Financial economics between science, ideology and governance

If we look at the present situation in the proper historical perspective, as Carmen Reinhart and Kenneth Rogoff did in their monumental investigation of financial crises over eight centuries, covering sixty-six countries across five continents*1, a rather different picture emerges. The authors argue that there is one common theme to the vast range of crises they consider in their book: «it is that excessive debt accumulation, whether it be by the governments, banks, corporations, or consumers, often poses greater systemic risk than it seems during a boom […] Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced». Most debt-fueled booms, Reinhart and Rogoff argue from their careful study, end badly. They look at long spans of history «to catch sight of “rare” events that are all too often forgotten» and conclude that sovereign defaults, banking crises (bank runs and bank failures) or exchange rate crises, all related to excessive debt in some way or another, never ceased to exist. As they say «an event that was rare in [a] twenty-five year span may not be all that rare when placed in a longer historical context». But twenty-five years means one generation, enough time to forget the lessons of the past. Moreover – this is one of the major points made by Reinhart and Rogoff – governments have always been «little more transparent than modern-day banks with their off-balance sheet transactions and other accounting shenanigans». One more quote from this remarkable book: «we show that in the run-up to the subprime crisis, standard indicators for the United States, such as asset price inflation, rising leverage, large sustained current account deficits, and a slowing trajectory of economic growth, exhibited virtually all the signs of a country on the verge of a financial crisis - indeed a severe one. This view of the way into a crisis is sobering; we show that the way out can be quite perilous as well. The aftermath of system banking crises involves a protracted and pronounced contraction in economic activity and puts significant strains on government resources».

All this being said, what is different each time a financial crisis occurs is the specific path which leads to this crisis. Commenting on the situation in the g erman newspaper Handelsblatt on October 13, 2008 – at a time of great anxiety – Tommaso Padoa-Schioppa, a respected Italian former minister of finance, established a relevant distinction between “a crisis in the system” – such as the Latin American or Asian crisis of the nineteen-nineties or the bursting of the high-tech bubble at the beginning of the new century – and “the crisis of a system”, such as the one triggered by the subprime collapse. Hence the importance which is now attached to the necessity of surveillance mechanisms to detect early signals of future systemic crises.

Before pointing out some of the major issues at stake, let me underline that the current mess is primarily the outcome of an intellectual and ideological failure. Everybody remembers this famous quote of John Maynard Keynes: «The ideas of economists and political philosophers, both when they are right or when they are wrong, are more powerful than is commonly understood […] Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist».

In his best-seller The Myth of the Rational Market*2, Justin Fox puts the blame on the rational market postulate and more specifically on the efficient market hypothesis, formulated at the University of Chicago in the 1960s with reference to the US stock market. According to this hypothesis «financial markets possessed a wisdom that individuals, companies, and governments did not». This hypothesis, from which such models as the celebrated Black and Scholes formula for options pricing derive, is nothing more than the transposition to the financial sphere, thought as isolated from the real economy, of a simple version of the Arrow – Debreu's model of general economic equilibrium. The model of Arrow and Debreu is rightly considered as one of the greatest achievements of economic theory in the twentieth century, and I have practiced it myself extensively, but it is more useful to understand what reality is not than to describe what it is. Its purely financial version may have seemed more realistic to epistemologically imprudent authors such as Stephen Ross and others*3. For sure, Alan Greenspan never was a mathematical economist but he clearly became involved in the efficient market ideology, like so many “practical men”, to use Keynes' terminology.

Justin Fox starts his book with the story of the former Federal Reserve Chairman sitting at the witnesses' table in a hearing room of the US House of Representatives, at the end of October 2008. Greenspan had to admit that he had misunderstood how the world works. The Chairman of the House Committee on Government Oversight and Reform summed up: «In other words», he said, «you found that your view of the world, your ideology, was not right. It was not working».

«Precisely», replied Greenspan. «That's precisely the reason I was shocked, because I had been going for forty years or more with very considerable evidence that it was working exceptionally well».

«As Fed Chairman», writes Justin Fox, «Greenspan had celebrated [the] financialization of the global economy. “These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it”, he said in 1999, refering to derivatives in particular. Greenspan had once expressed the worry, in 1996, that stock markets might be losing themselves in a frenzy of “irrational exuberance”. When they kept rising after that, he took the lesson that the market knew more than he did».

Believer as he was, before the fall of 2008, of the efficiency of market, Alan Greenspan welcomed uncritically financial innovation, rejected as undesirable if not impractical the idea of looking for monetary instruments to avoid the formation of financial bubbles, and similarly looked at balance of payments structural disequilibria with benign neglect. I have a personal memory of a private conversation with him in the nineties on this last point. He then had told me the substance: «I have been going for thirty years or more with very considerate evidence that things were going exceptionally well». His ideology was widely shared not only in Washington and on Wall Street, but also almost everywhere in the world, when the concept of market efficiency and globalization tended to be identified with each other. Indeed, at the turn of the millenium, the dominant view was that «the central problem of depression – prevention [had] been solved, for all practical purposes». Such was the statement of Robert Lucas, -1995 Nobel Laureate in Economics for his contribution to the concept of rational expectations - , speaking at the annual meeting of the American Economic Association in 2003. As Paul Krugman comments in his book Return of Depression Economics*4, «Lucas didn't claim that the business cycle, the irregular alternation of recessions and expansions that has been with us for at least a century and a half, was over. But he did claim that the cycle had been tamed, to the point that the benefits of any further taming were trivial: smoothing out the wiggles in the economy's growth, he argued, would produce only trivial gains in public welfare. So it was time to switch focus to things like long-term economic growth». Such was also the view of Ben Bernanke, who was to become Greenspan's successor.

As always, there were a few dissidents. Krugman, recipient of the 2008 Nobel p rize in Economics, published the first edition of The Return of Depression Economics in 1999. The French economist Maurice Allais, who was awarded the Nobel p rize in 1988, never ceased to argue about the potential instability of the world economy due to excessive debt. But like some others their voices - especially that of Allais who never was a good communicator - were lost in the desert.

To be fair, I must stress the fact that the debate about taming the economic cycle goes back to the heydays of keynesianism. Indeed, the essence of the Keynesian vulgate was to pretend having solved the «central problem of depression – prevention» thanks to the multiplier mechanism. In this view of the world, money and debt play no role. Such was not the view of Milton Friedman, whose empirical, theoretical and political fight over decades was about the primacy of monetary policy. He claimed to have demonstrated that depression like inflation are always monetary phenomena. But, contrary to the dreams of some of the best post World War II scholars, including the great Paul Samuelson himself – with whom I was fortunate to have once a conversation on this subject, in the eighties -, economics is not and probably never will be an exact science like classical mechanics or even thermodynamics, essentially because men do not act like robots. And in a way modern economic theory – including game theory - looks like robotics. As a human discipline, political economy is bound to remain a combination of art and science, as the central bankers know too well.

Two related conclusions emerge from this discussion. Firstly, it is essential to take a long term historical perspective if we want to avoid the repetition of more or less serious financial and economic crises. Forgetting past mistakes ensure their reproduction and the endlessness of cycles. Secondly, we should not take economics too seriously, that is to the point of converting classes of theoretical models into ideologies, which may be a temptation for scholars in search of fame. Ideologies, too, follow cyclical patterns. At present, two forces are clearly at work, in opposite directions. On the one hand, the wrong perception that the crisis is over may increase resistance against the needed new governance mechanisms, and precipitate a new major financial earthquake. On the other hand, a return to indiscriminate state interventionism hidden behind an apologetic return to “keynesianism” is a no lesser risk. George Akerlof and Robert Schiller brilliantly remind us of the ”Animal Spirits” *5, a term coined by Keynes, but it would be unreasonable to swing from one extreme to the other and proclaim that all market are “irrational”. It should be a major goal for the G20 to help find an appropriate balance between these two ideological forces. This is an urgent task, because nothing is more difficult than be uproot a well-established ideology, short of a major shock. This is the reason why, although those who denounce the responsibility of public authorities (governments and international organizations) in the current crisis may be right, they should recognize that public authorities too are subject to dominant ideologies. Greenspan was no exception. Moreover, at the end of the day, in democracies, governments and event Central Bankers can hardly resist the wind when it blows too strongly.

Let me now turn briefly to three specific and related policy issues, which are part of the bread and butter of the G20.

First, an exit strategy must involve, in the major developed and emerging countries, medium to long term policies to resorb excess liquidity and to reduce pre-crisis and post-crisis debt levels. As I said at the beginning, financial crises are always related to a debt problem. Incidentally, if something is missing in the standard macroeconomic models, it is a proper treatment of debt, which has not found its place in the “neo-classical synthesis”. Debt reductions must be credible, and they should be gradual in order to avoid deflationary effects.

Second, there is no doubt that the persistence over time of major macroeconomic disequilibria, such as the US balance of payment deficit and the Chinese surplus, are unsustainable. By buying huge amounts of dollars to avoid appreciation of their currencies, creditor countries have contributed to a massive increase of liquidity, and to artificially low interest rates. This, together with oversophisticated financial innovation and excessive securitization, lifted dramatically upwards the supply curve for credit. For the future, we need more conservative monetary policies and early care to prevent asset bubbles. But this will hardly be feasible without correcting macroeconomic disequilibria. This is turn implies typically an increase of saving rates in the US and of the consumption rate in China. Although some signs point to that direction, the spirit of macroeconomic coordination is clearly insufficient at present. In the same vein, we need to take a fresh look at the international monetary system, that is the discipline of Exchange Rates and the ways to reduce their volatility, and a better management of world liquidity. In an era of troubles, avoiding direct or indirect (typically through industrial policies) protectionism will be increasingly difficult in the absence of concerted fiscal and monetary policies, supported by an unbiased IMF.

Third, rules must be strengthened, aiming at more transparency for government or non state actors financial activities, at improving capital and liquidity ratios, at abolishing at all levels the practice of off balance-sheets transactions, at revisiting accounting procedures too much impacted in the recent past by the “myth of rational market”. Following the advice of former fed Chairman Paul Volcker, President Obama now wants to restrict the size and activities of the US's biggest banks. The White House wants commercial banks that take deposits from customers to be barred from investing on behalf of the bank itself – what is known as proprietary trading – and says the administration will seek new limits on the size and concentration of financial institutions. Under the “Volcker rule”, banks would be prohibited from owning, investing in or advising hedge funds or private-equity firms. These ideas are clearly designed to combat “too big to fail” institutions. They may, however, go too far.

Looking at these issues, it is clear that progress cannot be achieved without substantial and genuine coordination among the major world economies. This raises two key points, one on efficiency and one on legitimacy. Efficiency implies a relevant internal organization of the G20, a review of its relationship with other institutions such as the IMF or the World Bank, procedures to follow up etc. l egitimacy implies ways to take into account the interests of non-G20 countries. More fundamentally, like any other G playing a role in world governance, the G20 cannot function properly if its members do not share a cooperative spirit and do not look at their collective action as a positive sum game. It is far from clear that such is the case today. The best way to test the willingness of the group to act as a real community might be to elaborate a written covenant describing in a precise way the rights but also the duties of its members. The first steps of the G20 were promising, and helped to check panic in the aftermath of the Lehman Brothers bankruptcy. This fortunate fact was essentially psychological, and therefore related to the “animal spirits” of Mr. Keynes. To consolidate credibility on a more sustainable basis, we need more than that. There may be here a great challenge for Korea's leadership.

Thierry de Montbrial
February 24th, 2010

*1 Carmen M. Reinhart and Kenneth S. Rogoff. This Time is Different . Princeton University Press, 2009.

*2 Justin Fox. The Myth of Rational Markets. Harper Business, 2009.

*3 Stephen A. Ross. Neoclassical Finance. Princeton University Press. 2005.

*4 Paul Krugman. The Return of Depression Economics. Norton, 1999 and 2009

*5 George A. Akerlof and Robert J. Shiller. Animal Spirits. Princeton University Press, 2009.