Should economists have foreseen the credit crunch? A few were warning of an overheated world economy with excessive credit and risk taking. Most economists prior to 2007/8, however, were predicting a continuation of steady economic growth. Inflation targeting, fiscal rules and increasingly flexible markets were the ingredients of this continuing prosperity. And then the crash happened!
So why did so few people see the downturn coming? Were the models used by economists fundamentally flawed, or was it simply a question of poor assumptions or poor data? Do we need a new way of modelling the economy, or is it simply a question of updating theories from the past? Should, for example, models become much more Keynesian? Should we abandon the new classical approach of assuming that markets are essentially good at pricing in risk and that herd behaviour will not be seriously destabilising?
The following podcast looks at these issues. “Aditya Chakrabortty’s joined in the studio by the Guardian’s economics editor Larry Elliott, as well as Roger Bootle, the managing director of Capital Economics, and political economist and John Maynard Keynes biographer Robert Skidelsky. Also in the podcast, we hear from Nobel prize-winning economist, Elinor Ostrom, Freakonomics author Steven Levitt, and UN advisor and developmental economist Daniel Gay.”
The Business: A crisis of economics Guardian podcast (25/11/09)
See also the following news items from the Sloman Economics news site:
Keynes is dead; long live Keynes (3/10/09)
Learning from history (3/10/09)
Macroeconomics – Crisis or what? (6/8/09)
The changing battle grounds of economics (27/7/09)
Repeat of the Great Depression – or learning the lessons from the past? (23/6/09)
Animal spirits (30/4/09)
Keynes – do we need him more than ever? (26/10/08)
Questions
- Why did most economists fail to predict the credit crunch and subsequent recession? Was it a problem with the models that were used or the data that was put into these models, or both?
- What was the Washington consensus? To what extent did this consensus contribute to the current recession?
- What is meant by systemic risk? How does this influence the usefulness of ‘micro’ financial models?
- What particular market failures were responsible for the credit crunch?
- What is meant by ‘rational behaviour’? Is it reasonable to assume that people are rational?
- Is macroeconomics too theoretical or too mathematical (or both)? If you think it is, how can macroeconomics be reformed to improve its explanatory and predictive power?
- Does a ‘really good economist’ need to have a good grounding in a range of social sciences and in economic history?
In a speech to Scottish business organisations, Mervyn King, the Governor of the Bank of England, argued that it might be necessary to split banks up. The aim would be to separate the core retail banking business, of receving deposits and lending to individuals and businesses, from the more risky and exotic wholesale acitivites of banks, such as securitisation, speculation and hedging – so-called ‘casino banking’.
Governments around the world, as represented at the G20 meeting at Pittsburg in September, have favoured tougher regulation of banks. But Mervyn King believes that this is not enough. It may not prevent the reckless behaviour that resulted in the credit crunch and bank bailouts by the government. “Never has so much money been owed by so few to so many. And, one might add, so far with little real reform.” And if regulation were to fail and banks were to get into difficulties, what would happen? There would have to be another bailout. As Mervyn King said, “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.”
There are two key problems.
The first is Goodhart’s Law. If rules are set for bank behaviour, banks may adhere to the letter of the rules, but find ways around them to continue behaving in risky ways. The rules may cease to be a good measure of prudent behaviour.
The second is moral hazard. If banks know that they will be bailed out if they get into difficulties because they are too big to fail, then this encourages them to take the risks. As Mervyn King said in his speech, “The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history. The ‘too important to fail’ problem is too important to ignore.”
So should the banks be split? Is there any likelihood that they will? Or are Mervyn King’s proposals merely another headache for the government? The following articles looks at the issues. The first link below is to his speech.
Speech by Mervyn King, Governor to Scottish business organisations, Edinburgh (20/10/09)
Mervyn King: bail-outs created ‘biggest moral hazard in history’ (including video of part of speech) Telegraph (20/10/09)
Governor warns bank split needed BBC News (20/10/09)
A sombre warning BBC News, Stephanomics (20/10/09)
Alistair Darling rebuffs Mervyn King’s attack over timidity of banking reforms Guardian (21/10/09)
King and Brown in rift over whether to split the banks Independent (22/10/09)
Tucker set to join calls for stricter controls on banks Scotsman (22/10/09)
Testing times for bank regulators Financial Times (21/10/09)
Mervyn King is right – the economy is changing and we’re blindfolded, without a map Telegraph, Edmund Conway (22/10/09)
Questions
- Explain what is meant by ‘moral hazard’ in the context of bank bailouts. Are the any ways in which banks could be prevented from failing during a crisis without creating a moral hazard?
- Does regulation necessarily involve Goodhart’s Law? To what extent is it possible to devise regulation and avoid Goodnart’s Law?
- What are the arguments for and against splitting banks’ core business from more risky ‘casino banking’?
- Does the separation of retail and investment banking necessarily involve splitting banks into separate organisations? If they are not split, how can the government or central bank underwrite retail banking without underwriting riskier investment banking?
In times of recession, some companies can do well, even in industries where there are supply problems. One such example is Pacific Andes, a Hong Kong based frozen seafood firm. Many fishing companies have found times tough in an era of dwindling fish stocks and fishing quotas imposed by governments anxious to preserve stocks. The following article looks at Pacific Andes and how it has managed to prosper despite supply challenges and the global recession.
Casting a wide net The Standard (Hong Kong) (24/8/09)
Details of overfishing in the UK can be found at: EyeOverFishing
The site provides a “map of the UK fisheries system, the problems with it, and solutions that are possible today”.
Questions
- To what extent can the concept of income elasticity of demand be used to help explain why Pacific Andes has managed to prosper during the recession?
- What specific business strategies has Pacific Andes adopted and why?
- Why, if overfishing is to the detriment of the fishing indsutry, do fishing fleets still overfish many parts of the oceans? Explain why this is an example of the ‘tragedy of the commons’.
- What would you understand by an ‘optimum level of fishing’ for a particular type of fish in a particular part of the oceans? Explore whether the concept of a ‘social optimum’ in this context is the same as an ‘environmental optimum’?
When anyone buys assets – shares, a house, a car or whatever – one important consideration is their likely future value. But the future is uncertain. Your decision to buy, therefore, depends not just on the direct return of the asset (the rate of interest or the pleasure from using the asset) but also on your predictions about the future value of the asset and your attitudes to risk. But with the future of markets so uncertain, or at least the timing of market movements, what’s the best thing to do? The article below considers some of the issues.
The irrelevant future Investors Chronicle (6/4/09)
Questions
- Distinguish between ‘risk’ and ‘uncertainty’.
- What is meant by a ‘bear’ in the context of investing in shares? Explain why ‘intelligent bears’ would ‘leave some money in the market’.
- Faced with uncertainty, why might sticking to a simple ‘do nothing’ rule be the best policy?
- If capital markets were efficient in the strongest sense, where everyone has perfect information about the future, would people be able to make large returns on investing in shares and other assets?
Times of economic uncertainty often lead to people seeking what they consider as ‘safe havens’ for their money. Traditionally gold has been one of these safe havens. This financial crisis has been no exception and the price of gold has risen, but there has also been a rapid growth in demand for gold bullion and gold coins and dealers have found themselves besieged by people looking to protect their savings. ATS Bullion, a London gold bullion dealer, has even seen queues: something quite unprecedented for them.
There’s gold in them thar’ shops: the rush is on Guardian (2/10/08)
Austria witnesses new gold rush BBC News Online (12/10/08)
Gold rush as investors pile into bars Financial Times (3/10/08)
Market turmoil sparks gold rush to specialist funds Times Online (13/10/08)
Questions
| 1. |
What the main determinants of demand for gold coins and gold bullion? |
| 2. |
Using diagrams as appropriate, show the changes that have taken place in the market for gold coins in recent months. |
| 3. |
Discuss the extent to which the supply of gold bullion is likely to keep up with the rapid growth in demand. |