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Financial crisis: is economics really broken?

Are rumours of the dismal science's demise greatly exaggerated, or have things really changed?

By Jay Elwes  

Are non-doms a help, hindrance, or irrelevance? © Joe D

Read Diane Coyle and Andrew Haldane on what’s wrong with economics, also available in the print edition of January’s Prospect, out Thursday 11th

Writing in the January issue of Prospect, Andrew Haldane, the Chief Economist of the Bank of England, and Diane Coyle, Professor of Economics at Manchester University, have said that: “Internally, economics is more fractured than perhaps at any time in a generation.”

In an extended essay assessing the state of economics teaching and research, Haldane and Coyle say: “The reason for this is not difficult to find: the global financial crisis has made economists’ pre-crisis self-confidence look, in hindsight, more like hubris.”

It is not hard to recall that hubris, which as the essay notes was especially prevalent in the fields of financial economics and macroeconomics. One of the most high-profile examples of such hubris came almost a decade before the crisis, with the collapse in 1998 of Long Term Capital Management, the hedge fund. Following Russia’s default on its debts, the firm’s trading model collapsed with losses of $4.6bn, a failure so large that the New York Federal Reserve was called in to prevent a wider financial collapse.

But perhaps even more shocking was the reason for the firm’s loss. Like all hedge funds, LTCM’s trading decisions were predicated on highly complex calculations based on the behaviour of markets and the probability of future market events. But these highly complex models proved useless.

The creation of these highly complex financial economic models is described by Haldane and Coyle as being, on some occasions: “a highly specialised area, which often uses PhD-level mathematical techniques to understand the minds of financial traders.” This was certainly the case with Long Term Capital Management, as well as with other trading outfits, some of which have used similar techniques with great success. But the assumptions contained in models like these have brought to financial economics—and to economics more broadly—a misleading sense of certainty. Stochastic models of the sort used in financial economics, though they may have about them the appearance of scientific proofs and may even share some structural similarities with them, cannot deliver anything like the same degree of certainty.

The Credit Crisis of 2007-8 reinforced this shortcoming: assumptions made in the modelling of the probability of defaults in credit derivatives proved to be incorrect—and what is more, almost all economists failed to grasp the extent, or in some cases even the existence, of that threat, assuming that the risk models that graded these credit derivatives as a safe investment must be correct. It is staggering to think that the models used for gauging the risk of Collatoralised Debt Obligations became useless for no other reason than that US house prices began to fall.

Discussing in general terms the tendency of economics to reduce market activity to a collection of mathematical axioms, Coyle and Haldane write: “The world described by these models was a fictional construct. In them, a crisis was not just unthinkable, it was impossible.”

If the standing of economics—and economists—is to be maintained then, as Haldane and Coyle make clear, economists must spend more time “thinking the unthinkable,” so that the next time a crisis comes, they will not, once again, have “missed the unmissable.”

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