Never Let a Serious Crisis Go to Waste
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Another comparable attempt to manufacture a consensus out of unpromising materials, the mysteriously titled Squam Lake Report,81 was even less venturesome in endorsing a potpourri of unrelated yet relatively ineffectual reform proposals. In that case, the quasi-anonymity was more calculated, since some of the members of the group had individually suffered extremely bad press in the period just prior to the release of the report in 2010: Frederic Mishkin and John Campbell had just been exposed to ridicule in the movie Inside Job, and John Cochrane has already been mentioned above. The roster also included several other prominent neoliberals, such as Raghuram Rajan, Robert Shiller, and Matthew Slaughter. However, significantly, the report was widely trumpeted in the press as eminently “nonpartisan,” justified by pointing to the inclusion of more “centrist” figures such as Martin Bailey and Hyun Song Shin. Nevertheless, Squam Lake turned out to be yet another instance of the “layering” techniques of the neoliberal Russian doll: although publicly promoted out of the supposedly centrist Brookings Institution, the money and organization can be traced back to the Maurice Greenberg Center for Geoeconomic Studies at the Council of Foreign Relations, itself an unabashed neoliberal think tank that boasts staff such as Sebastian Mallaby, Benn Steil, Jagdish Bhagwati, and Amity Shales.82 Maurice “Hank” Greenberg was the disgraced former chairman and CEO of AIG. If there was a consensus inscribed in the Squam Lake documents, it was less representative of the full economics profession than it was more intently slanted toward codification of the minimum that the banking sector could get away with in the tense political aftermath of the debacle of the crisis, rather than any serious attempt to rethink the financial sector from the ground up.83 Indeed, the report rarely exhibits the ambition to actually repair much of anything, but instead proposes thin bromides like “more information” or “greater capital requirements,” which one reason so much of it ended up looking like much of what eventually became the Dodd-Frank legislation. Of course, greater capital requirements for banks amount to no binding constraint if there is continued enhanced freedom to identify as “capital” almost anything you want (debasing its “quality”), if there is no serious confrontation with the shadow banking sector and especially the plague of repo financing, and nothing whatsoever addresses the virtues of the possibility of separation of banking functions into different insulated institutions, such as the so-called Volcker Rule. Here the British Vickers Report was more venturesome, although also hardly radical.84
The one way that the Squam Lake Report was revealed as the product of the crème de la crème of the orthodox American economics profession was in its luxuriant excess creativity when it came to inventing new Rube Goldberg devices to “ameliorate” future financial crises, but to no avail. The regimen of constructing little toy models to get published in major journals was now made manifest in extravagant ingenuity in imagining pointless financial contraptions that have never before existed. Further, the Squam Lake group tended to conflate “regulation” with these contraptions. One centerpiece was to require banks to issue newfangled “contingent convertible [CoCo] bonds,” which would transform debt into equity given certain stipulated macroeconomic triggers. Much of this excess ingenuity was dead on arrival, due to the fact that the bulk of existing financial innovation that had already occurred in actual markets was concertedly attuned to blur the distinction between debt and equity, in order to evade regulatory strictures. And then there was the cute innovation of requiring “too big to fail” banks to file living wills, as if they could or would voluntarily undergo expedited circumspect bankruptcy in case we had another meltdown. That trifle did make it into Dodd-Frank, and has become probably the only successful permanent make-work program to come out of the Obama administration: unfortunately, the sole beneficiaries have been white-shoe law firms.85
The Squam Lake cadre didn’t seek to actually rein in unchecked financial innovation; all they wanted to do was to augment it with a little more of their own strategems. But more telling, in question-and-answer sessions at the rollout of that report, one of the authors was forced to admit that orthodox finance theory (in the guise of the “Modigliani-Miller” theorem) actually contradicted a number of their own prescriptions in the report, since the theory deemed that debt/equity ratios did not matter in an efficient market. Here were the crown princes of academic finance conveniently suppressing one of their own key tenets: faithfulness to orthodoxy proved more treacherous than they had anticipated. Their supposed consensus therefore had no intellectual foundations in the canon being taught in most basic economics courses, and in any event, was not politically astute, since once again it entirely ignored the problems of regulatory capture and the Gresham’s Law of financial instruments. So much for the consolations of “consensus.”
There are many other similar examples from the last few years, but it may be more helpful to tackle the more general issue of the meaning and significance of “consensus” when it comes to the crisis. Much pointless debate emerges from a mistaken impression that, to qualify as a “science,” all bona fide members of a profession must be seen to agree on almost all the propositions characteristic of that field. While this tends to be the lay impression, the history of science reveals that there is often substantial room for dissention in real sciences.86 There abide no stone-scratched Ten Commandments of physics or geology or statistics, however much pedagogy for tyros tends to be prosecuted on that basis. Indeed, the more self-assured the science, the less one finds regularly scheduled expulsion ceremonies for apostates. Instead, one often finds membership in a thought collective correlated with a diverse range of litmus tests: use this model, that empirical technique, this set of subject matters, that rhetorical convention of argumentation, this borrowed bit of theory from a collateral subfield, and so on. Real innovation comes from questioning the full monty in various subtle ways, staying sufficiently within the range of sanctioned methods.
The reason that the economic orthodoxy and journalists had been so obsessively fixated upon the supposed existence of consensus in economics is that many people suspect that economists are little more than crude shills for powerful interests. I doubt that skeptics are as rigidly concerned with logical consistency—since how would that be judged definitively?—as they are with the notion that arguments get repeatedly trumped by instrumental and venal considerations. This is a recurrent topic on blogs, for instance.87 These people are therefore fixated on the sociology of the discipline, and not so much its intellectual trajectory. Thus, for lay spectators of the economics profession, the degree of dissensus serves as a rough proxy of the weight and resources arrayed for and against a particular issue, which are largely unobservable. The fact that this stance presumes a ground state of no outside manipulation to be indexed by full and sweet concord reveals that the underlying image of science is more than a little bit faulty.
Neoclassical economists attempt to get around this problem by proposing a “rational choice” explanation of their predicament. To quote one of their number, the Princeton economist Alan Blinder and his version of Murphy’s Law: “Economists have the least influence on policy where they know the most and are most agreed; they have the most influence on policy where they know the least and disagree most.”88 The problem with this, as with so many other folk generalizations within the neoclassical tradition, is that it has precious little grounding in a body of empirical research. What area of fundamental research has received more attention from economists in the twentieth century than macroeconomic failure and financial crises? And yet, when the time comes to proclaim that there abides a stable corpus of knowledge that constitutes the fruits of all that labor, consensus does not just congeal, but needs to be created from scratch, and shorn up with Sisyphean efforts. And this just as readily occurred in the area that Blinder himself believed was least contentious within the orthodoxy, that is, microeconomics.
The discomposure of dissensus did not end with the subsequent deflation of the bubble. It then broke out in the theoretical are
a concerning whereof the vast majority of neoclassical economists were most proud: the microeconomics of a fully competitive market.89 One of the most worrying heralds of fresh mortification was the so-called flash crash that occurred in New York share markets on the afternoon of May 6, 2010. For twenty minutes, starting at 2:30 p.m., trading volume spiked dramatically as a wide range of shares fell more than 5 percent in a matter of minutes, only to recover equally sharply (Figure 4.7). The same also happened on a number of exchange-traded indexes.
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Figure 4.7: The “Flash Crash” of May 6, 2010
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Source: Bloomberg
Some individual share prices dropped to mere pennies in price, forcing the various exchanges to impose “broken” or canceled trades on something like 27 percent of all transactions. Then many prices immediately recovered, although not all the way to previous levels. Incredulity toward the validity of registered prices struck at the heart of the economists’ pretences to expertise. Such behavior belied all bedrock neoliberal claims of the efficacy of the marketplace in converting information into valid prices. This unprecedented behavior was initially attributed by some journalists to “fat finger” computer-entry mistakes, but their trademark attempt to simplify causality through personification of the economy quickly collapsed, as later reconstruction of events tended to reveal that explanation was false. Perhaps more distressing, a month later, the government investigators and financial economists were no more the wiser as to the real causes of the whipsaw movement.90 What was more disconcerting was that a brawl subsequently broke out among economists over which of the myriad “innovations” in trading may have been the culprit: high-frequency automated trading, the dispersal of trades among numerous for-profit exchanges, robo-trading in general, the practice of “stub quotes,” the role of exchange-traded funds, and so forth. Other, smaller flash crashes have occurred in financial markets since then, among which may be counted the BATS IPO fiasco and the Knight Capital spasm. Distressingly, no consensus interpretation of the flash crashes has taken hold among economists. While this should give market participants pause, you might have thought it would frighten economists even more, since this phenomenon potentially contradicts everything their core models postulate about market behavior. Neoliberals should equally take umbrage, since the wonderful information processing capacities of the market seem impugned by such events. Furthermore, since it occurred on exchanges that were previously deemed to be relatively open and transparent, so that the concurrent prescription that enforced transparency and exchange listing would be able to somehow “fix” the proliferation of specialty OTC derivatives with their faulty pricing (something that purportedly constituted one of the major causes of the last crash) seemed to be put at risk. That is, if anyone was still concerned with making logical arguments.
Disturbing phenomena such as the low-grade fever of flash crashes in asset markets, which continues intermittently down to the present, should have been taken as a warning that the crisis was slowly undermining neoclassical microeconomics as well; and yet nothing of the sort has transpired. Instead, most economists kept pretending that, should any disconfirmatory experience of the crisis exist, it had remained localized somewhere in the neighborhood of “macroeconomics” alone.91 One of the strangest aspects of this crisis has been the utter failure of repeated attempts to insist that the orthodox economics profession in the face of crisis hews closely to a solid consensus, anchored to Walrasian general equilibrium theory, combined with the neurotic insistence that the damage has been contained to some relatively small subset of orthodox economic thought. It is astounding that neoclassical economists seem predisposed to accuse everyone other than themselves of something they called “irrationality” in the crisis, when a good working definition of irrational action is the repetition of the same old behaviors in hope of a different outcome.
How Did Neoclassical Economics Dodge the Bullet?
And yet the profession has not really suffered any dire consequences from the litany of embarrassments enumerated above. Economists are still invited to talk shows, profiled in The New Yorker and PBS Newshour and BBC Newsnight and the Wall Street Journal, respectfully solicited for their opinions without being ridiculed openly (even on the recurrent occasions when any pair of them sequentially asserts A and not-A with a straight face). Orthodox economists propound a neoclassical orthodoxy awash in waves of willingly submissive students, are paid salaries frequently second only to the research MDs at their universities, and allowed to preach the self-congratulatory proposition that they remain in firm possession of a self-confident science. Under the influence of the brief uprising known as the Occupy movement in 2011, when a group of students noisily walked out of Gregory Mankiw’s introductory economics lecture at Harvard, it was treated as some passing undergrad hijinks by the press: Who were they kidding? Economists have been treated with relative impunity even on The Colbert Report. They are continually importuned to prophesy: Is the crisis over yet? Will things get better? Where should I park my pitiful 401(k) account? Economists, it appears, have unexpectedly displaced the clergy as the untouchable Delphic oracles in modern society.
There are two rough tacks that one can pursue to try to understand the Teflon ascendancy of the economics profession throughout the crisis. The first is to baldly insist that nothing of substance that has transpired contradicts the intellectual core of the orthodox scriptures. One still infrequently encounters this take-no-prisoners gambit, especially on occasions when some Nobel graybeard is trotted out to defend the profession;92 but I feel fairly confident that if you have read this far, you will agree that this ploy has been utterly implausible and ultimately unavailing; it may even be suffering diminishing returns as time passes. It is just undeniable that, as the crisis drags on, the pall does tend to besmirch the shiny surfaces of the tablets upon which the neoclassical commandments are inscribed.
The other tactic is to engage in serious sociological examination of the profession and its foibles, as we do here. The economics profession can seem to have escaped scot-free from the crisis only because certain fundamental intellectual trends and supportive institutions conspired to maintain its standing in the face of screaming headwinds. Intellectual orthodoxies never persevere out of pure inertia, not over the long haul; it takes more than a village to keep them on life support.
The armory of defense mechanisms in the particular case of neoclassical economics will become apparent only with the fullness of time and the diligent efforts of future serious intellectual historians of economics; but in the interim, I shall venture to suggest four major sources of the deliverance of economics from its critics.
The Immunity Granted by the Financial Sector and the Fed
We have already encountered the gist of this assertion, but the time has arrived to make it explicit. I have spent inordinate time on the Federal Reserve in this chapter for one very salient reason: If it was indeed the case that the orthodox economics profession was heavily integrated with the formal financial sector, which means both the banking and allied spheres and the major governmental institutions tasked with their regulation, then in the eventuality that both spheres will have managed to come through the crisis intact, then the economics profession would also be sheltered from the storm. The evasion of consequences from the crisis by the banking sphere, however achieved, translates directly into evasion of contumely by orthodox economists. In a counterfactual world, had the reaction been instead the breaking up of the big banks and cleaning up the shadow banking sector, say by some new resolution authority, not to mention the sweeping purge of the Augean stables at the Fed and (say) the SEC and CFTC and even the IMF, then the economics profession would have acutely discovered a badly exposed and vulnerable flank. Once heads started to roll, the press would have been more inclined to discover economists’ craniums skittering hither and yon, and then it would have proven far more difficult to maintain the pretense of serving as detached spectat
ors, guarantors of the public weal.
The interlocking connections between the pinnacles of the economics profession and the glittering heights of the financial sector have been briefly noted in passing, but tended to get lost when many of those firms were rescued or otherwise saved by the Fed. The movie Inside Job attempted to foreground the subject of how there must have been something systematic about an entire profession getting paid to be on the wrong side of a degenerating financial infrastructure, and then shielded from audit thereafter; but perhaps predictably, the lesson was rapidly interpreted as concerning the decrepit morality of a few individuals taking a little money “on the side.” The riposte was predictable: Defenders were readily recruited to huff, and intone with gravitas: these people really believed what they preached, were not craven lickspittles, and could not be corrupted by modest emoluments. One indication that this interpretation was itself faulty was that the amounts of money involved were many multiples of their official academic salaries. Another is that the point being made about the Teflon economists has nothing to do with their personal probity or cherished beliefs: rather, it concerns the ways in which these figures led the economics profession to be suborned to the financial sector.