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Uneconomic Economics and the Crisis

of the Model World

DOI: 10.1057/9781137385499.0001
Building a Sustainable Political Economy: SPERI Research & Policy

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DOI: 10.1057/9781137385499.0001
Uneconomic Economics
and the Crisis of the
Model World
Matthew Watson
Professor of Political Economy, University of
Warwick, UK
ESRC Professorial Fellow, 20132016

DOI: 10.1057/9781137385499.0001
Matthew Watson 2014
Softcover reprint of the hardcover 1st edition 2014 978-1-137-38548-2
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ISBN: 9781137385499 PDF
ISBN: 978-1-349-48126-2

A catalogue record for this book is available from the British Library.
A catalog record for this book is available from the Library of Congress.
doi: 10.1057/9781137385499
To my new nephew, Nathan. Welcome to the family.

DOI: 10.1057/9781137385499.0001

Acknowledgements viii
List of Abbreviations x
1 Setting the Scene: From a Crisis of Economics
to a Crisis of the State 1
Introduction 2
Competing crisis narratives of symptom
and disease 3
The rehabilitation of economic theory 8
The crisis and the economics curriculum 12
Structure of the book 17
2 The Collapse of the Model World: From Faith in
Equations to Unsustainable Asset Bubbles 20
Introduction 21
The growth of increasingly complex
secondary mortgage markets 25
The uneconomic economics of asset-price
valuation techniques 30
Performativity and counter-performativity
in financial markets 36
Conclusion 41
3 The Creation of the Model World: From
Formalist Techniques to the Triumph of
Uneconomic Economics 45
Introduction 46
The return of the policy ineffectiveness
proposition 49

vi DOI: 10.1057/9781137385499.0001
Contents vii

The quest for a fully specified general equilibrium

framework 55
Formalist technique and the logic of market
self-regulation 59
Conclusion 65
4 Looking Ahead: From Uneconomic Economics to
a Different Future 68
Introduction 69
The definition of good economics 70
The significance of historicised method 75
Final words 80
References 84
Index 102

DOI: 10.1057/9781137385499.0001
This book had its genesis through a very fortunate coinci-
dence of events. In the same week that I was asked to review
the application for the SPERI Palgrave Pivot Series, Building
a Sustainable Political Economy, I was in London attending
an interview for an ESRC Professorial Fellowship. The con-
versation turned at the instigation of the interviewers to
whether it might be possible to use the underlying insights
from my proposed Rethinking the Market project to join
the now voluminous debate about the implications of the
global financial crisis. This struck me as being a very good
idea whether or not I was awarded the Fellowship, and I
determined at once to look into the possibility of writing
a book from this perspective for the SPERI Palgrave Pivot
Series. The result of the subsequent endeavours is what
appears in the pages ahead.
Luckily for me, the story has a double happy ending in
that I was awarded the Fellowship to pursue my project: I would like to
thank the Economic and Social Research Council for its
continuing support of my research, as well as for all the
opportunities for continued publishing that have opened
up from the award of a three-year Professorial Fellowship.
This, then, will be the first of a number of books on related
themes to appear over the next few years.
In itself, it represents where my thinking has currently
evolved to since I first began to explore the relationship
between economists purely abstract use of a device
they call the market and the actual markets that can be
encountered in everyday life. I suspect that in continued

viii DOI: 10.1057/9781137385499.0002

Acknowledgements ix

conversations about this issue I will find plentiful reasons to allow my

thinking to move on even further in the future. I certainly know how
much it has benefited from similar conversations in the past. These have
been too numerous for me to identify people by name without running
the risk of a series of very important omissions from the ensuing list. For
that reason I hope that colleagues past and present from Warwick and
beyond, peers and friends within the profession and, perhaps above all,
successive cohorts of my PhD students will forgive me if I consequently
offer a generic thank you for all that everyone has done to shape the
research which appears here. It is by no means a less heartfelt gesture of
appreciation for appearing in this form.

DOI: 10.1057/9781137385499.0002
List of Abbreviations
CDO collateralised debt obligation
CDS credit default swap
DSGE dynamic stochastic general equilibrium
EMH efficient markets hypothesis
MBS mortgage-backed security
QAA Quality Assurance Agency
RAE Research Assessment Exercise
REF Research Excellence Framework

x DOI: 10.1057/9781137385499.0003
Setting the Scene:
From a Crisis of Economics
to a Crisis of the State

Abstract: The financial crisis which began in 2007 has seen

villains latterly recast as saviours and blame subsequently
apportioned to people whose actions played no part in its
causes. The social authority of orthodox economics opinion
has been restored the more that the dominant political
narrative of the crisis has come to rest on a government living
beyond its means. State-of-the-art macroeconomic models
were silent on the problems being stored up as asset prices hit
a bubble phase, but they come complete with a readymade
solution for allegedly excessive imbalance in the public
finances. Prominent financial models in their turn ruled out
the very possibility of irrational bubble phenomena, but they
also have no difficulty highlighting the way in which deficit
spending distorts the pricing mechanism.

Keywords: austerity; bank recapitalisation; fat tails;

global financial crisis; quantitative easing; uneconomic

Watson, Matthew. Uneconomic Economics and the Crisis of

the Model World. Basingstoke: Palgrave Macmillan, 2014.
doi: 10.1057/9781137385499.0004.

DOI: 10.1057/9781137385499.0004
Uneconomic Economics and the Crisis of the Model World


Economic crises are there to be won and lost; argued over and written
about; defined into and out of existence; influenced, shaped and recon-
stituted. Events never reach a critical point solely because of their own
internal logic, but need to be tuned into as a potential threat to everyday
normalities (Innes 2004: 352). They must be named explicitly through a
particular problem frame if they are ever to be genuinely experienced as
a crisis: the activation of a fear machine might well be conducive to such
an outcome (Altheide 2002: 41). Whereas an economic recession has an
official definition which provides it with a formal start and end point,
economic crises are much more ephemeral entities linked as much to
a manufactured emotional state within society at large as any statistical
indicator of whether or not a critical limit has been breached.
The process of naming a crisis, of course, is deeply politicised (Cohen
1972: 204). Crises can be explained away in one form just as readily as
they can be explained in another, and blame can be avoided in exactly
the same breath as it can be attributed. The distribution of responsibil-
ity is a fundamental aspect of narrating a crisis, and because any given
event sustains a number of different causal narratives the imposition
of responsibility is always a negotiated process. Political mobilisation
around competing crisis constructions is designed to get members of the
general public to endorse the idea that they are not only living through
a critical moment but are experiencing a particular type of crisis. In
other words, they must be made to believe that events have unfolded in
a specific way if they are to consent to being led away from their causes
in an equally specific political direction. The ultimate political effects of
a crisis are always every bit as much about the narration of the underly-
ing condition as about its materiality: crises must be felt as well as lived
(Furedi 2005: 131).
All of this is certainly the case with the difficulties that have engulfed
the British economy since the spectacular downturn in the fortunes
of the financial sector in 2007. The materiality of the events resulted
from the self-interested decisions taken within the banking sector in
the search for greater profits, higher rates of remuneration and an ever
expanding bonus pool. Yet from the subsequent pattern of blame that has
shaped political constructions of the recent past it no longer feels that
way (Johal, Moran and Williams 2012: 71). We see around us successful
attempts to initiate a crisis narrative which separates the materiality of

DOI: 10.1057/9781137385499.0004
Setting the Scene

the underlying situation from the political effects of the response. There
is a distinct possibility that this will be remembered as the first financial
crisis in history in which finance was exonerated. In this book I try to
tell the story of how this has happened, as well as charting the influence
that shifting crisis narratives have had on the perceived respectability of
orthodox economics opinion.

Competing crisis narratives of

symptom and disease

Almost every other financial crisis has been followed by efforts to use the
political system to exact penitence from the banking sector in the form
of tighter controls on its range of activities. Today, by contrast, precious
little thought is being given in Westminster to systematically reconfigur-
ing the role of finance in everyday life as a means of bringing greater
balance to the British economy. The only rebalancing being sought is to
attack the alleged culture of welfare dependency that is purported to be
evidence of a wider social malaise. It should go without saying that it
was not benefit claimants who dreamt up the wonderfully exotic credit
default swaps that allowed synthetic collateralised debt obligations to
be constructed from mortgage-backed securities, and therefore they
should be immune from criticism as the resulting markets imploded
and brought the worlds financial system to its knees. But this is to miss
the point. The most important lesson from the past few years is that the
political direction in which this particular crisis is being exited depends
not on what actually happened to trigger it but on what type of crisis
it is now deemed to be. The collapse of financial markets has passed in
popular political narration from being a condition caused by the flawed
trading strategies of banks to something that can be put right only by
curtailing the excessive generosity of the welfare state. Despite the pres-
ence of consistent dissent from this view from beyond parliamentary
politics, the divorce of the dominant crisis narrative from the underlying
materiality looks as if it might be almost wholly complete.
What we have seen is first the development of two distinct narrative
structures and then their increasing separation. They can be thought
of in terms of the particular crisis symptoms and the underlying crisis
disease, and are distinguishable insofar as the former is directed at the
immediate imperative of stopping things from getting completely out

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Uneconomic Economics and the Crisis of the Model World

of hand and the latter at preventing easy reoccurrences. A convincing

holistic crisis narrative should seek to tie the two together in a plausi-
ble move from discussing visible pressure points at a given moment in
time to discussing their source. There is no necessary reason, though,
why such a happy marriage will prevail, as the British example nicely
In the immediacy of the most threatening days in 2007 and 2008 the
crisis symptoms were located squarely within the banking sector and the
feverish political activity that ensued was conducted solely in the inter-
ests of preventing banks from going under. Such activity has by no means
disappeared, even if its intensity has become somewhat muted. The Bank
of England, for instance, has racked up nearly 400 billion of public debt
ownership through its quantitative easing programme in the first five
years of that programmes life (Bank of England 2012: 4). Subsequently,
however, the underlying disease has come to be understood very differ-
ently from the symptoms which presumably brought the disease to light
in the first place. The quantitative easing programme has passed from
being an emergency measure introduced pretty much on the hoof to an
increasingly normal component of the technical interventions designed
to stimulate new forms of growth. The spotlight of the dominant crisis
narrative has been refocused elsewhere.
This is an important development and thus deserves further attention.
The alternative to saving the banks from their own mistakes was never
seriously contemplated by the Labour Government, either when the run
on Northern Rock occurred in September 2007 or when there was a
real prospect of cascading bank collapses in the autumn of 2008 during
the post-Lehmans phase of the financial unravelling. The only question
being asked was how to proceed with the rescue rather than whether to
act in this way.
The first solution to be tried was to flood the short-term inter-bank
lending market with new money, in the hope that this would be enough
in itself to keep the banks in their trading positions, to eliminate the risk
of default and therefore to buy the time to allow the banks to unwind
their own increasingly dysfunctional investments in mortgage-backed
securities. This strategy was exemplified most obviously by first the
introduction and then the extension of the Special Liquidity Scheme
in April and September 2008 (Bank of England 2008a). The Bank of
England positioned itself as the only willing buyer in the increasingly
distressed market for mortgage-backed securities, making itself available

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Setting the Scene

to purchase those assets at the pre-crash price first by engineering swaps

at that price with triple-A rated government debt offerings and then
through direct cash transactions. Banks with balance sheet problems
received a windfall payment roughly five times the prevailing market
price to conclude the deals, the aim of such state-sponsored largesse
being to ensure that their overall positions remained liquid (Watson
2009a: 425; 2009b: 186).
At this stage the crisis symptoms were being thought of in terms of the
absence of adequate levels of market liquidity to keep banks in their out-
standing trading positions (Langley 2010: 78), whilst discussions of the
wider crisis disease referred overwhelmingly to an imploding financial
logic (Roubini and Mihm 2010: 88). However, the problems persisted,
reaching a new acute stage in late autumn 2008 in the aftermath of the
US Treasury allowing Lehmans to collapse. This persuaded the Labour
Government to lead the way internationally in guaranteeing the contin-
ued solvency of the banking structure, promising to take public stakes
in individual banks as a form of deposit insurance (Eichengreen 2008:
20). The perceived crisis symptoms thus changed from, on the one hand,
a lack of liquidity preventing banks from continuing to execute their
trades to, on the other hand, a lack of capital preventing banks from
showing that they would definitely stay in business. Nonetheless, a crisis
of capitalisation narrative still situated the wider disease solely within
the financial sector.
Looking back from todays perspective this all seems a very long time
ago. The original narrative of crisis symptoms today makes little sense in
relation to the now constant refrain that nothing will change for the bet-
ter until public expenditure is once again brought to heel. This changes
the dramatis personae of the crisis in fundamental ways. The bankers
who innovated in complex financial instruments for the purpose of self-
enrichment have been allowed to exit stage left. They have been replaced
from stage right by anyone whose livelihood depends on transfer pay-
ments made available by the state. The materiality of the crisis has been
explained away in an attempt to design into the dominant crisis narra-
tive solutions intended to promote individual character as a substitute
for welfare support. An ideological move has thus very definitely been
What interests me in particular in this specific instance of crisis
displacement is the effect that the shift has had on the reputation of
orthodox economics opinion. It has not been widely commented on in

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Uneconomic Economics and the Crisis of the Model World

the academic literature until now, but there was another crisis narrative
that was prominent in 2007 and 2008 but which has increasingly slipped
off the radar again today. This was the very forcefully argued feeling
that the financial crisis also represented a crisis of economics. For as
long as the banks were at the forefront of suppositions about what had
gone wrong with the world economy, economics was placed alongside
it in the dock. The increasingly complex structure of assets being traded
in secondary mortgage markets had, after all, first seen the light of day
in the pages of economics journals. The same was certainly true also
of the flawed assumptions about mortgage default correlation which
persuaded traders to flock to those markets. Wherever one looked for
explanations of how financial market actors had come to cause such
damage to their own behavioural environment, the influence of main-
stream economics models was not far from the surface. Economics,
it was said, had questions to answer because of its involvement in the
design of underlying market conditions that eventually brought about
the ensuing sense of crisis. That questioning stance, though, did not
last long. The subsequent eclipse of crisis narratives locating the wider
disease in the financial sphere has rejuvenated orthodox economics
opinion and restored it to the position of social authority it had enjoyed
for some time before the crisis.
By focusing simultaneously on narratives of crisis symptoms and cri-
sis disease I am able to situate myself firmly within the existing political
economy literature on recent events before attempting to transcend it.
There is no real novelty in saying that this was, still is and has always
been in essence a crisis of finance made manifest in banks wilfully
endangering their balance sheet health. Broad agreement exists in the
wider political economy literature that this is where the crisis disease
is located and that only by continuing to name the critical conditions
specifically as those relating to contemporary financial logics is it pos-
sible to tackle the disease at source. This much is evident in what has
been published thus far by academics writing primarily for one another
(for instance, Gamble 2009; Moschella 2010; Grant and Wilson 2012),
by journalists writing for a broader audience (for instance, Mason 2009;
Tett 2009; Kaletsky 2010) and by a number of economists whose recog-
nised role as public intellectuals has allowed them to target the crossover
area between the two (for instance, Krugman 2008; Shiller 2008; Stiglitz
2010). Each intervention into the debate documents in its own way the
moments of high drama that led to the eventual market dysfunctionality.

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Setting the Scene

Yet all insist that the ultimate responsibility for the collapse rests with
those who were trading on the possibility that a greater fool might
always be found to take the most extreme speculative positions off their
hands. The greater fool theory appears frequently in historical accounts
of asset-price bubbles, stating that any price can appear reasonable at the
time it is paid as long as there is no reason to expect that market par-
ticipants will suddenly lose faith in the underlying trajectory of prices
(Taleb 1997: 62; Gauthier 2011: 21).
My point of departure is to move away from the existing literatures
general focus on why, under post hoc examination, it is always possible
to show that such confidence was misplaced (for example, Bennett 2012).
I ask instead about the broader intellectual conditions which allowed
systematic overconfidence that markets always tend towards equilibrium
to take hold in the first place. Adair Turner, Chair of the UK Financial
Services Authority until its abolition in March 2013, spoke in compelling
terms in the earlier stages of the crisis about the problem of regulatory
capture through the intellectual zeitgeist (Turner 2009). In this he was
giving voice to a suspicion long held within the academic literature that
banking regulation had become increasingly prey to instinctively giving
banks what they wanted (Baker 2010: 653). The argument is that if bank-
ing interests are the only lens through which regulatory practice comes
to be conceived then the ensuing regulation is hardly worth the name.
Nothing can be done to assert the need for compliance from the outside
if the outsiders perspective has increasingly become indistinguishable
from the insiders (Persaud 2000: 20).
Whilst recognising this as an important dynamic in its own right, I
wish to push the argument about facilitative conditions one stage further.
The attention thus far in the literature has usually been on the proxim-
ity that emerged at the practical level between banking interests and
banking regulation, but the two were related in more ways besides. Most
importantly they had a common intellectual heritage, with both using
mainstream economics models as the means of visualising the broader
behavioural environment. Intellectual capture thus ran much deeper
than the elite of the banking industry being able to enforce its will in
dealings with regulators (on which see Kay 2012). Insofar as this was a
repeated feature of the pre-crisis context it was possible only because
both sets of actors were taking their cues from mainstream economics
models. Orthodox economics opinion thus acted as a mutual starting
point for both regulators and regulated to understand the most likely

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Uneconomic Economics and the Crisis of the Model World

operation of contemporary financial markets. It gave banks their instinc-

tive feel for the way in which money could be made by trading increas-
ingly complex instruments, and it also gave bank supervisors their feel
for where the outer limits of prudent behaviour were to be located. It is
no great surprise that regulators struggled to rein in purely speculative
trading activities when they were working with the same classes of risk
assessment models that were driving the banks trades (Thirkell-White
2009: 690; Warwick Commission 2009: 28).

The rehabilitation of economic theory

The underlying materiality of most of todays asset markets was dreamt

up in the first instance in the imaginaries of economics before being
made real by the activities of innovating market-makers (Bernstein 1992:
212; Mehrling 2005: 130). Markets of this nature provide the singularly
best example of how an equation designed to express hypothetical pure
market relations can be used in a performative sense to create actual
trading environments. There are few occasions in which equations have
had worlds produced in their own image but, as Donald MacKenzie
(2003: 831) has shown, this is one of them. Moreover, much of the politi-
cal effort that has been expended to try to restart failing markets afresh
has merely been a way of imagining new worlds on the basis of the old
equations (for example, IMF 2009: 77115). The crisis in economics
revealed by the meltdown in supposedly robustly calculable asset prices
has therefore not gone away, even if political priorities to initiate alterna-
tive crisis narratives have at least partially removed it from view.
The challenge of the SPERI Palgrave Pivot Series is to point the way
towards a sustainable recovery that breaks the links with a growth model
which has already failed once too often. A recovery of this nature, I argue,
must involve restoring to a position of prominence the discussion of the
crisis of economics that took place when the dominant crisis narrative was
still resolutely one of finance. It has to acknowledge that, performativity
loops notwithstanding, there is no clear relationship between the dynam-
ics which propel abstract markets in economic theory to their equilib-
rium price and the dynamics enacted in actual markets as individual
traders engage in a process of price discovery. The two types of market
might appear to be of analogous character, but the inverted commas
placed around the only ever abstract market of economic theory signify

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Setting the Scene

an essential difference. It is captured best in the distinction between the

fundamentally economic practices that shape the process of price deter-
mination in actual markets (this being the result of traders learned intui-
tion for how other participants are reading market signals at the time) and
the fundamentally uneconomic practices that show where the equilibrium
price is to be located in an abstract market (this being a property of the
internal logic of the corresponding model). From my perspective, the
route to a sustainable recovery involves transcending the tendency towards
promoting what I call uneconomic economics.
Uneconomic economics results from a significant shift in the orthodox
practices of economists. There was a time when economics was largely
aligned behind the perceived need to understand the historical dynam-
ics that led at one time or another to either functional or dysfunctional
market arrangements (Heilbroner 1989: 10). The objective in this view
of the subject field was always to try to identify verifiable patterns of
economic socialisation to particular price expectations, which in turn
serve as the fulcrum of the underlying form of everyday economic rela-
tions (Oakley 2002: 98). Instead, the focus is now primarily on specify-
ing ideal market conditions read off from the logical implications of the
behavioural axiom of rationality (Davis 1998: 1). No attempt is generally
made to match the postulated logical relationships with observed eco-
nomic socialisation and, as such, the resulting accounts of economic life
are fundamentally uneconomic in nature. The economic essence of eco-
nomics has increasingly been replaced by an aesthetic essence, where the
test of a good argument comes not through confirmation of its contents
but through the elegance of its form (Hutchison 2000: 19).
This has done little so far, though, to diminish the authority of econo-
mists to deliver policy advice (Mirowski and Nik-Khah 2007: 203). There
was a distinct opportunity for this to have changed with the outbreak of
the current crisis in 2007, because at that moment the perceived prestige
of economics was at a noticeably low ebb. That prestige has been restored
with such effect, however, that orthodox economics knowledge in my
terms of the distinctly uneconomic nature now occupies a curious
position which is heavily laden with double standards. It appears to be
the leading authority for deriving insight when the question is how to
create a self-regulating structure of financial markets, but equally also
when the question is changed to how to restore balance to the public
finances after the collapse of such structures has produced the need for a
temporarily sharp increase in public spending. The irony appears to have

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Uneconomic Economics and the Crisis of the Model World

been lost that it is the same assumptions now being used to advocate
austerity measures as were used to promote the market structure which
required large injections of public money to preserve the integrity of its
primary participants trading positions. These incommensurable claims
survive because the alternative in each case is to introduce distortions
into the way that hypothetical market models suggest that real markets
should operate, and this in turn is a pet hate of uneconomic economics.
As governments around the world struggled in 2007 and 2008 to
provide banks with first the liquidity and then the capital they needed to
stay afloat, the uneconomic economics which said that markets should
always be able to match supply with demand found itself massively
compromised as it had no credible claim to provide real-life analogues.
It simply had no explanation for why a systemic credit crunch might
arise when each bank looked at its own balance sheet, assumed that all
other banks were faced with the same problems and then began to doubt
that any of them could be trusted to stay in their trading positions. The
market, its models suggested, would always be able to auto-correct
having discounted one participants changed circumstances. Missing
liquidity was just not a possibility from this perspective because a
trader will always be able to spot the market opportunity arising from
one participants changed circumstances to plug the gap. Equally, when
other governments followed New Labours lead in shifting the focus
of policy to replenishing banks capital base, once more uneconomic
economics was rendered silent. The logic of market self-adjustment
was exploded by the fact that no injection of fresh liquidity, whatever
its size, was having an effect on emboldening investor confidence in the
inter-bank lending market. The only comment that was forthcoming
from orthodox economics opinion at this time was that the models on
which the faltering secondary mortgage markets were based still looked
to be sound in theory. Therefore, a bad apple conjecture was all that was
left to explain how a number of rogue individuals must have corrupted
the market structure. This, of course, was not a view that was likely to
gain much favour at a time when big questions were being asked about
why the economics profession had failed to spot the difficulties as they
were first developing and when the only potentially workable solutions
being offered were from people who consciously positioned themselves
beyond the economics mainstream.
This shows just how important the political efforts to redefine the cri-
sis have been for economics. Orthodox economics opinion might have

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Setting the Scene

had next to nothing to say when the crisis symptoms revealed problems
of market liquidity and bank capitalisation, but its social authority was
restored when the underlying crisis was described in terms of a state
trying to live beyond its available means. This latter crisis narrative
spoke of a scenario which looks much more familiar from the perspec-
tive of uneconomic economics. Economists have always had recourse to
abstract models that express the virtues of budgetary balance and warn
of the monetary transmission mechanisms that translate imbalances
into danger for the economy as a whole (Persson and Tabellini 1990:
300). Indeed, from the 1970s onwards the test of a good macroeconomist
has generally been the elegance with which the monetary transmission
mechanisms can be elucidated and thus the case for removing distort-
ing public expenditure can be made (Drazen 2000: 119). Having been
outcasts for failing to have foreseen the market breakdowns and for hav-
ing devised the models that underpinned the broken market structure
in the first place, orthodox economists suddenly had a chance to return
to favour again. They had in their possession a series of explanations for
why state expenditures had to be cut both deeply and rapidly, and in
making such a case they also had on their side the argument that their
opinions were sustained by models that represented the theoretical
Of course, it should not be forgotten that there have been notable
dissenters to the idea that austerity is the only game in town, amongst
both academic economists and professional economists working in
international financial institutions. At the same time there have been
enough economists who have been willing to make the case for budg-
etary balance to sustain the will of governments that were going to
choose austerity for ulterior ideological motives come what may. The
Conservative-led Coalition Government in Britain is just one very
obvious example. However uneconomic it has become in its abstraction
from the real world, then, economics is not principally responsible for
governments having chosen austerity. The decision to assert the neces-
sity of public expenditure cuts was enacted at a moment of political least
resistance in an attempt to play to the interests of social forces who are
always best served when welfare spending is retrenched.
As has been shown by in-depth academic analysis of British news-
paper coverage of the crisis, the right-wing print media might not have
known how to name the crisis in its earliest stages, yet this did not stop
it from taking advantage of every opportunity to berate a supposedly

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profligate Labour Government and its alleged support for a culture of

welfare dependency (Pirie 2012: 343). The fact that Labour ministers
were already presiding over a squeeze on welfare entitlements (Chote,
Emmerson and Tetlow 2009: 18) made no difference to this construction
of events, because there is no necessary connection between the mate-
riality of a crisis and its ultimate naming (Ungar 2001: 276). For their
part, the more liberal sections of the press began by attempting to focus
on the financial excesses that had precipitated the market meltdown,
but they fairly quickly fell in line by eventually publishing primarily
stories about public debt (Pirie 2012: 353). Orthodox economics opinion
has had its prestige restored, then, as a fortunate happenstance of these
ideological moves. Moreover, it continues to be in rude health, at least if
the pattern of student enrolment and the structure of economics degree
programmes is anything to go by.

The crisis and the economics curriculum

Alan Blinder (2010: 385) has described the crisis as truly a teaching
moment for economics, yet there is little of the work of what Nouriel
Roubini and Stephen Mihm (2010: 38) call the crisis economists actually
being delivered in the lecture theatre. There is, perhaps, an easy explana-
tion for why everything has gone quietly back to its pre-crisis status quo:
what is taught in economics is what is researched there, and whilst the
research continues to be conducted around the existing core everything
is also likely to stay the same in the classroom (Shiller 2010: 403). This
is ultimately where the problem is to be found. As George Akerlof and
Robert Shiller (2009: 1) argue: The public, the government and most
economists had been reassured by an economic theory that said we were
safe. The we in this instance, of course, referred only to the position
of those abstract personae who inhabit economists models rather than
people in the real world per se. Yet there is a translation mechanism
linking the two with the emergence of social authority figures acting in
a pedagogical role, trained to deliver orthodox economics opinion in
a language that everyone else can understand (Fracasso, Genberg and
Wyplosz 2003: 4).
Most economists continue to cling to this same opinion, but by no
means all (see Keen 2013: 229). There are some who deliberately place
themselves beyond the parameters of orthodoxy to ask about the effects

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Setting the Scene

that economics has had in creating particular behavioural patterns

within the actual economy (Lucarelli 2011: 147). From this perspective
the projection of the perfectly symmetrical relationships of the model
world into assumptions about how the actual economy works produces
a state of mind that prevents warning signs from being read as anything
other than statistical blips. In the world of uneconomic economics,
where the logical purity of the internal dynamics of the model world
is considered paramount, even a crisis of the magnitude of the one we
are today still passing through can be reduced to an aggregation of such
blips (see Frydman and Phelps 2013: 23). It is a perfect storm, we are told:
an event of such freak occurrence that it has no place on a standard bell
curve plot of historical data, a fat tail to end all fat tails. Alan Greenspan
(2013: 95), former five-time Chair of the US Federal Reserve and doyen of
orthodox economics opinion, has even been moved to describe the tails
of the probability distribution in evidence when the crisis first struck as
morbidly obese.
There is a parallel here between the dominant political narrative of
the crisis disease and the exoneration of economics in the production of
the crisis symptoms. The assertion that this is now to be understood as a
crisis of excessive state spending exogenises the self-made distress of the
banking sector, and the allied assertion that the crisis conditions were
entirely unforeseeable using routine forecasting processes also places
the blame squarely on exogenous shocks. Mainstream macroeconomic
theory today is based overwhelmingly on dynamic stochastic general
equilibrium (DSGE) models (Canova 2007: 26). These models have
shown themselves to be capable after the fact of reproducing the type of
behaviour witnessed during the crisis, but only on the proviso that a suf-
ficiently large exogenous shock is introduced into the model parameters
(McKibbin and Stoeckel 2009: 582; Ireland 2011: 33). But this serves only
to highlight what is wrong.
The disruption to the market environment was a real-life and not
merely a statistical event, and in any case DSGE models have attained
their professional standing due to an abstract quality that requires for
irregular statistical events to be assumed away. Instability of any sort is
typically reduced to random features that are allowed to play no part in
the formal specification of the model, whereas acute instability is placed
in the box of uniquely unpredictable multiple standard deviation events
(Ganley 2011: 54). As Nobel Laureate Robert Lucas (2009: 67) put it in
defence of his discipline: One thing we are not going to have, now or

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ever, is a set of [macroeconomic] models that forecasts sudden falls in

the value of financial assets. This, in his view, means that financial crises
are inherently unavoidable because the knowledge of how to carefully
deflate an emerging bubble is too scarce a commodity to expect to find
in the gift of a regulator. If these people exist, he said (ibid.), falling back
on the notion of a perfectly efficient market for rewarding talent, we will
not be able to afford them. Exogeneity thus once again reigns supreme.
The possibility of market distress is not factored into DSGE models
because they are designed to allow the modeller to understand only those
relationships in a market which always clears perfectly and therefore
cannot become distressed (Edge and Grkaynak 2010: 209). They thrive
on an uneconomic economics that pays no attention to real historical
detail when seeking to derive the logical properties of equilibrium states.
Somewhat controversially, Thomas Sargent was awarded the Nobel Prize
in 2011 for his work refining this class of models at exactly the moment
that those refinements could tell us least about what was going on in the
world beyond the ivory tower (Mirowski 2013: 158). Asset prices were in
a tailspin, banks were technically bankrupt, businesses were closing their
doors, jobs were being lost, employment contracts were being rewritten
to make work more onerous and welfare recipients were increasingly
finding themselves cast as scapegoats, but all the while DSGE models
preached the virtues of equilibrium. The economy being envisioned in
DSGE models is clearly not the economy being experienced during the
crisis, and indeed it does not represent a set of economic relations that we
could ever hope to experience. The model world is precisely that, which
should warn us to guard against presenting it as though it is capable of
replicating the dynamic path being described by the world around us.
In the same way, then, as abstract markets should not be mistaken for
actual markets, the abstract economy expressed in DSGE terms must
be strictly differentiated from the actual economy. Orthodox economics
opinion can talk authoritatively only about the former, and a leap of faith
is required to make it apply equally to the latter.
The inverted commas around market and economy, inelegant though
they may be, therefore contain important analytical meaning. For one
thing, they point towards what Robert Skidelsky (2009: 28) had in mind
when writing that: [A]t the root of the crisis was not failures of char-
acter or competence [hence, dismissing the bad apple theory], but a
failure of ideas ... The practices of bankers, regulators and governments,
however egregious, can be traced back to the ideas of economists. The

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Setting the Scene

explanation of the crisis as a once-in-a-thousand-years statistical aberra-

tion merely confirms that the intellectual radar of orthodox economics
opinion has seriously malfunctioned. As another Nobel Laureate, Paul
Krugman (2009a: 1), has put it: [T]he economics profession went astray
because economists, as a group, mistook beauty, clad in impressive-
looking mathematics, for truth ... Unfortunately, this romanticized and
sanitized version of the economy led most economists to ignore all the
things that can go wrong.
This is what Deirdre McCloskey (1994: 133) has repeatedly referred to as
a myopic focus on the blackboard economy. The curse of losing oneself
in the abstractions of the blackboard is not that they lack sense-meaning
in their own terms, but that the behavioural situations of which they
can make sense are so idealised that they can never be directly appre-
hended in practice. In its uneconomic guise at least, economics tends
to skip the all-important methodological step of subjecting its abstract
models to systematic empirical testing using real historical data (Blaug
1992: 238). As the professional popularity of macroeconomic models of
dynamic stochastic general equilibrium amply demonstrates, the claim
to scientific status rests on the ability to manipulate the models abstract
relationships and to retro-fit the data to the cleanest possible account of
those relationships. Yet according to John Eatwell and Murray Milgate
(2011: 10), this leads to a predilection for empty formalism, through
which models retain their plausibility only because they act as an expres-
sion of the choices that members of the political classes are in any case
inclined to make (see also Blaug 2002a: 38). They are not intrinsically
meaningful in their own terms.
The tide of uneconomic economics, though, has by no means been
turned back in the face of these attacks. However, the recognition
that economics had a role in the cause of the crisis despite its sub-
sequent rehabilitation offers tantalising glimpses of what the future
might bring if a shift takes place away from a distinctly uneconomic
economics. This, of course, is a very big if , and at the current time
it appears most unlikely. Nonetheless, in Krugmans (2009a: 1) words,
it could lead to a situation in which economists will have to learn to
live with messiness ... and accept that an elegant economic theory of
everything is a long way off . In practical terms, he continued, this
will translate into more cautious policy advice and a reduced willing-
ness to dismantle economic safeguards in the faith that markets will
solve all problems.

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It must be noted, though, that the market is much more than a con-
cept used by economists. It also has other forms in a more vernacular
language that is used to address those who are not trained in the techni-
calities of algebraic expressions. Its spill-over into everyday language of
political priorities and social organisation provides a means of sheltering
orthodox economics opinion from attempted rearticulation. The insights
of DSGE models can thus be re-told as a series of seemingly common-
sense propositions about the desirability of markets as if they applied to
something other than the model world (Engelen et al. 2011: 16). These
stories cannot admit that there is blame to be attributed to economics
for the crisis, because this would dissolve the authority that an epistemic
community of central bankers, finance ministry officials, market watch-
ers and businesspeople has previously seized for itself when translating
the teachings of uneconomic economics for public consumption. Such
authority is based on purporting to know better than anyone else how
financial markets work and how they must be regulated if they are to
operate in line with what DSGE models say about the economy in
general. The redefinition of the crisis no longer as one of finance but of
a wilfully profligate state allows this epistemic community what Ewald
Engelen and co-authors (2011: 52) have dubbed econocrats to continue
to reproduce its authority to act.
A complex relationship thus seems to hold between political moves
designed to change the ideological frames through which the crisis is
understood and the ability of those who think about the world through
the lens of mainstream economics models to provide support for the
political status quo. Writing this book would have been a much more
straightforward proposition had this relationship been the simple one
of pro-market ideology amongst the community of economics scholars
leading to pro-market policy outcomes. However, there is more to the
story than this. The remaining chapters are structured in an attempt to
bring further clarity to the complicated picture that emerges when ask-
ing whether mainstream economics models bear any responsibility for
the crisis. I am particularly interested in the unintended consequences
of uneconomic economics: the political effects produced in everyday
translation as a result of the search for professional esteem rather than
the political effects produced through conscious appropriation of the
ideological structure of society. It is at this level of translation that
the more profound effects of economists role in the crisis are to be

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Structure of the book

The next chapter deals most directly with the dynamics of the ongo-
ing crisis. I return to the initial diagnosis of the crisis symptoms by
insisting that the whole episode continues to be understood specifi-
cally as a crisis generated within the contemporary structure of finance
and enacted through financial markets. The originality of my account
comes from the way in which I attempt to place orthodox economics
opinion at the heart of my explanation of events. Much of the politi-
cal economy literature which mentions the role of economics in the
market breakdowns does so merely to remind the reader that main-
stream economists did not see the crisis coming. It then uses this fact
to infer political motivation to the selectivity of their sight. Economists
refused to see the crisis coming, so this argument goes, because to
have acknowledged the presence of early warning signs would have
been tantamount to auto-critique of their own pro-market worldview.
There is something distinctive about economists and their conception
of market dynamics, I argue, but it is not as straightforward as simple
ideological affiliation.
The important point to my mind is that the style of thinking which now
connotes good economics simply did not permit the warning signs to be
identified for what they were. If economists chose to ignore the predict-
ably destabilising effects of asset bubbles, then, it is for professional rather
than political reasons. What matters most in this instance, I suggest, is
not the presence of political content in the models used by economists
so much as the absence of economic content. The markets on which
economists models can provide insight are not markets as they might
be experienced in everyday economic life but rather markets as abstract
manifestations of perfect allocation functions. As a consequence, when
economists talk about economic relationships these refer to patterns
of behaviour guided by efficient allocation within an equally abstract
economy. The inverted commas might continue to look cumbersome,
but they help to guide a significant observation. The early indications of
a coming crisis were revealed in market tensions as they related to the
actual economy, but in the model world in which economists establish
their name they simply did not show up. I illustrate this claim in relation
to some of the major theoretical moves that distinguish market from
market and economy from economy, before showing how they became
facilitative causes of the crisis.

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This allows me to situate my work both within the broader literature

which advises a systematic rethink of economic possibilities in the after-
math of the crisis, but also against it in one important respect. Whereas
regulatory capacity tends to be the focus of the recommended rethink as
a means of bringing finance once more to heel, my concern is with the
style of thinking that eroded the distance between banking interests and
regulatory practice. The remainder of the book asks how this situation
came to pass in the first place. It thus complements the call of many of
the most overt critics of orthodox economics opinion for the study of the
economy to be reunited with the study of history. In my case, though, I
am primarily concerned that sufficient attention be paid to the history of
economic thought.
Part of the science myth in which orthodox economics opinion
is trapped is that its history is unrelentingly linear in its underlying
orientation, whereby what comes later is always likely to be a better
approximation of the scientific ideal and, therefore, truer (Tabb 1999:
29). This makes it much more possible than in other social science fields
to identify decisive turning points (Medema and Samuels 2001: 2). These
are moments at which a key intervention acts as an attractor to produce
a realignment in the very notion of what genuine economic analysis is
deemed to be. Studying the history of economic thought allows such
shifts to be brought to life, as well as making it possible to try to under-
stand their political implications. Whatever its claim to genuine scientific
status, economics must always be read politically because of its ability to
shape the language that is used to discuss whether the world might be
constructed differently.
Operating from this perspective it becomes important, I suggest, to
learn more about the way in which dividing lines were introduced in
economics between market and market and between economy and
economy. The history of economic thought shows that attention has
been paid increasingly in recent years to the latter of the paired concepts,
and a political reading of that history forces us to ask with what practical
effects. It is now the major concern of methodologists of economics that
the testing which seeks to reunite the pairs is chosen specifically because
it allows political challenges to the status quo to be sidestepped (Boland
1989: 133). It often takes the form of so-called calibration tests, which pro-
vide parameter estimates selected deliberately so that the model might
be able to copy known patterns in the historical data (Blaug 2002b: 33).
Yet this is to get the relationship between the real world and the model

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Setting the Scene

world the wrong way round. Trends in historical data are selected to
prove that the real world can sometimes conform to the model world
and not that the model world is capable of accounting for more than
this one set of observations (Gregory and Smith 1991: 297). Robustness
and representativeness tests do not enter the process. However, this is to
subordinate economy to economy by consciously searching for those
moments in which market outcomes mimic the market construction
in the model. Economists blind spots in the build up to the crisis arose
primarily from the need to demonstrate to one another that they were
comfortable working with relationships within uneconomic economics
that operate solely at the model level of market.

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The Collapse of the Model
World: From Faith in Equations
to Unsustainable Asset Bubbles

Abstract: The meltdown in financial prices in 2007 and 2008

prompts the question of why the previous peak prices were ever
regarded as reasonable. Prevailing pricing dynamics were in
part produced by the influence of economists valuation models,
which supposedly gave insights into the one true price that
would emerge under conditions of market self-regulation. The
valuation models thus helped traders to justify paying higher
prices for all sorts of esoteric derivatives instruments, but not
because their inputs produced an accurate representation of the
relationship between historical price data and verifiable patterns
of real-world economic socialisation. They were readily accepted
despite being devoid of genuine economic content because they
provided a means of visualising an ever more complete financial
market structure built purely on demand-and-supply dynamics.

Keywords: collateralised debt obligations; Gaussian copula

formula; Kuhnian exemplar; mortgage-backed securities;
probabilistic risk models; Schumpeterian Vision

Watson, Matthew. Uneconomic Economics and the Crisis of

the Model World. Basingstoke: Palgrave Macmillan, 2014.
doi: 10.1057/9781137385499.0005.

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The Collapse of the Model World


Macroeconomic models of dynamic stochastic general equilibrium

(DSGE) and financial models exhibiting the efficient markets hypoth-
esis (EMH) are generally treated as distinct entities. However, they
come together very clearly in a single vision of the substantive phe-
nomenon of the economy. In this regard they are two of the primary
bastions of orthodoxy. DSGE models provide the image of a set of
interconnected markets that are capable of reaching their equilibrium
states simultaneously. The EMH, for its part, shows how the connec-
tions can be made between these individual markets through the
process of financial arbitrage. Taken together, DSGE and EMH models
provide the major impetus for envisioning the economy through a
general equilibrium lens.
Moreover, maybe this should not be vision with a lower-case v in a
generic sense so much as Vision with an upper-case V in the specific
Schumpeterian sense. In his classic History of Economic Analysis, Joseph
Schumpeter insisted that all economists must necessarily begin with an
ingrained idea of what they are trying to achieve: a Vision. This, he wrote
(Schumpeter 1994 [1954]: 41), is a preanalytic cognitive act that supplies
the raw material for the analytical effort. Economics gives the impres-
sion of a unified subject field whenever individual contributions appear
to be organised around the same guiding themes. DSGE and EMH
models provide the basis for one such alignment by sharing the Vision of
a market system regulated ultimately by the forces of demand and sup-
ply alone. The vernacular translation of abstract economic theory might
well qualify some of the extreme versions of market ideology to make it
easier to sell to the public, but it is nonetheless still an essential element
of the same underlying Vision. The outer limits of orthodox economics
opinion must therefore be to focus on the inherent stability of markets.
This involves defining out of what counts as serious economics anything
belonging to a counter-Vision of market instability. Schumpeter (1994
[1954]: 41) made reference in this respect to the process of visualiz[ing]
a distinct set of coherent phenomena as a worth while object of [econo-
mists] analytic effort.
The interesting point from a history of thought perspective, however,
is the divorce of todays dominant demand-and-supply Vision of market
equilibrium from the programme of research that initially set it free.
Frank Ackerman (2002a: 132) has been moved in this regard to pronounce

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not merely the death of the wider general equilibrium approach but
more specifically its continuing death in the face of repeated attempts to
revive it. The underlying image of market stability may well live on as
an organising motif for orthodox economics opinion, but general equi-
librium economics does not pass the test of a progressive research pro-
gramme, and moreover it has been known for some time that this is the
case (Weintraub 1977: 11). That test in its original Lakatosian terms at
least (Lakatos 1978) is whether the theoretical framework facilitates an
expanding range of insightful empirical investigations into the substan-
tive nature of the world. In the case of general equilibrium economics it
does not (Clower 1995: 308).
Kenneth Arrow (in 1972) and Grard Debreu (in 1983) were awarded
Nobel Laureates for specifying the theoretical outlines of the general
equilibrium approach. They were responsible for the seminal 1954 paper
that first demonstrated the logical possibility of the existence of a state in
which demand-and-supply dynamics alone could clear all markets in a
single moment (Arrow and Debreu 1954). It hardly needs saying that this
solution refers to an abstract economy rather than to a set of economic
relations that could ever hope to be lived. Debreu (1959: viii) was explicit
that the theory, in its strict sense, is logically entirely disconnected
from its interpretations, even insisting on emphasising the disconnec-
tion textually by ensuring that all the definitions, all the hypotheses ...
are distinguished by italics. The ArrowDebreu model, then, relates in
a manner in which its authors were only too well aware to a series of
points in mathematical space, leaving the contours of actual habitable
economic space entirely unexplored. Moreover, general equilibrium
economics is revealed as a degenerative research programme again
to use Lakatosian terminology precisely in those moments in which
comparability is sought between points in mathematical and economic
A whole generation of exceptionally gifted mathematically informed
theoretical economists have followed in the ArrowDebreu tradition, and
they have demonstrated the ever more exacting economic restrictions
that have to be imposed if the original existence theorem is to produce
stable conditions in the model. Given the continuing significance of the
underlying Vision of the market world to orthodox economics opinion,
some rather startling results have ensued. They have culminated in the
SonnenscheinMantelDebreu theorem, which points out that even
in the most straightforward case, and even when allowing all market

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participants to be fully rational and utility maximising in their actions,

the Law of Demand cannot be shown to work for even a single market
in isolation (Sonnenschein 1973; Mantel 1974; Debreu 1974). It is not
possible, in other words, to scale up individual action to produce a state
of textbook market efficiency without needing to fall back on further
mathematical sleight-of-hand (Duarte 2012: 217). Abu Turab Rizvi (2003:
384) points to a spectacular series of impossibility results produced in
the 1970s, which showed that formalist general equilibrium theory had
reached a dead end. To put this as simply as possible, the language of
the economy that is used to structure everyday experiences of economic
life has been shown by one of the founders of the general equilibrium
approach to lack genuine economic meaning. The concept of equilibrium
which helps to shape that language might well have a mathematical solu-
tion but only within its own self-referential system (Clower 1995: 317).
Dynamic stochastic general equilibrium models thus appear to be
shorn of their foundations, and what is true of them thus must also
hold for the efficient markets hypothesis that explains the inter-market
connections in DSGE models. The underlying Vision which gives lustre
to both would therefore seem to be almost free-floating. However, the
language of general equilibrium has been much more effective in shap-
ing everyday economic life than general equilibrium economics has been
as a progressive research programme. This is perhaps most apparent in
political projects designed to complete the market. For current purposes,
the most potent example of this tendency relates to the attempts to use
the process of financial innovation to close the gap between the trading
structures of individual asset markets. This is evidence of the continu-
ing practical relevance of the demand-and-supply Vision of orthodox
economics opinion, which is perhaps why, historically, members of the
epistemic community surrounding that opinion have been particularly
prominent in challenging suggestions for regulating the process of finan-
cial innovation. Arguments for full market completeness have been used
for some time now as a political tactic to disarm the counter-argument
of public protection against market failures.
The SonnenscheinMantelDebreu theorem, though, should once
again be kept in mind at this juncture. It suggests that the uniqueness of
equilibrium cannot be relied upon as a stable point even in mathematical
space because of the possibility of multiple solutions (Grandmont 1992:
2). The assumption of individual optimisation is insufficient on its own
to place restrictions on well-behaved aggregate excess demand functions

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within the general equilibrium approach (Kirman and Koch 1986: 458).
As a consequence, it is also incapable of ruling out persistent market
failures within the parameters set by the demand-and-supply Vision of
orthodox economics opinion. Only the introduction of what Andreu
Mas-Colell, Dennis Whinston and Jerry Green (1995: 604) have called
additional strong assumptions have allowed the mathematics of general
equilibrium to continue to work. Strong, in this sense, is a sugar-coated
synonym for out-of-this-world.
According to Tony Bryant (2010: 191), the interests of mathematical
tractability have been served in this way, but only at the direct expense
of the search for economically reasonable conditions for the uniqueness
of equilibrium. Moreover, even here Bryants definition of economically
reasonable is instructive. He does not mean anything that will satisfy
my concern for going beyond the prevalence of uneconomic econom-
ics and to work with conditions that can be corroborated by empirical
studies of real-world economic socialisation. He only means conditions
implied by underlying microeconomic theory, but even on the basis of
asserting ideal-typical rationality structures onto all human agents there
is no reason to assume that the key findings of the general equilibrium
approach have any real practical purchase. This is the backdrop against
which we should understand the removal of social insurance against
market failure in the interests of budgetary balance, plus the related
renewed emphasis on further completion of the market system as a way
of promoting healthy public finances in the future.
In an attempt to shed more light on these issues, this chapter now
proceeds in three stages. In the first section I discuss the type of asset
trading that ultimately led to the financial crisis. I focus in particular
on the secondary mortgage market and the various forms in which
collateralised debt obligations were bought and sold. The assumption
that instruments of this nature have genuine economic value was never
challenged, because the question was not asked in the first place. The
only issue to be seriously tackled was how markets might be made in
those instruments to increasingly complete the overall system and not
what the difference might be between those markets and the market
structure as it had initially been outlined on paper. In the second sec-
tion I turn to the specific theoretical move that allowed the process of
market-making to take shape. The pricing structure within second-
ary mortgage markets and, indeed, the structure of the markets
themselves reflected the influence of Lis Gaussian copula formula.

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That formula has no genuinely economic content and is therefore an

important instance of the shift towards a distinctly uneconomic eco-
nomics, and its prominence demonstrates the way in which the Vision
of market equilibrium runs ahead of its analysis. In the third section I
explore this claim in greater detail as a means of understanding more
about the push towards market completeness and the use of orthodox
economics opinion to justify moving in that direction. This allows me
to tie the discussion of the general equilibrium approachs economic
failures but political successes back to the emphasis on changing crisis
constructions evident in the introductory chapter.

The growth of increasingly complex secondary

mortgage markets

An abundant popular economics literature now exists on the causes of

the market breakdowns of 2007 and 2008 (for instance, Cooper 2008;
Gamble 2009; Immergluck 2009; McDonald and Robinson 2009; Rajan
2010; Stiglitz 2010; Buckley and Arner 2011; Osband 2011; Picciotto 2011;
Gorton 2012; Rethel and Sinclair 2012; Temin and Vines 2013). Almost all
of it is written by well-regarded economists or by equally well-regarded
financial journalists, and it takes the reader behind the drama of who did
what and with which consequences. It sticks resolutely to the earliest cri-
sis narrative that this was, without doubt, a crisis born of self-regulating
finance. It consequently locates the scene of unfolding events in financial
markets, in trading rooms, in banks back offices and, ultimately, in the
assumptions about price discovery to which each of these behavioural
spaces was oriented. Trading machismo had become the order of the day
in these various sites of global finance, whereby it was assumed that a
market could be made for anything at all.
One of the primary drivers of this frenzy was the increasing use across
the financial sector of probabilistic models of risk. Roubini and Mihms
(2010: 3860) crisis economists have always eschewed all such models.
Instead, they make the mathematically much messier assumption that
financial risk is an endogenous property of the trading environment.
From this perspective risk is an absolute feature of any market in which
it is impossible to draw a strict dividing line between where arbitrage
stops and speculation starts (Davidson 2009: 32). Yet this represents a
poor fit with the demand-and-supply Vision in which all speculation is

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stabilising because its mere presence imposes a pure arbitrage mentality

on all market participants (Friedman 1953: 173). The general equilibrium
approach that allows the efficient markets hypothesis to explain the
dynamic processes that govern the trajectory of macroeconomic adjust-
ment simply cannot permit there to be insights in the crisis economists
view of risk. It is unsurprising, then, that recent trends in economic
theory have exogenised risk and enabled it to be seen as a calculable
element of a probability distribution that can be hedged successfully
through the creation of the right sort of trading instrument.
Much depends, of course, on what is meant by right as the structure
of the instrument is taken away from well-behaved blackboard formulae
and placed in the hands of traders seeking to make a quick buck at one
anothers expense. A veritable alphabet soup of derivatives instruments
entered trading environments in the build-up to the crisis as mortgage
risk was split into supposedly calculable elements that could be bought
and sold for profit (Smith 2011: 100). Much uneconomic economics
effort was expended on the blackboard to show that these derivatives
instruments could be traded in complete safety because they had all
of their downside risk removed. Rating agencies were also using the
same risk models and therefore very frequently gave mortgage-backed
securities (MBSs) the highly coveted triple-A rating (Steland 2012: 326).
The resulting investment grade status allowed institutional investors to
purchase secondary mortgage market assets in huge numbers, thus pro-
viding incentives for banks to leverage the whole of their balance sheets
to guarantee the continued supply of tradable assets (Muolo and Padilla
2008: 228). We now know, of course, that these were not the safe trading
options they were purported to be, because the very act of trading them
created risks that were not part of the original calculations.
Whilst this is very clearly an important part of the story of why the
financial system got into such acute trouble, it is by no means all of it.
This event was much more than a translation failure involving the need
for more capable regulation of secondary mortgage markets when taking
them off the blackboard and operating them in practice. For the cumu-
lative value of subprime MBSs never represented more than a drop in
the ocean compared with the overall value of global capital markets. In
mid-2007, when pricing dynamics within financial markets first began to
show signs of distress, positions on MBS trading accounts amounted to
less than one half of 1 of total outstanding worldwide financial liabilities
(Bank of England 2008b: 20). The collapse of asset values in secondary

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mortgage markets is not the event in its entirety, then, so much as the
most representative example of a wider problem.
With very few exceptions the whole of the global financial system was
being operated on the proposition that risk could be rendered know-
able and thus effectively disarmed for trading purposes by using the
correct statistical techniques (de Goede 2004: 206). This proposition
might look somewhat disingenuous when the whims of investor senti-
ment are allowed to enter the explanation of how real-world markets
and not just hypothetical markets work. Yet they have been fundamen-
tal to the staggering growth of global capital markets in recent times,
and they have also created the context during the bubble phase in which
lots of traders made lots of money for the banks for which they worked
(Potters 2010: 32). Perhaps more importantly for current purposes, they
also provide unstinting support for the demand-and-supply Vision on
which orthodox economics opinion is founded. If risks really do follow
a standard statistical distribution function, then they are sufficiently
predictable to disqualify the argument that the market environment
requires extensive external regulation.
The collapse of MBS prices served such a totemic function because
it brought the whole demand-and-supply Vision into question. If these
markets could not be sustained in the face of evaporating demand, was
the price structure of any financial market sufficiently robust to sustain
investor confidence? In an attempt to capture the systemic nature of
unfolding events, Timothy Sinclair (2009: 452) has described the ensu-
ing paralysis of financial pricing mechanisms the so-called credit
crunch as a valuation crisis. Bank after bank looked at the assets-side
of their balance sheets, no longer being able to trust the valuation that
they had put on those assets when purchasing them, and when the belief
hardened that all other banks were in the same position they increasingly
refused to extend credit to one another. The prospect of issuing credit to
a competitor that might then default on the loan was enough to make
every bank fearful that it was only one rash decision by someone else
from being tipped over the edge. Yet by acting on those fears all banks
subsequently frog-marched one another into a situation in which all
had essentially illiquid trading balances (Watson 2009b: 185). This situ-
ation was not resolved in the UK at least until the Brown Government
recapitalised the banks through guaranteeing the continued integrity of
their balance sheets. Throughout the intervening period and, indeed,
until a new crisis narrative emerged to deflect attention away from the

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banks faith entirely evaporated in the valuation techniques that bank-

ing practice had taken from mainstream economic theory. This is why
the effects of the rupture in subprime MBS prices became systemic.
After the initial period of introspection, much of the later fight-back
by economists has been organised around the defence of statistically
rather than economically oriented valuation techniques. Now that more
knowledge has been gleaned of the sorts of prices that lack credence, we
are told, it is much easier to plug a more reasonable set of numbers into
the valuation model. In other words, the real world acts as a laboratory
for the implementation of blackboard economics, and one failure in
translation between the two should not stop further efforts from being
made to do the same thing again. It is the case, of course, that a political
scapegoat has been found to prevent the banks from having to pay the
full cost of their mistakes, now that the emphasis on resolving the crisis
has turned to rebalancing the public finances. This has allowed the
argument to be made that with better information to hand about the
structure of securities that delivers robust valuations, the securitisation
process should start again (IMF 2009: 78). This in turn enables the ini-
tial valuation crisis to be seen merely as a manifestation of the wrong
sort of securitisation allied to the wrong sort of risk-reducing model,
with the right sort of both now available on the back of a technically
proficient innovation in risk management. Viewed from this perspec-
tive there is no need at any stage to question the underlying valuation
technique through which the securities become tradable entities, and
certainly not to question the Vision of economics which lies at the heart
of that technique.
To see why this argument just will not do, though, it is necessary to
look no further than the dynamics that led to the US Federal Reserves
eleventh-hour rescue of the terminally stricken investment bank,
Bear Stearns. At the end of 2007, Bear had a US$30 billion exposure
to the secondary subprime mortgage market in what the US Financial
Accounting Standards Board classifies as level three assets (Bamber and
Spencer 2008: 45). These are tradable instruments which are so complex
in form that their input values are deemed for accounting purposes to
be unobservable (Valentine 2010: 207). Assets of this nature cause dif-
ficulties when trying to determine the overall health of a banks balance
sheet because there are no agreed auditing principles to calculate the
likely resale value of the assets. In place of such principles a figure is
derived from a model whose parameters are themselves provided by the

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bank in question using estimation techniques originating from orthodox

economics opinion (Arnold and de Lange 2004: 758).
Threats emerged to Bears survival in the midst of the valuation crisis
because of the particular nature of the level three assets it was carry-
ing on its books (Greenberg 2010: 187). They consisted to a very large
degree of increasingly convoluted collateralised debt obligations (CDOs)
on mortgage-backed securities. Each MBS was sliced and diced into a
variety of tranches which lined up from least risky to most risky, with
the risk/return structure of each individual tranche being determined
using probabilistic calculus. The nominally least risky tranches were
constructed out of bundles of mortgages sold to people whose previous
credit history suggested that they would meet their repayments both
on time and in full. Their top-end investment grade credit ratings gave
out the impression that they were as safe an investment as US Treasury
bonds: the two posted a similar pre-crisis pattern of returns on the
assumption that they had the same basic default risk (Denninger 2011:
39). As underlying US housing market conditions remained extremely
strong throughout the early 2000s, lower quality MBS tranches also per-
formed consistently whilst delivering significantly higher returns than
simple interest-bearing Treasury bonds (Schwartz 2009: 142).
The CDOs purchased by Bear Stearns worked by applying the same
slicing and dicing principle used for ordinary MBSs to individual
tranches of the MBS (Prins 2009: 58). Some of the tranches not consid-
ered worthy of a top-end investment grade credit rating most often
those of around a BBB rating were further divided into their own
tranches with a range of different risk/return characteristics. Banks were
emboldened in bringing CDOs to the market by assuring themselves that
they could use clever financial engineering practices to turn intrinsically
bad investment opportunities bundles of mortgages sold to people
with far from pristine credit histories into good investment opportuni-
ties (Nesvetailova 2008: 108).
This view could only follow from the triumph of uneconomic econom-
ics. Economic theory could be relied upon to show how the financial
engineering might work in the context of a purely hypothetical market,
but its explanation of the internal market dynamics was based on what
is known mathematically about the properties of statistical distribution
functions and not what is known economically about the social basis of
functioning market environments. Reasserting the significance of the
genuinely economic dimension shows that the pursuit of value in MBS

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CDOs is the equivalent, in Gillian Tetts (2009) memorable phrase, of

chasing fools gold. There simply is no economic reason to assume that
a step increase in creditworthiness can be secured merely through the
strategic repackaging of assets.
However, the prevalence of this style of thinking led to the subsequent
creation of CDO-squareds and CDO-cubeds. The slicing and dicing
principle was taken to such an extreme that these latter assets were
CDOs of CDOs of CDOs of MBSs. Their structure was such that they
defied all stress testing (Wigan 2010: 116), as the computational capacity
has not yet been developed to discover in timely fashion all the possible
permutations of default risk correlations on the underlying mortgage
repayment schedules. After all, creating a triple-A rated CDO out of a
triple-B rated MBS tranche, let alone innovating in CDO-cubeds, does
nothing to put more money into the pocket of the original mortgage
holder and therefore makes it no more likely that they will successfully
pay off their loans. These intensely complex level three instruments were
purchased often, as the case of Bear Stearns demonstrates, in substan-
tial volume purely out of faith that the Vision of orthodox economics
opinion would hold and that there would always be sufficient demand
for the market to clear.
This is the overall structure of securitisation that has been restarted in
the search for the right securities to replace the wrong securities. Even
when insisting that the crisis should be seen fundamentally as a crisis
of finance, though, it would be a mistake to reduce the discussion of
what should happen next to a technical matter of finding a suitable risk-
reducing model to enable everything else to carry on as before. It is to
explain away the systemic nature of the crisis to treat it as a breakdown of
pricing dynamics in one field that then spread contagiously to all others.
This was a truly systemic crisis of valuation that just so happened to have
its initial outbreak in the subprime securities sector (Sinclair 2009: 453).
Further discussion of the basis of the underlying valuation technique is
therefore required.

The uneconomic economics of asset-price valuation


David Lis (2000) Gaussian copula formula was increasingly used by

practitioners to place a value on collateralised debt obligations as the

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securitisation revolution really took off. He was neither a trader nor an

economist by profession, thus having neither the all-important feel for
the prices that actual markets could bear nor the instinctive sense of the
gap that exists between those markets and the hypothetical markets
about which he could write. He was trained as an actuary and went back
to what he had learnt for that job in search of a solution to the problem
of how to generate discrete valuations for individual CDO tranches
(Kolb 2010: 234). This meant estimating at what point losses would begin
to accrue to tranches of increasing seniority without first collecting
data from individual homeowners about how other people defaulting
on their mortgages might affect their ability to continue meeting their
repayment schedule (Fleckenstein and Sheehan 2008: 208). Yet maybe
this is to overstate the difference between the actuarys and the econo-
mists craft. Lis Gaussian copula formula depicts a securities market
that is entirely in line with the demand-and-supply Vision of orthodox
economics opinion. It also provided uneconomic economics with what
it needed to know before giving the CDO market its seal of approval.
On this particular issue actuarial and economic science appear to be one
and the same thing.
At the very least, those economists who specialise in copula formulae
have been eager to exonerate Li from culpability for the crisis. Once
again the image emerges of the actual economy being little more than
a laboratory for testing economic theory as the argument comes across
that there is nothing wrong with securitisation per se only the wrong sort
of securitisation. Because of the drawbacks of the one-factor Gaussian
copula model, it has been suggested in this vein (Choro, Ibragimov and
Permiakova 2010: 88), numerous new approaches have been proposed.
The whole style of thinking does not need to be superseded, so the
uneconomic economics mantra tells us, because a different application is
always available whenever evidence emerges that previous applications
have large social costs.
The tweaking that has subsequently occurred with Lis formula has
therefore all been within the context of his original Gaussian copula:
Pr [TA<1, TB<1] = 2(1(FA(1)), 1(FB(1)), )

As is immediately apparent, the mathematics here is not overly difficult

in its own right. It is also intuitively plausible, because it says simply
that the probability of joint default amongst any two members of, say,
a mortgage pool (Pr [TA<1, TB<1]) is a function () of the distribution

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(FA, FB) of the probabilities that each will individually still keep meeting
their repayments and of a correlation parameter () that suggests how
those probabilities are linked. Perhaps the authorising managers on bank
trading desks never really needed to understand how the model worked
as long as it seemed to be generating such high levels of return. But the
apparent simplicity with which it produced readily comprehensible pric-
ing rules that chimed with bankers intuitions of how markets operate
acted as a siren call for the unwary. It lulled them into a sense that they
knew enough to continue committing huge sums of money to positions
enacted in the formulas name but without knowing in detail about the
hidden depths in the mathematics which showed that highly unusual
circumstances were consistently necessary in practice if the Gaussian
copula market and the actual mortgage market were to behave in the
same way.
The Gaussian copula formula told traders what they had to do to stay
in their trades and to ride the CDO market for all it was worth. This
involved committing their own banks to purchasing some of the less
attractive tranches for which no commercial customer could be found,
so as to retain the integrity of the whole CDO structure (Kuttner 2010:
6). These were called liquidity puts and helped to ensure that Lis formula
continued to punch out numbers to show that adventures in ever more
exotic secondary mortgage markets could sustain an impressive rate of
profit. Yet this was an activity that took place in the murkiest parts of
the mathematics, where genuinely specialist knowledge was required
to understand the pressure points that might build up in the trading
position. Former US Treasury Secretary Robert Rubin explained that
he did not even know what a liquidity put was as his banks trades in
those instruments were unravelling in the summer of 2007 (Jennings
2012: 182). He had been Senior Counsellor and a member of the Board
of Directors at Citigroup at the time, but such exalted status within the
bank was no guarantee that he was aware of what was going on when his
company was in the process of amassing US$25 billion of liquidity puts
for which it had to seek a federal bailout in 2008 (Ritholtz 2009: 223).
Bear Stearns had also found itself in a similarly unenviable position at
the point at which only a Fed intervention prevented a wholesale liqui-
dation of its balance sheet (Waggoner 2008: 79). It is little wonder, then,
that in the first phase of the crisis when the surrounding political nar-
rative focused on the need to pump lots of fresh liquidity into financial
markets all of those new injections seemed to rapidly disappear into

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banks balance sheet black holes (Langley 2010: 74). The same simple
mathematical formula that had persuaded banks to invest in liquidity
puts in the first place throughout the crisis churned out probability read-
ings that gobbled up extra liquidity voraciously.
Yet it is not the widespread uptake of Gaussian copula mathematics
that is most noteworthy to an analysis of uneconomic economics, so
much as the analogy that was used to allow the underlying model to
initially become operative. His reputation has taken a hit because of the
financial crisis (Salmon 2012: 16), but before that time Li was hailed as a
genius for the way in which he had turned a genuinely economic ques-
tion (how might defaults within a bond pool be linked to one another
via a shared macroeconomic context?) into a fundamentally uneco-
nomic one (what might be said about the probability that one data point
on a bond curve reflects another under a normal distribution?). Such is
the extent to which orthodox economics opinion is driven by insights
from uneconomic economics that it might be necessary to re-read these
questions carefully before recognising just how different they are. Only
the former has genuine economic meaning, whereas the latter at most
has implied economic meaning and only then if it is to be assumed that
there are no relevant distinctions between hypothetical markets and
actual markets.
The fact that Li was working to a standard of implied economic mean-
ing is shown by how he chose to model the CDO market. He treated
default correlations within a bond pool as being directly analogous to
what in his previous life as an actuary he had known as the broken heart
syndrome (Spreeuw 2010: 317). This is the finding that it is relatively easy
to hedge joint-life insurance that is sold to married couples where the
annuity from the first death is paid only until the time of the second.
The historical data show that the death of a husband makes the surviving
partner twice as likely to die within the next twelve months statistically
speaking as against the same-age population as a whole whereas the
death of a wife makes it six times more likely (Orrell 2010: 133). Having
lived together for so long appears to adversely affect the surviving part-
ners willingness to fight disease when they suddenly find themselves
on their own. Li (2000: 45) completely disregarded the rather obvious
observation that two completely independent mortgage holders drawn
from often completely different geographical units within the national
housing stock are simply not going to exhibit the psychological effects
resulting from the intimacy of a committed lifelong relationship. There

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is no reason at all let alone a genuinely economic reason why the fate
of two discrete mortgages rests on the personal psychology of the broken
heart syndrome. Yet still this is the assumption Li allowed himself to
make when modelling the CDO market on the basis of a straightforward
actuarial analogy. Despite acknowledging that there is little theoretical
justification of the current framework (Li, cited in Beneplanc and Rochet
2001: xxvi), he has nevertheless insisted that the analogy holds: Default
is like the death of a company [or of a mortgage], so we should model
this the same way we model human life (Li, cited in Whitehouse 2005).
The Gaussian copula formula enabled the CDO market to be visual-
ised in a particular way through the adoption of an analogy with the
broken heart syndrome, as well as for the visualisation techniques to
subsequently have performative effects (Clarke 2012: 272). Without first
being able to see the market through Lis model, the credit rating agen-
cies would not have been able to grant investment grade status to CDOs
(MacKenzie 2009: 179), and they certainly would not have been able
to act as de facto consultants in advising issuers how to structure their
CDOs if they wanted to sell them as triple-A bonds (Sinclair 2013: 356).
In the absence of such stamps of approval, though, the markets could
never have been made in practice because there would have been no
buyers for the securities. Li visualised for future participants what that
market might look like and then the mathematics of the Gaussian copula
formula did the rest.
It is necessary to be clear, though, that what emerged as a result was a
dual market structure. There was the smooth and ultimately predictable
process of adjustment in the only ever hypothetical Gaussian copula
market, but there was also always going to be the irregularities of the
actual market in which the integrity of the balance sheet was wagered
against the possibility that fortunes were there to be made. Lis model
might well have unleashed performative effects, but such dynamics
are never sufficient on their own to enforce a perfect one-to-one cor-
respondence between market and market. The ultimate irony in this
respect is that Lis model was designed to allow traders to fully calculate
correlation risk within the bond pool as a way of eliminating the dif-
ferences between the hypothetical and the actual markets (Froeb and
McCann 2010: 229). Yet the fact that almost all traders were using
the Gaussian copula technique to calculate correlation risk meant
that the model itself became the most prominent source of that risk
(Orrell 2010: 134). It was designed as an abstract descriptor of the most

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efficient pricing rule, but it turned into an attractor of new trading on

the assumption that the models price had discounted all market risk
(Dowd and Hutchinson 2011: 183).
This became a particular problem because of the way in which Li had
tried to impose economic meaning onto the mathematical relationships
described by his model. The forecasts that can be made using any model
are always dependent on the quality of the inputs with which the model is
populated (Patterson 2012: 27). Li used the market price of credit default
spreads rather than any actual historical data on home foreclosures as
his reference point for the distribution of the probability of individual
mortgage default (Webb and Cropsey 2011: 209). These were much easier
numbers to get hold of and were consistent with the general outlook of
uneconomic economics, but it meant that nobody following in Lis foot-
steps could stand outside the demand-and-supply Vision of orthodox
economics opinion to see whether the Gaussian copula formula looked
quite as enticing from that alternative vantage point. If Li was to be able
to match his input of credit default swap (CDS) prices with his output of
risk-neutral CDO prices, it had to be assumed that efficiency ruled not
only the hypothetical market of economic theory but also actual finan-
cial markets. The Gaussian copula formula looked as though it might
help realise the economists goal of ever greater market completion by
linking CDOs with CDSs. However, this was achieved only by creat-
ing a highly unstable structure of synthetic CDOs in which individual
tranches were made up of credit default swaps rather than outstanding
mortgage obligations.
All of this relied on an unquestioning attitude to the mysterious
correlation parameter, , and what Felix Salmon (2009: 4) calls its
all-powerful properties. Writing in 2005 before the collapse of second-
ary mortgage markets, the Wall Street Journal journalist Mark Whitehouse
(2005) reflected on the way in which Lis model runs the data through
the copula function and spits out a default correlation. The fact that a
number emerged that would give impetus to the trading mindset was
considered more important than what the number was or whether it had
genuine economic meaning. We might therefore usefully return to Chris
Clarkes (2012: 274) argument that the Gaussian copula formula dem-
onstrated performative potential by providing traders with a suitable
visualisation technique for the CDO market. But did it only allow them
to see what in any case they wanted to see? Was its appeal that it gave
the best possible description of actual mortgage securitisation markets

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or that it most accurately captured what investors needed to believe

the structure of the underlying markets to be if they were to convince
themselves that their investments were sound? In a world governed by a
genuinely economic economics it would have to be the former, but this
is not the world in which we live. As Li himself once said, The most
dangerous part [of his model] is when people believe everything coming
out of it (Li, cited in Partnoy 2009: 291). But why might such beliefs
have materialised?

Performativity and counter-performativity

in financial markets

Traders typically take their templates for understanding the broader

behavioural environment from academic economics studies of finance
(Bernstein 1992: 215). However, very few finance theories have moved
beyond an instinctive assumption that prices must be right if they have
been produced by markets to saying exactly what the prevailing price
structure should be. The difference here is important, because it suggests
straightaway that there are at least two distinct routes through which eco-
nomic theory can perform the market it purportedly merely describes.
One is at the general level of recognising what a market is through a post
hoc rationalisation of its pricing dynamics using the demand-and-supply
framework. The other is at the much more specific level of being able to
tutor market participants to spot whether individual markets are gener-
ating the technically correct price. The latter clearly has the former as a
necessary condition, because without having the underpinning market-
conforming Vision in the first place it would be impossible to visualise
precise points of market stability: in other words, the whole language
of equilibrium would be likely to disappear from economic vocabulary.
Yet the move from replicating Vision to reproducing visualisation ena-
bles a bolder set of claims to be made about the performative effects of
economic theory: it is the move from accepting a particular conceptual
apparatus to using its associated conceptual language.
Such a move is clearly visible in the use of Lis Gaussian copula for-
mula to price assets in credit derivatives markets. It has been widely
hailed as the industry standard in reference to the conceptual apparatus
that showed what was possible within the behavioural environment (see
Chaplin 2005: 224). Moreover, in a direct allusion to the significance of a

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shared conceptual language to guide expectations of who would position

themselves where within the behavioural environment, Nicholas Dunbar
(2011: 93) has suggested that it acts as the lingua franca of credit deriva-
tives traders. In this respect it is hardly surprising that it has become
known as the BlackScholesMerton of the credit industry, because the
BlackScholesMerton equation was the performative trailblazer when
helping to institutionalise functioning options markets.
As Donald MacKenzie (2006: 24375) has shown to great effect,
prices in actual options markets very quickly came to shadow what the
model said they should be, at least in part because one of its originators,
Fischer Black, was active in selling data sheets comparing the techni-
cally correct BlackScholesMerton price with the observed market
price (Mehrling 2005: 140). Traders who were willing to pay Black the
required fee were thus immediately presented with the opportunity to
make some quick money through arbitraging the difference away. Even
those who were sceptical about rewarding Black in this way were often
brought into line because of the equations use for risk management
purposes by banks who wished to keep their traders on a relatively tight
rein (MacKenzie 2007: 73).
By presenting traders with an easy way of passing judgement on
observed prices, the BlackScholesMerton equation set a precedent
that was later to be followed by Lis Gaussian copula formula. Lis model
appeared to generate new information about prices by allowing traders
to think in terms of price discrepancies and the distance that observed
prices might be at any moment of time from the price that guaranteed a
stable equilibrium within the whole trading structure. Those differences
between market price and market price might often have been very
small and could never be more than temporary if pretty much all market
participants were approaching their business using the same visualisa-
tion techniques. They could still be highly profitable, however, if traders
were allowed by their managers to leverage their positions sufficiently. If
one thing has become apparent when reflecting on the financial crisis,
it is that even if traders went to the bother of seeking such permission it
was only denied in really exceptional circumstances.
Both Lis Gaussian copula formula and the BlackScholesMerton
equation are based on elevating the assumption of a normal distribution
above what is actually known about the performance of the assets that
the distribution is intended to describe. Both do so, moreover, for aes-
thetic reasons related to the respective models underlying mathematics

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(Shiller 2012: 132). However, it remains important not to overstress their

similarities. The crucial difference is that the BlackScholesMerton
price mimicked the characteristics of the short-term risk-free interest
rate and provided the basis for a trading rule that allowed options prices
to be set directly in relation to the prevailing price of money. The idea
of a technically correct price within actual options markets therefore
had an anchor in the returns that were available from investing in the
safest possible bonds. In other words, a replication-and-arbitrage recipe
existed, involving further economic activity in real-world markets, to
enforce the market mechanism implied by the BlackScholesMerton
equation (Dunbar 2011: 93). The same is not true with Lis Gaussian
copula formula. There is a pricing rule here but not an associated trading
rule. The hypothetical price that the formula produces has no anchor
in other real-world prices and therefore nothing of known dimensions
against which it can be compared. It is technically correct only in the
strictly limited sense that it has been produced by the model and not
because it represents a trade in which all risk has been hedged. Trading
desks might still be prepared to bet the integrity of their banks balance
sheets on the numbers coming out of Lis Gaussian copula formula, but
not on the replication-and-arbitrage basis of the BlackScholesMerton
In the stock options market, to give the most compelling example,
actual prices converged on the hypothetical BlackScholesMerton
price to a remarkable extent in the run-up to the 1987 stock market
crash (MacKenzie 2006: 15877). From an average mark-up of around
30 when the original papers were published in 1973 (Black and
Scholes 1973; Merton 1973), the premium shrank all the way to 2 by
1978 and half of the remaining mark-up again was eliminated by 1987
(Rubinstein 1994: 774). No such targets were available to guide Lis
Gaussian copula formula prices, precisely because the arbitrage func-
tion was not present in his model. In the absence of a clearly specified
arbitrage function, Lis model would therefore seem to have less claim
than BlackScholesMertons to being a genuine risk management tool
(Dowd and Hutchinson 2011: 184).
Yet maybe this should come as no great shock, seeing as Lis model was
originally designed to match credit default swap prices to collateralised
debt obligation tranche prices in a way that has no readily apparent risk-
reduction purposes. Some markets, after all, become latterly speculative
having been established originally to facilitate hedging impulses, whereas

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others cut out all the intermediary phases and are dominated by specu-
lation from the very first. The market implied by the Gaussian copula
formula would appear to be of this latter type. It was devised merely to
answer the general question of what a real-world market would look like
for trading CDOs, not the more specific question of how to trade them
in a risk-free fashion.
In this respect Lis model seems to work most effectively as a Kuhnian
exemplar. This notion was Kuhns (1977: 297) attempt to respond to his
critics by adding further detail to his earlier influential but controversial
work on the structure of paradigmatic thought (Kuhn 1970). The earlier
publications represented a radical challenge to presumptions about sci-
entific rationalism (Anderson, Hughes and Sharrock 1986: 251), but in its
reconstituted form Kuhns thinking was much more about how groups
of scientific practitioners coalesce around the adoption of a [particular]
rationality at the metalevel (McMullin 1993: 65). Exemplars thus
become a means of linking the institutional to the intellectual dimen-
sions of knowledge production in an attempt to explain how profession-
alised common-sense is passed down from one generation to another
(Hollis 1994: 86). According to Kuhn (1970: 11926), their pedagogical
power results from the way in which due deference to the visualisation
they facilitate allows how the world might look in theoretical terms to
be treated as more important than how it looks in observational terms
(Musgrave 1980: 47).
Kuhn thus described in general terms a role that Lis Gaussian copula
formula has definitely played in the specific case of credit derivatives
markets. Exemplars provide a translation device which not only renders
a possible state of the world intelligible in theoretical terms but also pro-
motes it to the desired form that the world might be made to take (Barnes
1982: 18). In Lis case it is the demand-and-supply Vision of orthodox
economics opinion that is placed on such a pedestal. There is nothing
in the exposure to an exemplar to say that it captures actual patterns of
socialisation to be discovered in real-world environments, only what is
to be gained for the uniformity of scientific practice in accommodating
oneself to the exemplars view of the world.
What Kuhn suggested and the industry standard status of Lis model
seems to confirm, then, is the existence of a distinct division between
an external world of nature and the phenomenal world that scientific
practice constructs (see Sharrock and Read 2002: 178). Particular prac-
tices come to predominate assuming a normal distribution for the

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probabilities of mortgage default, for instance, when all evidence points

in a different direction but not because they offer a genuinely robust
set of insights into the constitution of the external world (Hoyningen-
Huene 1993: 35). They are accepted because they are explicable in their
own terms from the perspective of the paradigmatic thought processes
out of which the prevailing phenomenal world is conceived (Hacking
1983: 185). The result is that in Kuhnian terms at least scientific
progress is not about comparing theories with nature. Rather, it revolves
around comparing theories with their own stated views of how nature
should perform as governed by the tutoring effects of exemplars. The idea
that there is a technically correct price follows directly from the assump-
tion that an equilibrium-oriented market system should be capable of
generating such a price. Lis Gaussian copula formula is merely a way of
giving meaning to that assumption.
The tradition of uneconomic economics as described here would
seem to fit particularly well Kuhns account of how relationships first
envisioned in the phenomenal world are adopted as if they are direct
substitutes for the external world. However, there is still one final twist
in the tale. For Kuhn (1977: 301), whenever natural scientists shift from
one theory to another this is merely changing sides in the conversation
between different phenomenal worlds. Natural states are not altered sim-
ply because of the ebb and flow of interpretations of those states (Kuhn
1981: 7). Yet the finance theory of orthodox economics produces very
different effects in the relationship between external and phenomenal
worlds (Mehrling 2005: 914; MacKenzie 2006: 1220). Kuhns notion
of an external world perhaps in any case lacks a direct counterpart in
relation to the economy, because all economic systems are of human and
not natural design. More specifically, though, the performative effects
of finance theory have the capacity to align the economic equivalent of
the external world with the prevailing phenomenal world (Miller 1998:
1959). The hypothetical structures of the dominant theory therefore
have a good chance of being manifested, at least partially, in practice.
As the collapse of the CDO market in the early phase of the financial
crisis suggests, however, the production of market structures through
performative effects is no guarantee that those structures will be endur-
ingly stable. The concept of equilibrium implies otherwise, but the
SonnenscheinMantelDebreu theorem shows that this is a problem
with the concept and not with the market to which it is applied. No
amount of theoretical commitment to the technically correct price of the

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The Collapse of the Model World

prevailing phenomenal world can ever be sufficient on its own to secure

against adverse price movements in practice. And is there any wonder
in relation to the credit derivatives market when the Gaussian copula
formula consistently underestimates risk by deliberately assuming away
the much fatter tails of the distribution of probabilities of mortgage
default (Orrell 2010: 137)? This might be a deliberate ploy to facilitate
more aggressively speculative trading positions, but that in itself is
merely an additional factor of market instability. The task of determining
the precise structure of default correlation is notoriously difficult given
the wealth of empirical material required to come up with a reasonable
estimate. But does this really justify the easier to handle approach [of]
assuming some kind of homogeneity at the portfolio level (Laurent
2008: 411)? Even the possibility of very high upper tail correlation was
strategically overlooked by choosing to treat as representative mortgage
data from a short period of time in which house prices had gone up at
record-breaking speeds (Beneplanc and Rochet 2011: xxv). This highly
restrictive data was used to reinforce the view that a total market col-
lapse could happen only around once every 10,000 years, despite the
fact that in adverse market conditions downside asset-price trends are
much more highly correlated at the high-probability-of-default end than
anywhere else within the distribution (Danielsson 2011: 25). Once more
it would seem to suggest that the visualisation techniques provided by
Kuhnian exemplars allow people to see only what they are professionally
preconditioned to want to see through their ingrained Schumpeterian


The crux of the matter, then, is what could reasonably have been spot-
ted in economic data to suggest that all was not well either in specific
asset markets or the economy as a whole. It is a question of what could
have been seen but, for reasons of intellectual subservience to the core
economics Vision, was not. There are a number of examples, it should
be noted, of heterodox economists signalling clear and apparent danger
from their reading of the economic data (see van Treeck 2009: 468). As
Steve Keen (2013: 248) has pointed out, little attention was paid outside
of heterodox circles to a finding that was increasingly well known within
them: namely, that observed changes in the so-called credit accelerator

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mapped very closely onto indicators of macroeconomic instability that

DSGE models simply cannot recognise. Tracking the dynamic path of
the ratio of private sector debt to GDP in any number of variants of the
Minsky financial instability hypothesis should have been enough to warn
of troubles ahead (Schularick and Taylor 2012: 1030). This escalating
private sector debt resulted largely from households greater exposure
to ever expanding house prices and from banks increasingly wholesale
adoption of a valuation technique that enabled them to make the most
money possible from secondary mortgage markets.
Lis Gaussian copula formula was instrumental in tying together
these two aspects of accelerating private sector debt via its impact on
an increasingly frenzied MBS CDO market. Mortgages were issued
in the increasing absence of reasonable due diligence tests (House of
Commons Treasury Committee 2008: 166; Financial Services Authority
2009: 45) because it was mortgage volume and not the intrinsic viabil-
ity of individual mortgage repayment schedules that mattered most
to the ability to create mortgage-backed securities. Without those
securities the corresponding CDO market that Lis model depicted as a
potential trading goldmine would have been unimaginable. The move
to mass mortgage issues helped to keep house price increases bowling
along, which at the same time seemed to confirm the robustness of
Lis model, as it would work for as long as the immediate future shad-
owed the recent past by avoiding a housing market downturn (Muolo
and Padilla 2008: 171). The fact that the Gaussian copula formula
copied the DSGE traditions distinct lack of interest in business cycle
effects suggested that such downturns were nothing to worry about
(Blinder 2010: 386).
Despite all the evidence of the increasingly dubious selling of mort-
gages as the bubble inflated, then, this had no impact on the visualisation
technique embedded in Lis model. It continued to suggest that the prob-
ability of individual mortgage default was seeable only as autonomous
points on a scatterplot governed by past personal credit history and
completely unaffected by contagion effects produced by the bubble itself.
Default correlation therefore continued to be treated as if it reflected
the bell curve characteristics of a normal distribution that was entirely
resilient to changes caused by the dominant price trend. Yet the influ-
ence of the individual homeowner on the ability to continue meeting
mortgage repayments is marginal compared with how changes in the
broader economy impact upon whether or not the original purchase

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The Collapse of the Model World

price was sensible. Actuarial assumptions about a persons character,

their past willingness to renege on other loans and their general financial
competence might help to fix them in a particular position on a normally
distributed scatterplot of mortgage default probabilities. Such differences
are quickly washed away, however, when adverse pricing trends send the
housing market as a whole into reverse.
House prices display a direct and positive correlation of such sig-
nificance that it becomes necessary to think of their serial correlation
(Watson 2008: 289). Put simply, the most important signal of how
the price of an individual house is likely to change today is how the
housing markets average price changed yesterday. A genuinely eco-
nomic economics would be fully attuned to the patterns of economic
socialisation which link all houses together in a super-portfolio of
this nature. The connection is provided by the cultural construction
of a housing ladder which, if climbed successfully, provides simulta-
neously for both enhanced asset wealth and social advance (Malpass
2005: 14). Yet such a conception fits uneasily in an era of uneconomic
economics, where the convention is to concentrate on the pricing
dynamics of individual assets and not on the pricing dynamics of the
asset market as a whole (Mehrling 2005: 237). The former is consist-
ent with a focus on demand and supply alone, but the latter makes it
necessary to also take into account a whole host of social indicators of
housing market success.
When reconfiguring the housing market conceptually as a super-
portfolio of serially correlated house prices, the chances of individual
homeowners defaulting on their mortgages must in turn be serially
correlated to a potentially enormous degree. This possibility, unfor-
tunately, is fundamentally unseeable from the perspective of Lis
Gaussian copula formula. The purpose of this book, however, is not
to blame Li for the market collapse that led to the financial crisis,
because the problem is more deeply rooted than that. The criticism
I want to lay at the door of uneconomic economics is not even that
it failed to foresee the crisis per se. It is that the crisis was funda-
mentally unforeseeable from within the perspective that now defines
economics orthodoxy and that the attempt to explain the crisis away
as a fat-tail event of monster proportions does nothing to suggest a
rethink to the basic way of visualising the economy. These are choices
to render some significant aspects of economic life generically unno-
ticeable in the name of economic science. The desire to view the world

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through a market completeness lens in spite of the contrary teach-

ings of the SonnenscheinMantelDebreu theorem would seem in
the first instance to reflect professional ends rather than ideological.
But how did it come to be this way? That is what I try to answer in
the next chapter as I turn my attention to the formalist revolution in

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The Creation of the Model
World: From Formalist
Techniques to the Triumph
of Uneconomic Economics
Abstract: Orthodox economics opinion took a fundamentally
new direction in the 1950s so that it could become more abstract,
more technical and more dedicated to the use of complicated
mathematical models. This in turn allowed equilibrium to be
visualised as a point in mathematical space. That concept was
no longer economically derived, but its meaning continues
to be incorporated into an economic vernacular which has
significant political implications. The theoretical possibility of
the existence of a mathematically derived equilibrium can make
it look as though the hypothetical markets of the model world
are a good guide for the workings of actual markets. The ascent
of uneconomic economics has therefore been accompanied by
assumptions of a much diminished role for government as a
stabilising influence within the economy.

Keywords: ArrowDebreu; formalist revolution; general

equilibrium economics; market self-regulation; policy
ineffectiveness proposition; Walrasian auctioneer

Watson, Matthew. Uneconomic Economics and the Crisis of

the Model World. Basingstoke: Palgrave Macmillan, 2014.
doi: 10.1057/9781137385499.0006.

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Uneconomic Economics and the Crisis of the Model World


The rescue package introduced in the wake of the financial crisis allowed
the proponents of orthodox economics opinion to once more flex their
muscles. Should the banks be saved? A widespread silence on the issue
from the DSGE models that struggled to even comprehend the question
was in general treated as covert agreement. Rescuing the banks, after all,
was considered necessary for once again allowing markets to perform
their in-built functions of efficient allocation. Should the rescue package
also be extended, though, to saving jobs? Here, widespread silence and
covert agreement were often replaced by vocal tub-thumping and overt
disagreement. The banks that had fuelled the crisis were worthy of public
support, it seems, but to orthodox economics opinion in any case not
the workers whose economic opportunities were much diminished in
the fallout from the crisis.
Not all economists thought likewise, but the very fact that this opin-
ion was heard at all was evidence of what could and what could not be
said through the lens of orthodoxy. Paul Krugman (2009b), for one,
made much of macroeconomics being pushed back into the Dark Age
by the refusal of those who could not see beyond their own ingrained
demand-and-supply Vision when confronted with proposals for a major
coordinated G20 reflation. This phrase has been a source of irritation
for economists with professional reputations to defend in the purity of
DSGE models (see Lucas 2009: 67), but Krugmans deliberately provoca-
tive comment was itself a sign of his concern that policy debates might
be hijacked by orthodox economists anti-intervention models (Skidelsky
and Wigstrm 2010: 1). The observation that thoughtful economic opin-
ion was being overrun by barbarians in the grip of an obscurantist faith
rather gave the game away in this respect (Krugman 2009b).
Krugmans frustration was with a sense that economists were playing
pass-the-parcel with the crisis: restating their commitment to a style of
thinking that had allowed the credit bubble to inflate, whilst volunteering
other people to shoulder the human costs of the crisis when the bubble
burst. The primary target of his criticism was 2013 Nobel Laureate Eugene
Fama, the person most associated with the efficient markets hypothesis
(EMH). Fama had blogged stridently that the overall effect of a stimulus
package could never be higher than zero, relying on his EMH intuition to
say that markets will always accommodate all information about public
expenditure increases to shift a corresponding amount of money away

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from private investment. This lost consumption and investment, and

the incomes they would create, are the big costs of a bailout, he wrote
(Fama 2009). We tend to forget ... the businesses that close or the new
businesses that dont start because the bailout displaces productive activi-
ties elsewhere. He was supported in this view by a fellow Nobel Laureate,
Thomas Sargent (2011: 9), who argued that the equilibrium concept can
disable someone who proposes to improve outcomes, thereby delivering
a humbling message to all policy-makers.
Fama thus introduced into the policy debate about post-crisis inter-
vention a strong version of the EMH (see Fama 1991: 1576). Indeed, it
was a much stronger version than can be justified by his own empiri-
cal work on the outer limits of market efficiency (Fama and French
2004: 26). His comments on the impossibility of sheltering workers from
the fallout from the crisis consequently provide a compelling example
of how economists sight can be impeded by their professional Vision,
when what they think they are looking at as a market is in fact nothing
more than a market of their own trained imagination.
Put another way, it is very difficult to impose the status of observa-
tional science on economics when what is being observed is carefully
controlled so that the patterns emerging from the data do not look out
of place with the underlying theory. If the right restrictions are placed
on what market to view at what moment of time and in what way, then
it is very difficult to rule out the possibility that markets are sometimes
efficient (Shleifer and Vishny 1997: 36). But does this mean that market
efficiency can be ruled in to the point of being a definitive statement
about the nature of the world? Famas own reluctance to let the strong
version of the EMH shape his later work suggests quite conclusively that
it cannot, even if, as Cornelis Los (2003: 47) points out, most textbooks
in finance have blindly adopted this theoretical idealization of financial
Such a view requires that the EMH is a transcendental truth embed-
ded in nature. As John Kay (2010: 92) tellingly notes, though, the efficient
markets hypothesis is not a theoretical representation of anything that
can ever be true or false per se. It is a way of thinking about the world
prior to observing relationships within it, rather than an imprint of that
world which can then be used as a means of structuring thought about
it. The EMH is perhaps the best example in economics of a Kuhnian phe-
nomenal world that increasingly comes to be used as a direct substitute
for an external world of actual economic relations. The two worlds might

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occasionally come together as even relatively close approximations, but

this tells us very little about the truth claims genuinely contained within
the EMH. The most that can be said is that the more these approxima-
tions are treated as certain knowledge the more popular the EMH has
become amongst economists as a way of viewing their own phenomenal
world. The EMH is embedded in something, but that thing is the eco-
nomics profession and not nature. Famas intervention into the debate
about the fiscal stimulus not to mention the way in which other econo-
mists have rallied to his defence when the notion of efficient markets has
come under attack provides a notable insight into the depth of that
It also shows that it remains easy to read into the demand-and-supply
Vision of orthodox economics opinion a simple ideological preference
for subjecting social relationships to market tests. After all, both starting
points lead to the same denial of a constitutive role for the government in
repairing an economy damaged by the financial crisis. Famas crowding
out argument is familiar from the 1970s attacks on tax-and-spend poli-
cies, when the same argument about the perfect substitutability of public
and private investment was used to launch avowedly ideological pro-
market alternatives to the existing policy settlement. However, Famas
repetition of his EMH intuition in the face of government proposals to
correct a clear case of market failure might also just as easily represent a
professional defence of the models through which he made the reputa-
tion that has subsequently culminated in a Nobel Prize. The formalist
turn in economics, after all, has elevated the purity of the form of eco-
nomic models over their content. From this perspective, the stimulus
package would have looked more of a threat to the general equilibrium
framework within which orthodox economic models are situated than
it would have done to the political principles of economic organisation
such models might be said to carry in them.
In an attempt to pursue such a claim, the chapter now proceeds in
three stages. In the first section I show how the analytical commitment
to formalism has evolved into a series of macroeconomic models which
always treat active government as harmful. The most obvious expression
of this way of thinking comes from those who follow the well-known
Sargent and Wallace (1975) policy ineffectiveness proposition. Famas
statements about the self-defeating nature of using government stimulus
to negate the fallout from the financial crisis are merely one example of
such an approach. The remaining sections then locate this almost wholly

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negative attitude towards macroeconomic stabilisation policy in the

demand-and-supply Vision of general equilibrium economics. In the
second section I review the main analytical achievements of the pioneers
of the general equilibrium approach, and in the third section I read the
subsequent evolution of that approach politically. In common with the
rest of the book I seek to separate the initial inspiration for deriving gen-
eral equilibrium conditions from its later political use, whilst recognis-
ing that the demand-and-supply Vision of orthodox economics opinion
often blurs the lines between the two. The uneconomic economics of
formalist methodology can very quickly become a distinctly political
economics, even if the politics is only to deny government capability
within the economy. I conclude by showing how this is consistent with
the renarration of the financial crisis as one of overextended and debt-
financed state expenditures.

The return of the policy ineffectiveness proposition

John Eatwell and Murray Milgates (2011: 10) concern that economics has
become dominated by an empty formalism can be extended beyond their
original claim. Historically, this charge has always related to an empirical
emptiness. It is perhaps best captured in Mark Blaugs (1992: xxii) com-
plaint about the reveling in technique for techniques sake. Peter Bauer
(2002: 45, emphases in original) has an equally arresting turn of phrase
for the same phenomenon: What we see is an inversion of the familiar
Hans Andersen story of the Emperors New Clothes. Here there are new
clothes, and at times they are haute couture. But all too often there is no
emperor within. The charge against orthodox economics opinion is that
what is typically presented as economic analysis is usually the manipula-
tion of purely mathematical relationships dressed in descriptors that seem
to imply some connection to everyday experiences of the economy (Birner
2002: 161). All too often, though, it presents precise and logically consistent
mathematical concepts which differ considerably from socially produced
economic realities that might not have the same experiential meaning for
two people or even for the same person twice. The translation between the
mathematical and the economic realms falls down because it has to talk
across incommensurable ontological planes (Hutchison 2000: 19).
The decisive moment in the history of empirical emptiness within for-
malist but uneconomic economics can be located in a seven-page paper

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written in the early 1950s by Kenneth Arrow. He had previously been at

the forefront of attempts to show that a higher degree of generality could
be obtained by shifting from the less abstract mathematical structure of
algebra to the more abstract mathematical structure of convex set theory
(Arrow 1951). The technique of separating hyperplanes as drawn from
convex set theory was applied to argue that the line produced at the
crossover of planes representing indifference and transformation curves
could be thought of as the manifestation of a relative price differential
(Niehans 1990: 483). The individuals whose actions result in plane-
consistent indifference and transformation curves clearly do not exist
in any real sense (Pagano 2004: 262). It would be unrealistic to expect
anyone even leading economists like Arrow himself to have the opti-
misation skills relevant to the mathematical procedures. In the search
for something that looked like a plausible economic interpretation of
set theory, however, he proceeded without any recourse whatsoever to
verifiable patterns of individual economic socialisation, exorcising from
his markets individuals as sociologically recognisable entities.
In their place Arrow inserted a generalised idea of an options market,
one that might apply to every imaginable commodity in every imaginable
state of the world (Warsh 2006: 163). All pretence to matching economic
theory to what is known about how real people behave in different eco-
nomic circumstances was thus sacrificed in the interests of mathematical
precision. The process of embedding a distinctly uneconomic economics
consequently required moving from what Alfred Marshall (1920: 1) had
described as the study of mankind in the ordinary business of life to
the study of purely hypothetical market scenarios. Less than two gen-
erations later, Jack Hirshleifer (1985: 53), one of the leading advocates of
an imperialist approach to extending the reach of this new economics
into an uber-model for all of the social sciences, derided the Marshall
definition as terribly narrow, dull, bourgeois. The relationships from
the blackboard had consequently completely supplanted relationships
that could actually be lived as the touchstone of economic knowledge
(McCloskey 1994: 178).
Within this new phenomenal world, Arrow had provided for econo-
mists such a mathematically precise way of interrogating every conceiv-
able market state that all possible holdings of goods both now and in
perpetuity could be represented as an element of a separating hyperplane.
Significantly for the story of the model worlds demise as told in the
previous chapter, this changed the meaning of uncertainty in economics.

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In all previous phenomenal worlds the more so, moreover, in those

defined by a distinctly economic economics uncertainty was deemed
to be an absolute feature of the theoretical system because it was consti-
tuted through unpredictable future behaviour (Davidson 2009: 35). With
Arrows set theory recasting unknowns as knowables, though, uncertainty
thus became a statistical conception to be plotted as if it followed easy-to-
grasp probability distributions (Jackwerth and Rubinstein 1996: 1613).
This seemingly innocuous mathematical move had the effect of chang-
ing the meaning of some of the most important concepts in economics,
all the while placing them more firmly in the camp of uneconomic
economics. Competition, for instance, had originally had an intuitive
economic meaning linked to the degree to which impediments existed to
the free movement of resources across sectors, but in the new phenom-
enal world created by convex set theory it became possible to talk instead
of the mathematically precise but economically only ever hypothetical
perfectly competitive market. Likewise, the notion of a competitive
equilibrium had started life with the equally intuitive economic meaning
of progress in the direction of more equal profit rates, but post-Arrow
the focus has increasingly been on single points in mathematical space
produced by the interaction of infinitely repeated acts of price-taking
behaviour (Mongiovi 1999: 9).
With this new conceptual repertoire to hand, Arrow was able to show
that his geometric representation of a market-oriented system exhibited
a property identified by mathematicians as duality. This meant that
every problem captured within the separating hyperplane methodology
could be stated in two ways at once: either in its own terms or through
its obverse known as the dual (Warsh 2006: 161). The demand-and-
supply Vision of orthodox economics opinion became central to Arrows
phenomenal world when the line joining the intersection of two planes
was shown to be a pricing problem when read in its own terms and
an allocation problem when read through its dual. As the market had
already come to be defined as a mechanism of efficient resource allo-
cation, all prices produced by the models equilibrium features must
therefore necessarily also be assumed to be the most technically efficient
prices. Such prices do not have any real empirical meaning because the
process through which they are derived exists nowhere other than in the
phenomenal world created by convex set theory. Nonetheless, they are
the closest thing to providing this way of thinking with some connection
to something that is recognisably economic in nature.

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If this is the source of the empirical emptiness of formalist economics, it

also provides the roots of its political emptiness. The same changing con-
ception of competition and of competitive equilibrium not merely enables
a mathematical solution to be found for hypothetical market arrange-
ments. It also supplies a set of solution conditions that allow no room
for active government. The economy exists in this phenomenal world as
a manifestation of its own internal structural logic and as nothing more
than that. Each side of the pricing/allocation dual makes perfect sense of
the other without the need for any external intervention. Indeed, any such
intervention is merely a market distortion that corrupts the elegance of
the mathematical system and, by implication, it also corrupts the logic of
the associated economic system. Government is consequently not only
exogenised, but exogenised as an unremitting negative. It is in this way,
for instance, that contemporary dynamic stochastic general equilibrium
(DSGE) models are silent on how public spending might help to coun-
teract the worst excesses of the business cycle, to the point at which even
when additional stabilisation expenditures were entirely necessary to stop
the financial crisis from getting completely out of hand their usefulness
made no impression on macroeconomic orthodoxy (Goodhart 2010:
53). The very presence of government in the economy went against the
logic of the phenomenal world created by convex set theory and therefore
made it easy for orthodox economics opinion to raise concerns with the
stimulus package as soon as the crisis was politically renarrated as a crisis
of overextended public debt holdings.
The renarration of the financial crisis therefore appears to have
breathed new life into Thomas Sargent and Neil Wallaces (1975:
249) policy ineffectiveness proposition: namely, that [t]here is no
systematic rule that the authority can follow that permits it to affect
the unexpected part of the price level. This in turn was an early state-
ment of the radically pro-market political potential of Robert Lucass
(1972) rational expectations revolution. In straightforward terms, the
SargentWallace proposition says that real output effects can only
emerge from surprise changes to the money supply, but that individu-
als holding rational expectations will become increasingly effective
at second-guessing such surprises. Active stabilisation policies must
therefore necessarily be wasted effort at best and counterproductive at
worst (see Frydman and Phelps 2013: 23). Some early tests were devised
in apparent support of the policy ineffectiveness proposition, but these
said less about rigorous empirical proof than they did about the desire

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to want there to be support for the old neoclassical concept of a natural

rate of unemployment (Frisch 1983: 136).
However, the jury has subsequently found decisively against the
SargentWallace position. It might still be politically appealing for
those whose suspicions of government run deep to have access to a
macroeconomic theory that denies the public good justification of
active stabilisation policy, but there is no empirical basis for believing
that the theory represents anything more tangible than the preference
for one phenomenal world over another. After a period of more exact-
ing testing it has been concluded most politely that the policy ineffec-
tiveness proposition is merely an approximation that is not likely to
be strictly true (Sheffrin 1996: 42, 47) given that its earlier ostensible
confirmations could not be substantiated (Gottschalk 2005: 99). When
the gloves have come off a little more, the relationships it discusses have
been dismissed as terra incognita (Buiter 1989: 69), the evidence on
which it is based as weak (Mishkin 2007: 3) and its broader vision as
a failure (Snowdon 2002: 136), culminating in the seemingly definitive
conclusion that its associated programme of research has been left to
die neglected and unmourned (Gordon 1989: 179). It should therefore
cause raised eyebrows to discover the policy ineffectiveness propositions
body-doubles walking around in such renewed vigour in the aftermath
of the financial crisis.
The original SargentWallace position was derived from modelling
government attempts to inject new money into the economy as a param-
eter intervention. The mathematics of such models allowed Lucas (1976:
104) to treat as an obvious fallacy what he took to be the standard inter-
ventionist argument that inflation can induce a permanent economic
high. In practice, however, all that can be shown from this perspective
is that a monetary expansion that has an impact on the probability dis-
tribution of the price level does nothing to alter the relative pattern of
forces acting upon its mean. Because the effect on the probability distri-
bution will be perfectly symmetrical about the mean under a parameter
intervention, it shifts the mean to the right on a standard demand-and-
supply diagram but without any compensating real effect (Frydman and
Phelps 2013: 22). The whole impact of the policy change will feed into the
price level and not into the level of output, such that rational expecta-
tions economics depicts the real sector of its macroeconomic models as
being entirely autonomous of anticipated monetary policy (McCallum
1980: 724). Once more we are confronted with the apparently ubiquitous

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probability distributions to tell us how blackboard market relationships

impose themselves on the actual economy.
If this particular blackboard representation is to allow policies to work,
the governments pre-announcements have to dupe the representative
individual into believing that the policy path to be followed is different
from the one that has actually been embarked upon (Gottschalk 2005:
98). Yet this must still be a suboptimal policy within a demand-and-
supply Vision because it relies upon people being systematically misled
about the true nature of where the demand and supply schedules are
located (Marin 1992: 92). From such a perspective optimal policy can
only ever be crafted out of a well-publicised policy rule that then is
adhered to rigidly, thus neutralising the real effects of any intervention
(Kydland and Prescott 1977: 479). The consistently successful optimiser
keeps both themselves and the entire macroeconomic system in equi-
librium by restricting their economic decisions to the effects of real
factors they know cannot be altered by stabilisation policy (Sent 2006:
13). What basis is there for such a supposition? Certainly not strong,
in-depth empirical findings, as is shown by the accusations of empirical
emptiness levelled persistently against formalist economics. Instead, it is
determined by the mathematics that allow monetary expansions to be
modelled as parameter interventions.
However, the mathematics that facilitate the policy ineffectiveness
proposition also make a series of demands about how to conceive of a
functioning economic system. It must be a purely hypothetical economy
taking the form of a continuous set of perfectly clearing ArrowDebreu
markets, otherwise even the assumption of rational expectations is not
sufficient on its own to demonstrate that monetary expansions have
no effect (Sheffrin 1996: 45). Again, then, the inverted commas here
carry significant meaning. The earliest tests of the policy ineffectiveness
proposition could show that fluctuations in output appeared to occur
independently of anticipated monetary changes (Barro 1977: 102), but
at no stage was this finding extended to its necessary corollary: that
price changes occur instantaneously to fully reflect anticipated nominal
changes to the money supply (Gordon 2004: 229). The assumption of
automatic market clearing had to be retained to prevent the whole argu-
ment from completely falling apart, but it was never more than a thinly
veiled sticking plaster allowing market price and allocation effects to act
as one anothers duals. Nothing, moreover, has changed in this respect
over the past 35 years, so the policy ineffectiveness proposition is no

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more a plausible position now than it was then: it remains what Willem
Buiter (1989: 75) has called the macroeconomics of Dr Pangloss.
Translating the mathematics of parameter interventions into something
recognisably economic requires the insertion into the theoretical system
of perfectly flexible multi-period contracts stretching out interminably
into the future. The only way of achieving the necessary flexibility for the
desired price behaviour is to model all economic activity as contingent
forward contracts located within institutional arrangements that permit
no price rigidities at all. It is clear in this regard that we are talking about
an economy situated in an ArrowDebreu phenomenal world rather
than an actual economy. How else could we possibly interpret Sargent
and Wallaces (1975: 241) insistence that [i]t turns out that the prob-
ability distribution of output ... is independent of the particular deter-
ministic money supply rule in effect? We are returned for yet another
time to those probability distributions and their role in performing the
visualisation of market relationships. The modern general equilibrium
approach provides arguably the most compelling framework of a purely
hypothetical market world ever to be devised in the name of economic

The quest for a fully specified general

equilibrium framework

Economics has a long history of the pedagogical thought experiment: a

theoretical exposition of the demand-and-supply Vision around which a
reorientation of the field takes place, professional reputations are made
and, these days at least, Nobel prizes are awarded. To be truly successful
in Kuhnian terms, a thought experiment leaves the blackboard for the
textbooks and becomes the means through which successive generations
of students learn the most basic orthodox visualisation techniques of the
subject field (Margolis 1993: 7). Anyone who has studied economics in
its Anglophone tradition will be only too familiar with being required to
learn by rote the process of market price adjustment using the standard
demand-and-supply diagram. Kuhn (1977: 297) latterly came to believe
that perhaps the greatest influence of a disciplinary paradigm was its
proponents ability to produce self-referential thought experiments
that rendered the underlying Schumpeterian Vision less susceptible to

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Significantly, Kuhn placed the thought experiment firmly in the phe-

nomenal world of theoretical abstraction (Hacking 1983: 185). However
plausible it was, however closely it chimed with perceptions of lived
experience, and however much it could be explained using vernacular
language drawn from everyday life, nothing could displace the thought
experiment from its essential function of helping to organise the way in
which a community of theorists engages one another professionally. Kuhn
(1981: 7, emphases in original) was adamant that the new understanding
produced by thought experiments is not an understanding of nature
but rather of the scientists conceptual apparatus. Thought experiments
have no direct corollary in the external world to allow them to be tested
against data in an explicitly confirmatory sense. Instead, only subsidiary
testing of real-world approximations is possible. However, Kuhn (1981:
14) insisted that testing a thought experiment in the first instance as a
matter of its own internal logic was never more than a propadeutic to
the full discussion pending subsequent systematic empirical investiga-
tion. In other words, to allow ones thinking to be formally contained by a
thought experiment is to elevate the underlying Vision to a plateau from
which it is increasingly impervious to empirical refutation. Imre Lakatos
(1978) called this a subject fields hard core, protected axioms that do not
need to survive continual testing to preserve their integrity.
Both Lis Gaussian copula formula and the BlackScholesMerton
equation to which it is so often likened act as thought experiments.
Interestingly, though, because they facilitate respectively a pricing
rule and a trading rule which have been extensively adopted within
financial markets, they have at times been responsible for helping to
produce their own performative effects (see Chapter 2). The qualifier, at
times, is important here, because as multiple financial crises show it is
always possible for counterperformativity to set in as prices collapse in
markets based on Li and BlackScholesMerton models. Performative
effects and empirical proof should not be treated as the same thing,
then, especially in a context such as financial market trading in which
traders learned intuitions of what constitutes a fair price can always
be overwhelmed by their fear that the entire market price structure is
on the verge of collapse. Besides, both Lis Gaussian copula formula and
the BlackScholesMerton equation, whilst thought experiments in
their own right, are themselves epiphenomenal of a more generic and
therefore a more important thought experiment. In the Russian dolls
formation of thought experiments underpinning orthodox economics

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opinion, none arguably casts a larger shadow than that associated with
the general equilibrium framework.
It has long been the goal of economists to demonstrate the possibility
that demand-and-supply dynamics alone are sufficient to create a self-
sustaining and self-functioning economic system. By adding the condi-
tion that an economy of this nature operates at an equilibrium level, an
unnecessary rhetorical flourish has burdened the search for a workable
solution. To talk in terms of an equilibrium state is an act of analytical
bravado placed on top of the wider search for an explanation of how
conditions generally attributed to an abstract market might serve to
coordinate countless instances of individual economic behaviour. This
so-called market coordination problem is the key to whether there are
genuine economic justifications for the introduction of market institu-
tions within society (Watson 2005: 156). Other reasons might be given
in pursuit of straightforward ideological objectives, but this is very
different from being able to say that market institutions should always
be adopted because they will automatically facilitate enhanced levels of
economic performance. It is little wonder, then, that some of the very
brightest stars in the economics firmament have set their sights on the
market coordination problem. Its solution is, in many respects, orthodox
economists professional Holy Grail.
The first of the great economists to lead the search was Lon Walras, in
various editions of his path-breaking articulation of what we now know
in shorthand as the neoclassical tradition, Elements of Pure Economics. He
was not responsible, however, for setting the market coordination prob-
lem within the context of infallible demand-and-supply dynamics, and
certainly not a politicised reading of that Vision. This was a later addition
from the hands of a Walrasian School that had succumbed to the attrac-
tions of formalist methodology. Walras was a dedicated late nineteenth-
century social reformer whose instincts were to use increasingly precise
statements about the limits of acceptable market regulation to assist the
process of poverty alleviation. Much of the post-crisis defence of the
general equilibrium framework from Nobel prize-winning economists
has scapegoated the poor and passed the costs of clearing up the mess
left by the banks onto their shoulders (see, for instance, Lucas 2009:
67; Sargent 2011: 29). Walrass politics, though, were very different. His
intellectual interest in the market coordination problem was stimulated
by his political interest in specifying those aspects of social policy that
should remain free from encroachment by the policing effects of market

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logic. It was only by isolating the economic dynamics that might explain
successful market self-reproduction, he believed, that it would also be
possible to show where markets should have no role (van Daal 2006: 52).
It is impossible to open the pages of his Elements, be confronted with all
the equations to be found there and not conclude that Walras worked
within the purely abstract language of market. Yet he did so precisely to
facilitate commentary on real-world markets. The move between mar-
ket and market must therefore be seen as an essential feature of Walrass
It is therefore not without the greatest irony that Walrass eventual fail-
ure to imbue with genuine economic meaning the adjustment process
attributable to markets has latterly been treated as proof that real-world
markets can be trusted to guide the social relations of production. The
fact that Walras did fail in his ultimate objective is not acknowledged
anywhere near as readily as it should be in textbook accounts of the his-
tory of economic thought, as so great has been the rush of uneconomic
economics to try to identify a genuine economic foundation on which
it might be based. Walras certainly set off with the intention of solving
the market coordination problem economically (Jaff 1980: 545). The
earlier editions of his Elements treated the process of price determination
as an in-time historical phenomenon (Walker 1987: 759). Time delays
were consequently inserted into his system of simultaneous equations
to capture the sense that not all prices are necessarily market clearing
prices. As a result, a price that arises from the interaction of demand
and supply at one moment of time may evolve in a series of stages over
subsequent moments of time to correct current market imbalances, but
equally it may not do (Walras 1984 [1954]: 7380). Walrass concept of
equilibrium is thus not a condition automatically ascribed to markets
so much as a condition that might or might not be approached when
observing iterative pricing dynamics.
Walras used the notion of ttonnement to describe the outward
appearance of prices groping towards a position of stability. However,
even when using restrictions in his theory of economic agency which
he readily admits are a fiction suited only to the phenomenal world
described by his system (Walras 1984 [1954]: 37), he was unable to go
beyond saying that an equilibrium structure of prices might exist so that
all markets might clear at the same time (Jolink 1996: 127). Walrass system
did not reveal the secret of why such a structure should be expected to
materialise. In the first three editions of the Elements, he tried to resolve

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The Creation of the Model World

this issue within the mathematical framework of his model whilst none-
theless retaining the image of a price determination process that gropes
towards the final level at which it will settle. He was not successful,
however, in ever getting his simultaneous equations to tell the economic
story he wanted to recount. Indeed, he was moved as far as to give up on
trying to model the emergence of equilibrium in noticeably economic
terms (Bridel and Huck 2002: 524).
The fourth edition of the Elements is generally considered to be Walrass
definitive treatment of the market coordination problem, and it is on the
basis of reading this edition that failure often gets mistaken for success.
There, though, ttonnement itself only a heuristic concept but at least
one that has some degree of genuine economic resonance disappeared
altogether. It was replaced by what has subsequently become known as
the Walrasian auctioneer (Fisher 1987: 26). The degree to which Walrass
theory had entered the realm of uneconomic economics is made clear by
the way in which the auctioneer construct is described in the secondary
literature: as an economy-wide market secretary (De Vroey 1999: 427)
capable of replicating the actions of a computer-like intellectus angelicus
(Jaff 1967: 2). Its job was to cry out a single price at which all markets
would clear simultaneously. The idea that all markets do not always clear
all the time was therefore sacrificed in the interests of mathematical
tractability. Walrass system of simultaneous equations suddenly became
solvable after the introduction of the auctioneer construct, but only by
dictating that all production, all exchange and all consumption had
to take place in a single moment of time (Walras 1984 [1954]: 242). In
this one analytical move the fourth edition of the Elements reduced the
notion of equilibrium to something that could conceivably be visualised
as a single mathematical point, and this has been a hallmark of orthodox
economics opinion ever since.

Formalist technique and the logic of

market self-regulation

The Walrasian tradition that has cohered into modern general equilib-
rium economics appears to have learnt more from Walrass mathemati-
cal sleight-of-hand in the fourth edition of the Elements than from the
economics of the first three editions. It is not the mathematics per se
that has become controversial, so much as the use of a particular type

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of mathematics that all but eliminates meaningful economic interpreta-

tion (Eatwell and Milgate 2011: 4). The two languages that economists
routinely use economics on the one hand and mathematics on the
other are therefore often in open conflict. The discussion in the after-
math of the financial crisis has revealed that, in such circumstances, the
professional training of orthodox economics encourages its practitioners
to display their gifts as mathematicians in the first instance and to worry
later about what this allows them to say economically. This trend has
become so pronounced that Blaug (1992: xxii) has written that economics
should probably be re-christened social mathematics, which he defines
as a brand of mathematics that appears to deal with social problems but
does so only in a formal sense. Unfortunately, he has continued else-
where (Blaug 2002b: 31), macroeconomics in recent years has fallen prey
to empty formalism in which the principal goal of theorizing seems to
be analytical elegance and not a better grasp of practical problems and
hence greater control of economic events.
The separating hyperplanes of modern general equilibrium econom-
ics are the spiritual heirs of Walrass reduction of all economic activity
to a point in mathematical space. They are also a prime example of what
Blaug is alluding to when he expresses concern about how far modern
macroeconomics is now removed from the old-fashioned art of public
management of the economy (see also Colander 2001: 9). Frank Hahn
(1984: 78), one of the foremost exponents of the general equilibrium
approach and its most thoughtful internal interlocutor, has put it this
way: [I]t is obvious to me that we [his fellow macroeconomists] do not
possess much certain knowledge about the economic world and that our
best chance of gaining more is to try in all sorts of directions and by
all sorts of means. This will not be furthered by strident commitments
of faith. Yet this latter perspective is what has been most obviously wit-
nessed since the initial crisis narrative shone the spotlight onto the eco-
nomics community and its adoption of complex mathematical methods
(Goodhart 2010: 55). Macroeconomists of an orthodox persuasion closed
ranks around the mathematics of separating hyperplanes, the structure
of ignorance it leaves behind about how real people are likely to act in
real markets, and the ideological burdens carried by their professional
The result is a continuation of the process through which orthodox
economics opinion is set up primarily to solve problems that are of
economists own making rather than problems that are inherent in the

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world of practice (Dppe 2011: 60). It is thus in danger of becoming self-

referential, where the existing structure of the dominant models deter-
mines what the research agenda will be, not the way in which changes
in production techniques and consumption patterns are reshaping
peoples everyday economic experiences (see Hutchison 2000: 18). We
are told many stories using DSGE models about what equilibrium will
look like when we are there, but disappointingly few about where we are
now, how far this is from the promised land, what would be entailed to
get from here to there, and even whether that gap is bridgeable. Would
we recognise that we had arrived in practice at equilibrium even if by
some fortuitous happenstance we managed to alight there? Could we
ever be conscious of even our general point of existence on a separating
hyperplane, let alone know how to adjust our behaviour to target precise
points on it?
These questions need to be answered in the affirmative if the market
coordination problem is to be resolved in an economically meaningful
manner. Clearly, though, this is to impute onto the economic agents
who inhabit the blackboard models cognitive capacities that they sim-
ply could not be expected to replicate in real life. However, these are
the assumptions that are now made in an increasingly unquestioning
manner as the Walrasian tradition has migrated, seemingly en masse,
from one mathematically oriented type of visualisation technique for the
economy to another. Walras himself had used a system of simultaneous
equations to envision the economic relationships he wished to explore,
where terms such as output and price still had the same generic mean-
ing to economists as they did to non-economists (Coddington 1975: 540).
However, by the time of the ArrowDebreu advances in general equilib-
rium economics, convex set theory had displaced a system of simultane-
ous equations as the favoured visualisation technique (Weintraub 1993:
96). In such circumstances, words such as output and price are simply
names given to vectors that help the desired mathematical functions to
be performed. They are stripped of their essential economic meaning,
and the same mathematical solution could be derived by using two
nouns selected entirely at random to name the vectors.
In textbooks on structural macroeconometrics, this move tends to be
celebrated as the formal imposition of theoretical discipline on reduced-
form characterizations of the economy (DeJong and Dave 2011: 3). Yet
there are clearly a number of difficulties in assuming that what orthodox
economics opinion most needs is more theoretical discipline rather than

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filling its empty formalism with something that translates the lemmas
of pure theory into the sense that an actual economy is being described.
Walrass insistence that general equilibrium economics would be valid
only as a descriptive tool was quickly replaced by the inability to talk
about any market structure that existed beyond Walrasian equilibrium
(Bnassy 2002: xii). Still, though, the general equilibrium approach has
maintained an exalted status as an authority symbol within economics,
providing a mechanism for the selective rewriting of the subject fields
history (Ackerman 2002a: 126). Much of the genuinely economic content
of pre-Walrasian economics including that of Walrass own work has
been written out of a disciplinary history which favours the image of lin-
ear progress towards todays general equilibrium approach (Tabb 1999:
102). Little attention has thus far been placed on how the political content
of economists modern meaning of equilibrium consequently comes to
structure what their formalist models can say about the world in a way
that empties them of any active role for government.
Economists use of orthodox DSGE models thus appears to have
forsaken their descriptive potential in favour of direct advocacy of the
political implications of their own preferred interpretation of equilib-
rium (Edge and Grkaynak 2010: 209; Canova 2007: 440). The political
emptiness of modern macroeconomics therefore extends only as far
as prescribing no role for government. By committing themselves to
working within the DSGE tradition as part of the wider defence of their
demand-and-supply Vision, members of the macroeconomics fraternity
have redefined themselves as political actors although presum-
ably inadvertently through their allegiance to the general equilibrium
framework. This is particularly ironic given that orthodox economists
broader ontological commitments to the rationality postulate are always
likely to cast political activity as self-defeatingly self-interested (Udehn
1996: 19). Nonetheless, in an acute analysis that gets right to the heart of
the issue, Robert Clower (1995: 314, emphases in original) has written the
following about Debreus seminal Theory of Value: Debreus [market-
bound] agents appear to be placeholders for plans or thoughts
fathered by the wishes of a single principal that I shall denote by T and
call the theorist ... In truth, there is just one decision unit, T, there are no
independent agents, and the notion that the analysis deals with anything
decentralized is an abuse of language.
The distance could hardly be greater from Walrass original intentions
when first setting out to tackle the market coordination problem. He

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had wanted to express relationships as they applied in his hypotheti-

cal market in terms of autonomous decision-makers who created the
impression of engaging in coordinated behaviour whilst following no
conscious design whatsoever (Walras 1984 [1954]: 35). The language
of decentralised market relations may live on in modern Walrasian
theory, but Walrass mathematical system of simultaneous equations
allowed for truly decentralised behaviour in a way that the modern
mathematical system of general equilibrium economics does not. It is
as if the theorist has become the Walrasian auctioneer, dictating the
behaviour that must occur within the economy if convex set theory is
to be allowed to do its work.
The mathematician John Lighton Synge (1970: 18) calls the resulting
effect the Pygmalion Syndrome after a sculptor in a story by Ovid. The
story recounts how the goddess Venus brought one of Pygmalions stat-
ues to life not only because its artistic beauty had made him fall in love
with it but also because it had encouraged others to treat it as if it were
real. The aesthetic appeal of the best mathematical models in economics
should not be in doubt, and as long as enough economists place their
faith in them they begin to take on an aura of reality in broader public
discourse (Shiller 2012: 133). The vernacular redescription of the models
main findings is also often enough on its own to blur the dividing lines
between properties that belong solely to abstract markets and relation-
ships that might be thought to hold in real-life markets (Engelen et al.
2011: 16). For the concept of equilibrium to come to life as a template for
political action, it is necessary to impose onto thinking about the real
world clearly hypothetical conditions of infinitely lived economic agents
with eminently perfectible optimisation capacities (Etro 2009: 37). This
is Arrows complete market what in vernacular redescriptions has
now often been shortened for political purposes simply to the market
in which so-called state contingent formulations allow the theorist to
posit the existence of a perfectly efficient trading mechanism for every
conceivable commodity at every conceivable time (Farmer 1999: 199).
According to David Warsh (2006: 165), Coded and installed on com-
puters, the state-contingent Arrow-Debreu model became, in effect, a
spreadsheet ... no ordinary spreadsheet, however; thanks to set theory
and the mathematics of convexity, it was an infinite-dimension spread-
sheet, with vectors instead of columns and rows, capable of describing,
at least in theory, all the possibilities for all the markets for all the com-
modities in the world.

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However, the performative effects of economics add a further dimen-

sion to the Pygmalion Syndrome in this instance. Venus was able to
bring Pygmalions statue to life in its entirety, but no degree of intel-
lectual commitment by economists to the ArrowDebreu phenomenal
world and its associated Schumpeterian Vision can ever be sufficient to
establish in practice a complete market. The language of market com-
pletion has been used to justify all manner of financial innovations in
lightly regulated tradable instruments, in an effort to make the actual
economy look more like Arrows initial depiction of an economy of infi-
nite options markets. Yet no amount of activity of this nature however
sophisticated in design, however novel in application and however well
supported in political circles can ever hope to match the criterion of
catering for demand-and-supply decisions of infinitely lived economic
agents populating infinite options markets. The abstraction of a com-
plete market must therefore always remain at that level. It might well
be a staple of modern-day Walrasian thinking to envision the economy
as a giant options market, but its dimensions stretch indefinitely into
the future in such a way as to rule out any possible transposition of the
hypothetical market conditions into reality. Both DSGE and EMH
models thus rely for their political relevance on the creation of a wan-
tonly unfeasible complete market structure. The imaginaries of market
completeness are unlikely to go away anytime soon given their deep
political embeddedness. Yet they reflect economists attachment to their
subject fields underlying Vision more than they do a realisable regula-
tory plan of action.
It is thus easy to see once again just how far modern Walrasian eco-
nomics has travelled from Walrass own starting point. Walrass initial
embrace of a general equilibrium approach was designed to set the hands
of policy-makers free, providing them with a rationale drawn from
economic theory to act decisively in the interests of progressive social
reform (Backhouse 1985: 82). Modern Walrasian economics, by contrast,
is positioned at the forefront of arguments that a well-intentioned stabi-
lisation policy can only ever do more harm than good (Davidson 2009:
172). As is demonstrated only too vividly in the political redefinition of
the financial crisis, the poor can be placed in an extremely precarious
position as a result. The new diagnosis of a state spending beyond its
means on welfare support has turned people who did not make a penny
out of the previous period of financial excess into scapegoats for the
ensuing financial crisis (Blyth 2013: 14). Only unprecedented levels of

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The Creation of the Model World

state support to stop the complete implosion of banks balance sheets

prevented the crisis from taking on a systemic dimension of truly
breathtaking proportions. Yet still this has done nothing to deter the
proponents of no government dynamic stochastic general equilibrium
models from declaring that policy activism is powerless to enhance
peoples everyday experience of life (Mirowski 2013: 158). As Sargent
(2011: 10) put it in his Nobel acceptance speech, [o]ur concept of equi-
librium ties our hands.


General equilibrium economics has a curious history. It has failed in its

own terms and has little of any compelling interest to say beyond its own
self-referential phenomenal world. However, its continued significance
as a prescriptive code for managing economic affairs in the external
world has, if anything, got stronger even as its intellectual shortcomings
have been increasingly exposed (Ackerman 2002a: 126). This counterin-
tuitive inverse relationship between a theoretical dead end and increased
practical relevance suggests that modern Walrasian economics is now
more important politically than economically. A body of literature that
has not lived up to its own promise has nonetheless retained its authori-
tative status to lecture on the preferred role of government. Existence
proofs on their own are empirically uninformative, but as a Kuhnian
thought experiment seeking to naturalise the image of perfectly clearing
market structures they work admirably. They also continue to resonate
politically to turn insights about markets into practical advice about
The uneconomic nature of modern Walrasian economics should be
abundantly clear. An economic economics would be likely to jettison the
notion of equilibrium altogether, at least if it was first impossible to show
that historical patterns of socialisation to prevailing economic norms
had produced in-time dynamics that were a good approximation of an
equilibrium state. General equilibrium economics has never achieved
such a feat, and neither have its proponents ever treated it as anything
approaching a priority (Milonakis and Fine 2009: 297). John Hicks,
another Nobel Laureate and the person mainly responsible for bringing
Walrass style of thinking to the English-speaking world in the 1930s,
latterly became a critic of this aspect of the modern Walrasian tradition

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(Davidson 2009: 175). Existence proofs take on a hugely important sym-

bolic character for those who are concerned with the defense of capital-
ism , he wrote later in his career (Hicks 1983: 279), because they enable
such advocates to show the possibility of an arms length equilibrium.
Yet that particularly desired point in mathematical space can be found
only because it is specifically being looked for. The existence in general
equilibrium proofs is not a condition that can ever be experienced in the
external world, where it would remain resolutely undiscoverable were
empirical testing to occur to see what it might look like. To consequently
appropriate the purely hypothetical construction of equilibrium and
to use that language as a means of offering policy advice is, according
to Hicks (1939: 23), the equivalent of producing rabbits out of a hat.
His next sentence sums up perfectly the significance of the difference
between an economic and an uneconomic economics: It is fascinating to
try to discover how the rabbits got in; for those of us who do not believe
in magic must be convinced that they got in somehow.
I have attributed the increasing popularity of uneconomic economics
to the strength of the demand-and-supply Vision that provides the core
of orthodox economics opinion, rather than to a simple pro-market
ideological position. Admittedly, they lead to very similar conclusions
in lots of instances, most obviously manifested today in the argument
that government must accept a restricted role in welfare provision in
the interests of budgetary balance. However, the general equilibrium
approach has attracted economists who have served as advisors to
politically progressive administrations just as frequently as to politi-
cally conservative administrations. The important point, to my mind,
is how that approach dangles the large professional carrot of being able
to visualise the economy in a state of equilibrium. Under the influence
of the formalist revolution, though, equilibrium has been stripped of
its economic content, where what is now most important is that its
existence can be shown to be a logical possibility using increasingly
complicated mathematical models. The fact that orthodox economics
opinion appears prone to the Pygmalion Syndrome means that policy
advice continues to be offered on the basis of relationships that exist
only in the mathematical models.
Here, then, we see the full effects of the shift from an economic
economics to an uneconomic economics. The ultimate failures of the
general equilibrium approach readily admitted as they have been by
those who have done most to explore its theoretical boundaries (for

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The Creation of the Model World

instance, Sonnenschein 1973; Mantel 1974; Debreu 1974; Hicks 1983; Hahn
1984) are much easier to discuss from the vantage point of an avowedly
economic economics. The approach can be seen for what it is from there,
which is a very sophisticated way of modelling states of the world that
have no directly translatable meaning in practice. Under efforts to see
how these hypothetical equilibrium states relate to verifiable patterns of
economic socialisation, the conclusions of more substantively minded
economists are clear: the general equilibrium approach has failed all the
empirical tests it has been set (Clower 1995: 317). From this perspective,
markets and markets must be kept fully separate, whereupon being
able to talk authoritatively about the former should not be confused
with talking authoritatively about the latter. The gap between the two
is collapsed and knowledge gained purely from the model world is
assumed to hold practical relevance only with the move to a distinctly
uneconomic economics.
That move has been described in this chapter through reference to
the effects of the formalist revolution of the 1950s. Orthodox economics
opinion remains, to a considerable degree, bound by the dictates of a
formalist methodology in which the mathematical precision with which
a model can be specified delivers much greater professional esteem than
its economic content. It is within this context that the most important
question about equilibrium became not how the world might arrive
at such a state economically but whether that state could be imagined.
Increasingly complex abstract models of the economy demonstrated
that equilibrium was a mathematically tractable condition, but not
whether it belonged to the economy more specifically. Clearly it is the
latter rather than the former that allows for the derivation of policy-
relevant knowledge, but this has not stopped a purely hypothetical
condition of equilibrium from being applied politically. The question
that animates the discussion in the concluding chapter is where to go
from there. How might orthodox economics opinion be reconstituted
so that the understanding of the economy it delivers is more genuinely
economic in nature?

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Looking Ahead: From
Uneconomic Economics
to a Different Future

Abstract: There is more to the case for a genuinely economic

economics than simply wanting to wish it into existence.
To activate such a change first requires equality in the
likely reception of arguments for and against a new style of
economics, so that each argument might be evaluated in its
own terms without prejudgement. However, professional
incentives within economics in the UK exert a strong
reinforcing influence in the interests of maintaining orthodoxy.
The reproduction of those incentives acts as an obvious obstacle
to removing uneconomic economics from its current position of
power within policy-making circles. The demand-and-supply
Vision of orthodox economics opinion can therefore rely on
much more than its own inherent believability whenever future
crises in the real-world economy place it under scrutiny.
Keywords: Diamond List; dynamic stochastic general
equilibrium; efficient markets hypothesis; probability
distribution; Research Excellence Framework;
SonnenscheinMantelDebreu theorem

Watson, Matthew. Uneconomic Economics and the Crisis of

the Model World. Basingstoke: Palgrave Macmillan, 2014.
doi: 10.1057/9781137385499.0007.

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Looking Ahead


The question what is to be done? looms large from the preceding chap-
ters. They have focused in the main on diagnosing where we find our-
selves today, asking about the limits that orthodox economics opinion
places on what might be known about the economy. After all, deciding
where to go next always requires some sense of where the journey has to
begin: plotting the route from A to B is impossible without knowledge
of where both A and B reside. In this instance, though, it is necessary to
confront the very real possibility that the most desirable of all potential
Bs may be unattainable.
All successful crisis narratives have built within them a readymade
solution for current travails in the form of clearly articulated guidelines
for what has to lie ahead. Perhaps here rests the most important reason
for why the crisis of economics construction, despite being heard fre-
quently in the earliest days of the financial crisis, has latterly petered out.
Crisis narratives become successful at the point at which they begin to
be lived publicly in shared assumptions about current conditions. The
public has to show that it wants to be led somewhere new before such
narratives gain traction and the journey can begin. The most important
public in relation to the crisis of economics construction is academic
economists, but taken as a whole they have shown themselves to have
been largely unmoved by arguments for rethinking the way they inter-
act professionally. The range of possible Bs currently under discussion
amongst academic economists, then, still looks conspicuously like A.
John Quiggins (2010) Zombie Economics captures this dynamic neatly,
showing how dead ideas continue to suppress the living even as the
crisis has signalled how detached they have become from actual eco-
nomic circumstances. The so-called Great Moderation of the preceding
period, when the combination of financial liberalisation and inflation-
targeting macroeconomic policy coincided with reasonably strong
growth performance, is clearly a thing of the past, but the economics
that described the historical abnormalities of the Great Moderation lives
on as the self-styled cutting edge of the subject field. Quiggin (2013:
23) has referred to this in unflattering tones as the complacency of the
economics profession. Yet almost certainly there is more to it than that.
Amidst the general response that there is nothing wrong with the status
quo, a much more aggressive tone has been added to the suggestion that
change is unnecessary (Mirowski 2013: 279). The defence has become so

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Uneconomic Economics and the Crisis of the Model World

strident that both the efficient markets hypothesis (EHM) and models of
dynamic stochastic general equilibrium (DSGE) have been depicted as
aspects of nature (Palley 2012: 11).
There is only partial merit, then, in answering the what is to be done?
question with a wish-list of things that economists might do differently.
This is still an important task to accomplish, and I would want to stand
by my analysis of the problems that have resulted from the shift over
time to an increasingly uneconomic economics, as well as my advocacy
of the move back towards more genuinely economic forms of economic
analysis. However, there should be no mistaking the difference between
the relative ease with which the diagnosis might be delivered and the
extreme difficulty of acting decisively upon its recommendations. Force
of argument alone can never be sufficient to change the style of thinking
that has come to define the standards used by academic economists when
determining what counts as good economics. Such arguments are in any
case disputed by so many people who have forged their reputations pro-
ducing the research that is now being said by economics outsiders to be
emblematic of a subject field in crisis. Professional standing is therefore
at stake, and many structures have been established within academic
economics to ensure that professional standing continues to operate as
a prop for economics orthodoxy. Moreover, those structures look to be
really rather secure, possibly even to the point of being impervious to a
successful crisis construction.

The definition of good economics

Economics differs from all the other social sciences insofar as it is so

much more straightforward to identify a disciplinary core (Pheby
1988: 61). Economists tend to line up hierarchically across the divide
between orthodoxy and heterodoxy in a way that simply is not repeated
elsewhere (Mki 2001: 10). Other fields comprise competing traditions
of thought, but they are set up more as co-existing heterodoxies rather
than as something that can be considered representative of the field as a
whole with everything else depicted as its other. A greater spirit of equal-
ity is in evidence elsewhere, with the search for authority within each
tradition often pitting scholars against one another but with no single
tradition having exclusive rights to authority (Della Porta and Keating
2008: 9). Economics stands alone amongst the social sciences precisely

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Looking Ahead

in having a common benchmark against which one piece can be said to

be unproblematically the best of all the good work. The signal of what
makes a good economist comes solely from the researchers ability to
manipulate the formal models which, as outlined previously in the book,
have become increasingly uneconomic in nature.
Such a mark has been progressively institutionalised in the UK by
the outcome of successive research assessment systems established by
the Higher Education Funding Council for England and its Scottish
and Welsh counterparts. The outcome of the Research Excellence
Framework (REF) assessment of 2014 is not yet known, but as the results
for economics have proved by far the most stable of all the social sciences
throughout the Research Assessment Exercises (RAEs) of 1992, 1996,
2001 and 2008, little difference is expected this time around (Holland
2014: 119). Both research assessment systems have operated under the
principle of peer review, but in the case of successive economics panels
this has merely prompted the questions of who counts as an appropriate
peer and what is meant by review. The suspicion has long circulated that
proxy indicators are used when judgements are made about the quality
of submitted pieces, rather than genuine review based on in-depth read-
ing, scholarly reflection and an open mind. Critics fear that grades are
given depending on whether the publishing outlet is indicative of where
the assessors would expect top-ranked pieces in economics to appear: in
short, whether it is where people like them would want to publish. This
means that selection criteria for panel members becomes all-important,
and the single most significant signal a UK-based economist can send
if they want to be considered for panel membership is that their pub-
lishing strategy is oriented around the journals that promote orthodox
economics opinion. The Schumpeterian Vision that has facilitated the
move towards an increasingly uneconomic economics is thus formally
inscribed into UK state-sponsored research assessment systems. Perhaps
predictably in such circumstances, the results of each exercise have
progressively promoted an intellectual monoculture built around a style
of thinking emphasising equilibrium points in mathematical space and
assuming social relations consistent with such points.
Of course, this was also the style of thinking that was initially called to
account for being part of the cause of the financial crisis (Dunbar 2011:
40). The ensuing divergence of opinion was never more marked than with
the announcement of the RAE2008 results. Heterodox economics asso-
ciations from around the world had made numerous recommendations

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Uneconomic Economics and the Crisis of the Model World

for panel members, all of which were rejected (Lee, Pham and Gu 2013:
714). Those who stood outside of orthodox economics opinion to use
explanatory methods that prioritised the often messy but empirically ver-
ifiable and genuinely economic dynamics of everyday life were therefore
left without allies on the assessment panel. Their models had, in many
instances, predicted the looming financial crisis with a great degree of
accuracy (Keen 2013: 245), but still the highest grades at RAE2008 went
to those departments whose members eschewed heterodoxy in favour of
the mathematical clarity that had rendered orthodox models silent on the
crisis. Indeed, no other subject field was as generous to itself (Dearden,
Machin and Vignoles 2011: 85). Economics was awarded scores which on
average outperformed everyone elses, even though this top ranking was
announced in the midst of desperate government attempts to prop up
economists failing model world by throwing an unprecedented amount
of money at imploding markets cast in its image.
Donald Gillies (2012: 39) suggests that the number one position held
by economics should be seen as a weakness rather than a strength. It is,
he argues, merely a residue of the intellectual monoculture that has put
paid to all but orthodox economics opinion as a serious academic pur-
suit. The ability to talk persuasively about the world by using a narrative
method more obviously associated with literary techniques might well
connect directly with peoples lived experiences, but increasingly it is
now considered to be unreturnable to UK research assessment exercises
(Goodhart 2010: 55). As David Colander (2011: 2) notes, when academic
economists write for other academic economists, common sense seems
too common, as in ordinary or unprofessional; so even those who have
it learn to hide it. The process of research management conducted by
departments in pursuit of elite-status rankings provides the most obvi-
ous means of removing from view the genuinely economic economics
that tends to result when economists talk in common-sense tones (Lee,
Pham and Gu 2013: 695). Affirmation of such decisions comes in the
recognition that like-minded economists are increasingly likely to be the
only ones invited to serve on the research assessment system panels that
determine what counts as good economics. This is all very circular, but
that is the way of intellectual monocultures: self-referential markers of
esteem ever more adopt the appearance of objective indicators of quality.
Whatever starting advantage orthodox economics opinion had at the
earlier RAEs has now mushroomed into something that has become
increasingly difficult to reverse (Gillies 2012: 36).

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Looking Ahead

The governance structure established for economists ostensibly to

identify quality has therefore in truth delimited an intellectual space out-
side of which any acknowledgement of quality is to be withheld (Whitley
2007: 21). Once more the image of a Schumpeterian Vision comes to the
fore: only those pieces exhibiting the prescribed Vision can be deemed
worthy of inclusion in the intellectual space of serious economics. It is
perhaps no surprise, then, that almost without exception every article
accepted for publication in the so-called Diamond List journals is based
on visualisation techniques through which the economy is understood
in simple demand-and-supply terms. These are twenty-seven highly
regarded economics journals which, when taken together, are assumed
to represent the peak publication outlets for economists aspiring to the
heights of their profession (Dunn 2008: 121). Early RAE rankings were so
closely correlated with the proportion of the departmental submission
appearing in these publications that the Diamond List has subsequently
become an attractor in its own right (Lee 2007: 311). In other words, if
RAE panels seemed to produce departmental rankings as if the Diamond
List was the only thing that mattered, then the instrumentally rational
course of action was to promote a research culture particularly suited
to publishing in those outlets. Heterodox understandings of economic
relations not bound by the expression of simple demand-and-supply
dynamics have, at best, a problematic place within such a culture.
This all adds up to a distinct narrowing of what can be said under the
banner of supposedly serious economics. It is not without irony that the
mathematical elegance of equilibrium existence proofs counts under
that banner, despite the fact that it promotes a distinctly uneconomic
economics, but narrative techniques designed to reveal routinised
patterns of everyday economic relations do not. Five core areas domi-
nated UK economics departments returns to RAE2008, accounting
for fully one half of all submitted pieces (Lee, Pham and Gu 2013: 706).
Moreover, there was a preponderance of publishing in these five areas
in the Diamond List journals, so proportionately they contributed to
considerably over half of the most highly ranked departments RAE
scores. Those areas were macroeconomics (exemplified by the DSGE
models reviewed throughout this book), finance and monetary theory
(ditto with the EMH models), microeconomics (providing the basis for
the ontological restrictions which allow both DSGE and EMH models
to work in their own terms), econometrics (providing the methodology)
and development economics (cast resolutely, in most instances, in the

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Uneconomic Economics and the Crisis of the Model World

image of market-clearing dynamics). In all of these privileged areas of

the subject field, then plus in the journals which bestow such status
upon them a simple demand-and-supply Vision reigns.
Moreover, these narrowing effects do not stop there. With pedagogical
commitments to research-led teaching being all the rage, restrictions on
the remit of research likewise find their way onto the teaching syllabus
(Simonetti 2007: 109). Those economists who were able to warn about
the possibility of the coming crisis might have been able to pass on to
their own students the visualisation techniques that made the ensuing
mess foreseeable. Their students, though, would have been the excep-
tions in this respect. Students taking degrees in one of the most highly
ranked departments would have experienced something else entirely.
When asked what they would like to be taught, economics undergradu-
ates consistently say that they would prefer more of what I have here
called economic economics: that is, studying forms of knowledge about
the economy that are rooted in broader social scientific traditions and
that privilege direct experience of economic structures (Thornton 2013:
108). When asked by contrast what they think they need to know if
they are to show the required proficiency for a career as an academic
economist, they equally consistently nominate the areas and the cor-
responding techniques that are most strongly represented in Diamond
List outlets (Colander and Klamer 1987: 100). This is what being housed
in the RAE-designated best departments delivers to them, with the
intellectual monoculture spilling over from research to teaching.
None of the departments achieving elite status at successive RAEs
publicised a plural view of their overall programme objectives (Lee
2007: 315). Indeed, each emphasised its proximity to the UKs Quality
Assurance Agencys (QAA) revised subject benchmark statement for
economics. This document describes the first of the key intellectual fea-
tures that characterise the economists approach as the ability to abstract
and simplify in order to identify and model the essence of a problem
(QAA 2007: 1), whilst noting that the most important attainment to be
expected of students in pursuit of such a goal is [u]nderstanding of rel-
evant mathematical and statistical techniques (QAA 2007: 3). The elite
economics departments in UK universities are therefore much more
likely to produce the next generation of David Lis than Hyman Minskys,
Thomas Sargents than John Maynard Keyneses. These people will be well
versed in the application of probabilistic thinking to mathematically ori-
ented thought experiments in abstract market dynamics, but they will

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Looking Ahead

continue to be caught napping when crisis events arise from beyond the
normal tails of the probability distributions. Hyperplanes will continue
to be separated in the interests of demonstrating the logical possibility
of perfect allocative efficiency, but the transposition of this finding into
policy advice will always require mistaking the phenomenal world of
economists own models for the external world of directly apprehended
There are obvious limitations, then, to simply asserting the need for
a reawakening of a more obviously economic economics. How might it
spread within a profession that is currently set up along unsympathetic
lines? From what might it take root in the first place? With the recent
introduction of 9,000 per year fees, the business models of RAE top-
ranked departments now involve generating an operational surplus
through strong student recruitment so that it can be invested in Diamond
List stars who will deliver the higher departmental ranking at REF2014
that is necessary for continuing strong student recruitment. Yet all this
does is ratchet up the cycle through which preponderant Diamond List
publications enforce the demand-and-supply Vision as the only way of
conceptualising the economy. Nonetheless, this does nothing to dimin-
ish the significance of asking why a more genuinely economic economics
might still be preferred.

The significance of historicised method

The probability distributions which feature so prominently as the default

setting of uneconomic economics models contain nothing by way of
genuine historical information. They are based upon assumptions of
what the economic system might be expected to do in normal times, but
the historical information required to confirm these assumptions is itself
forced to fit the shape of a normal distribution. The content which gives
life to the models allowing them to work in their own terms and also
allowing them to be used for policy advice is a mathematical property
inherent in the models and not an empirical property against which the
success of models can be tested (Kling 2011: 132).
From the perspective of an uneconomic economics, with its associated
markers of esteem manifested in Diamond List publications, this might
not matter too much. Nobel prize-winner Robert Lucas, for instance,
suggested that it was unfair to try to hold economists to account for

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Uneconomic Economics and the Crisis of the Model World

the financial crisis when their demand-and-supply Vision gave them

no vantage point to comment on such possibilities in the first place.
The simulations [of equilibrium-oriented macroeconomics] were not
presented, he wrote (Lucas 2009: 67), as assurance that no crisis would
occur, but as a forecast of what could be expected conditional on a crisis
not occurring. Fellow Nobel Laureate Thomas Sargent (2010: 28) agreed,
dismissing the critics for their foolish and intellectually lazy remark[s]
and saying that their concerns reflect either woeful ignorance or inten-
tional disregard for what much of modern macroeconomics is about.
British bankers might well have used their summons to appear in front
of the Treasury Committee in early 2009 to apologise for their role in the
crisis, but it is clear that discipline-shaping economists feel no compul-
sion to do likewise.
From the perspective of a genuinely economic economics, of course,
everything looks very different. I write of course because this is really
the whole point of having emphasised the distinction between an uneco-
nomic and an economic economics throughout the book: to highlight
how these very different ways of visualising the world lead to equally dif-
ferent ways in which that world might be experienced. Viewed through
the lens of uneconomic economics there are generic experiences each of
which is able to be placed on a fairly predictably shaped probability dis-
tribution. History, in this sense, is merely the aggregation of the unique
points on the probability distribution, with all events that fail to conform
to expected patterns being dismissed under post hoc examination as an
abnormal and therefore an a priori unexplainable event (for example,
Ireland 2011: 32). From the perspective of an economic economics, by
contrast, history is only ever lived once rather than being something that
fits a potentially infinitely liveable normal distribution. That is, every
event reflects its own unique prior process of economic socialisation and
therefore must be understood within its own context (Shiller 2010: 407).
The idea that each historical moment assumes a form of its own makes
historical study much more important to economics. This in itself,
though, first requires that the data through which economic possibilities
might be understood is produced in a manner that is unaffected by stra-
tegic selections to make them fit a pre-existing model (McCloskey 2013:
14). Thinking through the prism of probability distributions provides
one such shortcut to strategic selections, but it is merely a means of try-
ing to impose certainty on group events out of admission of ignorance
about individual events (Collier 2011: 58). Economics would change in

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Looking Ahead

significant ways were the test of what makes a good economist to reflect
rather more closely the ability to explain individual events.
The underlying issue here is whether it is possible to have, in Paul
Krugmans (2009a: 1) words, a theory of everything based on orthodox
economics principles. The proponents of those principles suggest that
it is, but only by seeking connections to an external world that might
be acted upon through policy interventions via the manipulation of
market-conforming abstractions. Yet what can they really reveal along
those lines if that sort of behaviour is only a property of the self-made
phenomenal world of orthodox economics opinion (Quiggin 2013: 25)?
The unifying model belongs to a phenomenal world which simply cannot
approximate the social multidimensionality of actual economic relations
as they evolve between one unique form and another (Colander 2011:
20). The economy might therefore still give out the impression of coor-
dination insofar as it makes sense to think of it as a single entity, but the
mode of coordination differs between economy and economy. As soon
as the move is made to question whether it is possible to have a unified
model that foreshadows an economic theory of everything, we are back
to the issue that stumped Walras and separated his work from that of the
later Walrasians. The simple demand-and-supply Vision can be used to
create models of coordination, but they are not ones that belong in the
realm of genuinely economic economics. There is therefore something
of a gap between what the models can say in their own terms and what
can be said about policy, and a rather crude leap of faith is required to
bridge it in the manner of the no government tradition of dynamic sto-
chastic general equilibrium (see Chapter 3). Arnold Kling (2011: 126) has
described policy advice constructed in this way as nothing more than
the hunches of the model jockeys.
The modellers problem results from the fact that a genuinely economic
economics can only ever deal with individual episodes rather than with
the repeatable experiments that bring probability distributions to life
(McCloskey 1994: 177). Economic models of both the DSGE and EMH
type are based on a woefully inadequate number of data points relative
to the range of plausible control variables. The behavioural foundations
of the research subjects encapsulated by economics models are therefore
extremely precarious, but the modellers nonetheless persist as if noth-
ing is wrong (Ackerman 2002b: 60). They present their models using
methods suited only to quasi-experimental data, but the actual data
appealed to in ostensible confirmations come nowhere near meeting this

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Uneconomic Economics and the Crisis of the Model World

standard. A shortcut has been enacted to make the available data appear
to be of the right sort. This has been to replace the social level of enquiry
with that of the individual (Milonakis and Fine 2009: 98). However, this
is a cardboard cut-out version of an actual individual economic agent,
one who has had removed all of its social stimuli, social influences and
social experiences. This is a person who comes closer to producing the
sort of data that can make the models work in their own terms, but it is
not anyone who could ever be encountered in everyday life because it
is completely beyond history (Kirman 1992: 118). The first step towards
creating a genuinely economic economics, then, is to be working with an
account of the historical socialisation practices of real-world economic
Socialisation practices serve as a means of making the surprises which
result from uncertainty less of a shock to daily routines. The content of
the prior socialisation serves as a vernacular explanation for whatever it
is that has just caused the surprise. This content is pretty much impos-
sible to model (Dppe 2011: 190), so instead uneconomic economists
insert a probability distribution to substitute given event horizons for
anything that would otherwise be a priori unknowable (Davidson 2010:
17). The whole process of learning how to position oneself relative to the
prevailing economic structure is dismissed from the models, because
the permissible pattern of uncertainty is already given by the probability
distribution (Evans and Friedman 2011: 83). The unlearning agent is
anathema to both other social sciences and to most of the heterodox
traditions attempting to reimpose a genuinely economic economics.
However, it is a fundamental part of the cognitive apparatus which
provides uneconomic economics with its signature demand-and-supply
To see why this matters as well as to confirm that Schumpeter
(1994 [1954]: 41) was absolutely right to focus on what he called the
preanalytic element of economists Vision it is necessary to look no
further than the analytical weaknesses of the whole demand-and-supply
model. Such weaknesses are explored in great technical detail in the
SonnenscheinMantelDebreu theorem (see Chapter 2). This theorem
shows that even enforcing the assumption of perfect rationality on all
cardboard cut-out economic agents is insufficient to allow individual
preferences to be scaled up into a unique market-clearing equilibrium
(Rizvi 2003: 384). But it is not necessary to go that technical to make
the same point. Kenneth Arrow had long before cast doubt on the basic

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Looking Ahead

demand-and-supply diagram as a useful heuristic. Economics textbooks

continue to present this diagram as the essential starting point for under-
standing how the simplest of all markets is deemed to operate within
orthodox economics opinion. Yet it is now more than fifty years ago that
Arrow (1959: 41) asked the still-to-be answered question of why it is, if
everyone acting within the confines of the textbook market is required
to behave as an essential price-taker, that a coordinating function nev-
ertheless kicks in to guide the economy through the price adjustments
that are necessary for the attainment of equilibrium. Both Arrow and
Debreu, then the Nobel Laureates, remember, who first demonstrated
the logical possibility of an existence proof under conditions of general
equilibrium quickly lost faith in the ability of this whole way of think-
ing to produce genuine economic meaning.
The move to a genuinely economic economics would therefore seem
to involve downgrading the textbook demand-and-supply diagram
from its current all-encompassing position in the syllabus to one of
many competing opening heuristics. At the very least, pluralism in cur-
riculum design would seem to be a more likely end-point the greater the
attention on exposing the strict limits on the application of the standard
textbook demand-and-supply model. Currently, it almost always gets
presented as the key to understanding the market in its entirety, whereas
in truth it can speak authoritatively only to the purely abstract per-
fectly competitive market structure (Hodgson 2001: 255). In any other
situations the posited relationships which also form the basis of the
policy advice arising from both DSGE and EMH models simply do
not materialise. Under conditions of perfect competition every actor
within the economic environment must take on the persona of a price-
taker, but pure price-taking activity is defined in such exacting terms
within the textbook demand-and-supply model that its accompanying
diagram should not be expected to describe an economic environment
that can ever actually be experienced (Tabb 1999: 141). The language
of a market-clearing equilibrium now takes many vernacular forms to
guide the mindset within which potential policy solutions are thought
through. Yet the SonnenscheinMantelDebreu theorem coupled with
Arrows own scepticism suggest that even the most basic building
block of orthodox economists Schumpeterian Vision cannot explain
why the relationships captured by everyday economic language might
hold. The equilibrium solution within the perfectly competitive market
structure is built upon such fanciful simplifying assumptions as to be

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Uneconomic Economics and the Crisis of the Model World

almost entirely extracted from history, whilst anything other than the
equilibrium solution renders the perfectly competitive model internally
inconsistent (Hills and Myatt 2010: 65).
Under uneconomic economics, assumptions are made about the
future so as to ensure that the pretence is maintained through which
the textbook demand-and-supply diagrams equilibrium solution might
always be considered real in the present. It is assumed, in effect, that
the samples from the future are as readily available for the purposes of
statistical corroboration as random samples from the past (Davidson
2009: 36). The data on which calibrations of DSGE and EMH models
are constructed is, in any case, at best somewhat flimsy (Bhid 2010:
119). Despite this, the influence of the so-called ergodic hypothesis,
which allows for the future to be essentially knowable, simply projects
the shape of data samples from the past onto all possible data samples
that might be explored in the future. Nothing else can keep the move-
ment of the economic system constantly focused on the attainment of
equilibrium. Ergodicity is an assumption taken from the hard sciences,
in which changes in the phenomenal world of theorists models cannot
have a performative effect on the external world of which they speak, and
therefore in which the state of the external world can be expected to be
the same tomorrow as it is today (Davidson 2006: 150). Such conditions
do not apply to economics, though, where the translation of theoretical
insight into vernacular language suited to policy guidance means that
the relationship between phenomenal and external worlds is much more
intense. Strict dividing lines between the two are always clearly visible
in the hard sciences, but where are they to be drawn between market
and market, economy and economy? Orthodox economics opinion
obscures rather than reveals the answer.

Final words

It is necessary to end where I began, with some further reflections on

the effect upon economics of the changing narration of the ongoing
crisis situation. In its original articulation as a financial crisis founded
on suspect banking activities, wholesale emergency state interventions
were sanctioned to save the financial system from total collapse. Policy-
makers looked into the most likely future, saw that it was completely off
the scale of economists probability distributions, did not like the image

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Looking Ahead

that was evident to them and therefore acted accordingly to prevent

this particular future from materialising. Policy was constructed in this
phase of the crisis on the assumption of a non-ergodic future. Latterly,
by contrast, the renarration of the crisis as one of overextended public
finances has meant that the political system has been increasingly ori-
ented to finding ways of rowing back on normal, let alone emergency,
state spending. Once it was clear that the banks had been rescued from
themselves, policy-makers were able to look into a very different future,
one that this time had a defined place on orthodox economists probabil-
ity distributions and where the future could be thought to simply reflect
the past. In this way, they were able to hold open the possibility of restor-
ing to prominence their demand-and-supply Vision even in the midst
of rampant market failure. Austerity increasingly came to prominence
as soon as orthodox economics opinion was restored to a position of
authority and the corresponding switch could be made between assump-
tions of a non-ergodic and an ergodic future.
At heart, this captures an essential difference between two distinct
ways of thinking and talking about everyday economic relations. One
is exemplified by orthodox economics opinion, being characterised by
a scientific form and manifested in the use of mathematical models as
evidence of its supposed scientific credentials. The other encompasses
just about every other way of visualising the economy, where a literary
form is allowed greater scope and argument by narrative is preferred to
argument by mathematics on the basis of its more obvious real-world
traction. This is not currently a fair fight within economics itself, how-
ever, because internal professional incentives are set up to privilege the
scientific over the literary. As Deirdre McCloskey (1976: 439) already
feared had happened back in the 1970s, economics burned the bridges
long ago between these competing social scientific cultures, debilitating
the instincts of subsequent generations of economists by removing alter-
native foundations of thought from their education (see also McCloskey
2013: 14). This would perhaps not be such an issue if it was only an intel-
lectual problem, but it is a practical problem too. Again, the crossover
between the phenomenal and the external worlds should be plain to see.
Competitive market structures are the only ones that are able to be visu-
alised once the decision was made for orthodox economics opinion to
revoke literary in favour of scientific techniques. According to Rod Hills
and Tony Myatt (2010: 71), though, such structures act most obviously as
an enabling myth politically: Using the competitive model as a generic

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Uneconomic Economics and the Crisis of the Model World

tool applicable to a broad range of markets irrespective of the number

of producers, heterogeneity of the product or information imperfections
creates an inbuilt bias against government market intervention.
It is this model, more than anything else, that the strategic renarra-
tion of the ongoing crisis has served to revive. Amidst faltering financial
markets and the prospect of banks collapsing like dominoes it was rela-
tively easy to pour scorn on notions of socially optimal, competitively
produced equilibrium states. However, as soon as the focus turned to
alleged government overspending in the pre-crisis period, it was those
exact same assumptions that began to drive the embrace of austerity
(Blyth 2013: 72). UK policy-making now seems to be locked-in to a
variant of Alberto Alesinas theory of expansionary austerity (Alesina,
Ardagna and Gal 1998: 492). The scientific credentials of the model on
which this theory is founded seem to be firmly in place, the mathematics
of the model ticks the box in terms of both rigour and elegance, and
the demand-and-supply Vision provides the initial impetus for think-
ing in this way in the first place. The model infers future data samples
which will show that the fiscal multiplier associated with government
expenditure is substantially negative in other words, active stabilisation
policy will always crowd out more private sector economic activity than
it creates and therefore the only way for the economy to grow is for the
government to shrink. The one-to-one displacement implied during the
crisis by discipline-leading economists crowding-out arguments against
stimulus spending therefore looks tame by comparison to Alesinas even
bolder conclusions.
In this context it is fitting that the very last word should be reserved
for a study firmly grounded in alternative literary techniques. Victoria
Chick and Ann Pettifor have examined 100 years of historical data for the
UK fiscal stance prior to the election of the Conservative-led Coalition
Government in 2010. Their aim was to isolate those moments of genuine
fiscal contraction when nominal government spending went into decline,
and to contrast them with the sustained periods of nominal government
spending increases. A very interesting finding emerges. Despite all of the
prevailing political rhetoric about the virtues of putting ones house in
order (Whiteley et al. 2013: 276) amply reflected as it has been within
the British media (Pirie 2012: 342) Alesinas theory of expansionary aus-
terity is turned completely on its head. The demand-and-supply Vision
of orthodox economics opinion might well point to inevitable market
corrections through which increased government spending first nullifies

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Looking Ahead

and then displaces private sector economic activity. Economists models

of both the DSGE and EMH types also suggest exactly the same. How
much should we be prepared to defer to the data, though, in the face of
such a cacophony of voices asserting that the crisis must be understood
in terms of an overextended state satisfying its appetite for additional
expenditure by taking on more and more debt? It is necessary to ask
the question because the data actually say something very different to
what can typically be heard in British public debate. Chick and Pettifor
(2010: 2) have discovered seemingly very robust relationships between,
on the one hand, fiscal expansions and an increased ability to pay down
existing debt commitments and, on the other hand, fiscal contractions
and a worsening debt position. Contrary to the assumptions on which
UK policy-makers are currently operating, then, austerity has histori-
cally made the countrys debt position worse and not better.
This is a hugely important finding, because it challenges all sorts of
assertions about prudent housekeeping that currently frame UK eco-
nomic policy debates. An alternative future beyond austerity is possible,
it suggests, maybe even one in which the ultimate costs of the recent
banking debacle do not have to be shouldered disproportionately by
the poorest sections of society. Yet the prospects for realising such an
alternative rest on the presumption that the data will be allowed to speak
for themselves and that facts relating to the actual economy count for
as much as opinions relating to the hypothetical model economy. If the
preceding pages tell us one thing above all else, though, then it is that
this is by no means guaranteed. The institutionalised position of ortho-
dox economics opinion is so strong and, if anything in the UK, getting
professionally stronger all the time that there are very real reasons
to worry about the difference a few contradictory facts might make. I
remain fully committed to the view that a sustainable economic recovery
requires the move beyond todays dominant brand of uneconomic eco-
nomics. The prime casualty in such a move would be the Schumpeterian
Vision of market-clearing dynamics that has thus far prevented the data
from being taken at face value. Realising such a move would allow what
we think about the economy to be reconnected with what more substan-
tive studies of the economy show to be true about it, but this is much
easier said than done.

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social authority of, 9, 11, 16, 62, fear machine, 2
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unification of, 21, 77 financial liberalisation, 69
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economists fiscal multiplier, 82
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expansionary austerity, 82 Great Moderation, 69
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Hicks, John, 657 Keen, Steve, 12, 42, 72
Higher Education Funding Council for Keynes, John Maynard, 74
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home foreclosures, 35 Kydland, Finn and Prescott,
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human costs of financial crisis, 467 Law of Demand, 23
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ignorance, 76 Lee, Frederic, Pham, Xuan and Gu,
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Immergluck, Dan, 25 Lehman Brothers, 45
impossibility results, 23 leverage, 26, 37
indifference curves, 50 level three assets, 28, 30
individual optimisation, 234 Li, David, 24, 307, 43, 74
inflation, 53 linear history, 62
inflation-targeting macroeconomic liquidity put, 323
policy, 69 Los, Cornelis, 47
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institutional investors, 26 Lucas, Robert, 1314, 46, 523, 57, 756
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market completion, 235, 35, 44, 57, money supply, 54
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613, 77, 80 mortgage-backed securities, 34, 20,
market distortions, 10, 52 26, 29, 42
market failure, 234, 48 Moschella, Manuela, 6
market self-regulation, 20, 45, 57 multi-period contracts, 55
markets versus markets, 812, 14, multiple standard deviation events, 13
1619, 24, 27, 29, 325, 37, 45, 47, Muolo, Paul and Padilla, Mathew,
54, 589, 625, 67, 745, 80 26, 42
Marin, Alan, 54 Musgrave, Alan, 39
Marshall, Alfred, 50
Mas-Colell, Andreu, Whinston, narrative method, 723, 813
Dennis and Green, Jerry, 24 natural rate of unemployment, 53
Mason, Paul, 6 nature, 478, 56, 70
mathematics, 15, 23, 312, 345, 37, 45, neoclassical economics, 57
4955, 601, 63, 667, 715, 81 Nesvetailova, Anastasia, 29
McCallum, Bennett, 53 newspaper coverage of crisis, UK,
McCloskey, Deirdre, 15, 50, 767, 81 1112, 82
McDonald, Larry and Robinson, Niehans, Jrg, 50
Patrick, 25 Nobel Laureates, 13, 22, 467, 57, 65,
McKibbin, Warwick and Stoeckel, 756, 79
Andrew, 13 Nobel Prize in Economics, 14, 48, 55, 65
McMullin, Ernan, 39 non-ergodic world, 81
Medema, Steven and Samuels, normal distribution, 3740, 423, 545,
Warren, 18 68, 756, 78, 801
Mehrling, Perry, 8, 37, 40, 43 Northern Rock, 4
Merton, Robert, 38
microeconomic theory, 24, 73 Oakley, Allen, 9
Miller, Daniel, 40 observational science, 39, 47, 56
Milonakis, Dimitris and Fine, Ben, ontological planes, 4950, 55, 60, 62,
65, 78 67, 73, 80
Minsky financial instability optimal macroeconomic policy, 54
hypothesis, 42 optimisation skills, 50, 63
Minsky, Hyman, 74 options market, 378, 50, 55, 64
Mirowski, Philip, 14, 65, 69 Orrell, David, 33, 41
Mirowski, Philip and Nik-Khah, orthodox economics opinion, 1, 3, 58,
Edward, 9 1011, 1516, 18, 212, 25, 29, 40,
Mishkin, Frederic, 53 46, 489, 512, 602, 669, 712,
model world 77, 79, 81, 83
collapse of, 2044 Osband, Kent, 25
creation of, 4567 Ovid, 63

DOI: 10.1057/9781137385499.0009

Pagano, Ugo, 50 rating agencies, 26, 34

Palley, Thomas, 70 rational expectations economics, 524
paradigmatic thought, 3940, 55 rationality, 9, 24, 78
parameter intervention, 535 reflation, 46
Partnoy, Frank, 36 regulatory capture, 7
Patterson, Scott, 35 relative price differentials, 50
peer review, 71 representative individual, 54
perfect allocation function, 17, 46, 51, representativeness tests, 19
54, 75 Research Assessment Exercise, 715
perfect storm, 13 Research Excellence Framework, 68,
performativity, 8, 13, 3441, 557, 64, 71, 75, 83
76, 80 Rethel, Lena and Sinclair, Timothy, 25
personal credit history, 29, 42 risk assessment models, 8
Persaud, Avinash, 7 Ritholtz, Barry, 32
Persson, Torsten and Tabellini, Rizvi, Abu Turab, 23, 78
Guido, 11 robustness tests, 19
Pheby, John, 70 Roubini, Nouriel and Mihm, Stephen,
phenomenal world, 3941, 478, 503, 5, 12, 25
556, 58, 645, 75, 77, 801 Rubin, Robert, 323
Picciotto, Sol, 25 Rubinstein, Mark, 38
Pirie, Iain, 12, 82
pluralism in curriculum design, 79 Salmon, Felix, 33, 35
political status quo, 16, 18, 27, 69 Sargent, Thomas, 14, 47, 57, 65, 74, 76
policy ineffectiveness proposition, 45, Sargent, Thomas and Wallace, Neil, 48,
48, 525 523, 55
policy rule, 54 scapegoats for crisis, 14, 28, 57, 64, 83
Potters, Marc, 27 Schularick, Moritz and Taylor, Ann, 42
poverty alleviation, 578, 64 Schumpeter, Joseph, 21, 78
price mechanism, 1, 7, 20, 27, 30, 36, 43, Schumpeterian Vision, 203, 28, 41,
51, 54, 58 556, 64, 71, 73, 789, 83
price-taking activity, 79 Schwartz, Herman, 29
pricing rule, 325, 38, 56 scientific rationalism, 39
Prins, Nomi, 29 secondary mortgage market, 6, 2430,
probabilistic risk models, 20, 25, 2930, 32, 42
33, 42, 745 securitisation, 28, 301, 35
progressive research programme, 223 Sent, Esther-Miriam, 54
prudent housekeeping, 83 separating hyperplanes, 501,
public good, 53 601, 75
Pygmalion Syndrome, 634, 66 Sharrock, Wes and Read, Rupert, 39
Sheffrin, Steven, 534
Quality Assurance Agency, 745 Shiller, Robert, 6, 12, 38, 63, 76
quantitative easing, 1, 4 Shleifer, Andrei and Vishny, Robert, 47
Quiggin, John, 69, 77 Simonetti, Roberto, 74
simultaneous equations, 589, 61, 63
Rajan, Raghuram, 25 Sinclair, Timothy, 27, 30, 34
randomness, 13 Skidelsky, Robert, 14

DOI: 10.1057/9781137385499.0009

Skidelsky, Robert and Wigstrm, transcendental truths, 47

Christian Westerlind, 46 transformation curves, 50
slice and dice, 2930 Turner, Adair, 7
Smith, David, 26
Snowdon, Brian, 53 Udehn, Lars, 62
social insurance, 24 uncertainty, 501, 60, 76, 78
Sonnenschein, Hugo, 23, 67 uneconomic economics, 1, 914, 17, 19,
Sonnenschein-Mantel-Debreu 246, 2936, 40, 43, 4568, 701,
theorem, 223, 40, 44, 68, 789 73, 756, 78, 80, 83
Special Liquidity Scheme, 4 definition of, 9
speculation, 8, 25, 389, 41 Ungar, Sheldon, 12
SPERI Palgrave Pivot Series, 8 university research management, 723
Spreeuw, Jaap, 33 US Federal Reserve, 13, 28
stabilisation policy, 46, 49, 524, 62, US housing market, 29, 412
64, 82 US Treasury, 5
state contingent formulations, 63
statistical events, 13, 15, 27, 29 Valentine, James, 28
Steland, Ansgar, 26 valuation models, 20, 2730, 42
Stiglitz, Joseph, 6, 25 valuation crisis, 27
stimulus, 46, 48, 52, 82 van Daal, Jan, 58
stock market crash, 1987, 38 van Treeck, Till, 41
stress tests, 30 vectors, 634
student fees, 75 Venus, 634
subject benchmark statement, 745 visualisation techniques, 17, 201, 347,
subprime assets, 26, 28, 30 39, 413, 45, 47, 55, 59, 61, 64, 667,
super-portfolio, housing market, 43 734, 76, 81
Synge, John Lighton, 63
synthetic collateralised debt Waggoner, John, 32
obligations, 3, 35 Walker, Donald, 58
Walras, Lon, 5760, 6265, 77
Tabb, William, 18, 62, 79 Walrasian tradition, 57, 5961,
Taleb, Nassim, 7 635, 77
ttonnement, 589 Warsh, David, 501, 63
tax-and-spend policies, 48 Warwick Commission, 8
teaching syllabus, 1216, 745, 79 Watson, Matthew, 5, 27, 43, 59
Temin, Peter and Vines, David, 25 Webb, Andrew and Cropsey, Keith, 35
Tett, Gillian, 6, 30 Weintraub, Roy, 22, 61
textbooks, 47, 55, 58, 61, 79 welfare dependency, 3, 5, 12, 64, 66
Thirkell-White, Ben, 8 Whitehouse, Mark, 345
Thornton, Tim, 74 Whiteley, Paul et al., 82
thought experiment, 557, 65, 745 Whitley, Richard, 73
trading rule, 38, 56 Wigan, Duncan, 30

DOI: 10.1057/9781137385499.0009