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RADIO 4 CURRENT AFFAIRS ANALYSIS TRANSCRIPT OF A RECORDED DOCUMENTARY Presenter: Stephanie Flanders Producer: Sandra Kanthal Editor: Innes Bowen BBC White City 201 Wood Lane London W12 7TS 020 8752 7279 Broadcast Date: 02.11.09 2030-2100 Repeat Date: 08.11.09 2130-2200 CD Number: Duration: Interviewees Include: Danny Quah, Professor of Economics, London School of Economics Charles Bean, Deputy Governor, Monetary Policy at the Bank of England Richard Thaler, Professor of Behavioural Science and Economics, Chicago Booth School of Business, University of Chicago and co- author of Nudge Lord Robert Skidelsky, Author, Keynes, The Return of the Master Myron Scholes, Chairman, Platinum Grove Asset Management Michael Sandel, Professor of Government, Harvard University and Author, Judge FLANDERS: In this lecture hall at the London School of Economics are the next generation of economists – here for an introduction to macroeconomics at the start of the autumn term. It’s an august setting but an inauspicious time. In the wake of the financial crisis, it’s been said that most of the macroeconomics of the past thirty years has turned out to be spectacularly useless at best and harmful at worst. And it wasn’t an idle basher of the dismal science who said that – it was the Nobel prize winning economist, Paul Krugman. So, why economics? Why now? LSE STUDENT 1: I think a lot of time economics gets it wrong like you can have on economist saying something based on these models and then you can have someone saying look these models don’t communicate to the real world so I guess it’s the continual pursuit of trying to get from these models to reality and trying to improve on that. LSE STUDENT 2: It should help try and think about what kind of growth would be better for societies but of course it’s very difficult to know if economists will succeed and its actually quite frustrating to see that they’re not succeeding at that at the moment FLANDERS: Their Professor, Danny Quah, agrees that this year’s course is different QUAH: The global economic crisis has changed dramatically the course on the surface because the facts that I use, the puzzles that I pose, the correlations and events that I talk about – a lot of them turn on the things that have emerged in the current financial global crisis but I think all of this again goes back to more enduring macro economic ideas. FLANDERS: There’s been a lot of talk about the causes of the financial crisis – and economists’ role in it is an interesting debate – but not nearly as interesting to me as the question of where economics goes from here. Somehow, somewhere, large parts of the profession seem to have lost their way – or at least lost their connection to the world as it is. I want to know what it needs to find its way back. Charlie Bean has been on the frontline the past few years – first as Chief Economist now as a Deputy Governor at the Bank of England. I asked him what he thought the biggest lessons for the profession were. BEAN: Charles Bean, Deputy Governor, Monetary Policy at the Bank of England Part One I think one needs to be careful about jumping to simplistic, superficial conclusions and simply saying oh economics is a waste of time, throw it all away, we need a completely different approach. I mean I take the view that a lot of what has gone wrong can be understood using the standard tools of economics. Part of the problem I think was that that if you like more subtle understanding of market failures, hadn't percolated across into macroeconomics where too often thinking was guided by models which assume markets are functioning well pretty complete. So I think we need a macroeconomic framework which reflects those shortcomings. I think, also, we need to stop thinking of financial crises as pathologies that happen at other times and other places. They’ve been happening for at least 300 years, since Tulip mania and I think we should aspire to be able to explain them as part of the normal course of events. FLANDERS: I think any sensible person listening to you and thinking about what’s happened would be sort of surprised to learn that macroeconomics, which was supposedly a science describing what happens to economies, doesn’t actually have a way of properly incorporating financial crises when, as you say yourself, that’s been a major element of the experience of economies in the last 100, 300 years. I mean isn’t that, isn’t that rather an indictment that you don’t that you have that rather small but crucial hole in your theories? BEAN: Standard macroeconomic models don’t really have interesting banking sectors, interesting sectors where financial intermediaries play an important role. There is a reason for that. Remember macroeconomics was born out of the Great Depression and so forth, and was developed during a post-war period where, amongst the advanced economies, financial crises were relatively infrequent. FLANDERS: So they didn’t think about crises because they hadn’t happened for a while. If you’re sitting in Charlie Bean’s chair, it’s clear that economists need to get back their sense of history – that depression history, especially. But of course, some never lost it. As John Maynard Keynes’ official biographer, Lord Robert Skidelsky has spent a lot of his life studying the crucial debates within economics in the 1920s and 30s. In his new book: Keynes, the Return of the Master he argues that the Keynes is as relevant today as it was then. In fact, he thinks it shows how backward economics is, as a science, that it’s had all these conversations before SKIDELSKY: Well I think Keynes would have said that the present state of economics is pretty bad. In fact, he said that his ‘General Theory’ in 1936. He said he had written it to bring to a head - disagreements between economists which had rendered economics useless as a tool of policy. And we have the same disagreements today. And the interesting thing is that they are the same. They’re arguing about exactly the same things they were arguing about before, between the view that the market is self-correcting and between the view that it isn’t. FLANDERS: The crux of the argument between the classical economists and the upstart Keynes was indeed that the classical thought markets were self- correcting – whereas Keynes thought it was possible to get stuck in a slump, from which the economy might well not recover. At least, not without government help. The Great Depression seemed to prove Keynes right – and for several decades a version of Keynes was taught alongside classical economics, as an agreed exception to the rule. But even in the supposed heyday of Keynesian ideas after the war, Skidelsky thinks a lot had got lost in the desire keep classical and Keynesian economics under the same roof. Above all, they lost Keynes’ animal spirit and his insistence that economic life was uncertain – that it usually couldn’t be reduced to a mathematical model. Not surprisingly, Skidelsky now thinks all of that has to go back in. SKIDELSKY: I think macroeconomics has to be rethought from top to bottom. The fact that macroeconomists failed to predict the crisis, I don’t think is so important because Keynes said the future is unpredictable and therefore obviously you can’t predict any specific event. What he would have said; that an economic system set up in the way it has been without governments trying to manage the economy, without adequate banking regulation was bound to get into a mess sooner or later, and there would have been warning signs about that. But Keynes didn’t predict exactly that there would be a great depression in 1929 either. It’s just a consequence of the future being uncertain that these things are unpredictable. But still the way, the way macroeconomists and particularly the way I would say the new classical economists do their economics suggests that these things can’t occur at all, and that is what has to be changed. FLANDERS: The US economist and former Treasury Secretary Larry Summers, now President Obama’s chief economic advisor, once talked about “ketchup economics” – you establish that a one litre bottle of ketchup costs twice as much as a half-litre bottle – then conclude the market for ketchup is efficient. His point was that if you take such a narrow view, there’s a lot you are going to miss. To really know what’s going on you need to know, among other things, how many producers there are in the market, how much it costs to make the sauce, what’s going on in the market for tomatoes. It seems a more telling criticism today than when Summers first made it. The dominant macro- economic models on Wall Street and in finance ministries around the world before the crisis seem to have left so much important stuff out. We’ve heard a Deputy Governor of the Bank of England admit that those models had very little to say about real-life financial systems – or history. And even those that did focus on financial markets seem to have focussed on mathematical models, forgetting Keynes’ warning that the stuff you can count is not necessarily the stuff that counts. SKIDELSKY: The reason they do their economics in the way they do is that they’re all mathematicians and in order to get determinate results, you can’t have unknowns. And therefore to make the maths possible, you have to theorise on the basis of perfect information and prices always being correct and so on. Now just, reduce the amount of maths in the subject and you get closer to real life. FLANDERS: Paul Krugman says, “They mistook beauty for truth” in their models. SKIDELSKY: I think Paul’s absolutely right and there was a kind of ideal world. That’s how they model economic life. Well actually it’s a banal thing to say but economic life consists of a lot of human beings with different choices, different values, different ideas of what’s going to happen, and somehow one is losing that whole realistic sense of life if one tries to reduce it all to maths. FLANDERS: It’s a simplification, of course. Plenty of free market economists – especially from the Austrian school – don’t think mathematical models are all that useful either. But behavioural economics is one strand of economic thought that has come out of the global financial crisis with its reputation intact. That may be because it starts from the real-life behaviour of actual humans – they’ve found, for example, that default options matter. Whether you’re talking company savings plans or shopping online, we tend to stick with the option we’re given. Opting in, or out, is a bigger leap. Professor Richard Thaler of Chicago, and co-author of Nudge, is one of the best-known behavioural economists. I put it to him that he and his fellow-travellers had had rather a good crisis. THALER: I do think the crisis has put a little egg on the faces of economists who were really defending the view that agents in the economy behave rationally and that markets work nearly perfectly. I mean that’s clearly false. FLANDERS: Do you consider yourself to be part of the counter culture of economics? Are you now … or do you think now you’re going to be in the ascendant? THALER: Well you know certainly 30 years ago when I started doing this, it was not even counter culture. It was the ignored culture. But now if you ask economists under 40 about behavioural economics, a typical reaction is to say, look, I look at the data. So when we show evidence that the difference between opt-in and opt-out makes a big difference, and that that’s not predicted by economic theory but the data speak quite loudly, most young economists have no problem with that and they say okay, sure, can incorporate that. So we’re not really trying to develop a completely new economics. We’re trying to enrich the economic model to incorporate the fact that the agents in the economy are human beings. FLANDERS: Even Alan Greenspan – the exalted Chairman of US central bank for most of the boom years – has now admitted, in testimony to the American congress last October, that he appears to have been a poor judge of human nature. A pretty monumental admission. GREENSPAN (extract from testimony to congress) “Those of us who have looked at the self interest of lending institutions to protect shareholders equity, myself especially, are in a state of shocked disbelief” FLANDERS: Richard Thaler again. THALER: Well let’s take Greenspan’s comment. And in typical Greenspan fashion, he said what he did in a sort of cryptic way. So I wouldn’t stress the word ‘self-interest’ in that comment. I mean they were trying to act in their self-interest. I think they didn’t know how. And I think one, one thing that I’ve been stressing for years that comes naturally out of behavioural economics is that we need to distinguish between easy problems and hard problems. And normally we don’t do that in economics. So let’s contrast two problems. One is figuring out how much milk to buy when you go to the grocery store. Most families pretty much know how to do it and they do it through trial and error. So that’s an easy problem in part because there’s lots of opportunities for learning. Now compare that with say playing chess. No-one plays chess perfectly, even Gary Kasparov - otherwise the game wouldn’t be interesting, it would be solved - and most of us play horribly. Now a theory that says we buy milk and play chess equally well is just preposterous. We need to accommodate degree of difficulty. Now the way this relates to the banking crisis is that being a banker has just gotten a lot harder. If you go back to the world of the banker in that Christmas movie ‘It’s A Wonderful Life’ - that guy was making loans to people he knew in his town. And you know that’s a pretty easy problem. Now, if you’re buying and selling mortgage backed securities, that’s pretty hard. And if you’re running a bank that has a hundred divisions, each of which are engaged in highly complicated transactions, the job of being a CEO has become immensely difficult. And CEOs haven’t gotten any smarter. We don’t evolve all that quickly. So we have the same brain power that we had fifty years ago, but we’re doing much harder jobs, so in some ways it’s not surprising that mere humans find the job of managing companies that have trillions of dollars more than they can handle. FLANDERS: The complicated models gave Wall Street a false sense of confidence – people felt they could solve the really hard problems after all. As Greenspan continued in his confession of “shocked disbelief” – an entire industry grew up out of those models, every year devising new products which you needed a PHD and a complex computer programme to understand. But it turned out the entire system was built on sand. GREENSPAN (extract from testimony to congress) In recent decades, a vast risk management and pricing system has evolved combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel prize was awarded for the discovery of the pricing model that underpins much of the advance in the derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year. FLANDERS: Professor Myron Scholes won the Nobel prize that he was talking about – for being one of the first the first to establish a way of pricing financial derivatives. In an important sense, the Black and Scholes pricing formula was where the entire modern derivative market began. Partly as a result of his work, many on Wall Street wrongly supposed that the problem of risk had been solved, that you could hedge anything, given the right model. Still, Scholes appears to be remorse-free. SCHOLES: My feeling is that part of the crisis that we’ve seen resulted from the belief that we had tamed over time and that previous shocks, that those shocks didn’t have a large consequence on the economy, they had short-run effects; governments were telling us macroeconomics was working, the world was tamed, we had spread risks, So, I think a lot of models were used in the financial world by banks and other institutions. But, once the models were developed those models were turned over to others to use and the others had to put data into the models. So, sometimes you can build a wonderful car such as a Porsche or a Lamborghini and turn it over to someone to drive it who has no skills and causes it to crash or fail. FLANDERS: Listening to this you might be surprised to hear that Scholes has been at the steering wheel himself - He now chairs the hedge fund Platinum Grove Asset Management but he’s more famous for co-founding Long-term Capital Management in the 1990s. Using his models that fund made a packet – till it lost nearly $5bn in 4 months in 1998 and had to be bailed out. But listen to him talk about the crisis, you would think it had all happened to someone else – that someone else crashed the car: he takes no blame - he still thinks models are the thing. And if this enormous crisis helps make them better, well, that’s all to the good. SCHOLES: We know that models are an incomplete description of reality but we need models. Without models we are not going to improve our understanding and if we improve our understanding then we can make the models richer. And, we shouldn't let a shock itself just be lost because a shock redirects our thinking and instead of retribution and instead of anger we should really learn from shocks because we learn when shocks occur.” Dur: 1:01 FLANDERS: As you might imagine, the behavioural economist Richard Thaler thinks the problem goes deeper. THALER: The models kept assuming people were smarter and smarter, but the world was getting harder and harder and so the models were getting further away from reality. So if banking was like in ‘It’s A Wonderful Life’, then the old models might be fine. But when you have Citibank selling liquidity puts and the Vice Chairman of Citibank admitting later that he had never heard the term ‘liquidity put’, then you know you’re dealing in a completely new world. FLANDERS: At the Bank of England, Charlie Bean saw the same problem at close hand – not least, at Northern Rock. BEAN: People made the mistake of believing the models. The way you should think of models is as a crutch for helping to think through interconnections and so forth, but when you get into the business of calibrating them and starting believing that that’s how the world is, that’s when you’re potentially heading into trouble. You need a healthy dose of scepticism with any model, and you always need to be standing back and questioning the viability of the assumptions that you’re making. FLANDERS: And there wasn’t enough of that? BEAN: And there certainly wasn’t enough of that. FLANDERS: So, we all expected far too much of economists – and their models. And a fair few of us are now paying the price. But what should we expect of them now? As ever, Robert Skidelsky thinks that Keynes had the answer. SKIDELSKY: That echoes a rather famous remark that Keynes made “I hope that one day economists will be useful citizens like dentists”. But, I don’t decry economics. I think it’s a very important discipline - what I would say is it sets a limit on your fancy. You can’t just believe anything. And also it gives you a sense of magnitudes and it’s also a way of thinking logically about things, so it’s a branch of logic and logic is always, always useful. And I think there’s such economic illiteracy around, that’s the normal state of humanity; that it’s good to have a sharp, cutting tool there - say look, this is nonsense, if you do this, you must expect this - and to think these things through logically. The problem is it’s colonised everything else. And again Keynes said something about economics, which I think is very relevant. He said “It’s better to be vaguely right than precisely wrong”, and I think economics often leads you to be precisely wrong". FLANDERS: Keynes meant wrong in a practical sense – not a moral one. And so does Lord Skidelsky. But he still has what you might call an economist’s view of the problem. Like Charlie Bean, he thinks that economists need to be more humble about what they can achieve – less bound up with being a science, more alive to economic history. But it’s all about the logic, and about what works. But there are those, standing outside economics and looking in, who think it needs to go much further. Michael Sandel is a Professor in Political Philosophy at Harvard and author of a new book, Justice. He thinks the profession ought to go back to its roots – to a time when economists were much more concerned with the route to a good society – not just an efficient one. SANDEL: I think that what, what needs to be done to enrich the study of social and economic life is to reconnect the study of economics with the normative questions that traditionally attended it back in the days of Adam Smith. FLANDERS: What would that look like, that kind of economics? SANDEL: Well broadly speaking, it would be less formalistic, less abstract and less detached from normative questions. But that’s a negative description. Positively, it would I think have two features. First, it would be more alive than current economics is to the effect that marketising goods has on the social norms that inform those goods. Take an example. There was a sociologist, Richard Titmuss, who did a study about marketising blood, comparing the US and the UK. In the US, blood was bought and sold; in the UK, it was only donated. And he found that in the UK, the supply - including the quality - was better than in the US where blood was bought and sold in a market. And he speculated about the reason for that. He thought that where the giving of blood was an altruistic act, it was informed by certain social norms of benevolence. Where it was bought and sold, one might think well people can go on donating blood if they want to, even as other people are selling theirs. But what happened is that the market norm crowded out the non-market norm - the altruism in this case. So now people who were giving their blood while other people were making money from theirs now they thought of themselves less as altruists than as suckers. So the marketising of a good does not leave the social meaning of that good untouched. It changes it. FLANDERS: I put it to him that the outrage over bail outs and bonuses had rather put questions of morality and the market at the centre of debate. SANDEL: Yes. It’s interesting. When some economists working for the American administration, the Obama administration, were responding to the AIG bonuses - bonuses being paid by firms that were receiving taxpayer subsidies and bailouts - they voiced the outrage of course that an administration has to express, even as they defended the bailouts. But what was interesting...I was interested in the economists who were making this critique. They said it’s terribly greedy. What I wish the journalists had asked them was is there a distinction between greed and self-interest, do you think? Strictly speaking, no mainstream economist would recognise any such distinction, and yet for political purposes they attack greed as if it’s a thing independent of self-interest. Now even to make that distinction, it’s interesting. Citizens generally who looked at this - at the bailouts and the bonuses and been outraged - they believe there is a difference between greed and self- interest. But there’s no way of capturing that intuition in economic analysis because, according to economic analysis, in any case one is deploying self- interest or greed, which is simply self-interest squared, to serve a social purpose. That’s what the economic model says. And you have to introduce some normative assumption about what is excessive pursuit of gain in order to make sense of greed as a vice independent of the self-interest that all of the economic models presuppose. So I think there are intuitions in everyday life that people have that the economic models simply don’t capture, and greed is one of them. FLANDERS: Charlie Bean has more humble ambitions for his profession. BEAN: I think we have to be modest in what we can aspire to. Economics is difficult as a discipline because it’s quite difficult to do controlled experiments. Even though economists’ understanding will often turn out to be misplaced, that doesn’t mean to say that we’re worse off using economic thinking than using gut reaction and all sorts of completely uninformed thinking. And what distinguishes a good economist from a poor economist is that the good economist understands the limitations of what he knows, and recognises what he doesn’t know and what he doesn’t comprehend properly. FLANDERS: But if you’re Michael Sandel, society often is worse off for economic thinking. In fact, the “modest” sort of economists – the ones that like to present themselves as dentists - might be the ones you have to watch out for the most. SANDEL: I think that quote of Keynes suggests … the dentistry analogy - it’s at once a modest role for the economist but also an inflated role. To compare an economist to a dentist sounds … It’s a wonderful quote. It sounds like it’s a reach for modesty, so that economists would be unobtrusive and not noticed. But there is something dangerous in that. If the dentist is actually doing heart surgery, we should know that and we should make sure that he or she is well qualified to do that, and we should find out if that dentist may need a bit of help to do the heart surgery. And that’s what I’m suggesting economists may need as well. But I think economists should be enlisted and I would like to enlist them. I think there should be a joint venture among economists and political theorists and other social scientists to reconnect the study of economics with broader questions of social and political theory, including a moral and political philosophy. I think that for too long the values underlying economic reasoning have been obscured or even denied to be values. I think that was always a mistake, it was always a delusion. Even when the stock market was rising and housing prices were rising, I think it was misconceived. And so perhaps together we can reinvent the old-fashioned discipline of moral and political economy. Less scientific, but I think truer to the world and more directly connected with questions of what makes for a just society and what makes for a good society. FLANDERS: I suspect that it will take more than a financial crisis to make Wall Street economists want to think about the quest for justice as well. But in the universities, Richard Thaler says that economists are now on the case. Just don’t expect them to move very fast. THALER: On the one hand, I will say I’ve never seen the economics profession so engaged. You go to lunch and certainly for the first six months of the crisis it’s all anybody wanted to talk about and you know the publication process in economics takes years - so you write a paper, you submit it to a journal and the referees pan it, and if you’re lucky it comes out three years later. So the things that will appear in the journals and eventually in the textbooks, it’ll take ten years before we see a big change in what economists are doing. But you know someone once said that science marches on funeral by funeral, and I think that’s true. Most economists rarely admit changing their mind about anything. Greenspan’s mea culpa speech was an exception, but he hasn’t really spelled out what he was wrong about. And I think that the new theories will come from the new people coming into the profession and they will have lived through this and will start to write down models that make more sense. FLANDERS: All of which takes me back to those fresh faced graduate students introductory at the London School of Economics. It’s a bad time to be an economist, perhaps, but one hell of a time to study economics. END OF TRANSCRIPT