Reviews

Zombie Economics: How Dead Ideas Still WalkAmong Us, by John Quiggin (Princeton Uni-versity Press, Princeton, NJ, 2010), pp. 216.

The otherwise diverging opinions surroundingthe current global financial crisis (GFC), alsoknown to some – with love for the past – as theGreat Recession, seem to converge when itcomes to the prophecy about the future of eco-nomics: It is doomed to fail. Although there isno reason why economics should fail, the ver-dict nonetheless has some prominent and well-known supporters. The argument usually runs asfollows: Economics not only failed to predict anevent as catastrophic as the GFC but it is alsoincapable of providing any unified solution thatcould help nations recover from the GFC. Whatis the use of a field that can’t help solve a prob-lem? This is a question that should interest any-one who even remotely cares about publicpolicies and how economic models help shapethem. John Quiggin, an Australian ResearchCouncil Federation Fellow Professor of Eco-nomics at the University of Queensland, arguesthat this is not the first time that the models andideas of economics have failed the litmus test ofrelevance. There have been many recessions andvarious failed monetary and industrial policiesbased on erroneous economic models adoptedby governments around the world, which shouldhave been sufficient to discredit these ideas, butthe current GFC should seal the fate againstthese ideas, forever. But, alas, like zombiesthese ideas still reign supreme in the profession.How can that be? And what are these incorrectideas? This is precisely the subject matter ofthis book, which is written for a general audi-ence and is highly informative and entertaining.The author’s extensive work in the field of pub-lic policies and decision theory and his generalinterest in politics allows him to explain theproblem from a very applied perspective. Andwhile reading the book it was obvious to methat the author is angry about the way thingsare in economics. There are five main dicta,and in each chapter Quiggin explains them fromboth current and historical perspectives. The

five main ideas identified by the author thatneed debunking are: (i) The Great Modera-tion; (ii) The Efficient Market Hypothesis;(iii) Dynamic Stochastic General Equilibrium(DSGE) Models; (iv) Trickle Down Economics;and (v) Privatization. The book, however, pre-sents a lopsided view in its incessant criticismwhile it fails to provide any alternative exceptwhen it cursorily proposes using models thatrely on ‘heuristics’, i.e. behavioral economics. Itis not quite clear what economic model one issupposed to use, nor, more fundamentally howto approach economic problems. It is the hopeof this reviewer that Quiggin takes up this issueand provides what he thinks is the solution tothe problems he raises, perhaps in a new edition.It would not only complete the book as it is butalso will be useful as a guide for the futuregeneration of economists.

In the remainder of this review, I will try toconnect the aforementioned five ideas togetherwhile using an extremely simplified example ofa bank loan which draws heavily from (Keyset al., 2010). For the purpose of illustration,consider a bank in the USA that provided homeloans to individual borrowers in a subprimemarket, i.e. with (FICO) credit scores less than650.1 Since the bank issued and held the loan itwas in its self-interest to collect costly informa-tion, both ‘soft’ and ‘hard’, on the credit worthi-ness of the applicants. Soft information is anyinformation that is non-contractible (possiblybecause it cannot be verified in the court); FICOcredit score is an example of hard information.Historically, the issuance giant AIG pushed andpromoted a rule of thumb: Anyone with score of620 or higher is a safe client. This model hadsurvived and worked pretty well until veryrecently. Now, consider a new asset thatallowed the bank to securitise (bunch) loans and

1 FICO comes from Fair Isaac & Company whodeveloped software in the USA that helps determinecredit worthiness. The FICO score ranges from 350 to800, and about 60 per cent of the population havescores between approximately 650 and 799, withmedian score at 723 in 2006.

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sell them to a third party (investors) as long asthe FICO score was at least 620. At the outset,this new asset was deemed good and welfareenhancing because it distributed the burden ofrisk from the bank (who could not afford it) tothose who could – the big investors. Thisarrangement served to increase the size of themarket. The US Government, directly throughderegulation and privatization and indirectlythrough its vast institutions (Freddie Mac andFannie Mae) promoted this asset type by becom-ing a guarantor of these assets. Suddenly theAmerican dream of universal home ownershipwas becoming possible. Some big insurancecompanies stepped in to allay the fears of theinvestors by selling a special insurance (creditdefault swaps) against the event of any defaultby the borrowers. Suddenly, the bank’s incen-tive changed and because it no longer held theloans (and the associated risk) it stopped screen-ing applicants on soft information: Virtuallyanyone with a 620 FICO score could now get aloan, an example of moral hazard. This laxscreening results in an increase in loan applica-tions from those who cannot afford a loan, anexample of adverse selection. It is therefore notsurprising that even people with better creditscore (greater than 620) defaulted 30 per centmore often than those with lower score (lessthan 620); see (Keys et al., 2010). In this exam-ple, it is very difficult to single out any oneplayer or any one single idea as a culprit, andthe message of the book should be that econom-ics, when viewed piecemeal, leads to disastrousconsequences. One should resist the temptationto say that both the FICO score and the capacityof the market to correctly price the asset, theso-called Efficient Market Hypothesis (EMH),are useless (Chapter 2).

Let us consider the parties involved in thisexample: the bank who wants more profit; theborrowers who want to buy houses even whenthey can’t afford one; the investors who buy theassets in the hope of reselling them; the insur-ance companies; the government who (for politi-cal gain) promoted home ownership and, as away to prop up demand, stood as a guarantor ofthese loans and actively pursued privatizationand deregulation of the market. The main themeis that everyone is driven by self-interest, whichmight lead to a bad social outcome such as theGFC. The author illustrates in an excellent waywhy the proponents of markets were wrong inbrandishing ‘Black-Scholes’ as the cure to

market failure. The proponents of markets claimthat the market (and not the government) knewhow to internalise any information in pricing theassets. According to those who believed themarket could solve the problem, the investors inthe example could use the ‘Black-Scholes’ for-mula (or some variant of it) to exactly price theworth of the asset, and since the price dependson the fundamentals (the credit worthiness ofthe borrowers) the price at equilibrium willalways lead to the most efficient outcome. Theyignore three important points: (i) the FICO scoredoes not provide full information; (ii) marketsmay fail in the presence of private information(the banks and the borrowers have private infor-mation about the quality of the asset); and(iii) the investors would invest only if theythink they can re-sell at a higher price, but ifthe prices reflected true worth there would be noresale. Fundamentally, there is an inherent para-dox built into the system, as beautifully illus-trated by Grossman and Stiglitz (1980).

How could this have gone for as long as itdid? Why wasn’t this complex market regulated?Was the government unaware that it was promot-ing excessive risk-taking? The book tries toanswer this by unpacking the intricate relation-ship between economists who advised thegovernment and the goals of the government,particularly in the USA. Such political economysubjects are usually ignored by sophisticatedeconomic models. The US Government, withstrong ties to academia, pushed and promotedthe idea of higher home ownership, even forpeople who couldn’t afford it. According tothe Great Moderation (Chapter 1), economistsclaimed that, post-World War II, the economyhad matured such that recessions were shorter,business cycles were stable and there was steadygrowth resulting in sustained prosperity.2 Thepolicy makers reckoned that in the future eventhose who cannot currently afford a house willultimately be able to afford one. This beliefjustified increasing the liquidity in the mar-ket through promotion of exotic assets andessentially becoming a guarantor for all mort-gage-backed securities. Investors were becomingricher without taking risks, but the government

2 Stock and Watson (2002) had essentiallydebunked this notion by attributing most of the stabil-ity to mere chance.

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didn’t fret because it believed that the wealthwould eventually trickle down to the masses (the‘trickle down effect’) and ignored the inefficientredistribution of wealth. The path of this trickledown is usually taken to be in terms of increasedlabour productivity. But we know this has notbeen the case with the current crisis as thelabour market is more or less frozen at levels ofvery high unemployment. The effect of thefinancial crisis and the ensuing moratorium onfinances to small and local business meant a sig-nificant dent in the employment-carrying powerof the economy as a whole. High unemploymentin Greece, Spain, Portugal and the USA is thesubject matter of a chapter devoted to theDynamic Stochastic General Equilibrium model(Chapter 3). The book argues decisively that thebasic approach of the model is flawed because itassumes smooth transitions from any shocks tostable equilibria, has no room for discontinuityor lumpiness and, most importantly, relies exces-sively on the Efficient Market Hypothesis tomodel the dynamic behavior of the agents. Aswe know, the EMH need not work. Under EMH,there is no provision for bubbles, for example,which we know are possible with fresh examplesin our memory. The book argues that the deathof the EMH is sealed by the scale and scope ofthe crisis, 4 trillion dollars (10 per cent of worldproduction). Unlike the great depression, thiscrisis is completely due to financial assets. Theblind belief in the market led many to push forprivatization reform all across the world, therebysystematically removing any oversight by thegovernment. This idea of privatization is studiedin the last chapter of the book.

The failure of the ideas post the crisis is alsoexemplified by the inability of the economicprofession as a whole to agree on the right wayforward. The controversy surrounding the bail-outs of the banks, justified on account of theirbeing ‘too big to fail’ screams for better eco-nomic models. But I think it is important toacknowledge that there were, and still are, econ-omists and economic models that explain whatcould happen. For example, in terms of bankbailouts, (Diamond & Dybvig, 1983) showedthat we must insure bank savings to save theeconomy from the collapse of banks. In anearlier paper (Kareken & Wallace, 1978) hadwarned us that we must not ignore the incentiveeffect of such an act on how banks will behave.It is our fault that we have ignored the warning.Recently, economics as a profession has started

to think seriously about the political aspectof governance. Why governments redistributeincome inefficiently (Acemoglu & Robinson,2001) and how should we govern the govern-ment (Myerson, 2006), among many others.Lastly, in economics we favor a deductiveapproach, where conclusions are drawn fromsome axioms, consistency and rigour of amodel. But unlike in the hard sciences thateconomists try to emulate, we do not judgemodels based on their empirical relevance. Thispractice has cost us dearly, and the time is ripeto put emphasis on the testability of axioms andbe cautious towards models with non-testableassumptions. The usefulness and efficacy of eco-nomics depends on a renewed emphasis onempirical relevance and a timely approach to itsimplementation.

GAURAB ARYAL

Australian National University

REFERENCES

Acemoglu, D. and Robinson, J.A. (2001), ‘InefficientRedistribution’, American Political Science Review,95 (3), 649–61.

Diamond, D.W. and Dybvig, P.H. (1983), ‘Bank Runs,Deposit Insurance and Liquidity’, Journal of Politi-cal Economy, 91 (3), 401–19.

Grossman, S.J. and Stiglitz, J.E. (1980), ‘On theImpossibility of Informationally Efficient Markets’,The American Economic Review, 70 (3), 393–408.

Kareken, J.H. and Wallace, N. (1978), ‘Deposit Insur-ance and Bank Regulation: A Partial-EquiblirumExposition’, The Journal of Business, 51 (3), 413–38.

Keys, B.J., Mukherjee, T., Seru, A. and Vig, V.(2010), ‘Did Securitization Lead to Lax Screening?Evidence from Subprime Loans’, Quarterly Journalof Economics, 125 (1), 307–62.

Myerson, R.B. (2006), ‘Federalism and Incentives forSuccess of Democracy’, Quarterly Journal of Politi-cal Science, 1, 3–23.

Stock, J.H. and Watson, M.W. (2002), ‘Has the Busi-ness Cycle Changed and Why?’, NBER Macro-economics Annual, 17, 159–218.

Explorations in the Economics of Aging, byDavid Wise (ed.) (University of Chicago Press,Chicago, IL, 2011), pp. ix + 388.

This year is the 10th anniversary of the Aus-tralian Treasury’s first Intergenerational Report(IGR). The IGR presented long-term projections

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