What If the Economy is a Creature?

What if the economy is a creature? What if the financial system is a critter, perhaps a type of varmint? What do we do then?

The doyennes of economic orthodoxy hold that the economy can be understood and explained by identifying fixed relationships between a number of variables. To legitimize their field as science, and themselves as experts, they prefer that these relationships be susceptible to mathematical expression. They secure for their research vast amounts of computer power, and hunt endlessly for reliable data. (The latter is by far the harder to get.) Statistical analysis and robust results well-buttressed by high confidence levels engender the belief that economists might actually know something. Peer review by others equally enamored of tidy regression analyses validate the assumptions made and the banishment of data points deemed outliers in the pursuit of statistically significant confidence levels. The seeming clarity of the results is comforting, not only to professional economists, but also government officials, legislators and the general public.

Then how could economists have missed the real estate and credit bubbles so badly? How could they have misunderstood the tech stock bubble of the late 1990s? What if the baseline assumption of economics--that there are fixed relationships between and among relevant variables that can be uncovered and mathematicized--is wrong? The economy and financial system proved to be a lot less predictable than the doyennes expected. The only thing that is clear is that economists, as a profession, know a lot less than they, and many of the rest of us, believed.

Perhaps the economy, being the combined interaction of large numbers of organic beings (i.e., people), is itself organic. Instead of a constant set of fixed relationships, it may consist of a swirling vortex of dynamically changing interactions that never precisely repeat themselves. People change and adjust the ways they live as the world around them changes. The Boomer generation learned to read and write with paper and pencil, and did its high school research using printed encyclopedias. Yet in a few decades, it has transitioned from Gutenberg's technology to Bill Gates' and Steve Jobs' technology. Information is much more readily available and relationships between people have changed as e-mail, social networking, and more have rendered distance irrelevant and downtime (i.e., time for yourself) a thing of the past.

Isn't it possible, and indeed probable, that the economy has similarly changed? The Phillips Curve, a supposed inverse relationship between inflation and unemployment, was once deemed by economists to be virtually engraved in stone. And for a short period of time, it appeared that way. But after leisure suits ceased to be fashionable, the Phillips Curve became increasingly more difficult to discern in the real world. Conventional economic thought holds that the Phillips Curve was too simplistic. Maybe the truth is that it once had explanatory power but the economy mutated away from it.

Similarly, the gold standard of monetary policy, the lowering of interest rates to stimulate economic activity, seems to have had limited efficacy in recent times. Perhaps changes in and the greatly increased complexity of the financial system has undermined the efficacy of monetary policy. A salient feature of the financial system of the 1990s and the early 2000s was the shadow banking system created with mortgage-backed and other asset-backed securities. A large portion of the economy's credit flowed through this unregulated market. The regulated banks and brokerage firms turned away from extending credit to earning fee income and speculating in proprietary trading. They became less significant as conduits of credit. The shadow banking system collapsed with the financial crisis of 2007-08, and has largely not been replaced. Thus, lowering interest rates has had limited stimulative efficacy because the true conduits for credit have to a large degree ceased to exist.

A visitor from Mars, unburdened by the dogma of conventional economics, would conclude that the economy and financial system aren't driven by fixed relationships, but are dynamic processes whose only constancy is change. The economy, simply put, is a creature that is always changing and evolving. The financial system, infused with Wall Street's voracious appetite for ever-new, high-margin financial engineering, mutates even more rapidly than the economy as a whole, and can sometimes be a nasty varmint if not handled properly.

The notion that the economy is a creature would be disquieting to many economists, as it would cast them into the tar pits of behavioral economics and other potentially mushy bodies of thought. But human relationships and human interactions are mushy. Indeed, they often are blobs. Understanding the economy and the financial system is a never-ending, sometimes Sisyphean struggle to discern changes in economic relationships and interactions. Risk managers in financial institutions and financial regulators have to understand that creative destruction doesn't simply apply to businesses and industries. It also applies to asset classes and the very relationships and processes of the economy and financial system. The Flash Crash wouldn't have happened a few years ago. But it's happened now and can happen again. Monitoring risk, and especially systemic risk, requires knowing not only what's going on, but what's changing and what's likely to change and how. Government officials might have to delve deep into the financial engineering of the big banks and the major trading firms, even as it's evolving and notwithstanding the protests of influential executives about proprietary secrets and preserving competitive advantages.

The Federal Reserve appears likely, under the financial regulatory reform now moving toward enactment, to end up with the greatest share of the responsibility for monitoring systemic risk. Thus, it will have the greatest responsibility for casting aside doctrine and diving into the unknown. Most significantly, regulators may have to apply an element of judgment even when statistically significant analyses aren't easily obtained. Problems can't always be avoided simply because they can't readily be quantified. Regulatory agencies are given, by law, a measure of discretion and they should bring common sense, as well as statistical technique, to bear. That won't be easy, as the Fed's governors and staff sometimes seem more inclined toward stalwartly manning the Maginot Line of economic orthodoxy than anticipating a blitzkrieg through the Ardennes. But financial panics and crises are like the flu virus, constantly mutating and appearing in unexpected forms that existing preventive measures weren't meant to address. Recognizing the organic nature of the economy and financial system, and reacting quickly, before all desired information is available, may well be crucial to ensuring that the financial crisis of 2007-08 and other painful disruptions don't happen again.