Does Wall Street Fuel The Economy Or Drain It?

In his recent New Yorker article, reporter John Cassidy asks "What Good is Wall Street?" Cassidy writes that Wall Street once helped build up new industries, by providing the capital they needed to grow and prosper. But these days, Cassidy says, it's only investment banks that are prospering. Cassidy is the author of "How Markets Fail: The Logic of Economic Calamities," excerpted below.

By John Cassidy

During the first three months of 2010, realtors in the Hamptons—the upscale summer retreat on the eastern end of Long Island— noticed an encouraging development. Properties that had been on the market for many months, or years, were starting to sell, particularly the most expensive houses and estates. Twenty-eight such properties changed hands for at least $5 million each, compared to seven in the same quarter of 2009. “It’s as active in the Hamptons as I’ve ever seen,” Alan Schnurman, a local real estate investor, told the Associated Press. What motivated this burst of activity? January and February is bonus season on Wall Street, which had just enjoyed the most profit- able year in its history. The New York–based securities industry, after posting total losses of $42.6 billion in 2008, generated $55 billion in profits in 2009, smashing the previous record, and it paid out $20.3 billion in bonuses. As winter gave way to spring, the Wall Street gusher continued to spew money. Between January and March 2010, Citi- group’s investment banking division made more than $2.5 billion in profits. Goldman Sachs’s traders enjoyed their best quarter ever, generating an astonishing $7.4 billion in net revenues.

Barely a year and a half after the collapse of Lehman Brothers, Wall Street was once again doing well for itself—obscenely well, it seemed to many people who weren’t attending open houses in Southampton and East Hampton. “[F]or most Americans these huge bonuses are a bitter pill and hard to comprehend,” noted Thomas P. DiNapoli, the comptroller of New York State, whose office tracks Wall Street profits. “Tax-payers bailed them out, and now they’re back making money while many New York families are struggling to make ends meet.” In other parts of the country, Americans weren’t merely resentful; they were practically ready to lynch the Wall Street bonus recipients, and the politicians who had rescued them. “Hank, Americans don’t like bailouts,” Sarah Palin, John McCain’s running mate, had warned Treasury Secretary Henry Paulson in October 2008. By the summer of 2010, riding a populist revolt, the former governor of Alaska had emerged as the front-runner for the G.O.P. presidential nomination in 2012.

And yet, judged purely in economic terms, the Bush-Obama rescue program had proved fairly successful. Beginning in July 2009, U.S. GDP had expanded for four consecutive quarters, confirming the predictions of recovery that Timothy Geithner and Ben Bernanke had made. The rate of growth was modest rather than spectacular—about 3 percent on an annualized basis—but it belied the doomsters’ prognostications. The Great Recession, as it was now known, had ended more quickly than expected. In May 2010, the Organization for Economic Co-operation and Development, an economic research body based in Paris, said the world economy would grow by 4.6 percent for 2010 and 4.5 percent for 2011. Despite widespread fears of a “double dip” recession, the global recovery appeared to be continuing.

Aside from allowing Lehman to collapse, policymakers had avoided the mistakes of the 1930s. By injecting taxpayers’ money into struggling financial institutions and guaranteeing their debts, they had arrested the vicious cycle of falling asset prices, panic selling, and further falls in prices. By reducing short-term interest rates virtually to zero, they had halted a similar downward spiral in the real estate market. (With the cost of mortgage loans at historic lows, bargain seekers entered the market, putting something of a floor under prices.) And by introducing tax cuts and additional public spending programs, governments had counteracted the economy-wide vicious cycle in which tumbling demand for goods and services prompted firms to reduce their work forces, unemployment rose, and demand slipped further.

The authorities in Washington and elsewhere had demonstrated that Keynes had been right: economies suffering from a speculative bust didn’t have to be left to nature’s cure or, more accurately, to the markets’ cure, which Andrew Mellon, Herbert Hoover’s Treasury Secretary, famously described as “liquidate, liquidate, liquidate.” But while the aggressive use of fiscal and monetary policy could be labeled “Keynesian,” other elements of the rescue program didn’t fit neatly into any paradigm. The Fed’s innovative liquidity programs harked back to Walter Bagehot’s edict that central banks should lend freely in a crisis, while its resort to buying up Treasury bonds and mortgage securities—so-called quantitative easing—was akin to the “helicopter drop” of cash that Milton Fried- man had advocated as a cure for deflation. The bank bailouts and other less-visible subsidies to the financial sector weren’t associated with any particular economic creed: they were emergency measures that had been adopted reluctantly. Rather than relying on a particular theory of the crisis or a single policy tool, policymakers had adopted a flexible and pragmatic approach, trying a number of things together and adjusting the mix as they went along. “You can’t point to one thing alone: there were three or four things,” Nariman Behravesh, chief economist at IHS Global In- sight, a leading economics consulting firm, said to me early in 2010. “Look, U.S. policymakers pulled out all the stops, and it worked.”

Only on Wall Street was the recovery palpable, however. Elsewhere, there was a stark contrast between public sentiment and the optimistic statements of policymakers and economists. In July 2010, 9.5 percent of the U.S. workforce was still out of work, and that didn’t include more than eleven million people who had stopped looking for jobs or who had been forced to accept part-time employment. Taking account of these folks, the March 2010 rate of “underemployment’’ was 16.5 percent—about one in six. Even for those fortunate enough to be in work, worries remained. Many households were saddled with mortgages bigger than the value of their homes. In Miami, real estate prices were about 50 percent below their 2006 peak; in Las Vegas, they were down 55 percent; nationwide, the decline was about 30 percent. Rather than going out and spending, many households and firms were hoarding cash and rebuilding their savings. In the second quarter of 2010, the annualized growth rate of U.S. GDP fell back to 1.6 percent, raising more fears of a return to recession.

Across the Atlantic, meanwhile, the financial crisis had never really gone away. In the fifteen-country Euro bloc, GDP fell 4.2 percent in 2009, compared to a decline of 2.4 percent in the United States. Modest growth returned during the first quarter of 2010, but another blowup in the markets quickly overshadowed it. As the recession had deepened, many countries, the United States included, had run up huge budget deficits, which were starting to spook investors in government bonds. In early May, the European Union, together with the International Monetary Fund, finalized a Euros 110 billion (about $140 billion) lending package for Greece, where government spending exceeded tax revenues by about 13 percent of GDP. Far from calming the markets, the Greek bailout created fears of similar problems emerging in Spain, Portugal, and other heavily indebted European countries. With speculators continuing to short the Euro, the EU hastily created a Euro 750 billion stabilization fund, which could be used to aid other member governments that ran into difficulties funding their operations.

If this was a recovery, it was a fragile and embittered one. While the authorities’ response to the crisis had prevented a wholesale economic collapse, it had failed the political test of winning popular support—something Timothy Geithner freely admitted. “My basic view is that we did a pretty successful job of putting out a severe financial crisis and avoiding a Great Depression or Great Deflation type of thing,” the Treasury Secretary told me in early 2010. “We saved the economy, but we kind of lost the public doing it.”

Given the nature of the policies that the Bush and Obama administrations had adopted, public anger was inevitable. By the end of 2009, almost all the big banks had repaid their TARP bailouts, but they continued to be the recipients of official largesse. With the Fed holding short-term interest rates at virtually zero, firms like Citigroup and Goldman Sachs could borrow money from one arm of the government (the Fed) or from investors (by issuing short-term commercial paper) for next to nothing and lend it to another arm of government (the Treasury) at an interest rate of 3 or 4 percent. By playing “the spread,” any moderately competent Wall Street trader could generate large returns for his desk and a big bonus for himself without actually doing what banks are supposed to do: furnishing money to firms and funding capital investments. While bank profits were soaring, many businesses and individuals were still finding loans hard to come by.

The other losers in this game were those who had cash stashed in a savings account or money market mutual fund. “What we have right now is a situation where every saver in the country is, essentially, paying a huge tax to bail out the banking system,” noted Raghuram Rajan, the University of Chicago economist, who, back in 2005, had issued a fateful warning about the dangers of a financial blowup. “We are all getting screwed on our money market accounts—getting 0.25 percent—and the banks are making a huge spread on nearly every asset they hold, because they are financing them at pretty close to zero rates.”

The Obama administration didn’t come out and say so, but enabling the banks to make big profits was one of its policy objectives. Rather than seizing control of sickly institutions, such as Citi and Bank of America, it had settled on a policy of allowing them to earn their way back to sound health, while also encouraging them to raise money from private investors. This was the rationale behind the controversial “stress tests,” which the Treasury Department and the Fed carried out in the spring of 2009, and which were meant to find out how much new capital the banks needed to survive a deep recession. In May 2009, when Geithner announced that the nineteen biggest U.S. banks needed to raise just $75 billion, many economists had accused him of understating the banks’ remaining exposure to toxic assets. In fact, the official loss estimates were similar to those produced by independent analysts. But the government stress testers were assuming that other parts of the banks’ businesses, particularly their trading operations, would record greatly enlarged profits in 2009 and 2010, which would help them withstand big losses in real estate and commercial lending. Buried in the Treasury’s official report on the stress tests was the prediction that Citigroup’s net revenues in 2009 and 2010 would exceed its loan-loss provisions by $49 billion. For Bank of America, the projected profit figure was $75.5 billion. For Wells Fargo, it was $60 billion.

When these enormous profits duly materialized and the banks distributed some of them to their employees, the public was outraged. Critics accused the Obama administration of overlooking less offensive options for stabilizing the financial system. One idea, widely canvassed in early 2009, would have been to seize control of troubled firms, move their tarnished assets into a state-run “bad bank,” and eventually refloat them on the stock market as smaller, healthier institutions. Twenty years previously, during the savings and loans crisis, this approach had been adopted successfully. Theoretically, it would have enabled the government to fire reckless bank managers, wipe out bank shareholders, and impose a “haircut” on bank creditors, thereby punishing the guilty rather than rewarding them with a bailout. “While the Obama administration had avoided the conservatorship route, what it did was far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses,” the Nobel-winning economist Joseph Stiglitz wrote in his 2010 book, Freefall:America, Free Markets, and the Sinking of the World Economy.

Members of the administration countered that its critics had greatly underestimated the practical difficulty of pursuing the nationalization option. If the government had seized Citi, one senior Treasury official told me, it could well have created creditor “runs” at other banks suspected of being on the government target list. The only way to prevent this from happening, the official said, would have been to spend $3 trillion and take over all the big banks. That figure may be an exaggeration, but the fear of sparking another financial crisis was a real one, and so were the political concerns of the White House and the Treasury Department. Neither President Obama nor Geithner had any appetite for a policy option that smacked of radicalism and big government.

In economic terms, the most serious problem with the rescue programs was not that they further enriched the loathed bankers but that they exacerbated some serious incentive problems at the heart of the financial system. By extending trillions of dollars in loans, capital injections, and debt guarantees to troubled firms, the U.S. government and its counterparts overseas had greatly extended the public safety net for banks and other financial entities. Left unchecked, this expansion will surely lead to more blowups, followed by even bigger bailouts.

The problem is one of rational irrationality. Once people in the financial sector come to believe the government will cap their losses, they have an incentive to step up their risk-taking. Simply announcing that there won’t be any more bailouts won’t solve the problem—a point noted by two Bank of England economists in an important paper published in November 2009. “Ex ante, they”—policymakers—“may well say ‘never again’ ” wrote Andrew Haldane and Piergiorgio Allesandri,

“But the ex post facto cost of a crisis means such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of ‘never again’ announce-
ments. This is a doom loop.”

The Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Obama signed in July 2010, while containing many worthwhile individual measures, didn’t really get to grips with this problem. I stand with the judgment of the previous chapter that, taken overall, the reform effort amounts to “tinkering with the existing system rather than fundamentally reforming it.” Any comparison with FDR’s regulatory response to the Great Depression is specious. By the end of Roosevelt’s first term, the financial system had been transformed. The House of Morgan and other big banks had been split up into their investment banking and commercial banking components; through the newly founded SEC, the government was exercising close supervision of Wall Street; through the Reconstruction Finance Corporation, which had acquired and kept equity stakes in many big financial firms, it was forcing reluctant bankers to extend credit; and through the Justice Department, it was prosecuting a number of prominent financiers. At the end of 2010, there are fewer independent Wall Street firms than there were a few years ago, and the survivors have a bit less freedom to maneuver than they used to have. Overall, though, the financial system looks pretty much the same as it did in 2007.

Overseas, the same is true. For all their attacks on American free market dogmatism, European and Asian governments have shown little inclination to clean up their own financial systems. The big European countries, in particular, which have a lot of big universal banks, lobbied strenuously against any attempt to break them up. On the torturous issue of bank capital requirements something similar happened. Under the auspices of the Bank for International Settlements, in Basel, Switzerland, negotiators from dozens of countries spent many months discussing a new set of international banking regulations. When the talks began, there was talk of forcing banks to build up excess reserves of capital during periods of prosperity and of imposing a surcharge on the very biggest ones. But in September 2010, when the new capital standards were announced, they were so modest that many big banks, having replenished their coffers, already satisfied them.

Here in the United States, after all the mergers that the government had orchestrated during the crisis, six huge firms—Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo—now dominate the financial industry, wielding enormous market power and political influence. (Together, their assets come to about 60 percent of GDP.) The ratings agencies remain unreformed, and so do the myopic compensation packages for Wall Street traders and CEOs that helped bring on the crisis. The one really innovative idea that the administration put forward—imposing a hefty “pollution tax” on the risk-taking of financial institutions—didn’t feature in the Dodd-Frank reform bill and has faded from view.

After all that had happened, forcing financial institutions to maintain more capital, shifting derivatives trading onto exchanges, and setting up a new agency to protect consumers from predatory lenders were the least that could have been done. And even in those areas, the Dodd-Frank bill contained a number of sops to the financial lobby. The big U.S. banks still don’t face any hard caps on leverage; neither do their international competitors, such as Barclays, Deutsche, and UBS. A significant but undetermined amount of derivatives trading is exempt from the new regulations, and the issuance and trading of naked credit default swaps—bets that a certain company or country will go bankrupt—remains perfectly legal. The new consumer protection bureau, rather than operating as a stand-alone body, in the manner of the Food and Drug Administration and the Environmental Protection Agency, is housed inside the Fed, an institution that failed abjectly in overseeing the mortgage market. (Confirming the old adage that nothing succeeds like failure, the Fed was also given new power to act as a “systemic risk regulator,” overseeing the activities of the biggest banks.)

During the debate on Capitol Hill, it is true, some steps were taken to toughen up the reform bill, notably the inclusion of the so-called Volcker Rule, which prohibits banks from proprietary trading and places limits on how much money they can invest in hedge funds and private equity funds. When this directive is enforced, it may prompt Goldman and Morgan Stanley to give up the commercial banking licenses they acquired in 2008 and revert to being investment banks. Bank of America, Citi, JPMorgan, and Wells, which are much more invested in commercial lending, will have to scale back their proprietary trading desks. (Citi has already done so.)

But former Fed chairman Paul Volcker’s laudable idea, which the White House adopted at the start of 2010, was that non-depository institutions shouldn’t be allowed to shelter under the government safety net, and, legally, at least, they won’t be able to. The U.S. government now has the legal power, during a crisis, to take them over and close them down. (In the cases of Bear Stearns and Lehman Brothers, this authority was lacking.) However, it is one thing to empower the Treasury and the Federal Deposit Insurance Corporation to fire senior bankers, wipe out stockholders, and impose losses on creditors. It is quite another thing for the authorities to exercise these powers. If Goldman, say, was to run into serious trouble shortly after giving up its banking license, it is hard to believe that the Treasury and Fed would shut it down and let the dominoes fall where they may. With the markets plummeting, and with creditors, depositors, and other counter-parties rushing to liquidate their positions, the authorities would come under enormous pressure to prop up the firm, or find a healthier rival to take it over. Then we would be back to September 2008.

Despite the best intentions of Volcker and others, the big six banks and an undetermined number of other financial firms are almost certainly still too big to fail. Taxpayer rescues of systemically important institutions can’t be legislated away: the real issue is what can be done to reduce their likelihood. Apart from regulating individual lines of business that involve big risks, a tricky enterprise at the best of times, the options are greatly reducing the leverage that banks can take on or breaking them up, so the failure of any one of them would no longer pose an insurmountable risk to the system. Neither of these ideas is exactly revolutionary. Practically everybody agrees that excessive leverage played a key role in the crisis, and the idea of splitting up the largest banks has won the support not just of progressive economists but of the British Conservative Party, which formed a coalition government in May 2010, of Mervyn King, the governor of the Bank of England, and even of Alan Greenspan, the former Fed chairman. “If the banks are too big to fail, they are too big,” Greenspan said in October 2009, and he went on to say, “In 1911, we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole. Maybe that’s what we need.”

But far from insisting on smaller banks and drastic reductions in leverage and smaller banks, the Obama administration connived against measures designed to bring these things about. Senator Susan Collins, of Maine, and Senator Blanche Lincoln, of Arkansas, both proposed amendments that would have forced the biggest banks to hold substantially more capital—and real capital, not hybrid securities that are more like subordinated debt. After the Senate passed the Collins and Lincoln amendments, the White House and Treasury pushed Congress to drop them from the final legislation. A move to break up the biggest banks, such as Wells Fargo and Bank of America, which was sponsored by Senator Ted Kaufman, of Delaware, and Senator Sherrod Brown, of Ohio, didn’t even get that far. The Democratic leadership in the Senate joined with Republicans to kill the amendment, which was voted down 61–33. “If we’d been for it, it probably would have passed,” a senior Treasury official told New York magazine. “But we weren’t, so it didn’t.”

The doom loop cannot be wished away, and neither, despite the best efforts of some Chicago stalwarts, can the failures of utopian econom- ics. When, toward the end of 2009, I was reporting a story for The New Yorker about the Chicago School’s reaction to the economic crisis, Robert Lucas, the proponent of the rational expectations hypothesis, refused to be interviewed. (“Bob looks like a refugee from Verdun,” one of his colleagues said.) Eugene Fama, the expounder of the efficient markets hypothesis, told me that his pet theory “did quite well in this episode.” Contesting the standard account that the financial markets spun out of control bringing the rest of the economy down with them, Fama argued that the markets were casualties of the recession rather than its instigator. He said the economic slowdown predated the collapse of the U.S. mortgage market. As job and income growth slowed, some homeowners couldn’t make their monthly payments, especially subprime borrowers. The credit markets, acting as a rational discounting mechanism, repriced subprime mortgage securities at lower levels, and banks that had invested heavily in them suffered big losses, which prompted them to cut back their lending. “As a consequence, we had a so-called credit crisis,” Fama said. “It wasn’t really a credit crisis: it was an economic crisis.” But if the subprime blowup didn’t cause the recession, what did? “That’s where economics has always broken down,” Fama said with a chuckle. “We don’t know what causes recessions. Now, I’m not a macro-economist, and I don’t feel badly about that.”

Ingenuity and denial often go hand in hand. Appearing at the annual meeting of the American Economic Association, Ben Bernanke defended the Fed’s reluctance to raise interest rates during the housing boom, saying that financial innovation and lax supervision rather than cheap money was responsible for creating the bubble. This sounded suspiciously like a rationalization of Greenspan’s argument that policy-makers ought to leave the financial markets to their own devices (except, of course, after a crash, when the policymakers should slash interest rates). However, Bernanke did add that policymakers must remain open to raising interest rates to head off future bubbles—a clear departure from Greenspan and another sign that pragmatism had replaced wishful thinking as the ruling ideology in Foggy Bottom.

At the International Monetary Fund, another bastion of economic orthodoxy, things were changing too. In a paper entitled “Rethinking Macroeconomic Policy,” Olivier Blanchard, the IMF’s chief economist, and two of his colleagues, conceded that policymakers had put too much emphasis on low inflation and not enough on financial stability, arguing that the latter should be made an explicit policy goal. Furthermore, central banks should consider raising their inflation targets—from 2 to 4 percent, say—so they would have more room to cut interest rates in a recession. As doubts persisted about the global economic recovery, the IMF also backed away from its traditional insistence on balanced budgets. In early 2010, its director general, Dominique Strauss-Kahn, argued that, for the time being, governments should maintain their Keynesian stimulus programs rather than trying to spend and raise taxes.

Even in the academic world, where, as Paul Samuelson famously quipped, progress normally proceeds funeral by funeral, there was a brief outbreak of self-analysis. At the same meeting of economists where Bernanke spoke, a panel of eminent scholars addressed the question “How Should the Financial Crisis Change How We Teach Economics?” Harvard’s Benjamin Friedman implicitly took issue with his colleague Greg Mankiw’s view that economists should continue to emphasize the pre-crisis orthodoxy, noting, “[M]any in our profession seem to like to write and teach, not about the world in which we live, but about the world in which they wish that we lived.” During my visit to Chicago, Gary Becker, the most eminent living member of the Chicago School, conceded to me that financial markets weren’t fully efficient and that certain ideas associated with Chicago, particularly the rational expectations hypothesis, hadn’t fared well. Judge Richard Posner, the conservative jurist, explained why he had recently converted to Keynesian thinking, saying more recent macro doctrines couldn’t explain the financial crisis or what needed to be done about it. “I think the challenge is to the economics profession as a whole, but to Chicago most of all,” Posner said. Even Eugene Fama conceded that the banking system needed tighter supervision to prevent future blowups and bailouts.

Utopian economics is on the defensive, just like it was in the 1930s, but it is too early to hail the triumph of reality-based economics. For one thing, the political environment is very different from the one that Roosevelt and Keynes operated in. During the Great Depression, many of the unemployed went hungry, and there was real desperation: it was widely accepted that free market dogma had failed and that the authorities should step in to put things right. Despite its global scope, the Great Recession doesn’t really compare with the Great Depression, and many ordinary people remain suspicious of government interventions to correct market failures. “I think you are not going to see a huge increase in the role of government in the economy: I’m more and more confident of that,” Gary Becker said. “Economists will be struggling to understand how this crisis happened and what you can do to head off another one in the future, but it will be nothing like the revolution in the role of government and in the thinking that dominated the economics profession for decades after the Great Depression.”

As if to confirm Becker’s point, the summer of 2010 saw a powerful reaction against Keynesian deficit spending. On both sides of the Atlantic, there were calls for an end to stimulus programs; in Germany and Britain, the center-right coalition governments of Angela Merkel and the newly elected David Cameron moved to cut public spending and raise taxes. Partly a reaction to the Greek debt crisis, this policy turnaround also reflected a revival of the “Treasury view” of the late 1920s and early 1930s, which saw the main threat to economic recovery not as a shortage of overall demand but as a dearth of confidence in the public finances on the part of businessmen and investors. With the triumph of the “General Theory,” this argument had seemingly been consigned to history, but here it was again, modified hardly at all, on the lips of conservatively minded economists, commentators, and policymakers. “Germany has never agreed to an austerity package to this extent, but these cuts have to be made in order for the country to establish a stable economic future,” Chancellor Merkel said in announcing the German budget cuts.

To be sure, budget deficits equal to ten percent of GDP or more, which some countries, such as the United States and Britain were running, couldn’t be sustained indefinitely. (Germany’s deficit was much smaller: less than five percent of GDP.) But the best way to bring down deficits is to get the economy going again, which leads to higher tax revenues and lower spending on unemployment benefits. Shifting to retrenchment during the early stages of a recovery smacked of the mistake that the second Roosevelt administration made in 1936–37, when, giving in to Wall Street orthodoxy, it slashed spending and raised taxes to balance the budget, only to see the U.S. economy plunge back into recession. The economists advising President Obama, fortunately, had no intention of repeating this policy error. In an article in the Financial Times, Lawrence Summers, the head of the National Economic Council, pointed out that reviving growth and reducing the deficit were complementary rather than competing objectives. “Reducing the spectre of prospective deficits will enhance near-term growth,” Summers wrote. “And ensuring adequate growth in the near term will reduce long-term deficits.” In September 2010, the U.S. administration proposed another round of tax cuts and infrastructure spending.

Without the original $787 billion stimulus program, the public finances and the overall economy would almost certainly have been even weaker. Persuading the public to take account of a counterfactual is far from easy, however, and opinion polls showed that most Americans agreed with conservative economists who said the stimulus program had failed. The economic arguments put forward against the stimulus, such as the claim that increases in government spending generate off- setting falls in private spending, were largely specious, but they jibed with the ordinary American’s feeling that many, if not most, tax dollars are wasted.

In the United States, at least, efforts to correct market failures often run into an entrenched skepticism about the efficacy of government actions. Another challenge facing reality-based economics more generally is that, unlike utopian economics, it isn’t a fully formed ideology. (Ben Friedman again: “Few ideas offer more appeal than a model that is simple, elegant, and wrong.”) Rather than supplying a single, all-encompassing way of thinking about the world, reality-based economics basically says that things are complicated, and no one theory can explain everything. Competitive markets sometimes work well; in other cases they send the wrong price signals. Financial-incentive schemes can elicit hard work and innovation; they can also encourage myopic, destructive behavior. Some economic events can be predicted with precision; others are impossible to forecast. Typically, various outcomes are possible and which one is selected depends on all sorts of things, including the past behavior of the system and participants’ (biased) expectations of the future. (This is the problem of “multiple equilibria.”)

In the language of chaos theory, the economy is a complex adaptive system. Of course, acknowledging the complexity of the economy only gets you so far; as economists, we want to know how the chaos gets resolved. Fortunately, reality-based economics provides some analytical concepts that have great explanatory power, such as negative externalities (Pigou), rational irrationality (Keynes), disaster myopia (Minsky), and the representative heuristic (Kahneman and Tversky). The challenge today is to develop these ideas, supplement them with new ones, and apply them to particular policy problems. As I hope I have made clear, some progress has already been made in this direction, and, as you read this book, economists unhappy with the ruling orthodoxy are busy applying game theory, principal-agents models, the mathematics of chaos, and new statistical techniques to deepen the insights of Keynes, Pigou, and Minsky.

Some of this research is taking place within established economics departments. Wealthy benefactors unhappy with the state of economics are also supporting some of it. Paul Woolley, a veteran English fund manager who now teaches at the London School of Economics, has endowed a Centre for the Study of Capital Market Dysfunctionality, which is already producing high-level theoretical work that challenges the efficient markets hypothesis. George Soros has endowed an Institute for New Economic Thinking, which in April 2010 held its inaugural conference at King’s College, Cambridge, the home of Keynes. One of the guest speakers was Lord Adair Turner, an economist and businessman who chairs the Financial Services Authority, which oversees the British financial system. In a wide-ranging talk entitled “Economics, Conventional Wisdom, and Public Policy,” Turner explored many of the same themes that this book has raised, stating: “The proposition is that we need a fundamental challenge to recent conventional wisdom. I strongly endorse that proposition.”

The fact that somebody of Turner’s views could be appointed as the top regulator in what is, by many measures, the world’s largest financial market demonstrates that progress is possible, and it is only fitting, I think, to end with something else Turner said in Cambridge. After raising the question of whether economists should pursue rational- irrationality type models with rational actors, or behavioral models that incorporate emotional and instinctive behavior, Turner said the answer is we need pursue both of these approaches, and others too:

We need to recognize, as Adam Smith did in his Theory of Moral Sentiments, that humans are part rational and part instinctive. We need to accept that the economist must, as Keynes said, be “mathematician, historian, statesman, and philosopher in some degree.” And we need to understand, as Mervyn King and others have put it in a recent paper, that because beliefs and behaviors adapt over time in response to changes in the economic and social environment, that “there are probably few genuinely ‘deep’ (and therefore stable) parameters or relationships in economics” as distinct from in the physical sciences, where the laws of gravity are as good an approximation to reality one day as the next. Which, I’m afraid, is going to make doing and communicating new economic thinking rather hard. Because one of the key messages we need to get across is that while good economics can help address specific problems and avoid specific risks, and can help us think through appropriate responses to continually changing problems, good economics is never going to provide the apparently certain, simple, and complete answers which the pre-crisis conventional wisdom appeared to. But that message is itself valuable, because it will guard against the danger that in the future, as in the recent past, we sweep aside commonsense worries about emerging risks with assurances that a theory proves that everything is okay.

In the economy, as in other areas of human endeavor, everything is seldom okay. And the very thought that it might be—disaster myopia—often generates patterns of behavior that ensures it isn’t. Such is the beauty and challenge of economics.

Copyright © 2009 by John Cassidy.