Turner, Adair - Economics, Conventional Wisdom and Public Policy

8/13/2019 Turner, Adair - Economics, Conventional Wisdom and Public Policy

1/14

1

Economics, conventional wisdom and public policy

Adair Turner

Institute for New Economic Thinking

Inaugural Conference

Cambridge, April 2010

We have been through a severe financial crisis, which has done greatharm to human welfare. But it could have been far worse if authoritiesacross the world had not taken exceptional actions to underpin financialsystems and prevent a collapse of nominal demand. And they wereconfident in taking those actions because economic theory does providesome compelling insights, and because the economic history of the GreatDepression told us what not to do.

The difference between 2010 and 1931 is, therefore, in some ways a great

success for good economics. But there is also a strong belief, which Ishare, that bad economics or rather over-simplistic and overconfidenteconomics helped create the crisis. There was a dominant conventionalwisdom that markets were always rational and self equilibrating, thatmarket completion by itself could ensure economic efficiency andstability, and that financial innovation and increased trading activity weretherefore axiomatically beneficial. And as warning signs of potential

problems emerged, that dominant conventional wisdom was used todismiss the concerns expressed by several commentators by, for

instance, Bill White in his BIS Reviews, or by Raghuram Rajan in his paper at Jackson Hole in 2005. 1

So its in response to the apparent harmful influence of a dominantconventional wisdom that the Institute for New Economic Thinking has

been established. The proposition is that we need a fundamentalchallenge to recent conventional wisdom. I strongly endorse that

proposition. But success will not come easy, because there were reasonswhy the recent conventional wisdom became so dominant, and the issues

1 Raghuram Rajan, Has Financial Development Made the World Riskier , Jackson Hole Symposium ,August 2005


2/14

2

we face are complex ones to which there are no easy answers. And it isabout the allure of conventional wisdoms and the challenges ofcomplexity that I will comment this evening before highlighting somekey issues of financial regulation where new economic thinking is

required.

Let me begin with a caricature of the dominant conventional wisdom.

For over half a century the dominant strain of academic economics has been concerned with exploring, through complex mathematics, howeconomically rational human beings interact in markets. And theconclusions reached have appeared optimistic, indeed at times

panglossian. Kenneth Arrow and Gerard Debreu illustrated that acompetitive market economy with a fully complete set of markets wasPareto efficient. New classical macroeconomists such as Robert Lucasillustrated that if human beings are not only rational in their preferencesand choices but also in their expectations, then the macro economy willhave a strong tendency towards equilibrium, with sustained involuntaryunemployment a non-problem. And tests of the efficient markethypothesis appeared to illustrate that liquid financial markets are notdriven by the patterns of chartist fantasy, but by the efficient processingof all available information, making the actual price of a security a goodestimate of its intrinsic value.

As a result, a set of policy prescriptions appeared to follow:

Macroeconomic policy fiscal and monetary was best left tosimple, constant and clearly communicated rules, with no role fordiscretionary stabilisation.

Deregulation was in general beneficial because it completed moremarkets and created better incentives.

Financial innovation was beneficial because it completed moremarkets, and speculative trading was beneficial because it ensuredefficient price discovery, offsetting any temporary divergencesfrom rational equilibrium values.

And complex and active financial markets, and increased financialintensity, not only improved efficiency but also system stability,since rationally self-interested agents would disperse risk into thehands of those best placed to absorb and manage it.


3/14


4/14

4

any intellectual influence, but with the reasonably intellectual men andwomen who are employed in the policymaking functions of central

banks, regulators and governments and in the risk managementdepartments of banks, who are aware of intellectual influences, but who

tend to gravitate to simplified versions of the dominant beliefs ofeconomists who are not yet defunct but still very much alive.

For it is striking in the pre-crisis years how dominant and howoverconfident, at least in the arena of financial economics, was asimplified version of equilibrium theory which saw market completion asthe cure to all problems, and mathematical sophistication decoupled from

philosophical understanding as the key to effective risk management.Institutions such as the IMF, in its Global Financial Stability Reviews, setout a confident story of a self-equilibrating system. Thus, for instance inthe April 2006 GFSR, only 18 months before the crisis broke, recordedthat: There is a growing recognition that the dispersion of credit risks toa broader and more diverse group of investors has helped make the

banking and wider financial system more resilient. The improvedreliance may be seen in fewer bank failures and more consistent credit

provision. Market completion, in other words, as the key to a safer system. Numerous speeches by Alan Greenspan enunciated a theory, adoctrine indeed, that market completion via financial innovation wasdelivering both economic efficiency and stability. Risk managers in banksapplied the techniques of probability analysis to value at riskcalculations, without asking whether samples of recent past events trulydo carry strong inferences for the probability distribution of future events.And in regulators such as the FSA, the assumption that financialinnovation and increased market liquidity were valuable because theycomplete markets and improve price discovery were not just accepted,they were part of the institutional DNA, part of the belief system.

The belief system did not, of course, exclude the possibility of market

intervention. But it did determine assumptions about the appropriatenature and limits of intervention. Regulation to protect retail customerscould be appropriate: requirements for information disclosure could helpovercome asymmetries of information between businesses andconsumers. Regulation and enforcement to prevent market abuse was

justifiable, because rational agents can also be greedy, corrupt orcriminal. And regulation to increase market transparency was not onlyacceptable, but a central tenet of the doctrine, since transparencycompletes markets and helps generate increased liquidity and price

discovery. But the belief system of market regulators and financial policymakers in the most financially advanced centers tended to exclude the


5/14

5

possibility that rational profit seeking by professional market participantsmight generate rent extraction and financial instability rather than social

benefit even though several economists had clearly shown why thatcould be the case.

What the dominant conventional wisdom of policymakers thereforereflected was not a belief that the market economy was actually at anArrow-Debreu nirvana but the belief that the only legitimateinterventions were those which sought to identify and correct the veryspecific market imperfections preventing the attainment of that nirvana.Transparency to reduce the costs of information gathering was essential:

but recognising that information imperfections might be so deep as to beunfixable, and that some forms of trading activity might be sociallyuseless, however transparent, was beyond the ideology. Stigler but notStiglitz as it were.

So we have had a varied and fertile academic economics, which intranslation to policy formulation became both oversimplified andoverconfident.

Why did that translation occur? Jagdish Bhagwati, in his famous ForeignAffairs article on the Capital myth, talked of a Wall Street/Treasurycomplex, of the fusion of interests and ideologies and he argued that

both played a role in the process by which liberalization of short-termcapital flows became an article of faith of the Washington consensus,despite sound theoretical reasons for caution and slim empirical evidenceof benefits. 2 And in the wider triumph of the precepts of financialderegulation and market completion, both interests and ideology haveclearly played a role.

Pure interests expressed through lobbying power were undoubtedlyimportant to several key deregulations in the US, whose political system

and campaign finance rules are peculiarly conducive to the power ofspecific lobbies. 3

And interests and ideology often interact in ways so subtle that is difficultto disentangle them, the influence of interests achieved through anunconsciously accepted ideology. The financial sector dominates non-academic employment of professional economists who, however

2 Jagdish Bhagwati , The capital myth: the difference between trade in widgets and in dollars, Foreign

Affairs , May/June 19983 See e.g Simon Johnson and James Kwak, 13 Bankers: The Wall Street takeover and the next financial meltdown , Pantheon, 2010


6/14

6

rigorously independent in their judgements on specific issues, will, because only human, tend implicitly to support or at least notaggressively challenge the conventional wisdom which is in the interestsof their industry. Market efficiency and market completion theories can

help reassure the top executives of major financial institutions that theymust in some subtle way be doing Gods work even when it looks at firstsight as if some of their trading is simply speculation. Regulators need tohire industry experts to regulate effectively; but industry experts arealmost bound to share the industrys implicit assumptions.Understanding these social and cultural processes which straddle theinterest to ideology divide could itself be an important focus of newresearch.

But we should also not underplay the importance of an ideology in itself of a set of ideas complex and internally consistent enough to haveintellectual credibility, but simple enough to provide a workable basis forday to day decision-making. Complex human institutions such as thosewhich together form the policymaking and regulatory system aredifficult to manage without guiding philosophies and guiding

philosophies are most compelling when they provide clear answers. Anda philosophy which asserts that financial innovation, market completionand increased market liquidity are always and axiomatically beneficial,

provides a clearer basis for the decentralisation of regulatory decision,making one which teaches that innovation is sometimes valuable andsometimes not, depending on the market and depending on thecircumstances.

And here, I suspect, lies the greatest challenge for new economicthinking. For while the simplified pre-crisis conventional wisdomappeared to provide a complete set of answers resting on a unifiedintellectual system and methodology, really good economic thinking will

provide multiple partial insights, based on varied analytical approaches.

Good economics is inherently non-monolithic.

Take for instance the assumption of rationality. Should the new economicthinking accept or reject it? Its a debate Ive had several times withGeorge Soros. I tend to use the wording that one of our key challenges isthat liquid financial markets are susceptible to irrational herd ormomentum effects: George always counters that the volatile divergenceof markets from equilibrium is the product of interactions between agents

who are acting in a perfectly rational self-interested fashion. And it isclearly the case that hugely important insights can be derived from the


7/14

7

exploration of how information imperfections, skewed incentives, andimperfect principal-agent relationships, can produce results far away froma Pareto efficient equilibrium even if we assume individual rationality.Both financial sector rent extraction and potentially harmful volatility are

compatible with individual rationality.

But it is also valuable that behavioural economics, drawing on theinsights of neuroscience and evolutionary biology, has pointed out thatour human brains include both areas devoted to the rational deliberative

processing of information, and parts where decisions are made oninstinctive and emotional bases. And while financial bubbles can beexplained by the interaction of rational agents, it is, I think, also insightfulto ascribe a role for what Keynes labelled animal spirits, or the delicate

balance of spontaneous optimism, or for confidence in the very specificfashion (implying trust) in which Akerlof and Shiller use it in their recent

book 4. And from Keynes too we should take the insight that the theory ofrational expectations breaks down, not only because of specificallyidentifiable imperfections of information, nor even because peoplesometimes act in spontaneous emotional ways, but because the very ideathat the expectations of economic agents are distributed around theobjective probability distribution of future outcomes is a philosophicalcategory error, since no probability distribution of future outcomesobjectively exists the future, and therefore financial markets which linkthe present and future being characterized by an element of inherentirreducible uncertainty.

So, should new economic thinking explore the implications which wouldfollow even if people were fully rational but operating within real worldconstraints? Or should it explore the role of instinct and emotion? Orrecognize Keynesian inherent irreducible uncertainty and, as a result, bedeeply sceptical of any attempt to achieve in economics the preciseconclusions of the physical sciences?

The answer is all three. We need to recognize, as Adam Smith did in hisTheory of Moral Sentiments that humans are part rational and partinstinctive. We need to accept that the economist must, as Keynes said,

be mathematician, historian, statesman and philosopher in some degree.And we need to understand, as Mervyn King and others have put it in arecent paper, that because beliefs and behaviours adapt over time inresponse to changes in the economic and social environment, that thereare probably few genuinely deep (and therefore stable) parameters or

4 G. Akerlof and R. Shiller Animal Spirits: How human psychology drives the economy and why itmatters for global capitalism , Princeton University Press, 2009.


8/14

8

relationships in economics as distinct from in the physical sciences,where the laws of gravity are as good an approximation to reality one dayas the next. 5

Which, Im afraid, is going to make doing and communicating neweconomic thinking rather hard. Because one of the key messages we needto get across is that while good economics can help address specific

problems and avoid specific risks, and can help us think throughappropriate responses to continually changing problems, good economicsis never going to provide the apparently certain, simple and completeanswers which the pre-crisis conventional wisdom appeared to. But thatmessage is itself valuable, because it will guard against the danger that inthe future, as in the recent past, we sweep aside common sense worriesabout emerging risks with assurances that a theory proves that everythingis OK.

But, to be useful, new economic thinking must help us address real world problems and its the real world problems of financial regulation thatkeep me busy at the FSA. And new economic thinking is needed toensure that in our response to the financial crisis we are adequatelyradical addressing the fundamental drivers of instability, not just thesymptoms. And one crucial question for economics is whether the crisisrevealed problems in specific institutions and in the incentives they face,or inherent problems with any system of credit extension throughfractional reserve banking, or inherent problems with liquid financialmarkets

Specific institutions: Too Big to Fail

Obviously the crisis was in part one of specific large systemicallyimportant banks. In response, there is an intense debate about the TooBig to Fail problem. Politically, that debate focuses on the costs of

bailout and on tax schemes designed to get our money back. Foreconomists the debate focuses on the moral hazard created by ex-anteexpectations of bailout, which reduce market discipline on excessive risktaking. Numerous policy options to deal with this problem are now beingdebated: higher capital ratios for systemically important banks, moreintensive supervision, limits on trading activity, pre-designated resolutionand recovery plan, or the use of taxes for Pigovian purposes, not to getour money back but to internalise externalities and create betterincentives.

5 Mervvn King et al Uncertainty in macroeconomic policy making: art or science? Royal SocietyConference, March 2010


9/14

9

And I am certainly convinced that finding answers to the Too Big to Fail problem is necessary indeed it is the central issue being considered bythe Standing Committee of the Financial Stability Board which I chair.

But we must not confuse necessary with sufficient and there is adanger that too exclusive a focus on Too Big to Fail could divert us fromstill more fundamental issues.

In the publics eyes the focus appears justified by the huge costs ofrescue. But when we look back on this crisis in, say, ten years time, whatmay be striking is how small the direct costs of rescue will then appear.Many government funding guarantees will turn out to be costless: central

banking liquidity support provided at market or penal rates will oftenshow a profit; capital injections will be partially and sometimes whollyrecovered when stakes are sold. Emerging estimates of the total fiscalcosts of rescue vary by country but are usually just a few percentage

points of GDP. But as a result of this crisis UK and US government debtto GDP will likely rise by 40 to 50 percentage points, and the even moreimportant measures of economic harm are GDP growth foregone,unemployment, and individual wealth and income losses.

Which implies that the crucial problem is not the fiscal cost of rescue, butthe macroeconomic volatility induced by volatile credit supply, firstsupplied too easily and at too low a price, then severely restricted. And itis possible indeed I suspect likely that such problems of volatile creditsupply would exist even if the Too Big to Fail problem were effectivelydealt with. In the US, this crisis has seen over-exuberant commercial realestate lending by regional banks, which if they fail are resolved by theFDIC in the normal fashion, and where that has always been the marketsex-ante anticipation. In the UK, similarly, we have had problems withmidsized mortgage banks, and with poor commercial real estate lending

by mutual building societies, as well as problems with two large banks.

Ireland faces huge economic problems as a result of a commercial realestate boom driven by banks which by global standards are relativelysmall.

There is therefore a danger that a too exclusive focus on Too Big to Fail becomes a new form of the belief that if only we can identify and correctsome crucial market failure in this case the moral hazard arising fromToo Big to Fail status that then, at last, we have will have achieved astable and self-equilibrating system.


10/14

10

Inherent dangers of fractional reserve banking

If, instead, fixing Too Big to Fail is necessary but not sufficient, then the

roots of credit volatility are deeper and the policy response may need to be more radical.

The essence of the problem appears to lie in the specific character ofcredit demand and credit supply. Hyman Minsky in his distinction ofhedge finance, speculative finance and Ponzi finance highlighted that inthe exuberant phase credit demand is significantly driven not byentrepreneurs seeking to finance new investment which they hope willgenerate profits enough to service the debt, nor by householders seekingto smooth consumption across their life cycle in a sustainable fashion, but

by companies or households using credit in the anticipation of short tomedium-term capital gain, in particular in real estate markets. 6 And thatdemand is in turn met by banks, institutions which have evolved in aspecific institutional form with liquid resources very small relative totheir short-term liabilities and with capital reserves very small relative tototal assets. That combination Minsky and others have argued createsthe potential for self-reinforcing cycles, which are not just one potentialcause but the essential cause of macro volatility, both in the upswing andin the downswing: and which could arise as much in a system of multiplesmall banks as in one of large Too Big to Fail banks.

Now, of course, that view of the world raises many complex issues whichrequire more detailed discussion than is possible this evening. But Icertainly find the arguments compelling and have explored them in moredetail elsewhere. 7 And if this is where the fundamental problems lie, thenradical policy implications follow along one or both of two dimensions:

The first would entail imposing increases in banking systemliquidity and capital requirements which are not just large buttransformational, taking us back to the highly liquid and much lessleveraged banks of the 1950s or before. Larry Kotlikoff indeed,echoing Irving Fisher, believes that a system of leveragedfractional reserve banks is so inherently unstable that we shouldabolish banks and instead extend credit to the economy via mutualloan funds, which are essentially banks with 100% equity capital

6 Hyman Minsky, Stabilising an Unstable Economy ,Yale University Press 19867 Adair Turner, What do banks do, what should they do? , Cass Business School, March 2010


11/14

11

requirements. 8 For reasons I have set out elsewhere, Im notconvinced by that extremity of radicalism. 9 And even if we dontgo that far, but do require a revolution in bank capital and liquidityrequirements, we would need to transition to them over very long

time periods, decades rather than years, since if we start with anunsustainably leveraged system, rapid transition to a sound systemwill itself stymie recovery. But we do need to ensure that debateson capital and liquidity requirements address the fundamentalissues rather than simply choices at the margin. And that requireseconomic thinking which goes back to basics and which recognisesthe importance of specific evolved institutional structures (such asfractional reserve banking), rather than treating existinginstitutional structures either as neutral pass-throughs in economicmodels or as facts of life which cannot be changed.

The second, either alternative or complementary policy response,would use discretionary through-the-cycle policies tools to offsetthe risks of self-reinforcing credit and asset price cycles. This couldentail the countercyclical variation of bank capital requirements,and might need to involve their variation by credit category orsector, given the very different elasticity of credit demand indifferent sectors of the economy using credit for different purposes.Constraints specifically on commercial real estate lending, forinstance, to reflect the fact that across-the-board constraints couldwell curtail new investment across the economy long before theyslowed down a boom in real estate prices. 10 New tools to take awaythe punch bowl before the party gets out of hand, and even perhapsto take it away from the already drunk but not from the still sober.All of which would take us far away from the dominantconventional wisdom of the last several decades, where optimalresults are achieved provided financial regulators identify andcorrect specific market failures, while central banks use oneinstrument alone to pursue one unchanging inflation objective. Butinevitably so given the large and inherent procyclicalities againstwhich we need to lean.

8 Laurence Kotlikoff, Jimmy Stewart is dead: Ending the worlds ongoing financial plague with limited purpose banking , Wiley, 2010. See also John Kay, Narrow Banking , 2009, for the alternative (butcompatible) suggestion that deposit taking banks should operate with 100% liquid assets requirements.9 See Turner What do banks do, what should they do? op cit10 Such tools could operate on borrowers, e.g. through Loan to value limits , rather than or as well ason lenders. LTV limits on mortgage lending indeed are already used as prudential regulatory tools in

several countries. The case for such macro prudential tools and the complexities involved in theirapplication are also discussed in the Bank of Englands Discussion Paper , The Role of Macro Prudential Policy, November 2009


12/14

12

Inherent problems of liquid financial markets

But it is possible that our response to the crisis should reflect a still moreradical analysis of the specific nature of financial markets and financial

contracts: their inherent potential instability and potential for rentextraction.

Tests of the efficient market hypothesis, illustrating the absence ofchartist patterns, were assumed by many devotees of the conventionalwisdom to imply that markets were self-equilibrating and collectivelyrational. In fact, no such inference follows: as Richard Thaler has put it,

proof that there is no free lunch does not prove that the price is right.And instead there is a wealth of evidence for instance Robert Shillers 11

that liquid traded markets can be subject to self-reinforcing herd andmomentum effects. The question is not whether financial markets arecollectively subject to irrational exuberance and overshoot: but how muchit matters and whether we can do anything about it.

In credit markets volatility surely matters a great deal. And while therecent crisis was partially one of classical banks making loans on balancesheet, it was also the first crisis of complex securitised traded credit. Thedevelopment of securitised credit and related credit derivatives was hailed

before the crisis as a positive virtue, bringing to credit extension the benefits of liquidity and price discovery. Thus the IMFs GFSR of April2006 noted favourably that credits derivatives enhance the transparencyof the markets collective view of credit risks [and thus] providevaluable information about broad credit conditions and increasingly setthe marginal price of credit. But setting the marginal price of credit byreference to a liquid market in credit derivatives is only economicallyvaluable if one believes, in line with an over-simplified interpretation ofthe efficient market hypothesis, that the markets collective view ofcredit risks is by definition correct. If instead we note that CDS spreads

for major banks fell steadily in the four years before the crisis to reach ahistoric low point in early summer 2007, and provided no forewarning atall of impending economic disaster, we should be worried that increasingreliance on market price information to set the marginal price of credit,rather than relying on independent credit analysis, could exacerbate creditsupply and asset price volatility. How far and under what conditionsadditional price discovery via the CDS market is economically valuablemust therefore be an open issue. And I have concerns that creditextension via loan mutual funds, such as Larry Kotlikoff has proposed,

11 Robert Shiller , Market Volatility , MIT Press 1992, : Irrational Exuberance , Princeton ,2002


13/14

13

could prove just as if not more volatile than credit extension via banks, with falls in mark-to-market valuations driving investor fundwithdrawals, fire sales and sudden stops to credit extension. The problemof volatile credit extension thus not solvable by abolishing banks and

moving to a 100% securitised credit model.

But more generally the idea that additional market liquidity, supported byadditional position taking or speculative activity, is always and in allmarkets beneficial which was one of the central articles of faith ofregulators such as the FSA before the crisis has to be challenged.Reasonably liquid markets clearly have some benefits: but those benefitsmust be subject to diminishing marginal return. The benefits ofalgorithmic or flash trading, which provide price discovery over afraction of a second, must be at best minimal and arguably nil. And thereare good theoretical reasons for believing as Joe Stiglitz has set out that financial trading activity can in some instances be zero sum of thesocial level, but profitable to individual players, as a result attracting tofinancial activity more skilled resources than optimal, which might be

better employed in other sectors the economy. 12 And any liquid-tradedmarket which overshoots whether it be an equity market, an FX market,or any other can produce resource misallocation or harmful macrovolatility. Foreign exchange carry trades are, as far as I can see, of zerovalue and potentially destabilising.

What follows from these insights, however, is not straightforward. Ifmarket liquidity is valuable up to a point, but not beyond it, regulatorsmay have no ability to design regulation to achieve the point of socialoptimality. If equity markets overshoot, that may result in misallocatedresources unnecessary dotcoms set up in the Internet boom but themacroeconomic consequences may be much less important thanovershoots in credit markets, precisely because equity contracts are theflexible residual. And if there is misallocation of skilled resource to the

financial sector, attracted by rent extraction opportunities, provided thescale is not too great we may just have to accept that, as we acceptmisallocations in other areas of the economy. If new economic thinkingrejects the idea that the market will naturally deliver a perfectequilibrium, it should equally be wary of believing that public policy canachieve it.

But knowing that market liquidity, speculation and price discovery is notlimitlessly and always beneficial still implies a profound change of

12 For instance , Joseph Stiglitz, Using tax policy to curb speculative short term trading , Journal ofFinancial Services Research , 1989


14/14

14

approach from that which dominated in the pre-crisis years. It impliesthat we should take financial transaction taxes and short-term capital flowcontrols out of the index of forbidden thoughts. And it means that indebates about prudential risk controls, such as capital requirements

against trading books, we should be less susceptible than before toarguments that specific regulations are inappropriate because they willreduce market liquidity.

To sum up therefore, we need new economic thinking, but even moreimportantly, we need to ensure that the public policy debate is notconstrained by acceptance of an over-simplified version of one strain ineconomic thinking, nor constrained by the assumption that evolvedinstitutional structures are necessarily unchangeable, but open to the greatvariety of insights which good economics has always given us.

Adair Turner

Documents

Turner, Adair - Economics, Conventional Wisdom and Public Policy