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Fri 4 Sep 2009 04:00 AM

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Royal reasons for overlooking financial meltdown

Economics hasn't offered convincing theories explaining the current crisis, says Matthew Lynn.

A new game has emerged in UK intellectual life in the past few weeks: trying to explain the financial crisis to Queen Elizabeth II.

In November last year, the British monarch visited the London School of Economics. There she asked a simple question: how come all the economists didn't notice that the credit crunch was about to happen?

Last month, the British Academy, the UK's national academy for the humanities and social sciences, assembled a group of experts to offer her an explanation. This month, another panel of public thinkers was put together to send an alternative view to Buckingham Palace. At this rate, every economist in the country will have a theory for Her Majesty.

That isn't a futile exercise. Economics has failed to explain why the financial crisis of the last two years wasn't predictable. And until it can do so, the profession needs to work harder. If economics can't explain it, then the dismal science must itself be in dismal shape.

When the queen visited the LSE last year, the professors were rightly embarrassed to be put on the spot. The LSE is one of the most prestigious schools anywhere in the world. And yet, none of its experts had seen the storm clouds looming on the horizon. Nor could they offer a convincing reason for that failure or refer the queen to Oxford and Cambridge academics for answers. Harvard and Yale couldn't do any better.

In response, the British Academy sent an open letter to the queen written by Tim Besley, an LSE professor and a member of the Bank of England's Monetary Policy Committee, and Peter Hennessy, a historian at the University of London.

Their letter didn't break any new ground, though it was a fair summary of how the global economy got into such a mess. It "was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole," they wrote.

Not everyone was happy with that. The consulting firm Abundancy Partners had its own group of academics, environmentalists and public thinkers who sent a letter to the queen. It pushed a green analysis of the crisis, nailing a culture of excessive consumption as the real culprit.

Presumably this is a game anyone can join in. No doubt every economics department in most of the world's major universities will be preparing their own theories, and popping them in an envelope to Buckingham Palace.

Perhaps Her Majesty could canvass the views of the rest of the royal family. "It's all the fault of Johnny Foreigner," Prince Philip might observe. "It's all the fault of Diana," Prince Charles might suggest. And if anyone asked Prince Harry, the answer might be even crisper: "Who cares about the credit crunch. Let's just have another drink."

Joking aside, the debate is telling us something. The queen, with the confidence that comes from having been on the throne for more than half a century, has identified a problem. For all words devoted to the subject, no one can say why the credit crunch wasn't avoided. The question she asked is, after all, the one that everyone has asked. It's just that more effort is made to answer the queen.

We know that banking bonuses encouraged a system of excessive risk-taking. But we don't really know why the financial firms pay their staff so lavishly, and feel compelled to take such massive risks with their capital.

We know the huge trade imbalances between China and the US and Europe have created vast pools of capital that have to be recycled somehow. But we don't really know whether those imbalances are inevitable, or whether they can be unwound.

We know the environment is threatened by climate change. But we don't really know whether we can stop that without a drop in our living standards that we'll find hard to accept.

We don't really know whether huge government-stimulus programs, and the furious efforts of central banks to print more money, will lift the world out of recession. Or whether it will just create hyperinflation and a bigger crash in a few years.

And that surely points to a broader failure of the science of economics. It isn't able to come up with convincing theories that explain the world we live in. Nor is economics really capable of reassuring us that our experts have the foggiest idea how we got into this mess or how to get out of it.

The world's leading economists should keep sending more letters. Until Her Majesty is finally able to reply: "Thank you, gentlemen. Now I get it."

Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.

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Madhav Bodas 11 years ago

While the search for answers for the financial meltdown may look as elusive as the Higgins particle, I hope our scholars have not ignored to factor in an all pervading parameter called Avarice. For this alone afflicts all forms of human pursuits, be it Politics, Banking, Finance, Wall street, and the ordinary citizen seeking to build a house of his dreams. It's time that our Social sceintists are able to put this one in some form of Econometrics.

Simona 11 years ago

I'm afraid this suggestion that no economists spotted the meltdown is simply wrong. Many many economists did. The problem was not that the economists didn't spot the crisis, the problem was that society chose to listen to the ones who were optimistic and ignore the ones who were looking at the deeper issues. For my part, my family sold nearly USD10 million of stock during the second half of 2007/first half of 2008. That was because we listened to the right economists.

Juspassinthro 11 years ago

Well thought and written comment, Mr Bodas. A fresh whiff of quality thought very rare in the AB comments section. "Avarice" - a very difficult parameter to quantify and incorporate in any econometric model, but an extremely important one at that. To my mind, a polarisation of knowledge may also be considered. In the last decade, just like the economic 'haves' and 'have nots', a new genre of people emerged - some who understood pieces of the complex puzzle while others had just no idea. While and average 'joe on the street' knew his tools, trade, basic economic fundamentals, family and aspirations in the 80s, how many of the current generation knows anything about the hugely complex labyrinth we are in today - trade imbalance, oil, geo-politics, derivatives and complex financial products (structured or not), interplay of various hitherto independent economic entities in a highly globalised world? And of course, its effect on one's daily life? And of course, ability to think independently and say, "Wait a minute, half a million dollars for a roof, with 99% mortgage, ever increasing profits of financial firms (banks, brokerages et al) who creates nothing new but are just brokers of paper, automobile companies who never tried hard to find a credible alternative to oil despite 70s crisis, polarisation of religions and emergence of extremism, a generation that hardly appreciates art and literature)

Telco guy 11 years ago

Claiming that economists did not see this coming is pure fiction. The even more embarrassing truth is that there were way too many people who either had a vested interest in keeping things this way while milking the system (bankers bonus) or found it easier to let it go as puncturing the bubble would have a terrible (personal) cost (these are the politicians) or like most of the population preferred to listen to a nice story rather than face the ugly truth (the Omars of the world). The whole world was playing the same game, with some places (Spain, UAE and Ireland making the worst offenders, and UK and the US being the biggest) being more into it than others. But of course when times are good nobody want to listen to Casandra.

MA 11 years ago

Matt lynn always writes good articles, but for some reason cant refrain from banker bashing. Which is surprising given that his employer's lifeblood are those same bankers. Anyway, banks provide investment bankers with bonuses in leiu of a generally low salary - 120 hrs a week, for only $2000 a week? Thats only $16.66 an hour, which is more than my hairdresser makes! These individuals spend over $350,000 on their post secondary education (gven they tend to attend the best schools globally, which are also the most expenseive), and I'd imagine they should get a reward commesurate with that, as opposed to earning the same as a hairdresser. The banks could simply increase salaries (which a lot are now doing), but that increases the banks' fixed costs, which is actually worse for shareholders. But lets not let facts and logic interfere with good soundbites...

Telco guy 11 years ago

the flaw with the existing IB bonus system (and for what matters with many other industries) is the fact that it provides a reward today for a risk that will bore by the bank over a longer period. This happens in many other industries as promotions are granted for short term results that have undesirable long-term effects, but certainly in no industry is so obvious as in IB. The result we all could see, but this was no news, this has been discussed for a long time, and the flaws of the model were not a surprise to anyone. Why bank shareholders accepted this, that can not explain, but seriously blows a hole in the efficient market theory. The existing bonus system incentivized reckless gambling as risks and profits were "unbundled" to different groups of people. If this is not a clear case of principal agent conflict, then you tell me. If we are going to discuss the bonus issue then do it properly. The system did not work, it was criticized for a long time, and still the industry sticks to it. That does not make it "right" in any sense. Markets are not always correct, we know this since the Dutch started investing in tulips, but it is very tempting to ride the wave for at long as it lasts.