An Intellectual Bailout
We must add another field to the list of those in need of rescuing -- economics itself.
The financial crisis has killed the claim that economics deserves to be treated as a science. The measure of a science is its capacity to explain, predict, and prescribe. And most economists not only failed to anticipate the nature and evolution of the catastrophe, but their conflicting recommendations on how to stabilize the situation exposed the unreliability of their knowledge. As much as Wall Street and Main Street, the economics profession needs a bailout of its own.
Policy gyrations and faulty calls have revealed that economics itself is in crisis: The experts simply have no idea what to do. No less an expert than U.S. Federal Reserve Chairman Ben Bernanke repeatedly declared the worst was over, only to admit with chagrin much later that "I and others were mistaken early on in saying that the subprime crisis would be contained." As recently as mid-November, Bernanke told the U.S. Congress that he thought the measures that had been taken "appeared to stabilize the situation," a pronouncement that proved wrong almost as soon as it was made. The fault lies less with Bernanke for trying to calm the markets than with the accumulated body of economic knowledge that failed miserably to equip him and other policymakers with more reliable tools to anticipate and navigate the crisis.
So, along with banks and brokerages, mortgage holders and emerging markets, it’s time to add another rescue effort to the list — for economics itself. This intellectual bailout will force economists to revise the models and methods unquestioned during the boom years. It will force them to produce new tools suited to a new era and reinvigorate their thinking by borrowing more intensively from other disciplines, such as psychology and political science.
Continuing to assume, for example, that corporations always behave as profit maximizers and dismissing the importance of the self-interested behavior of their unaccountable managers will become much harder after this crash. Prolonged good times encourage bad habits and complacency not only among corporations and consumers but also among economists. The crash will stimulate creativity and the new thinking that comes from recognition of failure; the years ahead are bound to replenish the intellectual capital on which economists base their influence.
Certainly, the intellectual failures and the policy mistakes that led to the Great Depression produced a surge of innovative economic thinking. Thanks to the insights of John Maynard Keynes and others, governments now know that battling a crisis with tight money, spending cuts, and trade barriers fuels the economic fires instead of dousing them. So, they’ve put in place humongous bailouts and even larger fiscal stimulus packages that we are all hoping will work. If they do, economists will earn back some of their tarnished reputation.
Regaining intellectual respectability will be sorely needed to reverse some of the bad policy ideas that are gaining currency in the present crisis. Deriding deregulation, for example, is commonplace in the new blame game; so is bashing the rise of risk-spreading financial instruments. But economists know that deregulation does not always lead to reckless behavior and that financial derivatives are not always a scam. No matter. In many influential circles, saying that credit-default swaps can be beneficial or that deregulation can lift people out of poverty is now sacrilegious. It will take years for the pendulum to swing back to a desirable middle ground between the excessive and damaging deregulation of the past decade and the equally damaging regulatory exaggerations that we are bound to see in response to the justified indignation over the catastrophe. Economists can help in this rebalancing, but their current disrepute undermines their ability to persuade an angry public that they know what they are talking about.
This crisis of confidence comes as credible economists are urgently needed to deal with other nefarious consequences of the crash. Consider the alarming concentration of the financial industry. As banks and other companies go out of business or are absorbed by their rivals, only a handful of giant corporations remain with a disturbing concentration of assets and overall market share. Bank of America is now the bank for about half of all American families. Globally, Citigroup and UBS have been deeply damaged, allowing JPMorgan Chase to become a largely unchallenged behemoth. Typically, such markets with a few large players are vulnerable to collusion and other anticompetitive practices; in such a world, it’s the customers who suffer.
Competition is also being inhibited by financial protectionism. While economists worry that the crisis will spur countries into raising barriers to international trade in goods, significant restrictions on international financial integration have already been quietly created in recent months. Trade protectionism is a risk; financial protectionism is already here. The measures governments are taking to salvage banks and buttress their financial sectors have the side effect of making it very hard for newcomers to compete with existing players. Unfortunately, lessened competition is one of the costs we will all be paying for years to come.
Worrying about this collateral damage while the fire is still burning might seem a diversion. But it is worth remembering that our current mess was caused in large part by the "solutions" used to minimize the end of the dot-com bubble, the Asian financial crisis, and other crashes. These economic maladies were "cured" using medicines that weakened the patient and brought us the current catastrophe. We did not have a Keynes to alert us to the toxicity of the cure. Let’s hope that we will soon get one — or many — of his successors, not only to bail out their profession but, more importantly, to save us from a new crisis created by the solutions to this one.