Prospect Magazine and economics

Prospect Magazine and economics. Prospect Magazine recently invited a number of economists to opine on the state of their discipline and what in their view single measure needs to be addressed. The state of macroeconomics remains dire with macroeconomists having largely failed to anticipate the Great Recession and struggled to come up with solutions to the problems created in the post GR period. In no particular order, starting with Martin Wolf of the FT, he bemoans the state of the discipline and its reliance on encouraging debt and high property prices to boost demand. Larry Summers, ex US Treasury Secretary wants us to get to grips with economic cycles and Brad deLong of University of California thinks we are running out of options to deal with the next downswing. Jim O’Neill once of Goldman Sachs wants us to learn from China whose macro-economic management seems to be better than ours. Barry Eichengreen of Columbia University wants us to focus more on employment. Jagdish Bhagwati, also of Columbia University wants us to defend the benefits of free trade and globalisation. Robert Gordon of Northwestern University bemoans the failure of technology to have any impact on productivity. And Ruth Lea thinks we are all hopeless at forecasting. Adair Turner wants us to clip property’s wings (not just bricks and mortar but intellectual property as well) based on the rising rent from such property is leading to increased inequality. He could perhaps have added that gearing up lending on property led to much of the financial sector’s problems in 2007/08 and in previous recessions, e.g. the S&L crisis in the late 80s. What all these prognoses do is focus on is the real economy, and yet the crisis of 2007/08 was a financial crisis. The economics profession has been good at modelling the real economy and, more debatably, the financial economy but hopeless at merging the two. The only economist who has come close to it was the late Hyman Minsky yet he remains outside the mainstream of the profession. Tim Congdon of the Institute of International Monetary Research wants us to study how the banking sector interacts with real economy, a vital first step. Ann Petifor of Policy Research in Macroeconomics argues that there can never be a market in money. It has always been assumed that it is governments that print money yet recent monetary thinking suggests that it is banks that create money. This is what Mervyn King calls financial alchemy, the liabilities of the banks being money which is liquid but the assets being long-term loans which are not. The asset/liability mismatch of the banking sector is the cause of much of our problems. John Kay takes this a stage further. Bankers are rewarded by taking as much risk as possible and model their operations accordingly. In normal times, the models work but occasionally they don’t and when they don’t, disaster beckons as happened in 2007/08. He calls this ‘radical uncertainty’ (as does Mervyn King) and accepting this will radically undermine much of modern finance theory, for the better. Tinkering with regulation will not work as the regulators failed miserably in the run up to the GFR. Personally I do not think the problem lies with the ‘real’ economy but our failure to come to grips with the banking sector. Deposit insurance ensures a substantial implicit subsidy to banks. Banks have been forced to substantially increase their capital base which is no bad thing, but we still have no real idea how much capital banks should have. In order to make a return on expensive equity, they have every incentive to gear their balance sheets and to run rings around regulators. But the political will to radically reform the structure of the banking sector is largely gone as the GFR becomes a distant memory. And anyway, why worry as Deidre McCloskey of the University of Illinois says, economic development is a positive sum game and our economies continue to deliver.