Institute for Financial Transparency

Shining a light on the opaque corners of finance


PhD Economist Derp: Not Just Another Opinion

Simon Wren-Lewis rolled out another defense of the indefensible.  This time arguing an Economist’s opinion about the economy is more valuable than a balloon filled with hot air.  As he more politely puts it:

when it comes to macroeconomic policy, experience suggests you are much more likely to get economic policy right if you ask an academic macroeconomist than if you ask anybody else.

Is this true?

Mr. Wren-Lewis puts forth his best argument for why it is true.

Does the financial crisis reveal that economists are at the leeches and mercury stage of their subject, and as a result policy makers and the public have every right to ignore what they say? Does the fact that economists working in finance failed to recognise the prospect of a systemic crisis, and that macroeconomists both took finance for granted and as a result failed to investigate financial-real links, mean that we should ignore what economists say when it comes to Brexit?
The answer to the first question is an unqualified “YES”.  The answer to the second question is a little trickier because everything before the word “mean” is both unambiguously true and a reason not to treat Economists’ opinions as being special in any way.
Having set the stage, he moves on to explain why “Yes” is the wrong answer.
Why don’t we look at what has happened since the financial crisis.

Macroeconomists, having learnt the lessons of the 1930s, immediately recommended that policy makers do three things after the crisis: cut interest rates sharply, embark on fiscal stimulus and bailout banks. Policy makers took that advice in 2009, and as a result we avoided another Great Depression.

Regular readers know the claim advice from Economists resulted in avoiding another Great Depression is false.

This claim was shown to be false in a very important,  though clearly unintentional observation made by Nobel prize winning Economist Paul Krugman.

So the world financial system and the world economy failed to implode. Why?

We shouldn’t give policy-makers all of the credit here. Much of what went right, or at least failed to go wrong, reflected institutional changes since the 1930s. Shadow banking and wholesale funding markets were deeply stressed, but deposit insurance still protected a good part of the banking system from runs. There never was much discretionary fiscal stimulus, but the automatic stabilizers associated with large welfare states kicked in, well, automatically: spending was sustained by government transfers,while disposable income was buffered by falling tax receipts. [emphasis added]

Professor Krugman finds it was the institutional changes made during and since the 1930s that prevented a second Great Depression.  These institutional changes include deposit insurance and the welfare state (which was begun under FDR and subsequently expanded under Lyndon Johnson’s Great Society).

Was there any reason to think the people who lived through the Great Depression wouldn’t have put in place everything needed to prevent a second Great Depression?  NO!

Was there any reason the existence of deposit insurance and automatic stabilizers the Great Depression generation put in place wouldn’t have been knowable at the very beginning of the acute phase of the Great Financial Crisis in 2008?  NO!

If you were aware of what the Great Depression generation put in place, was there any reason to think a second Great Depression was possible in 2008?  NO!

Of course, all of this should have been obvious to academic Economists who learned the lessons of the 1930s.

Now let’s focus on the three specific policy recommendations Wren-Lewis trumpets.

First, academic Economists argued for cutting interest rates sharply.  Was this really a good recommendation?  In the 1930s, a gentleman by the name of John Maynard Keynes wrote about how he agreed with Walter Bagehot and interest rates should never be reduced below 2% because it creates problems with both the financial system and the real economy.  Was this minimum interest rate included in the academic Economists policy recommendations?  No.  Apparently they chose not to only partially learn this lesson.

Second, academic Economists argued for embarking on fiscal stimulus.  As Professor Krugman points out, the automatic stabilizers were set in place in the 1930s.  Therefore, fiscal stimulus was already assured.  What the academic Economists could have argued for was “additional” fiscal stimulus.  But that is not what they did.  They argued for “embarking” which clearly indicates they were unaware fiscal stimulus was already assured.  It appears Wren-Lewis would like to take credit for something the academic Economists policy recommendation had no impact on.

Third, academic Economists argued for bank bailouts.  Regular readers know bank bailouts aren’t necessary.  The existence of deposit insurance means the taxpayers automatically become the silent equity partner for every insolvent bank.  Hence, the banks can continue to function even though they are insolvent until such time as the government chooses to close them.  (If you doubt me, just look at the US Savings & Loans who were insolvent for years before being closed down).

Regular readers also know bank bailouts prevent the financial system being used as it is designed to protect the real economy by absorbing the losses on the excess debt in the financial system.  Sweden and Iceland showed when banks are used as designed in response to a financial crises the real economy quickly begins a self-sustaining recovery.  When banks don’t absorb the losses on the excess debt, the burden of this debt is placed on the real economy.  The result, as shown by Japan, is decades of economic malaise where a self-sustaining recovery is elusive.

I could go on and on with other bad consequences of bailing out the banks, but readers get the picture bank bailouts made the crisis worse than it had to be.

When it came to recommendations for how to respond to the financial crisis, the Academic Economists were wrong on two major recommendations and showed a lack of understanding when they made the third recommendation.  Not exactly a track record suggesting they should be listened to.

After wading through all this PhD Economist Derp, I have to agree with Wren-Lewis the Economics profession is at the leeches and mercury stage of development of its subject.