The economist Axel Leijonhufvud quipped in his essay “Life among the Econ” that,
"The Math-Econ [tribe] make exquisite models finely carved from bones of Walras. Specimens made by their best masters are judged unequalled in both workmanship and raw material by a unanimous Econographic opinion. If some of these are “useful” – and even Econ testimony is divided on this point – it is clear that this is purely coincidental in the motivation for their manufacture."
Read the whole essay because it's very funny. It’s an inside joke; the father of math models in economics was Leon Walras. I thought of the essay when reading Martin Wolf’s recent article in the Financial Times, “Economics failed us before the global crisis.” Wolf’s is only the latest in a long line of laments over the “usefulness” of macroeconomics after the Great Recession. He wrote,
"The tests of this discipline are whether its adepts understand what might go wrong in the economy and how to put it right. When the financial crisis that hit in 2007 caught the profession almost completely unawares, it failed the first of these tests. It did better on the second. Nevertheless, it needs rebuilding.”
How does Wolf know that macroeconomists did better at the second, putting the economy right? Because we didn’t have another Great Depression:
"A comparison between what happened in the 1930s and this post-crash period shows we have indeed learnt some important things. Compared with the Great Depression, the immediate declines in output and rises in unemployment were far smaller. Moreover, prices have also been far more stable this time. These are true successes.”
In other words, because we didn’t have a depression like the Great D that proves the money printing and deficit spending worked to save us. Wolf reminds me of another joke: a police officer approached a man furiously blowing a trumpet in the park and asked him why he was doing that. The man said he was keeping elephants away. The policeman said there never have been elephants in the park, to which the trumpeter responded, “It’s working!”
Wolf’s problem is he doesn’t know economic history, but then few economists do. The US has suffered through about 70 recessions/depressions since 1790. Before 1929, the US economy recovered from depressions with no help whatsoever from a central bank or the federal government. All of them were milder than the Great one. The Great D became the worst ever because the government decided to rescue us. The Smoot-Hawley tariff destroyed international trade so much that it took another 70 years to recover. Other efforts by FDR to “save” us caused equally bad outcomes and made the depression in the US last longer than in any other country.
Some think the Great Recession was almost as bad in terms of GDP decline, but combining the recessions of 1981 and 1982 (six months apart) produces one equally as bad. In response, the Fed kept interest rates high and Reagan did nothing to bail us out, yet the economy recovered very fast.
During the Great Recession, Congress passed no Smoot-Hawley tariff so there was no reason to think the latest recession would turn into a Great Depression. Wolf and most mainstream economists predicted that the Great Recession would turn into an “elephant in the park” so when no elephants appeared they declared victory. It’s an old political ploy to predict the worst and when it doesn’t happen take the credit. Politics is all about taking credit for the work of others and most macroeconomists act like politicians.
Wolf blames macroeconomists' assumptions of the efficient markets hypothesis and rational expectations for their failures, but those were never problems. The roadblock has always been the desire for precise math model, like those “carved from the bones of Walras.” Making their models work required the assumption of equilibrium, which assumes away the very things we want explained, such as recessions. Wolf is correct that “it is better to be roughly right than precisely wrong.” But he doesn’t seem to know that the quote comes from FA Hayek’s Nobel speech, not from Minsky. Hayek was trying to convince economists to get some therapy for their obsession with their equilibrium models.
Wolf stepped dangerously close to the truth about the causes of crises with this:
“Moreover, crises are endogenous: that is to say, they come from within the economy. They are a result of the interaction between tendencies towards excessive optimism and the fragility of any system of highly leveraged financial intermediaries.”
But then he flinches and runs away. Had he been made of sterner stuff, he would have asked, where does the excessive optimism and high leverage come from if not from central bank monetary policies flooding the world with cheap money? And if high leverage is the problem, how is it also part of the cure? Is bourbon the solution to alcoholism?
And his remedy shows some promise:
“Obvious solutions include eliminating the incentives towards leverage in our tax systems, encouraging greater use by the economy of equity finance and debt that can be readily converted into equity, raising the reserve and capital requirements of banks and moving swiftly towards the issuance of digital central bank cash.”
But what about the chief dealer of the drug he calls leverage, the Federal Reserve? Even without the policies he mentions, excessive leverage could never happen if the Fed allowed the market to determine interest rates and didn’t keep them near zero for over a decade. And those same policies can never prevent the Fed from flooding the country with cheap money and increasing leverage.
Wolf and mainstream economists see the impact of money printing as asymmetric: it produces only good outcomes in the short run and nothing worse than inflation in the long. He thinks that because he has an emaciated theory of money. If he learned a robust theory of money as the Austrian school teaches he would see the devastating effects of money printing in the near term. Keynes was addressing economists like Wolf when he said, “In the long run we’re all dead.” Most fail to quote the next sentence:
“Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again.”
In other words, mainstream economists fixate on the long run effect of inflation to the exclusion of the near term storms.
Wolf sets before economists two tasks:
“The first is how to make the body economic more resistant to the consequences of manias and panics. The second is how to restore it to health as quickly as possible. On both counts, we need to think more and do more.”
By identifying the problem with leverage, Wolf is very close to the Austrian business-cycle theory (ABCT), which blames central bank policies for creating high leverage through 1) below market interest rates and 2) expanding the money supply by buying US treasuries from banks. Loose monetary policy encourages people to go into debt and causes unsustainable expansions that end in manias. The inevitable crash causes panics. Why can’t he connect the dots?
He can’t because of his socialist tendencies. Wolf, like all mainstream economists, wants to blame capitalism for crises. He can’t indict the real culprit, the quasi-governmental central bank, because that would let capitalism off the hook and put the burden on his idol, the state.
We are probably now in another recession, which typically last 18 months. What will mainstream econ say about it in two years?