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Our Best Minds Are Failing Us

With America in deep trouble, our economists are AWOL, and our scientists are still off financial engineering.

by Michael HirshSeptember 16, 2010

Corbis The most terrifying moment in modern economic history occurred two years ago this month. For several long days after the fall of Lehman Brothers on Sept. 15, 2008, the financial system was in danger of total collapse, and the United States seemed on the precipice of another Great Depression in that Black September. Just as bad, our economists and senior policymakers had barely any idea why this was happening. The assumptions of an entire era had been proved wrong. The Great Moderationthe period of postCold War prosperity in which capitalism was said to have been tamed and risk masteredwas revealed to be an illusion. Alan Greenspan professed his shocked disbelief that the Wall Street institutions he had trusted in were so reckless as to blow themselves up. The whole intellectual edifice has collapsed, the former Fed chairman told Congress that fall. Economists said they would have to come up with new theories for how markets worked, in particular how the financial system functioned and interacted with the real economy. Large swaths of economics are going to have to be rethought on the basis of what happened, Larry Summers, the presidential adviser who doubles as a world-renowned economist, told me in an interview shortly after Barack Obama took office. Two years on, that rethinking has barely begun, and only with the most painful reluctance by economists. Meanwhile, policy and political debates still driven by outdated economic theory have been racing out of control, bitterly dividing the nation. Whether the arguments are about stimulus, financial reform, health care, or jobs, the discussions in Washington tend to be

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dominated by simplistic black-and-white views that are little different from the conceptual framework that prevailed before the collapse: markets always work better than governments. Advocates of government spending are socialists. Champions of markets are laissez-faire ideologues or slaves of Wall Street. And never the twain shall meet. A vast new regulatory framework has been set in motion, but many experts say it has done little to change the way Wall Street or the real economy functions, and there is no new economic theory underlying it.

The Financial Meltdown's Best Quotes The Financial Meltdown's Best Quotes The failure of the economics profession to address our deeper problems theoretically is mirrored by the failure of other sciences on a more practical level. To wit: Americas best minds are still heading to Wall Street to an unnerving, even pathological degreefurther evidence that finance remains the dominant sector of the economy. The evolution of the financial sectors trading and banking practices into arcane rocket science in recent decades had a lot to do withrocket scientists. After the end of the Cold War and the collapse of the Soviet Union in late 1991, top physicists and engineers and other major-league brains werent needed as much. With the advent of the peace dividend (read: Pentagon cuts), many of them headed for Wall Street and became quants. This trend brought two new, big things to Wall Street: a whole-new level of intellectual horsepowerthe upper reaches of the IQ scaleand a new layer of important players who had no reason to doubt that markets worked as formulaically as the weapons systems they had once puttered over. Thats partly how structured finance, derivatives, and other products have grown so complex that not only regulators but even Wall Street CEOs can no longer understand them. Yet this trend in turn cant change without a reordering of what economists call incentives. Pay scales on Wall Street continue to outstrip those in other professions outrageously. The Obama administration and Congress have done little legislatively or through use of the bully pulpit to try to reorient compensation practices so that perhaps some of our greatest minds wont go into useless financial engineering but instead will begin to consider real engineering again. Wall Street execs have been whining for two years that to reduce pay incentives and bonuses would cost the firms their best talent. The governments response should be YES! Thats precisely the idea. Finance was once a means to an end: the growth of the real economy. Banking once served industry and services. Now finance has become the end, and the real economy is subservient to financial services (its no surprise that after the crisis, overthe-counter derivatives trading quickly climbed back up to more than $600 trillion). At some

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point in our recent past, finance lost contact with its raison dtre, European Central Bank chief Jean Claude Trichet said earlier this year. Finance developed a life of its ownFinance became self-referential. As long as this pathological state of affairs persists, questions of global growth and social welfare will continue to depend on Wall Street and the enduring fallacies of free-market finance. Recently, the National Science Foundation sent out a query asking economists and social scientists to draw up grand challenge questions that are both foundational and transformativea request that one recipient, Andrew Lo, a highly regarded financial economist at MIT, says is a first in his experience. But one problem is that the economics profession has gotten much more intolerant of divergence from orthodoxy, says Philip Mirowski, an economic historian at Notre Dame. The range in which dissent happens is so narrow. In a sense they still cannot imagine the system can operate to undermine itself. That is not a position that is allowed anywhere in the economics profession. The field got rid of methodological self-criticism. This Great Moderation stuff was just arrogance, hubris. Indeed, the joke on economists, says one of them, Rob Johnson, is that they create simplistic models that depend on people behaving as rational actors motivated by self-interest, yet they have a blind spot regarding themselves. The way they squabble mulishly to defend now-indefensible positions is itself evidence of how flawed those rational-actor models are. New thinkers say they are still having trouble breaking in. Among the new NSF grant awardees is J. Doyne Farmer, a physicist at the Santa Fe Institute who is trying to bring the idea of complexity back into economics by making use of advanced computing power to map human economic behavior the way weather or climate change is tracked. But Farmer says he got his $450,000 grant for a three-year study of systemic risks in markets only after a sympathetic NSF case officer overruled negative assessments by neoclassical economists who reject any model that doesnt tend toward general equilibrium. The established view just holds this stuff back, Farmer says. One of the dangerous cultural patterns that economics has fallen into is an excessive emphasis on theorem proof for its own sake rather than what gives you scientific results. Thats led to a disdain for computer simulation. Johnson, who is director of the new Institute for New Economic Thinking funded by George Soros, says: You do see some new thinking, but it doesnt get traction in terms of policy. Its a symptom of how far right society has gone. The great names in the profession have not necessarily helped. The top economists in the Obama administrationSummers; Christina Romer, the just-departed chair of the Council of Economic Advisers; and her replacement, Austan Goolsbeeare all part of the orthodoxy. Critics say Summers should know as well as anyone how the old thinking has been outstripped. As a Harvard professor, Summers wrote after the 1987 stock-market crash that it was impossible to believe any longer that prices moved in rational response to fundamentals. He even cautiously advocated a tax on financial transactions. Yet Summers, one of the worlds most astute economists, later abandoned these positions in favor of Greenspans view that markets will take care of themselves. And in the current era, Summers and the rest of the Obama team seem to have underestimated the depth and systemic nature of the economic crisis. Stimulus spending was timid (in deference to political antipathy to big government), mortgage workouts meager, and financial reform minimalist. The administration maintains it did as much as it could under the political constraints, but others disagree. The financial-reform bill and other changes in the regulatory landscape are more incremental, says MITs Lo. Its a reaction to the most immediate set of events as opposed to a more profound rethinking about the underlying causes of the crisis.

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A little history is in order here: it was largely because the field of economics came to be dominated by neoclassical thoughtor the idea that markets are rational and can reach equilibrium on their ownthat so-called financial innovation on Wall Street was allowed to run amok in recent decades. That led directly to the crisis of 200709. No matter how crazy or complex the products got, the theory was that, with little government oversight, the inherent stability of markets would keep things from getting too out of hand. It was in large part because of this way of thinking that government intervention of any kind in the markets, including regulation, came to be seen as a kind of heresy, especially after the Soviet Union collapsed and command economies and statism were thoroughly discredited. The new financial-reform law has changed that to some degree, but it still leaves most of the major decisions about government oversight to the same regulators who failed last time. We are still, to a large extent, flying blind in conceptual terms. Just as the Great Depression demonstrated to John Maynard Keynes and his followers that markets often behaved badly leading to the Keynesian reinvention of economics in the 30sthis present crisis drove home the truth, or should have anyway, that rational models of markets dont work well because there are too many unknowns. People most often dont behave as rational actors. There is no real equilibrium in the real world. Above all, market economies are capable of destroying themselves. This is especially true in the world of finance, which has always worked according to different rules than other sectors of the economy and is much more prone to panics and manias. In 1983, a young Stanford economist named Ben Bernanke published the first of a series of papers on the causes of the Great Depression. The financial system, Bernanke said, was not unlike the nations electrical grid. One malfunctioning transformer can bring down the whole system. Ive never had a laissez-faire view of the financial markets, Bernanke told me, because theyre prone to failure. Even Friedrich Hayek, the godfather of 20th-century laissezfaire thinking, believed that financial markets were more subject to bouts of instability, says one of his biographers, Bruce Caldwell of Duke University, a self-described libertarian scholar. Yet amid the free-market triumphalism of the postCold War era, all this hard-won wisdom about the differences in finance was forgotten or ignored. To policymakers in Washington, it seemed silly and nitpicky to treat finance as a different animal. The dominant thinkers were the rational expectations economists of the Chicago school who simply assumed capital flows, no matter how open, would be stable. We now know differently. But the question remains: how should we think about our outsized financial sector now, and how can it be made to serve the larger economyrather than the other way around? Shouldnt we have learned our lesson from the Great Recession, just as economists did after the Great Depression? Should there not be a new economics that develops fresh concepts reordering the balance between markets and governments, accepting the necessity of both? The great economist Paul Samuelson used to say, paraphrasing the physicist Max Planck, that economics progresses one funeral at a time. It was necessary for the old lions to pass on, in other words, before new seminal thinking took hold. But we may not have time to wait upon funerals. Policy is driving relentlessly ahead, and the economics profession and other sciences have been left far behind. Hirsh is the author of the newly published Capital Offense: How Washingtons Wise Men Turned Americas Future Over to Wall Street.

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9/19/2010