HUBRIS
Why economists failed to predict the crisis and how to avoid the next one
Meghnad Desai
HarperCollins Publishers
287 pages; Rs 399
Why did nobody notice it?
It was a deceptively simple inquiry that Queen Elizabeth put to a gathering of economists at the London School of Economics and Political Science, questioning their collective failure to foresee the financial crisis of 2008.
The answer, though, was far from satisfactory.
Sure, there were Cassandras. Raghuram Rajan, the then chief economist of the IMF, and Nouriel Roubini, a professor at New York University's Stern Business School, both warned of impending risks to the system.
But few heeded their warnings because, by then, the belief that financial innovation had greatly reduced risk and that the great moderation had finally solved the problem of booms and busts was deeply ingrained in the economic discourse. So much so that Mervyn King, governor of the Bank of England, boldly proclaimed the future to be one of non-inflationary continuous expansion.
Since then, although much analytical work has tended to focus on what exactly caused the crisis, few have questioned the legitimacy of the ideas that continue to dominate the mainstream economic discourse. Meghnad Desai's aptly titled book Hubris does just that in crisp and gripping prose.
To explain how macroeconomics came to its current pass, the book stretches back to the founding fathers of the discipline - Adam Smith, David Ricardo, Leon Walras, and Alfred Marshall for insight - and adds a dash of philosophical inputs from Locke and Hume among others. The ideas of these towering figures and their impact on economic thought are explored in great detail and lucidity.
Prof Desai punctures the claim that the Great Moderation was the result of central bankers' ingenuity. In his view it was the entry of China and other Asian economies into the global supply chain that depressed prices. These countries could manufacture goods at a fraction of the cost of the developed world, and this led to the phase of low inflation. But in the public discourse the myth is one of the masters of the universe slaying the inflation demon.
On the critical issue of why economists were caught unawares by the financial crisis, Prof Desai blames economists for not remembering this history. Their blinkered view, he argues, tends to discount the theory of long business cycles, and of the previous occurrences of banking crises and financial crashes that can serve as a useful guide to predicting when the next one will strike.
Prof Desai chastises his fellow travellers for their overdependence on the neo-classical paradigm that, he argues, is grounded in the unrealistic assumption that people make rational decisions and operate in efficient markets. As a result, the models that economists rely on are often divorced from reality and tend to take a truncated view. He blames this myopic view for the failure to foresee the crisis.
The book is a clarion call to economists to expand the body of work they rely on to include the works of Marx, Hayek and Kondratieff. In his view, the crisis of 2008 could have been predicted had economists paid more attention to these theories and reduced their dependence upon abstruse models.
Prof Desai's explanation on how to get out of the current predicament is, however, patently contestable. His argument rests on the line of thinking that increasing government spending is unlikely to solve the problem as this is not a Keynesian problem.
This is surprising at two levels. One, given his ideological moorings it is intriguing that he tilts in favour of austerity. He sees the UK's recovery as vindication of his views. Never mind the fact that, after two disastrous years, David Cameron was forced to abandoned his austerity programme. As Paul Krugman points out, Britain's economic recovery followed only after this change in policy.
Two, during balance sheet recessions, when households and firms are paring debt levels, there is a strong argument to be made for increasing government expenditure to boost growth. During downturns, government spending is likely to boost output without crowding out private investment. In fact, a common refrain among economists has been that given the scale of the crisis, the US' stimulus package wasn't expansive enough.
The final section, which outlines his views on the framework that economists should employ, is, to put it charitably, disappointing. Prof Desai tries to weave a narrative based on an odd blend of theories - Schumpeter/Kondrateiff's theory of long cycles coupled with Wicksell-Hayek's theory of short cycles, peppered with Marx's notion of the cycle of changing labour and profit shares driven by demography and technology.
It may be a grand vision, but it is much more complex than Prof Desai lets on. The ability to build such a model to predict the next crash is questionable. It is also difficult to see how the model will incorporate the increasing complexity and interconnectedness of systems, the multiplicity of agents, both rational and irrational, and "black swan" events, to offer predictions with a reasonable measure of certainty.
As Prof Desai himself acknowledges "It would be a challenge to build a formal econometric model which can encompass these elements." So while he may have answered Her Majesty's question in this book, he has been less than satisfactory in devising solutions to avoid the next great crash.
