The state of economics and the challenges for economics

Comments on Doug McTaggart, Christopher Findlay and Michael Parkin “The state of economics”, 21/05/2009, http://www.eastasiaforum.org/2009/05/21/the-state-of-economics/#more-4471

As an amateur economist, I sort of agree with the author’s points’, but only to a certain degree. The second dot point at the beginning was like the story of a bottle half empty versus a bottle half full, depending how you look at it. While it sounds obvious right, one can’t help have a sense of tautology in the argument. Nevertheless, it may inject some fine-tuning to the hot debate on strengthening financial regulations with some cold reasoning.

The third dot point appears to be too much of a defence of the indefensible probably to save some face for the economist profession. The authors provided some examples to show their point. To quote from them:

[Evidence of a problem had started to accumulate from early 2007 and economists were already working on scenarios associated with sub-prime problems in the US. In early 2008, the body of academic economists in the US had sessions in their annual conference on exactly that topic. Nouriel Roubini and Paul Krugman were then making their warnings.
The focus at that time was on the sub-prime assets associated with housing loans and it was expected that any shock there would be a relatively small and manageable. That expectation was not met, because of the interconnectedness of the financial markets in different countries, the extent to which banks in other countries were exposed to these assets and the extent of leveraging that had taken place.]

It seems that the very examples they used actually disproved their point at the same time when they tried to argue it and shot their own feet. The root of the current crisis had its origine much earlier than 2007. As the authors said, in as early as 2002 the Fed began its overly loose monetary policy and persisted with that unwise monetary stimulus policy until 2006. The sub-prime would have started also well before early 2007 when the author said economist were working on that. As the author said, only until early 2008 “economists Nouriel Roubini and Paul Krugman were then making their warnings”.

Was that strong enough to say that economists didn’t fail to anticipate and avoid the crisis? As an amateur economist, I don’t feel that way, to be frank. To say otherwise is too defensive, if not being interpreted as offensive.

The fourth dot point is obvious correct, but is incomplete in the sense that it does not say there have been significant failures in economics, both at the microeconomics and the macroeconomics levels. From microeconomics point of view, there are the issues of correct valuation of securities, derivatives and etc, as well as the associated information failure. Economics needs to contribute to the resolution of those issues.

At the macroeconomics, the conventional macroeconomic tools or policies provided few ready policy prescriptions for the authorities to use to combat the financial and economic crisis, so that the Fed have recently had to resort to the so-called non-conventional methods in its attempt to find a way out. Conventional monetary policy has long become ineffective when interest rates are very low, as have been the cases in a number of countries.

The effectiveness of conventional fiscal policy has also been in doubt. This is because the levels of government debts in quite a number of advanced economies were high and further rises in government debts run into political difficulties and also undermine confidences. More to the point, if the private sector stops, it is probably too much to expect that the government can fill the entire void left. There are also the longer run consequences of too much government spending and debts. The long run efficiency of the economy is at risk if government plays too much the role of the private sector. More importantly, fiscal policy does not appear to be the right approach to solve the current financial and economic crisis, a balance sheet recession as some economists calls it, as opposed to insufficient aggregate demand, similar to the Japanese case following the bubble burst in the early 1990s that gave rise to the lost decade for Japan.

Economists’ two main arms of macroeconomic tools or policies have been ineffective. Like it or not, that has been the fact and economists should have the courage to admit it. Only by truthfully realising the failures of economics, can economists create new theories to remedy those failures, to provide new and more effective prescriptions for authorities to deal with similar future challenges.

The Keynesian theory was born following the great depression. Although having been criticised and ridiculed by many, it including both the conventional fiscal and monetary tools, has contributed in preventing another great depression until this great recession.

New theories will arise from the experience of this great recession. They will further enrich the body of economics and provide theoretic guidance to policy makers when they face another one. But hopefully, if advances in microeconomic theories can effectively address the correct valuation of securities and risks, we may not experience another great recession.

While it is too early or premature to say what is needed of macroeconomics, it appears that it might need to keep the stability and correctness of “asset market values”. They can’t be allowed to grow too fast to balloon to bubbles. Nor can they be allowed to fall too much when bubbles burst to such a degree that severely affects both the supply (firms don’t produce) and demand (consumers don’t consume) as a result of battered balance sheet due to falling assets values.

What the authorities in many countries have done so far have an effect to lift the values of both the housing markets and the equity markets or at least to prevent them to fall further, intentionally or not. But the efforts so far have appeared to lack of potence. But they are trying without the guidance from economists, or maybe ignoring theirs.

It is in this sense of advancing both microeconomics and macroeconomics that I totally agree with the authors’ fourth dot point, that is more economic research is the best hope. It is high time for economists, especially those who are in academics with considerable freedom to choose their research topics to meet the challenges as both the important and the emergent as the current ones.