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What causes financial crises? Unfortunately, as I wrote elsewhere (see here), mainstream macroeconomists have very little to say about the subject, given their decision to ignore the role of money, credit and finance. This error has a long history that can be traced back to the works of Adam Smith, Jean Baptiste Say and John Stuart Mill.
In its current incarnation, money is treated as a “veil” over the real economy and is thus viewed as irrelevant based on the belief that it is a commodity and banks are only intermediaries between savers and borrowers. However, as the Bank of England (2014) and others have recognized, this view is factually incorrect. In the real world, banks create credit (and, given double-entry bookkeeping, deposits, which are money).
As a result of this error, mainstream macroeconomics (as espoused by Krugman, Bernanke, et al.) did not anticipate the crisis in 2008. Here is a disturbing comment issued by Robert Lucas, a Nobel Prize winner and former president of the American Economics Association in defense of mainstream macroeconomic models in The Economist Magazine in 2009:
The charge is that the forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring.
Andrew Haldane, with the Bank of England, responded that:
This is no defense. Economics is important because of the social costs of extreme events. Economic policy matters precisely because of these events. If our models are silent about these events, this jeopardizes the very thing that makes economics interesting and economic policy important.
Yet, little has been (or can be) done to rectify mainstream models, known as dynamic stochastic general equilibrium (DSGE) models. As Paul Roomer, former professor of economics at New York University, who now works as chief economist at the World Bank (and is therefore, in his own words, liberated from the constraints imposed by the academy) stated in an article entitled “The Trouble with Macroeconomics,” “For more than three decades, macroeconomics has gone backward.” We will have to look elsewhere for answers.
Fortunately, some economists did see the crisis coming, including (to name two) Richard Werner and Steve Keen. Yet, their work has been largely ignored by mainstream macroeconomics, which even today continues to argue that money and credit do not matter. Is this simply another inside battle of ideas among economists? Not quite – in fact, the mainstream view has had significant real-world consequences, as we discovered in 2008. The question from the Queen of England resonates: “Why did no one see it coming?”
How does this discussion impact investment strategies?
Investors have twice lost 40% of the value of their portfolios since 2000. One loss of 40% necessitates a gain of 67% just to get back to even. This has happened twice in less than twenty years! Mainstream macroeconomic theorists (and many financial market practitioners) justify these losses based on the mischievous “black swan.” I disagree. In fact, these losses could have been averted, or at least reduced, had macroeconomic and financial stability risk been properly integrated. Unfortunately, mainstream economic theory is trapped – its foundation (belief system) in equilibrium, and its decision to ignore money and credit, makes adaptation to the messy real world complicated. And so it maintains its factually incorrect belief that banks are simply intermediaries between borrowers and lenders, as opposed to what they truly are, which are creators of credit and money.
By John M. Balder, read the full article here.
