There are two main lessons that we can draw from the 2007 to 2009 global financial
crisis: the failure of mainstream economics to predict and solve the crisis, and its
inability to explain the rise of the Chinese economy. There is of course a simple
explanation for this blind spot. Mainstream theory, especially quantitative economic
models, makes too many assumptions on the political factors involved. The current
generation of Chinese economists, trained largely in these traditional theories, needs
to distinguish between the ideology of free markets and the ground reality that politics
drives economics. The two are inseparable, but both ignore each other at the peril of
systemic failure.
Mainstream economic and finance theory failed to predict the financial crisis and
devise solutions for it because its underlying assumptions about many complicated
issues related to the real world were incorrect. First, it is now well known that
techniques used by central banks and finance ministries in all major markets to
predict growth trajectories, like the dynamic stochastic general equilibrium models,
completely ignored the existence of the financial sector, assuming that financial
assets and liabilities net to zero. This crisis proved that many models of risk
management currently in use are at best flawed and at worst useless in the face of
"black swan" tail events.
The next mistake was to concentrate on risks that were defined as measurable
volatilities, while ignoring uncertainty and unknown factors. For example, the former
Governor of the Bank of England Lord Mervyn King, confessed in his new book, The
End of Alchemy, that monetary theory had failed to produce a good analysis of money
and ignored the element of "radical uncertainty" in the world of finance.
The third flaw, common to organizational theory and macroeconomics, is that
specialists and departmental agencies know more and more about less and less and
are unable to connect the dots to view the economic and social system as a whole.
This fragmented view creates a "silo effect" that assumes that your point of view is
the best and the problems caused by your actions are really due to the fault of others.
Policy makers ignore the spillover effects of globalization on national policies, and
there is no collective action at the global level because of geopolitical rivalries. This
partial view means that economists and fragmented state agencies completely miss
the reality that it is the interaction between the parts that actually determine systemic
outcomes. Policies that focus on domestic objectives, while ignoring their global
impact and vice versa have made these measures ineffective and detrimental to the
global economy.
This is particularly true of monetary policy tools adopted by countries that are widely
used as reserve currencies. For example, large stimulus drives in several big
economies increased the volatility of global capital flows and put pressure on
exchange rate stability. Unconventional monetary policies by the U.S. Federal
Reserves, the European Central Bank and Bank of Japan that pushed interest rates
to zero and even negative levels added to the complexity of managing the yuan and
affected China's national development policies. Efforts to stabilize the yuan are
affected by very low US interest rates, because any attempt to use interest rate
policies could trigger large capital flows leading to more volatile exchange rates. At
the same time, the Fed is aware that if it tries to raise interest rates, the dollar would
become stronger, slowing down economic recovery in the United States.
Political obstructions to the use of fiscal policies have shifted the entire burden of
dealing with growth on monetary policy. As interest rates fall to zero or negative
levels, long-term growth prospects have dropped towards levels that can trigger
another global recession.
Economics in the time of Adam Smith stressed on the importance of the political
economy, where political goals were inseparable from economic mercantilism. But the
belief that free markets could solve everything is flawed. Financial liberalization and
globalization as ideologies may fit some countries, but is a disaster when applied to
the world as a whole.
Andrew Sheng is Distinguished Fellow at the Asia Global Institute in the
University of Hong Kong
This article first appeared in Caixin Online, 24 May 2016
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