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The Econobubble Revisited

In a recent article, I discussed the 2010 Economics Nobel Prize in rather unflattering terms.  However, nothing beats the decision to award the 1997 Economics Nobel to Robert Merton and Myron Scholes for developing “a pioneering formula for the valuation of stock options.”  “Their methodology,” trumpeted the Nobel committee, “has paved the way for economic valuations in many areas.  It has also generated new types of financial instruments and facilitated more efficient risk management in society.”  If only the hapless Nobel committee had known that in a few short months the lauded “pioneering formula” would cause a spectacular multi-billion dollar debacle, the collapse of a major hedge fund (the infamous Long-Term Capital Management [LTCM] in which Merton and Scholes had invested all their kudos) and, naturally, a bailout by the reliably kind US taxpayers.

That episode was, as it turned out, nothing more than a flash in a pan when compared to the much larger shock which almost tumbled financial capital from its pedestal in 2008 and plunged the world into a bleak future.  For it was in the decade that followed the LTCM debacle that financial engineering intensified the paper-asset production line, using the methods pioneered by economists like Merton and Scholes.  While the true causes of the Crash of 2008 extend well beyond financialization, financial innovations amplified the crisis and enhanced its scope.  In short, it mass-produced real suffering at an industrial scale.  For this reason, it would probably not be too farfetched to draw a comparison with a hypothetical Nobel Prize in medicine based on work that led the Nobel laureate, a few short months later, to create and globally deploy the newest and most virulent of chemical weapons.

Should the Nobel committee have known better?  Yes.  In a masterpiece entitled Science and Method, Henri Poincaré had warned them back in 1914: “Probability is the opposite of certainty; it is thus what we are ignorant of, and consequently it would seem to be what we cannot calculate. . . .  Among the phenomena whose causes we are ignorant of, we must distinguish between fortuitous phenomena, about which the calculation of probabilities will give us provisional information, and those that are not fortuitous, about which we can say nothing, so long as we have not determined the laws that govern them” (emphasis mine).  In short, no one can possibly claim to know the chances of a financial crash while ignorant of its underlying causes.

How then did the economists convince the world, and the Nobel committee, that they could estimate the probabilities of events that their models assumed away not just as improbable but, in fact, as untheorizable?  The answer lies more in the realm of rhetoric and psychology than in economics itself: they relabeled ignorance and marketed it successfully as a form of provisional knowledge.  For instance, when unemployment seemed stuck at, say, 5%, and economists had no plausible explanation to offer, they called it “the natural rate of unemployment.”  No need to explain it — it was “natural”!  Or when they could not explain the deviations of human behavior from their predictions (e.g. in laboratory experiments), they (a) labeled such behavior “out-of-equilibrium strategies” and then (b) assumed that such behavior is random and “explainable” in the manner physicists describe white noise.

This thinly veiled form of intellectual fraud (i.e. the whole of what passes today as modern economic analysis) provided the “scientific” fig leaf behind which Wall Street tried to hide the truth about its “financial innovations.”  The basic truth that Poincaré had exposed being willfully ignored, the three decades that led us to the Crash of 2008 coincided with the rise of a Holy Trinity that permeated all economic wisdom: the Efficient Market Hypothesis (EMH), the Rational Expectations Hypothesis (REH), and the so-called Real Business Cycle Theory (RBCT): impressively marketed theories whose mathematical complexity succeeded for too long in hiding their feebleness.  Let’s take a glancing look at each one:

EMH: Financial markets contrive to ensure that current prices reveal all the privately known information that there is.  In effect, no one can systematically make money by second-guessing the market.  Some market players overreact to new information, others underreact.  Thus, even when everyone errs, the market gets it “right.”

REH: No one should expect a theory of human action to predict well in the long run if it presupposes that humans systematically misunderstand that very theory.  Sounds good, doesn’t it?  A bullet between the eyes of patronizing social theorists who believe that they are closer to the truth about your behavior and mine than we are.  Ay, there is the rub, for behind the façade of an anti-patronizing hypothesis lies a seriously insidious assumption: when people predict some economic variable (e.g. inflation, wheat prices, the price of some share), their errors are random — untheorizable, unpatterned, uncorrelated.

It only takes a moment’s reflection to see that anyone espousing EMH and REH cannot possibly expect recessions, let alone crises.  Why?  Because recessions are systematic events.  However surprising when they hit, they unfold in a patterned manner, each of its phases being highly correlated with what preceded it.  So, how does a believer in EMH-REH respond when her eyes and ears scream to her brain: Recession, Crash, Meltdown?  The answer is: by turning to RBCT for a comforting explanation.  So, here it is:

RBCT: Taking EMH and REH as its starting point, the theory portrays capitalism like a well-functioning Gaia.  Left alone it will remain harmonious and never go into a spasm (like that of 2008).  However, it may well be “attacked” by some “exogenous” shock (coming from a meddling government, a wayward Fed, heinous trades unions, Arab oil producers, aliens, etc.) to which it must respond and adapt.  Like a benevolent Gaia responding to a large meteor crashing into it, capitalism reacts efficiently to exogenous shocks.  It may take a while for the shockwaves to be absorbed, there may be many victims on the way but, nonetheless, the best way of handling the crisis is letting capitalism get on with it, without being subjected to new shocks administered by self-interested government officials and their fellow travelers who pretend to be standing up for the common good.

In a sense, each of the three hypotheses is a different incarnation of a touching faith that markets know best, both at times of tranquility and in periods of crisis.  You and I may think that this is just madness, but it is a lot more than that.  At the political level it is the rationale behind powerful forces ranging from the Tea Party to the Bundesbank, from the UK coalition government’s self-imposed austerity to the austerity imposed upon the Greek government by the IMF-Eurozone-ECB troika.  This dangerous self-delusion is founded on a hidden analytical bond: each tentacle of the EMH-REH-RBCT nexus presupposes that for the price of every different type of financial asset there exists (what statisticians refer to as) a unique sufficient statistic.  One that the market converges toward, albeit in a noisy manner.  But, as Poincaré knew, it is pure folly to presume that such unique statistics exist without first having established the laws that govern the determination of prices.  And since in capitalist societies these laws are radically indeterminate, the very foundation of the EMH-REH-RBCT nexus is rotten to the core.

Anyone who brings a fresh pair of eyes to the EMH-REH-RBCT nexus should arrive very quickly at the firm conclusion that it is a childish theory upon which to found an analysis of capitalism.  And yet it condemned a whole generation of economists to thinking of the most complex, disintegrated, precariously balanced period in the history of capitalism, the 1971-2008 period, as the era of an equilibrium-bound Gaia gallantly and successfully working out of its system all externally induced non-economic shocks.  Why, and how, did they fall for such a sorry lie?

My answer turns on that era’s main game: the “new” US Grand Strategy, circa 1971, of dealing with the profit and deficit crisis of US capitalism that ended Bretton Woods, not by curtailing the US budget and trade deficits but, rather, by expanding these twin deficits and paying for them by inducing huge capital inflows from the rest of the world (what Paul Volcker, citing Fred Hirsch, later described as part of a “controlled disintegration” of the world economy).  To implement this Grand Strategy, the US government needed to promote deregulation in labor and financial markets; a process essential for the “controlled disintegration” which was completed in the 1990s by the aggressive Clinton-Rubin-Summers deregulatory moves.

Once the Grand Strategy paid off, with billions of dollars flowing daily into the US (net), at a time when American workers were seeing their wages fall behind following a vicious attack on unions and labor market regulations, it was inevitable that Wall Street would find ways to profit handsomely from both (a) the inflows of foreign capital and (b) the floods of home-grown debt that the American workers were forced to take on in order to keep up with the Joneses.  This amplification of capital and debt flows was the cause of financialization and of the fabulous new “financial innovations” that it spawned.

Notice a common element between (a) the government policy that pushed deregulation and (b) the financial engineering drive that saw so-called “financial engineers” securitize mortgages and turn them into collateralized debt obligations (CDOs), manufacturing a mountain of essentially private money out of poor people’s debt, Wall Street’s bets, and foreigners’ hard-earned surpluses.  The common element was the assumption, contrary to Poincaré’s caution, of the existence of a plausible single sufficient statistic for each of the crucial variables.  In the context of government policy, deregulation rested on the presumption that unfettered capitalism would walk a predetermined, socially beneficial equilibrium path and, therefore, that each variable of significance (e.g. house prices, inflation, long-term interest rates, unemployment) would gravitate toward some given virtuous number: its own unique sufficient statistic.  In the financial sector, the main game was the securitization of US mortgages into CDOs, the aforementioned financial engineers using high-order mathematical statistics and computer algorithms to turn options’ contracts into an impenetrable maze.  None of that would have been possible without a crucial assumption: that a single, stable price could be attached to each CDO.

When the CDO market crashed and burnt in 2008, bringing down with it Wall Street and Main Street alike, the world in agony demanded to know how so many intelligent people could have believed the formulae behind the derivatives and, in particular, why no one questioned the “sufficient statistics” upon which they were founded.  Why did they not demur at the sight of formulae which assumed away the possibility of “correlated defaults,” which is techno-speak for “crisis”?

The answer is simple: First, it would have gotten in the way of a great deal of money making.  Stopping to think in a middle of a feeding frenzy means a smaller catch for great fish and small.  Secondly, because the “best” economists in the best economics departments were winning Nobel Prizes with theories proclaiming that all “deviations” from equilibrium were untheorizable and, therefore, best left out of a theory, save for an error term reducible to a simple parameter; i.e. “deviations” happen for reasons external to capitalism and, as such, are the sort of events that cannot possibly be given an economic explanation.  Who were they, whether traders or politicians, to dispute the brightest Nobel Prize winners?

In conclusion, the Bubble that burst in the real world in 2008 had an accomplice, inflating itself at the same time, in the realm of ideas: the Econobubble that was taking over the best departments of economics the world over.  While the Bubble was shifting power and resources unsustainably from industry and labor to the financial sector, the Econobubble was busily purging out of economics textbooks all sensible references to capitalism as a contradictory system.  By peddling a form of mathematized superstition which made them look unassailably scientific (an image that real scientists, like Poincaré, would have laughed at), economists were arming the financiers with the superhuman, and super-inane, confidence needed to bring down (against their wishes) the very system which nourished them.  A very contemporary tragedy indeed, which, alas, is never-ending.  For it is now clear that, even though the Bubble has burst, the Econobubble has not.  After a year or so of keeping a low profile, it is now, once again, being pressed into service by powerful interests whose sole concern is to make sure that the post-crisis burden is foisted upon those who have suffered the most since 2008 and who had benefitted the least before it.


Yanis Varoufakis is Professor of Economic Theory and Director of the Department of Political Economy in the Faculty of Economic Sciences of the University of Athens. Varoufakis’ books include: The Global Minotaur: The True Origins of the Financial Crisis and the Future of the World Economy (forthcoming); (with S. Hargreaves-Heap) Game Theory: A Critical Text (Routledge, 2004); Foundations of Economics: A Beginner’s Companion (Routledge, 1998); and Rational Conflict (Blackwell Publishers, 1991).  The above article summarizes arguments made in Chapter 12 of Modern Political Economics: Making Sense of the Post-2008 World, authored by Yanis Varoufakis, Joseph Halevi, and Nicholas Theocarakis (to be published in March 2011 by Routledge).




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