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Home > Macroeconomic Issues Viewpoints > Understanding and Forecasting the Credit Cycle—Why the Mainstream Paradigm in Economics and Finance Collapsed

Macroeconomic Issues Viewpoints

Understanding and Forecasting the Credit Cycle—Why the Mainstream Paradigm in Economics and Finance Collapsed

by Richard A. Werner


Professor Richard A. Werner, DPhil (Oxon), BSc (Economics, LSE), began his academic career as Marie Curie Fellow of the European Commission at the University of Oxford. From 1997 to 2004 he was Assistant Professor at Sophia University, Tokyo. Since 2004 he has been at the University of Southampton, School of Management, where he is Chair in International Banking and founding director of the Centre for Banking, Finance and Sustainable Development.

Professor Werner has two decades of experience in the financial sector, including as chief economist at Jardine Fleming Securities (Asia) Ltd, Senior Managing Director at Bear Stearns Asset Management, and as senior consultant or visiting researcher at the Asian Development Bank, the Japanese Ministry of Finance, the Bank of Japan, the Japan Development Bank and the Nomura Research Institute. Richard served as member of the asset allocation board of a US$6.5bn Japanese corporate pension fund, and has been working as global macro fund manager and provider of forecasting services and economic policy advice to investors and governments.

His book Princes of the Yen was a no. 1 bestseller in Japan in 2001. In his 2005 book New Paradigm in Macroeconomics, he warned about the dangers of “recurring banking crises,” including the pending financial collapse in the UK, and detailed the required policy responses. Richard has been voted one of the top economists by investor surveys and is sought as a commentator by the media. The World Economic Forum, Davos, selected him as “Global Leader for Tomorrow” in 2003.

Crises Have Disproven Mainstream Neo-Classical Economics

The global financial crisis has led many observers to question the success of an array of government policies adopted in the past decade or so in many countries. Most have been directly or indirectly based on the thinking that markets should be the ultimate arbiter, and hence deregulation, liberalization, and privatization was the policy mantra.

The doubters are now in good company. For about two decades, Alan Greenspan, chairman of the Board of Governors of the Federal Reserve System from August 1987 to January 2006, has been considered the oracle on any issue involving banking, monetary, fiscal, and economic policy. The “Maestro” has been a staunch champion of the deregulation mantra and the belief that markets, if left unregulated and to their own devices, would produce the best possible outcome for society. Likewise, he also believed that bankers should not be further regulated as their self-interest would ensure an optimal result. This thinking is commonly known as “mainstream” or “neo-classical” economics. From about 1980 onwards, it was initially adopted by international organizations such as the IMF and the World Bank in their policies imposed on dozens of developing countries, but since the mid-1980s it has became the guideline of other Washington-based decision-making bodies, such as the US government (hence it is often called the “Washington Consensus” on economic policy). It has since also become the basis of government policies worldwide, such as in Thatcherite and New Labour Britain, or more recently in Japan, Korea, or Germany. Even nonmarket economies such as China have begun to adopt a growing set of recommendations derived from this free market economics.

Dr Greenspan, an academically trained economist and key promoter of this creed, has, however, now changed his mind. On October 23, 2008, he admitted—reluctantly, under cross-examination by irate Congressmen—that this entire approach to economics is flawed and that his faith in the free markets had been wrong. Greenspan had been summoned to give formal testimony to the House Committee on Oversight and Government Reform of the US House of Representatives about his role and involvement in the events that led to the financial crisis. His testimony must be considered a watershed in the debate about different economic theories and policy recommendations.

Representative Henry Waxman of California, chairman of the committee, asked him: “You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. Do you feel that your ideology pushed you to make decisions that you wish you had not made?”

Greenspan: “…Yes. I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.” The exchange goes on:

Waxman: “You found a flaw in the reality.” Greenspan: “…[A] flaw in the model that I perceived as the critical functioning structure that defines how the world works, so to speak.”

Waxman: “In other words, you found that your view of the world, your ideology was not right. It was not working.” Greenspan: “Precisely. That’s precisely the reason I was shocked…”

There was a second admission, concerning the methods used to calculate and manage risk in the entire financial sector: “This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year,” Greenspan testified.

The crisis has with one stroke not only discredited the particular decisions by those responsible for the crisis—central bankers, financial regulators, and bankers—but it has disproved the entire mainstream “neo-classical” paradigm of thinking about economics and economic policy. The Washington Consensus, the basis for recent government and central bank policies all over the world, has been proven wrong.

But the current crisis is not the only piece of evidence that there has been something seriously amiss with the mainstream economic theories and the policies based on them. Other evidence includes the increasingly visible environmental destruction, or the many previous financial and economic crises the world has seen. Indeed, banking and financial crises have recurred with such frequency over the past centuries that their occurrence must be considered one of the few constants in economic life. Each time, much surprise is exhibited by the experts. Over the past three decades, the number of banking and financial crises has increased (to over 100 countries) and the swings of the business cycle have become more pronounced. (It is noteworthy that this happened, as central bank independence and power over economic policy has increased significantly during this time period).

Thus the experience in many countries has contradicted key aspects of mainstream theories. There is one country, however, where the number of “anomalies” or contradictions of the mainstream approaches has been the largest: this is Japan, the second largest economy in the world. First, Japan’s meteoric postwar rise, which was based on nonmarket policies, cartels, and “guidance” of industries and credit, could not be explained. Then, in the 1980s, Japan experienced a surge in asset prices and capital outflows that economists had not expected (and could not explain). Just when observers were predicting that Japan was about to take over the world, in the early 1990s, asset prices fell sharply and economic growth decelerated for over a decade (soon we will have clocked up two decades). These almost twenty years of recession, deflation, and economic depression have occurred despite all the textbook recommendations having been implemented. During the 1990s, record fiscal spending delivered record government debts, but there was no recovery. Lowering interest rates to zero failed to accelerate growth. Structural changes increased deflation and bankruptcies, but did not boost demand.

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Further reading


  • Richard A. Werner. New Paradigm in Macroeconomics. Basingstoke, UK: Palgrave Macmillan, 2005.


  • Werner, Richard A. “Towards a new monetary paradigm: A quantity theorem of disaggregated credit, with evidence from Japan.” Kredit und Kapital (1997): 276–239.
  • Werner, Richard A. “Soundness of financial systems: Bank restructuring and its impact on the economy.” Paper presented at the International Conference on Central Banking Policies, May 14–15, 1999, Macao. Published as: Werner, Richard A., “Post-crisis banking sector restructuring and its impact on economic growth.” Japanese Economy 30:6 (November–December 2002): 3–37.

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