A retired City of London banker, who happens to be a remarkably charming man, sent me an email commenting on my recent piece in which I criticise economics in general and Paul Samuelson in particular. Jerry (for that is his name) suggested that (despite the economists’ fixation with weird models of little significance) we economists were not to blame for the Crash of 2008. Below I post his long letter for the simple reason that it is replete with important points. As I am now deeply immersed in writing my Global Minotaur, such letters offer much needed food for thought. I begin with my reply to him and then post his letter almost intact:
Good morning Jerry,
…The piece you read (the article on Samuelson) was intended for an audience of academic economists. When addressing fellow economists, I feel the need to emphasise the fact that the Crash of 2008 was both an economic crisis and a crisis of economics. But this is more a case of correlation than one of pure causation. I, like you, do not believe that economics caused the Crash. Only that economic doctrine provided an ideological cover for policies that had completely different, hardnosed, causes. That is not, however, to say that economic doctrines played no significant role on the sidelines. They operated at the basis of feedback, in the form of reinforcement mechanism which, in the end, provided the likes of Greenspan (as well as the financial engineers) with the confidence to do and think what they did and thought. But no more than that. The deeper causes must be sought, as you suggest, elsewhere.
If I were to draw a wobbly parallel, it would be with the Crusades. Christian theology can never explain the crusaders’ sacking of Constantinople or their deeds in the Holy Land. But, nevertheless, religion and its organised expression did provide the ideological and moral veneer that smoothened the Crusaders’ path.
On matters of substance regarding the Crash of 2008, when you come to Chapters 11 and 12 (here I am referring to the book that Routledge will be bringing out in April entitled Modern Political Economics: Making sense of the post-2008 world, and authored by myself, Joseph Halevi and Nicholas Theocarakis) , you will see that our views are very similar. So much so that my explanation of the Crash turns on the mortal wounding of what I label The Global Minotaur (which is also the title of the book I am currently writing). This fictitious beast of mine is none other than the US twin deficits. In this sense, I am really looking forward to your input after you reach that point in the book…
And now here is Jerry’s email:
For the moment let me just say that I really don’t consider the Crash of 2008 to be one that can be attributed to bad economists or in the main, to bad economic theory. I couldn’t agree with you more, that modern economics with its obsession with formalization, it’s attitude that if one doesn’t have a PhD in math one cannot do economics, is sad and terribly outdated (I’m terrible in math). Economists in the last 30 years have been trying to make economics either a pure language, or suffer from physics envy and, as you argue, force the real world into one which is unrecognizable because of its lack of variables. Things must either be endogenous to the system, or they are left out with a little smile that says, but not seriously, that after all, it’s only a model. The waiver is soon forgotten.
Where I disagree is that the rational man and efficient markets assumptions drove the Crash. The crash came about from a witches’ brew of American triumphalism that “markets work”, heavily influenced by Republican idealogues and avidly subscribed to by the libertarians (Greenspan still admits to being a fan of Ayn Rand – who most normal people outgrow in high school). This combined with the gradual disintegration of good government that caught fire under Reagan and took over with Bush, which almost completely vitiated effective regulation across all supervisory areas in the US, from agriculture to the environment, to food safety, to real science, to financial markets. There was effectively no government and the children were left to play in the post Glass Steagall sand box unimpeded.
This combined with a cultural shift within the banking industry, championed by my ex boss [name withheld, YV], who, in the early 1960’s, committed First National City Bank to grow its earnings 15% a year, unheard of before, but reflecting bankers’ frustrations as being seen as the boring side of the stock market when compared with the IBMs of the world. From then on, the concept of fiduciary responsibility bled out of the banking industry, and the new drivers became marketing, sales, market share, top line/bottom line. This led to transaction banking, which necessitated deal buying, which meant buying risk. Attention then turned to managing risk. I was part of it, alternately thoroughly enjoying the exhilaration of doing deals, and at the same time appalled at the lack of fiduciary ethic in the business.
None of this had anything to do with economic theory or economists. Managing risk did. It brought in Black Scholes, and ultimately, VaR – Value at Risk. I won’t bother going into that, because people like me who understood the role of models, and had some bear markets in their history, understood that all of the models evaporated when markets seized up. Nevertheless, the VaR models came to justify the most egregious risk taking of our financial institutions. But I think the key point, is that the assumptions underlying VaR, Black Sholes and the million lines of code programs that modeled banks’ risk, where only a very small part of the equation which led to the crash.
The biggest part, was created by the tsunami of cash generated by US imports, Greenspan monetary policy, the Bush reprise of Lyndon Johnston’s act of simultaneously fighting a war and creating the biggest social spending program since the New Deal (except Bush replaced the New Deal with tax cuts for the rich), which meant both an enormously accommodative monetary policy along side of a wildly expansionary fiscal policy.
I remember very well, after the dot com crash, the search for yield amongst international investors who were appalled at the low interest rates. The pressure on investment banks to come up with structured finance deals which offered higher yield, was enormous. Bankers, needless to say, responded, with CDO’s. swaptions, interest rates swaps, and wildly complicated one-off deals with so many embedded options they could never be modeled. My structured finance desk was under siege by the German and Italian banks to do these deals, which became so opaque that they were complete black boxes. They were bought in spite of all the health warnings we gave.
In the beginning, the mortgage backed market was quite professional. But as demand for higher yield built up, the industry got caught up in a whirlwind of creating deal after deal. It must be remembered too, that it was under Clinton that the US government started mandating Fannie Mae and Freddie Mac to finance sub prime mortgages, and it was the USD government which pushed, even stipulated, that sub prime mortgage lending be expanded.
It’s not irrelevant that during this period, and totally independently, bonuses went through the roof. When , in 1980, I went to work for Kidder Peabody, an annual bonus equal to one’s annual salary was considered a sure sign one was going to be made a partner. Five years later, I was present at a meeting of senior market makers when one of the group announced the first million dollar bonus. Within six years, this would have been considered a pittance. The dynamic of the investment banking industry was that traders or corporate finance guys who created profits for the firm, should get roughly 25-30% as bonus. More professional firms would calculate the numbers after charging the trader for cost of capital, overhead, risk etc., but still, as the volumes got bigger due to the increasing size of the deals, due to the increasing supply of money, the bonuses got bigger and bigger.
The combination of massive trade flows, surplus international savings, ideologically driven or collaborative governments in the US and elsewhere, with an extremely accommodative fiscal and monetary policy in the US, low interest rates and search for yield, (and I’m not being pejorative here) creative investment banking , strong institutional demand for high yielding products, greed, dishonesty, stupidity, bad management, and cynicism was really what created the crisis. The bad economics behinds the VaR models, efficient market theory and rational man, were simply fig leaves.
So let’s not blame the crisis on economics or economists. It resulted from a broth of trade flows, excess savings, bad government, lack of regulation, greed, dishonesty, stupidity and lack of accountability.
And by the way, nothing much has changed. But the academic economists can stop beating themselves. The talking heads on CNBC should commit hari kiri