Last Thursday, the Queen visited the Bank of England. It has been widely claimed that during this event she was “finally” given a response to her question in 2008 about why no one saw the financial crisis coming. Such reporting exemplifies all that is wrong about economic discourse today. Newspapers blandly reported the explanatory remarks offered to the Queen by one of the Bank’s economists, Sujit Kapadia, who picked up on her pertinent enquiry four years ago. Not one report examined the real content of Kapadia’s comments, let alone asked if it was correct.
As a result, it went totally unremarked that what Kapadia said is a shocking indictment of economic theory. Whether by good luck or good planning, Her Majesty received advice from a rare economist who has managed to escape the brainwashing of economic orthodoxy, is prepared to rethink some of the field’s deeply held—and misconceived—notions, and is looking for fresh inspiration outside the narrow boundaries of the mainstream tradition.
Kapadia’s comments focused on three issues: that economic crashes, like earthquakes, are inherently unpredictable; that “because the economy was stable there was [a] growing complacency”; and that “people didn’t realise just how interconnected the system had become.”
The newspapers seemed happy with the Queen’s interpretation of the charge of complacency: “people got a bit lax.” But that is not exactly what Kapadia said, and it is dangerously misleading to propagate the idea that the problems began just because folks were a little slapdash. An earlier response to the Queen’s question from the British Academy in 2009 said that, on the contrary, “Everyone seemed to be doing their own job properly on its own merit. And according to standard measures of success, they were often doing it well.”
“The failure, the Academy went on, was to see how collectively this added up to a series of interconnected imbalances… Individual risks may rightly have been viewed as small, but the risk to the system as a whole was vast.” In other words, the problem was not about individual performance—it was systemic. And Kapadia appreciates this, as his comments on interconnectivity reveal. A part of Kapadia’s own research focuses on trying to understand the particular vulnerabilities that arise from the complex network of loans, debts, risks and dependencies in the financial sector. He is making use of recent research on complex networks that has emerged in the physical sciences, about which most traditional economists remain indifferent if not ignorant.
The complacency that Kapadia referred to was not, then, laziness, but a refusal to question prevailing belief—in both economic theory and practice—about how the entire financial system works. It’s the kind of complacency that led Gordon Brown in 2002 to say, “we today in our country have economic stability, not boom and bust.”
What is most dismaying of all is that this complacency was not an all-too-human tendency to imagine that the good times will go on forever—it is enshrined in traditional economic theory itself. Kapadia said it simply enough: “People thought markets were efficient.” That this remark has been accepted by the press with nothing more than dull nods is scandalous. It is as though a physicist suggested to the Queen that we have been a little foolish in believing the second law of thermodynamics and no one batted an eyelid.
For the “efficient markets hypothesis” is a cornerstone of conventional economics. It holds that market prices always reflect all of the publicly available information, to which all traders respond rationally. It is one of the ideas that has allowed economists to believe the nonsense that markets are perfectly balanced equilibria, ruffled gently by a little randomness. It is what encouraged the view that boom and bust could be vanquished forever and that anything other than laissez-faire—regulation, say—would only impede the efficiency with which markets operate.
Kapadia is right to call out this fiction. Now, some academic economists will sit back and claim they knew that markets have inefficiencies. They will point to Nobel-winning work that explores such “inefficiencies” and “imperfections,” probably without pausing to consider how the very idea that these are examples of markets “behaving badly” betrays an addiction to the equilibrium paradigm. They will point to prominent dissenters such as Nobel laureate Joseph Stiglitz, who said in 2010 that “this crisis has provided numerous examples of markets that cannot be described as efficient in any reasonable way.” Few will wonder why, if they are so comfortable with inefficient markets, that message never (and probably still hasn’t) reached the CEOs, politicians and decision-makers who determine the course of the economy.
Finally, Kapadia’s comment that economic crises are like flu pandemics and earthquakes in being impossible to predict accurately passed without remark. Again, he is spot on—but the point here is that both of those other catastrophic occurrences are an intrinsic aspect of how the respective systems work, not (as economists would insist of crashes) events forced on them by external circumstances beyond control. Moreover, earthquake planning aims to make systems robust against the unpredictable. But economic theory denies that these catastrophes can ever occur. This denial is an explicit component of the models: the random “noise” that they incorporate makes crashes vanishingly rare. That’s right: in these models, crashes are not allowed to happen—because if they were, the models become too hard to solve mathematically. This failure to acknowledge the true statistics of economic ups and downs is vital to the Nobel-winning maths (the Black-Scholes equation) used to compute risk on derivatives, which has been blamed for much of the current crisis. If they used the right statistics, the calculations would be too messy.
In effect, Kapadia told the Queen that the failure to anticipate the crisis was due to fundamental misconceptions in the theories that most economists are taught and use. If some crusty professor or economics editor had piped up to denounce this presumptuous upstart, I’d at least feel reassured. But the tragedy is that no one even noticed.
“Is there another [crisis] coming?” the Duke of Edinburgh blustered to Kapadia and his colleagues. As long as we are content to go on like this, what do you reckon the chances are?