The great depression

The 2008 financial crisis sank many of the world’s economists deep into mourning. They have only just now reached the fourth stage of the grieving process: depression

Author: David Orrell
January 10, 2017

It has been fascinating – if a little uncomfortable – to watch the slow, painful, but necessary process of economists struggling to come to terms with their sector’s role in what has become known as the Great Financial Crisis.

The crisis came as a profound shock to many economists. The profession’s status had never been higher than in the period between 1985 and 2005, during what Ben Bernanke and others called the Great Moderation, when it seemed inflation and macroeconomic volatility were under control. In a 2003 lecture, Nobel Laureate Robert Lucas told his audience: “My thesis in this lecture is that macroeconomics in this original sense has succeeded: its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”

This complacency was shaken by the crisis, which must rank as one of the greatest predictive failures of our time. Models that were based on assumptions of stability, equilibrium and efficiency were of little use when markets were cratering, real estate was sinking into the mud, and oil and food were spiking. And with the growing realisation of what role economic models and theories had played in the crisis – for example, by creating an illusion of security – economists experienced a major loss of prestige.

The long road to acceptance
The first phase of the resulting grief process, denial, was particularly long and drawn out, in part because many leaders of the field refused any culpability at all. Tom Sargent, who received the 2011 Nobel Prize in Economic Sciences, said: “It is just wrong to say that this financial crisis caught modern macroeconomists by surprise.”

Models that were based on assumptions of stability, equilibrium and efficiency were of little use when markets were cratering

Robert Lucas (the 1995 winner) preferred to put the blame on the unpredictability of efficient markets. The Nobel committee apparently agreed with him, awarding Eugene Fama – the founder of the efficient market theory – the economics prize in 2013.

The next phase, anger, saw an outburst of what I have referred to as “book-burning economists”. In the bargaining stage, economists argued the models were okay – it was just that, for various reasons, the wrong ones had been used. According to this argument, critics of the field – including the numerous student groups that have sprung up in protest – just don’t understand the awesome diversity of economic thought, and are attacking a simplified straw man.

It therefore comes as a positive development, and something of a relief (at least for we critics), that some economists at least appear to be moving – or sinking – into the next, more passive stage of the grief process: depression. As evidence for this movement, we present a paper called The Trouble with Macroeconomics by Paul Romer.

Romer is famous in economic circles for being a pioneer of something he called “endogenous growth theory”, as well as for coining the phrase “a crisis is a terrible thing to waste”. He was talking about a crisis in education levels, but the phrase was soon used in reference to the financial crisis. However, in his latest paper he compared the state of economics with that of another area: the physics of string theory (the title of his paper was modelled on that of Lee Smolin’s The Trouble with Physics).

Both areas, Romer noted, are dominated by an emphasis on abstract mathematical models that have little to do with experimental reality. Economists and string theorists also share an almost tribal sense of identity, to the point that some see it as “an extremely serious violation of some honour code for anyone to criticise openly a revered authority figure… neither facts that are false, nor predictions that are wrong, nor models that make no sense matter enough to worry about”.

Just as Smolin complained about the lack of progress in physics, Romer wrote in his paper: “For more than three decades, macroeconomics has gone backwards.”

Regression into pseudoscience
Of course, heterodox economists have been saying the same thing for years (and I made a similar comparison to string theory in my 2012 book, Truth or Beauty). However, as Paul Mason from The Guardian observed, Romer’s paper is a “big thing” because he is not an outsider or a rebel, but “a doyen of the profession, and from the heart of the US academic mainstream”.

In his assessment, Romer refreshingly did not try to apply a positive or optimistic spin to these events, or celebrate the “steady progress” which is the norm, instead admitting that his “pessimistic assessment of regression into pseudoscience” was unusual. He also noted that he sees himself more as a practitioner, rather than an academic, and so feels free to speak out, but many people are afraid to criticise leaders in their field because of the “unpleasant reaction” that it may evoke. He recalled meeting someone who was so angry with him for criticising a paper by Robert Lucas that “at first he could not speak. Eventually, he told me: ‘You are killing Bob’.” Yikes.

Most interesting, though, is that Romer started his paper by addressing a subject that seems to be almost taboo in respectable (as opposed to heterodox) economic circles – namely, the exclusion of money from most economic models. As he noted, such models assume the money supply plays only an incremental role in the economy, affecting price levels but nothing at a more structural level. But “if the Fed can cause a 500 basis point change in interest rates, it is absurd to wonder if monetary policy is important”.

Romer’s paper is written with commendable honesty and obvious concern for the state of economics. However, it offers no real solutions and does not acknowledge the contributions of heterodox economists, who have made similar criticisms for decades. As a consequence, the final stage of the grief process – acceptance – will have to wait. In the meantime, it seems that what Lucas called “depression prevention” has not been solved after all. Let’s hope this stage doesn’t go to waste.