Economic crisis, and a crisis for economics
First published in the Telegraph on 30 July 2009
Some things can be reliably forecast: the movements of the planets, the boiling point of water, the likelihood that an English sports team will fail dismally in at least one tournament a year. But the rest of life is far more difficult to predict – especially the field of human behaviour, which, as economists have been unpleasantly reminded, is the bedrock of their profession.
Following its failure to fix the current mess, economics has tumbled into a full-blown existential crisis. The fall has been something to behold. Not so long ago, the discipline seemed omnipotent: if you wanted to fix anything from environmental ruin to welfare policy, there was only one solution: call in an economist.
But late last year, Alan Greenspan, the former Federal Reserve chief and high priest of capitalism, was forced to admit in a Congressional hearing that he had “found a flaw” in the foundations of his economic understanding. Nice euphemism. And at the weekend, a panel of leading economists wrote to the Queen trying to explain why they got it wrong. If there were such a thing as a car-crash letter, this was surely it.
The problem, said the experts, was a “failure of the collective imagination of many bright people” (by which they presumably meant themselves). Some of us had warned about the chances of a crisis, they added, but no one got the timing or the configuration quite right. Which is rather like a golfer insisting that although his drive was way off centre, his practice swing was simply faultless.
These excuses might wash when all that is lost is a tournament, but not when millions of people are losing their jobs. The world’s financial system lies in ruins, as do the fiscal balances of almost every major Western nation, after having to bail out their banks and splash billions of dollars of rescue money into the broader economy. Everyone is suffering, as unemployment climbs, house prices fall, and companies rack up losses or even face collapse. Yet the economists have still failed to find their form again.
Last autumn, when this newspaper suggested that interest rates – then just below 5 per cent – could come down to as low as 1 per cent, most of them scoffed (as it transpired, our prediction was on the conservative side). Even last week, when the GDP figures were published, no one anticipated the scale by which the economy had shrunk in the second quarter of the year.
Despite this ineptitude, it is going much too far to conclude that economists are good for nothing. The primary purpose of what its practitioners call “the dismal science” has never been to predict the future. But somehow, this was the idea some in the trade propounded, and the rest of us were taken in. Yes, many experts did envisage a crisis of sorts: most expected house prices to fall, and some warned of the dangers of the build-up of debt around the Western world. But despite what the recent letter said, no one really foresaw precisely how this crisis would pan out. Given how many variables are at play in everyday life, to have done so would have been akin to providing an accurate weather forecast for every week of the following year.
Human nature, however, is such that we crave certainty. When we discover something that looks like a feasible theory, we stick to it doggedly, until something proves us wrong. This was our collective error a few decades ago, when economics was hijacked by something called the efficient markets hypothesis, a seductive theory that both tied in with Adam Smith (postulating that most asset prices would always be a fair reflection of supply and demand) and seemed able to predict the future with more than occasional accuracy.
No matter that it ran against the grain of the past century of economic experience, pockmarked by boom and bust – it made enough financiers enough money for long enough to drown out the noises of scepticism. Rather like the One Ring in The Lord of the Rings, which was irresistible, but had the power to sap the life out of its bearer, this theory crowded out all other original thought in economics. Far from being a thriving discipline at the time of the crunch, the field had been intellectually moribund for some decades.
But in a strange way, the by-product of this financial collapse has been to free economics of this burden. In the corridors of the Bank of England and Treasury, there is a distinct whiff of excitement. For the first time in decades, economists have been able to throw away their textbooks and go back to first principles; to exhume once-sacrilegious figures such as John Maynard Keynes or Friedrich Hayek. It is unsettling, no doubt, but this is a fertile moment, an opportunity from which may be born a better model of how to run an economy.
We are already seeing the consequences. In the future, markets will be less free; there will be more regulation; the state will be more interventionist. Taxes may become more redistributive. But from the ashes of the crisis may come a new understanding of how to run an economy that is both more successful, and more stable, than the failed models of the past.