Some self-criticism from economists

February 9, 2009

In the current crisis, the economics profession is thinking about some of its failures to anticipate and grasp the underlying developments leading up to the current financial and economic crisis. A top international political economist, Daron Acemoglu, from the MIT, published an insightful and very thoughful paper over at the Centre for Economic policy Research, entitled “The crisis of 2008: structural lessons for an from economics“.

A few of his points are the following:

First, in the last years, economists have underestimated the risk of economic volatility (i.e. boom and bust cycles), since, as he said, “many measures showed a marked decline in aggregeate volatility since the 1950s).” This has fueled what he calls a “myth of the end of the business cycle”:

“The same economic and financial changes that have made our economy more diversified and individuals firms better insured have also increased the interconnections among them. Since the only way diversification of idiosyncratic risks can happen is by sharing these risks among many companies and individuals, better diversification also creates a multitude of counter-party relationships. Such interconnections make the economic system more robust against small shocks because new financial products successfully diversify a wide range of idiosyncratic risks and reduce business failures. But they also make the economy more vulnerable to certain lowprobability, tail events precisely because the interconnections that are an inevitable precipitate of the greater diversification create potential domino effects among financial institutions, companies and households.”

Second area where economists have been uncautious:

“our too-quickly-accepted notion that the capitalist economy lives in an institutional-less vacuum”. “Forgetting the institutional foundations of markets, we mistakenly equated free markets with unregulated markets”.

“Sure enough, institutions have received more attention over the past 15 years or so than before, but the thinking was that we had to study the role of institutions to understand why poor nation were poor, not to probe the nature of the institutions that ensured continued prosperity in the advanced nations and how they should change in the face of ever evolving economic relations.”

“We must now start building a theory of market transactions that is more in tune with their institutional and regulatory foundations.”

Third problem of economic analysis lately:

“our trust in the self-monitoring capabilities of organisations”.

It is very difficult to punish excessively risky behaviour, such as those of bankers, because only bankers have the skills to run a financial system, for example.:

“Whenever the incentives to compromise integrity, to sacrifice the quality, and to take unnecessary risks are there, most companies will do so in tandem. And because the ex post vacuum of specific skills, capital and knowledge that their punishment will create make such a course of action too costly for society, all kinds of punishments lose their effectiveness and credibility.”

However, to Acemoglu, foresighted economists have a lot to say on the implicaitons for economic growth of current recovery plans and stimulus packages:

“The design of policies to contain and end the global crisis has considered many economic factors. But their impacts on long-run economic growth, innovation, reallocation and political economy have been conspicuous in their absence in the ensuing debate.”

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