Cognitive Dissonance and Financial Crisis

I'll never forget how in the first economics course I took, the professor remarked early on, "The problem with the world is that it's ran by lawyers instead of economists." Though most economists probably wouldn't put it so bluntly, this is a common undercurrent of the field. We economists have been trying to get governments to stop doing stupid shit for almost 250 years now, and the results have been less than inspiring.

Except, it would seem, for that holy grail of economic governance: monetary policy. When the Federal Reserve totally lost its shit and kicked the economy when it was down, took its wallet, and pulled its pants down back in the 30s, it was because several of the people on the board of governors had absolutely no economics training whatsoever and didn't know what they were doing. The Fed was primarily a political grab-bag, just like the rest of the government, and economists didn't have much more influence over it than any other political institution.

But over the years economists rallied around the high cause of an independent central bank managed by - go figure - economists who would actually know how to prevent depressions and severe inflation from happening. And starting in the late 70s with the appointment of Paul Volcker all our hard work finally started paying off. When Ben Bernanke took over as Chairman in 2006 it looked like the apotheosis of economics. Here was an Ivy-league academic and world premier of macroeconomics, a man who had publicly stated that the Fed had caused the Great Depression, who had written extensively on how, with proper guidance, it could be used to prevent another one, now running the most important economic institution in the world. Take that, law professors!

As central banks became more and more temples for economists, economists, including Bernanke, began hailing a new age, the "Great Moderation." With us experts at the helm, it was gonna be smooth sailing from here on; no more pesky government types getting in the way of Maximum Sustainable Economic Growth.

Well, for reasons I cannot quite fathom, at the first sign of trouble, the macro textbook went out the window, and Bernanke let those drunken government sailors back in the captain's room, with trillion-dollar corporate bailouts, trillion-dollar pork-barrel "stimulus," deflation and double-digit unemployment as a result. Now, the proper response by the economics profession to all of this should have been mutiny. Instead, mainstream macro went into hiding and Keynesianism and ad-hoc interventionism rose from the grave. I happened to be taking a course on central banking and monetary policy during Fall 2008, at the height of the crisis. We started by having to model the effects of changes in the federal funds rate or the discount window on the price level, but as events developed we had to start building models of the the Term Auction Facility, the Primary Dealer Credit Facility, the Money-Market Investor Funding Facility, the Commercial Paper Lending Facility, the Term Asset-Backed Securities Loan Facility, and the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. We wrote essays on subprime mortgages, shadow banking, collateralized debt obligations, credit default swaps, and asset-backed securities. Price stability was rarely talked about. Never was it considered that perhaps all of this was bullshit.

So why did economists so quickly start cheerleading for policies and theories they would have condemned a few short years ago? I think a large part of the answer has something to do with cognitive dissonance. The thinking goes something like this:

The Fed is run by economists
Economists would do everything necessary to prevent another Great Depression
Therefore everything the Fed is doing is necessary

Throughout the Great Moderation, this was a reasonable syllogism to hold, and I think it got to the point where it became part of economists' identity. So when it got to the point that "everything the Fed is doing" had nothing to do with mainstream macroeconomic theory, indeed was the exact opposite of what mainstream macroeconomists such as Bernanke advised Japan to do under similar circumstances, the contradiction forced economists to either discard their syllogistic faith in the Fed or the power of their macro models. Unfortunately, most went for the latter, they said "This time is different" everything has been obfuscated by the complexity of the financial system, and the Fed had to use "unconventional methods" to save it from systemic collapse.

A more realistic interpretation, I think, is that power still corrupts, even economists, even world-renowned ones like Ben Bernanke. His actions these past couple years have been drawn not so much from Principles of Macroeconomics, but from Machiavelli's The Prince. Economists still consider him one of their own and so it's all glossed over. I imagine that, just as Milton Friedman shined a light on the Great Depression and showed us the true cause, economists will someday look back and realize, once again, that this time it was the Fed's fault too. But I wonder if it'll make any difference.