The Dismal Science has never been more dismal. Economics as a profession, a science, or policymaking tool is under widespread attack.
Thomas Carlyle, a Scottish historian of the 19th century, gave economics the nickname "dismal science" in response to economist Thomas Malthus’ 18th century prediction that population growth was exceeding the rate of growth in the food supply and widespread starvation would result. Today, economists’ failures to predict the current recession, or at least its severity, and a lack of consensus as to what should be done, are destroying their reputations.
The Economist magazine recently wrote that “In the public mind an arrogant profession has been humbled.” Likewise, the April 16 cover of Business Week read “What Good Are Economists Anyway”.
Writing in the Financial Times, Paul De Grauwe, professor of economics at the University of Leuven, said, “Before the financial crisis, most macroeconomists were blinded by the idea that efficient markets would take care of themselves. They did not bother to put financial markets and the banking sector into their models. This is a major flaw.”
If the economic models (macroeconomics) were correct, capital markets and banking sector (financial economics) would be perfectly competitive, that is, supply would always equal demand. However, in reality these markets are not perfect.
The problem is not a failure of the market models, but a failure of the markets themselves.
A market failure is any situation where the market left on its own fails to allocate resources efficiently. These markets will operate inefficiently (i.e., fail) when one of two broad conditions is present – an externality or market power.
An externality is an impact from one person’s actions on the well-being of a bystander. Market power is the ability of a single market participant (or a small group) to substantially influence market prices. Market power is clearly present in the capital markets.
A small group of capital market participants has substantial influence in the capital markets, particularly on interest rates. The stock market remains broadly competitive and thus relatively efficient.
The Wall Street Journal reported this week that more employers are including low-cost index funds and exchange-traded funds in 401(k) retirement plans. This trend is in response to long running evidence of stock market efficiency – passively managed index funds consistently outperform actively managed mutual funds.
The bond, or debt, markets are not equally efficient because of two market-power cases. First, the banking industry is highly concentrated, reducing the ability to compete in lending markets. Second, the U.S. Federal Reserve system faces only limited competition in the market for money.
According the first-quarter report of the Federal Deposit Insurance Corp., there are 8,246 financial institutions in the United States, of which 78 percent were profitable, and the industry as a whole earned $7.56 billion. However, only 1.4 percent of the institutions (115) accounted for 92 percent of these profits ($6.976 billion).
This concentration of market power is only getting larger during this recession. Large banks like Goldman Sachs, JP Morgan and Credit Suisse all reported improved profit and market share this week.
Meanwhile, the Fed faces little worry about value of the dollar. In testimony before Congress this week Federal Reserve Chairman Ben Bernanke said “the financial shocks that hit the global economy in September and October were the worst since the 1930s, and they helped push the global economy into the deepest recession since World War II.”
Despite such terrible conditions the U.S. dollar has risen over 5 percent against other currencies. The Fed faces little competition in the supply of money it makes available.
Earlier this year economist Judy Shelton pointed out the irony of this market power, writing in The Wall Street Journal, “Given that the driving force of free-market capitalism is competition, it stands to reason that the best way to improve money is through currency competition. Individuals should be able to choose whether they wish to carry out their personal economic transactions using the paper currency offered by the government, or to conduct their affairs using voluntary private contracts linked to payment in gold or silver.”
Competition for the dollar could come from such a change in its legal status, or indirectly from improvements in the capital markets of other currencies. Investors may soon gain more confidence in the currencies of developing countries like India and Brazil, and the power of the Fed over interest rates will wane.
U.S. Treasury Secretary Timothy Geithner this week is urging Congress to revamp the financial regulatory system by the end of the year. Any new legislation should aim to improve competitive issues across both the domestic and international money markets.
Economists could change their models and not assume perfect competition, or regulatory conditions can improve competition. Changing the models, unfortunately, leads to only more dismal economics. Improving competition makes everyone better off.
Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.