The Future of Macro: Barry Eichengreen's Take
Barry Eichengreen:
The Last Temptation of Risk: We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history.... We thought that financial institutions and markets had come to be self-regulating—that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.
We now know that much of what we thought was true was not.... The question is how we could have been so misguided.... [T]he problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists.... [S]cholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations.
SO WHERE were the intellectual agenda setters when the crisis was building?... For economists in business schools the answer is straightforward. Business schools see themselves as suppliers of inputs to business.... J. P. Morgan makes clear the kind of financial engineers it requires, and business schools deem to provide. In the wake of the 1987 stock-market crash, Morgan’s chairman, Dennis Weatherstone, started calling for a daily “4:15 Report” summarizing how much his firm would lose if tomorrow turned out to be a bad day.... Value at Risk, as that number and the process for calculating it came to be known, quickly gained a place in the business-school curriculum.... Getting the machine to spit out a headline number for Value at Risk was straightforward. But deciding what to put into the model was another matter.... Value at Risk, like dynamite, can be a powerful tool when in the right hands. Placed in the wrong hands—well, you know. These simple models should have been regarded as no more than starting points for serious thinking. Instead, those responsible for making key decisions, institutional investors and their regulators alike, took them literally....
For some years those who relied on these artificial constructs were not caught out. Episodes of high volatility, like the 1987 stock-market crash, still loomed large in the data set to which the model was fit. They served to highlight the potential for big shocks and cautioned against aggressive investment strategies.... WITH TIME, however, memories of the 1987 crash faded. In the data used by the financial engineers, the crash became only one observation among many generated in the course of the Great Moderation.... Meanwhile, deregulation was on the march.... [W]here the accelerating pace of change should have prompted more caution, the routinization of risk management encouraged precisely the opposite....
[W]here were the business-school professors while these events were unfolding? Answer: they were writing textbooks about Value at Risk.... Business schools are rated by business publications and compete for students on the basis of their record of placing graduates.... But what of doctoral programs in economics (like the one in which I teach)?... [T]heir faculties do not object to the occasional high-paying consulting gig.... Generous speaker’s fees were thus available to those prepared to drink the Kool-Aid... there was nonetheless a subconscious tendency to embrace the arguments of one’s more “successful” colleagues in a discipline where money, in this case earned through speaking engagements and consultancies, is the common denominator of success.
Those who predicted the housing slump eventually became famous, of course. Princeton University Press now takes out space ads in general-interest publications prominently displaying the sober visage of Yale University economics professor Robert Shiller, the maven of the housing crash.... But such fame comes only after the fact. The more housing prices rose and the longer predictions of their decline looked to be wrong, the lonelier the intellectual nonconformists became....
WHY BELABOR these points? Because it was not that economic theory had nothing to say about the kinds of structural weaknesses and conflicts of interest that paved the way to our current catastrophe... agency theory... compensation practices in the financial sector as encouraging short-termism and excessive risk taking and heightening conflicts of interest.... A Nobel Prize for work on this topic was awarded to Leonid Hurwicz, Eric Maskin and Roger Myerson in 2007... information economics.... George Akerlof, Michael Spence and Joseph Stiglitz were awarded the Nobel Prize for their work on it in 2001. Here again the potential problems of an inadequately regulated financial system would have been quite clear had anyone bothered to look.... [B]ehavioral finance... this small step in the direction of realism can transform one’s view of financial markets... herd behavior, where everyone follows the crowd, giving rise to bubbles, panics and crashes. Economists have succeeded in building elegant mathematical models of decision making under these conditions and in showing how such behavior can give rise to extreme instability. It should not be a surprise that people like the aforementioned George Akerlof and Robert Shiller are among the leaders in this field.
Moreover, what is true of investors can also be true of regulators, for whom information is similarly costly to acquire and who will similarly be tempted to follow convention—even when that convention allows excessive risk taking by the regulated.... And what is true of investors and regulators, introspection suggests, can also be true of academics....
What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises.... Rather, the problem was a partial and blinkered reading of that literature....
WITH THE pressure of social conformity being so powerful, are we economists doomed to repeat past mistakes?... Maybe so. But... there is at least one reason for hope.... [T]he IT revolution has altered the lay of the intellectual land.... [I]t is now empirically oriented graduate students who are the hot property when top doctoral programs seek to hire new faculty. Not surprisingly, the best students have responded....
In contrast, the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.
Should this reassure us that we can avoid another crisis? Alas, there is no such certainty. The only way of being certain that one will not fall down the stairs is to not get out of bed. But at least economists, having observed the history of accidents, will no longer recommend removing the handrail.
