28 September 2015


Why Economists Failed to Predict the Crisis and How to Avoid the Next One

Meghnad Desai
2015, Yale University Press, 256 pages, £18.99

Reviewer: Christine Shields, Shields Economics

Meghnad Desai has produced a tour de force in his latest book, Hubris. He is a very readable author, writing clearly and free of jargon, and with great humility. I welcomed his introductory remark that economics is not an exact science; how very true and somewhat at odds with the certainty with which some fellow economists laud the output from one or other model. He cleverly lays out the backdrop of the boom years in the run-up to the Global Financial Crisis, not just in UK or European terms but also encompassing many emerging markets, another welcome context often downplayed in the analysis of that time.

This said, he skilfully charts the evolution of the crisis from mid-2007 before attempting to set it in the context of economic theory, starting ambitiously with the inflationary consequences for Europe of Columbus finding the Americas, stemming from the extraction of gold and silver from South America. He then moves to Adam Smith’s invisible hand, skirts over monopolies like the East India Company before reaching Ricardo who developed today’s economics into more of a science than a moral philosophy. Walras then added the mathematical aspects, since greatly expanded. Next come cycles, Marx and the Gold Standard, Wicksell, Schumpeter and Kondratieff, again set in global historical context. Moving towards current times, Marshall, Keynes and the Great Depression follow, encompassing the emergence of econometrics.

Reaching from the interwar years into the 1950s and 1960s, the Keynesian versus monetarism debate is explored, then the oil shock of the 1970s and the subsequent inflation. The best quotation in my view is in the second part of the book: “Economics aims to be a science. Yet political events constantly change its agenda.” How true. And no single one of the theories fully accounts for the complexity of the modern economy – hence the hubris of the title. Rather what was important was that the share of wages versus the share of profit mattered in the generation of inflation and the shift in the west from manufacturing-dominated economic structures to service-based. Stagflation exacerbated the deindustrialisation of the west, so that manufacturing shifted to lower-wage destinations in Asia. This more globalised world rendered much of the earlier theory redundant as it rested on closed economies, not the open world we now know – open to both trade and capital, as well as labour in some places. Tracking back to the theory, Desai works through ISLM analysis into general equilibrium theory and the emergence of the large global models to determine policy that eventually cover assets brings us to portfolio selection and financial services.

Moving into the present day, the third part of the book explores globalisation. Starting with the 1997 Asian crisis, the role of capital flows and innovative financial services products such as securitisation is pursued into the fate of the banking system and the collapse of Lehmans. In turn, this moves the analysis  on to asset valuation and the role of regulation in tempering market excesses. The key point here is that market valuations tend to assume equilibrium. Once a market is out of equilibrium, there are no hard and fast rules for valuing capital. Hence, theory failed again. Desai points out that in the crisis, capital values plummeted, while productive equipment, human capital and prices such as interest rates did not change to the same extent. Add to this the fact that in the Global Financial Crisis, debt levels were generally far higher than in the past. Households and governments were constrained by this, while the existence of global imbalances – those countries with huge external surpluses or deficits - added to the stress and impeded recovery. High debt meant that the usual Keynesian response of public borrowing was not an option in many countries. Yet hugely expansionary monetary policy has also failed to revive economies such as the UK and the US.

Some explanation for this lies in the fact that with debt levels still too high, there is a problem of stock disequilibrium. Borrowing is a flow, while debt is a stock. Liquidity problems arise if the stock of debt (a portfolio choice) cannot be serviced out of the flow of income. Solvency problems – which are systemic – are where assets and liabilities are unbalanced and unserviceable. Keynes looked at flow equilibrium – savings balanced with investment so that the economy is in full employment even if debt is rising. And public debt is not a constraint on public spending in Keynesian theory. Hence it again falls short of providing answers to the current crisis. Also the debt is not just an intergenerational transfer as in the new classical theory. Nor is it just what an economy owes itself as Keynes believes. Rather the debt can be held worldwide – a tradeable asset just as goods are. This difference is why economists failed to anticipate the crisis. In touching on the problems in the Eurozone, Desai talks of the challenge of lifting inflation to central banks’ target rates even with extremely loose monetary policy. He points out that, “There are no permanent laws in economics. Only historically contingent truths.”

Finally, Desai attempts to explain why the crisis happened. First, he argues, a long Kondratieff cycle coincided with a short cycle. Within this, the struggle between labour and capital for income share has played out globally, with labour losing relatively in the west as trades union power fell in parallel with large- scale industrial employment. That became reflected in politics – the demise of Labour. Capital won relatively more share of output and spread overseas as trade flows multiplied and supply chains emerged. The emerging world in aggregate over-saved, partly in response to the lessons from the 1997 Asian crisis, while the advanced economies over-consumed, financed by running up debt. Second, wages as a share of global income fell. This ‘new normal’ means that future growth will be slower, perhaps with falling prices – secular stagnation. Third, technical progress has brought displacement rather than an overall advance in prosperity. Inequality has increased, and in Desai’s view that is a consequence of capitalism. Capitalism itself is a dynamic system that works through creating cycles and crises. It is a disequilibrium system. He ends with Marx, optimistically stating that mankind tends to solve its problems. But if we do solve the problems, no-one can yet say just how.

So a technically wide-ranging and complex book that still remains accessible to non-professional readers. It is immensely ambitious in reach and coverage as well, but actually a remarkably fulfilling read. I recommend it.