Why Don’t Economics Textbooks Focus on Financial Crises?

That’s the good question posed by the always-thoughtful David Warsh, proprietor of Economic Principals. Here is his lead:

How peculiar is it that the leading introductory economics texts scarcely mention the cycles of manias, panics, and crashes that have been a familiar feature of global capitalism since its emergence in the 17th century?

No propensity to bubble or bail is among the ten big ideas that govern economics in N. Gregory Mankiw’s text, for example. Ben Bernanke, in the book he wrote with Robert Frank before he became chairman of the Fed, discusses the 1990’s banking crisis in Japan, the dot-com episode in the U.S., and the Argentine collapse in 2001, along with the Great Depression, on which he is an expert; he even mentions in passing the “reckless lending” that led to the U.S. savings and loan crisis in the 1980’s: but the tendency to repeated financial crises is not remarked, and neither “bubble” nor “credit crunch” appear in the glossary.

There’s a lucid discussion of banking panics in Paul Krugman’s principles text with Robin Wells; he asks whether the Fed should have sought to puncture the stock bubble of the late 1990’s: but the “sovereign debt bomb” of the 1970’s and the S&L crisis of the 1980’s have disappeared in the dim mists of time. Even Karl Case and Ray Fair don’t make much of a case for the perennial nature of crises (at least in my edition), though Case, of Wellesley College, and his colleague Robert Shiller, of Yale University, have played a prescient and central role in the analysis of the real estate crash.

Some might say that normative economics doesn’t dwell on such crises because they are not normative events; which is exactly why a lot of people don’t like to pay much attention to what most economists have to say about such matters. Any boat is safe in calm seas — just as nearly any economic theory is defensible in calm time; but in crises — well, a lot of good-looking theories tend to get swamped.

Warsh ends his piece with the truest line of all:

It is the next secretary of the U.S. Treasury who will have the really interesting job.

Here’s the latest on whom Obama and McCain might pick.

Early short lists: McCain likes Warren Buffett, Meg Whitman, and John Chambers; Obama likes Tim Geithner, Larry Summers, and Roger Altman. (McCain again touted Whitman in last night’s debate; Obama played it coy.)

There was speculation a while back that Phil Grammwould almost certainly be Treasury secretary in a McCain administration,” but Gramm probably whined himself out of that possibility.

Although InTrade has written a few contracts on future presidential maneuvers, I don’t yet see a market for Treasury secretaries. Won’t be long, I imagine.

Side note: one characteristic of this financial meltdown that I find noteworthy is the lack of bull-by-the-horns leadership. Bernanke and Paulson are plainly doing their best, but they seem to have inspired very little public confidence.

The president is typically in a position to inspire such confidence, but when Pres. Bush goes on TV these days to talk about the crisis, he seems to be largely ignored. That is what happens when a politician has squandered his political capital. But markets, just like nature, abhor a vacuum. Which is why I suspect that November 5 will be a healthy day for the markets no matter who wins.


flix

Zachb,

"This is free market fundamentalism, and is exactly the kind of naivete’ and dogmatism that got us into the mess we are in now."

I beg to differ. Spend a little time examining our banking system and you'll see it fits quite well the definition of govt. sponsored cartel- much like OPEC.

Take a look at US econ. numbers, govt. spending, etc... or just look at the reactions to the crisis to see that the prevailing establishment mentality is hardly "free market fundamentalism".

But hey, keep on reading, you've hardly scratched the surface.

A E Pfeiffer

Re. Simulations (for Larry and anyone else who's interested) - there's an interesting description of a simulated stock market about three quarters of the way down this page:

http://www.leggmason.com/thoughtleaderforum/2004/conference/transcripts/arthur_trans.asp

The writer is Brian Arthur, an economist noted for his theories on the importance positive feedback, path dependence and increasing returns. His simulation basically shows how a high rate of learning creates a highly volatile situation. In his experiment if the learning rate was set low and all agents started out with similar forecasting machines, he found that the market converged around rational expectations, duplicating the standard economic model and reaching equilibrium.

But if the learning rate was set higher, the market became complex and a market psychology emerged. If some agents discovered a better method to forecast they'd take heavier positions, which would shift the behavior of prices and in turn cause other agents to shift their forecasts. This sometimes resulted in periods of volatility there were huge moves in prices, giving "fat tails" not normal distribution of prices - behavior which is seen in real markets.

Worryingly, Arthur's results imply that the faster markets assimilate new information (i.e. the higher the learning rate), the more they're likely to tend towards volatility and extremes. So the best thing for the current crisis might be to shut down the financial markets, the internet, the mobile phone networks, the TV, the radio, the news networks, etc. for a week in the hope that it persuades people to calm down and break out of this tailspin.

Read more...

Johnny E

Econ 101 used to talk about the multiplier effect where if you spent a dollar in a community it would be worth something like 8x that because it would move around the local economy. I never heard an economist calculate the multiplier effect on our economy of a dollar sent to Bangalore, China, or Saudi Arabia. I think Voodoo Economics finally came home to roost.

The past 8 years we invested in stuff that didn't return much on our inbestment. Ike had it right. Investing in military hardware instead of schools and factories is a poor investment practice. Raising the mortgage deduction limit helps subsidize MacMansions so there is no low-income housing available. A rational choice would be to take out a sub-prime mortgage with no income when the only alternative would be to live on the street. Subsidizing CEO compensation to the tune of 20 billion in the hopes that it would trickle down is silly because there are more effective ways to stimulate the economy. Living wages might help. Giving the workers a piece of the productivity pie would help.

Read more...

Nabeel

whatever happened to speculations of Thain for McCain?

frankenduf

Bernanke and Paulson are "plainly doing their best"- lol- dude, you gotta read the initial bailout plan they submitted to Congress- a 700bil check and a directive to kneel before hank- this of course was bad enough, but it actually put congress in a bind- they were politcally forced to react to the plan, rather than coming up with a better one (see the British plan, which hopefully we will follow)- so now we're in limbo until the next administration can actually think through how to get out of this mess

peter r.

It's remarkable how little the economics profession can contribute to the solution at the moment. Their main theories seem to be as bankrupt as the banks. I hope that academics are being purged as fast as high rolling bankers, or at least they are losing their funding. Their textbooks only teach free market economics: that's the thinking that got us into this mess. Anyone who wants to learn economics from now on will have to look elsewhere for ideas and theories that relate to the real world and not to some 'general equilibrium' utopia. Paul: you must be aware of the problem, what is the state of mind within academia?

ricE

Economists don't really know much about financial crises to begin with.

Joe Smith

"Please do not be confused. Is not free market which has failed. What has failed is the regulator. Autorities allowed banks to lend money in low quality market segments."

Excuse me. It seems to be precisely a failure of the free market when the problem results from the banks investing in what they chose to invest in rather than being limited by the government as to their choice of investments.

Conrad Black is serving serious prison time for doing a lot less damage than the leaders on Wall Street have caused. It is time for senior people on Wall Street to start going to prison and facing forfeiture hearings - starting with Mr. Fuld. And as the Black case has taught us - relying on your lawyers is no defense.

Larry Elliott

To #89

No, I'm not the Larry Elliott of the Guardian.

Interesting that you mentioned Copernicus. When I try to explain science to my children and grandchildren I use the example of gravity. People have always been aware of it, but in the late 1600s Isaac Newton developed a mathematical model that described how gravity behaved (but not what it was). His was a very good model, and you can still go the moon and back using Newtonian physics. However, by the early 20th there were observations that couldn't be explained by Newtonian Physics. Albert Einstein's Theory of Relatively was able to explain Newtonian Physics plus the new observations. Does that mean that Einstein's Theory of Relatively is correct? Maybe, but all we know for sure is that the Theory of Relativity provides a more comprehensive model for how the real world works than does Newtonian physics.

It seems that in economics we don't have an Einstein, let alone a Newton (or even a Copernicus), which was your very valid point.

My suggestion of a financial model was intended to put the whole business on an empirical footing. Any model that didn't include cycles and crashes would automatically go to the bottom of the heap. I suspect that Genetic Programming might lead to a breakthrough. Some factors that would have to be considered, that are more on the behavior side, are: There are many people who make decisions that have little individual affect on the economy, and progressively fewer people who make more significant decisions. The level to which people adhere to ethical standards varies. (If power corrupts, then too much money corrodes). To what degree has legislation created a disconnect between risk and responsibility.

As I mentioned in my original post, I'm aware that such a model would be incredibly complex, and there are certainly dozens, or even hundreds of other factors that would have to be considered.

Sadly, although I'm a retired capacity/performance analyst, I simply don't have the time, the knowledge or the facilities to do this on my own.

Read more...

Clint Hulsey

I have had 3 classes that deal with tools to DIRECTLY deal with this crisis (advandced macro theory, monetary theory, growth theory), it is just that most econ graduates go micro, only a very few of us econ grads go macro or monetary theory for a speciliazation.

Larry Elliott

I find the endless arguments about what should be done to solve the financial crisis to be a non-scientific Tower of Babel. It all seems to be blind flying by the seat of our pants.

I would like to see the development of a simulation of the world of finance. I know it would be incredibly complex, but surely no more so than modelling the world climate. Perhaps it could be run as a set of Open Source projects. At any given time the winning project would be the model that most accurately reflected the real world. Once you have a model, you can start to do “What If” planning to get at least some sense of whether a proposed change or intervention would lead to the desired results.

The process would be open to constructive criticism, correction, and would constantly changing to yield better results, where “better results” are simply that they more accurately and comprehensively model the real world.

Read more...

Eric C Fleischer

The lesson we keep hoping our leaders will learn, but always seem to forgive them for fogetting, is that there will be another financial shift. Whether it is a crisis or not depends on how well one prepares for it. One cannot accurately predict the next fall, but one can prepare for that fall whatever it may be.

We rely on our elected and appointed officials to have a long term view and be the stewards of our future, not the enablers of our present. These officials must take advantage of the good times to prepare for the bad times. Just as a family must save for a "rainy day," so must the government. Any government that operates at rising deficits during boom years is unforgivably irresponsible and incompetant.

Part of the reason for this crisis being so precipitous is the almost complete lack of confidence in our leaders to have prepared for it and to deal with it. I would like to see a complete turnover of all elected officials in the next few election cycles. I would also like to see some job descriptions and qualifications established for elected officials. No wonder Americans can't elect competant professionals, because there is no basis on which to judge whether someone is appropriately prepared to assume responsibilities that are not known to the electorate or to the candidate.

Read more...

Grant

Maybe economists are so invested in the positive nature of capitalism that they consciously or unconsciously avoid talking about the darker aspects of capitalism?

I think it's mostly human nature to do things like that. Just a thought...

MG

The introductory material in Heilbroner and Thurow's "Economic Problem" describes capitalism as a system particularly prone to periodic crisis. This excellent text has the nerve to tell the truth about the US economy.

Joe Smith

Human beings are genetically predisposed to being momentum investors which results in financial markets being inherently unstable. I like Kindelberger's book on manias panics and crashes.

Ken

"Devil take the hindmost" by Edward Chancellor is a very good history of financial bubbles, from tulip bulbs to Japan. (It was written in the late 1990s, just a bit early to cover the tech bubble.) It examines the similarities and differences across bubbles.

patfla

#43 - while it's true that sometimes life imitates art, let's hope that it doesn't play out that way this time.

Jeff S.

Can someone please tell me how 2 government sponsored "corporations" fulfilling a mandate by the government to sell houses to people who couldn't afford them equals "free-market"?

I would also say that people do act rationally during a panic. They make the best decisions possible with the information they have at the time.

jep

If the economic history of the US in the last century can be seen as "the cycles of manias, panics, and crashes" where is this rational behavior that economics is based on? It seems to me that the humans who make up the financial markets are always irrational. They are either irrationally exuberant, panicking or fleeing in fear. Booms, busts & recessions. That is life in America.

Hunter

#6 - Doug B

When I tutored economics in college, the first thing I said was "economics is mob psychology." Once my students understood that, they seemed to "get" the basics much better.

And to all that think that economics best explains markets acting "normally," I've found that the true test of any theory or nugget of conventional wisdom is to take it to the extreme. If the theory holds up when under duress, it's probably worth keeping around. If it fails to explain the extreme, it probably fundamentally fails to explain the mean (although it may coincidentally account for most of the behavior encountered there).