I find it hard to agree with much of what the economist Paul Krugman has to say in his widely read newspaper columns, but there is no doubt he is the most readable economist of the modern era, continuing a tradition first begun in the postwar period by one of his mentors, Paul Samuelson, the first winner of the Nobel economics prize. Although neither is quite as good a phrasemaker as John Maynard Keynes, who set an impossibly high standard, both Mr Samuelson and Mr Krugman share the invaluable ability to communicate the essence of complex ideas in simple language that allows no mistaking of its meaning.
The importance of communication came back to me when trawling through a lot of archived material, searching for examples of pundits who could claim to have forecast the onset of the global credit crisis. Although the Queen echoed the feelings of many others when she demanded to know why nobody had seen it coming, my own recollection is that there were many siren voices in the run up to the crisis warning of the consequences of the lax monetary policy and reckless banking expansion that were features of Alan Greenspan’s later years at the Federal Reserve. Few of these voices, unfortunately, managed to be heard in the places where it might have made a difference. Although it will not happen, Terry Smith is surely entitled to point out that if it is right to strip Fred Goodwin of his knighthood, so too must there be a case for applying the same remedy to the notoriously gnomic former chairman of the Federal Reserve, knighted by the Queen “for his contribution to global economic stability”.
The interesting question is not whether the credit crisis could have been foreseen (it could have been and it was), but why so many of those you would expect to be professionally aware of the risks of excessive credit growth – bankers, politicians, investors and policy wonks alike – should have so wilfully blinded themselves to the potential consequences, when in history such rapid expansion of credit has only ever ended one way.
Whatever you think of his current policy prescriptions (not a lot, in my case), to his credit Mr Krugman wrote what I still think is one of the best accounts of why his own profession of economics failed so dismally to read the runes correctly (How Did Economists Get It So Wrong?, in the New York Times, September 2009). One of the themes that he draws out well is the extent to which, in macroeconomics at least, the profession entered the 20th century in what with hindsight appears to be a distinctly complacent frame of mind. After years of squabbles between neo-Keynesians and Friedmanites, economics had arrived at some kind of reconciliation, or “phony peace”, between the main tribal factions. In 2004, Olivier Blanchard, now the International Monetary Fund’s chief economist, in a paper that hailed “a broad convergence of vision” in the macroeconomics field, declared that the “state of macro is good”.
In parallel some high profile economists seemed to have acquired, albeit for the best of reasons, the dangerous habit, for any social scientists, of converging on certainty in their convictions. Before he took over as chairman of the Federal Reserve, Ben Bernanke famously announced that the Fed not only could – but could not fail to – prevent a repeat of the Great Depression of the 1930s, given the state of knowledge and the tools now at its disposal. He has since declared for good measure that he is “100 per cent confident” that he will be able to control inflation as well. Both he and Mr Greenspan repeatedly denied seeing any danger of a bubble in the US housing market.
Such certainties have been dangerously exposed for the nonsense they are. If we did not know before, we have all learnt that the world is rough at the edges and incapable of being precisely modelled, as economists once dreamed that it might be. “The central cause of the profession’s failure”, Mr Krugman concludes, “was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.” They opted for a “romanticised and sanitised” vision of the economy in preference to engaging with a world that in reality is messy and often irrational and unpredictable.
For professional investors, unfortunately, a similar story has unfolded over the past quarter of a century. While elegant and useful in many respects, depending in part on what value you place on derivatives, modern financial theory has been no more successful in building a template for successful investment decision-making than has macroeconomics in preventing boom and bust. When asked what he thought about modern portfolio theory, Sir John Templeton replied that it was interesting, but he doubted that any investor would ever make much money out of it.
After the benign and deceptive years of the Great Moderation, investors face the challenge of operating in a world where muddling through and “living with messiness”, as Mr Krugman puts it, is again the order of the day. The final outcome of the eurozone crisis, for example, another project conceived in misguided certainty, is still too complex to be analysed to a definitive conclusion, though one can attempt to cast probabilities.
In his article Mr Krugman quotes Keynes in 1930: “We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time – perhaps for a long time.” The challenge today is, alas, little different.
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