The limits, the failings and the uses of economics after the crash

ECONOMICS:Aligning the worlds of economists and policymakers can only improve how resources are allocated, writes DAN O'BRIEN

LEHMAN BROTHERS collapsed two years ago this week. Nothing has been the same since. The bursting of Ireland’s enormous property bubble 18 months earlier continues to ravage this State.

The failure of finance internationally and the property crash in Ireland have had terrible consequences, human and otherwise. In the “otherwise” category of consequences are questions about the value of economics as a discipline and the role of economists in economic affairs and the making of public policy. This is wholly appropriate. Economics has not had a good crisis.

Before discussing the failings of the discipline and its practitioners, humility demands that one’s own failings are admitted to up front, not least to avoid even the impression of self-defensiveness.

Despite having worked as an economist for a dozen years at the time of the Lehman collapse, I never thought that the international financial system could fail as badly as it did. I hesitate to speak for others, but I don’t think even the most pessimistic observers did either. This is very bad.

If those who spend their time trying to understand how something functions fail almost completely to understand how dysfunctional it is, then the value of their toil is justifiably brought into question.

Many in the profession, such as the huge numbers across the spectrum of microeconomics, were necessarily too involved in the detail of their specialisations to feel the tectonic plates shifting beneath their feet. But tens of thousands of people around the world spend their working lives as economists dealing directly or in part with issues related to the crisis – academic financial economists, macroeconomists and economists in financial institutions, central banks, ministries, financial regulators and credit rating agencies.

Complexity is central to the failing. The international financial system that has evolved over recent decades has a huge number of component parts. I have never met anyone who understands all of them. Understanding how they all interact with each other long ago moved beyond human comprehension.

Finance is a critical system. But it became super-complex and highly fragile. Ultimately it failed. Critical system failure is a very serious matter. Unfortunately, economics offers only limited insight into designing a safe financial system that functions effectively to support a sophisticated modern economy.

The situation in Ireland was very different from the international picture. Property manias are commonplace occurrences and relatively simple. There were plenty of warning lights flashing here in the years before the crash.

On the supply side, the numbers of homes being built reached multiples of the long-run average and the building industry had swollen to a size relative to the rest of the economy that was way out of line with history or comparable countries. Despite this, prices rose rapidly and at the sort of rates that usually signal something is awry. Rates of credit growth were in the stratosphere.

But as economics does not provide a good way of identifying the existence of bubbles with any certainty, a property crash remained a risk rather than a certainty. This strengthened the case of those who wanted to leave well enough alone, many of whom had a commercial or political interest in taking this position.

Among independent economists – mostly academics, with an honourable mention for David McWilliams – concerns existed. But too few people raised red flags. For instance, during the boom years there was nothing comparable to the letters about Nama which have been sent to this newspaper, signed by a string of academic economists.

In many ways this was understandable. The party was in full swing and there was little to be gained from pooping it, and plenty of grief for doing so. Today, among independent economists, there is an almost universal regret that they did not do more to voice their concerns.

An opportunity for redemption may be at hand. Economists have a lot to say about the design of labour market policy that can help reduce joblessness. This is among the State’s greatest challenges for the foreseeable future. Strangely, they are staying silent again.

Irish economists’ annual weekend away takes place in Kenmare next month. Last year’s gathering addressed issues such as the gains from taxi deregulation. This year’s will deal with the pressing matter of Britain’s budgetary difficulties, among others. On either occasion, the agenda featured nothing on Irish employment or labour market issues.

The online forum for economists – irisheconomy.ie – has 25 category headings ranging from the banking crisis and the world economy to teaching and higher education. There are no categories devoted to jobs or labour policy. There are many reasons for economists not contributing more to public debate. One is that the degree of interaction between policy makers and policy thinkers is less here than in any other country I know. They appear to inhabit entirely different worlds and frequently hold each other in mutual contempt. Officials grind their teeth at the know-it-all haughtiness of some economists who appear oblivious to the sub-optimal nature of decision-making in the messy context of politics. Economists are constantly aghast that those making enormous decisions on the State’s future are often functionally illiterate in economics.

There is much to be gained from bringing these worlds into alignment. On issues from health to welfare to education to managing the public finances, the discipline that is all about how resources are allocated is indispensable.

There are many ways to achieve greater alignment: from establishing a council of economic advisers to creating a dedicated recruitment stream of economists in the Civil Service, from the secondment of non-civil servant experts into senior positions to having more informal interaction between policy makers and policy thinkers.

Economics has its weaknesses and limitations, but when it comes to bringing rigour and insight to so many policy areas, it is all we have got.