Seeing the economy through wrong lenses

8 September 2009 - The deep global recession from which we are currently recovering came as a surprise to the majority of Wall Street analyst, as well as central bankers and academic economists.  It is not too difficult to nail them to the wall, because their assertions have been widely recorded in print and the general media.

There was an astonishing degree of complacency right on the eve of the downturn, even as danger signs increased.  Now, herd behaviour is very common in this line of business, and this was particularly so after the experience of a long period of robust low-inflation growth.  Everybody bought into the model and it became an article of faith that the blue skies would continue, as people routinely discounted contrary evidence.

For the individual analyst, it is always safer to issue opinions close to the consensus than to stand apart from the crowd.  Only occasionally will someone risk a radical departure from the reigning view, because the cost of getting it wrong may be higher than the temporary fame of being right.  Sticking your neck out may be a dangerous career move.  Being wrong, along with the majority, is a safer bet than being wrong alone.

But not all the analysts are docile sheep.  Some of them are independent thinkers who focus on danger signals and the possibility of untoward events occurring.  However, broadcasting those views to clients and the general public poses its own risks.

So there is a degree of self-censorship, or the imposition of editorial strictures, because of the fear that the intended audience of investors may become too alarmed and take precipitate action that can have damaging effects.  So the wording is watered down and the hard truth reserved for insiders only.

Central bankers not only got the forecasts thoroughly wrong but they were also the prime engineers of the boom that got out of hand and became a big bust.  We don’t want to get into another spate of Greenspan bashing but the record shows that he did cause a lot of trouble by continuing to puff up the balloon long after he should have stopped.  And his successor was totally in the dark, declaring that we had entered an era of “great moderation”, even as the storm clouds were evident overhead.

There was a great degree of faith in the reigning economic models.  Over the past decade, quantitative models derived from financial economics have been applied extensively in trading, portfolio management and risk control.  But some of them were found to be seriously wanting as the environment changed substantially.

There were evident design flaws and they often contained assumptions that only applied under certain circumstances.  As environmental conditions changed the failure rate of these models increased dramatically.  The financial losses mounted and the crisis spread jeopardising the global economy.

Nassim Taleb, of black swan fame, has had a field day over the past year disparaging the models and their creators.  One has to admit that there is a good deal of truth in what he has to say, though his enthusiasm for putting the boot in can be a bit overdone.

At heart is the failure of an economic model of the way the world works, as well as its accompanying ideology.  It’s the Newtonian neoclassical model of rational expectations, in which economic agents are well-informed rational actors taking optimal decisions, according to a correct model of the economy.

A rarefied cool and calculating world of automatons, far removed from the real one of herd-like crowds animated by palpable fear and greed.   In terms of the neoclassical model of the world, the financial crisis and the ensuing deep recession could not have happened; and yet it did.

In the next article we will take a closer look at the failure of orthodoxy and examine the alternative way of viewing economic and financial behaviour.