Monday, October 1, 2012

The Role Of Economics In The Financial Crisis

Andrew Haldane, who is an Executive Director of Financial Stability at the Bank of England, argues that economics was one of the many factors that contributed to the financial crisis.  He describes the intellectual viruses within economics that played a major role in financial crisis.

History is full of cycles in money and credit that have spilled over the real economy.  They have been ignored for several reasons.  The first reason is academic.  Central banks use DSGE models of the "real economy" in which asset prices, money and credit play a minor role because they have dominated macroeconomics since the 1970's.  The second reason is that inflation targeting assumed a dominant role in central banks.  The rapid rise in the ratio of bank assets to GDP since the 1970's did not concern central banks.  Moreover, bank regulators focused on the health of individual banks instead of system risk in the banking system.  Haldane concludes that economic history should receive more attention in economic curricula and that more attention should be given to the behavior of institutions such as central banks and commercial banks.

The second virus that affected economics is new and more virulent. Conventional economic models are based upon the behavior of representative agents that rely upon linear mathematics.  The financial crisis is better described as a complex interaction of tightly linked financial and social agents.  The system is highly adaptive when it is not stressed.  On the other hand, it behaves in a non-linear and maladaptive fashion when it reacts to fear. The break down in the system, following the collapse of Lehman Brothers, is not well captured by conventional models which assume representative agents.  Its time to move on from the DSGE models that are dominant in academics towards models that capture the system dynamics of the real world.

New paradigms in science do not easily replace dominant paradigms simply because they are contradicted by unpleasant facts.  It will be awhile before academics, whose prestige is based upon prevailing models, are ready to accept a new paradigm. In the meantime it is better to lessen the role that they play in policy making.  There is also an ideology underlying the DSGE models that has become part of our general culture, and which contributed to the financial crisis. It is the ideology of self correcting markets that work well as long a government does not attempt to intervene in the market.

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