IMAGE: NORRIE STEWART
Did economists turn a blind eye to the crisis?
Political bias among economists may have prevented them from foreseeing the 2008 financial crash
by Alex Porter
Since the 2008 crash tens of millions of people around the world have lost their jobs while families, businesses, governments and international bodies have been in crisis management mode. Five years later, and with economic storm clouds still hanging over the planet, the burning question that citizens are still patiently awaiting an answer to is: Why did our leaders not see it coming? A new study could finally have the answer – economists may simply have ignored the evidence.
People often disregard statistical information if it compromises their beliefs; however, new and astonishing research led by Dan Kahan – the Elizabeth K. Dollard Professor of Law & Professor of Psychology at Yale University Law School – shows that this phenomenon actually accelerates the better at maths the person is.
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Entitled 'Motivated Numeracy and Enlightened Self-Government', the research paper is a landmark study into the relationship between public conflict and decision-relevant science.
However, for humanity in general, perhaps the most urgent question raised by the study is: If there was evidence pointing to the 2008 crash but highly numerate mainstream economists simply ignored it out of ideological prejudice, how do we know the world is any safer today than it was prior to 2008?
Debt to Mankind: IOU an Explanation
The pioneering work of Australian economist, Steve Keen, serves as a classic case of the phenomenon the study reveals.
In 2010, Professor Keen won the Real-World Economics Review Revere Award for Economics for being the economist who most accurately forecast the 2008 crash. He received twice as many peer votes as his nearest rival Nouriel Roubini who was senior economic advisor to the US Treasury Secretary Timothy Geithner.
Figure 1: Compelling visual evidence? Not to a mainstream economist
Keen's work shows that, contrary to current mainstream economic thinking, private sector debt has been the primary driver of our economic activity.
Yet Professor Keen, author of Debunking Economics, has struggled to have fellow economists consider his data in the manner one would expect from a scientific discipline. He told Scottish Times about this experience:
“Eight years ago in December 2005 I began warning of an impending crisis that would commence when the rate of growth of private debt started to fall. My warnings hit a popular chord—journalists throughout the world picked it up and publicized my views. But my argument was ignored by the academic economics profession because, according to the dominant model of money, private debt has no impact on demand: as Ben Bernanke [Governor of the US Federal Reserve] put it, lending simply transfers spending power from lender to borrower, and “pure redistributions should have no significant macro-economic effects”...
“Yet the empirical evidence that change in debt does have “significant macro-economic effects” is compelling: the correlations of change in debt to the level of unemployment (Figure 1), and of acceleration in debt to changes in unemployment (Figure 2), are overwhelming.”
“This is visually compelling numerical evidence of what caused the crisis, and yet mainstream economists continue to ignore it, while less numerate journalists latched onto it. Why?”
Figure 2:Something else to ignore because it doesn't pass the a priori test
Answering Keen’s question could not be more in the public interest yet as late as June 2007, the Chief Economist of the OECD reported that: "the current economic situation is in many ways better than what we have experienced in years… Our central forecast remains indeed quite benign: a soft landing in the United States, a strong and sustained recovery in Europe … In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment."
In 2007, former Labour Prime Minster Gordon Brown repeated his claim to economic fame: “no more boom and bust”.
What is truly alarming is that while every pronouncement of mainstream economists at the OECD, IMF, treasury, in financial institutions and corporations are poured over by academia and the mainstream financial media, Keen – with an unrivalled track record in forecasting the most important economic event since the Great Depression – remains under the radar.
If you were extremely concerned about the chances of getting robbed why would you switch off the burglar alarm?
The cargo cult kaleidoscope
If Keen went unheeded by mainstream economists then is the discipline of economics in danger of becoming known as - what the Nobel Prize winning Physicist Richard Feynman called - a 'cargo cult science'?
Feynman was concerned that ordinary people were being intimidated by pseudoscience and pointed to the observed case of a tribal culture to argue how a branch of knowledge can be made to falsely resemble a science. He wrote:
“In the South Seas there is a cargo cult of people. During the war they saw airplanes land with lots of good materials, and they want the same thing to happen now. So they've arranged to imitate things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head like headphones and bars of bamboo sticking out like antennas--he's the controller--and they wait for the airplanes to land. They're doing everything right. The form is perfect. It looks exactly the way it looked before. But it doesn't work. No airplanes land. So I call these things cargo cult science, because they follow all the apparent precepts and forms of scientific investigation, but they're missing something essential, because the planes don't land.”
Sticking with the cargo cult metaphor - in public discussion over how economic activity is stimulated - Keen would argue, with justification, that mainstream economists will saturate the debate coverage with arguments over how the shape of the earphones, length of the bamboo shoots or the material used for the runway are the most important factors in improving economic life. They will also provide complex mathematical micro-economic models and tools to optimise those strategies but the reality is that what makes the planes arrive is something very different.
Clearly, expecting planes to land just because you have an airport is like Beckett’s Waiting for Godot – absurd. The something ‘essential’ that Feynman was referring to that would confirm economics a genuine science, Keen would argue, is acknowledging the principle of debt-driven economic activity in our current economic incarnation. For Keen, mainstream economic models which are used to inform government decisions on our behalf - just like the cargo cult metaphor - are static.
Recently, Adam Posen - former member of the Bank of England Monetary Policy Committee and current head of the Washington-based think-tank the Peterson Institute - warned that academic economists ignore empirical evidence that contradicts mainstream theories in favour of "overly technical nonsense".
What Keen argues is needed is a dynamic model of national economies. In February this year, Keen launched a crowd funding project to design such a model which he calls MINSKY. Within 24 hours of its launch the project had already raised 15 percent of its target.
What’s the Colour of Money?
Most economists - around 90 percent - are trained according to the neo-classical school of economics (NCE). In NCE, there is a core assumption that the impact of private debt on the economy is largely irrelevant.
Instead, NCE theory points to the 'Loanable Funds' model which assumes that savers lend to borrowers through the intermediary of banks; savers cannot spend the money they have lent then and so as borrowers spend the savers' money the economic impact is neutral - a zero sum activity.
What is easy to understand but difficult to believe is that private banks create money as debt. Using double-entry bookkeeping banks create new money at the point of lending it. They are not therefore mere intermediaries as NCE assumes.
This view of new money creation is not a theory but an accounting reality which any high level banker will confirm. And if you don’t believe this commentator then perhaps you might believe the former Governor of the Bank of England, Sir Mervyn King: "When banks extend loans to their customers, they create money by crediting their customers’ accounts."
This process of creating new money through credit is called 'Endogenous Money'. Steve Keen argues that understanding this is crucial to ‘dynamic monetary modelling’. Such dynamic models, Keen hopes, will help humanity forecast and so avert further economic crises.
The problem though is the NCEs treat the ‘Loanable Funds’ assumption as axiomatic and it is so critical to their world view any explanation of ‘Endogenous Money’ is met with the kind of denial you might expect from someone who has suffered a trauma event – cognitive dissonance or denial.
To sceptics, there is no substitute for seeing for yourself. So, try your own psychological experiment: Simply show the data in Keen's graph above to an economist, then stand back and watch what happens. You'll almost certainly find that he or she will simply refuse to engage with it.
They will ignore it entirely or ironically, dismiss it as one economist did recently, put the idea of money creation by banks down to “Chinese whispers” or something akin to a “Roswell conspiracy theory”.
Being on the NCE team
What Kahan and his fellow researchers call 'motivated numeracy' supports the idea of "Identity-protective Cognition Thesis" (ICT), which "treats cultural conflict as disabling the faculties that members of the public use to make sense of decision relevant science."
The study team’s experiment asked subjects to interpret the results of a fictional survey. As expected when the survey issue was not controversial – such as the effectiveness of a skin cream – numeracy was the key factor in whether the subjects interpreted the findings correctly. It also found that when the subject of the survey was highly controversial such as carrying guns (a huge ideologically divisive issue in the US) it was again those who had the highest levels of numeracy who correctly interpreted the data – so long as the data supported their beliefs. However, the finding that was most illuminating was that highly numerate subjects were more likely to interpret the data wrongly than less numerate subjects when the data appeared to contradict their ideological outlook.
Kahan’s team then explore the mental processing that could explain the intransigence of NCEs in the face of data which is a threat to their group identity: "when policy-relevant facts become identified as symbols of membership in and loyalty to affinity groups that figure in important ways in individuals’ lives, they will be motivated to engage empirical evidence and other information in a manner that more reliably connects their beliefs to the positions that pre-dominate in their particular groups than to the positions that are best supported by the evidence."
The findings of the study combined with the logic of ICT therefore provides us with a cogent explanation as to why highly numerate economists are prone to ignore data which is incongruous to their membership of the NCE camp because "numerate individuals are more likely to use their quantitative-reasoning capacity selectively" and use "Forms of information processing that reliably promote the stake individuals have in conveying their commitment to identity-defining groups".
At Scottish Times we looked at the study and related it to the frustrated efforts of Professor Steve Keen to have NCEs even consider the data he presented in the charts above. So, we asked him what he thought about this research and then if he thought it helped explain the reason he has been ignored by NCEs. He told us:
“This study explains why. You might think that the more numerate, the more you would take evidence like this [charts above] seriously, and this study found that this was true when the issue wasn’t a political hot potato—like whether evidence shows that a new skin cream reduces skin rashes—but not when it was--like Gun Control in the USA.
“They concluded that the more numerate someone was, the better they could interpret numerical evidence when the issue didn’t affect their sense of identity. But when it did, then very numerate people were worse at interpreting the evidence. The reason was they employed their numeracy skills to evade the evidence.
“This makes sense of why mainstream economists have been loath to acknowledge the evidence that (almost) Blind Freddie can see in these charts: to acknowledge this evidence would mean rejecting the “Loanable Funds” model of money that is a critical part of mainstream economics. So they refuse to look at it, despite the thousands of such charts that can now be easily found on the Internet.”
He who pays the piper calls the tune
A group identity may be based on a common outlook, however the bonds which hold such a group together can include the threat of the material consequences of developing a belief which is not ideologically acceptable to the group as a whole. The paper warns: "while forming a belief at odds with the one that predominates on it within important affinity groups of which they are members could expose him or her to an array of highly unpleasant consequences."
Should a budding economist currently question the 'Loanable Funds' model, as does Keen, would he or she pass their degree course? Pass a masters’ course? Receive funding for a PHD? Get published in academic journals? Receive academic citations? Be awarded a professorship? Win the Nobel Prize for economics?
Would the same motives not tend academic economists towards avoiding association with unorthodox economic thinkers such as Keen in order to avoid ostracisation?
Feynman raises the issue of dishonesty behind the emergence of ‘cargo cult science’:
“I was a little surprised when I was talking to a friend who was going to go on the radio. He does work on cosmology and astronomy, and he wondered how he would explain what the applications of his work were. "Well," I said, "there aren't any." He said, "Yes, but then we won't get support for more research of this kind." I think that's kind of dishonest.”
It could be argued then that mainstream academic economists built their collective professional identity on the ‘cargo cult science’ of NCE because funding available for academic research in economics has been predominately earmarked for NCE-related projects.
The question then is why is it that so much funding is available, across the board, almost exclusively for NCE projects? How could it be that economics departments at universities are so predisposed towards an economic doctrine which views the role of private debt in our economy as irrelevant?
Greek economist Professor Yanis Varoufakis explained to Scottish Times why he believes mainstream economists ignore the impact of credit on the economy: “(a) neoclassical economics is, by design, incapable of modelling debt which means that economists, who refuse to recognise phenomena that their models neglect have a strong incentive to assume that private debt will automatically 'clear' as long as financial markets are allowed to work their magical powers unimpeded, and
(b) the financial sector itself is as motivated to neglect the issue of private debt as it is... leveraged (and backed by the taxpayer whenever it goes belly up).”
If debt is the principle driver of our economic activity and the ability for borrowers to borrow is finite and close to reaching its limit, then those who create debt by creating money, namely banks, and those who also benefit from this process by selling bonds to banks to meet budget deficits, i.e. governments, would be highly motivated by short-term gain to exert their pervasive influence over academic patronage to have NCE research, which ignores debt from its models, exclusively patronised.
Politically aligned and corporate economists would therefore be vulnerable to accepting, without challenge, data which has been processed from an NCE perspective. Economic policies in the developed world are usually supported by neo-classical models and reasoning. Thus, should fearless economists support evidence which contradicts the policies of their political affinity groups or corporate culture, they may quickly find themselves deprived of prestige in public life and out of a job.
The Yale study considers the carrot and stick aspects of scientific group identity: “More numerate individuals are benefitted from forming identity-congruent beliefs just as much as less numerate individuals are, and harmed just as much from forming identity-noncongruent beliefs. But more numerate individuals have a cognitive ability that lower numeracy ones do not. ICT predicts that more numerate individuals will use that ability opportunistically in a manner geared to promoting their interest in forming and persisting in identity-protective beliefs.”
What emerges from the study when considering its application to Keen’s critique of NCE is that the world may not be facing an economic crisis but a crisis of economics.
Or, if economics is compromised by the ideological blinkers of its practitioners then we could more accurately observe that it is not the science of economics that is the problem but the economics of science.
If this is the case then is the public’s trust in economists putting the fox in charge of the henhouse? Certainly, given the criticality of the matter for humanity, it would be helpful to have anthropological studies investigating the motivational drivers within the NCE clan.
The potential consequences of what the study calls 'motivated numeracy' on the public debate over the economy do not bear thinking about: Our collective economic welfare is at stake, not to mention our related social, political and geopolitical realities.
If, as Keen points out, changes in private debt are so tightly correlated with economic activity as to be undeniably causal yet mainstream economics completely ignores it, then how much of the economic news can we take seriously? How deep does the rabbit hole go?
Politicians, civil servants, corporations and others depend on economists’ models to make forecasts and determine public policy. Are we absolutely sure we should trust in the competency of economists despite their visible self-confidence? If we do, are we not like the mythical lemmings which jump off cliffs?
If economists ignored warnings of the 2008 crash, can we view the endless talk of 'recovery' in the financial media as anything other than economic propaganda spread by economists and politicians who have no real idea where economic activity springs from? Remember the media narrative about ‘green shoots of recovery’ back in 2009? Have they all been smoked?
Should we be concerned that rather than coming out of the crisis we are, thanks to damaging policies spun out of cargo cult economics, plunging deeper into it? Do we now face a crash re-enactment?
If there is a plan B, it would be facing the private debt problem head on, so can we expect our mainstream economists and politicians to adopt it?
What would be the impact if a financial journalist, who understood the private debt to GDP relationship, reported honestly? It is likely that he or she would be welcomed by the minority of economists who are scientists but be marginalised by the cargo cult captains, thus diminishing their professional prospects and harming the commercial interests of the media brands they are associated with.
It is, perhaps, not a coincidence but shocking given the recent Libor-scandal and the bail-outs that the UK’s journalists are trusted equally to bankers. A recent poll by Ipsos Mori showed both enjoyed the trust of only 21 percent of the population with only politicians trusted less out of all the professions.
Meanwhile alternative economic media brands have become popular on the internet as particularly the young eschew ‘bolitix’. The Keiser Report on RT is presented by Max Keiser who The Independent newspaper predicted last December was about to “become the most widely watched newscaster on the planet”. Other shows which examine the role of debt in the economy such as Capital Account and Prime Interest are responding to this growing demand for alternative explanations.
What is surreal is that once you do give private debt its place in economic analysis then mainstream economic commentary becomes a kind of Alice in Wonderland trip.
The Emperor’s New Clothes
Take the currently contentious case of Scotland which faces an independence referendum in a matter of months. Anyone who places private debt at the heart of economic analysis cannot help but find the economic discussion over Scotland’s future very much of the cargo cult variety.
The pro-independence Scottish National Party favours, if it achieves a ‘yes’ vote, remaining within a Sterling Zone.
This is despite the UK’s private sector debt-to-GDP ratio being the worst in the developed world (see chart). The chart shows that should interest rates go up – a policy which would encourage productive growth through investment in manufacturing - even by a small amount, the UK economy would convulse as debt repayments would be well beyond prohibitive for economic stability.
Trapped, the UK government can only encourage banks to create more debt in the hope that this will stimulate economy activity; however the amount of debt the economy can support may have peaked explaining the 2008 credit crunch.
Last week, the hugely successful international investor Jim Rogers who - along with his co-founder of the Quantum Fund George Soros - “broke” the Bank of England and forced Britain out of the Exchange Rate Mechanism on Black Wednesday in 1992, warned: “The world is floating on an artificial ocean of printed money”. Mr Rogers has repeatedly issued warnings about the pound, arguing ”the UK has nothing to sell” while advising young Britons to emigrate.
However, Keen’s and Rogers’s alarm bells are immaterial if economists, trained in NCE orthodoxy, are to be believed.
Should Keen's data prove correct and the private debt bubble is about to pop again, then the UK faces a prolonged and irreversible period of contraction with implications Britons, already exhausted by austerity, cannot yet begin to imagine. Far from economic recovery, the British economy may face a decades-long economic correction presaged by another traumatic financial crash.
You would not be being unreasonable for thinking that this could and perhaps should therefore be the most crucial issue in the economic debate over Scottish independence - the risk to the international credibility of Sterling.
Based on the advice of the Fiscal Commission, the Scottish government’s white paper on independence describes the UK as an “optimal currency area”. However, as Scotland would have an economy underpinned by North Sea oil and England by financial services, many would find it absurd to imagine that monetary policies would be equally ideal for both parties post-independence.
This point was emphasised by Scottish public finance expert Jim Cuthbert who “strongly suggests that Scotland should not remain in a sub-optimal currency union which has sacrificed productive economy growth for conditions that suit financial speculation."
All that aside, how can any currency union even be described as ‘optimal’ if private debt is many times that area’s combined GDP?
In a currency union, an independent Scotland could be exposed to a Sterling crisis or a related economic shock, as forecast by Cuthbert, whilst unable to pursue correctional macro-economic policies because those powers would remain in London and controlled by rival interests. Furthermore there would be nothing to prevent, setting the question of motivation to one side, the City of London using leveraged finance to buy up Scottish businesses, real estate and so on because there would be no adjusting exchange rates to disincentivise such an asset spree. Over a period of a few months asset price inflation could rise dramatically across Scotland. Meanwhile, the nation could only look on helplessly as the Scottish government scrambled to provide an independent currency framework and economic decision-making migrated south for generations.
However, NCEs don’t factor money creation into their models and so the scenarios above are viewed as misconceptions and therefore not part of any risk analysis of either remaining in the Union or within the Sterling Zone – a ‘minimalist’ constitutional policy Professor Varoufakis warns today, in an article published today by Scottish Times, may lead to a ‘no’ vote.
The economics of Scottish independence is therefore a stale discussion over the measurement of runways, the length of bamboo shoots for antennas and the shape of wooden pieces used for headphones with no open mind over what makes planes filled with cargo land or crash.
It doesn’t help either that the Scottish government has little-to-no experience of working with monetary powers and institutions. It therefore has the outlook of NCE orthodoxy combined with a mindset which focuses exclusively on fiscal policy. Is having a few more pounds one constitutional way or the other of such importance if those pounds are going to be significantly devalued by the Bank of England and the City of London?
So, will Steve Keen succeed in his herculean effort to lift the neo-classical fog and inspire policy-makers to design policies which do not cause but fix crises?
In recent weeks, Nobel Prize winning economist Paul Krugman publicly acknowledged 'Endogenous Money' as an economic reality. Perhaps Keen's dogged determination is starting to pay off, however if the next credit bubble is ready to pop it may already be too late.
Integrity and Enlightened self-government
At the heart of the Yale study is a searching question: "Why does public conflict over societal risks persist in the face of compelling and widely accessible scientific evidence?"
Asking random members of the public what they would think if models, used to inform economic decisions taken on their behalf, ignore the role of money in the economy invites incredulity and accusations of meaninglessness.
Current wisdom has it that the role the general public has in political decision-making should be increasingly transferred to experts. The study however suggests that as experts exhibit higher degrees of motivated numeracy when it comes to controversial areas of public policy, it is scientists who exacerbate political polarisation: "the tendency to process information in this fashion will be strongest among individuals who display the reasoning capacities most strongly associated with science comprehension."
Kahan told Scottish Times that while he was concerned by the risk of ideologically motivated harm to the science communication environment he was optimistic that science itself will overcome this challenge: “it does seem true that greater analytical acuity of various types seems to aggravate rather than ameliorate motivational biases. But using the same faculties that are enfeebled by these dynamics, I am confident we will discover means for protecting ourselves from these influences and from the immense damage they can cause to human wellbeing.”
How then can the science of economics defend the public and itself from motivated numeracy and the drift towards cargo cult it creates?
The question goes to the heart of a disagreement between the two greatest figures of the Scottish Enlightenment. David Hume argued that “Reason is and ought only to be the slave of the passions” and that conscience is a separate matter while for Smith reason and conscience were synonymous.
The Yale study offers scientific evidence over two-hundred and fifty years later that Hume was right and that Smith, often described as the "founding father of modern economics", may have unwittingly spawned damaging economic ideologies over the intervening period including the NCE cargo cult that Keen argues led us to our current economic crises.
In considering the critical element that makes science science, Feynman argues: “It's a kind of scientific integrity, a principle of scientific thought that corresponds to a kind of utter honesty”. In order to avoid morphing into cargo cult scientists, Feynman suggested researchers must avoid fooling themselves and be willing to question and doubt their own theories and data.
To prevent the discipline of economics becoming further discredited, perhaps some kind of voluntary Hippocratic Oath which exists for doctors could be designed for economists. A duty to uphold the best scientific practices of economics would go some way to protect them from internal passions and external influences.
The idea of an oath for scientists was called for by Sir Joseph Rotblat in his Nobel Peace Prize acceptance speech in 1995 - a call which has been echoed numerous times since. There are possibly a good number of mechanisms which can save our economies from the motivated numeracy of economists. However, given the profession has failed recently to properly regulate the economy and prevent the crash, economists are unlikely to be trusted by the public to regulate themselves and so reform may have to come with help from outside the field from figures such as sociologist and anthropolgist Professor Bruno Latour who has extensively researched the realities of scientific method.
Given the import and urgency of our economic malaise there will likely be bottom-up impulses for such change. Was this the core mission of the Occupy movement that it tried to but failed to articulate?
Perhaps the revolution has already started. Recently, a group of students from Manchester University called the 'Post-crash Economics Society' banded together to demand a review of their syllabus dominated by NCE theory. One of the students, Joe Earle, told The Guardian newspaper: "It [NCE] is given such a dominant position in our modules that many students aren't even aware that there are other distinct theories out there that question the assumptions, methodologies and conclusions of the economics we are taught."
If Keen’s version of The Emperor’s New Clothes, where he points out that private debt has been driving our economic activity led to the 2008 ‘peak debt’ crash, then those agitation impulses can now only grow in intensity and frequency - driving suspicion and confrontation between citizen and state - until governmental institutions face reality.
After his high-precision warnings of impending crisis went unheeded by fellow economists and after all his efforts at trying to get them to simply look at his scientific data since are still being ignored, one would forgive the man for viewing the research with smug justification and cynicism.
However the indomitable, straight-talking Australian still has a job to do and so he pauses for a breather and quips: “Numeracy makes you blind. Who’d a thought?”
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