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Economists in denial as conventional tools fail

by Howard Davies

In an exasperated outburst, just before he left the presidency of the European Central Bank, Jean-Claude Trichet complained that, “as a policymaker during the crisis, I found the available [economic and financial] models of limited help. I would go further: In the face of the crisis, we felt abandoned by conventional tools.”

Trichet went on to appeal for inspiration from other disciplines — physics, engineering, psychology and biology — to help explain the phenomena he had experienced. It was a remarkable cry for help, and a serious indictment of the economics profession, not to mention all those extravagantly rewarded finance professors in business schools from Harvard to Hyderabad.

So far, relatively little help has been forthcoming from the engineers and physicists in whom Trichet placed his faith, though there has been some response. Robert May, an eminent climate change expert, has argued that techniques from his discipline may help explain financial-market developments.

Epidemiologists have suggested that the study of how infectious diseases are propagated may illuminate the unusual patterns of financial contagion that we have seen in the last five years. These are fertile fields for future study, but what of the core disciplines of economics and finance themselves? Can nothing be done to make them more useful in explaining the world as it is rather than as it is assumed to be in their stylized models?

George Soros has put generous funding behind the Institute for New Economic Thinking (INET). The Bank of England has also tried to stimulate fresh ideas. The proceedings of a conference that it organized earlier this year have now been edited under the provocative title “What’s the Use of Economics?”

Some of the recommendations that emerged from that conference are straightforward and concrete. For example, there should be more teaching of economic history. We all have good reason to be grateful that U.S. Federal Reserve Chairman Ben Bernanke is an expert on the Great Depression and the authorities’ flawed policy responses then rather than in the finer points of dynamic stochastic general equilibrium theory. As a result, he was ready to adopt unconventional measures when the crisis erupted.

Many conference participants agreed that the study of economics should be set in a broader political context, with greater emphasis on the role of institutions. Students should also be taught some humility. The models to which they are still exposed have some explanatory value, but within constrained parameters.

But it is not clear that a majority of the profession yet accepts even these modest proposals. The so-called “Chicago School” has mounted a robust defense of its rational expectations-based approach, rejecting the notion that a rethink is required. The Nobel laureate economist Robert Lucas has argued that the crisis was not predicted because economic theory predicts that such events cannot be predicted. So all is well.

And there is disturbing evidence that news of the crisis has not yet reached some economics departments. Stephen King, Group Chief Economist of HSBC, notes that when he asks recent university graduates (and HSBC recruits a large number of them) how much time they spent in lectures and seminars on the financial crisis, “most admitted that the subject had not even been raised.” According to King, “Young economists arrive in the financial world with little or no knowledge of how the financial system operates.”

I am sure they learn fast at HSBC. (In the future, one assumes, they will learn quickly about money-laundering regulations as well.) But it is depressing to hear that many university departments are still in denial. That is not because students lack interest: I teach a course at Sciences Po in Paris on the consequences of the crisis for financial markets, and the demand is overwhelming.

We should not focus attention exclusively on economists, however. Arguably the elements of the conventional intellectual toolkit found most wanting are the capital asset pricing model and its close cousin, the efficient-market hypothesis. Yet their protagonists see no problems to address.

On the contrary, the University of Chicago’s Eugene Fama has described the notion that finance theory was at fault as “a fantasy” and argues that “financial markets and financial institutions were casualties rather than causes of the recession.” The efficient-market hypothesis he championed cannot be blamed, because “most investing is done by active managers who don’t believe that markets are efficient.”

This amounts to what we might call an “irrelevance” defense: Finance theorists cannot be held responsible, since no one in the real world pays attention to them!

Fortunately, others in the profession do aspire to relevance, and they have been chastened by the events of the last five years, when price movements that the models predicted should occur once in a million years were observed several times a week. They are working hard to understand why, and to develop new approaches to measuring and monitoring risk, which is the main current concern of many banks.

These efforts are arguably as important as the specific and detailed regulatory changes about which we hear much more. Our approach to regulation in the past was based on the assumption that financial markets could to a large extent be left to themselves, and that financial institutions and their boards were best placed to control risk and defend their firms.

These assumptions took a hard hit in the crisis, causing an abrupt shift to far more intrusive regulation. Finding a new and stable relationship between the financial authorities and private firms will depend crucially on a reworking of our intellectual models. So the Bank of England is right to issue a call to arms.

Howard Davies, former chairman of Britain’s Financial Services Authority, deputy governor of the Bank of England and director of the London School of Economics, is a professor at Sciences Po in Paris. © 2012 Project Syndicate