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Economics shrugged

In the wake of the most devastating economic crisis in generations, how is the failure of prevailing economic models transforming economists’ research agendas? University Affairs asked a number of Canada’s leading economic thinkers

BY DANIEL MCCABE | MAR 09 2009

When former Federal Reserve Chairman Alan Greenspan went before Congress last October, he told American lawmakers that the economic meltdown had revealed “a flaw in the model” that he had not expected – that banks operating in self-interest would not self-regulate to protect their shareholders and institutions.

The moment was a powerful symbol of the intellectual failure of contemporary economic thinking. It showed that far from the pitched political battles, even the sagest of economic minds could not explain how we had steered ourselves to the cliff’s edge – and how we might avoid ending up there again.

That gaping hole in our collective understanding will have to be plugged sooner or later, a job that will inevitably fall to economists, including here in Canada. “This is an epochal moment,” says University of Manitoba economics professor Fletcher Baragar. “In a sense, all of our training has positioned us to make sense of what is going on.” Stephen Gordon, economics professor at Université Laval and author of a popular economics blog, “Worthwhile Canadian Initiative,” agrees. “This reminds me of the ’70s when we first saw stagflation,” says Dr. Gordon. “It was something new, something we had never really seen before, and several Nobel Prizes were handed out to economists for trying to explain it.” A confused public is understandably hungry for answers. Not long after Lehman Brothers, the international investment giant, stunned Wall Street by declaring bankruptcy last September, Dr. Baragar and some of his departmental colleagues organized an informal roundtable discussion at their university about the growing crisis. “The place was absolutely packed,” says Dr. Baragar. “Dozens of people couldn’t get in.” Journalists have been calling weekly – “some weeks, five or six” – for an explanation of what is happening. “It does make it a lot easier to teach,” says Dr. Gordon. “I’ve been teaching a class on international macro-economics and I’ve had no problem whatsoever keeping students interested in subject matter that people often find somewhat dull.” Here are some more views from leading economic thinkers on how the global economic crisis may affect the teaching and research of economics in Canada.

Mintz: ‘We were at fault’

Two years ago, when the University of Calgary announced it had recruited Jack Mintz to head up its brand new School of Policy Studies, the university probably didn’t realize just how prescient its choice would be. The new school aims to quickly establish itself as a key contributor to major public policy debates in Canada. There are precious few issues likely to eclipse the economic downturn anytime soon, and Dr. Mintz is well poised to help steer the discussions.

In fact, Dr. Mintz, the former president of the C.D. Howe Institute and a well-regarded fiscal and tax policy specialist, already finds himself in the thick of it. When Finance Minister Jim Flaherty assembled an advisory council of top business people and financial experts to offer him counsel on how to help the country contend with the economic challenges, Dr. Mintz was the only academic invited to take part. In response to accusations from some quarters that economists haven’t been as rigorous as they should have been in keeping an eye out for trouble spots in Western economies, Dr. Mintz pleads guilty. “Economists, including myself, are at fault for not seeing earlier the faults in the financial system,” he says. “But we weren’t the only ones – investors, borrowers, governments all misunderstood what was happening in markets.” Dr. Mintz expects that the “underpricing of risk” that played such an instrumental role in the economic crisis will become a hot subject matter for economics research in the years to come.

“Was it too much belief in mathematical models with assumptions that were too limited? Was it [a matter of psychology] on the part of investors discounting risk? Was it a failure of government in regulatory matters?” These are all topics that economists will need to explain, he says.

Redish: Changing economic models

University of British Columbia professor Angela Redish is one of the country’s most respected monetary historians and a former adviser to the Bank of Canada. She is fully aware that the ongoing worldwide recession has been wrenching for millions of people, particularly those who have lost their jobs, and she takes no pleasure in that. But it does make her job much more interesting as she watches history being made right in front of her eyes. “It’s somewhat embarrassing to say, but as a monetary historian, I find this great intellectual fun.”

Dr. Redish is assembling a team of academics – economic historians, labour economists and finance experts, as well as legal scholars and political scientists – to examine the crisis from a variety of viewpoints.

While economists knew for quite some time that a combination of factors, especially in the U.S., were going to inevitably lead to trouble – staggering trade deficits, a feckless approach to credit and an over-heated housing market, among them – the speed and severity with which the crisis finally struck caught just about everybody off guard.

“How did the monster creep up on us without us noticing it?” asks Dr. Redish. One reason, she says, is that people who have expertise in different facets of the economy “don’t necessarily talk to each other.”

Major economic crises tend to leave behind different sorts of legacies. The modern social safety net emerged largely as a result of the Great Depression. “I think that’s one of the more interesting questions regarding the current crisis – what sorts of government programs will be created as a consequence? What impact will it have on society?”

A crisis like this one also affects the discipline of economics itself. “It certainly has an impact on the economic models that emerge,” she notes. After the Asian crisis in 1997, “we heard a lot about ‘herd mentality’ as an important contributing factor,” when investors pulled out of the region en masse – making a bad situation even worse.

“Behavioural models of economics still aren’t central to economic theory,” says Dr. Redish. But that could change as a result of the current crisis, where widespread recklessness was an important contributing factor. “We might see behavioural models become more popular,” while models that emphasize stock market efficiency, “might be on the wane.”

Baragar: Long live Karl Marx

Can there be an upside to an economic crisis? Fletcher Baragar thinks there might be – at least in terms of the vitality of economics as an academic discipline.

Dr. Baragar is the sort of economist who thinks you don’t have to be crazy to believe that Karl Marx might still be relevant in this day and age, particularly in terms of identifying some of capitalism’s rougher edges.

“Marx was interested in the sources of instability that tend to reverberate in times of crisis,” says Dr. Baragar. “There is still much in the third volume of Das Kapital that hasn’t been carefully worked through. It is a treasure trove of ideas and rich insights.”

In recent years, that kind of talk wouldn’t exactly endear an economics professor to his colleagues. “In the last 20 years or so, there has been a sort of free-market triumphalism following the collapse of the Soviet Union,” continues Dr. Baragar, noting that in recent years dissenting voices in economics have been marginalized.

The trouble with having only one prevalent point of view, he goes on, is that important questions don’t get asked in that kind of environment. Questions like: “How robust is the system? Where do the problems lie? What could go wrong? That has been the Achilles heel in economics, both as a profession and as a discipline.”

But things could be changing, he believes. “The policy recommendations we’re hearing about now are demonstrably different from what they were several months ago,” noting that people are talking about Keynes again. John Maynard Keynes famously argued in favour of government intervention in the economy, especially in times of crisis, a notion that wasn’t held by the dominant Milton Friedman anti-regulation acolytes in recent years.

The crisis is having a more immediate impact on Dr. Baragar’s life. “In terms of my own work, it’s almost exclusively focused on these issues” he says. “Right now, this is my research agenda.”

Heath: Philosophical view

Though he is an associate professor of philosophy, the University of Toronto’s Joseph Heath is very interested in the workings of the economy. “Philosophers spend a lot of their time thinking about fallacies” – popularly held notions that turn out to be wrongheaded when given careful analysis. “When it comes to fallacies, economics is a gold mine,” he says.

Dr. Heath’s newest book is called Filthy Lucre: Economics for People Who Hate Capitalism. It examines a dozen of those fallacies – six of which tend to be held by the political left, the other six dear to right-wing adherents.

“There’s very little out there in the way of economics for non-economists,” says Dr. Heath, suggesting that economic misperceptions tend to be widespread because economists don’t explain basic concepts to the public, thinking that the public understands them already. But even in a university environment, filled with “lots of very intelligent people,” he’s “always struck by how little they grasp the details of how the economy works.”

As an example of widely held, wobbly thinking, Dr. Heath points to the notion that tax cuts stimulate an economy. “You can only stimulate an economy by pumping fresh spending into it, money that has to be borrowed from somewhere else,” says Dr. Heath. Cutting taxes just changes public spending into private spending, but it doesn’t actually bring any new money into the economy, he adds. “So the net result for the economy is really zero.”

While he hopes that people from all sides of the political spectrum enjoy his book, the former student radical is particularly keen to have an impact on the left, where people too often nurture such a visceral distaste for the workings of capitalism that they don’t bother to study the details of how it works. “You can be committed to social justice and still take the time to understand how the economy functions.”

Davies: Future not so rosy

Timing is everything, as University of Western Ontario economist James Davies discovered last year when a book he edited was published.

The book, Personal Wealth from a Global Perspective, examines how wealth is distributed to individuals in a wide range of countries. It’s an area in which Dr. Davies has a high profile: his co-authored 2006 study positing that one percent of the world’s population controlled 40 percent of its total household wealth attracted considerable media coverage. So he was hoping that his new book about the intricacies of personal wealth, including the situation in emerging economies like China and India and the developing world, would also prove influential.

But just a few months after the book hit the shelves, the world’s economic landscape was unexpectedly transformed. “Parts of the book already feel dated,” he admits. “The book is about the global distribution of wealth and a fair amount of that wealth has just disappeared.”

While it’s hard not to be nervous about the economy, Dr. Davies (who edits the journal Canadian Public Policy) hopes that Canadians don’t panic. “We aren’t the U.S.,” he says. “When it comes to the economy, Canada really did get it right in recent years,” citing efforts to reign in spiraling deficits in the ‘90s. “We were kind of scared straight.”

He isn’t saying that the government should stand pat, but he is concerned that Canadian politicians are feeling pressured to take action just so they can demonstrate that they’re doing something. Canadians should not look at what’s going on in Washington and think that Canadian governments aren’t doing enough, he says. “The situation there is terrible, and psychologically we’ve been affected by that.”

While Dr. Davies isn’t overly worried about the Canadian economy, he does have apprehensions about the state of Canadian economics.

“Economics departments in Canada have shrunk significantly in recent years. If you made a list today of the number of economists working at Canadian universities, it would be about half as much as we had during the ’70s,” he says.

“Economists tend to be fairly mobile. We’ve lost a number of very talented people to the U.S. and other countries where economists have been in demand and salaries have been going up. We were just starting to turn that around, and now [because of the economy], I don’t know what’s going to happen.”

PUBLISHED BY
Daniel Mccabe
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  1. Bellamy Hill / March 16, 2009 at 14:36

    << But it does make her job much more interesting as she watches history being made right in front of her eyes. “It’s somewhat embarrassing to say, but as a monetary historian, I find this great intellectual fun.” >>

    This is the sort of comment that makes people in the real world think university types are out of touch. Especially those with tenure. Yes, it’s encouraging that, once again, people are taking economists seriously, packing your classes and paying attention. But please show some humanity. This is a recession – not a jolly romp for academics.

  2. Ian Skaith / March 17, 2009 at 18:46

    There is no question that academic and business economists were too fixated on admiring the benefits of globalization. They forgot some old

    cycle theory that focusses on the creation of excess production capacity and inflated asset prices by governments that tolerate and encourage easy credit and non-transparent unregulated banking and investment practices.

    The developed and developing world moved above a sustainable growth path and now market prices have violently readjusted to a new level possibly under long term sustainable levels.

    If it was not for the weakening of traditional anti-recession policy tools and the risk of mismanagement of money issuance this global recession would not be so frightening.

    The amount of liquidity pumped into world economies creates a significant inflation risk. Lets hope this experience has gotten the attention of both academic economists,business leaders and government decision makers so stability of the global macro economy can be restored.

  3. tV / April 21, 2010 at 14:32

    — “Economists, including myself, are at fault for not seeing earlier the faults in the financial system,” he says. “But we weren’t the only ones – investors, borrowers, governments all misunderstood what was happening in markets.” —

    More precisely, a certain brand of economists who make their living advising the Bank of Canada and other investment firms didn’t see it coming as their job security depends upon supporting and not undermining the status quo.

    (Which should seriously call into question the efficacy of such economists.)

    The economists who did see it coming: Christian Marazzi, André Gorz & Franco Berardi, to name a few. Never heard of them? Not surprising. They spend a lot of time reading Marx. They also don’t fall for Rational-Actor-Theories and other such nonsense that still dominates most mainstream economics.

    By “mainstream” I mean the word that is scarce in this article: capitalist.

    That there are different possible *kinds* of economy is completely lost on prevalent economists.

    Of course, it’s good to hear that the “mainstream economists” are just catching up and brushing up on book 3 of Das Kapital — after the jury has already been hung, drawn & quartered, of course — though they might want to turn to the Grundrisse and the fragments on machines and the general intellect so they can grasp the correct assessments Italian economists and political theorists developed over 30 years ago.