In 2008, when Queen Elizabeth was being briefed by economists on the turmoil in financial markets that led to the global financial crisis, she asked them a pointed question: “Why did nobody notice it?”
She had a good personal reason to ask — the financial crisis wiped out about 25 per cent of her personal investment portfolio, or about $40 million.
It was a critical question because we are still struggling with the consequences of the failure of economists to warn of the risks from deregulated financial markets.
Millions of people around the world lost their jobs, their homes, their savings, and many will never recover.
A few months later, a group of economists responded, albeit lamely.
In their letter to the Queen, they explained that “the failure to foresee the timing, extent and severity of the crisis and to head if off, while it had many causes, was primarily a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.”
This was more excuse than explanation.
In truth, it would seem that economists had, in herd instinct, bought into a dubious proposition, namely that the market was rational and self- regulating and that the role of government was to get out of the way of the market. In that world, there could be no impending disaster.
That commitment to a dubious proposition may also apply to current orthodoxy that our failure to achieve strong economic recovery in the aftermath of the financial crisis is due to budget deficits, hence the priority to balance budgets.
This flows from the mistaken belief that it is deficits that slow economic growth and job creation — rather than the reality that slow economic growth and high unemployment contribute to deficits.
In the buildup to the financial crisis, many mainstream economists became cheerleaders for neo-liberal thinking and, in the process, suspended critical judgment.
Deregulation and self-regulation were the flavours of the day, with the view that if government got out of the way, the animal spirits of creative capitalism would unleash a wave of innovation.
What was ignored, as some commentators have subsequently acknowledged, is that markets need laws and rules and that absent these there is no sustainable market.
More recently, austerity has become the flavour of the day, with the emphasis on deficit elimination rather than growth and jobs.
This policy choice was reinforced in a 2010 paper by two Harvard University economists, Carmen Reinhart and Kenneth Rogoff, who concluded that countries with public debt exceeding 90 per cent of their GDP faced slower growth than countries with lower debt.
This conclusion was embraced by economists and politicians advocating austerity and claiming that the best way to reduce unemployment was to cut back on public spending.
Now, a study by a graduate student in economics, Thomas Herndon, has shown that the Reinhart-Rogoff paper was flawed.
But as Adam Posen, a former member of the U.K. Monetary Policy Committee and now president of a prominent U.S. think tank on international economics, says, “forget that specific paper.
The claim that there was a clear tipping point for the ratio of government debt to GDP past which an economy’s walls caved in never made any sense.”
There was no evidence of a causal link.
In the period after the Second World War, Canada, the U.S., and Britain had debt levels far above 90 per cent of GDP yet enjoyed growth in output and jobs.
In fact, slow growth could be the cause of high debt, rather than the other way around.
Posen offers a more optimistic scenario today.
“It is a victory for common sense and good public policy that the IMF has decided to reverse its past mistakes and come out clearly for sensible fiscal approaches — not least recognizing the impact on growth of cutting the deficit and that reducing public debt is a task that should primarily occur once countries are out of recession.”
In other words, “the moderate middle ground between panicked austerity and heedless spending is the right place for policy advisers to be.”
The global financial crisis and the subsequent misplaced emphasis on austerity and deficit reduction over jobs and growth both demonstrate the need for fresh thinking from economists.
Their recent failure to develop clear thinking on major policy issues has condemned millions of people to lost opportunities and poorer lives.
Economist David Crane is a syndicated Toronto Star columnist. He can be reached at crane@interlog.com.