Slaves of Defunct Economists

Daniel Gross writes articles for Slate magazine and has just published a book Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation that discusses the financial crisis. The following material from his book was published on Slate. I've pulled out the best bits, but you should read the whole thing. There's lots more detail there:

Which profession bears more blame for the global credit meltdown and its ensuing gazillion-dollar bailouts: bankers or economists?

This isn't a trick question.

So far, bankers have been getting most of the opprobrium. Yes, there are a few solid bankers who didn't destroy their firms. But pretty much all the prominent bankers failed. And their failures are writ large on the pages of the Wall Street Journal every day. They've been hauled before Congress, been deposed and fired, lost vast fortunes, and been the targets of populist rage. By common consensus, bankers (and by this I mean the term as it's used in the tri-state metro area: to describe anybody who works at a relatively high level in the financial services industry) blew it.

But they couldn't have created the Dumb Money debacle without a substantial assist from economists. Toiling in government and academia, at trade groups and Wall Street firms, practitioners of the dismal science provided the intellectual ballast and justification for much of the insanity of this past decade. At every step of the way, as an Era of Cheap Money devolved into an Era of Dumb Money and then into an Era of Dumber Money, Ph.D.s led the cheers. And when things started to go bad, they failed to grasp just how bad things would get. ...

In February, I recounted some of the economists' most egregious errors. Alan Greenspan, chairman of the Federal Reserve System, was easily the most influential economist of the last quarter-century. His intellectual virtues were many. So, it turns out, were his intellectual sins. Greenspan spent his career evangelizing for the Holy Trinity of low interest rates, deregulated markets, and the ability of financial innovation to insulate markets from calamities. Oops! The persistence of low interest rates sparked a speculative orgy in securities and derivatives. The tools that were supposed to help people manage risk instead created systemic risk. And deregulated, free, and open markets blew up so badly they required massive government interventions. The disaster was a feature of the financial operating code Greenspan had helped write, not a bug. (Bonus Greenspan screw-up: telling borrowers in February 2004 that adjustable-rate mortgages could help people save money—just as he was about to start boosting short-term rates.) ...

While the performance of many prominent economists during the boom was poor, their performance after it ended may have been worse. As a class—again, with significant exceptions—they failed to recognize that the fall of housing, which started in the summer of 2006, would have negative effects on the economy ("The worst may be over for housing," Greenspan declared on Oct. 9, 2006) and on the financial system. In November 2007, Bernanke estimated the losses stemming from subprime as being "in the ballpark" of $150 billion. (Must have been a really big ballpark.) Neither of the nation's chief economists, despite spending their days poring over economic data and meeting with professional economists inside and outside the Fed, seemed to have a clue that the virus of bad lending had spread far beyond subprime and far beyond housing and far beyond America's borders.

Economic forecasting is hard. But the dismal scientists collectively did a horrific job of prognostication as the economy shifted into recession and then plummeted into a sharp contraction. The recession, we now know, started in December 2007. The Blue Chip forecasters surveyed by the Philadelphia Fed in the fourth quarter of 2007, when the recession was about to start, projected the economy would grow by 2.5 percent in 2008 and the economy would add more than 100,000 jobs each month in 2008. (Instead, the economy lost jobs every month in 2008 and ground to a halt.) In the middle of the fourth quarter of 2008, one in which the economy was shrinking at a 6.3 percent annual rate, they took down their forecast for the quarter from 0.7 percent growth to a decline at a 2.9 percent annual rate. They projected the unemployment rate would be 7 percent in the first quarter of 2009. By March 2009, it was up to 8.5 percent.

Clearly, economic forecasters weren't asking the right questions, or looking at the right indicators. ...

So, back to our original question. Bankers or economists?

Bankers have clearly suffered more financial damage—they had a lot more to lose. But when it comes to reputation, I think it's a draw. One similarity between the two professions' reactions to the meltdown is that it doesn't seem to have occasioned much self-examination. The best Greenspan could muster was that he had "found a flaw" in his theories.

This all goes to show that Keynes was right when he said:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”