Despite their much vaunted economic expertise, the leading national and global institutions failed to prevent the financial and economic crisis they’re now arguing over how to clear up. The IMF’s Independent Evaluation Office (IEO) reported last month on why the IMF, as one such institution, failed to identify the risks and give clear warnings. The prime causes of that failure were identified as ‘analytical weaknesses’, which were actually shared by all relevant institutions. These analytical weaknesses included a tendency, among IMF economists, to be dominated by neoclassical free market dogma, and so to believe ‘market discipline and self-regulation’ would be sufficient to avoid financial disaster, and to trust the new mathematically based techniques for spreading financial risk, and to conflate the financial and industrial sectors, thus ignoring the influence of finance over the real economy. ‘Perhaps the more worrisome was the overreliance by many economists on models as the only valid tool to analyze economic circumstances that are too complex for modelling.’ (Paragraph 46).
These dangerously naïve views were shared by the ‘madmen in authority’ in the United States, Britain and other advanced economies. Referring to those national authorities, the IEO report concluded that ‘The IMF was overly influenced by (and sometimes in awe of) the authorities’ reputation and expertise’. In other words it wasn’t just the IMF’s economists, but all economists in authority, who were to blame.
So what has changed? Very little has been done to restrain or reduce the size of the ‘too big to fail’ financial sectors. There is no new understanding among those in authority of the relationship between the financial sector and the real economy, and in particular how the former has destroyed the latter in those economies most blindly adherent to the neoclassical ideology. There are no indications that the economic models, which famously discounted the possibility of unlikely events, are to be consigned to the recycle bin.
The ‘madmen’ continue to mouth neoclassical platitudes in the absence of a convincing alternative. The Austrian school’s free market fundamentalism has been revisited; von Mises argued that all government interventions distort market outcomes. But his system depended on a return to the gold standard, the biggest government intervention of all. That perspective applied to the current situation would argue for reducing the budget deficit as fast as possible. Pitched against that is the Keynesian rejection of full employment equilibrium as the inevitable result of free market operations and Minsky’s further assertion of the intrinsic instability of markets. In the current situation this perspective argues for government intervention to stimulate the economy and create employment and the exercise of extreme care in reducing the budget deficit. Neither perspective is convincing. The fact is nobody knows.
In Britain the size of the financial sector is crippling to the real economy and the long term aim must be to achieve a better balance between the two. In an economy that is now certainly in decline relative to the global economy, and surely in due course to be in absolute decline, this means reducing the size of the financial sector. And while that may be painful in the short term, the longer action is delayed the more painful it will have to be.