Friday 27 May 2011

The economics of don’t meddle and muddle through

The Age of Instability, by David Smith (Profile Books, 2010)

Gordon ‘no return to boom and bust’ Brown gets it so wrong in this book: still (relatively) happy, still giving Treasury drinks parties, still back in 2004, still sufficiently buoyed by financial boom to suggest to David Smith that he write a book on the ‘great stability’. What a difference a global financial crash makes.

Of course, it wasn’t just Brown’s crystal ball that let him down. Robert Lucas, giving his 2003 presidential address to the American Economic Association declared that the ‘central problem of depression-prevention [has] been solved, for all practical purposes’. Maybe heavier on the caveat next time, Robert?

So many economists were wrong, apparently, that Paul Krugman, who thinks he got it right, wrote an article called How Did Economists Get It So Wrong? in which he takes on most of his profession for not reading enough Keynes, the only game left in town according to him. The infighting continued with John H Cochrane’s How did Paul Krugman get it so Wrong?. Smith tells us how even the Queen joined in, asking the London School of Economics: ‘If these things were so large how come everyone missed them?’ The British Academy’s reply promised that economists would try harder next time: ‘Your Majesty, the failure to foresee… the crisis… was principally a failure of the collective imagination of many bright people… to understand the risks to the system as a whole.’

David Smith does list, however, those bright(er) sparks who got it less wrong: Nouriel Roubini; Robert Shiller; William ‘Bill’ White. Though, to be fair, it has never been the job of the ‘dismal science’ to predict the future. Your Adam Smiths and David Ricardos – back when economics was actually useful - didn’t go in for them. It seems harsh even to criticise economists today for getting their predictions wrong when hardly any of them seem interested in economics anyway. Smith’s account of the run up to the crash is full of mathematicians, risk analysts and behavioural psychologists but short on economists. Most everyone involved seems to have been happy to ride along on the crest of the wave and tweak theories to fit reality as it happened.

Whether, as Smith’s engaging account unfolds, it was the ‘lessons’ learned from the Asian financial crisis of 1997/98 (buy US treasuries), the bailout of Long Term Capital Management in 1998 (too big to fail), the housing boom (irrational exuberance), the crash itself as it played out with Northern Rock, Bear Stearns, Lehmans (too much risk, not enough regulation) and the subsequent panicked response to the spreading crisis (too big to fail, print money), one thing stands out: nobody made any real choices along the way. Economists made a virtue out of not tinkering with the money machine (efficient-market hypotheses, mark-to-market accounting) and politicians promised not to meddle.

Smith very usefully finds the origins of New Labour’s economic ‘prudence’ in the advice of the young Ed Balls in a 1992 Fabian Society pamphlet in which he suggested that the credibility gap between Labour and the City was best overcome by ‘limiting the freedom of action of politicians to mess things up’. He emphasised adherence to rules and responsibility rather than discretionary action. It’s an approach fully endorsed by the current coalition government who, no sooner had they the keys to the Treasury in hand, established an Office for Budget Responsibility to tie that hand even more tightly behind their backs. Their plan for the economy? The insightful economic theory? Look after the pennies… A stitch in time…

Not making decisions, not having a long-term strategy, ditching theory and rationality: all things that seem like virtues to the likes of Lord Skidelsky (‘economics is revealed to have no more clothes than other social sciences’), Paul Krugman (‘abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly’) and Anatole Kaletsky (the ‘future will always be unpredictable and ambiguous and inconsistent – just like human life’). Economics post-crash seems like a codification of messy pragmatism: to be anti-theory now in principle. Leaving us, of course, with things just the way they are.

The economics of don’t meddle and muddle through are certainly not rational. Nor is the concern with well-being and happiness rather than growth and GDP. Not that these concerns are new: Amartya Sen has been at it for decades and Gary Becker won the Nobel Memorial Prize in Economic Sciences in 1992 ‘for having extended the domain of microeconomic analysis to a wide range of human behaviour and interaction, including non-market behaviour’. Might as well give it to the Freakonomics guys next.

All that said, David Smith was right not to listen to Gordon Brown’s book advice and his predictions in The Age of Instability have not turned out so badly either. A jobs-light recovery (there has been recovery in employment but it is still some 330,000 below pre-recession levels), higher taxes (VAT and NI rises), subdued consumer spending (‘Consumption stagnated throughout 2010, remaining some 4% below its pre-recession peak — the largest shortfall at this stage of a recovery since quarterly records began in 1955’, Bank of England), staying green (trenchant emissions targets), and so on, through big government here to stay, suspicion of markets, a focus on equality and an accelerated shift to the East. As essential themes and emerging world trends these are certainly to be seriously considered by anyone wanting to understand the epochal shifts that are undoubtedly happening. For any economists still out there who have not completely lost faith in their profession, it would be useful to start engaging with what is really new about the world today.

One other of Smith’s predictions is not so much a prediction, much more a hope that risk-aversion will not stand in the way of creative destruction and the emergence of innovative new industries. If any one thing has really been strengthened since the crash it must be risk-aversion. Governments continue to show more willingness to bail out failing sectors of industry – for short-term political gain – than to take the risk of investing in the technologies of tomorrow. More and more regulation is required at every level of the economy, especially finance. The Vickers’ banking report says that bank’s retail arms should have to hold capital equivalent to at least 10 per cent of their assets, reducing the cash able for investment. Just where is the funding that is needed by innovative start-ups to come from? Smith ends by saying that we made it through the crisis but, for Western economies ‘standing still, however, will not be enough’. Taking off towards the future, though, will require a level of tough political decision making and hard choices that, so far, no one seems have the nerve to make or even contemplate.

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