, had seen the crisis coming, she received no satisfactory response. In 2009, Robert Lucas, a Nobel prize-winning economist from the University of Chicago, provided the orthodox economic explanation. He declared that economists’ models predict that such events cannot be predicted. So there!
One of Lucas’s disciples, Thomas Sargent of the University of Minnesota, was less subtle. Criticisms such as those made by Her Majesty, contended Sargent, “reflected either ignorance or intentional disregard for what modern macroeconomics is about”.
If the Queen had chosen to delve into history, she would have found that economists have a track record of making preposterous statements. Back in 1929, Irving Fisher, perhaps the most celebrated U.S. economist of his time, announced confidently on October 17, that “stock prices have reached what looks like a permanently high plateau”.
On October 21, 1929, came the Wall Street stock-market crash, which ushered in the 1930s Great Depression. Prices began to fall precipitately. Fisher had, however, put his money where his mouth was, and is reputed to have lost his considerable personal fortune in the financial crash. Fisher learned from his mistakes and, from a perspective of poverty, recast his views about how capital markets worked.
Seventy-five years later, Ben Bernanke, later to become Chairman of the U.S. Federal Reserve Bank, severely embarrassed himself with unfounded and untimely predictions about the state of U.S. economic health. In 2004 he told a distinguished audience that the U.S. was in a state of Great Moderation (that is to say, more or less permanent economic stability), which was the result of 20 years of sound economic policy.
A year later he asserted that soaring U.S. house prices reflected nothing more than the sound fundamentals of the housing market. Economists from the International Monetary Fund and the OECD in Paris voiced similar misplaced optimism.
The only dissenting voice among international civil servants came from a Canadian, William R. White, who at the time was research director at the Bank for International Settlements (BIS) — the Swiss-based reserve bank of reserve banks. He put forward a well-argued view that U.S. asset prices were critically overvalued and a crash was inevitable.
Despite Dr White’s qualifications, not much prominence was given to this view. Clearly it made no impression on the governor of the Reserve Bank of Australia, Glenn Stevens. Five years later, he asserted that nobody had anticipated the crash in 2007/08.
In fact, only a select group of independently-minded economists anticipated the crash. One among them, then a relatively little known British economist, was Ann Pettifor. In 2006 she wrote a book entitled The Coming First World Debt Crisis (Palgrave Macmillan, 2006).
The book bombed out on publication, but two years later became a best seller. Like White, and all the others who saw the crisis coming, Pettifor recognised that the levels of private debt were unsustainable.
Immediately after the 2007/08 meltdown, those caught out went to ground; but now, it seems, they are back, as if nothing had happened, once more driving the policy debate.
Where all of this might lead is not yet clear. Those on the outer extremes of the political right and left are no doubt rubbing their hands at the prospect of some economic catastrophe bringing them to power.
They are doomed to disappointment. A world economy, if put on a more durable path, is likely to leave political extremists stranded.
Now is not the time, and this article is not the place to outline, the shape of new structures. For anything like that to happen, we must wait for more of the dust to clear. Pessimists among the wiser heads are suggesting it might take another crisis before we will be ready to consider new and more enduring ways of managing our political and economic affairs.
Meanwhile, at the level of practical economics, some building-blocks are already being put into place. The Bank of England has recently published in its Quarterly Bulletin a 14-page paper called “Money creation in the modern economy”. It describes the reality of banking — in particular, how banks are able to lend money.
Contrary to popular belief — and what the economic textbooks have taught — banks don’t lend their depositors’ money; they actually create new money equivalent to the amount lent. On this score, the economic textbooks are wrong.
This is surely a big step forward in understanding how banks fuel lending in modern economies. It will be interesting to see how long economics departments can keep teaching a totally inaccurate form of financial economics.
There are a few other straws in the wind.
Alan Greenspan, Chairman of the U.S. Federal Reserve from 1987 to 2006 (i.e., the years leading up to the crash), and who, on any reading, is now acknowledged to be one of the architects of the debacle, has never admitted culpability. He is on record as saying he never imagined the capacity of banks to undermine their own interests with wantonly destructive practices.
He should be believed. Remember, it was Greenspan, along with Lawrence “Larry” Summers, who persuaded President Bill Clinton in 1999 to repeal the 1933 Glass-Steagall Act, which had regulated bank behaviour since the Depression of the 1930s.
Greenspan has recently written a book entitled The Map and the Territory: Risk, Human Nature, and the Future of Forecasting (Penguin Press, 2013).
Some time earlier the Scottish economist, John Kay, had written an essay entitled “The map is not the territory: An essay on the state of economics” (October 4, 2011).
Greenspan powerfully exhorts economists to work towards developing a reliable economic model which will accurately describes the behaviour of people in the real world economy.
Kay’s essay, by contrast, is all about why attempting such economic modelling is a futile and dangerous pursuit — futile because it is impossible, and dangerous because it perpetuates a belief that it is somehow possible to devise some kind of universal model of the world economy.
John Kay did not invent the phrase “the map is not the territory”. The term was first used in 1931 by Polish-American scientist and philosopher Alfred Korzybski (who later acknowledged his debt to mathematician Eric Temple Bell who coined the epigram, “The map is not the thing mapped”).
Abstract models having global reach, Korzybski insisted, including in economics, cannot help us to understand “the world as it really is”. The most we can hope from any model is help in understanding economic behaviour as it is observed specific to a time, place and context. A map (i.e., a model) embracing all territories will have no practical value in helping us understand the problems specific to time, place and context in a particular territory.
No economic model can describe the entire world as it really is. The best that can be hoped for are provisional approximations that might be applied pragmatically to particular situations. Economists who insist that their discipline is a science reject this contention.
They prefer to believe that by the application of scientific method they can understand the way economies function. If these principles are acknowledged, and accepted as eternal truths, then the lot of humanity can be permanently improved.
William R. White, the Bank for International Settlements researcher referred to earlier, considered this to be arrogance and that economists should direct their attention towards the attainment of more modest goals.
Today’s economic orthodoxy will have none of that — it seems to prefer the all-or-nothing approach. Economic models, they insist, can accurately describe how individuals, communities and nations can and should behave, independently of time place and context. On this view, the minutiae of actual behaviour, having universal and timeless application, can be replicated.
This belief contradicts Korzybski’s assumption that abstractions purporting to be a map of the economic world are incapable of explaining the world as it really is. The map is not the territory. Rather, the sum of the territories defines the map.
Economists who believe they have uncovered eternal economic truths undisturbed by time, place and context are hopelessly misguided — all the more so because they believe that abstract models contain predictive qualities.
If, in following that line of reasoning, economists believe that they have elevated their profession to the level of a science, they are mistaken. Science, like economics, finds it all too easy to be sidetracked by fads. But scientific advances have never profited from such an approach.
The best science acknowledges that the only reliable way forward is one step at a time, building upon observable facts about the present, with existing beliefs always subject to contradiction by the discovery of new, more compelling theories.
The territories construct the map, not the other way around.
Eternal truths and omnipotence surely are the exclusive preserve of the Almighty. Economists are not the Almighty. Neither is their discipline an infallible religion.
A starting point for meaningful change in approach should be a recognition of that important reality.
Colin Teese is a former deputy secretary of the Department of Trade.
Robert Lucas, “In defence of the dismal science”, The Economist (London), August 6, 2009.
Art Rolnick, “Interview with Thomas Sargent”, Banking and Policy Issues Magazine (Federal Reserve Bank of Minneapolis(, September 2010.
John Kay “The map is not the territory: An essay on the state of economics”, Institute for New Economic Thinking (INET) blog, October 4, 2011.
Michael McLeay, Amar Radia and Ryland Thomas, “Money creation in the modern economy”, Quarterly Bulletin (Bank of England), 2014 Q1.