What Have we Learned From the Financial Crisis? Part 1: Marc Lavoie

What follows are comments from a roundtable discussion held at the University of Ottawa on February 28, organized by Mario Seccareccia, and which featured participation from Marc Lavoie, Louis-Philippe Rochon, Mario Seccareccia, Slim Thabet and Bernard Vallageas.

Parts 2, 3, 4 and 5 will follow in subsequent blog posts.

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Marc Lavoie
Professor of Economics, University of Ottawa
Co-Editor, European Journal of Economics and Economic Policy:  Intervention

I would be tempted to say that we learned nothing, to end my remarks there and allow the other participants to speak.
The question is somewhat ambiguous: what do we mean by ‘we’?  What did Mario Seccareccia have in mind when he formulated the question? Indeed, by ‘we’, do we mean economists working in large international institutions, in governments, and in central banks? Or do we mean economics professors working in universities?

If by ‘we’ we are referring to the former, it is clear that the crisis has put an end, although perhaps only temporarily, to the deregulation of financial markets. For instance, in Basel, prudential constraints were raised, and  specialists there are discussing counter-cyclical solvency ratios for banks (the famous capital adequacy ratios).  Meanwhile, at the IMF, the crisis certainly created a small revolution. Now, the IMF defends Keynesian expansionary fiscal policies, which were, as we all know, completely forbidden during the 1997 Asian financial crisis.  The current crisis also led the IMF to question income inequalities and their impact on effective demand.

Moreover, it is now doubtful whether the efficient market hypothesis makes any kind of sense.  Indeed, a great many economists and bankers have discovered Minsky’s views on financial fragility and his financial instability hypothesis, according to which banks and financial markets cannot be left to themselves: we need regulations even though regulating markets may not succeed in avoiding another crisis once the memory of the current crisis has faded away.As told to me by a law student recently hired by Blackrock, the largest asset manager in the world, with assets totalling more than 3,500 billion dollars – that’s one and a half times larger than UBS and twice as large as PIMCO – many asset managers are now turning away from hiring neoclassical economists and actually prefer hiring engineers, sociologists and even philosophers. This said, in the end, I believe that this new fondness for heterodox ideas is likely to be short-lived.

Let me move on so as to discuss the university setting, which is decidedly an environment with which I am more familiar. I will discuss four anecdotes to show how in fact my colleagues have learned next to nothing. At the very height of the recession in Canada, in 2009, a few months after the collapse of Lehman Brothers, our doctoral programme came under review. As such, two respected external reviewers audited our programme. During a meeting with all the members of the department, one of the reviewers, from McGill University no less, told us that we needed to offer more mathematics in order to better train our students. I asked in what way more mathematics was going to help our students to better explain the causes and consequences of the financial crisis. The question was met with complete silence.

A few months later, and this is my second anecdote, the curriculum committee of our department met in order to discuss revamping our courses. In light of the meltdown of our financial markets, I would have naturally assumed that the theory of efficient markets would have been banned forever from our programme.  Alas, this was not to be. The newly-proposed course description for ‘Financial Economics’, still contained among its contents the ‘testing the efficiency of markets.’ When I objected to this, given the financial meltdown that we had just witnessed and the irrefutable evidence that this theory did not hold water, I was told that the theory of efficient financial markets still had to be tested to decide of its real-world relevance.

My third anecdote is about the revamping of our graduate courses.  Some two decades ago, Mario Seccarecia and I created a course on alternative views in monetary theory. After the crisis, some of our colleagues from Carleton University, with whom we share the PhD programme, suggested eliminating this course during a brainstorming session involving faculty members associated with this stream. Needless to say this never happened, but it is disheartening, to say the least, to see that despite the crisis our colleagues did not think it was wise for our students to be offered more pluralism and a heterodox perspective.

My fourth and last anecdote takes place at a session of the Canadian Economics Association conference last year, which was held in Montreal.  The session was dedicated to macroeconomics after the crisis. A colleague from McGill University, Christopher Ragan, explained how he had created a course on the financial crisis, in which his students were reading books by Galbraith, Kindleberger and Minsky. It was indeed quite a revelation, and I hope that Mario and I will be able to offer such a course in the future when we are no longer on semi-sabbaticals. But despite this initial glimmer of hope, the other panellists were not as encouraging.  Their message was that they might spend a little more time on the chapter covering money and banking. But in no way would they rethink the theoretical monetary approach and the macroeconomics that are found in these books.

The same can be said in the context of advanced macroeconomics. The famous DSGE models, which occupy many pages in our more illustrious journals, were shown to be quite useless during the financial crisis. Of course, this is not very surprising given the totally unrealistic assumptions of the model. I am told that these models have been greatly enhanced recently. Such models are now able to incorporate banks and the possibility of defaulting on debt. In other words, we are merely adding some semblance of realism in an otherwise unrealistic model describing a completely artificial economy, in which a rise in the rate of interest slows down the economy and leads to a fall in employment because households can afford to work less today because the higher interest rates will procure them as nice a retirement as was the case when interest rates were low.

To conclude, we are witnessing what psychologists call cognitive dissonance. While the financial crisis has shown quite convincingly that the real world bears no resemblance to the divagations of general equilibrium theory or of the efficient market hypothesis, the response from a great many academic economists has either been utter denial or that the financial crisis was the result of government regulations, which then created moral hazard, or the result of irresponsible governments which caused a public finance crisis, as happened in Europe. For almost all of my colleagues, it is not necessary to change economic theories and the efficient market dogma; it is enough to introduce some minor adjustments with minimal consequences.