In a must-read article for City AM, Andrew Lilico has taken aim at the ‘cranks’ who claim that orthodox economics cannot account for the 2008 financial crisis. As usual, his analysis is sharp and insightful. But I think he is in danger of overstating his case.
It is telling that he uses the Bank for International Settlements as his sole example of how the mainstream of the economics profession ‘warned of house price crashes or problems in complex derivatives markets creating problems for banks’.
I believe the most prescient work coming out of the BIS was authored by William White, and I assume Lilico had him in mind when naming that institution (White was issuing warnings of a financial crisis back in 2003). But although the BIS is a mainstream organisation, and White could be defined as a mainstream economist, his reasoning is hardly ‘orthodox’. White explicitly utilised the Austrian school in his analysis. In a 2006 paper he argued:
‘While many have rightly criticised the specifics of Austrian capital theory, the concept of erroneous investment processes driven by credit creation is still noteworthy. Moreover, while most Keynesian models assume a relatively smooth adjustment from one equilibrium to another, the Austrians stressed growing imbalances (cumulative deviations away from equilibrium) and an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it.’
The impression Lilico provides is that the BIS are a mainstream economics organisation, utilising orthodox economic theory. The former is true, but in the specific instances that Lilico wants to give them credit, they were straying from orthodoxy.
One could argue that Austrian economics isn't a truly heterodox school of thought (or that anything useful from the Austrian school is already contained in neoclassical economics, and one could argue that William White is not an Austrian school economist. Both of these arguments have merit. Indeed Lilico responded to me through Twitter that ‘White appeals to many entirely mainstream pieces of economic literature and economic theory. He's eclectic, not heterodox.’ I agree with this, but if Lilico considers ‘eclectic’ economists that utilise Austrian theory as being ‘orthodox’ - who isn't? His claim that orthodox economics is all you need to explain the crisis becomes true but trivial.
Many economists (and many cranks) have claimed to have ‘predicted the crisis’. For this claim to hold, we need to be clear about what prediction is being made. For me, it means more than just house price crashes, or problems with banks. It requires some causal theory to explain how changes in house prices will lead to an economic slowdown, and that this slowdown would be severe (i.e. a recession). A rudimentary list of people who fit this criteria are Fred Harrison, Steve Keen, Nouriel Roubini, Dean Baker, Fred Foldvary, Frank Shostak, Simon Kitson, Tony Deden and Sean Corrigan. Lilico himself deserves to be on it. But what is telling is that although these people have different reasoning, they are all pretty heterodox. Whether it's Georgism, Post-Keynesianism or Austrian, these are some distance from the mainstream. To restate the challenge I issued to Lilico: (1) who were the mainstream economists that issued warnings; and (2) did they use orthodox economic reasoning?
I don't endorse the analysis of all of the economists listed, and some of them may count as the ‘cranks’ Lilico refers to. But the claim I want to make is this: to the extent that mainstream economists did make accurate warnings about the 2008 financial crisis, it was often because they were utilising heterodox concepts. And, if I wanted to be especially cheeky, I'd point out that the best defence of economists’ inability to predict the crisis was made by Geoff Hodgson - a heterodox economist!: ‘economists did something even better than predict the crisis. We correctly predicted that we would not be able to predict it.’
I've mentioned previously that the financial crisis has led to a second revival in Austrian economics. I don't think we should be surprised that since 2008 Keynes and Hayek have both received renewed attention. I predict that textbooks will increasingly reflect this, and believe that this is a good thing. There is a need for the economics profession to adapt to the crisis, but it is doing so. My message to the general public is don't underestimate what economics had to say about the crisis. My message to other economists is don't underestimate what heterodox economics had to say about it.
Lilico's defence of orthodox economics rests on the fact that he considers himself to be an orthodox economist. I think he's too modest. If all orthodox economists were as eclectic as him, I don't think the profession would need defending.
Addendum: Lilico has responded to my challenge and mentioned himself and Roger Bootle as counter examples. I would be very interested in people leaving further examples (with evidence where possible) in the comments below. I have found this debate extremely enlightening.