Thursday, November 7, 2013
NEW HAVEN – I am one of the winners of this year’s Nobel Memorial Prize in Economic Sciences, which makes me acutely aware of criticism of the prize by those who claim that economics – unlike chemistry, physics, or medicine, for which Nobel Prizes are also awarded – is not a science. Are they right?
One problem with economics is that it is necessarily focused on policy, rather than discovery of fundamentals. Nobody really cares much about economic data except as a guide to policy: economic phenomena do not have the same intrinsic fascination for us as the internal resonances of the atom or the functioning of the vesicles and other organelles of a living cell. We judge economics by what it can produce. As such, economics is rather more like engineering than physics, more practical than spiritual.
There is no Nobel Prize for engineering, though there should be. True, the chemistry prize this year looks a bit like an engineering prize, because it was given to three researchers – Martin Karplus, Michael Levitt, and Arieh Warshel – “for the development of multiscale models of complex chemical systems” that underlie the computer programs that make nuclear magnetic resonance hardware work. But the Nobel Foundation is forced to look at much more such practical, applied material when it considers the economics prize.
The problem is that once we focus on economic policy, much that is not science comes into play. Politics becomes involved, and political posturing is amply rewarded by public attention. The Nobel Prize is designed to reward those who do not play tricks for attention, and who, in their sincere pursuit of the truth, might otherwise be slighted.
Why is it called a prize in “economic sciences,” rather than just “economics”? The other prizes are not awarded in the “chemical sciences” or the “physical sciences.”
Fields of endeavor that use “science” in their titles tend to be those that get masses of people emotionally involved and in which crackpots seem to have some purchase on public opinion. These fields have “science” in their names to distinguish them from their disreputable cousins.
The term political science first became popular in the late eighteenth century to distinguish it from all the partisan tracts whose purpose was to gain votes and influence rather than pursue the truth. Astronomical science was a common term in the late nineteenth century, to distinguish it from astrology and the study of ancient myths about the constellations. Hypnotic science was also used in the nineteenth century to distinguish the scientific study of hypnotism from witchcraft or religious transcendentalism.
There was a need for such terms back then, because their crackpot counterparts held much greater sway in general discourse. Scientists had to announce themselves as scientists.
In fact, even the term chemical science enjoyed some popularity in the nineteenth century – a time when the field sought to distinguish itself from alchemy and the promotion of quack nostrums. But the need to use that term to distinguish true science from the practice of imposters was already fading by the time the Nobel Prizes were launched in 1901.
Similarly, the terms astronomical science and hypnotic science mostly died out as the twentieth century progressed, perhaps because belief in the occult waned in respectable society. Yes, horoscopes still persist in popular newspapers, but they are there only for the severely scientifically challenged, or for entertainment; the idea that the stars determine our fate has lost all intellectual currency. Hence there is no longer any need for the term “astronomical science.”
Critics of “economic sciences” sometimes refer to the development of a “pseudoscience” of economics, arguing that it uses the trappings of science, like dense mathematics, but only for show. For example, in his 2004 book Fooled by Randomness, Nassim Nicholas Taleb said of economic sciences: “You can disguise charlatanism under the weight of equations, and nobody can catch you since there is no such thing as a controlled experiment.”
But physics is not without such critics, too. In his 2004 book The Trouble with Physics: The Rise of String Theory, The Fall of a Science, and What Comes Next, Lee Smolin reproached the physics profession for being seduced by beautiful and elegant theories (notably string theory) rather than those that can be tested by experimentation. Similarly, in his 2007 book Not Even Wrong: The Failure of String Theory and the Search for Unity in Physical Law, Peter Woit accused physicists of much the same sin as mathematical economists are said to commit.
My belief is that economics is somewhat more vulnerable than the physical sciences to models whose validity will never be clear, because the necessity for approximation is much stronger than in the physical sciences, especially given that the models describe people rather than magnetic resonances or fundamental particles. People can just change their minds and behave completely differently. They even have neuroses and identity problems, complex phenomena that the field of behavioral economics is finding relevant to understanding economic outcomes.
But all the mathematics in economics is not, as Taleb suggests, charlatanism. Economics has an important quantitative side, which cannot be escaped. The challenge has been to combine its mathematical insights with the kinds of adjustments that are needed to make its models fit the economy’s irreducibly human element.
The advance of behavioral economics is not fundamentally in conflict with mathematical economics, as some seem to think, though it may well be in conflict with some currently fashionable mathematical economic models. And, while economics presents its own methodological problems, the basic challenges facing researchers are not fundamentally different from those faced by researchers in other fields. As economics develops, it will broaden its repertory of methods and sources of evidence, the science will become stronger, and the charlatans will be exposed.
Thursday, September 5, 2013
The New York Times published an insightful article in The Stone by Alex Rosenberg and Tyler Curtain that questions the proposition that Economics is a Science, and draws out the implications of "economic science" for the future leadership of the US Federal Reserve. The take away point is that "economic theory should be understood more on the model of music theory than Newtonian theory. The Fed chairman must, like a first violinist tuning the orchestra, have the rare ear to fine-tune complexity (probably a Keynesian ability to fine-tune at that). Like musicians', economists' expertise is still a matter of craft. They must avoid the hubris of thinking their theory is perfectly suited to the task, while employing it wisely enough to produce some harmony amid the cacophony." Their article below is definitely worth a few minutes of your time. Enjoy.
NEW YORK: Recent debates over who is most qualified to serve as the next chairman of the Federal Reserve have focused on more than just the candidates’ theory-driven economic expertise. They have touched on matters of personality and character as well. This is as it should be. Given the nature of economies, and our ability to understand them, the task of the Fed’s next leader will be more a matter of craft and wisdom than of science.
When we put a satellite in orbit around Mars, we have the scientific knowledge that guarantees accuracy and precision in the prediction of its orbit. Achieving a comparable level of certainty about the outcomes of an economy is far dicier.
The fact that the discipline of economics hasn’t helped us improve our predictive abilities suggests it is still far from being a science, and may never be. Still, the misperceptions persist. A student who graduates with a degree in economics leaves college with a bachelor of science, but possesses nothing so firm as the student of the real world processes of chemistry or even agriculture.
Before the 1970s, the discussion of how to make economics a science was left mostly to economists. But like war, which is too important to be left to the generals, economics was too important to be left to the Nobel-winning members of the University of Chicago faculty. Over time, the question of why economics has not (yet) qualified as a science has become an obsession among theorists, including philosophers of science like us.
It’s easy to understand why economics might be mistaken for science. It uses quantitative expression in mathematics and the succinct statement of its theories in axioms and derived “theorems,” so economics looks a lot like the models of science we are familiar with from physics. Its approach to economic outcomes — determined from the choices of a large number of “atomic” individuals — recalls the way atomic theory explains chemical reactions. Economics employs partial differential equations like those in a Black-Scholes account of derivatives markets, equations that look remarkably like ones familiar from physics. The trouble with economics is that it lacks the most important of science’s characteristics — a record of improvement in predictive range and accuracy. (read more)
Tuesday, December 4, 2012
The December issue of the Harvard Business Review has an excellent op-ed piece by Ronald Coase, Nobel laureate in economics and a professor emeritus at the University of Chicago Law School, who argues that the academic discipline of economics has experienced a paradigm shift for the worse. In particular, economics as a field of knowledge production has isolated itself to such a degree--using abstract a-historical theories and mathematically complex tools--that the knowledge that is now being produced is no longer explanatory of the real-world economy and the managers and entrepreneurs that operate within it.
CHICAGO- Economics as currently presented in textbooks and taught in the classroom does not have much to do with business management, and still less with entrepreneurship. The degree to which economics is isolated from the ordinary business of life is extraordinary and unfortunate.
CHICAGO- Economics as currently presented in textbooks and taught in the classroom does not have much to do with business management, and still less with entrepreneurship. The degree to which economics is isolated from the ordinary business of life is extraordinary and unfortunate.
That was not the case in the past. When modern economics was born, Adam Smith envisioned it as a study of the “nature and causes of the wealth of nations.” His seminal work, The Wealth of Nations, was widely read by businessmen, even though Smith disparaged them quite bluntly for their greed, shortsightedness, and other defects. The book also stirred up and guided debates among politicians on trade and other economic policies. The academic community in those days was small, and economists had to appeal to a broad audience. Even at the turn of the 20th century, Alfred Marshall managed to keep economics as “both a study of wealth and a branch of the study of man.” Economics remained relevant to industrialists.
In the 20th century, economics consolidated as a profession; economists could afford to write exclusively for one another. At the same time, the field experienced a paradigm shift, gradually identifying itself as a theoretical approach of economization and giving up the real-world economy as its subject matter. Today, production is marginalized in economics, and the paradigmatic question is a rather static one of resource allocation. The tools used by economists to analyze business firms are too abstract and speculative to offer any guidance to entrepreneurs and managers in their constant struggle to bring novel products to consumers at low cost.
This separation of economics from the working economy has severely damaged both the business community and the academic discipline. Since economics offers little in the way of practical insight, managers and entrepreneurs depend on their own business acumen, personal judgment, and rules of thumb in making decisions. In times of crisis, when business leaders lose their self-confidence, they often look to political power to fill the void. Government is increasingly seen as the ultimate solution to tough economic problems, from innovation to employment.
Economics thus becomes a convenient instrument the state uses to manage the economy, rather than a tool the public turns to for enlightenment about how the economy operates. But because it is no longer firmly grounded in systematic empirical investigation of the working of the economy, it is hardly up to the task. During most of human history, households and tribes largely lived on their own subsistence economy; their connections to one another and the outside world were tenuous and intermittent. This changed completely with the rise of the commercial society. Today, a modern market economy with its ever-finer division of labor depends on a constantly expanding network of trade. It requires an intricate web of social institutions to coordinate the working of markets and firms across various boundaries. At a time when the modern economy is becoming increasingly institutions-intensive, the reduction of economics to price theory is troubling enough. It is suicidal for the field to slide into a hard science of choice, ignoring the influences of society, history, culture, and politics on the working of the economy.
It is time to reengage the severely impoverished field of economics with the economy. Market economies springing up in China, India, Africa, and elsewhere herald a new era of entrepreneurship, and with it unprecedented opportunities for economists to study how the market economy gains its resilience in societies with cultural, institutional, and organizational diversities. But knowledge will come only if economics can be reoriented to the study of man as he is and the economic system as it actually exists. (read more)
Tuesday, September 18, 2012
What explains the differences in prosperity among nations? How does a nation create sustainable broad base economic growth? Is growth the result of differences in human capital and technology? According to Daron Acemoglu, the Elizabeth and James Killian Professor of Economics at Massachusetts Institute of Technology, and James Robinson, the David Florence Professor of Government at Harvard University, the differences among nations cannot simply be explained by economic factors. The answer lies in the ability of nations to create inclusive (versus extractive) political, economic, and social institutions. Below is a conversation with Daron Acemoglu done by Edge.org that gives insight in how to view the economic system through institutional lenses.
BOSTON - When I got into economics one of the things that attracted me was thinking about why some nations are rich and some are poor, why some are democratic and others aren't, and why they're socially, politically, and economically so different. I grew up in Turkey and I came of age in the middle of a military regime and the economy wasn't doing well so those questions were in the air. That's the sort of thing that attracted me to economics.
When I came into economics I realized those weren't the issues that most economists worked on. I was still interested in economic development and economic growth, but I tried to think about it using the same approach as economists did. Then about 17 or 18 years ago, I started talking to James Robinson who became my long time collaborator, and James and I both had the same issues with the economics approach. A lot of the interesting issues related to politics, institutions, and the roots of the politics of policies and institutions were left out. We started working, thinking, and discussing to try to write papers on these things. At the time it wasn't a big area within economics.
The collaboration with James and my work and thinking on this has been the most defining aspect of my career. The main issues that I have worked on have all come out of that collaboration and that process. At the center of it is the huge difference in prosperity that we see around us. We live in a very integrated globalized world, but if you compare the United States to Haiti, that's not that far, or the United States to some countries in sub-Saharan Africa there are huge differences in prosperity. Depending on how you measure it there are 40, 50, 60-fold differences in income per capita.
At the time that Adam Smith wrote the defining text of economics in the 18th Century, the same gaps would have been four or five fold at most. So even though we're in a much more unified world, these gaps, these disparities are huge and I think that's one of the major questions facing social science. What I've been trying to do is trying to understand that. The standard economic approach is all about understanding why countries grow thinking about human capital—education, skills, and so on—thinking about physical capital—machinery or technology—but really at the root of these things there must be some other differences.
We can't really have a satisfactory explanation for why the United States is so much richer than Haiti by saying the United States has much better machinery, has much better education, and so on. The question is why? Why did the United States end up with this better machinery? Why did the people make the choices to go to schooling or why did they organize their production and factories differently?
The perspective that has shaped my thinking on this is all about institutions. 'Institutions' is a catch-all word. Many things in a society are part of its institutions. Douglass North who was one of the leading proponents of the institutions view defined it as the set of humanly designed constraints that shape human behavior. That's a very broad definition. What James and I tried to do is bring greater clarity and discipline to thinking about institutions both empirically and theoretically. We distinguish between economic and political institutions.
Economic institutions are those that really shape the economic incentives. They create opportunities or incentives for investment and innovation. They are crucially related to how level the playing field is. You now have many societies in which only a small fraction of the population are given the opportunity to get into the action. They are the only ones who can work in the modern sector. They're the only ones that can open businesses or open factories or get into trade or get into whatever occupations that they want. So that's really important to have this level playing field, in addition to economic institutions such as property rights and contracting institutions that give incentives to people to take advantage of whatever calling they have in life. (read more)
Thursday, September 13, 2012
What role has politics played in the Great Recession? Did politics play a causal role in creating and prolonging the recession? Or was the recession created by underlying economic forces? Economists have traditionally insisted on the primacy of economic factors. In studying growing inequality, for instance, they have focused on economic forces like trade and technological change. However, according to Jacob Hacker (Yale University) and Paul Pierson (UC Berkeley) the most compelling counter argument to the traditional economic story comes, ironically, from two Nobel price-winning economists. Hacker and Pierson state that "in recent years (in part through the urgings of iconoclasts like Krugman and Stiglitz) has there been a turn to politics to explain America’s distinctive economic challenges—a reorientation that brings economics back toward its original conception as the science of political economy. No one can doubt that the American political economy has changed dramatically over the last generation. Perhaps most fundamental is a transformation that Stiglitz and Krugman seem to assume and barely mention: the huge shift in the relative influence of business and labor."
NEW YORK - Five years after the onset of the financial crisis that badly damaged the US economy, the nation remains mired in chronic joblessness. The unemployment rate, stubbornly above 8 percent, actually makes the situation look better than it is. Many millions have given up looking for work and no longer figure in the statistics. Long-term unemployment remains at levels unseen since the Great Depression. Young Americans are entering the worst job market in at least a half-century. For both the long-term unemployed and new job seekers, this sustained absence from the workforce will have permanent effects on both their earnings and their well-being. And not just theirs. We have all lost, and continue to lose, from the prolonged mass idleness of potentially productive workers.
Yet Washington is stuck in neutral. Worse than neutral; it is in reverse. As the last elements of the 2009 stimulus phase out, the initial flood of federal aid has slowed to a trickle. If no agreement is reached before early next year, the trickle will become a huge backward flow, as President Obama’s payroll tax cut and all the Bush tax cuts expire while automatic spending cuts agreed to in previous legislative sessions kick in. Already, Republican leaders are threatening to replay last year’s standoff over the debt ceiling. Meanwhile, state and local governments—prohibited from running sustained deficits, increasingly dominated by anti-spending forces—continue to cut aid to those out of work and slash programs that invest in the nation’s future while laying off teachers and other public workers. Without those layoffs, the current unemployment rate would probably be around 7 percent.
Against this backdrop, no book could be more timely than Paul Krugman’s End This Depression Now! Since the crisis began, Krugman has argued with consistency and increasing frustration that the United States has become caught not in a normal recession, but in a “liquidity trap.” Since interest rates are already at rock bottom, normal measures, such as easy credit, won’t work, and expanded government expenditures must play a central part in boosting anemic demand. Otherwise, the efforts of private citizens to pay down debts laid bare by the financial crisis will continue to hold the economy back.
To Krugman, this is all the more regrettable because it is almost wholly preventable. We know what to do, he argues: increase public spending and make it clear that monetary expansion will continue until the economy fully recovers. Krugman advocates greater federal aid to state and local governments, as well as an aggressive effort to relieve private mortgage debts. He also argues that the Fed has been too timid in setting higher inflation targets to restore expectations of growth. “Unfortunately,” Krugman writes,
we’re not using the knowledge we have, because too many people who matter—politicians, public officials, and the broader class of writers and talkers who define the conventional wisdom—have, for a variety of reasons, chosen to forget the lessons of history and the conclusions of several generations’ worth of economic analysis, replacing that hard-won knowledge with ideologically and politically convenient prejudices.Krugman is at once ruthless and humorous in taking on these prejudices. (read more)
Saturday, August 11, 2012
Is the real level of inequality too high, too low, or just right? Traditional economics usually defines the ideal inequality from the perspective of economic efficiency: What level of inequality will motivate people to be the most productive and move up the wealth ladder? What level of inequality will allow those at the top to lift up society as a whole (say, by having the resources to invent new technologies)? What level of wealth will keep salaries low and competition high? Dan Ariely and Mike Norton, however, examine this question from a different perspective--that of regular (non-economist) people. They want to "examine inequality in terms of its effect on society as a whole, not just in terms of economic efficiency. After all, inequality is not just about economic efficiency. It's also about our day-to-day experience as citizens, the influence of envy, our social mobility, the importance of equal opportunity, our mutual dependency on each other, etc."
DURHAM - The inequality of wealth and income in the U.S. has become an increasingly prevalent issue in recent years. One reason for this is that the visibility of this inequality has been increasing gradually for a long time--as society has become less segregated, people can now see more clearly how much other people make and consume. Owing to urban life and the media, our proximity to one another has decreased, making the disparity all too obvious. In addition to this general trend, the financial crisis, with all of its fall out, shined a spotlight on the salaries of bankers and financial workers relative to that of most Americans. And on top of these, and most recently, the upcoming presidential election has raised questions of social justice and income disparities, bringing the issues into focus even more.
It is relatively easy to think about inequality as being too great or too little in abstract terms, but ask yourself how much you really know about wealth distribution in the U.S. For example, imagine that we took all Americans and sorted them by wealth along a line with the poorest on the left and continuing as wealth increases until on the right we have the richest. Now, imagine that we divide them into five buckets with an equal number of citizens in each. The first bucket contains the poorest 20% of the population, the next contains the second wealthiest tier, and so on down to the wealthiest 20% (see Figure 1).
With this in mind, from the total pie of wealth (100%) what percent do you think the bottom 40% (that is, the first two buckets together) of Americans possess? And what about the top 20%? If you guessed around 9% for the bottom and 59% for the top, you're pretty much in line with the average response we got when we asked this question of thousands of Americans.
The reality is quite different. Based on Wolff (2010), the bottom 40% of the population combined has only 0.3% of wealth while the top 20% possesses 84% (see Figure 2). These differences between levels of wealth in society comprise what's called the Gini coefficient, which is one way to quantify inequality.
HOW MUCH INEQUALITY DO YOU WANT?
We took a step back and examined social inequality based on the definition that the philosopher John Rawls gave in his book A Theory of Justice. In Rawls' terms, a society is just if a person understands all the conditions within that society and is willing to enter it in a random place (in terms of socio-economic status, gender, race, and so on). In terms of wealth, that means that people know everything about the wealth distribution and are willing to enter that society anywhere along the spectrum. They could be among the poorest or the richest, or anywhere in between. Rawls called this idea the "veil of ignorance" because the decision of whether to enter a particular society is disconnected from the particular knowledge that the individual has about the level of wealth that he or she will have after making the decision.
With this definition in mind, we did two things. First, we asked 5,522 people to create a distribution of wealth among the five buckets such that they themselves would be willing to enter that society at a random place. Their answers could range from a perfectly even distribution with 20% of wealth in each quintile to a fully biased distribution with 100% of wealth in one and 0% in the rest.
We found that the ideal distribution described by this representative sample of Americans was dramatically more equal than exists anywhere in the world, with 32% of wealth belonging to the wealthiest quintile down to 11% by the poorest (see Figure 3).
What was particularly surprising about the results was that when we examined the ideal distributions for Republicans and Democrats, we found them to be quite similar (see Figure 4). When we examined the results by other variables, including income and gender, we again found no appreciable differences. It seems that Americans -- regardless of political affiliation, income, and gender -- want the kind of wealth distribution shown in Figure 3, which is very different from what we have and from what we think we have (see Figure 2). (read more)
Wednesday, May 23, 2012
Every Spring the educational system produces a new cohort of well-trained and well-educated students who must become the new generation of employees. The recent college graduates offer new ideas and a new source for creativity. Additionally, they will one day be the new stewards of the economic and political systems. What advice should these new graduates and future employees be told upon their graduation? What role does their formal training play in their new careers? How does their career choice affect the larger society around them? Robert J. Shiller, the Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices, has an important message for college graduates who decide to pursue a career in finance.
NEW HAVEN – At this time of year, at graduation ceremonies in America and elsewhere, those about to leave university often hear some final words of advice before receiving their diplomas. To those interested in pursuing careers in finance – or related careers in insurance, accounting, auditing, law, or corporate management – I submit the following address:
Best of luck to you as you leave the academy for your chosen professions in finance. Over the course of your careers, Wall Street and its kindred institutions will need you. Your training in financial theory, economics, mathematics, and statistics will serve you well. But your lessons in history, philosophy, and literature will be just as important, because it is vital not only that you have the right tools, but also that you never lose sight of the purposes and overriding social goals of finance.
Unless you have been studying at the bottom of the ocean, you know that the financial sector has come under severe criticism – much of it justified – for thrusting the world economy into its worst crisis since the Great Depression. And you need only check in with some of your classmates who have populated the Occupy movements around the world to sense the widespread resentment of financiers and the top 1% of income earners to whom they largely cater (and often belong).
While some of this criticism may be over-stated or misplaced, it nonetheless underscores the need to reform financial institutions and practices. Finance has long been central to thriving market democracies, which is why its current problems need to be addressed. With your improved sense of our interconnectedness and diverse needs, you can do that. Indeed, it is the real professional challenge ahead of you, and you should embrace it as an opportunity.
Young finance professionals need to familiarize themselves with the history of banking, and recognize that it is at its best when it serves ever-broadening spheres of society. Here, the savings-bank movement in the United Kingdom and Europe in the nineteenth century, and the microfinance movement pioneered by the Grameen Bank in Bangladesh in the twentieth century, comes to mind. Today, the best way forward is to update financial and communications technology to offer a full array of enlightened banking services to the lower middle class and the poor.
Graduates going into mortgage banking are faced with a different, but equally vital, challenge: to design new, more flexible loans that will better help homeowners to weather the kind of economic turbulence that has buried millions of people today in debt.
Young investment bankers, for their part, have a great opportunity to devise more participatory forms of venture capital – embodied in the new crowd-funding Web sites – to spur the growth of innovative new small businesses. Meanwhile, opportunities will abound for rookie insurance professionals to devise new ways to hedge risks that real people worry about, and that really matter – those involving their jobs, livelihoods, and home values.
Beyond investment banks and brokerage houses, modern finance has a public and governmental dimension, which clearly needs reinventing in the wake of the recent financial crisis. Setting the rules of the game for a robust, socially useful financial sector has never been more important. Recent graduates are needed in legislative and administrative agencies to analyze the legal infrastructure of finance, and regulate it so that it produces the greatest results for society.
A new generation of political leaders needs to understand the importance of financial literacy and find ways to supply citizens with the legal and financial advice that they need. Meanwhile, economic policymakers face the great challenge of designing new financial institutions, such as pension systems and public entitlements based on the solid grounding of intergenerational risk-sharing.
Those of you deciding to pursue careers as economists and finance scholars need to develop a better understanding of asset bubbles – and better ways to communicate this understanding to the finance profession and to the public. As much as Wall Street had a hand in the current crisis, it began as a broadly held belief that housing prices could not fall – a belief that fueled a full-blown social contagion. Learning how to spot such bubbles and deal with them before they infect entire economies will be a major challenge for the next generation of finance scholars.
Equipped with sophisticated financial ideas ranging from the capital asset pricing model to intricate options-pricing formulas, you are certainly and justifiably interested in building materially rewarding careers. There is no shame in this, and your financial success will reflect to a large degree your effectiveness in producing strong results for the firms that employ you. But, however imperceptibly, the rewards for success on Wall Street, and in finance more generally, are changing, just as the definition of finance must change if is to reclaim its stature in society and the trust of citizens and leaders.
Finance, at its best, does not merely manage risk, but also acts as the steward of society’s assets and an advocate of its deepest goals. Beyond compensation, the next generation of finance professionals will be paid its truest rewards in the satisfaction that comes with the gains made in democratizing finance – extending its benefits into corners of society where they are most needed. This is a new challenge for a new generation, and will require all of the imagination and skill that you can bring to bear.
Good luck in reinventing finance. The world needs you to succeed.
Sunday, May 6, 2012
In 1994, a team of young, 20-something JPMorgan bankers on a retreat in Boca Raton, Fla. dreamed up the “credit default swap” — a complicated derivative they hoped would help manage risk and stabilize the financial system. Fourteen years later, they watched in horror as that global system — weighed down by the risk of credit default swaps tied to mortgage loans — collapsed.
The ensuing saga between that pivotal retreat and the start of the 2008 global financial crisis are “defined by daunting complexity,” writes Greg Evans in Bloomberg Businessweek today. But the first two hours of Money, Power and Wall Street, he adds, does an “exemplary job of walking viewers through [it].”
FRONTLINE’s four-hour epic on the global financial crisis goes inside the struggles to rescue and repair a shattered economy, exploring key decisions, missed opportunities and the unprecedented and uneasy partnership between government leaders and titans of finance.
“Money, Power and Wall Street is demanding — this isn’t Finance for Dummies,” Evans writes in the review. “But it’s a compact and thorough lesson.”
In the first hour, FRONTLINE takes you inside the rapid rise of credit default swaps, including the voices of those who created them. With the real estate market booming, bankers successfully tweaked the credit default swap to bundle up and sell home mortgage loans to eager investors. But despite the money flowing into banks’ coffers, credit default swaps also loaded the financial system with lethal risk. And when the housing bubble burst, the credit default swaps — originally designed to stabilize the system — brought the global economy to its knees. Regulators, who had often stood on the sideline and allowed Wall Street to police itself, saw the ugly consequences rapidly unfold before them.
In the second hour, FRONTLINE investigates the largest government bailout in U.S. history, a series of decisions that rewrote the rules of government and fueled a debate that would alter the country’s political landscape. It offers play-by-play accounts of several secret meetings that permanently altered the financial system. (read more)
Is it possible to solve the depression and return the economy to full employment without severe austerity measures? Has the political response in Western Europe, wherein Germany argues for greater austerity measures in the struggling Southern economies, been successful? A strong consensus is building among prominent economists, historians, and politicians that the depression and high unemployment can be solved relatively easily and quickly. All that is needed is to understand the historical patterns of economic recovery after financial crisis and to muster up the necessary political will to create policies that are in accordance with the economic truth. Paul Krugman, the professor of economics and international affairs at Princeton University and Nobel Laureate in Economics, argues in his forthcoming book that the depression we are experiencing is not necessary and that the right policies can have a significant affect on the depressed labor markets and economic system. The following article gives a brief summary of Krugman's argument.
PRINCETON-The depression we’re in is essentially gratuitous: we don’t need to be suffering so much pain and destroying so many lives. We could end it both more easily and more quickly than anyone imagines—anyone, that is, except those who have actually studied the economics of depressed economies and the historical evidence on how policies work in such economies.
The truth is that recovery would be almost ridiculously easy to achieve: all we need is to reverse the austerity policies of the past couple of years and temporarily boost spending. Never mind all the talk of how we have a long-run problem that can’t have a short-run solution—this may sound sophisticated, but it isn’t. With a boost in spending, we could be back to more or less full employment faster than anyone imagines.
But don’t we have to worry about long-run budget deficits? Keynes wrote that “the boom, not the slump, is the time for austerity.” Now, as I argue in my forthcoming book—and show later in the data discussed in this article—is the time for the government to spend more until the private sector is ready to carry the economy forward again. At that point, the US would be in a far better position to deal with deficits, entitlements, and the costs of financing them.
Meanwhile, the strong measures that would all go a long way toward lifting us out of this depression should include, among other policies, increased federal aid to state and local governments, which would restore the jobs of many public employees; a more aggressive approach by the Federal Reserve to quantitative easing (that is, purchasing bonds in an attempt to reduce long-term interest rates); and less timid efforts by the Obama administration to reduce homeowner debt.
But some readers will wonder, isn’t a recovery program along the lines I’ve described just out of the question as a political matter? And isn’t advocating such a program a waste of time? My answers to these two questions are: not necessarily, and definitely not. The chances of a real turn in policy, away from the austerity mania of the last few years and toward a renewed focus on job creation, are much better than conventional wisdom would have you believe. And recent experience also teaches us a crucial political lesson: it’s much better to stand up for what you believe, to make the case for what really should be done, than to try to seem moderate and reasonable by essentially accepting your opponents’ arguments. Compromise, if you must, on the policy—but never on the truth.
Let me start by talking about the possibility of a decisive change in policy direction.
Nothing Succeeds Like Success
Pundits are always making confident statements about what the American electorate wants and believes, and such presumed public views are often used to wave away any suggestion of major policy changes, at least from the left. America is a “center-right country,” we’re told, and that rules out any major initiatives involving new government spending.
And to be fair, there are lines, both to the left and to the right, that policy probably can’t cross without inviting electoral disaster. George W. Bush discovered that when he tried to privatize Social Security after the 2004 election: the public hated the idea, and his attempted juggernaut on the issue quickly stalled. A comparably liberal-leaning proposal—say, a plan to introduce true “socialized medicine,” making the whole health care system a government program like the Veterans Health Administration—would presumably meet the same fate. But when it comes to the kind of policy measures I have advocated—measures that would mainly try to boost the economy rather than try to transform it—public opinion is surely less coherent and less decisive than everyday commentary would have you believe.
Pundits and, I’m sorry to say, White House political operatives like to tell elaborate tales about what is supposedly going on in voters’ minds. Back in 2011 The Washington Post’s Greg Sargent summarized the arguments Obama aides were using to justify a focus on spending cuts rather than job creation:
A big deal would reassure independents who fear the country is out of control; position Obama as the adult who made Washington work again; allow the President to tell Dems he put entitlements on sounder financial footing; and clear the decks to enact other priorities later.
Any political scientist who has actually studied electoral behavior will scoff at the idea that voters engage in anything like this sort of complicated reasoning. And political scientists in general have scorn for what Slate’s Matthew Yglesias calls the pundit’s fallacy, the belief on the part of all too many political commentators that their pet issues are, miraculously, the very same issues that matter most to the electorate.
Most real voters are busy with their jobs, their children, and their lives in general. They have neither the time nor the inclination to study policy issues closely, let alone engage in opinion-page-style parsing of political nuances. What they notice, and vote on, is whether the economy is getting better or worse; statistical analyses say that the rate of economic growth in the three quarters or so before the election is by far the most important determinant of electoral outcomes. (read more)
Thursday, May 3, 2012
The 2008 financial crisis has evolved through many stages and now centers around the role of the state to stabilize markets while minimizing deficits. As one would predict, this has led to highly contentious debates both in America and Western Europe regarding the role of the state versus private actors to stabilize the economic system, the importance of long-term financial stability versus short-term growth, and the role of old versus new ways of economic thinking. These debates center around the following questions: should the state implement pro-growth strategies even though it is struggling to deal with decreasing tax revenue and increasing sovereign debt? Should a pro-growth agenda be put on hold to allow strong austerity measures to take affect? Global leaders, economic organizations, and governments around the world have taken different positions regarding these questions. Below is an insightful interview with Joseph Stiglitz--the Nobel Prize winning economist, co-founder of the Institute for New Economic Thinking (INET), and professor at Columbia University--that helps us understand the underlying conflicts in the academy and among politicians, and the potential solutions that are possible.
Question: Four years after the beginning of the financial crisis, are you encouraged by the ways in which economists have tried to make sense of it, and by the ways in which those insights have been taken up by policy makers?
Stiglitz: Let me break this down in a slightly different way. Academic economists played a big role in causing the crisis. Their models were overly simplified, distorted, and left out the most important aspects. Those faulty models then encouraged policy-makers to believe that the markets would solve all the problems. Before the crisis, if I had been a narrow-minded economist, I would have been very pleased to see that academics had a big impact on policy. But unfortunately that was bad for the world. After the crisis, you would have hoped that the academic profession had changed and that policy-making had changed with it and would become more skeptical and cautious. You would have expected that after all the wrong predictions of the past, politics would have demanded from academics a rethinking of their theories. I am broadly disappointed on all accounts.
Question: Economists have seen the flaws of their models but have not worked to discard or improve them?
Stiglitz: Within academia, those who believed in free markets before the crisis still do so today. A few people have shifted, and I want to give credit to them for saying: “We were wrong. We underestimated this or that aspect of our models.” But for the most part, the response was different. Believers in the free market have not revised their beliefs.
Question: So let’s take a longer view. Do you think that the crisis will have an effect on future generations of economists and policy-makers, for example by changing the way that economic basics are taught?
Stiglitz: I think that change is really occurring with the young people. My young students overwhelmingly don’t understand how people could have believed in the old models. That is good. But on the other hand, many of them say that if you want to be an economist, you still have to deal with all the old guys who believe in their wrong theories, who teach those theories, and expect you to believe in them as well. So they choose not to go into those branches of economics. But where I have been even more disappointed is American policy-making. Ben Bernanke gives a speech and says something like, there was nothing wrong with economic theory, the problems were a few details in implementation. In fact, there was a lot wrong with economic theory and with the basic policy framework that was derived from theory. If your mindset is that nothing was wrong, you will not demand new models. That’s a big disappointment.
Question: There seemed to have been quite a bit of disagreement among Obama’s economic advisers about the right course of action. And in Europe, fundamental economic principles like the absolute focus on GDP growth have finally come under attack.
Stiglitz: Some American policy-makers have recognized the danger of “too big to fail,” but they are a minority. In Europe, things are a bit better on the rhetorical side. Influential economists like Derek Turner and Mervyn King have recognized that something is wrong. The Vickers Commission has thoughtfully re-examined economic policy. We have nothing like that in the United States. In Germany and France, the financial transactions tax and limits to executive compensation are on the table. Sarkozy says that capitalism hasn’t worked, Merkel says that we were saved by the European social model – and they are both conservative politicians! The bankers still don’t understand this, which explains why we still see the head of the European Central Bank, Mario Draghi, arguing that we have to give up the welfare system at a time when Merkel says the exact opposite: That the social model kept us going when the central banks failed to do their regulatory job and used politics to change the nature of our societies.
Question: How have your own convictions been affected by the crisis?
Stiglitz: I don’t think that there has been a fundamental change in my thinking. The crisis has reinforced certain things I said before and shown me how important they are. In 2003, I wrote about the risk of interdependence, where the collapse of one bank can bring about the collapse of other banks and increase the fragility of the banking system. I thought it was important, but the idea wasn’t picked up at the time. The same year we looked at agency problems in finance. Now we recognize just how important those issues are. I argued that the real issue in monetary economics is about credit, not money supply. Now everybody recognizes that the collapse of the credit system brought down the banks. So the crisis really validated and reinforced several strands of theory that I had explored before. One topic that I now consider much more important than I did previously is the question of adjustment and the role of exchange rate systems like the Euro in preventing economic adjustment. A related issues is the linkage between structural adjustment and macroeconomic activity. The events of the crisis have really induced me to think more about them.
Question: The financial transaction tax seems to have died a political death in Europe. Now, economic policy in Europe seems largely dominated by the logic of austerity, and by forcing other European countries to become more like Germany.
Stiglitz: Austerity itself will almost surely be disastrous. It is leading to a double-dip recession that could be quite serious. It will probably make the Euro crisis worse. The short-term consequences are going to be very bad for Europe. But the broader issue is about the “German model.” There are many aspects to it – among them the social model – that allow Germany to weather a very big dip in GDP by offering high levels of social protection. The German model of vocational training is also very successful. But there are other characteristics that are not so good. Germany is an export economy, but that cannot be true for all countries. If some countries have export surpluses, they are forcing other countries to have export deficits. Germany has taken a policy that other countries cannot imitate and tried to apply it to Europe in a way that contributes to Europe’s problems. The fact that some aspects of the German model are good does not mean that all aspects can be applied across Europe.
Question: And it does not mean that economic growth satisfied the criteria of social fairness.
Stiglitz: Yes, so there is one other thing we have to take into account: What is happening to most citizens in a country? When you look at America, you have to concede that we have failed. Most Americans today are worse off than they were fifteen years ago. A full-time worker in the US is worse off today than he or she was 44 years ago. That is astounding – half a century of stagnation. The economic system is not delivering. It does not matter whether a few people at the top benefitted tremendously – when the majority of citizens are not better off, the economic system is not working. We also have to ask of the German system whether it has been delivering. I haven’t studied all the data, but my impression is no.
Question: What do you say to someone who argues thus: Demographic change and the end of the industrial age have made the welfare state financially unsustainable. We cannot expect to cut down on our debt without fundamentally reducing welfare costs in the long run.
Stiglitz: That is absurd. The question of social protection does not have to do with the structure of production. It has to do with social cohesion or solidarity. That is why I am also very critical of Draghi’s argument at the European Central Bank that social protection has to be undone. There are no grounds upon which to base that argument. The countries that are doing very well in Europe are the Scandinavian countries. Denmark is different from Sweden, Sweden is different from Norway – but they all have strong social protection and they are all growing. The argument that the response to the current crisis has to be a lessening of social protection is really an argument by the 1% to say: “We have to grab a bigger share of the pie.” But if the majority of people don’t benefit from the economic pie, the system is a failure. I don’t want to talk about GDP anymore, I want to talk about what is happening to most citizens.
Question: Has the political Left been able to articulate that criticism?
Stiglitz: Paul Krugman has been very strong on articulating criticism of the austerity arguments. The broader attack has been made, but I am not sure whether it has been fully heard. The critical question right now is how we grade economic systems. It hasn’t been fully articulated yet but I think we will win this one. Even the Right is beginning to agree that GDP is not a good measure of economic progress. The notion of the welfare of most citizens is almost a no-brainer.
Question: It seems to me that much of the discussion is still about statistical measurements – if we’re not measuring GDP, we’re measuring something else, like happiness or income differences. But is there an element to these discussions that cannot be put in numerical terms – something about the values we implicitly bake into our economic system?
Stiglitz: In the long run, we ought to have those ethical discussions. But I am beginning from a much narrower base. We know that income doesn’t reflect many things we care about. But even with an imperfect indicator such as income, we should care about what happens to most citizens. It’s nice that Bill Gates is doing well. But if all the money went to Bill Gates, the system could not be graded as successful.
Question: If the political Left hasn’t been able to fully articulate that idea, has civil society been able to fill the gap?
Stiglitz: Yes, the Occupy movement has been very successful in bringing those ideas to the forefront of political discussion. I wrote an article for Vanity Fair in 2011 – “Of the 1%, by the 1%, for the 1%” – that really resonated with a lot of people because it spoke to our worries. Protests like the ones at Occupy Wall Street are only successful when they pick up on these shared concerns. There was one newspaper article that described the rough police tactics in Oakland. They interviewed many people, including police officers, who said: “I agree with the protesters.” If you ask about the message, the overwhelming response has been supportive, and the big concern has been that the Occupy movement hasn’t been effective enough in getting that message across. (read more)