Economists are still bargaining with the financial crisis

Economists are still grieving the 2008 financial crisis, and have now entered the third stage of the process: ‘bargaining’. However, a fixation on what could have been done differently makes it harder to tackle the issues head-on

David Orrell
Author: David Orrell
September 25, 2016

In her 1969 book On Death and Dying, the Swiss psychiatrist Elisabeth Kübler-Ross identified the five separate stages of the grief process. These were denial, anger, bargaining, depression and acceptance.

The field of economics experienced a traumatic loss during the financial crisis, which left Alan Greenspan in what he called in 2008 testimony “a state of shocked disbelief”. Economists are now working their way slowly through the grief progress, as they realise that their treasured economic models not only failed to predict the crisis, but played an active role in creating it.

The first two stages have already been charted in World Finance. In 2014, we asked: “Is economics in a state of denial?” (The answer was yes). In 2015, we discussed the anger that some economists were venting on certain critics (e.g. me). The next stage – and the subject of this column – is ‘bargaining’.

Part of this is bargaining with the future – if we follow certain rules, perhaps we can put things right. Another is a kind of retroactive bargaining with the past, saying that the event would not have occurred if only such-and-such had happened.

A case in point is the book Economics Rules: Why Economics Works, When It Fails, and How To Tell The Difference by Dani Rodrik of Harvard University, which set out to explain “why economics sometimes gets it right and sometimes doesn’t”. Rodrik’s conclusion was that mathematical models “are both economics’ strength and its Achilles’ heel”. On the one hand, they offer a degree of clarity and consistency that is not possible with purely verbal descriptions. However, they are easily misused or taken out of context.

Economic models
As Rodrik pointed out, models are best seen as a kind of story: no single model can accurately capture every detail of the economy, but it can illuminate some aspect of the system. The trick is therefore to choose which model is the most suitable for any particular situation. One conclusion that Rodrik drew is that very large and general models – the sort often favoured by macroeconomists – are not very useful: “I cannot think of an important economic insight that has come out of such models. In fact, they have often led us astray.”

No model can accurately capture every detail of the economy, but it can illuminate some aspect of the system

If only economists had chosen the right model, perhaps something could have been done. One such model, which interestingly Rodrik does not mention, is that of Hyman Minsky, whose work on financial stability became famous after the crisis, but was all but unknown before it; an assessment published a year after his 1996 death concluded that his “work has not had a major influence in the macroeconomic discussions of the last 30 years”. Curious indeed.

Rodrik also seemed a little surprised by claims from student-based groups, such as Manchester University’s Post-Crash Economics Society, that economics is overly narrow and lacks pluralism. “How do we understand these complaints”, Rodrik asked, “in light of the patent multiplicity of models within economics?”

A possible reason might be that economists have what he calls a “guild mentality”, which “renders the profession insular and immune to outside criticism”. He observed in a couple of places that “only card-carrying members of the profession are viewed as legitimate participants in economic debates”. But later he cited the influence of behavioural psychologists and so on, to conclude that “the view of economics as an insular, inbred discipline closed to outside influence is more caricature than reality”.

His answer instead is that there is nothing wrong with economics per se – there is just a communication problem. Most economists are poor at presenting their arguments to the public, because they “see themselves as scientists and researchers whose job it is to write academic papers”. Undergraduate students at Manchester – or Rodrik’s Harvard, where students launched their own protest in 2011 – obviously don’t get exposed to the full rich diversity of economic thought. Though this still doesn’t quite explain why, as Cambridge University Economists Ha-Joon Chang and Jonathan Aldred wrote in 2014, their subject “is the only academic discipline in which a significant and increasing number of students are in an open revolt against the content of their
degree courses”.

Bargaining points for economists
Rodrik’s book concludes with 10 commandments for economists – though ‘bargaining points’ might be a better term – and 10 for non-economists. The latter list includes “if you think all economists think alike, attend one of their seminars” and “if you think economists are especially rude to non-economists, attend one of their seminars” (as if rudeness were a sign of healthy debate). However, there is no such exhortation for economists to attend seminars outside their own field; and the book makes little attempt to find out what these complaints from students, heterodox economists and other non-card carriers actually are.

One of the major criticisms of economic models is that they rarely account for the effects of money, banks, credit or the financial sector. This omission, which played a hugely important role in the crisis, is beyond curious – it is downright bizarre. But, as with other such books to emerge from the mainstream, there is hardly any mention of money, apart from the observation that phenomena such as bubbles and bank runs have been known about for a long time. Nor does the book come to grips with the interesting questions of why theories of non-conformists such as Minsky were repressed, or why the field’s core teachings of efficiency, rationality, etc came to be so perfectly aligned with the PR needs of the financial sector.

Economics Rules offers many useful and valid insights into the nature of economic models, but it also attempts to rationalise away the problems that the field faces, rather than addressing them squarely. So here is not a commandment, but a gentle suggestion to economists in this difficult time: let’s try and get stage four (‘depression’) over with quickly, as it’s time for stage 5: ‘acceptance’.