Über die Autorin bzw. den Autor

Arun Motianey worked for Citigroup from 1987- 2008. His positions included managing director and head of macro research and strategy in the company’s Global Wealth Management division.

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SuperCycles

The McGraw-Hill Companies, Inc.

Contents

Chapter One

Macroeconomics is riddled with fetishes. It has a spontaneous order fetish in its underlying philosophy where natural laws, no different from the laws of mechanics that determine the nature and movement of physical objects, govern our self-interested economic behavior to produce a collective outcome that is efficient if not always harmonious. Then there is an engineering fetish where monetary policy guides the economy to an optimal path and sets up a system to correct deviations from that path. This infatuation with the nineteenth-century science paradigms of the physical sciences has been our undoing because it has concealed the uncomfortable truth that macroeconomics fails the primary test of any modern science: it lacks predictive power, and, still more shockingly, it evades the unforgiving criterion of falsifiability. We will remain vulnerable to macroeconomics' failures until we take down the scaffolding and dismantle the structure of this false science. And since macroeconomists' theories are too important for merely scoring debating points—economists are, as Keynes said, the trustees of the possibility of civilization—the rebuilding of macroeconomics itself needs to commence with haste.

FINANCE'S PRIVILEGED POSITION IN THE MODERN ECONOMY

In 1990, upon seeing his country's economy begin its long slide into stagnation, Makoto Itoh, the great Japanese economist, wrote: "Capitalism seems to be running the film of history backwards by melting down the sustained trend of a century and returning to the older stage of liberalism.... [T]he reduction of the roles of the state and of trade unions with lighter industrial technologies makes capitalism in our age resemble capitalism in that earlier age."

Such words were not taken seriously anywhere at the time they were written, least of all in the groves of American academe, where ideas profoundly hostile to those of Itoh and other unorthodox economists had long fertilized, incubated, and hatched. The financial firestorm that began in 2007, and that we are still struggling to contain, is a direct consequence of those ideas.

The intellectual origins of this crisis are there for all to see. Yet the surprising fact is that they remain invisible to many of our most intelligent policymakers and economic commentators who have observed the events unfold at close quarters. Is it a case of preferring to fail by conventional means rather than succeed by unconventional ones, as Keynes once put it, or is it a cognitive blindness that Wittgenstein seemed to detect in so many of our thinkers?

Suffice it to say that until many of the practices and institutions of modern finance are uprooted and regrafted, we will be condemned to relive these crises with increasing frequency and with more disruptive effects each time, or we must reconcile ourselves to an economy made sluggish by the unredeemed sins of the past. The image of W. B. Yeats's rough beast "with a gaze blank and pitiless as the sun ... moving its slow thighs" comes to mind here.

In this section I will argue that while the constitution of modern finance is such that changing the way it functions in modern capitalism would be difficult if not impossible, the current crisis, by its sheer severity, should eventually succeed in producing a major shift. The foundations of asset pricing—and its astonishingly central role in what I shall refer to frequently in this book as the New Equilibrium Economics (NEE), a macroeconomic theory that has dominated universities, central banks, and multilateral financial institutions for much of the last quarter century—have cracked, and the edifice is being supported by a stubborn refusal to change. We will achieve very little if we fail to eliminate this noxious theory and its many fetishes from our conventional habits of thinking and replace it with one from which will emerge a new—or perhaps even an older but certainly simpler and more intuitive—way of establishing the role of finance in our capitalist processes.

Meanwhile there is the politics of change. Economists from different generations and as far apart in theoretical bent as Axel Leijonhufvud, professor emeritus at UCLA, and Simon Johnson, former economic counselor at the International Monetary Fund (IMF), have commented on the extraordinary sight that has greeted their eyes: the full sinews of the U.S. government and its agencies exerting themselves to hold up a massive and broken system. What has shocked these two astute and wise observers of the global economy is that the efforts of the authorities have gone far beyond the necessary and now verge on the corrupt. Johnson's frequent use of the term "oligarchs" and Leijonhufvud's use of the word "oligopolies" betray their outrage at the turn of events. Let's hear it in the words of the one who may have been involved in fewer crises (since he did not spend any time at the IMF) but who was among the first to warn us of the bastardization of Keynes's General Theory in the 1960s and was among the earliest to see this crisis for what it really is, namely, a crisis of political economy:

With the demise of Glass-Steagall fell the last bastion of Western populist opposition to the concentration of moneyed power in New York. The banking mergers of recent years have increased this concentration tremendously, and the political as well as economic power wielded by Wall Street is more palpable than ever. The Greenspan carry-trade years enriched these institutions and the people running them greatly. Nowhere has the upper tail of the income distribution been extended as far as in the financial industry.... The objective of preventing a deviation-amplifying financial collapse would admittedly seem to be in the public interest. But when we find the government repeatedly aiding and abetting the collusion of these financial behemoths, which we have allowed to become too big to fail, a rethinking of the relationship between government and big finance would seem to be in order.—Axel Leijonhufvud

These financial institutions play the same role in our global economy as the country of, say, North Korea or, as some would even venture to say, even more worryingly, as Pakistan does in the international security system; in both cases we have come to dread the consequences of their falling apart. And if they know that we fear their collapse, will they not manipulate us to get what they want? Both Leijonhufvud and Johnson have made it clear that the age of moral hazard—those years of deregulation and the U.S. Congress's being at the service of Wall Street—will not be left behind until the U.S. Federal Reserve and the U.S. Treasury are rinsed clean of their ideological bias that the financial markets are much more than a place where the supply and demand for credit meet, but are indeed necessary conditions for all economic agents to efficiently bridge the present to the future, the requirement for economic stability.

The U.S. Fed, in particular, sees its relationship with deregulated financial markets as being the same as that of a falconer and his predator bird. The essence of falconry—to catch, kill, and retrieve—is frustrated if the falcon is maimed. The bird is an extension of the falconer's capacity in the act of hunting; the relationship is almost symbiotic. The financial markets are in the same way an extension of the Fed. They will follow the central bank's directives as long as their meaning is communicated well. And while certain other central banks—the Reserve Bank of New Zealand, the Banco Central do Brasil, and the German Bundesbank come to mind here—may have been more rigorous in the application of their own monetary policy rules, none of them has shown the inclination of the Fed to require the unfettered functioning of financial markets as central to its own mission. I shall have more to say about this later in this chapter after we have taken full measure of the conceptual framework that places finance so high in the hierarchy of activities that constitute the market-based capitalist economy.

THE UNFALSIFIABILITY OF ECONOMICS

In a recent essay Harvard economist N. Gregory Mankiw criticizes the current state of macroeconomics and invites a riposte from an equally distinguished macroeconomist, Michael Woodford of Columbia University. Mankiw argues that since the rational expectations revolution in the 1970s—when economists cemented the central importance of self-correcting expectations in decision making at the level of each agent in the economy—too much stress has been placed on the development of macroeconomics as a science (with clear conceptual foundations) and too little on macroeconomics as a branch of engineering (an instructions manual for solving practical problems facing policymakers). As a result, he goes on to say, the emphasis on macroeconomic concepts and their internal consistency has "had little impact on practical macroeconomists" who work for or advise government departments and agencies. None of the recent advances in academic macroeconomics has been particularly useful in a practical manner. Because of this, Mankiw argues, policymakers depend on outdated macroeconomic theories to construct their models. Today's policy analysis, Mankiw says, appears to have descended from the work of Lawrence Klein and Franco Modigliani—models with hundreds of equations that do not include behavioral features. Mankiw is criticizing recent academic work in macroeconomics for being insufficiently pliable for policy use, leaving policymakers with little choice but to turn to obsolete formulations of the economy.

That Mankiw instead wishes for economists to become more like engineers reminds me of that doyenne of Cambridge Economics, the late Joan Robinson, whose comment on the peculiar fondness of American Keynesians—or pre-Keynesians as she would call them—for wanting to turn all of economics into a branch of engineering now rings so true. Had she lived a few more years, I can easily picture her speechless with anger at how macroeconomics has been turned into a vast graveyard for useless applications of industrial engineering, with the theory's frequent use of optimal control methods, as we shall see later in former Fed Governor Frederic Mishkin's comments on monetary policy.

A year after Mankiw's essay, Woodford presented his rejoinder, "Elements of a New Synthesis," at the 2008 Annual Meeting of the American Economic Association. The rejoinder is a defense of current policy analysis and formulation—at least against Mankiw's claim that it fails to include recent thinking from the dominant Neoclassical Synthesis school of thought, which as mentioned previously I prefer to call the New Equilibrium Economics (NEE). Woodford's objective is to show the "reduced level of dissension within the field." He then catalogs the intellectual pedigree of each of the macroeconometric models used by the IMF, the Riksbank (Sweden's central bank), the Norges Bank (Norway's central bank), the European Central Bank (ECB), and, of course, the U.S. Federal Reserve. Toward the end, he cites then–Federal Reserve Governor Frederic Mishkin's speech to MIT's Undergraduate Economics Association in 2007 with its multiple references to optimal control theory, which is how to determine the optimal path of monetary policy in an environment where policy instruments are blown off course by unanticipated shocks, as if to rest his case that Mankiw's argument that economists need to become more like engineers is without merit.

Yet I am sympathetic to at least the avowed aim of Mankiw's article—namely, that policymakers are lacking a set of tools that will help prepare them for the sort of seismic events that we have just come through. The conceptual framework that Mankiw found in its present form so intractable to the activity of problem solving has been turned into a rich vein of practical knowledge, if we are to be convinced by Woodford's citation of the many macroeconometric models in use throughout global banks. But we should remember that Woodford's answer to Mankiw's worries came in early 2008, just as the recent crisis had got under way but before the full scope and severity was felt. Woodford could confidently reel off the uses of modern theories in central bank models for price setting and expectations formation, but where did any of that help us when the global financial system began to fold in on itself a few months later?

Ever since Keynes wished for the day when economists would learn to regard themselves on par with dentists, engaged in modest but socially valuable activities of putting people out of discomfort, there has been a tendency for economists to emphasize the practical aspects of their training. But Keynes's dream sprang from the idea that the discovery of a robust theory would in turn yield methods to thwart the self-feeding spirals that capitalist economies were periodically prone to (and so protect society from the destructive effects of its own excesses); thus, economists would settle down into the humdrum existence of the journeyman. But those excesses—or rather, the predisposition toward those excesses—have not been wrung out of our economic system, not even with the sudden near collapse of the financial system that we have confronted in recent years. And so those methods that will forestall crises of this sort are still eluding us, and Keynes's wish cannot be satisfied just yet.

Mankiw implies in his article that modern macroeconomics is rich in concepts, each ripe with explanatory promise. So let's devote our efforts to writing an instructions manual for the central bankers or for those advising central bankers. My question is: can we? What is the predictive power of these concepts? Even in the crudely positivistic sense in which Milton Friedman made the case for economics in his classic essays, where as long as there was a correspondence between predictions and events—and even if it turned out that the "black box" from where the predictions emanated was little more than an abracadabra machine—there should be no need for any doubt. In precisely that naive sense as well, modern macroeconomics, the NEE, has failed us. Recent events in the global economy and the inability of so much of model-driven work of the central banks to make sense of—let alone control—those events should have made that amply clear.

Friedman's simpleminded approach to asserting the value of economics—saying that it was a science in the face of criticism from those who argued that its models were built on unrealistic assumptions of perfect competition—worked rather well as a rhetorical device as long as economics was not facing questions about its real worth. Today it is, among a handful of influential economic journalists, commentators, policymakers, and even a few economists. Yet for all the handwringing that has taken place in public, the members of the economics profession that are actively involved in guiding policymakers seem strangely quiet about the ineffectiveness of their work. Could it be that they are stricken by an intellectual paralysis? In my opinion—and I shall spend much of the rest of the chapter reaching this conclusion—the NEE, the standard canon of macroeconomic thinking on which the central banks of the world build their forecasts and construct their scenarios, is unfalsifiable. This means the theories of modern macroeconomics have no built-in mechanism that signals that the theory is wrong. Little can be predicted correctly, but everything is sought to be explained.

Let's unpack that a bit. For a theory to be falsifiable, it needs, first, to stick its neck out and say that given the following conditions, we expect Event A will occur. But that is not enough because, if this is all it offered, it would be the same as Friedman's positivist theory of correspondence and modern macroeconomics would have failed the Friedman test in every major crisis the global economy has faced in the last 25 years. Instead, the theory needs to go further; it must also say that given the following conditions, if Event B (or ITLITL or D) occurred, the theory will be proved wrong. This is the strong definition of falsifiability, and all robust scientific theories must demonstrate this falsifiability. A theory that cannot point to events that will prove it wrong is considered unfalsifiable.

By these measures, the New Equilibrium Economics is not a robust scientific theory. As in George Orwell's memorable metaphor of lifeless English, it is like the soft snow that falls on facts, covering all the details and blurring all the outlines. We are living through an economic convulsion that will leave deep rutted tracks in the global economy, and yet our body of macroeconomic thought has nothing meaningful to say about these events because it has neither the ability to predict nor to satisfactorily explain.

For instance, the American Economic Association's annual meeting in January 2008 had organized a series of papers to be presented on macroeconomics that came under the rubric "Convergence in Macroeconomics." Even as gale force winds were tearing up the global financial markets, the symposium's main paper was devoted to explaining the Great Moderation—the name given to the absence of macroeconomic volatility in the U.S. economy in recent history. Another was on why none of the canonical theories of NEE were yet ready for prime time since "some of its shocks and other features were not structural or consistent with micro evidence," which is just a technical way of saying that the shocks that hit the economy in the models are not consistent with the behavior of the representative agent in the same models and that more work needs to be done to achieve the desired consistency. The orthodoxy of modern macroeconomics is a hall of mirrors; yet it is still being applied inside central banks and policymaking institutions.

(Continues...)

Excerpted from SuperCyclesby ARUN MOTIANEY Copyright © 2010 by Arun Motianey. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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