Interview with Paul de Grauwe.

Kovanoa, Lukas

"I do not believe that all the blame rests on Clinton's administration. But the basis for this crisis was not laid by Bush--rather, it was laid by previous US Democratic administrations, which promoted the deregulation of the banking system," says Paul de Grauwe, Professor of Economics at the University of Leuven, foremost world economist and ideological founding father of the Eurozone.

One can view the financial crisis as a failure in market efficiency and human rationality. Asides from reforming the financial system, would you propose to reform textbook economics?

Yes. We have gone a little too far with our presumptions and the models that we have developed from them. That was a mistake. We need to look at other perspectives from other disciplines, such as psychology. We need to understand that people have only a limited capacity to act rationally. It is not true that the complexity of the world is universally understood; no one is fully informed, nor can anyone precisely predict the future. Markets are not efficient; prices do not always reflect real value. But this is precisely what is mistaken because people do not actually understand the markets and tend to be excessively optimistic at times.

Did this happen because economics became too closely aligned with math and physics, and too many economists developed models filled with equations that in the end reflected something far from reality?

Economists are really intoxicated with the technical and mathematical aspect of economics. And it is precisely their reliance on the idea of individual rationality and efficient markets that enables them to develop such beautiful mathematical models. Many people--especially young scientists--just love these models. I am surprised about how many young economists take these models as a given. It is all an act of faith. They do not even bother to subject them to empirical observation to determine whether they actually correspond with reality. We who reject these models appear to be dropouts to them because they look at economics as a belief rather than a science.

In your opinion, what then is the correct approach to economics? Verbal Economics?

No, no. We must indeed use math. It is a tool that enables us to express ourselves more precisely. Words alone are oft en inaccurate or misleading. It is difficult to test verbal definitions; it is a lot easier to test mathematical definitions. We cannot, however, fall into the trap or succumb to the idea of mathematical precision and use math excessively. Qualitative and historical analyses are important. What cannot be described in numbers, cannot, as we are seeing now, be considered uninteresting. Equations are simply unsuitable for many subjects. Let's not forget that the social sciences (and economics is such a science) are much more complex then natural sciences. While it may sound rather paradoxical, take for example, astronomy. Anyone could state that astronomy is very complex. This is true. On the other hand, predicting people's behavior is so much more complicated than predicting the movement of stars.

So math is a good servant, but a mean master?

Well said.

Are you an advocate for an interdisciplinary approach to economics--an approach that would connect economics with other science subjects other then math?

Yes I am. We can learn a lot from psychology and other subjects. In the past, economists were too arrogant. They considered other science disciplines as irrelevant. They were proud of the tools invented by economics to understand the world around us. I think that now it is evident that this feeling of superiority was unfounded. I am very influenced in this respect by the work of Portuguese neurologist Antonio Damasio who explains that emotions and rationality are in reality very closely connected. This connection is so powerful that people who lose their ability to experience emotions--for example due to brain damage--do not only lose the ability to love or be scared, but also the ability to make rational decisions. But for a long time economics reasoned the other way around: it removed feelings and emotions, and analyzed a perfectly rational "homo economicus." It created an individual, who like a machine, maximizes profits and gains. But we need emotions. We need feelings and senses. We need to distinguish between good and evil and thereafter make reasonable decisions.

Can we apply this reasoning to the current financial crisis? Did it originate from a lack of fear, which led people to make high-risk and even irrational investments? And, if there was a lack of fear, was there therefore a lack of rationality?

There is too much fear now that this crisis is upon us. But we cannot separate our rationality from our emotions--they are interconnected. The second fundamental thing I learned from other sciences, especially from psychology, is about the individual's limited capacity to process information and understand the world around him or her. Meanwhile, the individual derives his or her rational answers in life from heuristics (for example, educated guesses and common sense). Heuristics relies on learning from previous experiences; the individual uses previous and partial information from related experiences to make decisions that are pertinent in the present moment in time. I once wrote an article about this for the Financial Times. I made a great analogy in it regarding what happens when you introduce a new type of pralines to a Brussels' chocolate shop.

Do tell.

On the first day, the storekeepers sell the box for ten Euros. The second day for just three Euros--in contrast to the first day, not a single box sells. The customers stand at the window and shake their heads: "Just three Euros? That can't be good." The next day they raised the price to twenty Euros; as a result, the potential costumers expressed greater interest: "Twenty Euros? That must be good chocolate." Their customers relied on heuristics--previous experiences had taught them that something more expensive is of a better quality.

"The Snob Effect"--an increase in demand with an increase in price?

That is just one part of it. It shows decision-making in a world of incomplete information--heuristics underlies decisions made from common sense and lessons learned from previous experiences. Actually, one acts on the basis of heuristics all the time.

Again, this idea slightly contrasts with textbook economics.

Yes. But we can apply the theory of heuristics everywhere. What is, for example, the real value of the dollar in comparison with the Euro? What is the objective exchange rate? Who knows? But when the dollar rises, what do traders on the FX market do? They decide to buy the currency. And when the dollar weakens and they realize that everyone else is apparently selling, they too decide to sell. This is how bubbles are created, and this is how they burst; the same applies to booms and recessions.

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Herd behavior?

Yes, this exemplifies herd behavior based on incomplete information--collective movement.

And can we now observe a downwards collective movement?

Yes. Everyone says everyone is selling, so I will sell too.

In these times is it best to start buying--to go against the herd?

In this case we must ask ourselves, "Where is the end?" Let us not forget, however, that these cycles (which are based in the psychological theory of the masses) can devalue stocks and result in bank insolvency. The banks' balance sheets will reflect the negative mood of the markets. As more bad results are brought in, the stock value will continue to decline. It is a vicious cycle. That is why we need state organs that are outside of the market and are thereby able to intervene in such a situation.

Do you think that we should abandon the "mark-to-market" criterion, according to which the banks' assets are valued in accordance with their current market price which can, however, momentarily slip on account of the mood of the market?

Yes, and I also wrote about that in the Financial Times. This criterion is really a bad idea. Again, it is based on the theory of efficient markets, which presupposes that the market price is the most objective price. But during bubbles the market price is not at all objective; it does not reflect fundamental value. The "mark-to-market" criterion also blows banks' balance sheets out of proportion just like the bubble. It leads to virtual bank profits. Then, on the basis of these virtual profits, people buy more of that bank's stocks. But the increased value of the stock is also only virtual. Then comes the crash--again, as we have seen today, the "mark-to-market" criterion unreasonably increases the decline.

Why do you think the theory of efficient markets became so influential? Is there, after all, any consensus about it between economists?

Even imaginary markets go through their booms and recessions. In the 1980s, free market ideology replaced theory. Now we can see that uncontrolled markets are not the best solution.

Factories, for example, require routine check-ups to maintain ecological and health standards. We also need to regulate our financial markets; we cannot simply believe in fairytales of their incredible efficiency.

Let's talk about practice instead of theory now. It is generally believed that the Bush administration created the current crisis. You, however, have identified a moment even further in the past.

I do not believe that all the blame rests on Clinton's administration. The basis for this crisis was not, however, laid by Bush but by the previous Democratic administrations, which promoted the deregulation of the banking system. They did that--and this is connected with what we talked about before--on the basis of the belief that markets are efficient, self-regulating, and do not require supervision. Booms and recessions reflect an economic pattern that we cannot avoid. But we can avoid the extent to which the banking system gets involved in these cycles. This was the purpose of the Glass-Steagall Act; it separated commercial and investment banks. Commercial banks could not take part in high-risk operations on the financial markets. Those who insisted on the act's repeal (people from the Clinton administration in 1999) forgot how important it is for the commercial banking sector to stay out of high-risk activity. While the road to deregulation was already established in the 1980s, it intensified considerably during the Clinton years. Alan Greenspan, the former Chairman of the Fed, also shares some responsibility. Between 2001 and 2004 he kept interest rates much too low. Bush is by no means solely responsible for our current crisis.

The Glass-Steagall Act enabled commercial banks to take part in investment banking. In reaction to the crisis, the two investment banks--Goldman Sachs and Morgan Stanley--started to participate in commercial banking and thereafter became universal banks. The demarcation between commercial and investment banks completely dissolved.

Yes, that was a very bad solution. But investment banks had already begun to enter the domain of commercial banking before the crisis: investment banks were permitted to use short-term interbank deposits. Now, they have simply just taken the last step--like traditional commercial banks, they can use the deposits of regular depositors. These deposits are more secure and stable then interbank deposits. When interbank deposits are involved, even just the smallest decline in mutual trust can result in enormous negative effects. But we should not allow investment banks to become so indebted on the basis of short-term financing. Most of their investments are directed at long-term, primarily illiquid projects.

So would you favor the kind of financial reform which would again divide investment and commercial banking?

Yes. Since commercial banks acquire their short-term resources from regular depositors, they should be limited in what they can do with these resources; that is, to whom they can lend money. They should not assist in any bond exchange activity, derivatives trading, and so on. And while the investment banks should conduct high-risk transactions, these transactions should be financed from long-term resources like capital markets. Short-term resources like from a client's deposits or from another bank's resources should not provide financial backing.

Do you agree that one aspect of reform should also be some form of asset price control, which could prevent the creation of bubbles?

I agree. A central bank that only evaluates the price level rise in goods and services is not a good central bank because it overlooks possible bubbles on the asset markets. If a bubble exists in the asset market, for example in the real estate sector, a rise in demand will raise supply and investment in capacities such as construction (the bubble reduces capital which encourages more investment). Consequently, the price level may not change and the central bank can easily overlook the bubble. After it bursts, the central bank realizes that there was too much investment into unused capacities and the economy begins to show signs of decline. Increasing rates may help avoid inflation and decrease the size of bubbles, but it is not enough on its own. In the future, we need to directly monitor prices on the asset market.

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Alan Greenspan warned that interest rates are too inefficient a weapon against bubbles because they affect all sectors of the economy, not just those that are being blown up. He was skeptical even about monitoring bubbles.

I think that he never even tried it properly--except once perhaps. Let's also not forget that since he said that he has lost a lot of his reputation.

Paul De Grauwe

De Grauwe is a Belgian economist, a former MP of the Belgian parliament, and a professor at the Catholic University at Leuven. He is one of the ideological founding fathers of the Eurozone, which was created largely due to his theories. De Grauwe's book Economics of Monetary Union, published by Oxford University has been printed in its seventh edition.

According to him, Europe is heading into a deep recession and further stimulation measures will be necessary. De Grauwe believes that the fact that the Czech Republic still has its own currency may be advantageous once the crisis is over. It will be easier to start up the economy by depreciating the crown, which would not be possible as a member of the Eurozone. "For example, the Swedes used this method to react to the banking crisis in the beginning of the 1990s. They depreciated the national currency, which increased the competitiveness of their exports and helped to quickly recover the economy," De Grauwe explains. He is also a regular contributor to the Financial Times, enthusiastic runner and squash player, and admirer of economists such as Paul Krugman and Milton Friedman.

FOR FURTHER READING:

Batra, Ravi and Raveendra N. Batra. Greenspan's Fraud: How Two Decades of His Policies Have Undermined the Global Economy, (Palgrave Macmillan, 2006).

Benston, George J. The Separation of Commercial and Investment Banking: The Glass-Steagall Act Revisited and Reconsidered. (Macmillan, 1990).

Damasio, Antonio R. Descartes' Error: Emotion, Reason, and the Human Brain. (Avon Books, 1994).

Sheeran, Paul and Amber Spain. The International Political Economy of Investment Bubbles. (Ashgate Publishing, Ltd., 2004).

Lukas Kovanda is a Czech economist and journalist. He teaches at Prague's University of Economics and co-founded EUportal. cz, a eurorealist webpage in the Czech Republic.