John Maynard Keynes famously wrote that “the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than commonly understood. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”
But I suspect that a greater danger lies elsewhere, with the practical men and women employed in the policymaking functions of central banks, regulatory agencies, governments, and financial institutions’ risk-management departments tending to gravitate to simplified versions of the dominant beliefs of economists who are, in fact, very much alive.
Indeed, at least in the arena of financial economics, a vulgar version of equilibrium theory rose to dominance in the years before the financial crisis, portraying market completion as the cure to all problems, and mathematical sophistication decoupled from philosophical understanding as the key to effective risk management. Institutions such as the International Monetary Fund, in its Global Financial Stability Reviews (GFSR), set out a confident story of a self-equilibrating system.
Thus, only 18 months before the crisis erupted, the April 2006 GFSR approvingly recorded “a growing recognition that the dispersion of credit risks to a broader and more diverse group of investors… has helped make the banking and wider financial system more resilient. The improved resilience may be seen in fewer bank failures and more consistent credit provision.” Market completion, in other words, was the key to a safer system.
So risk managers in banks applied the techniques of probability analysis to “value at risk” calculations, without asking whether samples of recent events really carried strong inferences for the probable distribution of future events. And at regulatory agencies like Britain’s Financial Services Authority (which I lead), the belief that financial innovation and increased market liquidity were valuable because they complete markets and improve price discovery was not just accepted; it was part of the institutional DNA.
This belief system did not, of course, exclude the possibility of market intervention. But it did determine assumptions about the appropriate nature and limits of intervention.
For example, regulation to protect retail customers could, sometimes, be appropriate: requirements for information disclosure could help overcome asymmetries of information between businesses and consumers. Similarly, regulation and enforcement to prevent market abuse was justifiable, because rational agents can also be greedy, corrupt, or even criminal. And regulation to increase market transparency was not only acceptable, but a central tenet of the doctrine, since transparency, like financial innovation, was believed to complete markets and help generate increased liquidity and price discovery.
But the belief system of regulators and policymakers in the most financially advanced centers tended to exclude the possibility that rational profit-seeking by professional market participants might generate rent-seeking behaviour and financial instability rather than social benefit – even though several economists had clearly shown why that could happen.
Policymakers’ conventional wisdom reflected, therefore, a belief that only interventions aimed at identifying and correcting the very specific imperfections blocking attainment of the nirvana of market equilibrium were legitimate. Indeed, the Columbia University economist Jagdish Bhagwati, in a famous essay in Foreign Affairs entitled “Capital Myth,” talked of a “Wall Street/Treasury” complex that fused interests and ideologies. Bhagwati argued that this fusion played a role in turning liberalisation of short-term capital flows into an article of faith, despite sound theoretical reasons for caution and slim empirical evidence of benefits. And, in the wider triumph of the precepts of financial deregulation and market completion, both interests and ideology have clearly played a role.
Interests and ideology often interact in ways so subtle that is difficult to disentangle them, the influence of interests being achieved through an unconsciously accepted ideology. The financial sector dominates non-academic employment of professional economists. Because they are only human, they will tend implicitly to support – or at least not aggressively challenge – the conventional wisdom that serves the industry’s interests, however rigorously independent they are in their judgments concerning specific issues.
Market efficiency and market completion theories can help reassure major financial institutions’ top executives that they must in some subtle way be doing God’s work, even when it looks at first sight as if some of their trading is simply speculation. Regulators need to hire industry experts to regulate effectively; but industry experts are almost bound to share the industry’s implicit assumptions. Understanding these social and cultural processes could itself be an important focus of new research.
But we should not underplay the importance of ideology. Sophisticated human institutions – such as those that form the policymaking and regulatory system – are impossible to manage without a set of ideas that are sufficiently complex and internally consistent to be intellectually credible, but simple enough to provide a workable basis for day-to-day decision-making.
Such guiding philosophies are most compelling when they provide clear answers. And a philosophy that asserts that financial innovation, market completion, and increased market liquidity are always and axiomatically beneficial provides a clear basis for regulatory decentralisation.
Here, I suspect, is where the greatest challenge for the future lies. For, while the simplified pre-crisis conventional wisdom appeared to provide a complete set of answers resting on a unified intellectual system and methodology, really good economic thinking must provide multiple partial insights, based on varied analytical approaches. Let us hope that practical men and women will learn that lesson.
Adair Turner is Chairman of the United Kingdom’s Financial Services Authority and a member of the House of Lords