Riding in Cabs with: Paola Subacchi

Following the global financial crisis of 2008, economists have had a spectacular fall from grace. I am John Andrews and I am going to be talking today with Paola Subacchi. She is the senior research fellow in international economics at Chatham House – The Royal Institute of International Affairs – and we will be talking about the crisis in her profession as we ride around London in a cab. Paola, thank you very much for being with me in this cab. Wow, that’s great! Now, we’re supposed to talk about economics, and you are a well-known economist, and you’re at the Royal Institute of International Affairs, Chatham House. Now, your colleagues famously failed to predict the global financial crisis and I seem to remember that the Queen, Queen Elizabeth, asked them why not. Now, I don’t remember what their answer was. What’s yours? Well, I don’t want to have any responsibility for predicting or not predicting the next crisis. The thing was… actually I think it was a very complex answer that came out in several papers, because I think people who were asked the question were set back. And economists can always make things complex. Yes, exactly, and one of the problems is probably economics is too complex and we need to go back to the essentiality of economics and really focus on what is economics, and in particular what economics has to do with the real world, the world we are in, and unfortunately we made it too difficult, too abstract in order to partly comply with, you know, academics. And did we become too mathematically based? We are, actually, but the thing is math is a very important tool. It should be used, but it shouldn’t become, the tool shouldn’t become the purpose of analysis, right, and that’s what exactly what it is, and if you think back at the global financial crisis, when the problem was that this beautiful model didn’t include the financial sector, which is actually essential in our economy, and how can you actually have a tool which reflects the real world if you forget to put in its importance. But, I mean, one of the criticisms of the financial sector was that so many of the, well, quants and other… you know, the derivatives traders and so on, they were dealing with products that even their bosses didn’t understand. Now, do economists understand them as well, or not? I am not sure about that. I am not sure anybody could understand those products. The thing is, again, there was this… the fallacy here was the idea that by making financial products more complex, you could, actually, slice the risk, and spread it among different products. Actually, risk doesn’t work like that. So, in reality what happened, the risk was somehow leveraged by spreading around the system. And, again, 10 years ago there was this idea then, ‘oh, yes, we have got this product, there are a lot of different things in it, we have put a lot of different – we put subprime mortgages, we put all sorts of products, but we actually made the risk less…’ And there is a sort of phenomenon of musical chairs, where as long as you could get rid of the products onto someone else, you could postpone your own downfall. Well, there was money to be made in the market, and that was very clear. And I think it was the head of Citi who said very clearly, until the music goes on, we need to play, we need to dance, and we need to stop and get the chairs, as a musical chair game. How do you factor that into economics? This is really behavioral; I don’t know how you factor in. And the thing is, again, there is, somehow, a disconnect between the real world where people, actually, again, one of the, if you like, assumptions of economics is then people are driven by profit and you do not do anything by goodwill but because you make your own profit. So, how we can actually factor it into the process, the fact that people stay in the game and the risk goes up, because profits – obviously, the risk goes up, therefore, profits go up. But there was always this – I say always – there was for a long time the assumption that man was a rational economic being, and I think behavior economists have rather disproved that. Absolutely. Why did we hold onto the idea that we were rational? It is easy; you can model that very easily. When you start to introduce all the variables in the human behavior, like different preferences, different attitudes, different things, then how can you model? You can’t. So that is very simple. Paola, thank you very much indeed, it has been a pleasure talking to you. Thank you.

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