David Orrell Quantum Economics, 2019, p 238
The penny drops
While … many mainstream economists have continued to make excuses for their epic forecasting miss , not all have been so sanguine . George Akerlof and Robert Shiller wrote in their 2015 Phishing for Phools : ‘ It is truly remarkable that so few economists foresaw what would happen . There are about 2 ¼ million article and book listings regarding finance and economics on Google Scholar . That may not indicate enough economist – monkeys to randomly type Hamlet , but it should have been enough to generate quite a few papers that would tell how Countrywide , WaMu , IndyMac , Lehman , and many , many others would in short order flame out and crash . We should have known that their positions in mortgage – backed securities and credit default swaps were fragile . At the time we should have also foreseen the future vulnerabilities of the euro . ’ The authors ascribe this to the ‘ mental frame ’ of economists which sees markets as fundamentally efficient , blames pathologies on externalities , and ignores the fact that ‘ competitive markets by their very nature spawn deception and trickery , as a result of the same profit motives that give us our prosperity ’ . ( An exception was Shiller , who himself pointed out in 2005 that the US housing market was in a bubble . 64 ) Indeed , this points to a basic contradiction in neoclassical models , which assumes on the one hand that people are rational utility – optimisers , and on the other hand that they will always honour contracts – so no systematic fraud from bankers , or ‘ jingle mail ’ from homeowners returning the keys rather than pay their mortgage .
In July 2016 , Narayana Kocherlakota – who like Chari was formerly a president of the Federal Reserve Bank of Minneapolis – noted in a report that ‘ we simply do not have a settled successful theory of the macroeconomy ’ . A couple of months later Paul Romer, who is now chief economist at the World Bank , released a paper called ‘The Trouble With Macroeconomics’ in which he described the area as a ‘pseudoscience’ because the models are packed with implausible assumptions and parameters that are made up to give reasonable – looking answers , and all changes are attributed to external shocks ( Chari responded by saying that ‘ Burning down the edifice , and saying we’ll figure out what we’ll build on its foundations later , just does not seem like a constructive way to proceed ’ , though it would be a start ) .
Finally , some ten years after the crisis began , in a May 2017 speech , Portuguese economist Vítor Constâncio of the European Central Bank told his audience : ‘ In the prevalent macro models , the financial sector was absent , considered to have a remote effect on the real economic activity . In these model frameworks , macroeconomic fluctuations resulted mostly from technological or productivity shocks or from monetary policy unexpected measures . The economy was supposed to be mostly self – correcting and move quickly towards its steady state . No defaults of any agent were possible . Thus , excessive debt could not be a problem . As many wrote , for any debtor there was a creditor and so debt was a non – event at the macro level . This ignored the fact that banks create money by extending credit ex nihilo within the limits of their capital ratio . ’ ( Weather forecaster : with the benefit of hindsight , it may have been a mistake to leave out all the wet stuff . ) One reason perhaps for this omission is that , as discussed in Chapter 5 , the ability of private banks to create money out of nothing was only spelled out by the Bank of England in 2014 .
Constâncio’s comment points to the real issue , which is not that mainstream economists failed to predict ‘ the timing , extent and severity ’ ( as the London School of Economics put it ) of some freak storm – economists have never been held to any such standard of forecasting skill , and no one asked for an exact date . It is that they could not have predicted or warned of the crisis , even in principle . Furthermore , the models directly contributed to the crisis both by creating a false sense of security , and by enabling the financial sector to develop increasingly risky and dangerous products . The efficient market hypothesis did not perform well during the crisis , unless you count creating it . Because the models could not understand the causes of the crisis , they were not useful for suggesting the appropriate policy responses afterwards . And the main reason for this failure is even simpler than leaving out things like deception and trickery ( Akerlof and Shiller ) , or insufficient data / rationality / funding ( Chari ) – it is because the models left out money ( which of course is a main cause of deception and trickery ) . Only by doing so could economists maintain the illusion that independent rational consumers and producers with set supply and demand curves drive the economy to a stable equilibrium through what amounts to barter . Chari mocked the idea that we should ‘ stop using mathematical models of oil pressure ’ in the event of an oil spill , but in economics the problem was that money – what David Hume called the oil of trade , what Jean – Baptiste Say compared to ‘ oil in a machine ’ – wasn’t there . 69 It was therefore impossible to detect that the housing bubble was feeding the money supply , which was feeding the housing bubble , and so on , with complex derivative schemes helping to hide the risk .
By interpreting crises as random shocks , the models also eliminated any sense of responsibility for failing to prevent them . According to Dean Baker ( who presciently warned in a 2005 paper with David Rosnick that for economists to miss the housing bubble would be an ‘ act of extraordinary negligence ’ 70 ) , a rough but conservative estimate would be that it cost each person in the US around $ 27,000 in lost earnings – to say nothing of the human impact in terms of things like mental health and youth unemployment – so ‘ how about a little accountability for economists when they mess up ? ’ 71 Many people lost their jobs , but it seems no economists did . Remarkably , in the US their salaries even ‘ reached a historical high during the recession year of 2009 ’ , which as Kocherlakota noted in 2016 , ‘ might help explain the lack of a paradigm shift in macroeconomic research ’ .