Predicting a Monetary Hurricane - Vivek Kaul's Diary
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Predicting a Monetary Hurricane

Jan 9, 2017

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Should the bank of England have seen the 2008 financial crisis coming?

Everyone's favourite economist Andrew Haldane - chief Bank of England economist and "let's abolish cash and impose negative interest rates" proponent - certainly thinks so.

He may or may not be right. Plenty of people did see the financial crisis coming. Not many of them were in positions of authority. But then, there's a difference between authority and credibility.

But that's all ancient history now. What's more worrying is the logic behind what Haldane said. It's dangerous and misguided. It shows a flaw in the thinking of the people "in charge" of the economy. And it could end up putting your wealth in real danger.

A big claim for a Monday morning I know! Let me explain what I mean.

Haldane compared the bank not seeing the crisis coming, to meteorologist Michael Fish claiming in 1987 that Britain wouldn't be hit by a hurricane. He was wrong. So was the bank. Haldane wants to explain why. Here's an excerpt from his speech.

  • It's a fair cop to say the profession is to some degree in crisis. It's not the first time it has happened. It happened back in the 1930s and [during] the Great Depression.

    But out of that something good spread. It brought us [John Maynard] Keynes and the birth of modern macro-economics. Out of this crisis, there could be a rebirth of economics. I'm not someone who would say that all that's been done in the past is terrible. It's just that the models we had were rather narrow and fragile. The problem came when the world was tipped upside down and those models were ill-equipped to making sense of behaviours that were deeply irrational.
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Here's an idea for why the profession is in crisis. It's a profession that pretends to be a science, when it's not. So for all the seemingly-scientific models and forecasts, it's really just a case of observing something that's far too complex to be fully understood, and then using those observations to interfere.

That's the real problem - and the real danger.

Consider the analogy he makes between economic forecasters and meteorologists. There are some similarities. They both involve closely observing a complex system (the weather, the economy) and using those observations to make forecasts. You can never know what will happen; only guess from what is happening.

But there are two key differences.

Firstly, meteorology is a science. There are certain things we know to be scientifically, provably true. All things being equal, hot air will always rise. That's a fact. You can run that test as many times as you like. It's a "known".

Economics isn't based on those principles. That's because it involves people's decisions, which involve unpredictable emotions. If you send interest rates negative, will that make people spend or hoard capital? You can't know. You can guess. But until you do it, you don't know. And if you repeat the experiment you may get a completely different result, based on the mood and psychology of the actors within the economy.

The second point is even more fundamental. Meteorologists observe and forecast the weather. They don't then interfere to try and create a "desirable" outcome. Economists do. At least, those at central banks do. They observe, forecast and then interfere in the economy to try and change things.

To complete the analogy, a meteorologist doesn't sit down and say "let's try and find the optimal level of rainfall for the nation this year". Perhaps they could. They could attempt to geo-engineer the world to find what they consider the "correct" amount. But think about how dangerous that would be - how could anyone ever know what is or isn't "correct"?

Central banks do exactly this. They don't observe, they interfere. They set interest rates (which leads to credit bubbles blowing up and bursting if they're too low). They can inject capital into the markets to "correct" things. Maybe next year they'll start making the sun shine more to stimulate the economy. Maybe that's what Mr Haldane is trying to tell us!

Either way, it's a dangerous analogy and a dangerous logic. And it serves as a reminder of just how the people "in charge" of our nations' monetary system think.

Please note: This article was first published in Capital and Conflict on January 09, 2016.

Nick O'Connor is a writer and editor at Moneyweek. He is also the publisher of Exponential Investor.

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