Economic Orthodoxy and the Relevance of Shadow Banking

Various bloggers have commented recently on economic orthodoxy and whether changes are needed to the teaching of economics.  Paul Krugman (largely) defends the mainstream.  I was particularly interested in one comment he made (in this post).

"It’s true that few economists tracked the rise of shadow banking that bypassed the traditional safeguards — but that was a problem of vigilance, not bad theory."

I'd agree that vigilance was lacking when it comes to regulatory matters, but I suspect that theoretical orthodoxy is also partly to blame here.

There were lots of things happening that contributed to the crisis, which is why you hear so many different explanations.  However, the following process played an important part.

1. In the years leading up to the crisis, developments in the financial sector increased the supply of credit to households.

2. The greater flow of credit increased household spending at the same time as it led to rising debt to income ratios.

3. The higher the debt to income ratio goes, the more likely it is that the flow of credit will slow or go into reverse.

4. When the supply of credit eventually slows, household spending will fall.

To understand why the financial sector was lending so much requires some knowledge of the regulatory environment and things like shadow banking.  However, you didn't need any knowledge of these things to be able to see the growth in household debt.  Even if you had never heard of shadow banking, the growth in debt should have been clear from the data.

I would not expect any economist to be able to predict the details of a crash.  The things that determine timing and extent are too complex and vague to be the subject of forecast.  It's not usually even possible to say whether a crash will in fact occur, or whether there will simply be a slow unremarkable correction.

My point here is that the process I have described is very easily explained and understood within a simple Post Keynesian analytical framework.  There might be disagreement on the precise mechanics, but the basic picture is clear.  It is less easy to see within a framework of maximising representative agents.  Sure - it is possible to extend these ideas to incorporate all sorts of things, as supporters of the mainstream would be quick to point out.  But making the models more complex does not help highlight the important issues.  After all, the important issue here is not the rationality or otherwise of financial institutions - it is the hard fact of credit growth.

The relationship between credit supply and spending should be basic economics.  If the orthodox approach means we can't spot it when it's going on right before our eyes, then that approach is lacking.  This is the problem with not taking the pluralist view in economics.  Economies are by their nature too complex to be captured by any one method of analysis.  All any approach does is provide us pointers and clues to help see what is going on.  Ignoring those that seem to contradict our preferred worldview can blind us to what is really going on.