Meghnad Desai - Hubris: why economists failed to predict the crisis and how to avoid the next one

Copyright 2015 Meghnad Desai

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CONTENTS

FIGURES

PREFACE

In July 2007, I was invited by the Ministry of External Affairs, Government of India to give a talk to a group of Foreign Services Officers on the prospects for the global economy. The group consisted of 150 people of a variety of ages and included ambassadors and senior diplomats. The discussion quickly turned to the global boom and I was asked by a senior diplomat from Brazil whether this boom would last. Over the course of my many years within the field of economics, I have learnt that there are two things that are certain; the longer a boom lasts, the more people buy into the idea that it will carry on forever and, secondly, the longer the boom, the greater the likelihood it will end soon. But economics is not an exact science so I could not give the diplomat a precise date for when the boom would end; just the certainty that a turning point would come and it would be sooner than he thought.

By mid-2007, two events had taken place, in quick succession, which indicated that the global economy was changing direction. The first occurred in the autumn of 2006 when the US housing market bubble burst; this was followed by the collapse on the Shanghai stock market in February 2007. These events were, at the time, viewed as isolated incidents, unconnected to the larger web of the global economy. During the Great Moderation, words like capitalism and business cycles were no longer a part of the vocabulary of modern economics used by self-respecting economics departments. Perhaps because of this, when the crisis finally hit, its severity took some time to register. Just as in World War I, belligerent nations expected the troops to be home within four months, by Christmas, many economists took the view that the crisis was temporary and self-correcting. Others said that while the crisis was serious, we had the means to solve the problem. The first batch were the New Classicals and the second Keynesians. My own view was that this recession was not only one of the deepest we had ever seen, but also that the usual Keynesian remedies would not work.

In February 2009, as the British Prime Minister Gordon Brown was proposing a massive internationally coordinated Keynesian reflation package at the G20 summit in London, I wrote an article for the online edition of a major UK newspaper about the perils of following a Keynesian policy It was clear to me that the cure would not come from a repetition of the old policies of borrowing and reflation. Globalization had fundamentally changed the context. To find a solution to the crisis we needed to explore the underworld, as Keynes described it, the world where economists who had gone out of fashion lived. Karl Marx, Joseph Schumpeter, Nikolai Kondratieff, Friedrich Hayek (and even Knut Wicksell, who was still read but not understood) viewed capitalism as a system which was subject to the waves of up and down cycles as a dynamic disequilibrium system. Modern economics views the market as a stationary equilibrium system where decisions taken are compatible, so in essence supply equals demand.

When he came to office in January 2009, Barack Obama understood that the financial collapse had created a problem for the real economy. He launched a program for reviving the economy of nearly $800 billion which would have been right for a normal recession. Six months later, Alistair Darling, the British Chancellor of the Exchequer, became the first senior politician to recognize that the severity of the crisis was unprecedented. British elections were imminent by the autumn; along with my colleagues in the House of Lords, we were discussing what should go in the Labour Partys manifesto. I recall venturing that there was no money for any spending initiatives. The contest was going to be about whether Labour could do austerity better than the Conservatives. The answer came from above that we were not talking of austerity but of investment and growth.

Undaunted, in February 2010, along with a group of 19 other economists I signed a letter to the Sunday Times saying that, whichever party came to power, its government would have to cut the budget deficit within one Parliament. Among my fellow signatories were my colleagues at the London School of Economics Tim Besley and Christopher Pissarides (Nobel Prize 2012), David Newbery from the University of Cambridge, Tom Sargent from New York University (Nobel Prize 2011), Ken Rogoff from Harvard, and others. I was the sole signatory who had a political affiliation. There were two contrary responses in the form of letters to newspapers from my Keynesian friends Lord Richard Layard and Lord Robert Skidelsky, with many, many, more signatures for each. In the United States Paul Krugman was arguing strongly for a massive fiscal boost, while the New Classical economists of Chicago and Minnesota were skeptical of the need for, or the effectiveness of, any stimulus. Only among the central bankers of the United States and the United Kingdom was there agreement that the money supply had to be boosted by quantitative easing.

Four years later and with hindsight, we can see that the crisis was severe one of the deepest ever. We also know that the recovery is fragile, at best, in the UK and the US, and non-existent in the eurozone. With the possibility that the recovery may be destabilized by the slightest wrong turn, now is an opportune time to reflect on what went wrong. The problem was not so much with the economy but more importantly with economics and economists. I want to address some of the questions that have been raised about economics: why economists failed to predict the crisis, what happened, why it happened when it did, and why economists wont admit that they were wrong. I also want to address the criticisms of the overuse of mathematics in economics and to see whether there is a new economics which can cope with future economic catastrophes better.

I write as someone who has lived through and even participated in the changes in economics that I describe herein. During my 50-plus years as an economist, I was a Keynesian while a student and in the first decades of my career. I battled against monetarism, writing articles and a book. But I also explored political economy in the works of Marx, Schumpeter, and Hayek through my entire career as an economist. As time went on, I witnessed the change in the culture of academic economics. It abandoned empirical habits of studying the economic reality and became wedded to aprioristic reasoning which replaced skeptical inquiry. Uncertainty and doubt were replaced by certainty and hubris. I tried my best to resist it. I continued trying to interpret the world anew in light of events with the tools of empirical research combined with a deep grounding in the heritage of economic theory. It continues to be an unfinished task. It is this change that I wish to bring home here. I hope readers will gain some insight from reading this book.