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Our Best Minds Are Failing UsWith America in deep trouble, our economists are AWOL, and our scientists are still off financial engineering.

by Michael Hirsh September 16, 2010

Corbis

The most terrifying moment in modern economic history occurred two years ago this month.For several long days after the fall of Lehman Brothers on Sept. 15, 2008, the financial systemwas in danger of total collapse, and the United States seemed on the precipice of anotherGreat Depression in that Black September. Just as bad, our economists and seniorpolicymakers had barely any idea why this was happening. The assumptions of an entire erahad been proved wrong. The Great Moderationthe period of postCold War prosperity inwhich capitalism was said to have been tamed and risk masteredwas revealed to be anillusion. Alan Greenspan professed his shocked disbelief that the Wall Street institutions hehad trusted in were so reckless as to blow themselves up. The whole intellectual edifice hascollapsed, the former Fed chairman told Congress that fall. Economists said they would haveto come up with new theories for how markets worked, in particular how the financial systemfunctioned and interacted with the real economy. Large swaths of economics are going tohave to be rethought on the basis of what happened, Larry Summers, the presidential adviserwho doubles as a world-renowned economist, told me in an interview shortly after BarackObama took office.

Two years on, that rethinking has barely begun, and only with the most painful reluctance byeconomists. Meanwhile, policy and political debates still driven by outdated economic theoryhave been racing out of control, bitterly dividing the nation. Whether the arguments are aboutstimulus, financial reform, health care, or jobs, the discussions in Washington tend to be

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dominated by simplistic black-and-white views that are little different from the conceptualframework that prevailed before the collapse: markets always work better than governments.Advocates of government spending are socialists. Champions of markets are laissez-faireideologues or slaves of Wall Street. And never the twain shall meet. A vast new regulatoryframework has been set in motion, but many experts say it has done little to change the wayWall Street or the real economy functions, and there is no new economic theory underlying it.

The Financial Meltdown's Best Quotes

The Financial Meltdown's Best Quotes

The failure of the economics profession to address our deeper problems theoretically ismirrored by the failure of other sciences on a more practical level. To wit: Americas best mindsare still heading to Wall Street to an unnerving, even pathological degreefurther evidencethat finance remains the dominant sector of the economy. The evolution of the financialsectors trading and banking practices into arcane rocket science in recent decades had a lotto do withrocket scientists. After the end of the Cold War and the collapse of the SovietUnion in late 1991, top physicists and engineers and other major-league brains werent neededas much. With the advent of the peace dividend (read: Pentagon cuts), many of them headedfor Wall Street and became quants. This trend brought two new, big things to Wall Street: awhole-new level of intellectual horsepowerthe upper reaches of the IQ scaleand a newlayer of important players who had no reason to doubt that markets worked as formulaically asthe weapons systems they had once puttered over. Thats partly how structured finance,derivatives, and other products have grown so complex that not only regulators but even WallStreet CEOs can no longer understand them.

Yet this trend in turn cant change without a reordering of what economists call incentives.

Pay scales on Wall Street continue to outstrip those in other professions outrageously. TheObama administration and Congress have done little legislatively or through use of the bullypulpit to try to reorient compensation practices so that perhaps some of our greatest mindswont go into useless financial engineering but instead will begin to consider real engineeringagain. Wall Street execs have been whining for two years that to reduce pay incentives andbonuses would cost the firms their best talent. The governments response should be YES!Thats precisely the idea. Finance was once a means to an end: the growth of the realeconomy. Banking once served industry and services. Now finance has become the end, andthe real economy is subservient to financial services (its no surprise that after the crisis, over-the-counter derivatives trading quickly climbed back up to more than $600 trillion). At some

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point in our recent past, finance lost contact with its raison dtre, European Central Bankchief Jean Claude Trichet said earlier this year. Finance developed a life of its ownFinancebecame self-referential. As long as this pathological state of affairs persists, questions ofglobal growth and social welfare will continue to depend on Wall Street and the enduringfallacies of free-market finance.

Recently, the National Science Foundation sent out a query asking economists and socialscientists to draw up grand challenge questions that are both foundational andtransformativea request that one recipient, Andrew Lo, a highly regarded financialeconomist at MIT, says is a first in his experience. But one problem is that the economicsprofession has gotten much more intolerant of divergence from orthodoxy, says PhilipMirowski, an economic historian at Notre Dame. The range in which dissent happens is sonarrow. In a sense they still cannot imagine the system can operate to undermine itself. That isnot a position that is allowed anywhere in the economics profession. The field got rid ofmethodological self-criticism. This Great Moderation stuff was just arrogance, hubris. Indeed,the joke on economists, says one of them, Rob Johnson, is that they create simplistic modelsthat depend on people behaving as rational actors motivated by self-interest, yet they have ablind spot regarding themselves. The way they squabble mulishly to defend now-indefensible

positions is itself evidence of how flawed those rational-actor models are.New thinkers say they are still having trouble breaking in. Among the new NSF grant awardeesis J. Doyne Farmer, a physicist at the Santa Fe Institute who is trying to bring the idea ofcomplexity back into economics by making use of advanced computing power to map humaneconomic behavior the way weather or climate change is tracked. But Farmer says he got his$450,000 grant for a three-year study of systemic risks in markets only after a sympatheticNSF case officer overruled negative assessments by neoclassical economists who reject anymodel that doesnt tend toward general equilibrium. The established view just holds this stuffback, Farmer says. One of the dangerous cultural patterns that economics has fallen into isan excessive emphasis on theorem proof for its own sake rather than what gives you scientificresults. Thats led to a disdain for computer simulation. Johnson, who is director of the newInstitute for New Economic Thinking funded by George Soros, says: You do see some newthinking, but it doesnt get traction in terms of policy. Its a symptom of how far right society hasgone.

The great names in the profession have not necessarily helped. The top economists in theObama administrationSummers; Christina Romer, the just-departed chair of the Council ofEconomic Advisers; and her replacement, Austan Goolsbeeare all part of the orthodoxy.Critics say Summers should know as well as anyone how the old thinking has beenoutstripped. As a Harvard professor, Summers wrote after the 1987 stock-market crash that itwas impossible to believe any longer that prices moved in rational response to fundamentals.He even cautiously advocated a tax on financial transactions. Yet Summers, one of the worldsmost astute economists, later abandoned these positions in favor of Greenspans view thatmarkets will take care of themselves. And in the current era, Summers and the rest of theObama team seem to have underestimated the depth and systemic nature of the economiccrisis. Stimulus spending was timid (in deference to political antipathy to big government),mortgage workouts meager, and financial reform minimalist. The administration maintains it didas much as it could under the political constraints, but others disagree. The financial-reformbill and other changes in the regulatory landscape are more incremental, says MITs Lo. Its areaction to the most immediate set of events as opposed to a more profound rethinking aboutthe underlying causes of the crisis.

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A little history is in order here: it was largely because the field of economics came to bedominated by neoclassical thoughtor the idea that markets are rational and can reachequilibrium on their ownthat so-called financial innovation on Wall Street was allowed torun amok in recent decades. That led directly to the crisis of 200709. No matter how crazy orcomplex the products got, the theory was that, with little government oversight, the inherentstability of markets would keep things from getting too out of hand. It was in large part becauseof this way of thinking that government intervention of any kind in the markets, includingregulation, came to be seen as a kind of heresy, especially after the Soviet Union collapsedand command economies and statism were thoroughly discredited.

The new financial-reform law has changed that to some degree, but it still leaves most of themajor decisions about government oversight to the same regulators who failed last time. Weare still, to a large extent, flying blind in conceptual terms. Just as the Great Depressiondemonstrated to John Maynard Keynes and his followers that markets often behaved badlyleading to the Keynesian reinvention of economics in the 30sthis present crisis drove homethe truth, or should have anyway, that rational models of markets dont work well becausethere are too many unknowns. People most often dont behave as rational actors. There is noreal equilibrium in the real world. Above all, market economies are capable of destroying

themselves. This is especially true in the world of finance, which has always worked accordingto different rules than other sectors of the economy and is much more prone to panics andmanias. In 1983, a young Stanford economist named Ben Bernanke published the first of aseries of papers on the causes of the Great Depression. The financial system, Bernanke said,was not unlike the nations electrical grid. One malfunctioning transformer can bring down thewhole system. Ive never had a laissez-faire view of the financial markets, Bernanke told me,because theyre prone to failure. Even Friedrich Hayek, the godfather of 20th-century laissez-faire thinking, believed that financial markets were more subject to bouts of instability, saysone of his biographers, Bruce Caldwell of Duke University, a self-described libertarian scholar.

Yet amid the free-market triumphalism of the postCold War era, all this hard-won wisdomabout the differences in finance was forgotten or ignored. To policymakers in Washington, itseemed silly and nitpicky to treat finance as a different animal. The dominant thinkers were therational expectations economists of the Chicago school who simply assumed capital flows,no matter how open, would be stable.

We now know differently. But the question remains: how should we think about our outsizedfinancial sector now, and how can it be made to serve the larger economyrather than theother way around? Shouldnt we have learned our lesson from the Great Recession, just aseconomists did after the Great Depression? Should there not be a new economics thatdevelops fresh concepts reordering the balance between markets and governments, acceptingthe necessity of both? The great economist Paul Samuelson used to say, paraphrasing thephysicist Max Planck, that economics progresses one funeral at a time. It was necessary forthe old lions to pass on, in other words, before new seminal thinking took hold. But we may nothave time to wait upon funerals. Policy is driving relentlessly ahead, and the economicsprofession and other sciences have been left far behind.

Hirsh is the author of the newly published Capital Offense: How Washingtons Wise MenTurned Americas Future Over to Wall Street .

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