Crisis confessions of the Undercover Economist

5th August, 2010

Ingram Pinn illustration

Illustration by Ingram Pinn

Anniversaries are a time for reflection and, as the third anniversary of the credit crunch approaches, I have been doing some reflecting on where I went wrong as an economist. My own errors, of course, are of particular interest only to me, but I fear that they are fairly representative of the economics profession.

To soften the blow, I have also been thinking about where I didn’t go wrong. I still believe that government interventions tend to be clumsy; I still believe that markets usually provide good solutions to economic problems; and I still believe that people tend to respond rationally to incentives. I may be wrong about all of these things, but not because the banking crisis has demonstrated that they are false.
The near-collapse of the banking system demonstrated that governments are indispensable – but indispensable klutzes nonetheless. The various interventions were botched, unduly expensive, late and ill-suited to preventing a future crisis. But this is not surprising: all government interventions are designed by people with limited knowledge of conditions on the ground, tend to be one-size-fits-all, and are inevitably compromises between the public good, the knee-jerk bias of an ill-informed electorate and some formidable lobbyists. I am still profoundly grateful that governments did something rather than nothing.
As for the effectiveness of markets, this has surely not been called into serious doubt. The British government used to own British Airways, much of British Petroleum, British Telecom, the electricity industry, the gas industry and Rolls-Royce. Nothing in this crisis suggests that these companies must all be renationalised as soon as possible. But as the greenest student of economics will tell you, there are counter-examples to the principle that markets work and the financial system of the past five years has made a compelling case to be added to the list.
The belief in rationality may seem the most quixotic of all, but many elements of the crisis were provoked not by irrational behaviour but by rational responses to perverse incentives. Too many people were able to take the following bet: “Heads I win, tails the financial system loses.”
The countervailing view comes from behavioural economics, the intersection between economics and psychology. Like the young man who at the age of 14 thought his father was an idiot, and was then astonished at how much the old fellow had learnt in just a few years, I take behavioural economics much more seriously now than I used to. But this is not because the crisis has provided any great vindication of the discipline. Recent popularisations of behavioural economics, published as the crisis was beginning, talk about the psychological quirks that make people susceptible to predatory lending, but not about excessive leverage or hazardous financial instruments such as CDOs of CDOs.

True, the crisis has provided yet another feather in the cap of the behavioural economist Robert Shiller. Prof Shiller correctly identified the dotcom bubble in the late 1990s and then spotted the housing bubble a few years later. This is impressive and many economists took him seriously on both occasions. But the real puzzle here was not the existence of these two bubbles but the fact that the first burst with minor consequences while the second provoked a financial bloodbath.
The crisis provided just as much vindication for Raghuram Rajan, an eminent but perfectly orthodox Chicago-school economist, who in 2005 pointed to elevated house prices and to perverse incentives for investment fund managers, and warned that risk-management tools might be leading to an increased risk of catastrophe. There was no clever psychology here: Prof Rajan simply looked closely at what the basic incentives were and where they might lead.
Similarly, my colleague Gillian Tett made headway because she asked simple but probing questions: Where had all these derivatives come from? What were they supposed to be achieving? How exactly did they work? Spotting the warning signs required not some profoundly different worldview about the likelihood of rational behaviour or the merits of the market, but a curiosity about the details of what was going on under the hood of the financial system.
Which is what I got so wrong: I thought that the details did not much matter. Derivatives sounded like a sensible idea in principle and that was all I needed to know. I said very few silly things about banks only because I said very few things about banks, full stop. I wasn’t paying enough attention.
This is a failing that comes naturally to economists. One of the first and best popular economics books, The Armchair Economist, is as advertised: a collection of incisive essays about the world as an economist would think about it from his armchair. We economists like to ponder questions such as “why does popcorn cost so much at the movies?” and there is plenty we can say on the subject that is both true and counterintuitive. But the armchair does preclude one obvious research angle, which is to ask the people who run the cinemas.
The irony is that critics of economics often make the same mistake. I recently debated with the psychologist and social commentator Oliver James, who announced that the commendable qualities of the Scandinavian psyche had insulated them from the banking crisis. Well, that is one possible explanation: another possibility is that the Swedes have already had a severe banking crisis, commendable psyche notwithstanding, and remember what one looks like. (In other news, your office mate isn’t sipping water because of his ascetic character but because he has a hangover.)

But perhaps that is unfair. It is not the job of a clinical psychologist to study the history of banking crises, but it should be the job of an economist. It is all very well to believe that people respond to incentives, but we economists also need to ask what the incentives are.
So I shall be trying to take my own advice. I sometimes joke that although I didn’t know anything about banking when the credit crunch began, at least the people running the banks didn’t know anything about banking either. The joke always gets a laugh. I wonder if it is really that funny.

First published at FT Comment on 4 August 2010

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