Attacking economics is a diversionary tactic

Forgive the numbered note form. For some reason it seems appropriate to me in this case

1. The financial crisis in the UK was the result of losses by banks on overseas assets, originating from the collapse in the US subprime market. It was not a result of excessive borrowing by UK consumers, firms or our government. As the Bank’s Ben Broadbent points out, “Thanks to the international exposure of its banks the UK has been, in some sense, a “net importer” of the financial crisis.” This overseas lending caused a crisis because banks were far too highly levered, and so could not absorb these losses and had to be bailed out by the government.
   
   
2. This is why UK macroeconomists failed to pick up the impending crisis. They did routinely monitor personal, corporate and government borrowing, but not the amount of bank leverage. Macroeconomists generally acknowledge that they were at fault in ignoring the crucial role that financial sector leverage can play in influencing the macroeconomy. There has been a huge increase in the amount of research on these finance-macro linkages since the crisis.
   
   
3. But supposing economists had ensured that they knew about the increase in bank leverage and had collectively warned of the dangers of excessive risk taking that this represented. Would it have made any difference? There are good reasons for thinking it would not.
   
   
4. The main evidence for this is what has happened after the crisis. Admati and Hellweg have written persuasively that we need a huge increase in bank capital requirements to bring the ‘too big to fail’ problem to an end and avoid a future banking crisis, and the work of David Miles in the UK has a similar message. I have not come across an academic economist who seriously dissents from this analysis, but it has no impact on policy at all. The power of the banking lobby is just too strong.
   
   
5. So the response of economists to the financial crisis has been as it should be. The error in neglecting bank leverage is being addressed. Economists have come up with clear proposals about how to avoid the crisis happening again. And these proposals have been pretty well ignored.
   
   
6. In terms of conventional monetary and fiscal policy, academic economists got the response to the crisis right, and policymakers got it very wrong. Central banks, full of economists, relaxed monetary policy to its full extent. They created additional money, rightly ignoring those who said it would bring rapid inflation. Many economists, almost certainly a majority, supported fiscal stimulus for as long as interest rates were stuck at their lower bound, were ignored by policymakers in 2010, and have again been proved right.
   
   
7. So given all this, why do some continue to attack economists? On the left there are heterodox economists who want nothing less than revolution, the overthrow of mainstream economics. It is the same revolution that their counterparts were saying was about to happen in the early 1970s when I learnt my first economics. They want people to believe that the bowdlerised version of economics used by neoliberals to support their ideology is in fact mainstream economics.
   
   
8. The right on the other hand is uncomfortable when evidence based economics conflicts with their politics. Their response is to attack economists. This is not a new phenomenon, as I showed in connection with the famous letter from 364 economists. With austerity they cherry picked the minority of economists who supported it, and then implemented a policy that even some of them would have disagreed with. (Rogoff did not support the cuts in public investment in 2010/11 which did most of the damage to the UK economy.) The media did the rest of the job for them by hardly ever talking about the majority of economists who did not support austerity.
   
   
9. The economic costs of Brexit is just the latest example. Critics have focused on the most uncertain and least important predictions about Brexit, made only by a few, to attack all Brexit analysis. The fact that this prediction involved an unconditional macro forecast, while the assessment made by a number of groups about the long term cost involves a conditional projection based largely on trade equations, seems to have completely escaped the critics. More important, the fact that the predicted depreciation in sterling happened, and is in the process of already causing a large drop in living standards, is completely ignored by these critics.
   
   
10. Attacking economists over Brexit is designed to discredit those who point out awkward and uncomfortable truths. Continuing to attack economists over not predicting the financial crisis, but failing to ignore their successes, has the effect of distracting people from the group who actually caused this crisis, and the fact that very little has been done to prevent a similar crisis happening in the future.
    

Miles on Haldane on Economics in Crises

Anything that says economics is in crisis always gets a lot of attention, particularly after Brexit (because economists are so pessimistic about its outcome), and Andy Haldane’s public comments were no exception. But former Monetary Policy Committee colleague David Miles has hit back, saying Haldane is wrong and economics is not in crisis. David is right, but (perhaps inevitably) he slightly overstates his case.

First an obvious point that is beyond dispute. Economics is much more than macroeconomics and finance. Look at an economics department, and you will typically find less than 20% are macroeconomists, and in some departments there can be just a single macroeconomist. Those working on labour economics, experimental economics, behavioural economics, public economics, microeconomic theory and applied microeconomics, econometric theory, industrial economics and so on would not have felt their sub-discipline was remotely challenged by the financial crisis.

David Miles is also right that economists have not found it difficult to explain the basic story of the financial crisis from the tools that they already had at their disposal. Here I will tell again a story about an ESRC seminar held at the Bank of England about whether other subjects like the physical sciences could tell economists anything useful post-crisis. It was by invitation only, Andy Haldane was there throughout, and for some reason I was there and asked to give my impressions at the end. In the background document there was a picture a bit like this.

UK Bank leverage: ratio of total assets to shareholder claims. (Source Bank of England Financial Stability Report June 2012) Added by popular request 17/1/17 [3]: 

I made what I hope is a correct observation. Show most economists a version of this chart just before the crisis, and they would have become very concerned. Some might have had their concern reduced by assurances and stories about how new risk management techniques made the huge increase in leverage seen in the years just before the crisis perfectly safe, but I think most would not. In particular, many macroeconomists would have said what about systemic risk?

The problem before the financial crisis was that hardly anyone looked at this data. There is one institution that surely would have looked at this like this data, and that was the Bank of England. As Peter Doyle writes:

“ .. it was not “economics” that missed the GFC, but, dare I say it (and amongst some others), the Bank of England.”

If there is a discussion of the increase in bank leverage and the consequent risks to the economy in any Inflation Reports in 2006 and 2007 I missed it. I do not think we have been given a real account of why the Bank missed what was going on: who looked at the data, who discussed it etc. I think we should know, if only for history’s sake.

What I think David Miles could have said but didn’t is that macroeconomists were at fault in taking the financial sector for granted, and therefore typically not including key finance to real interactions in their models. [1] As a result, the crisis has inspired a wave of new research that tries to make up for that, but this involves using existing ideas and applying them to macroeconomic models. There has also been new work using new techniques that has tried to look at network effects, which Andy Haldane mentions here. Whether this work could be usefully applied much more widely, as he suggests, is not yet clear, and to say that until that happens there is a crisis in economics is just silly.

The failure to forecast that consumers after the Brexit vote would reduce their savings ratio is a typical kind of forecasting error. Would they have done this anyway, and if not what about the Brexit vote and its aftermath inspired it, we will probably never know for sure. This kind of mistake happens all the time in macro forecasting, which is why comparisons to weather forecasting and Michael Fish are not really apt. [2] That is what David Miles means by saying it is a non-event.

What is hardly ever said, so I make no apologies for doing so once more, is that macroeconomic theory has in some ways ‘had a good crisis’. Basic Keynesian macroeconomic theory says you don’t worry about borrowing in a recession because interest rates will not rise, and they have not. New Keynesian theory says creating loads of new money will not lead to runaway inflation and it has not. Above all else, macroeconomic theory and most evidence said that the turn to austerity in 2010 would delay or weaken the recovery and that is exactly what happened. As Paul Krugman often says, it is quite rare for macroeconomics to be so fundamentally tested, and it passed that test. We should be talking not about a phoney crisis in economics, but why policy makers today have ignored economics, and thereby lost their citizens' the equivalent of a lot of money.

[1] In the COMPACT model I built in the early 1990s, credit conditions played an important role in consumption decisions, reflecting the work of John Muellbauer. But as I set out here, proposals to continue the model and develop further financial/real linkages were rejected by economists and the ESRC because it was not a DSGE model.

[2] Weather forecasts for the next few days are more accurate than macro forecasts, although perhaps longer term forecasts are more comparable. But more fundamentally, while the weather is a highly complex system like the economy. It is made up of physical processes that are predictable in a way human behaviour will never be. As a result, I doubt that simply having more data will have much impact on the ability to forecast the economy.

[3] Total asset are the size of the bank's balance sheet. Shareholder claims are the part of those assets that belong to shareholder, and which therefore represent a cushion that can absorb losses without the bank facing bankruptcy. So at the peak of the financial crisis, banks had over 60 times as many assets as that cushion. That makes a bank very vulnerable to loss on those assets.