It’s been called the dismal science. But it’s not really. There is a renaissance in economic thinking that is taking place outside the restrictive boundaries of the economics discipline that will revolutionise the way we think about macroeconomics, microeconomics and monetary policy.
This revolution is being led by the Institute for New Economic Thinking (INET), which was founded by George Soros and based in Manhattan, N.Y. One of its major partners in this enterprise is the Centre for International Governance Innovation, founded by Jim Balsillie and based in Waterloo, Ont. Together, these institutions are funding a shift in the study and practice of economics, encouraging economists — many of them young — to take real intellectual risks in the way we approach the world’s problems.
Many of these ideas were on full display at the annual INET-CIGI conference that was held in Toronto earlier this year.
This was no arid, theoretical discussion of economics characterised by unfathomable-sounding papers filled with indecipherable terminology, ponderous mathematical equations and legions of mind-numbing statistics. Instead, one of the striking qualities of this highly animated, three-day conversation among economists and business leaders was its relatively jargon-free, open and highly accessible nature.
It was also a discussion that would have made John Maynard Keynes, the father of modern economics, proud, because it connected economics to real-life problems and vital questions of public policy.
Many of these thinkers stand conventional economic wisdom on its head. Take Bill Janeway, a brilliant economist-turnedventure-capitalist, who has just published an important new book, Doing Capitalism in the Global Economy. In it, he argues that financial speculation can be a real boon to innovation, especially in the high-tech sector, where risk and uncertainty abound. Access to financial markets, he argues, can actually stimulate growth and innovation in critical sectors of the economy when there are financial bubbles.
However, the reason this works is because of structural problems in the economy when it comes to demand and access to capital. And as Mr. Janeway himself concedes, bubbles may not be the most efficient way to stimulate growth and innovation.
Other INET economists are studying the impact of the digital economy on economic growth and development. Their work shows that even relatively low cost innovations such as the introduction of automated online trading are changing the operation of commodity markets in the developing world in ways that are beneficial to producers.
The introduction of mobile payment systems in a country such as Kenya, for example, is also helping to leverage that country’s resource and human capital endowments on a global scale.
New thinking in economics also points to the critical role governments can play in fostering innovation and growth. When governments invest in infrastructure, underwrite the availability and speed of broadband access in rural areas and develop enabling, as opposed to restrictive, regulatory frameworks, they can be important drivers of economic growth.
As University of Sussex economist Mariana Mazzucato carefully documents in her outstanding book, The Entrepreneurial State, government intervention is justified not only to address market failures, but also to underwrite risky research and commercialisation processes that the private sector will not touch.
Such trailblazing investments by government were critical to providing a much-needed platform to launch the internet, develop the touchscreen technologies behind Apple’s iPhone and iPad and other key innovations in biotechnology, nanotechnology and even agriculture. Ms Mazzucato says venture capital alone cannot sustain the kind of slow, painstaking research required for innovation success.
However, when governments embark on a wholesale deregulation of financial markets and services as the U.S. did during the 1990s, they create thin financial hulls that can be easily punctured.
Perhaps one of the most important insights of this new economic thinking is the light it sheds on the complex relationship between monetary policy, investment patterns and economic growth and productivity.
There continues to be lively debate about the origins of the 2008-09 global economic crisis and who was culpable in the greatest financial disaster we have seen since the Great Depression. Fingers have been pointed at the greedy bankers and stock traders of Wall Street, who played a deadly game of financial roulette with hedge funds, derivatives and various other mysterious financial products that were concocted to conceal the real value of the assets and liabilities being traded.
Hollywood has given its own spin to this story in The Wolf of Wall Street, in which Leonardo DiCaprio portrays the cocaine-snorting stock trader who plays fast and loose with the hard-won earnings of his clients. Everyone loves a moral tale of self-indulgence, unrequited greed and anti-heroes who lead lives of reckless debauchery that eventually come to an ignominious end with prison sentences and a life spent delivering mea culpas and motivational seminars when they finally get out of jail.
If only the truth were so simple. As some of INET economists’ work shows, what played a key role in the last financial crisis was policies of central banks that helped to create distortions in capital markets through the creation of “asset bubbles” in tech stocks in the 1990s or the housing market in the last decade. In the case of the latter, a perfectly wellintentioned attempt to open up home ownership to the disadvantaged classes led to the now well-known abuses of overlending to clients who were in no position to assess what kind of mortgage agreement they had entered into.
Easy money, fuelled by low interest rates, also encouraged risky behaviour as investors looked for ways to gain higher yields. Traders and purveyors of financial services, in turn, created highly novel financial products that seduced private investors and corporations alike in an endless betting game that drove up asset prices well beyond their real value.
Government regulators in most countries — Canada was a notable exception — looked the other way as investors ran like sheep into this dazzling new casino. Some left grinning with giant wads of cash in their hands. Others lost their shirts.
After the world headed into deep recession bordering on depression at the end of the last decade, like the drunk who takes a chaser to cure a hangover, central bankers resorted to priming the monetary pump again with low interest rates and a novel policy of “quantitative easing,” through which they sucked up assets from banks and other financial institutions at bargain-basement prices instead of the more traditional policy of buying up government bonds and treasury bills to pump additional liquidity into the economy in an effort to free up credit.
The problem now is that, as before, easy money is flooding back into global equity markets instead of being used to promote investment in new business ventures that promote economic growth and stimulate productivity, innovation and employment.
The reason is simple. Investors see higher returns in the stock market and the act of buying and trading equities and other financial products.
Think of it this way: You have $10 and your neighbour next door is running a poker game in his basement. The total pot if you win the game is $100. On the other side of the street, your other neighbour is building a lemonade stand and has asked you to contribute to its construction with the promise that once it’s up and running, he will pay you a modest, guaranteed monthly dividend of 50 cents — and possibly more if his business succeeds.
Where would you put your money? Most people would opt for the poker game because the anticipated returns are much higher. The downside is that if you lose, you get nothing.
Some economists argue that current monetary policies have spurred the growing distortion in equity and credit markets, just as the flow of easy money into equity markets and sloppy regulation led to the crisis in the first place.
They also argue that central bankers have been too wedded to old ways of thinking that are focused on targeting inflation instead of carefully monitoring the consequences of monetary policy on specific asset market inflation — such as housing — where distortions occur when money is “cheap” and investors trade assets that have no productive value.
But as the new economic thinking also reveals, efforts to regulate financial markets by imposing capital ratio and liquidity requirements on financial institutions fail to take into account the interactive effects between credit, equity and capital markets and the devastating negative consequences when there are asset-based fire sales. Prices can drop like a stone and financial institutions will take the hit as shockwaves reverberate throughout the entire financial system.
We also now have bigger banks and more concentrated financial markets than ever before. The regulatory process has become so complicated that even the regulators don’t fully understand it. The legislation to implement the “Volcker Rule” to restrict the investment activities of banks runs a staggering 2,400 pages. In contrast, the Federal Reserve Act of 1913 ran about 31 pages and the Glass-Stegall Act of 1933 was a mere 37 pages.
Simply put, the banking system is too fragile and dangerous. There is still too much debt in the system. Insolvency risks run deep. And there remains a built-in bias in the financial system against business loans in favour of trading in equity markets.
Banks are major traders in this unproductive game of equity roulette. They are perversely addicted to borrowing in order to finance their own “gambling” habits. And they aren’t being constrained by newly imposed capital requirements in Basel III (a voluntary global regulatory standard for banks.) The proverbial Wolf of Wall Street is the entire system and its interlocking set of institutions.
As these new economic thinkers argue, when financial institutions fail, taxpayers become the equity investors of last resort — a situation akin to paupers bailing out the princes.
Taxpayers are generally a poorly informed and disenfranchised lot when it comes to understanding how financial markets really work, but they are the ones who have to provide the safety net when the system fails. And fail it will unless we go back to an era in which banks do what they are supposed to — lend to business and stop playing the stock market — and central banks change their own outdated benchmarks for measuring inflation and the health of economies.
As Nobel Laureate Joseph Stiglitz, one of the founders of new economic thinking, said to his Toronto audience, “the financial sector is no longer the servant of the rest of the economy. It has become its master. The financial system used to manage risk. Now it creates it.”