This global crisis in not only about financial market failures but also government failures in several countries as reflected in failure to contain the housing bubbles and credit booms, bad regulations, and lack of supervision and enforcement). Both in advanced and developing countries, there are second thoughts on open markets, private ownership of nationally ‘strategic’ industries (autos, banks), and movement of transnational financial and industrial firms, and migrant labor. Trade and financial protection is on the increase as countries that have been less reliant on exports and foreign capital are weathering the storm better. In this semi-open global environment, would export-led growth strategy be combined with industrial policies to protect domestic industries, and/or emphasize resource-dependent growth, where possible?
Before we respond to these questions, it will be useful to focus on what went wrong in economics in 2007-08. Some economists are re-inventing economics to respond to such a query.
Rationality vs. Animal Spirits. The economic profession as a whole has failed to anticipate the global crisis. Economic models have basically failed to predict such a crisis. At the core of the problem is that economists have over-extended the ‘rationality’ assumption, wherein individual economic agents, such as consumers and investors, behave rationally. Rationality means that each economic agents knows the probabilities of future events and therefore has all the information needed to make decisions about all future events. If actors are rational, then no “bubbles” which are irrational market responses should occur.
But Akerlof and Shiller (2009) argue in their recent book Animal Spirits, that the “current financial crisis was driven by speculative bubbles in the housing market, the stock market, and energy and other commodities markets.” Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying, and hence further speculative price increases – until the crash comes. Shiller and Case (2009) point out that a random survey of people indicated that they were (mistakenly) expecting housing prices to rise by 10 percent per year prior to the crash and that this expectation was based on a misunderstood belief that land was limited, housing materials were costing more and so on. Managing “bubbles” is therefore an important short term policy objective but the economics profession has failed to emphasize this point.
While rationality is a useful assumption for most microeconomic situations of supply and demand for certain goods and services, people almost never know the probabilities of future economic events. We live in a world where economic decisions are made under uncertainty and are fundamentally ambiguous, because the future is not a linear extrapolation of the past – past is not prelude. For most people, it always seems that “this time is different.”
Greed & Fear. We now know from work of neuroscientists and others that (i) “different parts of the brain and emotional pathways are involved when ambiguity is present”; (ii) “bull markets are characterized by ambiguity-seeking behavior and bear markets by ambiguity-avoiding behavior” and that changing confidence is an under-pinning factor. So when an economy is experiencing a positive or negative shock, people do not respond in a completely rational way to the shock. Moreover, the people’s responses to events are asymmetric – people hate to lose money more than they love to win money.
In the brain, monetary gain and cocaine stimulate the same circuitry and release of dopamine. Fear of financial losses activates the same circuitry as physical attacks and release of adrenaline and cortisol into the blood, which coincides with elevated heart rate and blood pressure.
Periods of economic prosperity coincide with a doped stupor and results in unnecessary risk-taking. So it is not surprising that one sees repeated episodes of rising house and stock prices, over-confidence and over-investment by investors, and risky behavior. The trust in and money placed with Madoff is a case in point.
It is easy to see how people’s greed becomes a drug and they are unable to resist the temptations, which lead to financial bubbles in tulip bulbs, internet stocks, gold, real estate, and fraudulent hedge funds. Such gains are unsustainable, and once the losses start mounting, our fear circuitry kicks in and panic ensues, a flight-to-safety leading to a market crash. This is where we are today.
Greed can be contained and need not lead to excess. Excess is just another word for greed combined with misaligned incentives and inadequate or defective regulation and supervision. Like hurricanes, financial crises are a force of nature that cannot be legislated away, but we can greatly reduce the damage they do with proper preparation. Because the most potent form of fear is fear of the unknown, the most effective way to combat the current crisis is with transparency, accountability and education.
Linearity vs. non-linearity. To be sure most regular economic events follow a certain amount of predictable, linear and continuous path. For example, if the supply of cars does not keep pace with the demand then prices will increase. But there are also once in a life-time events – the black swan, and little is known about the abrupt, discontinuous, and jumpy behavior found in some markets. Economic models do not capture such ‘rare’ events. Nonlinear dynamics is not a favorite tool of economists. As economics is about human behavior ‘on an average’ the normal or Gaussian distribution is deemed quite adequate to relate to regular economic activities and behavior of representative economic agent. The recent crisis has exposed the fact that ‘bubbles’ and ‘herding’ behavior lead to fat tail distribution or other forms of distribution. For example, Haldane (2009) describes in detail economic and financial variables that had smaller and slimmer tails during the years prior to the crisis compared with more normal distribution during the golden decade of 1995-2004. Risk models are developed around the assumption of normal distribution and stress-testing almost seldom is conducted on very extreme or rare event occurrence. There are also ‘threshold effects’ where up to a certain level economic variables do not pose any major problem, but beyond that certain level, there is a sudden and discontinuous jump in economic variables and impact. The sudden jump in oil-price hikes, debt dynamics, and financial crises are some examples of nonlinear behavior or threshold effects.
State vs. Markets. The Depression of 1930s gave rise to the Keynesian economics, which had at its core the theory that when an economy is faced with declining aggregate demand, there is uncertainty about future amongst households and firms, and government is the only player that can actively ‘prime the pump’ and stabilize the economy. This lesson of depression economics was used and abused by governments all the over world up until early 1980s. So the statist paradigm reigned supreme until 1980s when the neoclassical prescriptions of market-friendly ‘getting the prices right’ and minimal role of government gained momentum. The Washington Consensus of the international financial institutions captured this spirit of the market. The 1990s witnessed an augmentation of the Washington Consensus or also called the Third Way which extended market principles with social policies (e.g. social safety nets, labor protection, and sustainable development). The Consensus was challenged by (i) the disappointing results in Africa and to some extent in Latin America; (ii) the rise of some fast growing countries without full trade or capital liberalization (e.g. China, India, Vietnam); (iii) the sharp increase in income inequality during fast growth period in advanced and emerging economies despite falling rates of poverty.
In the aftermath of the Asian crisis in 1997-98, and as the frequency of financial crises rose in the 1990s, there was some change in new thinking on:
- the role of government as governments began to accumulate foreign exchange reserves; China and Gulf countries even built war-chests in the form of sovereign wealth funds, which were invested in advanced countries;
- reliance on financial flows, especially as there was a sudden stop and even reversal of financial flows from emerging markets during the Asian crisis and more recently during late-2008 as over $700 billion in flows reversed during a couple of months after the Leahman collapse in September 2008;
- market exchange rate as governments resorted to currency manipulation especially when backed by large foreign exchange reserves as in China, Russia, etc.
The Asian crisis therefore led us to a Beijing Consensus where practical solutions are being found with less reliance on Keynesian or neoclassical ideologies. The underlying idea is that “One Size Does Not Fit All”. Each country context is different and there are different paths to development – As Dani Rodrik reminds us: One economics but many recipes.
Regulated vs. unregulated markets. Ever since the Soviet Union disintegrated in late 1980s, capitalism was proclaimed as triumphant until the recent crisis. Bailing out the rich bankers and auto makers in US and Europe is only feeding into cynicism about the capitalist model. The current crisis is not a crisis of ‘capitalism’, defined as an economic system characterized by private ownership of most of the means of production, distribution and exchange, reliance on the profit motive and self-enrichment (i.e. greed) as the main incentive in economic decisions, and reliance on markets as the main co-ordination mechanism. Rather it is a failure of unregulated financial capitalism and financial risk management. Unregulated profit-seeking individuals and greed unchecked by appropriate institutions has resulted in rent-seeking, corruption and crime in free markets.
The key question is whether markets are inherently stable or unstable. In other words, markets correctly price goods, services, stocks, and other assets. Free-marketers believed that economies never go wrong or astray while Keynesians and others believed that economies usually deviate from the path of prosperity unless the governments regulate, intervene and correct. Neither side predicted the events of 2008-09
While Keynesians thought financial markets were a “casino” the neoclassical economists adhered to an “efficient market” theory and right pricing of assets at all times. Discussion of investor irrationality, of bubbles, of booms and busts, of destructive speculation, of ‘imbalances’ persisting for a long time disappeared. Investors were assumed to behave rationally and balance risk against reward -- the so-called Capital Asset Pricing Model, or CAPM. CAPM tells you the stock price and the value of company stocks, how best to choose a financial portfolio, how to price a financial derivative. More recently, as financial innovation increased complexity of computing risk that in part was related to complex firm structure and claim on claims etc, the CAPM needed mathematicians and physicists – so called quants – to compute risks and rewards. But none of them seem to ask the question whether stock prices made sense when economic fundamentals are being considered. Larry Summers, once mocked finance professors as “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient.