A decade has passed since the acute phase of the Great Financial Crisis began and the Economics profession has not produced a single idea that would have prevented the crisis.  To me, this is a sure sign that Economics as it is currently practiced by tenured professors at big name universities, highly compensated think tank staff members and in the corridors of the central banks has failed.

I can already hear these Economists protesting that isn’t true as they have championed the idea of macro-prudential regulation.  According to its supporters, macro-prudential regulators will scan the global economic system for developing risks and then take action to defuse these risks before these risks can erupt into a financial crisis.

There are two significant problems with this idea.

First, nobody would purposefully build a financial system with a single point of failure.  Everyone knows eventually this single point of failure will fail and a crisis will ensue.

Second, it only works in theory. There is zero reason to expect it to work in practice.  Why?  For starters, let’s look at who has been given the lead responsibility for macro-prudential regulation:  the central banks.  Who works at central banks?  PhD Economists.  Wait a second, weren’t the central bank PhD Economists the very ones who dismissed the warning about subprime mortgages at a Jackson Hole conference?  Yes they were.

As much as I hate to admit it, I admire the chutzpah of the individuals who failed to see the crisis coming saying their brilliant idea for preventing the next financial crisis is to leave it to them to identify and defuse financial risks that might cause another crisis.  Then, these same individual will say it is impossible to prevent all financial crises.  So don’t blame them if macro-prudential regulation doesn’t work.

So the best idea the Economics profession has to prevent another financial crisis is an idea they admit is unlikely to prevent a financial crisis.  This clearly supports a “yes” answer to the question “has Economics failed”.

I can hear the protests from the Economics profession this is unfair criticism (actually, they prefer to treat their critics and their criticisms with disdain) and they have learned from the Great Financial Crisis.  Really?

Ann Pettifor has a nice summary of the most basic concept the Economics profession cannot explain.

While there is surely much to admire in this work, none of it rises to the challenge of explaining the systemic nature of the economy: an economy that has evolved into a system of globalised markets in finance, property and labour – beyond the reach of regulatory democracy.  A system that is clearly fragile, that collapsed just ten years ago, that continues to cause living standards to fall in the UK and elsewhere, and that many fear may collapse again. This globalised system, these markets, did not make themselves. They are not the products of the ‘invisible hand’. They are the outcome of established economic theory and policies, taught in all our universities, and adopted wholesale by governments and international institutions like the IMF and World Bank.

But while the theory is faithfully taught, and policies implemented, the economics profession collectively still fails to understand the operation of the system – or so it seems to both outsiders and insiders….

Given the catastrophic nature of both the 2007-9 crisis, and the many, and increasingly frequent crises that preceded it– society demands to know why economists have not “discovered how the economy really works”.

Regular readers of this blog know I can easily explain the design and operation of the global financial system with a physical model of securities consisting of a plastic bag and a paper bag.  These bags illustrate the concepts of transparency and opacity and how transparency is necessary to assess and value the contents of a bag (security/investment).  With these concepts, we generate the 4 quadrants in the Information Matrix.

Information Matrix

We can then ask if you were designing a financial system which quadrant of the Information Matrix would you want transactions to occur in.  The only quadrant the Economics profession has shown that delivers positive results is the Perfect Information quadrant.  Not surprisingly, the design of our financial system attempts to make transactions occur in the Perfect Information quadrant.

Unfortunately, transactions occur in the Blind Betting quadrant.  And it is from this quadrant financial crises emerge.

Wow!  Look how easy it is for someone who isn’t a PhD Economist to explain the operation of the financial system and the source of systemic risk which generates financial crises.