John Maynard Keynes famously wrote that “the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than commonly understood. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”
But I suspect that a greater danger lies elsewhere, with the practical men and women employed in the policymaking functions of central banks, regulatory agencies, governments, and financial institutions’ risk-management departments tending to gravitate to simplified versions of the dominant beliefs of economists who are, in fact, very much alive.
Indeed, at least in the arena of financial economics, a vulgar version of equilibrium theory rose to dominance in the years before the financial crisis, portraying market completion as the cure to all problems, and mathematical sophistication decoupled from philosophical understanding as the key to effective risk management. Institutions such as the International Monetary Fund, in its Global Financial Stability Reviews (GFSR), set out a confident story of a self-equilibrating system.
Thus, only 18 months before the crisis erupted, the April 2006 GFSR approvingly recorded “a growing recognition that the dispersion of credit risks to a broader and more diverse group of investors… has helped make the banking and wider financial system more resilient. The improved resilience may be seen in fewer bank failures and more consistent credit provision.” Market completion, in other words, was the key to a safer system.
So risk managers in banks applied the techniques of probability analysis to “value at risk” calculations, without asking whether samples of recent events really carried strong inferences for the probable distribution of future events. And at regulatory agencies like Britain’s Financial Services Authority (which I lead), the belief that financial innovation and increased market liquidity were valuable because they complete markets and improve price discovery was not just accepted; it was part of the institutional DNA. This belief system did not, of course, exclude the possibility of market intervention. But it did determine assumptions about the appropriate nature and limits of intervention.
For example, regulation to protect retail customers could, sometimes, be appropriate: requirements for information disclosure could help overcome asymmetries of information between businesses and consumers. Similarly, regulation and enforcement to prevent market abuse was justifiable, because rational agents can also be greedy, corrupt, or even criminal. And regulation to increase market transparency was not only acceptable, but a central tenet of the doctrine, since transparency, like financial innovation, was believed to complete markets and help generate increased liquidity and price discovery.
But the belief system of regulators and policymakers in the most financially advanced centers tended to exclude the possibility that rational profit-seeking by professional market participants might generate rent-seeking behavior and financial instability rather than social benefit – even though several economists had clearly shown why that could happen.
Policymakers’ conventional wisdom reflected, therefore, a belief that only interventions aimed at identifying and correcting the very specific imperfections blocking attainment of the nirvana of market equilibrium were legitimate. Transparency was essential in order to reduce information costs, but it was beyond the ideology to recognize that information imperfections might be so deep as to be unfixable, and that some forms of trading activity, however transparent, might be socially useless.
Indeed, the Columbia University economist Jagdish Bhagwati, in a famous essay in Foreign Affairs entitled “Capital Myth,” talked of a “Wall Street/Treasury” complex that fused interests and ideologies. Bhagwati argued that this fusion played a role in turning liberalization of short-term capital flows into an article of faith, despite sound theoretical reasons for caution and slim empirical evidence of benefits. And, in the wider triumph of the precepts of financial deregulation and market completion, both interests and ideology have clearly played a role.
Pure interests – expressed through lobbying power – were undoubtedly important to several key deregulation measures in the US, whose political system and campaign-finance rules are peculiarly conducive to the power of specific lobbies.