Crises of Capitalism

For a while I have been interested in hearing the responses of economists to the seemingly widespread anger that society helds against the profession. Economists, many say, have failed society because they failed to predict and prevent the financial crisis that we are now suffering. I do not have yet a fully articulated response to that anger but let me say that two things are clear to me now: 1) Society has a distorted view of what Economics is about and what economists do 2) and that that is not society´s fault but mostly ours as economists because we have been often too shy and sometimes too arrogant to reply back.

Above all, we as economists should not be dismissive of society's arguments nor of arguments coming from "heterodox" or "critical" thinkers such as David Harvey, a Professor of Anthropology at CUNY, with a distinguished career as a social theorist. I wanted to show you this video in which one of Harvey's lectures on the crises of capitalism is illustrated as he speaks. The video is interesting for several reasons. One, because it is very nicely done. Second, because the first half makes a very nice summary of the arguments put forward as explanations of the financial crisis. And finally, because he proposes several arguments, probably wrong, but that can help to ignite some debate. As I said, I do not think that we should dismiss his ideas just because he is a marxist. We should reply with sensibility, arguments and evidence. And I would like to hear your views on it.

Lehman and the Financial Crisis

In a recent article in The Washington Post, John Cochrane and Luigi Zingales, both from the University of Chicago Booth School of Business, wrote about the collapse of Lehman Brothers, its bail out by the Federal Reserve and the ensuing financial crisis. In the article, they argue that those who believe that the Fed should have not intervened are wrong. But not for the standard reasons, not because of its enormous costs to the government budget. Banks now, they claim, know that they will be bailed out in the future. That will fuel more irresponsible behavior, that the Fed, so far, has been uncapable to deter. "A system with so much power vested in so few people, with so few rules, in which crises are managed with 2 a.m. conference calls, cannot possibly do better," they say. Cochrane and Zingales predict that the next crisis will be so global and so systemic that no government effort will be enough to avert it. "This system cannot go on," they conclude, in an unparalleled bold statement.

The Love Of Money

In the discussion panel on the Credit crunch, organized by the Economics Society about a year ago, my colleague Sevi Rodriguez-Mora pointed out, quite rightly, that most of what we could say about the crisis was just to descibe its chronology. At that moment, it was not very clear what caused it, and to some extent, that it is still the case (many entries in this blog has focused on this topic). The recent three-part BBC documentary The Love of Money illustrates perfectly this problem. Two of its parts ("The bank that bust the world" and "Back from the brink") recount the events that preceded and followed the fall of Lehman Brothers on 15th September 2008, widely considered as the starting point of the crisis. That "journalistic" narrative is interesting to a certain extent, but ultimately unsatisfactory to any economist who wants to understand the actual causes of the crisis.

The middle part of the programme, "The Age of Risk", does a much better job at uncovering the causes of the financial meltdown we experienced a year ago. According to it, its main culprit was Alan Greenspan. In the documentary, his career from just an unknown economists to head of the Federal Reserve is paralleled to the rise of the belief on self-regulating markets. The last five minutes of the programme are especially revealing. There, a tired and defeated Greenspan confesses that he still does not understand what went wrong. His surprise and disbelief is, at the same time, very telling, and very moving. It is probably the highlight of this interesting programme.

The website for the programme is here. You can watch each individual episode just by clicking on the links above. And then answer, is Greenspan to blame?

How/If Economists Got the Crisis All Wrong

Financial Crisis brought down not only the banks but led to questions on whether economists are to blame for all this mess. Below are two very different views of whether Economists are at fault for the crisis in a highly politically charged essays from a Nobel Laureat and a Professor of Economics at Princeton University Paul Krugman and a Professor of Economics at the University of Chicago Booth School of Business John Cochrane.

On September 2, 2009 PAUL KRUGMAN in an article How Did Economists Get It So Wrong? wrote:

"It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes — or so they believed — were both theoretical and practical, leading to a golden era for the profession... Last year, everything came apart. Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy."

Krugman then goes on to answer "What happened to the economics profession? And where does it go from here?" questions, and concludes that

"It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems." (to read more click here)


John Cochrane responded to Paul Krugman's accusations on September 11th, 2009 saying that

"Paul Krugman has no interesting ideas whatsoever about what caused our current financial and economic problems, what policies might have prevented it, or what might help us in the future, and he has no contact with people who do. “Irrationality” and “spend like a drunken sailor” are pretty superficial compared to all the fascinating things economists are writing about it these days."

he goes on to say:

"Again, what is the alternative? Does Krugman really think we can make progress on his – and my – agenda for economic and financial research — understanding frictions, imperfect markets, complex human behavior, institutional rigidities – by reverting to a literary style of exposition, and abandoning the attempt to compare theories quantitatively against data? Against the worldwide tide of quantification in all fields of human endeavor (read “Moneyball”) is there any real hope that this will work in economics?

No, the problem is that we don’t have enough math. Math in economics serves to keep the logic straight, to make sure that the “then” really does follow the “if,” which it so frequently does not if you just write prose. The challenge is how hard it is to write down explicit artificial economies with these ingredients, actually solve them, in order to see what makes them tick. Frictions are just bloody hard with the mathematical tools we have now." if you wan to read more click here.

Gary Becker speaks up for the Chicago School

My colleague Martin Fransman sends me this interview with the Nobel Laureate in Economics Gary Becker for the FT. In this interview, Becker vehemently defends the positions of the Chicago School and the validity of free markets. His argument seems to have two parts:

1. The crisis occurred because economists still do not understand financial instruments well enough. In other words, Economics as a science is not advanced enough to deal with such issues, pretty much in the same way as medieval medicine was not ready to fight viruses or used leeches to cure diseases.
2. The regulated know much better what to do than the regulator. The crisis should be solved by economic agents and not by the state because, paraphrasing Churchill's dictum on democracy, free markets are the worst economic system, except for all those other forms that have been tried from time to time.
   

You can watch the video here.

What do you think?

Who guards the investors?

In The Republic, Plato required his king-philosopher to have neither material possessions nor a family that he could favour. He also trusted law enforcement to a caste of guards. He was thus very aware of the problem of incentives. He also confronted the natural question that such idea begged, an idea that Alan Moore explored centuries later in his graphic novel Watchmen: Quis custodiet ipsos custodes? Who would guard the guards? Plato’s answer was that it was necessary that the guards should be highly moral and spirited individuals, able to look beyond their own material interests and able to sacrifice for their fellow citizens (compare that to Moore’s answer!). In the end, despite his advanced economic thinking, Plato placed moral behaviour at the top of the social pyramid he constructed, and gave it the role of that mythical “key stone” that it is said to support the structure of every gothic cathedral.

To a large extent, this dichotomy in Plato’s thinking reflects the two types of proposals made after the recent financial crisis: On the one hand, measures aimed at improving regulations and constructing better incentive schemes and, on the other hand, the calls to a more moral approach to business, to an ethical regeneration of the economic sphere, that allegedly would ameliorate the rampant greed that reigns in international markets.

But unless human nature had changed dramatically in the last two hundred years, I am afraid that these calls to a moral renaissance will be empty. In his wonderful book The Passions and The Interests, Albert O. Hirschman showed how capitalism, and thus greed, emerged precisely from the total failure of traditional moral systems, of those ethical principles based on religion or a shared national destiny; a failure that precipitated the religious and nationalist conflicts of the XVI and XVII centuries. As a solution, Adam Smith wanted to design a “theology without God”, whose centre would be occupied by a governing principle that humans would feel naturally inclined to follow without any appeal to supernatural powers. That force was self-interest. That force was greed. To illustrate this I will use the example I always give to my students: suppose you are a person that belongs to an ethnic or religious minority. You are walking down the street and suddenly a bunch of people from a rival ethnic or religious group start chasing you with very threatening intentions. If suddenly you started throwing £20 notes behind you, this people would immediately stop chasing your and start collecting the bank notes. Self-interest is a very powerful force, capable of overriding other forces of moral or ethical nature.

All this suggests that moral calls to businessmen, investors and bankers will prove useless. The stakes are so big, there is so much money to be made in international financial markets that there will be always someone ready to bend these principles. At the same time, regulation has proved ineffective in preventing these behaviours or at least that these behaviours meet monetary success. The only way out of this catch-22 situation is to acknowledge -the sooner the better- that the game between the regulator and the economic agents is a rat race, a fight in which the beast of self-interest that Adam Smith unleashed will always look for ways to break the chains that Leviathan wants to put on it.

More reflections on the state of economics

This is going to run for a while. Channel 4 had an item on its news programme on whether economics has failed, including appearances by Bob Lucas (Chicago, defensive) and Robert Skidelsky (critical). There is a video of Gary Becker defending Chicago economics and the market on the FT website, interviewed by Martin Wolf. Becker's view is that the issue was the various mortgage derivative products were fine on their own for spreading risks, but no one understood the systemic risks associated with them. Markets are still the best thing we have, though not perfect. better than government in any case. Finally, there is a long piece in the NY Times from Paul Krugman. Chicago economists were quite prescient for getting in their defence first, as Krugman is not particularly charitable. The Krugman piece is pretty much a regurgitation of his previously blogged opinions (see earlier postings on this site for many of these). Nevertheless it gives an interesting view on the development of macroeconomics and financial economics over the last hundred years or so. It also includes a version of the Capitol Hill babysitting circle story, just about the best illustration of how Keynesian economics works (see his excellent book, Peddling Prosperity, for more detail). Nevertheless there are a couple of issues that seem to be confused: the question of whether the economics profession should have predicted this crisis is logically distinct from whether your approach allows for such crises to occur. Prediciting crises, almost by definition, is very tough and it would be surprising if this could be done consistently.

Credit Crunch reading

Some recommendations from the Economics Department here at the University of Edinburgh:

This youtube video.

At Brown University, there was a "conversation" between Peter Howitt, David Weil and Ross Levine, who discussed the economic situation, the bailout, and the outlook for the future (with paerticular reference to the US). Here's the video, and a short description in the Brown student newspaper.

Robert Skidelsky's recent review in the New York Review of Books of Martin Wolf's book. This is a thoughtful review bringing in nicely the role played by the global imbalances.

Tim Besley was asked by the Queen why nobody had predicted the crisis. His reply to her on behalf of the British Academy can be found here.

Olivier Blanchard (chief economist at the IMF) gave a lecture which gives a good overview of causes and policy responses. The video of the lecture is here.

Feedback from the Credit Crunch Seminar 2

Simon Clark reports back from the Credit Crunch Seminar on March 12.


Take 60 ordinary people, roughly a cross-section of Edinburgh society, and invite them to give their views on the credit crunch and the economic crisis. Or rather, light the blue touch-paper and stand back, well back.

The meeting was permeated by a deep sense of injustice. How can people just walk away from the mess they have created, often with a big pension, when others lose their jobs and pensions though no fault of their own? You may think economics deals with efficiency and hard-headed analysis, and that concerns of equity and justice are the domain of the soft-headed disciplines (usually ending in 'ology'). Wrong for two reasons! Firstly, if people care about fairness then it will affect their behaviour. For example, they may avoid buying from businesses they see as treating their workers and suppliers badly, or not doing their bit for the environment. Or if people at work are treated fairly, they may be more productive. Secondly, think of the raw politics of the situation. You may disagree with knee-jerk reactions to punish greedy bankers, but if a political party can get support for measures to redress injustices, real or perceived, then - purely as a matter of economic forecasting - you need to take that on board in forming your expectations of future policy.

Capitalism Beyond the Crisis

Last summer, the Adam Smith Institute, a self-declared free-market think-tank organized a debate on Adam Smith's legacy with the motion ‘This House would prefer to be led by the Invisible Hand’. After a very heated and good humoured discussion, the motion was (loudly) approved. There were many "suits," many businessmen and people from "The City" in the audience that evening in The Caves. No wonder the result of the vote was the one it was. However, after all that has happened in the global economy since then, one is now left to wonder where those who voted "yes" are standing now. Are they still cheering and applauding the divine interventions of the Invisible Hand? But even more importantly, that debate, and even the name of the ASI itself, proved how Adam Smith's legacy has been appropriated by free-market fundamentalists, much to the dismay of those who hold other views.

In a recent article in The New York Review of Books, Nobel Prize Laureate Amartya Sen has made a much more impartial assessment of Smith's theories. In Capitalism Beyond the Crisis, Professor Sen reminds fundamentalists that Adam Smith did not see the free market functioning without the assistance of "moral sentiments". Trust is fundamental for the well-functioning of markets. In passing, Sen also rescues Pigou from the relative oblivion in which his contributions live these days. And also more remarkably, he puts John Maynard Keynes in his right place. Keynes is increasingly seen among non-economists and other carefree people as a rebel, as some sort of Luke Skywalker, the only hope against the evil dark forces of standard Economics. And although it is true that Keynes is ASI's favourite ghost, it is also true that he was not specially concerned by distributional issues nor with the welfare of the worst-off people in society.

One could argue that Sen does not contribute to the current debate on the "New Capitalism" with new ideas. He rather wants us to stop and think more carefully about our own arguments. But in this article, he shows once more his deep knwoledge of Economics and his relentless committment to create a more decent economic world.

Feedback from the Credit Crunch Seminar 1

Here are a few notes from the talk Simon Clark gave at the Credit Crunch Seminar on 12 March (see posting below). They are addressed mostly at the question of why it has happened. Bear in mind that the audience consisted not of academic economists, or even economics students, but of ordinary citizens, worried, angry, and vocal.


I don’t think we really fully understand why we are in the mess we are.

For one thing, we didn't see it coming: and that has been one of the important characteristics of the crisis: two or three years ago, many people, perhaps most – including politicians, bankers, economists – would have said that the UK economy was pretty healthy: we had had a decade or so of strong economic growth, and inflation and unemployment were low.

Even when the financial rumblings started in 2007, as the bad sub-prime loans started to surface in the US, even when Northern Rock had to be rescued – the first bank run in the UK for over a century – I don’t think many people foresaw how quickly the financial crisis would develop and deepen, and how quickly it would spread to the real economy.

Nevertheless I think we can offer a narrative, a drama in 1, 2, 3, who knows how many acts? The best place to start seems to be the US sub-prime market. The realisation that many of these loans were ‘bad debts’, unlikely to be repaid, had implications far beyond the US mortgage market. It was the immediate cause of the what one might call the central event in Act 1, namely the collapse of liquidity and the collapse of the interbank market. The main reason for this was the that the sub-prime loans were bundled up, repackaged with other assets, and sold on in the form of ‘collateralized debt obligations’. But these financial assets were so complex that very few people understood them, even the senior managers of supposedly reputable investment banks.

As banks became wary of other banks ability to repay, so they were less willing to lend to them – the interbank market dried up, and those institutions that were reliant on this kind of borrowing to finance their own lending - for example Northern Rock – were caught up. Northern Rock’s mortgages were nowhere near as bad as the sub-primes, but it did not have a solid retail base of many small depositors.

So, we had a kind of contagion that affected all financial institutions. The response of governments was uneven and unsure; they were faced with the choice of bailing banks out – offering guarantees, providing capital, lending taxpayers’ money – or holding back and letting ‘market forces’ sort things out. This second option had the supposed advantage that it did not encourage ‘moral hazard’: the phenomenon that if you forgive bad behaviour, you make it more worthwhile. This was initially the preoccupation of Mervyn King, the governor of the Bank of England, and also of the US authorities. In the US, Hank Paulson, the US Treasury Secretary, decided to give the capitalists a lesson in capitalism, and let Lehman Brothers, one of the biggest financial institutions in the world, go bust. By the end of Act 1, there was some serious blood on the stage.

It was now apparent that no institution, however big, was immune; no bank was too big to fail. If you had to pinpoint one event when the crisis spread beyond the financial sector, when it went from a local, possibly containable, problem of liquidity, to a full blown global economic problem, it was the collapse of Lehman Brothers. All banks were suspect, no one wanted to lend to banks, including other banks, and so banks themselves had less money to lend.

Act 2, then... [more]