Home > The Economics Profession, Uncategorized > The main culprit of the financial crisis — mechanical economic models

The main culprit of the financial crisis — mechanical economic models

from Lars Syll

Regulators, bankers, and ratings agencies bear much of the blame for the crisis. But the near-meltdown was not so much a failure of capitalism as it was a failure of contemporary economic models’ understanding of the role and functioning of financial markets – and, more broadly, instability – in capitalist economies …

After Lehman’s collapse, former Federal Reserve Chairman Alan Greenspan testified before the US Congress that he had “found a flaw” in the ideology that self-interest would protect society from the financial system’s excesses …


That belief can be traced to prevailing economic theory concerning the causes of asset-price instability – a theory that accounts for risk and asset-price fluctuations as if the future followed mechanically from the past. Contemporary economists’ mechanical models imply that self-interested market participants would not bid housing and other asset prices to clearly excessive levels in the run-up to the crisis. Consequently, such excessive fluctuations have been viewed as a symptom of market participants’ irrationality.

This flawed assumption – that self-interested decisions can be adequately portrayed with mechanical rules – underpinned the creation of synthetic financial instruments and legitimized, on supposedly scientific grounds, their marketing to pension funds and other financial institutions around the world …

Contemporary economists’ reliance on mechanical rules to understand – and influence – economic outcomes extends to macroeconomic policy as well, and often draws on an authority, John Maynard Keynes, who would have rejected their approach. Keynes understood early on the fallacy of applying such mechanical rules. “We have involved ourselves in a colossal muddle,” he warned, “having blundered in the control of a delicate machine, the working of which we do not understand.”

In The General Theory of Employment, Interest, and Money, Keynes sought to provide the missing rationale for relying on expansionary fiscal policy to steer advanced capitalist economies out of the Great Depression. But, following World War II, his successors developed a much more ambitious agenda. Instead of pursuing measures to counter excessive fluctuations in economic activity, such as the deep contraction of the 1930’s, so-called stabilization policies focused on measures that aimed to maintain full employment.


“New Keynesian” models underpinning these policies assumed that an economy’s “true” potential – and thus the so-called output gap that expansionary policy is supposed to fill to attain full employment – can be precisely measured.

But, to put it bluntly, the belief that an economist can fully specify in advance how aggregate outcomes – and thus the potential level of economic activity – unfold over time is bogus …

Yet the mainstream of the economics profession insists that such mechanistic models retain validity. Nobel laureate economist Paul Krugman, for example, claims that “a back-of-the-envelope calculation” on the basis of “textbook macroeconomics” indicates that the $800 billion US fiscal stimulus in 2009 should have been three times bigger.

Clearly, we need a new textbook.

Roman Frydman & Michael Goldberg

  1. yemiolutoye
    October 4, 2013 at 3:23 pm

    Reblogged this on yemiolutoye's Blog.

  2. Bruce E. Woych
    October 4, 2013 at 3:37 pm

    James Kwak: Baseline Scenario: The Wall Street Takeover Part 2
    In 2002, Art Wilmarth wrote a mammoth (262 pages) article titled “The Transformation of the U.S. Financial Services Industry, 1975–2000.” In that article, he identified many of the key trends in the financial sector—consolidation, deregulation, breakdown of Glass-Steagall, complex products, increased risk-taking—that would not only produce a financial crisis but make it so destabilizing for the economy later in the decade. Now he has written a shorter (164 pages) article, “Turning a Blind Eye: Why Washington Keeps Giving into Wall Street,” on the key question: why our government doesn’t do anything about it, even after the financial crisis.
    Turning a Blind Eye: Why Washington Keeps Giving In to Wall Street
    Arthur E. Wilmarth Jr.
    George Washington University Law School

    “Four principal factors account for Wall Street’s continuing dominance in the corridors of Washington. First, the financial industry has spent massive sums on lobbying and campaign contributions, and its political influence has expanded along with the growing significance of the financial sector in the U.S. economy. Second, financial regulators have aggressively competed within and across national boundaries to attract the allegiance of large financial institutions. Wall Street has skillfully exploited the resulting opportunities for regulatory arbitrage.

    Third, Wall Street’s political clout discourages regulators from imposing restraints on the financial industry. Politicians and regulators encounter significant “push-back” whenever they oppose Wall Street’s agenda, and they also lose opportunities for lucrative “revolving door” employment from the industry and its service providers. Fourth, the financial industry has achieved “cognitive capture” through the “revolving door” and other close connections between Wall Street and Washington. ”
    These are great reference works to file for arguing the normative course of (non-Marxian) classically ‘critical’ assessments of default (at least) in judgements, over the fanatically overextended network of interests that are creating a mixed economy of failure based upon ‘factionalized’ successes. But if interests are factional, the normative basis for this failed mosaic is inherently ‘fictional’ even if it appears intrinsically coherent. The vast majority of Americans are acting under a distinctive delusion and denial that the system works and is only being tweaked by some (sociopathic?) opportunists that have become path dependent with an addiction to excessive risk under moral hazard and perverted incentives as the new norm that goes unspoken in polite channels. It is about power and it is about crony capitalism in America as well as political economy gone wild.

    But When “moral hazards” are now at the expense of other peoples lives…not merely their financial risks alone, we can no longer think of systemic failure but of systemic fraud. Line this up with BCCI, with the 1978 Savings and Loan debacle, and the greatest robbery in the history of mankind as the LOOTING of the US Treasury…and we will get a closer focus on the real time grounded political-economic coup d’etat and the black market-off-shore systems that are sucking it dry. And now, of course, have taken on the informatively neutralizing title by high standing officials as not TBTF…but too Big to Jail! Just how blatantly stupid and bold does it get?
    When the mafia does this it is termed “busting out” but when Wall Street Executives enter Washington DC through crony capital ties we gingerly call it “revolving doors” and massive Bail Out.

  3. paul davidson
    October 4, 2013 at 3:39 pm

    as I have pointed out many times here, the problem is that the economic system is a nonergodic stochastic process. Hence the future is not knowable.

    Where Roman and Michael go wrong is not that we “know” how much deficit spending will assure full employment! What we should have learned by now is it is better to aim higher to get to full employment than to aim to low

    . To low allows the fools to say –see deficit spending stimulus does not work.

    Too high means that every one who wants a job has one and employers are still looking for more workers. At worse this may lead to some wage inflation demands — but an incomes policy could control that!

    Come un everyone, join the Post Keynesian economics!

    Paul Davidson

  4. Bruce E. Woych
    October 4, 2013 at 3:47 pm

    No disrespect intended but how can you seriously write an article entitled “The main culprit of the financial crisis — mechanical economic models” and not even mention:
    DERIVATIVES ??? Multiple articles from a simple search:

  5. Bruce E. Woych
    October 4, 2013 at 3:55 pm

    Uploaded on Feb 10, 2012

    the GDP of the entire world is 60 to 70 tillion dollars. The derivatives market just reached almost 1.5 quadrillion dollars.
    (You might ask, “What the hell is a quadrillion?” Take a million. Now take a thousand of those (which is a billion), and then take a Million of those. Meaning it’s a Million Billions. That’s a Quadrillion.)

    A trillion is a million millions, and a quadrillion is a thousand trillions.

    It’s 23 times the GDP’s of the entire world put togetrher, and more than 40 times the sum of all the stock markets in the world combined.

    • October 6, 2013 at 11:48 am

      What I find about most discussions of money and derivatives is that they are not 100 percent accurate. Even if you are 90 percent accurate, there is no much room to draw totally wild and misleading conclusions. This discussion of derivatives is one of them.

      Firstly, exchange traded derivatives are really no problem, because they are transparent. So derivatives per se are not the problem. It is the one quadrillion or more of notational value of over-the-counter (OTC) derivatives which are the problem, because they have inadequate reporting and not transparent (thanks to Larry Summers).

      A simple example of the problem is that two investment banks taking opposite positions of the same OTC derivative contract can potentially both report profits, which is obviously an impossibility. But the accounting regulation (FASB) allows this to happen, because each party can “mark-to-model” (their own models), which is really “mark-to-myth”.

      Even though the potential losses hidden are substantially less than the quadrillion dollars of notional value, because of “netting out”. Even 1% of notional value of hidden losses would equal to 10 trillion dollars. Given the highly geared nature of investment banks, many would be insolvent and by counter-party contagion, the most of the financial system could be insolvent.

      The losses are not anywhere near 23 times global GDP. But they may be one to a few times US GDP. But due to the highly leveraged nature of the financial system, it is more than sufficient to lead to its total collapse. Force majeure will not solve the OTC derivatives problem, because all the falsely declared profits (on all sides) would suddenly vanish.

  6. October 4, 2013 at 7:55 pm

    The analyses of Greenspan, Keynes etc are all totally off the mark, because the market, seen as “individuals participating in exchange” is seriously flawed. Financial markets, even in the days of Keynes, are mostly exchanges between intermediaries, whose actions determine the outcome of markets.

    Models of individual behavior are mostly irrelevant, because individuals do not determine the outcome of financial markets. Central bankers, investment bankers, proprietary traders, hedge fund managers, investment managers, pension fund mangers, stockbrokers etc. largely determine market outcomes.

    It completely wrong to assert, “excessive fluctuations have been viewed as a symptom of market participants’ irrationality”. Excessive fluctuations are created by broking intermediaries and others to force increased risk management trading by other intermediaries managing other peoples money.

    It is not “a symptom of market participants’ irrationality”, rather it is a symptom of market partcipants’ RATIONALITY, because it is not a case of individual irrationality, rather it is a case of intermediaries’ rationality.

    Market volatility is used as a mechanism to transfer massive wealth from ordinary individuals to the collective of financial intermediaries. With increased volatility, executive stock options and derivatives increased in value, proprietary traders and hedge

    funds make more profits, brokers earn increased commission, pension fund managers are seen to be earning their fees. Nothing is worst than a market with no volatility for finanacial intermediaries.

    The broad empirical evidence for what I’m saying is obvious and data on market volatility with financialization and on the increased wealth polarization confirm this. Ordinary peoples wealth are stolen through their savings in pension funds, their debt payments, and more recently through massive taxpayer funded bail-outs. In future, there will be outright confiscation of assets through bail-ins.

    The Keynesian conclusion that market volatility indicates individual irrationality is both wrong and seriously harmful to our wealth and liberty, because it leads to governments taking over “to protect irrational individuals”. Mechanical models are bad, but not understanding the problem is even worse.

    • Bruce E. Woych
      October 5, 2013 at 11:24 am

      Economics education and pluralism

      By Maria Alejandra Madi


      “In the post-war period, economics was broadly understood as economic science, that is to say, as a specific area of the development of human knowledge. In this context, the mainstream-heterodox controversies overwhelmed the economic organization and welfare distribution issues. After the 1970s, however, the perspectives on economics education revealed a deep crisis of post-war institutions. In truth, the main challenge to economics education has been the understanding of changing economic realities. In the current scenario, pluralist economics education has been overwhelmed by the attempt to apprehend the complexity of the real-world.
      Economics education should take into consideration history, quantitative methods and the awareness of diverse schools of thought within economics. The nuclear idea of the economics curriculum should be to assure the accomplishment of three purposes: pluralism, solid theoretical foundations and commitment to reality (http://weapedagogy.wordpress.com/2013/10/03/economics-education-and-pluralism/)”

      • October 6, 2013 at 12:05 pm

        On the post by Maria Alejandra Madi

        About the understanding of changing economic realities:

        To me, ‘uncorrected obsolescence’ in economics can only mean one thing: economists’ use of obsolete ideas of history to understand today’s economic reality. This leads to an educated blindness or Veblen’s “trained incapacity” to see or observe what is in front of their own eyes, except through the distorting lens of economics concepts of the irrelevant past.

        In fact, economic history has been harmful in understanding our world today, because “pluralism founded in history” becomes merely a collection of contradicting views based historical categories, which are no longer relevant. This Tower of Babel is unable to provide a viable alternative to the existing economic paradigm, total useless in any practical sense.

        Neoclassical economics, founded on simple goods markets of Adam Smith, is a misleading model of our world and has allowed the deregulation of highly intermediated financial markets, which have caused and are still causing today’s economic catastrophe.

      • Bruce E. Woych
        October 6, 2013 at 4:01 pm

        @lyonwiss #9 This is a very engaging set of thoughts and challenges some elaboration. In my perspective, however, it is not precisely Adam Smith that guides any specific line of economic theories (it actually impacted after he was dead). Instead, it is a “blank sheet” and an “invisible hand” for subsequent people who seek to legitimate their own motivations and incentives by crediting them with some “classical” shine of institutional authority from the presumption of hierarchical history itself. I think that some segment of educated training is certainly “conditioned” by a system of biased thinking, but ultimately it is adopted because it creates a veil of authority even if it is centrally flawed with fallacies of distinction with a “deformation professionelle” (professional myopia), cognitive & confirmation bias, and a full spectrum of cultural capture in its wake…defining its path dependence and its projected survival (future) with a viral desperation.

        As you say>>>
        “pluralism founded in history” becomes merely a collection of contradicting views based historical categories, which are no longer relevant.”

        But the true question is to whether these ‘relativities written as absolutes’ were ever (intrinsically) “relevant” in and of themselves…but in reality they sustain ‘rhetorical (extrinsic) foundation’ for ‘other’ self-serving relevance and self justified meanings. Justifications that sanction asymmetrical wealth as well as blind trust and asymmetrical knowledge over poverty.

        But Veblen, I don’t believe, was not addressing a culture of poverty or blaming the victims of poverty with his “trained incapacity” but (I believe) he had his eye on what eventually traps us from a transcendent cultural advancement and stops us at limits of achievement (that he believed was innate and impulsively driving us to achieve “purposeful” existence. He was addressing an authentic civilization of purpose as opposed to conspicuous consumption or wealth in itself and waste as its by-product.

        If it was adopted for behavioral modification and theories that were so useful to business, it is a collateral coincidence rather than a direct consequence of his ideas expressed. This was not inheritance in the history of ideas, it was distortion and mutation that took it into conditioned behavior (negative & positive) as the engine to labor and (presumptively) of society itself, its consumption, waste and planned obsolescence of not just product…, but of people themselves.

        Consider this polemic and place it in a decade by decade historic perspective:
        Wais, Erin (Fall 2005). “Trained Incapacity: Thorstein Veblen and Kenneth Burke”. K.B. Journal 2 (1).
        » Issue of KB Journal » Volume 2, Issue 1, Fall 2005

        Trained Incapacity: Thorstein Veblen and Kenneth Burke
        Erin Wais, University of Minnesota

        In this article (below) it is Kenneth Burke who takes a limited business utility model of Veblen’s attempt to expand the context of understanding the capacity of the human condition, and widens it as a general social classification of limitations and behavioral conditioning. Managerialism intensified under the dictates of a behavioral modification of labor interests under market realism. (A wide and ramified tangent from this discussion).

        Yet is of interest to note that Burke had a critical insight into economic society itself and his views extending “trained incapacity” from Veblen aside…he pronounced it precisely and concisely in his critique: http://blogs.sfu.ca/courses/fall2012/lbst311/?p=318

        Recipe for Prosperity: “Borrow. Buy. Waste. Want.” (1956)
        By Kenneth Burke Source:Nation; 9/8/1956, Vol. 183 Issue 10, p191-193)

        The economic models that follow are the tail wagging that dog; not the cause of its mania but certainly not the cure.

  7. October 4, 2013 at 10:44 pm

    How about this: The main culprit is the economics profession as a whole. Their main weapon is rarely showing the people real asset price histories, e.g.
    because these histories are SO instructive.
    This status quo is fully consistent with ‘education’ as a four letter word.

    • Bruce E. Woych
      October 5, 2013 at 11:05 am

      Right on Ed! And lest we forget the mainstream economic profession that benefits from these disinformation strategies (asymmetrical economics…if not asymmetrical class warfare itself…) is harbored from only a handful of University departments dominated by Chicago University, Harvard and their subordinate satellites (with faculty saturation from these two predominating and with mixed followings of advocates of the so-called salt and fresh water schools). Take this further and we end up with rationalization over rationing posited as so-called ‘free markets and invisible hands’ under institutionalized propaganda and a blatant failure to evaluate destructive economic models that are normalized as “bubbles” in a stream of repetitive cycles that are said to be self-regualting and self correcting.

      This is neo-pseudo-science sounding off with doctrine and dogma that legitimates itself by claims of being “classical” …when in fact, it is simply neo-class exploitations colonializing markets and characterizing it as ‘measured’ economic growth. All the while ignoring the losses AND “externalities” outside of their concerns that it leaves in its path of destruction now labeled “development” and progress.

    • Bruce E. Woych
      October 5, 2013 at 11:09 am

      apparently all my previous entries are still labeled “Your comment is awaiting moderation.” So I am guessing they are being censored out of the streams. Sorry you may not have had these opinions posted, I suppose “heterodox” means just the ‘other guys’ in economics.

  8. Bruce E. Woych
    October 5, 2013 at 2:44 pm

    More Derivatives Trading Now In The ‘Shadows’
    John M. Mason, September 13, 2013
    “Finance is nothing more than information … it is just zeros and ones! Information can be sliced and diced almost anyway one wants to cut it. Information is available almost anywhere in the world … instantaneously. And, one does not need massive scale in terms of computer equipment in order to be a player.”

    To the extent that these become mechanical mathematical models I think we can agree that the disconnect has had a solid place in creating not simply risk but outright threats to the “externalizations” perceived as outside of the transactions and immediately desirable outcome. In short myopia created by formulas of mechanical speculation for pure profit continues to be involved from the heavy ended business side of economic models.

  9. October 6, 2013 at 3:50 pm

    A simple question, True or False ?
    (Excerpted) THIS IS A FREE DOWNLOAD-




    This book attempts to clear up the mystery of money in its social aspect. With the monetary system of the whole world in chaos, this mystery has never been so carefully fostered as it is to-day. And this is all the more curious inasmuch as there is not the slightest reason for this mystery.
    This book will show what money now is, what it does, and what it should do. From this will emerge the recognition of what has always been the true role of money. The standpoint from which most books on modern money are written
    has been reversed. In this book the subject is not treated from the point of view of the bankers as those are called who create by far the greater proportion of money but from that of the PUBLIC, who at present have to give up valuable goods and services to the bankers in return for the money that they have so cleverly created and create. This, surely, is what the public really wants to know about money.

    It was recognized in Athens and Sparta ten centuries before the birth of Christ that one
    of the most vital prerogatives of the State was the sole right to issue money. How curious that the unique quality of this prerogative is only now being re-discovered. The” money-power ” which has been able to overshadow ostensibly responsible
    government, is not the power of the merely ultrarich, but is nothing more nor less than a new technique designed to create and destroy money by adding and withdrawing figures in bank ledgers, without the slightest concern for the interests of the community or the real role that money ought to perform therein.

    The more profound students of money and, more recently, a very few historians have realized the enormous significance of this money power or technique, and its key position in shaping the course of world events through the ages. In this book the mode of approach and the philosophy of money is expounded in the light of a group of
    new doctrines, to which the name ergosophy is collectively given, which regard economics, sociology, and history with the eye of the engineer rather than with that of the humanist. It is concerned less with the details of particular schemes of monetary reform that have been advocated than with the general principles to which, in the
    author’s opinion, every monetary system must at long last conform, if it is to fulfill its proper role as the distributive mechanism of society. To allow it to become a source of revenue to private issuers is to create, first, a secret and illicit arm of the government and, last, a rival power strong enough ultimately to overthrow all other forms of
    government. ”

    Justaluckyfool , may I ask, “IS the flaw to American capitalism: Our government has legislated the privilege of issuance of the sovereign currency as well as the right to tax that issuance to the Private For Profit Banks (PFPB). PFPB, who are obligated to maximize profits for their shareholders which is counter productive of using that revenue ( on average more than Double the issuance ) taken from the people… “to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defense, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity,…”?

  10. Bruce E. Woych
    October 6, 2013 at 4:08 pm

    lyonwiss #9: compare Veblen’s trained incapacity “critically” to the development of the contemporary ideas under “learned helplessness” and the subsequent critique of former APA president Martin Seligman’s “resilience program Comprehensive Soldier Fitness (CSF)” as a $125 million military training initiative http://www.counterpunch.org/2011/03/24/the-dark-side-of-comprehensive-soldier-fitness/ …..which arguably is rhetorically twisted and sophisticated brainwashing and conditioning program in anticipation of trauma inducing violence in contemporary combat.

  11. Bruce E. Woych
    October 6, 2013 at 6:20 pm

    http://en.wikipedia.org/wiki/Occupational_psychosis seem ‘germain’ to the issues of economics and reality in the history and theory of mainstream bias.

    Trained incapacity refers to that state of affairs in which one’s abilities function as inadequacies or blind spots. Actions based upon training and skills which have been successfully applied in the past may result in inappropriate responses under changed conditions. An inadequate flexibility in the application of skills will, in a changing milieu, result in more or less serious maladjustments.
    “Occupational psychosis is the concept that one’s occupation or career makes that person so biased that they could be described as psychotic. Especially common in tight occupational circles, individuals can normalize ideas or behaviours that seem absurd or irrational to the external public. The term was created by John Dewey.”

    “Professor Dewey suggests that a tribe’s ways of gaining sustenance promote certain specific patterns of thought which, since thought is an aspect of action, assist the tribe in its productive and distributive operations. This special emphasis, arising in response to the economic pattern, he calls the tribe’s occupational psychosis.”

    • Robert Locke
      October 7, 2013 at 6:11 am

      Perhaps John Dewey would have ranked neoclassical economists as suffers from “occupational psychosis.” But that would be inadvertent; if they create this economics purposively to serve the interest of a class or social group, what would you call that?

      • Bruce E. Woych
        October 8, 2013 at 2:51 pm

        I think they refer to it as the “invincible” hand? (I’m joking, of course…)

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