Keynes, markets and the GFC

In a stirring review of Robert Skidelsky's Keynes: The Return of the Master, Joseph Stiglitz manages a very good quick critique of economists and of finance markets.

On economists he noted (this is heavily edited);

While most of the blame for the crisis should reside with those in the financial markets ... a considerable portion of it lies with the economics profession. The notion economists pushed – that markets are efficient and self-adjusting – gave comfort to regulators. They provided support for the movement which stripped away the regulations that had provided the basis of financial stability ...; and they gave justification to those ... who opposed doing anything about derivatives.

We should be clear about this: economic theory never provided much support for these free-market views. Theories of imperfect and asymmetric information in markets had undermined every one of the ‘efficient market’ doctrines... [critics] had explained that Adam Smith’s hand was not in fact invisible: it wasn’t there. [critics] had explained that if markets were as efficient in transmitting information as the free marketeers claimed, no one would have any incentive to gather and process it.

Free marketeers, and the special interests that benefited from their doctrines, paid little attention to these inconvenient truths.

It remains extremely distressing that the choice left for the average citizen is to be a believer in unrestrained free-markets or to be labelled a socialist or believer in a planned economy.

There is a middle way which is to base public policy on a better understanding of how real markets work, and that the error cost of dampening some market activity unnecessarily can be far less than the error cost of taking no action when action is required.

Stiglitz disagrees with Skidelsky mostly in the extent to which the latter asserts the errors leading up to the GFC were from confusing risk and uncertainty. Instead Stiglitz focuses on the way incentives operate to guide corporate behaviour. As he notes;

But markets are not necessarily rational, and even when they are, they are not always well intentioned. The objective of a speculative attack is to generate profits for the speculators, regardless of the cost to the rest of society. They can make money by inducing panic and then feel pleased with their ‘insight’: their concerns were justified, but only because of the responses to which their actions gave rise.

So to the author's claim that "underlying the escalating succession of financial crises we have recently experienced is the failure of economics to take uncertainty seriously’" (Stiglitz description), Stiglitz response is not that we fail to deal with uncertainty but that we continue to use models of markets that we know to be wrong.

This creates an interesting aside for the philosophy of science as applied to economics. Both a Feyerabendian view and an inductivist view (as most recently promoted by James Franklin in What Science Knows: And How It Knows It the usefulness of a theory is context sensitive. For Feyerabend we use the theory because it works, in Franklin's case the theory is used because it accords to the observations in what is usually then specified as a confined domain.

Both theories therefore allow for the ongoing use of Newtonian mechanics, but both ith the proviso that distances and speeds are of "human" scale. Economists keep making the error of having a very well developed theory of markets that works in relation to some very specific assumptions (fully informed, lots of buyers and sellers etc) and applying it in circumstances where those constraints do not apply.

Thankfully we do not rely on these economists for designing integrated circuits or for planning space missions. Unfortunately, we seem to rely upon them for far more serious issues - like how to organise our economy so that our needs and wants can be met from our limited resources.