CARTA A LA REINA*

Su Majestad la Reina
Buckingham Palace
London
MaDaM,

C
uando Su Majestad visitó la London School of Economics
en noviembre pasado, preguntó muy acertadamente: ¿por qué
nadie advirtió que la crisis de crédito estaba en camino? La Acade-
mia Británica convocó un foro el 17 de junio de 2009 para debatir
su pregunta, con contribuciones de un conjunto de expertos de las
empresas, la City, sus reguladores, la academia y el gobierno. Esta
carta resume los puntos de vista de los participantes y los factores
que mencionaron en nuestra discusión, y que esperamos den una
respuesta a su pregunta.
Muchas personas previeron la crisis. Pero nadie previó la forma
exacta que tomaría ni el momento en que empezaría ni su ferocidad.
Lo que importa en tales circunstancias no es solamente predecir la
naturaleza del problema sino también el momento en que aparecerá.
Y también hay que detectar la voluntad para actuar y estar seguros
de que, como parte de sus poderes, las autoridades tienen los instru-
mentos correctos para enfrentar el problema.
Hubo muchas advertencias sobre los desbalances de los mercados
financieros y de la economía mundial. Por ejemplo, el Banco de Pagos
Internacionales expresó repetidas preocupaciones porque los
riesgos no parecían reflejarse realmente en los mercados financieros.
Nuestro
* Carta enviada a la Reina el 22 de julio de 2009 por la Academia Británica.
Publicada en [http://www.britac.ac.uk/events/archive/forum-economy.cfm]. Tra-
ducción de Alberto Supelano.
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propio Banco de Inglaterra publicó muchas advertencias acerca de

ello en sus informes semestrales sobre la estabilidad financiera. Se
consideraba que la administración de riesgos era una parte
importante de los mercados financieros. Según se dice, uno de
nuestros bancos principales, hoy casi totalmente de propiedad
pública, tenía 4.000 administradores de riesgos. La dificultad era
percibir el riesgo del sistema en su conjunto y no el de un préstamo o
instrumento finan- ciero específico. Los cálculos de riesgos muy a
menudo se confinaban a pequeños segmentos de la actividad
financiera, usando algunas de las mejores mentes matemáticas de
nuestro país y del extranjero. Pero frecuentemente perdían de vista el
panorama general.
Muchos también estaban preocupados por los desequilibrios de
la economía mundial. Habíamos disfrutado de un período de ex-
pansión mundial sin precedentes en el que muchas personas de los
países pobres, en particular de China e India, mejoraron sus niveles
de vida. Pero esta prosperidad condujo a lo que hoy se conoce como
el “exceso de ahorro global”. Esto llevó a que los rendimientos de las
inversiones de largo plazo más seguras fueran muy bajos, lo que a su
vez indujo a muchos inversionistas a buscar rendimientos más altos
a costa de riesgos mayores. Países como el Reino Unido y Estados
Unidos se beneficiaron con el ascenso de China, que disminuyó el
costo de muchos bienes que compramos, y el fácil acceso directo al
capital en el sistema financiero llevó a que las familias y las empresas
del Reino Unido se endeudaran. Esto a su vez alimentó el incremen-
to de los precios de la vivienda aquí y en Estados Unidos. Muchos
advirtieron que esto tenía peligros.
Pero a pesar de quienes lo advirtieron, la mayoría estaba convenci-
da de que los bancos sabían lo que estaban haciendo. Creían que los
magos financieros habían encontrado nuevas y brillantes formas de
manejar los riesgos. Incluso algunos sostenían que se habían dispersa-
do tanto a través de un imponente conjunto de nuevos instrumentos
financieros que virtualmente se habían eliminado. Es difícil recordar
un peor ejemplo de pensamiento basado en ilusiones mezclado con
arrogancia. También existía la firme creencia de que los mercados
financieros habían cambiado. Y los políticos de todo tipo estaban
seducidos por el mercado. Estos puntos de vista fueron instigados
por modelos financieros y económicos que eran buenos para
predecir riesgos pequeños y de corto plazo, pero pocos eran
adecuados para decir qué ocurriría cuando las cosas salieran mal,
como sucedió. La gente confiaba en los bancos cuyas juntas
directivas y cuyos altos ejecutivos estaban atestados de talento
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reclutado globalmente y cuyos

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directores no ejecutivos incluían personas de probada trayectoria en

la vida pública. Nadie quería creer que sus juicios fueran defectuo-
sos o que carecían de competencia para escudriñar los riesgos de las
organizaciones que administraban. Una generación de banqueros y
financieros se engañó a sí misma y a quienes pensaban que eran los
ingenieros que marcan el paso de las economías avanzadas.
Todo esto pone de presente las dificultades para desacelerar la pro-
gresión de tales desarrollos en presencia de un factor general de “buena
percepción”. Las familias se beneficiaban de un bajo desempleo,
bienes de consumo baratos y crédito fácil. Las empresas se
beneficiaban de unos costos de endeudamientos más bajos. Los
banqueros obtenían bonificaciones exorbitantes y extendían sus
negocios a todo el mundo. El gobierno se beneficiaba de altos
recaudos fiscales que le permitían aumentar el gasto público en
escuelas y hospitales. Esto generó fa- talmente una psicología de la
negación. Fue un ciclo alimentado, en gran medida, no por la virtud
sino por falsas ilusiones.
Las autoridades encargadas de manejar estos riesgos también te-
nían dificultades. Algunos dicen que su tarea debía de haber sido la
de “guardar el trago cuando la fiesta estaba prendida”. Pero esto
supone que tenían los instrumentos necesarios para ello. Había una
presión general por una regulación más laxa, por un leve tirón de
orejas. La City de Londres (y la Autoridad de Supervisión
Financiera, FSA) era elogiada como el mejor ejemplo de regulación
financiera global por esta razón.
Había consenso en que era mejor enfrentar las secuelas de las
bur- bujas de las bolsas de valores y de los mercados de vivienda que
tratar de evitarlas por adelantado. Se dio carta de credencia a esta
opinión cuando, debido a la experiencia, mal que bien se evitó una
recesión, especialmente en Estados Unidos, luego de que explotara la
burbuja “punto com” a principios del milenio. Esto alimentó la
opinión de que podríamos rescatar la economía después del evento.
La inflación siguió siendo baja y no dio ninguna señal de adver-
tencia de que la economía estaba recalentada. El Comité de
Política Monetaria del Banco de Inglaterra había contribuido a
generar un período de inflación baja y estable sin precedentes
conforme a su mandato. Pero esto significaba que las tasas de
interés eran bajas para los estándares históricos. Y algunos dijeron
que en consecuen- cia la política no estaba suficientemente
engranada para prevenir los riesgos. Algunos países sí elevaron las
tasas de interés para “orzar en contra del viento”. Pero, en general, la
opinión predominante era que
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lo mejor era usar la política monetaria para prevenir la inflación y no

para controlar los grandes desequilibrios de la economía.
Entonces, ¿cuál fue el problema? Todo el mundo parecía estar
haciendo su tarea adecuadamente por su propio mérito. Y conforme
a los indicadores estándar de éxito, a menudo se hacía bien. Se falló
para ver que colectivamente se acumulaban una serie de desequilibrios
interconectados sobre los que no tenía jurisdicción ninguna
autoridad individual. Esto, combinado con la sicología de rebaño y
el mantra de los gurús financieros y políticos, dio pie a una receta
peligrosa. Se podía considerar correctamente que los riesgos
individuales eran pequeños, pero el riesgo para el sistema en su
conjunto era enorme. En resumen, Su Majestad, aunque la falla para
prever el momento,
la extensión y la gravedad de la crisis y evitarla tuvo muchas causas,
fue ante todo una falla de la imaginación colectiva de muchas
personas inteligentes, de este país y del extranjero, para entender los
riesgos para el sistema en su conjunto.
Puesto que la falla de previsión es la médula de su pregunta,
la Academia Británica presentará algunas reflexiones para que los
servidores de la Corona en la Tesorería, la Oficina del Gabinete y
el Ministerio de Negocios, Innovación y Capacitación, así como el
Banco de Inglaterra y la Autoridad de Supervisión Financiera puedan
desarrollar una nueva capacidad para escudriñar el horizonte y
usted nunca tenga que volver a hacer esa pregunta. La Academia
patrocinará otro seminario para examinar más ampliamente la
cuestión de “nun- ca jamás”. Informaremos los resultados a Su
Majestad. Los eventos del año pasado fueron un choque saludable.
Que resulte benéfico dependerá de la franqueza con la que
diseccionemos las lecciones y las apliquemos en el futuro.

Tenemos el honor de seguir siendo, Madam,

los servidores más humildes y obedientes de Su Majestad

Profesor Tim Besley, FBA Professor Peter Hennessy,

FBA

FORO DE La AcaDEMIa BRITáNICa, 17 DE jUNIO DE 2009,

La CRISIS FINaNCIERa MUNDIaL – ¿POR QUé NaDIE La
aDvIRTIó? LISTa DE PaRTICIPaNTES

Professor Tim Besley, FBA, London School of Economics; Bank of England

Mo- netary Policy Committee
Professor Christopher Bliss, FBA, University of Oxford
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Professor Vernon Bogdanor, FBA, University of Oxford
Sir Samuel Brittan, Financial Times

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Sir Alan Budd

Dr Jenny Corbett, University of Oxford
Professor Andrew Gamble, FBA, University of Cambridge
Sir John Gieve, Harvard Kennedy School
Professor Charles Goodhart, FBA, London School of Economics
Dr David Halpern, Institute for Government
Professor José Harris, FBA, University of Oxford
Mr Rupert Harrison, Economic Adviser to the Shadow Chancellor
Professor Peter Hennessy, FBA, Queen Mary, University of London
Professor Geoffrey Hosking, FBA, University College London
Dr Thomas Huertas, Financial Services Authority
Mr William Keegan, The Observer
Mr Stephen King, HSBC
Professor Michael Lipton, FBA, University of Sussex
Rt Hon John McFall, MP, Commons Treasury
Committee Sir Nicholas Macpherson, HM Treasury
Mr Bill Martin, University of Cambridge
Mr David Miles, Bank of England Monetary Policy
Committee Sir Gus O’Donnell, Secretary of the Cabinet
Mr Jim O’Neill, Goldman Sachs
Sir James Sassoon
Rt Hon Clare Short, MP
Mr Paul Tucker, Bank of England
Dr Sushil Wadhwani, Wadhwani Asset Management LLP
Professor Ken Wallis, FBA, University of Warwick
Sir Douglas Wass
Mr James Watson, Department for Business, Innovation and Skills
Mr Martin Weale, National Institute of Economic and Social Research
Professor Shujie Yao, University of Nottingham

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1
Crises and Sunspots

During a visit to the London School of Economics as the 2008 financial

crisis was reaching its climax, Queen Elizabeth asked the question that
no doubt was on the minds of many of her subjects: “Why did nobody see
it coming?” The response, at least by the University of Chicago economist
Robert Lucas, was blunt: Economics could not give useful service for the
2008 crisis because economic theory has established that it cannot predict
such crises.1 As John Kay writes, “Faced with such a response, a wise
sover- eign will seek counsel elsewhere.”2 And so might we all.
England’s royal family is no stranger to financial crises, or to the
evolu- tion of economic thought that such crises have spawned. Our
standard eco- nomic model, the neoclassical model, was forged in
Victorian England dur- ing a time of industrial and economic revolutions
—and the crises and the cruel social and economic disparities that came
with them. This economic approach arose because the classical political
economy of Adam Smith and David Ricardo failed in this new reality. The
neoclassical model was cham- pioned by the Englishman William Stanley
Jevons, who experienced the effects of these crises firsthand, and was
prepared to bring new tools to the job. Jevons was the first modern
economist, introducing mathematics into the analysis and initiating what
became known as the marginalist revolu- tion—a huge leap forward that
reshaped our thinking about the values of investment and productivity.3
Nonetheless, despite all the areas in which Jevons’s approach improved
our thinking, the economic model he origi- nated still failed to predict or
elucidate crises. We can make a start in under-

3
4 CHAPTER 1

standing the limitations in the current standard economic approach to fi-

nancial crises, and what to do about them, by looking at the path Jevons
took in mid-nineteenth-century England.
This economic revolution was driven by a technical one. The railroad
was the disruptive technology. It reached into every aspect of industry,
commerce, and daily life, a complex network emanating from the center
of the largest cities to the remotest countryside. Railroads led to, in Karl
MarX’s words, “the annihilation of space by time” and the “transformation
of the product into a commodity.” A product was no longer defined by
where it was produced, but instead by the market to which the railroad
transported it. The railroad cut through the natural terrain, with
embankments, tunnels, and viaducts marking a course through the landscape
that changed percep- tions of nature. For passengers, the “railway
journey” filled nineteenth- century novels as an event of adventure and
social encounters.4
Railroads were also the source of repeated crises. Then as now, there was
more capital chasing the dreams of the new technology than there were
solid places to put it to work. And it was hard to find a deeper hole than
the railroads. Many of the railroad schemes were imprudent, sometimes
insane projects, the investments often disappearing without a trace. The
term rail- way was to Victorian England what atomic or aerodynamic were to
be after World War II, and network and virtual are today. When it came to
invest- ments, the romantic appeal of being a party to this technological
revolution often dominated profit considerations. Baron Rothschild quipped
that there are “three principal ways to lose your money: wine, women, and
engineers. While the first two are more pleasant, the third is by far more
certain.” Capital invested in the railway seemed to be the preferred
course to the third. Those with capital to burn were encouraged by the
engineers whose profits came from building the railroads, and who could
walk away uncon- cerned about the bloated costs that later confronted
those actually running the rail. A mile of line in England and Wales cost five
times that in the United States.5 The run of investor profits during the
manias of the cycle were lost in the slumps that unerringly followed. One
down-cycle casualty was Jevons’s father, who was an iron merchant.
In 1848, in the midst of this revolution and its cycle of crises, the great
economist and intellectual John Stuart Mill published his Principles of Politi-
cal Economy, a monument to the long and rich tradition of classical political
economy of Adam Smith, Jean-Baptiste Say, Thomas Robert Malthus, and
David Ricardo. With this publication, economics reached a highly
respect- able, congratulatory dead end, the station of those in a staid
gentlemen’s
 CRISES AND SUNSPOTS 5

club sitting in wing-back chairs, self-satisfied and awash in reflection.

Eco- nomic theory then languished for the better part of the next two
decades. Mill wrote that “happily, there is nothing in the laws of Value which
remains for the present or any future writer to clear up; the theory of the
subject is complete.”6
But over those two decades, with a backdrop of labor unrest and a rising
footprint of poverty, cracks began to emerge in the pillars of Mill’s
theory.7 His economics failed to see the essential changes wrought by the
Industrial Revolution. He put labor front and center. The more labor used
to produce a good, the greater that good’s value. This was reasonable when
production was driven by labor.8 But with the Industrial Revolution, capital
could mul- tiply the output of a laborer, and, furthermore, capital was not
fiXed. It could drive ever-increasing efficiency. At the same time, the
supply of labor was brimming over the edges because many small
landholders and agricultural workers moved to the cities as landholdings
were consolidated through en- closures into more efficient large estates. The
laborers were paid subsistence wages, while the economic benefit from
the increased productivity was captured by those controlling the
machinery, the capitalists.
For those whose success or luck of birth pushed them into the newly
emerging business class, life was filled with promise and stability. Men
would become gentlemen with country houses, providing an O Xbridge edu-
cation for their sons. For the working class, life held something less. Henry
Colman, a minister visiting the United Kingdom from America, reacted to
the factory life he observed in the cities: “I have seen enough already in
Edinburgh to chill one’s blood, make one’s hair stand on end. Manchester
is said to be as bad, and Liverpool still worse. Wretched, defrauded, op-
pressed, crushed human nature lying in bleeding fragments all over the face
of society. Every day that I live I thank heaven that I am not a poor man with
the family in England.”9 The clergyman Richard Parkinson wrote with irony
that he once ventured to designate Manchester as the most aristocratic town
in England because “there is no town in the world where the distance be-
tween the rich and the poor is so great, or the barrier between them so
difficult to be crossed.”10

The Birth of Modern Economics

Industrial age economics moved away from Mill in two directions. The one
traveled by MarX, based on historical analysis and with a focus on the human
consequences of the dominance of capital, fomented revolution that
would
6 CHAPTER 1

engulf the world. The other, based on mathematics, emulated the mechanics
of the natural sciences while ignoring the human aspect completely,
form- ing the foundation for today’s standard economic model, that of
neoclassical economics. This was the way pushed forward by William
Stanley Jevons.
To say that the development of the neoclassical approach ignored the
human aspect is to say that it was a product of its times. Arithmetic,
writes the historian Eric Hobsbawm, was the fundamental tool of the
Industrial Revolution. The value of an enterprise was determined by the
operations of addition and subtraction: the difference between buying
price and selling price; between revenue and cost; between investment
and return. Such arithmetic worked its way into the discourse and
analysis of politics and morals. The simple calculations of arithmetic could
express the human con- dition. The English philosopher Jeremy Bentham
proposed that pleasure and pain could be expressed as quantities, and
pleasure minus pain was the measure of happiness. Add the happiness
across all men, deduct the unhap- piness, and the government that produces
the greatest net happiness for the greatest number has de facto applied the
best policy. It is an accounting of humanity, producing its ledger of debit
and credit balances.11
This formed the starting point of Jevons’s Theory of Political Economy: a
quantitative analysis of the feelings of pleasure and pain. Of the seven
Ben- thamite circumstances associated with pleasure and pain, Jevons
selected intensity and duration as the most fundamental dimensions of
feeling. Clearly, “every feeling must last some time, and . . . while it lasts,
it may be more or less acute and intense.” The quantity of feeling, then, is
just the product of its intensity and duration: “The whole quantity would
be found by multiplying the number of units of intensity into the number
of units of duration. Pleasure and pain, then, are magnitudes possessing
two dimen- sions, just as an area or superficies possesses the two
dimensions of length and breadth.”12
Jevons was a polymath who started in the pure sciences and mathemat-
ics. He studied for two years at University College in London, winning a
gold medal in chemistry and top honors in experimental philosophy. He left
before graduating to take a post as an assayer in Sydney, Australia, for
the new mint, stopping on the way to study in Paris, receiving a diploma
from the French mint. While in Australia he expanded his interests beyond
chem- istry and mathematics, exploring the local flora, geology, and
weather pat- terns. In fact, for a time he was the only recorder of weather
in Sydney. He also wrote a manuscript for a book on music theory.13
 CRISES AND SUNSPOTS 7

His interest moved from meteorology and music into economics as he

became engaged in the economic travails of the New South Wales
railway, which no doubt echoed his family’s financial travails. He found
an immedi- ate affinity for the subject, which he wrote “seems mostly to
suit my exact method of thought.” He wrote in 1856 that, as his interests
moved to this new area, he felt he was “an awful deserter” of “subjects for
which I believe I am equally well or even better suited” and he doubted that
“I shall ever be able to call myself a scientific man.” In fact, Jevons did
remain engaged in mathematics and logic, and in 1874 would publish The
Principles of Science, which, among other things, laid out the relationship
between inductive and deductive logic, and treated the use of
cryptography, including the factor- ization problem that is currently used
in public key cryptography.14 But his formal studies moved from pure
science to political economy. In 1859, after five years in Australia, he
returned to University College to study political economy, where he won
a Ricardo scholarship and a gold medal for his master of arts.
He poured himself into his new focus of study, and by the following year
had already discovered the idea of marginal utility. He wrote to his brother
that “in the last few months I have fortunately struck out what I have no
doubt is the true theory of economy One of the most important axioms
is that as the quantity of any commodity, for instance plain food, which a
man has to consume increases, so the utility or benefit from the last portion
used decreases in degree.” In another letter he expanded on this discovery,
giving a succinct explanation of marginal theory and the implications of the
relationship between profits and capital: “The common law is that the
de- mand and supply of labor and capital determine the division between
wages and profits. But I shall show that the whole capital employed can
only be paid for at the same rate as the last portion added; hence it is the
increase of produce or advantage, which this last addition gives, that
determines the interest of the whole.”
Jevons wrote up his ideas in a paper, “A General Mathematical Theory
of Political Economy,” first presented in 1862, and these ideas gained broad
notice with the publication of his 1871 book, The Theory of Political Economy.
The temple of classical economics shuddered to a sudden collapse with this
publication, which was as much a manifesto against the prevailing wisdom,
a call to “fling aside, once and for ever, the mazy and preposterous assump-
tions of the Ricardian School,” as it was a scientific treatise on economics
theory.15
8 CHAPTER 1

Not long afterward, others were hot on the marginalist trail.16 And
the concepts of marginal utility and the application of mathematical
methods seemed to find precursors in many places, leading Jevons to
complain that books were appearing “in which the principal ideas of my
theory have been foreshadowed.” He found himself in the “unfortunate
position that the greater number of people think the theory nonsense, and
do not understand it, and the rest discover that it is not new.” Jevons gave
up on the hope that he would be able to establish a first claim to the
concepts, but took comfort that “the theory . . . has in fact been discovered
3 or 4 times over and must be true.”

Blinded by Sunspots: Jevons’s

Quest for a Scientific Cause of
Crises

Jevons not only brought mathematical rigor to the field but also was the first
economist to focus on the sources of economic crises. He had personal rea-
sons for this focus. Not only had his father suffered a failure during the rail-
road bubble while Jevons was still a boy, but others in his extended
family had suffered through similar difficulties. And he was brought up in
Unitarian circles where social inequities were a point of concern. He was
socially aware, and would take walks though the poor and manufacturing
districts of London to observe social costs up close.
Jevons viewed an understanding of crises as the key test of
economics. He believed that if economics could not explain market crises
and “detect and exhibit every kind of periodic fluctuation,” then it was
not a complete theory.17 The inquiry into the causes of phenomena as
complex as commer- cial crises could not approach the rigor or
mathematical purity of a science unless Jevons purged this subject of all
traces of human emotion, unless he assumed—even if he could not prove—
that some physical cause was acting on events others might describe as
socially driven. Without some observ- able natural phenomenon to serve
as causal agent, commercial crises threat- ened to become uninterpretable,
limiting the claim of economics to be a science.
Because Jevons patterned his economic methods after the scientific
methods used for studying the natural world, he looked for a natural
phe- nomenon as the anchor for his study of otherwise unexplainable crises.
This led him to theorize that sunspots were the culprit.18 He was
determined to link sunspot periodicity to the periodicity of commercial
crises. And Britain
 CRISES AND SUNSPOTS 9

had certainly been subject to them, most recently the 1845–1850 railway
mania bubble, which, like all bubbles, did not end well.
Jevons’s interest in sunspots was not mystical. He hypothesized that the
success of harvests might be one of many causes that could precipitate a
panic: “It is the abnormal changes which are alone threatening or worthy of
very much attention. These changes arise from deficient or excessive
har- vests, from sudden changes of supply or demand in any of our great
staple commodities, from manias of excessive investment or speculation,
from wars and political disturbances, or other fortuitous occurrences
which we cannot calculate upon and allow for.”19
Jevons used a sunspot cycle that had been determined by earlier re-
searchers to be 11.11 years. All that remained, then, was to show that the
cycle for commercial crises followed a similar course. A simple attempt at
matching the two came up short, but, convinced that this theory—attractive
from the standpoint of bringing economics into the fold of the natural sci-
ences—was correct, he looked past the contemporary data and reached
back to data from the thirteenth and fourteenth centuries. This attempt also
failed, because data were scant on both sunspots and commercial cycles.
After extending his dataset across time failed to prove this theory, Jevons
then cast a broader net geographically. He looked at records from India,
with the argument that British commerce relied on agricultural activity and
raw materials from its colony. This approach also failed. With a view that
“the subject is altogether too new and complicated to take the absence of
variation in certain figures as conclusive negative evidence,” he
continued to press forward, expanding the dataset to tropical Africa,
America, the West Indies, and even the Levant, stretching the logic of
including India, asserting that these parts of the globe also had a
demonstrable effect on British commercial activity. In addition to his search
for confirming data, he revised his eleven-year cycle, noting recent research
that suggested a shorter cycle. His data refused to fit the alternative cycle,
too.
Having discovered no evidence for his mathematically driven, mecha-
nistic model of crises in the historical or contemporary records, in the re-
cords of Britain, India, or the broader reaches of the globe, or through revi-
sions in the period of the cycle, Jevons still didn’t doubt the model. He
surmised that observational error must be at the root of his inability to con-
firm the sunspot theory. So he called for direct observation of the sun.
And he also added a further level of causality to his theory, which
smacked of astrology: he called for a study of the planets, which had an
effect on the
10 CHAPTER 1

course of the sun and thereby on sunspot activity: “if the planets govern the
sun, and the sun governs the vintages and harvests, and thus the prices of
food and raw materials and the state of the money market, it follows that
the configurations of the planets may prove to be the remote causes of
the greatest commercial disasters.”
Clearly a man not easily deterred, Jevons continued his advocacy of
the sunspot theory in the face of the lack of evidence: “In spite . . . of the
doubt- ful existence of some of the crises . . . I can entertain no doubt
whatever.” This advocacy, which bordered on the fanatical, was all in the
service of his dream of a mathematical foundation for economics that
would form a sci- entific basis to marry the study of economics to that of
the natural sciences.

Chasing Sunspots after All These Years

Jevons’s unrelenting drive to demonstrate the link between sunspots and

crises rests on two ideas: First, for economic theory to be complete and
valid, it must extend beyond the everyday and explain crises. Second,
eco- nomics “is purely mathematical in character [W]e cannot have a
true
theory of Economics without its [mathematics’] aid.” I agree with his first
point. Contemporary economics agrees with his second. And the motiva-
tion behind Jevons’s preoccupation with sunspots remains at the center
of economics, yet an unswerving adherence to mathematics fails in
predicting crises today just as surely as did Jevons’s unswerving focus on
sunspots.
And we do not have to go as far as failures in prediction. It is one
thing to predict where a battle line might be breeched. But before and
during the Great Recession, economists couldn’t even tell whether the
forces were on the attack or in retreat. Despite having an army of
economists and all the financial and economic data you could hope for,
on March 28, 2007, Ben Bernanke, the chairman of the Federal Reserve,
stated to the Joint Eco- nomic Committee of Congress that “the impact on
the broader economy and financial markets of the problems in the
subprime market seems likely to be contained.” This sentiment was echoed
the same day by the U.S. Trea- sury secretary Henry Paulson, assuring a
House Appropriations subcom- mittee that “from the standpoint of the
overall economy, my bottom line is we’re watching it closely but it
appears to be contained.”
Less than three months later, this containment ruptured when two Bear
Stearns hedge funds that had held a portfolio of more than twenty billion
 CRISES AND SUNSPOTS 11

dollars, most of it in securities backed by subprime mortgages, failed, mark-

ing a course that blew through one financial market after another over
the following siX months—the broader mortgage markets, including
collateral- ized debt obligations and credit default swaps; money markets,
including the short-term financing of the repo (repurchase agreement) and
interbank markets; and markets that seemed to be clever little wrinkles but
turned out to have serious vulnerabilities, such as asset-backed commercial
paper and auction-rate securities.
In early 2008, as the market turmoil raged, Bernanke gave his
semian- nual testimony before the Senate Banking Committee. He said
that there might be failures within the ranks of the smaller banks, but “I
don’t antici- pate any serious problems of that sort among the large
internationally active banks that make up a very substantial part of our
banking system.” That September, ten days after the spectacular collapse
of the investment bank Lehman Brothers, Washington Mutual became the
largest financial institu- tion in U.S. history to fail. In October and
November, the federal govern- ment stepped in to rescue Citigroup from
an even bigger failure.
Another bastion of economic brainpower, the International Monetary
Fund, did no better in predicting the global financial crisis. In its spring
2007 World Economic Outlook, the IMF boldly forecast that the storm
clouds would pass: “Overall risks to the outlook seem less threatening than
siX months ago.” The IMF’s country report for Iceland from August 2008
offered a reassuring assessment: “The banking system’s reported financial
indicators are above minimum regulatory requirements and stress tests
suggest that the system is resilient.” A month and a half later, Iceland was
in a meltdown. Iceland’s Financial Supervisory Authority began the take-
over of Iceland’s three largest commercial banks, all of which were facing
default, with reverberations that extended to the United Kingdom and
the Netherlands.
Economic theory asserts a level of consistency and rationality that not
only leaves the cascades and propagation over the course of a crisis
unex- plained but also asserts that they are unexplainable. Everything’s
rational, until it isn’t; economics works, until it doesn’t. So economics
blithely labors on, applying the same theory and methods to a world of its
own construc- tion that is devoid of such unpleasantries. The dominant
model postulates a world in which we are each rolled up into one
representative individual who starts its productive life having mapped
out a future path of invest- ments and consumption with full knowledge of
all future contingencies and
12 CHAPTER 1

their likelihood. In this fantasy world, each of us works to produce one good
and conveniently—because who wants to worry about financial crises?
— lives in a world with no financial system and no banks!
Lucas is right in his assessment that economics cannot help during fi-
nancial crises, but not because economic theory, in its grasp of the world,
has demonstrated that crises cannot be helped. It is because traditional eco-
nomic theory, bound by its own methods and structure, is not up to the task.
Our path cannot be determined with mathematical shortcuts; we have to
follow the path to see where it leads. Which might not be where we in-
tended. As the boXer Mike Tyson noted, everyone has a plan until they
get punched in the mouth.
This book explores what it would mean to follow the path to see
where it leads. It provides a nontechnical introduction to agent-based
modeling, an alternative to neoclassical economics that shows great
promise in pre- dicting crises, averting them, and helping us recover
from them. This ap- proach doesn’t postulate a world of mathematically
defined automatons; instead, it draws on what science has learned
recently from the study of real-world complex systems. In particular, it
draws on four concepts that have a technical ring but are eminently
intuitive: emergent phenomena, ergodicity, radical uncertainty, and
computational irreducibility.
Emergent phenomena show that even if we follow an expected path,
whether choosing to drive on a highway or buy a house, we’ll miss
insight into the overall system. And it is the overall system that defines
the scope of the crisis. The sum of our interactions leads to a system that can
be wholly unrelated to what any one of us sees or does, and cannot even
be fathomed if we concentrate on an isolated individual.
The fact that as real-world economic agents we couch our
interactions in our varied and ever-changing experience means that we
are a moving target for economic methods that demand ergodicity, that is,
conditions that do not change.
And we don’t even know where to aim, because of radical uncertainty:
the future is an unknown in a deep, metaphysical sense.
Neoclassical economic theory cannot help because it ignores key ele-
ments of human nature and the limits that these imply: computational ir-
reducibility means that the complexity of our interactions cannot be unrav-
eled with the deductive mathematics that forms the base—even the raison
d’être—for the dominant model in current economics. As the novelist Milan
Kundera has written, we are in a world where humor resides, a world filled
 CRISES AND SUNSPOTS 13

with “the intoXicating relativity of human things,” with “the strange pleasure
that comes of certainty that there is no certainty.”20 It is humor, intoXication,
and pleasure that economics cannot share.
These limitations are also at work in our day-to-day world even
though they are not very apparent or constraining. Lucas acknowledges
that “ex- ceptions and anomalies” to economic theory have been discovered,
“but for the purposes of macroeconomic analyses and forecasts they are
too small to matter.”21 A more accurate statement would be, “but for the
self-referential purposes of macroeconomic analyses and forecasts viewed
through the lens of economic theory, they are too small to matter.” Are the
exceptions and anomalies manifestations of the limits brought about by
human nature?
The performance of economics during crises is a litmus test for its
per- formance in other times, where the limits might be ignored, cast
aside as rounding errors. Thus, understanding crises provides us a window
into any broader failure in economics. Crises are the refiner’s fire, a
testing ground for economic models, a stress test for economic theory. If
standard eco- nomic reasoning fails in crises, we are left to wonder what
failings exist in the noncrisis state, failings that might not be so apparent
or that can be covered by a residual error term that is “too small to matter.”
Small, perhaps, but is it a small smudge on the floor or a small crack in the
foundation?
EXpecting rationality, casting the world in a form that is amenable to
mathematical and deductive methods while treating humans as mechanistic
processes, will continue to fail when crises hit. And it might also fail in
subtle and unapparent ways beyond the periods of crisis. But what can
re- place it?