The Crisis & Economics, Part 1: The Boom & The Bust

For critics of mainstream economics, the 2008 financial crisis represents the final nail in the coffin for a paradigm that should have died decades ago. Not only did economists fail to see it coming, they can’t agree on how to get past it and they have yet to produce a model that can understand it fully. On the other hand, economists tend to see things quite differently – in my experience, your average economist will concede that although the crisis is a challenge, it’s a challenge that has limited implications for the field as a whole. Some go even further and argue that it is all but irrelevant, whether due to progress being made in the field or because the crisis represents a fundamentally unforeseeable event in a complex world.

I have been compiling the most common lines used to defend economic theory after the crisis, and will consider each of them in turn in a series of 7 short posts (it was originally going to be one long post, but it got too long).  I’ve started with what I consider the weakest argument, with the quality increasing as the series goes on. Hopefully this will be a useful resource to further debate and prevent heterodox and mainstream economists (and the public) talking past each other. Let me note that I do not intend these arguments as simple ‘rebuttals’ of every point (though it is of some, especially the weaker ones), but as a cumulative critique. Neither am I accusing all economists of endorsing all of the arguments presented here (especially the weaker ones).

Argument #1: “We did a great job in the boom!”

I’ve seen this argument floating around, and it actually takes two forms. The first, most infamously used by Alan Greenspan – and subsequently mocked by bloggers – is a political defense of boom-bust, or even capitalism itself: the crisis, and others like it, are just noise around a general trend of progression, and we should be thankful for this progression instead of focusing on such minor hiccups. The second form is more of a defence of economic theory: since the theory does a good job of explaining/predicting the boom periods, which apply most of the time, it’s at least partially absolved of failing to ‘predict’ the behaviour of the economy. Both forms of the argument suffer from the same problems.

First, something which is expected to do a certain job – whether it’s an economic system or the economists who study it – is expected to do this job all the time. If an engineer designs a bridge, you don’t expect it to stand up most of the time. If your partner promises to be faithful, you don’t expect them to do so most of the time. If your stock broker promises to make money but loses it after an asset bubble bursts, you won’t be comforted by the fact that they were making money before the bubble burst. And if an economic system, or set of policies, promise to deliver stability, employment and growth, then the fact that it fails to do so every 7 years means that it is not achieving its stated objectives. In other words, the “invisible hand” cannot be acquitted of the charge of failing to do its job by arguing it only fails to do its job every so often.

Second, the argument implies there was no causal link between the boom and the bust, so the stable period can be understood as separate from the unstable period. Yet if the boom and the bust are caused by the same process, then understanding one entails understanding the other. In this case, the same webs of credit which fuelled the boom created enormous problems once the bubble burst and people found their incomes scarce relative to their accumulated debts. Models which failed to spot this process in its first phase inevitably missed (and misdiagnosed) the second phase. As above, the job of macroeconomic models is to understand the economy, which entails understanding it at all times, not just when nothing is going wrong – which is when we need them least.

As a final note, I can’t help but wonder if this argument, even in its general political form, has roots in economic theory. Economic models (such as the Solow Growth Model) often treat the boom as the ‘underlying’ trend, buffeted only by exogenous shocks or slowed/stopped by frictions. A lot of the major macroeconomic frameworks (such as Infinite Horizons or Overlapping Generations models) have two main possibilities: a steady-state equilibrium path, or complete breakdown. In other words, either things are going well or they aren’t – and if they aren’t, it’s usually because of an easily identifiable mechanism, one which constitutes a “notably rare exception” to the underlying mechanics of the model. Such a mentality implies problems, including recessions, are not of major analytical interest, or are at least easily diagnosed and remedied by a well-targeted policy. Subsequently, those versed in economic theory may have trouble envisaging a more complex process, whereby a seemingly tranquil period can contain the seeds of its own demise. This causes a mental separation of the boom and the bust periods, resulting in a failure to deal with either.

The next instalment in the series will be part 2: the EMH-twist

, ,

  1. #1 by Ben Brennan on June 2, 2014 - 9:17 pm

    If you take Lucas’s work showing that growth is much more important that business cycles at face value then Greenspan’s argument works. Granted Lucas kind of ignores distributional issues assuming that business cycles affect the population in the same way. But it’s not like Greenspan’s argument doesn’t have sound backing.

    • #2 by Unlearningecon on June 2, 2014 - 9:23 pm

      If you take Lucas’s work showing that growth is much more important that business cycles at face value then Greenspan’s argument works.

      Big if!

      But it’s not like Greenspan’s argument doesn’t have sound backing.

      Yes, it is. He’s arguing deregulated financial markets work great – except when they don’t. This is barely even an argument.

      • #3 by Ben Brennan on June 2, 2014 - 9:25 pm

        If they lead to higher growth then who cares if they make business cycles more volatile.

      • #4 by Unlearningecon on June 2, 2014 - 9:32 pm

        The people who lose their jobs/investments/standard of living/find themselves massively indebted/firms that go bankrupt.

        Besides, there is no evidence to support the proposition that “they lead to higher growth”.

  2. #5 by WatchingEthosInFreefall on June 2, 2014 - 11:59 pm

    While I am favorable about the overall content of this article and its usefulness, I did take exception to the assertion that economists ‘didn’t see it coming.’ If they didn’t, they shouldn’t be able to call themselves economists, because to anyone with any substance to their economic training it should have been like looking out over the desert and seeing an approaching thunderstorm. And in fact, I can remember listening to UM Prof. Michael Hudson at least as early as 2006, possibly earlier, predicting precisely what happened. So I don’t buy the ‘we didn’t see it coming’ nonsense put out by the mainstream ‘economists’ who are just shills for the FIRE sector, banks and other commercial institutions. Other than that, these are good talking points to be able to draw upon.

    • #6 by Unlearningecon on June 3, 2014 - 8:56 am

      What I said is that mainstream economists didn’t see it coming. Economists with alternative frameworks such as Hudson did indeed make frequent warnings and predictions. You’ve probably seen it, but if you haven’t, Bezemer (2009) gives a survey of who these economists were.

  3. #7 by Magpie on June 3, 2014 - 1:50 am

    There is a subject which, in my view, requires a lot of discussion: forecasts and predictions.

    In the immediate aftermath of the housing crash, with the exception of Fama and Lucas, practically everybody and their dog was agreed: no one saw it coming and they should have.

    Fast forward to the present. Both mainstream and many heterodox economists now claim that nobody saw it coming, because, well, nobody can see things coming. These things just happen, the ergodic thingy this and that; they are God’s will, or something.

    Bottom line, economic forecasts/predictions are impossible. That’s the fashionable thing now, the new black.

    Quite convenient, too, for those who didn’t see it coming: they just so happen to be off the hook.

    My question is: if predictions/forecasts are impossible, what on earth is economics good for?

    Because if we cannot predict anything, and these things just happen because God wills them, then we are left with only one thing: “thy will be done on earth as it is in heaven”.

    • #8 by Ben B (@likeasecret) on June 3, 2014 - 5:33 am

      This is like someone arguing that climate science is garbage because it snowed a lot. Predicting short run fluctuations is near impossible. Understanding fundamental forces and how things will adjust and correct in the long run is much more doable.

    • #10 by Unlearningecon on June 3, 2014 - 8:58 am

      As I said above, this is actually #3 in the series.

      Fast forward to the present. Both mainstream and many heterodox economists now claim that nobody saw it coming, because, well, nobody can see things coming. These things just happen, the ergodic thingy this and that; they are God’s will, or something.

      A far more frequent – and worrying – claim I encounter is the claim that economists did and do understand financial crises, and that there’s not really any problem beyond a few tweaks here and there. This is a mixture of #5 and #7.

      • #11 by Magpie on June 3, 2014 - 11:18 am

        Personally, I find this subject of prediction/forecast more worrying, because both orthodox economists almost to a man and even some heterodox claim now that predictions/forecasts are impossible.

        Note that once upon a time, according to Milton Friedman, the legitimacy of mainstream economics rested on its assumed ability to make predictions/forecasts.

        Now, when the predictions/forecasts failed to materialize, what is left to give legitimacy to mainstream economics?

      • #12 by Unlearningecon on June 3, 2014 - 11:44 am

        I feel like your problem is based on a conflation of two different types of ‘prediction’. When Friedman used the word, he didn’t necessarily mean ‘anticipating something that hasn’t yet happened’; what he meant was ‘match the empirical record’, which could refer to previous experiments or past data or what have you. I don’t think the former method of prediction is possible with any reliability.

        However, there is also a third type of prediction: conditional predictions. By my reckoning, this is the type of prediction required of economists. Yet they frequently equate it with forecasting, and hence wash their hands of responsibility for failing to make good conditional predictions.

  4. #13 by Boatwright on June 3, 2014 - 1:06 pm

    Economic “theory” is too often presented as science with a variety of arguments, models, equations, etc. offered as “evidence”. However, too often what we see is faux science — non-negatable, a-priori assumptions bolstered by simplistic analysis of the sort we saw from the likes of Alan Greenspan & friends.

    True science starts with observed phenomena, builds testable and negatable hypotheses consistent with observation and analyzes new information against the working hypothesis.. Most importantly: only after a long period of development, observation, and review does an hypothesis become a theory. True science necessarily evolves in an heuristic manner because the real world is not a logical construct, but always chaotic, evolving, and complex.

    To the degree that economics proceeds as the pronouncements of “experts” building wise sounding logical hot air balloons, it will always be in the position of successfully explaining the obviously sunny day and always failing to see the darkening horizon.

  5. #14 by Magpie on June 3, 2014 - 1:56 pm

    @ Unlearningecon (#12, on June 3, 2014 – 11:44 am)

    I am afraid you lost me.

    It’s true that Friedman used the word “prediction” as “matching the empirical record” (as you say) and not necessarily as “anticipating something that hasn’t happened yet” (which he, if memory serves, termed more specifically as “forecast”). In other words, for Friedman “forecast” is a species, “prediction” is the genus: forecast is a prediction of the future.

    I agree with you and I am aware of that. So, I apologize if somehow something I wrote gave you the wrong impression, but I don’t think I am conflating anything.

    Friedman also explains why predictions in general (including predictions of the future/forecasts) are required.

    First reason: they are required because “Any policy conclusion necessarily rests on a prediction about the consequences of doing one thing rather than another, a prediction …”.

    A little later Friedman gives examples of predictions (the parentheses are Friedman’s; the square brackets, mine):

    “An obvious and not unimportant example is minimum-wage legislation. … The difference of opinion [me: proponents vs opponents of minimum wage laws] is largely grounded on an implicit or explicit difference in predictions about the efficacy of this particular means in furthering the agreed-on end [me: to reduce poverty]. Proponents believe (predict) that legal minimum wages diminish poverty by raising the wages of those receiving less than the minimum wage… Opponents believe (predict) that legal minimum wages increase poverty by increasing the number of people who are unemployed…”.

    Without predictions there is no policy recommendations, without policy we have laissez-faire: Austrians and free-market libertarians welcome this position. They love speaking of unintended consequences (which is ultimately what unpredictability means).

    Second reason: also, predictions are required because Friedman adopts a positivist view of science. Without falsifiable predictions, economics cannot be a science.

    ———–

    Many critics of mainstream economics are happy denying economics the status of science, overlooking that they are leaving the door open to free-market libertarians. Deirdre McCloskey is much more consistent on that.

    So, again, without prediction, what’s the use of economics?

    • #15 by Magpie on June 3, 2014 - 1:58 pm

      Ooops.

      The Friedman quotes are all from The Methodology of Positive Economics.

    • #16 by Unlearningecon on June 3, 2014 - 6:47 pm

      I don’t think we’re disagreeing: the only problem are economists (such as BBrennan above) who equate forecasting style prediction (call this type A) with either conditional future predictions (call this type B). Friedman seems to be alluding to type B in your first quote, and later on he is talking about empirical ‘predictions’ in the general sense, which don’t necessarily have anything to do with the future (call this type C).

      If economics cannot do B it is of no use for designing policy, though it may still be used for interpreting available evidence if it can do type C. However, I agree with economists when they say it’s unrealistic to expect them to do type A. I just disagree that this means they can’t foresee financial crises in any sense at all.

      • #17 by Magpie on June 5, 2014 - 1:48 am

        Frankly, one may disagree with Friedman in many things; but, in my reading at least, one thing is clear and does not admit discussion: for Friedman, all predictions were created equal; in his view, as expressed in that article, there are no different prediction types.

        The only distinction Friedman makes within the set of all predictions is between predictions of the future and predictions “not of the future”: he calls the former “forecast”. The difference refers to the time only.

        Other than this, I think there is no reason to believe Friedman was considering differences between empirical and non-empirical predictions (what’s an empirical prediction?) or conditional future prediction vs non-conditional future prediction (again, what are those?).

        For me this talk about type A, B, and C is entirely new (so, I’d appreciate further details), because as things stand, I am not sure I see the relevance or the usefulness of these distinctions.

    • #18 by Boatwright on June 3, 2014 - 7:14 pm

      I do not accept the Hobbesian choice you offer.

      Surely it is possible to criticize mainstream economics as unscientific without surrendering to ideology. The problem is economic “theory” presented as scientific when it is nothing more than opinion clothed in logic…

      The solution, if one is to be found, is to proceed by the rules of science. Otherwise all we are really talking about is the virtues of one ideology over another.

      • #19 by Cameron Murray (@Rumplestatskin) on June 3, 2014 - 11:14 pm

        My view is that without type A prediction (out of sample, or conditional future predictions etc) economists is not ‘useful’.

        Prediction in this sense IS the scientific test of a theory. All other tests allow for ‘just so’ types of theories.

        Think about the following prediction of economic theory – that higher rates of capital investment lead to higher growth rates. I think that’s pretty sound and offers many predictions which are generally correct.

        I think the problem in macro is that the focus shifted towards growth, away from cycles. A theory that said after a boom comes a bust would also make useful predictions about the future. But for some reason the study of such dynamics was extracted from macro because it couldn’t fit in the optimising representative agent framework, hence we were left with the model of smooth growth interrupted by external shocks.

        Btw, I wouldn’t bother with Friedman for guidance on scientific methods.

  6. #20 by Magpie on June 5, 2014 - 2:00 am

    @ Cameron Murray (@Rumplestatskin) (#19 June 3, 2014 – 11:14 pm)

    “Btw, I wouldn’t bother with Friedman for guidance on scientific methods.”

    Maybe you wouldn’t, but I see no reason why I or others should not: the guy, whether one likes it or not, was influential. When students get any exposure to methodology/philosophy of economics, which is rare, they almost invariably learn of Friedman.

    And the categories he uses in that article seem useful, to me. At least, mainstreamers know what one is talking about.

    So, why should we declare him anathema?

  7. #21 by petermartin2001 on June 5, 2014 - 3:17 am

    I’m not a professional economist but I’ve listened to Stephanie Kelton talk about the three sector financial balances and she makes a lot of sense.. Recessions inevitably follow periods of excess credit which in turn causes government taxes to increase. The removal of money from the private sector then leads to that recession.

    So to prevent recession government needs to better control the economy with a combinataion of fiscal and monetary measures. There’s too much emphasis on monetary right now.

    Is there a flaw in her argument? If not why isn’t her theory more widely accepted?

    • #22 by Unlearningecon on June 12, 2014 - 6:54 pm

      Well, there are always debates to be had about economic theory, so I’m not going to claim Kelton’s approach (and others like it, such as MMT in general or Minsky/Godley/Keen) are gospel. However, the reason this kind of theory is not more commonly accepted is because most mainstream economic models subscribe, in one form or another, to the ‘neutrality of money’ theory. This holds that the ‘real’ economy (what is distributed, produced and exchanged) cannot be affected by the level of money or debt, at least in the long run. According to this framework, debt only entails a redistribution of money from one person to another, while an increase in the money supply itself will just affect prices rather than actual production patterns.

      It is an open question whether there is room for bankruptcy in a model like this, but in general it’s pretty clear that there is no such thing as ‘excess’ credit, since “one person’s asset is another’s liability”. This means money paid back will just go elsewhere rather than disappearing. In contrast, Kelton’s endogenous money model has credit created ‘out of nothing’ to fund current purchases, with an expectation that future sales/profits will fund the repayments. If this does not happen, the issuing institutions’ assets lose value, potentially causing it problems. Similarly, the recipient firm is unable to keep up with repayments and so could goes bankrupt. Clearly, this process can affect what is actually produced and exchanged.

      If you’re interested in more, I have previously written about the neutrality of money.

  8. #23 by Bring back immediately women's state pension at 60 / Against loss age related tax allowance at 65 on June 6, 2014 - 1:47 am

    Economists believe in the theory of Austerity during a recession, which is about the same as believing the earth is flat with a pillar at each 4 corners and the waterfall into the abyss over the edges.

    The elite throughout history have the role of Noblisse Oblige. Look it up. But not today.

    Economists believe that an ageing population is a demographic timebomb, as if people have not aged for a million years of human life.

    Economists believe that welfare reform saves a nation, when history tells you that leaving the poor to starve in huge numbers has never ended well for any economy. If people have no reason to support the elite, they will bring it down.

    The Roman Emperors gave free bread each morning, as a hungry population is a dangerous one.

    Economists believe that state pensions are some evil dragging a nation into the financial abyss, when leaving the old to starve is far more likely to bring a nation down as the old talk to their grandchildren, who are also going hungry, along with their kids getting so ill they get Rickets.

    Austeritry has not even happened. You look at the huge billions spent during an apparent recession by governments, especially on their own expenses, and on ‘solutions’ that actually just cost more.

    Economists say in glee that the economy is recovering, when people only see the ability to buy a loaf of bread receding away.

    Economists live in a word of magic, myth and legend, in a land far, far away of poor fantasy. There be unicorns and dragons and other mythical beasts in this fairy-tale world in which economists live.

    The real economists roam the streets in multitudes, buying little, conserving what little they have.

  9. #24 by petermartin2001 on June 13, 2014 - 9:45 am

    Reply to #22,

    I’ve read your blog and I think I now understand the neutrality of money argument. However, it would seem to me to be an unlikely theory which doesn’t explain what happens in real economies.

    I’m a Physicist by background and we have it drummed into us that what matters is that any Physical theory should fit the observable facts. It doesn’t necessarily mean that it is completely wrong, if it doesn’t, but it does mean that at least some modification of that theory is required.

    It strikes me as odd that Economics wouldn’t have the same approach. It has to be about fitting theories to observable facts in just the same way as any other science.

    • #25 by Unlearningecon on June 13, 2014 - 10:44 am

      This is because economics is, essentially, a form of moral philosophy. Ask an economists to think about a problem and you’ll get an abstract parable that tries to highlight one or two key issues, but clearly isn’t a reflection of reality. This might be a literal ‘story’ – such as Friedman’s helicopter drop or Paul Krugman’s work in books like the accidental theorist – or it might be a mathematical model, but no matter how sophisticated the maths the epistemology is the same. Economists draw on these special cases to try and tease out lessons, the same way philosophers do with partables like the runaway truck. Lest you think I’m misrepresenting, economists have recently said essentially the same thing.

  10. #26 by petermartin2001 on June 14, 2014 - 3:17 am

    Reply to #25

    Yes I’ve come across this argument before. Maybe there is a need to develop a new subject called Economic Science which concentrates on what actually happens in real economies. Those who are interested in “moral philosophy” and “abstract parables” can get on with their activities elsewhere and in a way that won’t bother anyone else. The last thing they should be allowed to do is advise governments on how to achieve policy objectives. That’s how we’ve ended up with the disaster of the Eurozone and the GFC.

    It the 21st century it should be quite possible to build computer simulators of real economies. So for instance a politician can input his budget ie tax and spending changes etc and the simulator will predict what will happen in the next year or two. Inflation, unemployment levels etc. There’s enough historical data for the simulator to be tested by the process of hindcasting. ie Known or closely estimated inputs for past events are entered into the model to see how well the output matches the known results.

    I know the objection will be that these models are going to be imperfect. All models are imperfect. That’s why from time to time the weather forecasters don’t get it right. They get it right more often than they would without their models and simulations though!

    • #27 by Unlearningecon on June 16, 2014 - 12:02 pm

      They get it right more often than they would without their models and simulations though!

      This is a really important point. I often wonder where political debate would be without economic theory, and I rarely conclude that, on net, economics has made a positive contribution to our understanding. What new and original insights into the ‘right’ policies has economics given us that couldn’t have been arrived at by standard political debate? I struggle to think of any.

      You wonder if there are any computational models of the economy these days: well, agent-based modeling (ABM) fits the bill. I was once told that it is like Sim City without the graphics. Mark Buchanan has a good post on why he thinks ABM will win out over the current macroeconomic orthodoxy.

  11. #28 by petermartin2001 on June 14, 2014 - 4:05 am

    PS to #26

    I just decided to Google the term “economic simulation” to find out what if anything already exists and I came across Prof Steve Keen’s “Minsky” Program. According to Wiki this was developed for $128k with an academic research grant. I’ve got to say that this is a pitifully small amount of money in comparison to the importance of this kind of work.

    How much has the GFC cost the western economies? $1 trillion? If Steve Keen and other economists can help develop some effective economic tools to prevent future disasters like they really should have some decent level of funding at their disposal.

  1. Is the Economic Crisis a Crisis for Economics? ...
  2. Is the Economic Crisis a Crisis for Economics? Part 2: The EMH-Twist | Unlearning Economics
  3. Is the Economic Crisis a Crisis for Economics? Part 3: Econoracles | Unlearning Economics