Not Knowing What to Do about the Economy

I found a flaw. . . . a flaw in the model.
—Alan Greenspan, October 2008

One of my themes here has been that although most people agree there are real problems with the global economy and that many of them reside in the financial sector, nobody knows what to do about it. Brian Collins has a long review in the LA Times of two books making similar arguments. Collins writes,

The global financial system still teeters on the brink of collapse, and virtually nothing has been done to avert another disaster. One would have to be pretty cynical to accept that only greed and personal political ambition are to blame for such thoroughgoing paralysis. In view of the spectacle of “extend and pretend” presently unfolding in power centers from Washington to Frankfurt, what needs explaining is why even the well-informed and quite high-minded remain committed to so unpromising a status quo. . . .

One reason for this dismal state of affairs, he suggests, is that economics as a science does not provide the knowledge we need:

Mainstream economists failed to predict the crisis because — though smart, hardworking, and for the most part well-meaning — they are formed in a discipline where adherence to market theory, and only market theory, is rewarded, and the fact that it doesn’t tell the whole story is unimportant. The theory works well enough. Until it doesn’t.

Summarizing the views of economist Yanis Varoufakis, Collins writes,

The great insight here is that, along with whatever reckless self-interest was at work, the crisis occurred and persists because an alternative was and is mostly unthinkable.

And here we reach the nub of the problem. What is the alternative to the current system? What the big banks mostly do these days, it seems, is sell each other ever more complicated financial products, earning money by adding another layer of risk at each step in the process. The numbers involved are huge; in 2007, the nominal value of all the derivatives traded on the markets was 8 times global income. To invest huge sums in such complex securities is a formula for recurrent financial disasters. But what can we do about it? To ban all derivatives (securities whose value depends on the value of something else) would seriously crimp important parts of the economy: global firms depend on derivatives to protect themselves from currency fluctuations, to take just one example. What we want to do is ban needlessly risky, useless derivatives, but how do you write rules to do that?

Economist Varoufakis and his colleagues wrote that

The only hope for a rational future is a massive transfer in social power away from the ‘markets’ (i.e. the banks) to those who cannot be captured by them because they are too many to bribe, threaten and extort.

That is, to workers. But what does it mean to transfer social power from bankers to workers?

All the reform plans I have ever heard, right or left, are dismal slurries of ideology, hope, hand waving, ax grinding, special pleading, and electioneering. The world economy is a complex system that we understand no better than we understand the weather, and I do not think anyone knows how to make it safer without stifling it.