Friday, May 29, 2009

What Was the Failure of Economics?

Macroeconomists have been taking a lot of heat for the failure of the sub-discipline to forecast and/or forestall the crisis. This has often been enlarged to suggest that there is something wrong with the economics discipline as a whole.

This suggests an attitude that I am increasingly running into when I identify myself as a professor of economics: that somehow 'economists' run the economy. Ummm, no. The most important thing to understand is that the economy exists as a natural artifact of human interaction. We don't create it, pull the levers, etc. What we strive to do is understand it, and through this understanding, help governments manage it better.

And here there was a failure. However, I don't think it was with macroeconomics in general, but in the failure of the IO principal-agent and contracting folks to interact enough with the finance and macro types. In other words, there was a trust of the internal incentives of the firm (in this case banks) on the part of finance/macro types that was misplaced. It shouldn't have been: there is a lot of research on incentive problems in CEO compensation, in principal-agent contracts and the like. But macro-types that set policy ignored the lessons of this literature in pushing too far on bank deregulation, trusing the internal incentives to do the trick.

Alan Blinder says something similar in an op-ed in the Wall Street Journal but he blames the corporate boards. But again, we know the incentives were/are skewed there too. Still, his answer is along the same lines, get the incentives right through increased regulation.


Will N said...

John C. Bogle (founder, Vanguard Funds) excellent book "The Battle for the Soul of Capitalism" has some interesting things to say about this. Both board and compensation suggestions.

A problem he sees is that stock ownership, which provides governance oversight of management, has become both so diffuse (lots of little owners) and so remote (via mutual funds, etc.) that owners don’t have the ability or interest in their ownership duties. Because they don’t, “ownership capitalism” has effectively been replaced with “management capitalism” and the executive suites are robbing owners by diverting unreasonably large amounts of owner returns to managements' own compensation. This is bad because the people taking the risk (owners investment $) aren’t getting appropriate returns for that higher-than-historical risk and eventually the system would implode from manager greed (written 2005).

FallPurple said...


Interesting premise--I should read the book. The diffusion of economic interest in the mortgage markets hasn't served us well--it hasn't managed risk by spreading it more widely. Rather it has magnified risk by removing all vestiges of governance and oversight.

kathryn jones said...

We have an excellent interview with John Bogle up on YouTube- he touches on a number of these issues and goes into detail on some of the most important points from "The Battle for the Soul of capitalism.

John C. Bogle on The Battle for the Soul of Capitalism

Kathryn Jones
Massachusetts School of Law