Arnold Kling  

Barry Eichengreen's Theya Culpa

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Everywhere I go, I see links to this article by Barry Eichengreen. I was expecting to find something good. Instead, it is a classic Theya Culpa, a one-sided exercise in finger-pointing, which educates no one, least of all the people who agree with it and fervently recommend it. Some excerpts follow.

the problem lay not so much with the poverty of the underlying theory as with selective reading of it--a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions' decisions. The consequence was that scholarship that warned of potential disaster was ignored.
I would like to see the scholarship that warned that mortgage securitization was a problem. I would like to see the scholarship that foresaw the problems with risk-based capital rules and market-value accounting. I would like to see the scholarship that saw the entire financial system as vulnerable to a decline in house prices.
where were the intellectual agenda setters when the crisis was building? Why did they fail to see this train wreck coming? More than that, why did they consort actively with the financial sector in setting the stage for the collapse?
Oh, yes. It was all a plot by the financial sector to set the stage for the collapse, with the aid of "intellectual agenda-setters" . I'm sorry, but I cannot equate this sort of conspiracy mongering with analysis.
Meanwhile, deregulation was on the march. Memories of the 1930s disaster that had prompted the adoption of restrictions like the Glass-Steagall Act, which separated commercial and investment banking, faded with the passage of time. This tilted the political balance toward those who, for ideological reasons, favored permissive regulation. Meanwhile, financial institutions, in principle prohibited from pursuing certain lines of business, found ways around those restrictions, encouraging the view that strict regulation was futile. With the elimination of regulatory ceilings on the interest rates that could be paid to depositors, commercial banks had to compete for funding by offering higher rates, which in turn pressured them to adopt riskier lending and investment policies in order to pay the bill. With the entry of low-cost brokerages and the elimination of fixed commissions on stock trades, broker-dealers like Bear Stearns, which had previously earned a comfy living off of such commissions, now felt compelled to enter riskier lines of business.
I have yet to hear one coherent explanation of how the relaxation of Glass-Steagall caused this crisis. At least the proponents of the view that it was all the Community Reinvestment Act (a view which I do not endorse) have a story to tell.

The other two elements in the "deregulation is on the march" paragraph are the end of deposit-interest ceilings and the elimination of fixed commissions on stock trades. Is there any economist out there who believes that deposit-interest ceilings were sustainable or that fixed brokerage commissions were economically justified? Is there an economist out there who buys the story that the way to restrain financial firms from innovating or risk-taking is to ensure that they obtain regulatory rents?

the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants.

This may be true. It may be a good thing. I would be the last person to defend the mathematical theorists. But I also think it is quite a stretch to try to pin much responsibility for the financial crisis on the theorists.

There are problems with the direction that mainstream economics has taken over the past thirty years (or more). But if the new way forward is represented by Eichengreen's McCarthy-esque conspiracy tales, I am afraid that things will get worse rather than better.

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COMMENTS (12 to date)
floccina writes:

With the entry of low-cost brokerages and the elimination of fixed commissions on stock trades, broker-dealers like Bear Stearns, which had previously earned a comfy living off of such commissions, now felt compelled to enter riskier lines of business.

IMO this shows that even good change can contribute to instability. It also is evidence that we would be better off in long run if we let the investment banks fail. They then might have been replaced by organizations with better more efficient models.

Robbie writes:

"I would like to see the scholarship that foresaw the problems with risk-based capital rules "

Benoit Mandelbrot made an attempt to explain deficiencies with the models used to calculate risks in a way necessary for risk based capital requirements.

I haven't read anything by him that mentions securitization.

I think that it would be hard to find anyone who convincingly predicted how the entire financial sector would respond to house price drops, simply because it is too vast a system to make anything other than vague points when talking about it as a whole.

David writes:

"the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants"

Excuse me? Economics has essentially been under the exclusive sway of the supposed "empiricists" since WWII. The ability to test theories empirically has been one of the primary arguments in favour of the increasing use of math in economics and the need for methods that, in the minds of their users, "formalize" economic theories and their implications. How did that work out? Not well, obvously, since we are apparently still fighting about whether fiscal stimulus works (amongst many other basic issues).

All too often, of course, things that appear to have been empirically validated are simply the "pretense of knowledge".

Mr. Eichengreen's general point seems to be that, if only government had taken the advice of the smartest social engineers (who have discovered ways of correcting for all of humanity's many flaws) and thus been even more meddlesome and hubristic, we could have avoided our present situation.

My view is that, when it comes to government intervention, there is only one thing that has been empirically validated: the law of unintended consequences.

On a separate note, I can never understand how one can argue that the problem was excessive risk-taking and yet be so dismissive of the role of regulation and intervention in creating moral hazard and increasing systemic risk by eliminating natural market incentives or restraints (on the part of depositors, bank shareholders or banks lending to other banks) necessary to discipline lending practices and ensure prudence.

There is no amount of regulation, no matter how sophisticated or clever its designers, that can replace the discipline of the market.

mobile writes:

The Glass-Steagall story (which I also do not endorse) is that it facilitated large banks entering the mortgage lending business, leading to:

1. Greater investment in financial innovations in that sector, some of which we know didn't go so well

2. A shift from regional risk (pre-repeal, a housing downturn would wipe out banks from affected states) to systemic risk

3. Perhaps additional systemic risk from a loss of information, or at least a change information, as mortgage underwriting no longer necessarily occurred in the same region that the mortgage was held. Global lenders may have been more susceptible to lemons problems than regional lenders, or the geeks vs suits divide might have been larger within larger institutions.

fundamentalist writes:

I agree with David. Has Eichengreen been asleep the past 50 years? Econometrics dominates econ theory. Eichengreen clearly doesn't understand the problems involved. The data is so vast that any crackpot theory finds support in it. All you have to do is choose the right time period and select the right variables and you can prove your pet theory from the data.

Lee Kelly writes:

Inductive economics? I believe it. Induction is arbitrary, and so is Eichengreen.

Steve Roth writes:

Arnold, I don't know why you (and here, Eichengreen) continue to ignore the Commodities Futures Modernization Act, which made it *illegal* to regulate the derivatives that are at the heart of this whole mess.

(Yes: Glass-Steagal, feh.)

I just searched econlog: not a word, except from commenters.

Edwin Lee writes:

I agree with you that pointing fingers is pointless. However, it serves a purpose for the individual who does so and for those who agree that "somone else is to blame".... it enables them to continue living as before while convinced that the solution to the crisis is that others must change.

I'll suggest instead that this mess started at least 25 years ago with our growing collective beliefs in an economic tooth fairy. I have outlined my position on my blog in an article "Stop Whining about taxes, we're in serious trouble" I suggest that we've only experienced the first 3 waves of a 7 or 8 wave tsunami. Rushing back to our vacations on the beach won't be a particularly intelligent choice.

Getting out of this mess will require us all to adjust our beliefs and behaviors to those of our Greatest Generation; something we will all biologically resist with a 5 step process that starts with Denial (and ridicule of messengers) and then moves to Anger and Blame. The third step, Bargaining, is where we look for a quick fix that changes our own lives as little as possible(the entire process is described in my blog article of March 27, "Failure is not an option, it is a biological necessity").

Edwin Lee

johnleemk writes:


Econometrics and math are not quite the same thing. One of my Austrian-leaning econ profs studied economics at the height of math's dominance, and it was completely removed from empirical reality. The whole point of a lot of math theory in econ is to simplify things so they are easy to use in models. (Unfortunately they usually become so far removed from reality that they don't tell us anything useful about it.) The whole point of econometrics is to gather data and test hypotheses against it. Both pure math and econometrics demand strong quantitative skills, but they don't have the same approach, not at all. My prof told us to be grateful we study econ in a time when the more empirically-minded econometrics is dominant, even if it overly fetishizes math nonetheless.

David writes:

Hi Johnleemk.

I understand the difference between math and econometrics. My problem is not with the use of math per se - it can sometimes be a very useful tool for extracting the logical implications of theory. The problem arises when it is pursued for its own sake and when it distorts the questions studied. As a result, we arrive at the present day situtaion in which most academic economists study extremely narrow and highly stylized models while, in reality, the most basic issues remain unresolved.

Formalizing economic theory through the use of math is also often necessary for purposes of deriving testable implications. In these cases, the use of math goes hand in hand with econometric testing.

My larger difficulty is with econometrics (not with math as a logical tool) which, in my view, often gives people a false impression that something has been empirically "proven".

After 25 years in the "regulation and policy wars", my feeling is that the notion that empirical validation is the exclusive determinant of whether we "know" something has hindered, not advanced, economic knowledge.

George writes:

The best question to ask when someone blames "deregulation" for the housing/banking mess (and I believe I got this from you, Arnold) is:

"Then which repealed regulation, in particular, would have made the current situation impossible?"

In other words, the burden of proof is on them; they do get to use hindsight, though.

On Glass-Steagall: I got the impression that repealing it actually helped in this case, as some investment banks were propped up by their commercial banking sides. Is this inaccurate? Anyway, Larry Summers and Bill Clinton were the ones who led that particular sacred cow to the slaughterhouse, so nobody's getting much partisan mileage out of it.

George writes:

Oh, and the obligatory pedantry, since my high-school Latin teacher is looking down on me from above:

"Sua Culpa" is the Latin rendering of "Their Fault". (I agree that "Theya culpa" is catchier, and that only priests and classicists will understand the real Latin.)

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