Econned by Yves Smith: A Book Review

Not often is the public permitted the opportunity to see the chicanery and of the financial industry exposed. Yves Smith, in her timely new title Econned, takes us behind the walls of Jericho that the financial industry hides behind to provide us a rare glimpse of the predatory, criminal, or borderline criminal activity embedded in Wall Street’s behavior.

Econned makes a bold claim that the “hard science” of economics has conned not only their own devotees and policymakers but also the public. The publics need to know this information. That much is essential. For it is the public at large who are the true stakeholders, whose economic interests are negatively impacted by the policy decisions that have been made based on the hard science of mainstream economics.

The “hard science” of mainstream economics, as Yves Smith points out, is a bit of a misnomer or euphemism. Much to the detriment of the public, false assurances, misleading euphemisms and claims of mainstream economics are at the heart of shaping public opinion and influencing policies that produce bad socio-economic outcomes.

Simply by raising public awareness, Econned, can help point us towards producing better socio-economic outcomes in the future. At a minimum, Econned should be included in the curriculums of college social science and business classes and thoroughly discussed. But it would be best if Econned were also made accessible to students in high school curriculums.

Ms. Smith opens Econned with a quote from John F Kennedy “Belief in myths allow the comfort of opinion without the discomfort of thought.” If the hard science of mainstream economics can be falsified, as Smith sets out and does in Econned, then mainstream economics is but a myth, loaded with ideological opinions devoid of much credible thought. A harsh indictment indeed! This ideological mythology, asserts Ms Smith, has been both dangerous and destructive to society. “Phony precepts of neoclassical economics helped bring about the financial crisis by endorsing policies and practices that allowed financial firms to exploit customers, shareholders, and taxpayers on a scale heretofore seen only in banana republics” says Ms. Smith.

Unfortunately for the public, the economic policies pursued by our policymakers, the same ones which produced what mainstream economists call the ‘Great Moderation’ (an economy of almost uninterrupted and unfettered growth with nary a downturn or severe recession and only intermittent mid-cycle expansion slowdowns) has produced what Yves calls a Potemkin, or false and illusory, prosperity. Ms. Smith describes the Great Moderation as having been produced by policies akin to that of steroid-abusing body builders. Deprived of steroids, these bodies waste away. Unfortunately, a wasting of America’s prosperity has come to pass as the dangerous destructive side effects of these policies take over.

Flawed policies based on economic myths and delusions have landed the US and many other economies into the throes of the worst economic crisis since the Great Depression. In terms of orders of magnitude, while there are differences of degree, the economic outcomes are not terribly different between this so-called Great Recession with that of the Great Depression (just consider the persistent and prolonged high double digit underemployment rate in 2010 that won’t go away as one case in point). By another name, these economic outcomes could be called a form of ‘shock therapy.’

Turning our attention to the bad business practices and bad corporate actors that contributed to the magnitude and scope of the financial crisis, there was clear and widespread fraud and securities law violations, almost no one has ever been prosecuted or accused of any criminal wrong-doing. Time after time, at Congressional hearings, and elsewhere throughout media channels the language used by lawmakers and others simply describe the criminal behaviors of the past few decades as “mistakes.” The lexicon used by lawmakers and the media must change asserts Ms. Smith. “Until we learn to call looting by its proper name, it is certain to continue” she contends. These ‘mistakes’ need to be legally reclassified as ‘criminal behavior.’

Mainstream economists, Ms. Smith points out, have also suffered from, and continue to suffer from their own cognitive biases. They have been overconfident, and have placed “undue faith in their own models” in the face of overwhelming contradictory evidence.

Economics is a highly complex social science. While good models filter out the “noise” all modeling “entails the loss of information.” This is an inherent weakness shared by all modeling. The weakness is problematic, Ms Smith observes, “because what was discarded to make the problem manageable may have been essential.” Worse yet, people engaged in modeling might be the last to see the shortcomings of their own economic constructs causing them to “stop engaging in critical thinking about one facet of a problem.” The most serious flaw regarding traditional neoclassical economic models are that they assume stability and certainty. These conditions simply do not empirically exist in the real world.

The conclusions drawn from the flawed assumptions built into these models simply do not follow. They are a non-sequitur. Worse, when implemented in risk management or economic policies, these models produce destructive socio-economic outcomes. Market forces are not efficient self-righting systems tending towards equilibrium and stability as neoclassical economists assume. Market forces can oftentimes be highly unstable, inefficient, and inherently uncertain, particularly when excessive leverage is involved (errantly permitted by regulators).

Even where economic assumptions are not flawed, mainstream economic theory is seldom tested making it very difficult to either prove or falsify. Economic theory that can’t be validated or confirmed should be considered meaningless noise and only so much drivel. Unfortunately, modern economic theory is far from meaningless or irrelevant to the public. The economic constructs behind these theories drive policy and have and continue to negatively impact the lives of millions of people.

Ms. Smith’ is not alone in her harsh indictment of the dismal science. Even before the economic crisis hit in 2007, many others had written books in the 1990s with a dismal view of mainstream economic theory as can be seen from the titles, Against Economics, The Death of Economics, and The Crisis of Vision in Mainstream Economic Thought.

Economic professor Peter Dorfman asserts that “economic theory taken as a whole is culpable…even though every organ of [the] 1960’s-era orthodoxy is mortally wounded, the entire body strides vigorously forward.” Problematically, nobody has been listening to the critics.

And that is not the worst of it. Cherished but flawed ideologies put forth by neoclassical economic thinkers from the 1960s have been preserved and zombified by many of today’s prominent and mainstream economists. Prominent economists cling to the flawed theories of this dominant ideology as articles of faith. This would not matter so if these same walking zombies of economic thought did not continue to shape public policy in harmful ways. Even after the financial crisis of 2008-09, the response of policymakers, through TARP, FinReg and other legislation, has been to preserve and zombify the same institutions which embraced the economic ideology that created the disaster. In this sense, public policymakers have truly lost their way, making things that much more challenging for middle class Americans. To the extent that the financial reform response of policymakers preserves and perpetuates the same financial system that played such a large role in creating this crisis of epic proportion, policymakers no longer serve the public interest. This is something we should bear in mind when these officials are up for re-election in November 2010 and beyond.

NY Times journalist David Leonhardt wrote an article called Making Economics Relevant Again in 2008. However, economics have been all too relevant and in highly destructive ways to the lives of far too many people. The aim should be to make economics less toxic and less relevant to the lives of everyday people. Ideally, folks should be largely unaware of the influence of economic policy on their everyday lives.

In chapter 3 Yves Smith details the evolution of modern financial economic theory. She begins with a tidy quote from the maestro, Alan Greenspan who in recent years observed with hindsight acumen that despite the combined “best insights from mathematicians and finance experts” the “whole intellectual edifice [of modern financial theory] collapsed.” (The question I ask is why have we allowed bank lobbyists, lawmakers, and policymakers to put the Humpty Dumpty edifice back together again after the financial system collapsed in September 2008?)

Yves Smith then proceeds to detail in easy to understand language the entire history of the economic constructs and financial models embraced by these financial experts. Yves begins this discussion with the fair game of chance, normal or Gaussian distribution, efficient market hypothesis EMH, Sharpe ratios, Black-Sholes, CAPM, and VAR. These are our modern day financial models and constructs. They have all been built upon the flawed assumptions of normal probability distributions, rational and efficient market behavior, stability, and predictability. Because of these flawed assumptions, “financial engineers had erected an edifice on quicksand,” Ms. Smith asserts. Worse, these flawed assumptions encouraged excessive leverage and risk-taking behaviors. These models led these financial engineers and innovators to be overconfident in their models; thus ignoring or overlooking significant tail risks, correlation risks and liquidity risks. In the end, these financial engineers, for all their so-called innovations, have all vastly misunderstood the grossly underestimated risk in a remarkable fashion and proceeded to build nothing more substantial than castles in the sand that were swept out to sea at the first sign of countercyclical adversity. And economic outcomes we find are not ‘normally distributed.’ For the banksters it was a game of heads I win, tails and the taxpayer loses.

Unfortunately, the US government rewarded the financial innovators with a taxpayer financed bailout. And then the financial innovators proceeded to award themselves with taxpayer financed record bonuses in 2009. The government’s flawed rational for the taxpayer bailout was that these firms were deemed to be too tightly coupled and too big to fail based on the fear-mongering opinions of the Federal Reserve chairman Ben Bernanke and US Treasury Secretary Hank Paulson. They ‘assumed’ the end of the world as they knew and understood it. They advocated the preservation of their Humpty Dumpty edifices, as any other reality would have been too horrific and painful to ponder. Thus another shot of steroids for the financial system was thus prescribed by the US government. In the aftermath, policymakers have rushed in to claim ‘mission accomplished,’ that all is well and will be well. Such reassurances that claim Nunca Mas, from the new US Secretary Treasury Timothy Geithner and other that this financial crisis will never be allowed to happen again, ring false and provide cold comfort.

In Chapters 4 and 5 Ms. Smith turns her attention to the framework of the dominant economic theory that has influenced mainstream thought and economic policy over the past 50 years: ‘laissez-faire neoclassical economics.’ The father of neoclassical economics, Milton Friedman understood there were many flaws to the theories of neoclassical economics; namely, that most every assumption of neoclassical theory is largely counterfactual.

However, Friedman’s opinion was that the real test of a theory is whether it “works.” That is all that mattered. Beyond all the counterfactual assumptions, which border on absurdities when examined critically, one of the most harmful effects of this school of thought is that they have howled incessantly over the past 40 years whenever there was any attempt to regulate the so-called “free markets” of capitalism. The Friedmanites have systematically branded all government intervention and regulations as interferences that distort one of their primary missions; namely, to ensure unfettered “free markets.” Under Ms. Smith’s critical examination, what we find is an economic theory “riddled with holes masquerading as science,” driving policy for nearly three decades.

In Chapters 6 and 7 Ms Smith tackles how ‘deregulation’ of the financial industry paved the way for predation and looting. Friedmanites and ‘free-market’ advocates held two ‘fixed ideas’ above all else. The first proposition was that all regulation was unequivocally bad and always produces suboptimal economic outcomes. The second proposition is that “government is incompetent.” Thus deregulation and self-regulation was strongly endorsed by bank lobbyists. Over the past thirty years, lobbyists accomplished their aim.

However, it did not take Ms. Smith long to disprove and shred both those free-makret propositions as false. Yves simply points to vivid historical precedents: free-market doctrines have repeatedly and abysmally failed whenever imposed on society. As Friedmanites spread their free-market ideologies throughout third world countries between 1970-2002, we learned time after time that the social costs of free market principles were enormous and too high a price to pay.

Historian Eduardo Galeano described how ‘free-market’ theories worked out when applied: “People went to prison so prices could be free.” Galeano grossly understates the political suppression, torture and death that accompanied the implementation of these free market experiments on country after country. This has been going on without interruption throughout the world for more than 30 years. Author of Shocked Doctrine, Naomi Klein, goes to painstaking efforts to detail this ugly history more fully. Today, the countries now feeling the brunt of the free-market ideologies ‘shock therapy’ appear to be the developed countries in Europe and America. Fiscal austerity, high structural unemployment, and so much worse yet to come are features of the free-market ideology. So, it is highly relevant and critical that the public understand as fully as possible the dark side of free-market principles still wreaking havoc throughout societies today.

As the financial system became increasingly deregulated in the 1980s and 1990s, rather than fulfilling their social utility, the more predatory the financial system became. The financial system grossly exceeded their traditional role in society. A month before the 1994 Mexican Peso blew up, a former Morgan Stanley derivatives salesman observed: “You have to be criminal to be good at this business.” In short, you had to be a bad corporate actor to really succeed in the financial industry, and this has been the norm for more than twenty years, think back to Drexel Burnham Lambert and other bad corporate actors in the 1980s.

To fully appreciate the full extent of predation, looting, fraud, securities violations, and other malfeasances as well as the government’s ongoing complicitousness (legalizing, backstopping, and incentivizing the financial industry to gamble with other peoples money (OTM), loot ‘go for broke’), you really must read the rest of the story as told by Yves Smith in Econned. The further Yves delves into the underbelly of the beast, the darker and more unseemly the story becomes. It is far darker than you can likely imagine. When all is said and done, there is nothing to be proud of here. The legacy Wall Street, policymakers, lawmakers, and regulators left behind is ultimately one of shame.

This is a story that must be read and understood as far and wide as possible, because even after the passage of financial regulation in July 2010, the reckless behaviors of Wall Street continue largely unabated, not in spite of the new financial regulation reform bill, but because of it.

Yves Smith is also publisher of NakedCapitalism.com, one of the top ranked financial-economic blogsites out there. Someone once said that it’s not what you read, but who you read that matters. Yves shares freely everything that she knows about current and past events on her blogsite, and I promise you it is substantial. Personally, I faithfully read Yves Smith’s blog every day. What I learn when I read Yves Smith is simply amazing. I promise that when you read Econned, you will be reading not only a highly relevant title, but one that will endure as a timeless title in the annals of our financial and political history.

Cheers!