The Dangers of Economic Dogma- Models and Financial Mayhem…

We recently came across an interesting paper by George Akerlof, a Nobel Prize winning economist in which he describes the unreality of the basic macro-economic models used by the profession in the half-century ending with the Great Financial Crisis (GFC).

In essence, Akerlof posits that the models used were misleading, because they failed to ascribe sufficient importance to the impact of the financial system on the wider economy. He also makes a point, often overlooked, that the choice of textbook used as the core for teaching a particular topic has far-reaching consequences, because it influences how students are taught and come to understand a subject, and thus how they apply their knowledge.

In the 1960s (before Friedman’s monetarism and economic neoliberalism took over the world), the basic model used (at least in most US universities, including Akerlof’s MIT) was the so-called Keynesian neoclassical synthesis, which was based upon the concept of finding equilibria between the various components of the underlying economic model, principally supply and demand. Unfortunately, in creating the “synthesis”, its acolytes decided that any changes to an equilibrium would be one step at a time and proportional. The models did not really address circumstances in which disorderly changes could occur- i.e., panic or crashes.

Somehow, they had forgotten, or overlooked, Keynes’ own “beauty contest” theory of market behaviour, under which individuals (and so corporations and banks) allocate their wealth and make financial decisions based not upon careful analysis of economic fundamentals, but rather on what they think others will see as the value of an asset- a version of the “greater fool” approach, which only works as long as the greater fool exists and behaves as expected!

As Akerlof explains, because the real world is a very complicated place, even for the DSGE (Dynamic Stochastic General Equilibrium) models now beloved of central banks, relying upon a model that essentially smooths out the impact of financial decisions is a recipe for macroeconomic mayhem, because it fails to account for the fact that systems and economies can appear very stable until, suddenly, they are not. In the case of banks, deregulation in the 1980s and 1990s removed both oversight and constraints, which, when coupled with malign incentives and dogma such as “housing prices cannot decline systemically”, created the conditions for the GFC, whose effects we are still living with today.

Strange as it may seem, the dominant economic models failed to include the impact of the financial system (as a system) on the wider economy. With a few honourable exceptions, the dismal science failed miserably in terms of its forecasting ability. Why? Because a model, which actually ignored a key tenet of its supposed creator (Keynes), became the basis for teaching a generation of economists- and questioning it was risky at the individual level.

One may ask what such a tale has to do with (re)insurance. Simply that there are dominant models and “orthodoxies” in the industry (as in many others) that are used to guide decisions, often without question. In reality, as we aim to do at Awbury, every time one uses a model one should always ask one’s self not only whether it is appropriate for the decision that will be based upon it, but also whether there any characteristics which place a boundary on the circumstances in which it will remain useful. In other words, is it truly fit for purpose?

As we all know, the real damage comes from the extreme left of the distribution (which, ironically, is another convention!); but, first, the distribution has to be grounded in some form of reality!

The Awbury Team

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