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The systemic failure of academic economics

Friday, February 27, 2009

A few barbs have been cast in the direction of Steve Keen from this little outpost in the financial blogosphere before (something having to do with an irreversible deflation death spiral or somesuch), but many thanks are in order today for bringing to our attention some amazing introspection by a few enlightened individuals who practice the dismal science.

In And you think I'm ornery?, Steve points us to The Dahlem Report(.pfd):

The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.
And that's just the executive summary.

The introspection becomes even more brutal another page or two in:
It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, “systemic crisis” appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession.
The entire paper is worth reading in its entirely - very nicely done.

It's possible that Floyd Norris at the New York Times may have had a look at this before penning yesterday's Failing Upward at the Fed in what is yet another scathing attack on central banks and their policies.
Books will be written on the failure of the Fed in the last cycle. It decided that it did not need to worry itself over rising asset prices. So it stood by, first in the technology stock bubble, then in the housing bubble. It saw credit getting excessively loose, and leverage piling up, but comforted us with assurances that if there was a bubble, the Fed knew how to clean up after it burst, principally by cutting interest rates.

It championed letting the shadow financial system grow without oversight, and shied away from doing anything about highly risky mortgages.

Perhaps most important, the Fed and other regulators had no idea how much risk they had allowed into the system. They knew that various financial innovations were designed to let banks make more money without being required to put up more capital, but they did not figure out that that meant the capital there might be inadequate. They threw up their hands at the complexity of it all, and said banks could use their own models to assess risk.

In sum, the Fed thought it had learned the lessons of the 1930s, but it had not learned the lesson of the 1920s, that allowing asset prices to soar to absurdly leveraged heights could lead to a financial collapse as the need to repay loans forced sales that drove prices lower, resulting in the need to repay more loans, and so on and so on.
Mr. Bernanke’s predecessor, Alan Greenspan, has been trying to restore his reputation without admitting any error beyond assuming that banks would act rationally in making loans, and therefore not requiring large enough capital buffers.

“The real lesson here appears to be that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic or whether a particular tranche of a collateralized debt obligation will default, or even if the financial system will seize up,” he said in a speech last week to the Economic Club of New York. It sounded to me a little like a failing student protesting, “Dad, nobody could have passed that test.”

Is the current Fed leadership so modest about its abilities? No doubt it cannot “fully or accurately” forecast what will happen, but does it think that it can do a much better job now than it did in the years leading up to the current crisis? If so, how?
These are all good questions. It's nice to see them being asked.



Nostradamus, apparently said...

Wow! Do these same guys write a report about the "academic science" behind Global Warming?

Yophat said...

Here's the scenario....

You've been loaning this person (Jake) more and more money for quite some time. Not a big deal since you create the money out of nothing. The money is created against the debt he takes on. You profit by siphoning off the interest and are a happy camper.

Jake's standard of living gradually falls as the benefits of his labor are steadily siphoned away in interest expense. He doesn't really pay attention as its hidden in the gradual increases of the costs in the goods he acquires. Eventually it gets to the point where you are loaning Jake money to cover interest costs.

Alarmed that your game might come to an end, you steadily lower Jake's interest costs (since the money is free to you anyways) in an effort to keep Jake producing and keep your interest coming. Jake responds by borrowing in ever increasing quantities as he is now fully addicted to debt. You remove all restrictions - accepting whatever collateral he proposes at whatever value he can assign to it.

Finally Jake gets to the point that he can no longer keep borrowing. Jake has reached the tipping point and can no longer sustain the interest costs of his current debt.

So the question is....Jake owes you a great deal of money. Jake is insolvent meaning he can no longer support the interest costs of the debt let alone pay you back principal.

What do you do?

You can forgive the debt - which could be a write off or the gift of debt free money; or

You can seize the assets which, at any value, is still a very nice return since you created the money out of nothing; or

You could seize the assets and put Jake to work directly for you. Jake becomes a slave to you. He keeps the assets producing and you now take all the benefits of his labor. You give him just enough to sustain himself and keep him producing.

What is your choice?

Yophat said...

Aaron needs to do a site on State implosions now!!!

Darrik said...


I think this statement from a global warming promoter could well have been the thinking in the financial industry when addressing those who thought the new financial instruments were dangerous:

"It's up to Mr Turnbull to pull his [global warming skeptics] into line.",27574,25104720-29277,00.html

Nostradamus, apparently said...



"It's up to Mr. Greenspan to pull his people into line."

I'm not smart enough to know who, if anyone, played the part of the skeptic in the Fed (or other economic leadership roles) in America as Dr. Jensen is playing in the Australian politics of Global Warming.

There seem to have been many of us 'normal' folks out there who were screaming bloody murder about the housing bubble and other crap. People like Tim who started this blog, for example.

I just can't think of any high official in government who was screaming...

Maybe that guy who was Comptroller and quit and made the movie "IOUSA"?

David something... I just can't remember.

Anonymous said...

This is right in line with an article series by George Reisman. You can check it out at

Nostradamus, apparently said...

Anon 12:11

Thanks for the heads up on the Reisman articles.

I just finished one about Laissez-faire capitalism and it was EXCELLENT!

Very, very clear thinking and writing. Very persuasive.

Thank You!

Anonymous said...

Translation: We have the common sense of a fence post on crack.

Anthony J. Alfidi said...

Raising questions like these ought to beg the ultimate question: Why do we even need a central bank that thinks it must keep the economy at some predermined level of employment or inflation?

Let's see academics do some research on that one.

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