Generally speaking trusting experts is a wise move. I do it often. But when it comes to economics I think the evidence is that many so called experts are in prominent positions not because their theories accurately describe the world, but because they espouse views that serve the interests of power and privilege.
We recently learned that the billionaire liberterian and activist Koch brothers have granted Florida State monies on the condition that they have a say in the hiring of faculty in the economics department. What do you expect the impact will be on the ideology of the economics faculty? Don't these ideologues have a vested interest in the policies that this economics faculty would advocate? Are our experts being corrupted?
Or for that matter are they already corrupted? How many of these experts saw the financial crisis coming? What kind of policies did they advocate in the lead up to the crash? Would it matter if the very people that advocated for the destructive policies in fact were on the payroll of the corporations that profited so immensely from these same destructive policies?
Glenn Hubbard is dean of the Colombia Business School. In November of 2004 he co-authored a paper, along with Goldman Sachs Chief Economist William C Dudley, entitled How Capital Markets Enhance Economic Performance and Facilitate Growth. The Executive Summary is worth reading. Capital markets have improved the allocation of risk, stabilized banking, produced more jobs and higher wages for the average American, reduced unemployment and volatility in the economy, and made recessions more mild and less frequent.
The general consensus is that this is precisely wrong. The exact opposite is the truth.
Here's a basic understanding of what caused the financial crisis of 2008 as described in the movie Inside Job. A financial tool, known as Collateralized Debt Obligations (CDO's) was developed in the late 80's. Prior to these when a bank offered a loan on a mortgage they were very interested in knowing if the borrower was capable of repaying the loan. What CDO's did was they allowed lenders to sell loans to a third party. They were variously grouped and sold to investors. Ratings agencies evaluated their risk. AAA is the highest ratings grade, equivalent to US Treasury Bonds. Ratings agencies had a financial incentive to rate CDO's high and had no penalties if the ratings proved to be wrong.
This is a rather perverse system. Effective capitalism relies on good information. Yet the information is coming from those that have an incentive to lie in the case when the product is junk. This would appear to be risky.
In addition another product was developed. Credit Default Swaps. These are effectively an insurance policy on an investment. That's not such a bad thing in itself. There's nothing wrong with covering your risk by buying an insurance policy.
But here's where it became a problem. In normal insurance you can only take out one policy on a product. So for instance I own my home and I purchase insurance for it in case of a fire. Only one person can do that. I can't have 6 of my neighbors likewise buying insurance protection against my home in case of a fire. The reason is obvious. If lots of people have an incentive to see my house burn, that's a perverted incentive structure.
Brooksley Born was appointed to the Commodity Futures Trading Commission and she realized that this was perverted and regulation was required. So she started to take steps to bring in oversight. She was immediately resisted by free market ideologues. They argued that regulations stifle innovation.
Fine. Maybe they do. And maybe that's good. What if the innovations being developed in fact make some people really rich while risking the entire financial system? That's exactly what we were dealing with. But the free market ideologues won the day. The result was the Commodity Futures Modernization Act of 2000. These prevented any regulation on these products.
So companies like Goldman Sachs not only sold products they knew were junk. They then went out and bought multiple insurance policies on that junk. They stood to make enormous gains if borrowers started defaulting. Holding the bag was large banks and insurance companies, like AIG.
Normally GS wouldn't collect all of their gains because their insurers would go out of business. But these insurance companies and banks are so large that their failure meant a total credit freeze. So those of us not involved in these transactions just going to work 9-5 find ourselves in trouble. The credit crunch means our employers can't pay us, we can't pay for services, and everything grinds to a halt. Government is required to bail out the mess created by the free market.
But a lot of the experts didn't see it that way leading up to the crisis. Here's Frederic Mishkin. Deregulation came to Iceland and it likewise caused a bubble that made certain people very rich. Mishkin, like Hubbard, thought this was really a great turn of events.
What he doesn't mention is that he was paid $140K by the Icelandic Chamber of Commerce to write this report extolling the virtues of unregulated financial markets. Then the whole thing collapses, requiring a state bail out.
You've got Martin Feldstein at Harvard. He's a professor of economics. He was a Reagan adviser and architect of his deregulation. He served on the board of AIG from 1988 to 2009. Larry Summers, a member of Clinton's financial team, was a major architect of the legislation that blocked regulation on derivatives and CDO's. He's now president of Harvard. Ruth Simmons is president of Brown University and makes $300K/yr on the board of directors at Goldman Sachs. Personally I don't think these are evil people. They probably honestly believe what they say. But they don't recognize how much incentives shape what it is that they find persuasive.
I think we should consider what the views are of the people that we can look back on and see understood the issues at the time. Charles Morris wrote a book, written in 2007 but published in early 2008, that very accurately described the financial conditions that we underwent and today are dealing with. In the movie "Inside Job" he shares his belief that the economics departments at the various universities are part of the problem. In my view Morris has earned some credibility. He may be quite right once again.
Most of this info is via Charles Ferguson's movie "Inside Job" BTW.