What Caused the Financial Crisis

12. The Financial Crisis and the Systemic Failure of the Economics Profession

Chapter 12 The Financial Crisis and the Systemic Failure of the Economics Profession DAVID COLANDER, MICHAEL GOLDBERG, ARMIN HAAS, KATARINA JUSELIUS, ALAN KIRMAN, THOMAS LUX, AND BRIGITTE SLOTH The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession. Since the 1970s, most economists have developed and come to rely on models that disregard key factors—including heterogeneous decision rules, revisions of forecasting strategies, and changes in the social context—that drive outcomes in asset and other markets. 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 systemic crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, ‘‘systemic crisis’’ seems to be an otherworldly event, absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon.1 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. Financial Crisis and Failure of the Profession 263 Economists’ Failure to Anticipate and Understand the Crisis The implicit view behind standard equilibrium models is that markets and economies are inherently stable and only temporarily get off track. The majority of economists thus failed to warn about the threatening systemic crisis and ignored the work of those who did. Ironically, as the crisis has unfolded, economists have had no choice but to abandon their standard models and produce handwaving common-sense remedies. Common-sense advice, although useful, is a poor substitute for an underlying model. It is not enough to put the existing model to one side, observing that one needs ‘‘exceptional measures for exceptional times.’’ What we need are models capable of envisaging such ‘‘exceptional times.’’ The confinement of macroeconomics to models of stable states that are perturbed by limited external shocks, but that neglect the intrinsic recurrent boom-and-bust dynamics of our economic system, is remarkable. After all, worldwide financial and economic crises are hardly new, and they have had a tremendous impact beyond the immediate economic consequences of mass unemployment and hyperinflation in various times and places. This is even more surprising given the long academic legacy of earlier economists’ study of crises, which can be found in the work of Walter Bagehot (1873), Hyman Minsky (1986), Charles Kindleberger (1989), and Axel Leijonhufvud (2000), to name a few prominent examples. This tradition, however, has been neglected and even suppressed. Much of the motivation for economics as an academic discipline stems from the desire to explain phenomena like unemployment, boom-and-bust cycles, and financial crises, but dominant theoretical models exclude many of the aspects of the economy that lead to such phenomena. Confining theoretical models to ‘‘normal’’ times without consideration of these aspects might seem contradictory to the focus that the average taxpayer would expect of the scientists on his payroll. The most recent literature provides us with examples of blindness against the approaching storm that seem odd in retrospect. For example , in their analysis of the risk management implications of CDOs (collateralized debt obligations), Krahnen 2005 and Krahnen and 264 Colander, Goldberg, Haas, Juselius, Kirman, Lux, Sloth Wilde 2006 mention the possibility of an increase of ‘‘systemic risk.’’ But they conclude that such risk should not be the concern of the banks engaged in the CDO market, because it is the governments’ responsibility to provide costless insurance against a system-wide crash. On the more theoretical side, a recent and prominent strand of literature essentially argues that consumers and investors are too risk averse because of their memory of the (improbable) event of the Great Depression (e.g., Cogley and Sargent 2008). The failure of economists to anticipate and model the financial crisis has deep methodological roots. The often-heard definition of economics—that it is concerned with the ‘‘allocation of scarce resources’’—is short sighted and misleading. It reduces economics to the study of optimal decisions in well-specified choice problems. Such research generally loses track of...