At the most recent Adam Smith Lunch at Boodle’s, in the presence of senior business figures and economists, Dr Peter Warburton talked about how macroeconomists failed to spot two of the trends which transformed our world and led to the credit crisis
Should the collective noun for macroeconomists be a ruination?
The lamentable condition of the UK macro-economy – and indeed that of many developed countries – owes much to the poor understanding of the transformation of its underlying processes over the past 15 years or so. Poor policy choices have surely worsened our predicament.
Much of this poor understanding reflects a neglect of the discipline of empirical analysis, by which is meant the testing of hypotheses and theoretical assertions against real data. Empirical analysis is messy work, involving data collection, organization and the calibration of macroeconomic relationships. It is immensely time-consuming and often frustrating. In the early years of my career at the London Business School, entire weeks and sometimes months disappeared in the search for a single robust empirical representation of an economic relationship.
During the 1990s, something happened to macroeconomics: empirical analysis fell out of favour and those who persisted with it found that their efforts to publish were confronted with interminable referees’ objections and criticisms. So, aspiring macroeconomists fell back on assertions, a dubious tradition of which Keynes himself was a part. As one LSE professor once confided, there are three methods of proof in economics: by induction, by deduction and by repeated assertion.
The retreat of macroeconomics into paradigm has been disastrous for our understanding and our policymaking. The irony is that, in the natural sciences, the acceptance of a paradigm is connected to its empirical validity, as illustrated by this web-dictionary definition:
‘An overall concept accepted by most people in an intellectual community, as those in one of the natural sciences, because of its effectiveness in explaining a complex process, idea, or set of data.’
In macroeconomics, it is most definitely a case of “Paradigm Lost”. Popular macroeconomic paradigms, such as DSGE (Dynamic Stochastic General Equilibrium), fail to explain the complex processes of the economy and fail to keep faith with the data. The carelessness of missing two revolutions Modern macroeconomics has missed not one, but two revolutions, and we are suffering the consequences. It missed the Credit Revolution that opened the door to the present Credit Crisis and it has missed the Supply Revolution that will shape economic outturns in the wake of the Credit Crisis. Please allow me to explain.
a) Credit Revolution
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The economics establishment missed the significance of the revolution of credit supply in the 1980s onwards, as traditional banking gave way to investment banking and securities dealing, and personal wealth migrated from bank deposits and gilts into equity funds and corporate bond funds etc. Disintermediation empowered companies to raise funds from the capital markets and gave consumers access to a wide array of financial products with more attractive returns.
But the ascent of capital markets was also instrumental in shifting the fulcrum of the whole financial system away from money markets – over which central banks had authority – to bond markets, over which central banks merely have influence. As the forms and varieties of non-bank credit proliferated, coupled with the headlong expansion of interest rate and credit derivatives, it became clear that aggregate credit growth was running persistently ahead of the growth of nominal GDP. The whole economy was becoming progressively leveraged with no obvious mechanism for its restraint other than the crises which peppered modern history from 1994 until the Big One duly arrived in 2007.
The paradigms, above, typically took the integrity of the credit system for granted; they assumed away the problem.
b) Supply Revolution
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Once again, macroeconomics has failed to understand the importance of a collection of remarkable developments in the realm of corporate governance (executive compensation, outsourcing, offshoring), the repeal of anti-trust legislation and the impact of technological innovation on industrial processes. The dismantling of dedicated local supply chains and their replacement with shared global supply chains was a force for disinflation before the Credit Crisis, but the fragility of these arrangements has been exposed. Structural disinflation is giving way to structural inflation as the importance of systemic reliability is reconsidered.
While macroeconomists have been playing with their elegant models, the supply-side of the economy has been transformed. Businesses have transferred production risk down the supply chain; business risk to the workforce through flexible working practices; re-tooling costs have been eliminated by advanced technological processes. So, productive potential can react more quickly to sudden shifts in demand. However, these intricate arrangements can be readily damaged by a crisis of credit access. With less slack in the productive system, supply shocks are transmitted more easily and with more dramatic consequences.
The real-world implication of disregarding these developments in the design of macroeconomic policy has been to rely upon the Keynesian paradigm of the Output Gap to quell inflationary pressures arising from super-stimulatory fiscal and monetary policies. Alas, supply constraints are closer at hand than the paradigm would allow, especially for food, potable water, energy and some basic commodities and minerals. These are items for which demand is price inelastic and which carry large weights in the construction of the Consumer Price Index.
In conclusion, we have arrived at a dangerous conjunction of economic history with a pre-disposition to global inflation, yet without the tools or the political resolve to confront it. Central bank inflation targets are likely to be challenged again over the next few months. A prevailing belief that the inflationary threat is distant and improbable is helping central banks to defer the tightening measures that might defend their inflation credentials. Stymied by the unintended consequences of past mistakes, the policy stance is liable to remain sufficiently loose to give free rein to inflationary forces in the years ahead.
As the prices of basic foodstuffs, water supply and energy soar, governments will find it difficult to resist the payment of additional benefits and pensions to enable them to be afforded, given the risks of civil unrest and economic dislocation. Investors, sensing the fragility of these basic infrastructures, will seek additional exposure to these commodities. Governments still appear to believe that there are these deep pools of private savings, eager to snap up every available government bond issue. As a greater proportion of these issues is taken up, instead, by the commercial banks, then the gradual process of monetization will carry us towards a full-blown inflation.
To design better policy responses, we need to return to empirical analysis and intelligent observation of the productive process.
