Fundamental Flaws in Economic Thinking and Practice

[After a 6-month break I have returned to working on The Nature of the Beast. A new version of Chapters 1-4 is available for download and comment – use the links at the top. More will follow soon. To whet your appetite, here is a sample, from the Introduction.]

The Global Financial Crisis, also known as the Great Recession, is the biggest economic malfunction since the Great Depression. You might think that those in charge when it happened, and those who designed the economic system within which it occurred, would have been chastened and purged, to be replaced by those who saw the crash coming and those who warned that the design of the economic system was prone to such failures.

However few of those responsible have been purged, and few seem to have felt chastened. Rather, they claim that no-one could have seen the crash coming. If that were true, what exactly has the economics profession been doing for the past eighty years? Everyone knows there was a Great Depression. Would it not be a top priority to figure out how it happened, so we might see the next one coming, or better still avoid the conditions that would trigger a depression? One might think so, but that is not how the great bulk of the profession has spent the past eighty years.

The result is they didn’t see the GFC coming, and the reason they didn’t see it coming was they were looking in the wrong place.  They were like the drunk looking for his car keys under the street light.  He knows he dropped them out in the dark, but he thinks there’s no point in looking where it’s dark, so he looks under the light.  However a few economists did venture away from the street light.  They carried a torch of curiosity.  They even located the keys.  But no-one would listen.

To those who were looking in the wrong place the Global Financial Crisis (GFC) is indeed inexplicable.  It may as well have been an act of the gods, or an act of nature, and their language implies as much. Indeed their language has long implied that the boom and bust of the so-called “business cycle”, of which the GFC was an extreme swing, is just part of the natural order of things.  However the GFC was not the result of some external calamity, like a tsunami, that disrupted the economic system.  The GFC was an internal malfunction of the economic system.  We should look within the economic system for the cause.

The cause of the GFC is not hard to locate, nor to describe.  So much debt was accumulated that it could not be paid back.  When some people started defaulting on their debt a chain reaction was triggered in which the more some people defaulted the more others could not pay their debts, so they defaulted, and so on.  The economy had boomed as long as more money was being borrowed and spent.  Then, when many people lost their money, and others were forced to pay down their debt rather than buy more stuff, the economy crashed.

There are different ways in which excessive debt can accumulate.  The particular way it happened in the United States was that mortgage loans were given to people who could not possibly repay them.  These were called “subprime” mortgages.  The logic used was that house prices always rise, so soon the house would be worth more than the loan plus any interest due.  It could be sold at a profit.  Even if a person failed to make repayments on the mortgage, the bank could sell the house and take the profit itself.  The fault in that logic was that there is no law of the universe that house prices should always rise.  Worse, the practice itself caused house prices to fall.

Subprime mortgages were given to so many people who could not even pay the interest, including people who had no job, that many did default.  The banks moved to sell those houses, but there were then so many houses on the market that prices levelled, and then started to fall.  Once prices started to fall the whole scheme fell apart, because there was no profit for anyone.  In the US, if you can’t repay your mortgage you can just return the keys to the bank and walk away.  The bank incurs the loss.  Prices went into free fall and bank losses mounted dramatically.  Many legitimate borrowers, just trying to buy their family home, found they were “under water”:   their homes were worth less than their mortgage.  Many of those lost their jobs as the economy suddenly slowed, then they lost their homes as well.

The story was complicated and aggravated by the clever “instruments” invented by the financial markets to magnify the scam.  Subprime mortgages were packaged into bundles, then mixed with regular mortgages in ways that were supposed to reduce or eliminate the risks from defaults.  The resulting packages were then sold to other “investors” (read gamblers and speculators) who had no way of knowing exactly what was in the packages, because the bundling was done by complex computer programs.  This disconnected the mortgage pushers from the consequences of their actions.  In other words they off-loaded the risk.  This is a fundamental breakdown of market mechanisms.

The financial industry invented many other clever instruments with funny names and acronyms.  A prominent one was the credit-default swap (CDS).  Basically, someone figured out you could insure an investment against potential loss and thereby eliminate any risk:  you would be guaranteed a profit.  This was hailed as a great advance for civilisation.  The only catch was you had to find an insurance company (or someone) that would insure your investment.  While this practice was new and uncommon, some convinced themselves the risk was reasonable.  Unfortunately the practice spread rapidly (why wouldn’t it, it was virtually free money) until it distorted the market and the risks were much bigger than predicted by the clever formulas underlying the CDSs.

If the practice sounds dubious, it is.  It was realised by a few that risk was not being reduced, it was merely being spread around and diluted.  It could thus grow much bigger than it would have if a few smaller companies had failed and revealed the falsity of the arguments.  Rather the risk grew until it was big enough to bring down the biggest operators, and the whole financial system.  That is why a trillion dollars or so of taxpayers  money was handed to Wall Street bankers, who recovered and have gone on to make even bigger profits.

The essence of all these fancy schemes is that they were  pyramid schemes.  One of the few financiers who was jailed for fraud was Bernie Madoff.  He was silly enough to run a naked pyramid scheme.  He persuaded people to invest in his scheme, promising big payouts.  He didn’t actually make much money.  Instead he used new “investments” to make handsome payouts to previous investors.  You can sustain this practice for as long as the number of investors is increasing.  However when you can’t recruit investors fast enough, the scheme collapses and everyone still in it loses their money.  Pyramid schemes have long been recognised as fraudulent, and are illegal in most places.  Another famous practitioner was Charles Ponzi, who operated in the 1920s, and such schemes are also known as Ponzi schemes.

The subprime mortgage scheme and its associated complex financial instruments amount to a Ponzi scheme.  It depended on rising housing prices, which depended on more and more mortgage loans being granted.  However once the supply of mortgagees slowed the scheme collapsed and those caught by it lost money.  No prosecutions for fraud have taken place.  One can think of several reasons why this might be:  the scheme involved complex instruments whose precise functioning is hard to pinpoint, a very large number of people was involved, and many of those people are in government, or sponsor government, and don’t want any prosecutions.

If such practices are known to involve high risk, and perhaps to be fraudulent, why were they allowed to continue?  Where were the economic managers?  Where were the academic economists?  Many of the economic managers are drawn from financial market players, on the grounds that they understand how the financial markets work.  Unfortunately such people usually share the collective delusion that financial markets are  self-correcting and serving an important and positive role in the economy.  Academic economists, one might think, would be more disinterested, but there seems to have been a century-long selection in the field for those who think the rich and powerful automatically serve an important and positive role in society.  Courtiers usually find their necks are safer if they flatter the King rather than contradicting him.

So we return to the economic system, and the question of how it works.  The GFC is an example of a dramatic malfunction of our present economic system, and the preceding account gives a taste of how self-interest, denial, wilful blindness and delusion have been involved in one dramatic economic episode.  There are many aspects of the present economic system and its management that are foolish, simplistic, deluded and distorted by self interest.  This claim might sound a little hyperbolic, but I will present a long series of follies for your edification, and you can judge for yourself.  Nor am I alone in making such claims, though dissenting voices are generally marginalised and not easy to hear.  However most other dissenters do not attempt such a fundamental and comprehensive reckoning as I present here.

There are in fact so many things wrong with how the economy is perceived and managed that one could start in many places.  For example the way economic accounting is done amounts to entering all transactions on the credit side of the ledger, whether they are an income or a cost, adding them up and claiming that a bigger total means we are better off.  Or one can examine the performance of the past few decades (prior to the GFC) which was mediocre at best, though that is probably not the message you have heard from politicians and the media.  The way banks are run and money is supplied to the economy maximises debt, promotes instability, pumps money to the already-wealthy and fosters parasitic speculation.  Despite this, the elaborate economic computer models used to justify economic policies do not include money or debt in their calculations.  Is it any wonder they didn’t foretell the GFC?  However a central feature of the past several decades has been the ascendancy of the idea of free markets, and this idea depends on a series of assumptions about the world that amply illustrate my claims of folly and delusion.

Mainstream economists think the economy is like a pendulum, always tending to swing back to the centre line, never getting too far to the side.  If something knocks the pendulum it may swing wider, but it will soon settle back towards the centre, the equilibrium point.  Free-market economists have a theory that says the economy always tends to settle towards a general equilibrium in which all supplies balance all demands.  The general equilibrium is their nirvana, a blessed state in which the economy functions at its greatest conceivable efficiency.  This nirvana occurs in a highly idealised theoretical world.  The question is whether this ideal world bears any useful resemblance to the real world.

If the general equilibrium theory described the real economy then the only time the economy would suddenly change would be when something external disturbed it, like a natural disaster or a war.  However the economy has repeatedly changed suddenly when nothing in particular was happening in the real world.  In 1987 stock prices dropped 30-40 per cent in one day, though 30 per cent of the world’s factories had not been bombed overnight.  In 1997 there was the Asian currency meltdown, during which a global financial freeze-up was narrowly averted.  Earlier this century we had the bursting of the Japanese property bubble and the American dot-com bubble.  These events straightforwardly demonstrate that economies have often been far from equilibrium.  It is not hard to argue, as will be done in this book, that modern economies are always far from equilibrium.  In that case the mainstream theory has nothing useful to say about how economies behave.  It is an irrelevant abstraction.  Furthermore, we can expect the behaviour of a far-from-equilibrium economy to be radically different from that predicted by the mainstream theory.

5 thoughts on “Fundamental Flaws in Economic Thinking and Practice

  1. Kevin Cox

    This is a great read. Looking forward to the next chapter.

    One of the interesting ideas about economies of scale that “kills off” monopolies is the following.

    We know that large organisations that have been producing the same thing for a long time have great difficulty in doing things differently. They tend to continue to do the same thing and because they have produced so much previously their rate of improvement is small.

    If a new organisation comes in and starts where the old organisation left off and is still able to do things as efficiently as the old organisation then the new organisation can make more rapid improvements than the old because its doubling of output can happen quite quickly. We find this happens a lot and this is described in the “Innovators Dilemma”.

    I don’t think it is economies of scale that cause monopolies so much as difficulty of change of ongoing customers. In the case of Microsoft it costs too much to change an organisation from using Microsoft Word to a less expensive, better and even free open source word processor. This means that people tend to stay with Microsoft.

    If the cost of change is high then we tend to get monopolies but if the cost of change is low then it is difficult for monopolies to arise.


  2. Geoff Davies Post author

    Yes, there’s a phenomenon called “lock-in” whereby it is hard to change the way something is done once it becomes established. The clumsy keyboard we use was designed to slow typists so the machines of the day would not jam. The is even an alternative, efficient layout called Dvorak, but nobody uses it. This was highlighted by Brian Arthur, as reported in the book Complexity, by Mitchell Waldrop.

    There are actually quite a few mechanisms that promote economies of scale.


  3. Pingback: The Durban Roadmap to Extreme Climate Danger | Better Nature: commentary by Geoff Davies

  4. Manuel Angeles

    I´ve just written a piece on the Third Crisis in Economic Theory, a bit of a take off on Joan Robinson´s 1971 AEA lecture. Your thoughts on “equilibrium” bring her to mind. Cheers!



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