Why did no one see it coming?

{bit.ly/PBwdno} In the wake of the Global Financial Crisis (GFC 2007), the Queen of England asked academics at the London School of Economics why no one saw it coming. The US Congress constituted a committee to investigate the failure of economic theory to predict the crisis.  Unfortunately, economists remain unable to answer this critical question. Some say that crises are like earthquakes, impossible to forecast. Others take refuge behind technical aspects of complex mathematical models. With monotonous regularity, more than 200 monetary crises have occurred globally, ever since financial liberalization started in the 1980’s. the methodology currently in use in economics systematically blinds economists to the root causes of these crises. Many leading economists have called for radical changes to bring economic theory into closer contact with reality.

Many who had hoped that the  GFC would serve as a wake-up call for the profession have been extremely disappointed by subsequent developments. Although there has been a flurry of papers on various aspects of the crisis, there has been no fundamental re-thinking. Theories which assume free markets will create full employment and maximal growth, continue to be taught at  universities. The rational expectations theory of Eugene Fama says that the stock market prices always correctly reflect the information available to the market, and there is no possibility of a bubble – a systematic over-valuation of all stock market prices. Under the influence of this theory, Robert Shiller’s demonstration that the stock market prices were over-inflated went unheeded. Similarly, warnings by many Cassandras like Steve Keen, Raghuram Rajan, Dean Baker, Nouriel Roubini, were ridiculed and ignored by senior level policy makers infatuated with free market dogma.

The last nail in the coffin of the US Economy was driven in when the Glass-Steagall act was repealed in 1999. The Great Depression in 1929 had been caused by irresponsible speculation by banks. In 1933, the Glass-Steagall act prohibited banks from investing in stocks, in order to prevent recurrences of this disaster. This prevented system-wide banking crises for 50 years, until the era of financial de-regulation ushered in by Reagan & Thatcher. Repeal of the act, combined with a lax monetary policy, led to precisely what it was meant to prevent. Banks went on a wild orgy of credit creation, enabling stock purchases of trillions of dollars backed by defective mortgage based securities. Banking crises like this routinely happen when banks are not strictly regulated, since they gamble with the depositors’ money. Financial moguls have created and popularized the misconception that banks are the backbone of the financial system, and must be supported regardless of misdeeds. Thus big banks are routinely bailed out when they indulge in wild gambles. This incentivizes banks to speculate: if they win, it is their personal gain. If they lose, someone else pays.

Even though economists blinded by free market ideologies could not predict it, the global financial crisis was very predictable. Giving permission to banks to gamble with other people’s money led to a financial crisis within the short span of eight years. However, what was surprising and perhaps unpredictable was the aftermath. Instead of being tarred and feathered, Eugene Fama went on to win a Nobel Prize in Economics. Nobel Laureate Robert Lucas, who confidently asserted that economists have learned how to prevent recessions, continues to enjoy the respect of the profession. Ben Bernanke, who presided over the Federal Reserve during the Global Financial Crisis, is being lauded as a hero. He has written a self-congratulatory book entitled “The Courage to Act” in which he praises himself for taking the heroic actions necessary to save the world from the complete collapse of the financial system. As Princeton economists Atif Mian and Amir Sufi have shown in their celebrated book “The House of Debt”, these actions were wrong, and harmful to the economy. The trillion dollar bailout given to banks by Bernanke should have been given to the distressed homeowners with the defaulting mortgages. That would have been just, and would also have saved the economy from the Great Recession, by preventing the large scale transfer of wealth from the impoverished mortgagers to the rich and criminal bankers.

Not only do the faulty theories which led to the crisis continue to be taught to unsuspecting students all over the world, but all efforts to reform the defective system have been blocked. In the US Congress, proposals to bring back the highly successful regulatory system which was created after the Great Depression failed. A few bills which were passed were quietly repealed later. There have been large numbers of seminars and conferences on the need for a new regulatory framework to protect the global financial system, but no action has been taken to create effective new regulations. Thus the system is ripe for another crisis, and there are many signs that another one is on the way.

The reader might wonder, like the author, why there has been no learning from experience? The answer lies in the statistics recently published by Oxfam. The number of people who own half of the wealth of the planet shrank rapidly from 388 in 2010 to only 62 in 2015. The richest people benefit vastly from the financial crises which destroy the wealth of the middle class. This is because the middle class is forced to borrow at interest from those who have the money. This enables the already wealthy to get rich much faster than in normal times where people have enough money for their own needs. To top it all, current economic theories make no mention of debt as an important economic factor. These seriously defective theories are of vital importance in concealing the workings of the mechanism which creates this massive concentration of wealth in the hands of a tiny minority. In subsequent articles we will explore the large number of ways in which current economic theory is defective, and the radical reforms needed to create a better economic theory for the twenty first century.

Postscript: For an extensive collection of quotes documenting the bafflement and surprise of economists at the occurrence of the GFC, in contradiction to their theories of rational expectations in financial markets, see: “Quotes Critical of Economics“. For a deeper explanation of why economic methodology systematically leads to theories dramatically in conflict with what we see in the world around us, see “The Methodology of Modern Economics“.