Wolfgang Münchau wonders if this is more than a simple financial crisis, because we’ve already had what seems like our 4th dip into this bathtub, and the financial system is still dirty.

Rather, he posits that the problem is that that the basic structure of our economies have been established by economist whose model of the world is simply wrong.

This is analogous to the Great Depression, where the economists and regulators, following a caricature of Adam Smith’s work, worked for creative destruction, to weed out the weak firms, and so, in the middle of a downward spiral, central banks restricted the money supply to wring out the “weakness”:

….Its principal villains are therefore not bankers, but economists – not in their role as teachers and researchers, but as policy advisers and policymakers.

So who are they? I recall a wonderful episode told by Jagdish Bhagwati in his book In Defense of Globalization when he quoted John Kenneth Galbraith as saying: “Milton’s [Friedman’s] misfortune is that his policies have been tried.” In fact, this is not the worst that could happen. The worst is for economists to try out their own theories themselves. This happened to several highly respected academics who have since become central bankers or finance ministers. If, or rather when, they turn out to be wrong, they risk a double reputational blow – as policymakers and as academics. So do not count on them to change their mind when the facts change.

In fact the collapse of Long Term Capital Management in the 1990s is a classic case of this, where you had world class economists with world class models being poleaxed by reality, which, through the wonders of leverage, caused a near collapse in world financial markets that required a Federal Reserve bailout.

I think that much of the genius of Keynes was that he was willing to adjust his theory when reality proved him wrong, which is rare in anyone, particularly an academic.

Interestingly enough, Münchau suggests that “Neo-Keynsian” model of the economy, where financial markets (which, BTW, would include the housing bubble) play no meaningful roll in the economy, had contributed mightily in the current crisis.

I’m not sure exactly what a “Neo-Keynsian” is. Truth be told, I barely grok what an old Keynsian is, though on hitting “the Wiki” it may be that “Neo-Keynesian” economics is akin to “Keynesian” in the same way that “Neo-Liberal” is to “Liberal”, which is to say “not at all”:

Several of them have been leading proponents of an economic theory known as New Keynesianism. It is, in fact, probably the most influential macroeconomic theory of our time. At the heart of the New Keynesian doctrine stands the so-called dynamic stochastic general equilibrium model, nowadays the main analytical tool of central banks all over the world. In this model, money and credit play no direct role. Nor does a financial market. The model’s technical features ensure that financial markets have no economic consequences in the long run.

This model has significant policy implications. One of them is that central banks can safely ignore monetary aggregates and credit. They should also ignore asset prices and deal only with the economic consequences of an asset price bust. They should also ignore headline inflation. An important aspect of these models is the concept of staggered prices – which says that most goods prices do not adjust continuously but at discrete intervals. This idea lies at the heart of some central bankers’ focus on core inflation – an inflation index that excludes volatile items such as food and oil. There is now a lively debate – to put it mildly – about whether an economic model in denial of a financial market can still be useful in the 21st century.

He is saying that academicians who value the consistency of their theory over reality have been placed in positions of regulatory authority, and that the inevitable regulatory failures are at the core of the credit crunch.

I agree wholeheartedly.

His prescription, creative destruction by allowing, “some defaulting banks to go bust,” is a part of the solution, but I do not believe that it addresses the “whys” of the bubble, it only wrings out the froth, leaving the ground fertile for another bubble.

I believe that the core of the problem is one of governance values, particularly in the US and the UK, that speculative arbitrage purely for profit is it’s own virtue.

Certainly, when Alan “Bubbles” Greenspan lauded financial innovation, this was his core value.

At the level of the regulator, this attitude needs to change. Speculation should not be viewed as a virtue, but rather an unavoidable and frequently toxic byproduct of a functioning financial market, much in the same way that, for example, dioxins are a byproduct of the paper making process.

We need the paper (in both senses of that work) to function as a society, but the toxic emissions (again in both senses of the word) should be kept to as low a level as is practical.

In the case of the financial markets, this means the following:

• That leverage should be regulated and restricted.
• That speculation should be discouraged though some mechanism (I favor Dean Baker’s idea of a financial transaction tax as a start)
• That overly complex financial instruments should be banned.
• That the means of determining pay and bonuses in the financial services industry needs to be mended somehow, because the current model encourages reckless behavior.