Why economists didn't see the big crunch coming

Psychologists call it "framing". When rarely they think about it, economists call it "models". What it means is that our understanding of things and our reactions to them are heavily influenced by the way we choose to look at them.

Macro-economics - the idea that governments can manage the economy as it moves through the business cycle - has really only been going since World War II. But it involves a particular way of looking at national economies, a way heavily influenced by the priorities of John Maynard Keynes and his followers.

Economic variables come in two kinds: they're either "flows" or "stocks". When you watch something increasing or decreasing over a period of time you're watching a flow variable.

It might be your wage, which comes in every week over a year, or it might be your spending on groceries, which is added to every time you go to the supermarket over a period.

When you measure something at a point in time you're looking at a stock variable. It might be how much you've got in the bank on a particular day - June 30, for instance - or how much you owe the bank. Or you could get a real estate agent to value your house.

That value applies at the time it was assessed, but may not be accurate a few months later. So a stock value is like a photograph: it shows you what the world looked like at the moment the photo was taken.

If you know anything about company accounts, you know about flows and stocks. The profit and loss statement shows flows: the flow of sales over the period, the flow of expenses over the period and the profit or loss made over the period.

The balance sheet, on the other hand, shows stocks: the stock of assets owned by the business on the last day of the period, the stock of debts and other liabilities owed by the business on that day, with the difference between the two being the value of the business to its owners on that day.

Here's the point: from the start, macro-economists developed the habit of focusing on flows and taking little interest in stocks. They studied the economy-wide equivalent of the profit and loss statement - the components of gross domestic product - and ignored the balance sheet. (National balance sheets have been added to the national accounts only in recent years.)

Another way to put it is that economists tend to focus on the "real" economy of getting and spending, production and consumption, not on the "financial" economy of who owns and owes what - assets and liabilities.

Yet another kink in the way macro-economists look at the economy is that they focus on the demand side of the economy (what people are spending their money on, consumption or investment) rather than the supply side (the economy's capacity to produce goods and services for people to buy).

The rationale for this focus on the demand side is that governments can influence demand in the short run, but supply (the number of machines and factories, the size of the labour force and its degree of skill) can be influenced only in the longer run. Hence macro is called "demand management".

Why am I telling you all this? Because all these biases in the way economists tend to think about the economy help explain the global financial crisis - which the world's sharemarkets' recent reaction to developments in Europe shows isn't over - and why economists didn't see it coming.

The global financial crisis had its origins in the financial economy (which most macro-economists don't take a great interest in), but this inevitably damaged the real economy of spending and employment.

What's happening in Europe (and to a lesser extent the US) is that people are getting increasingly worried by governments' high and rapidly rising levels of debt. What happens if the financial markets lose confidence in governments' ability to repay their debts?

Debts are a stock, incurred as a consequence of deficits, which are a flow. You have to borrow to allow a deficit to be incurred during a period and that leaves you with a (higher) stock of debt at the end of the period.

Because deficits - budget deficits, trade deficits, current account deficits - are flows, they're part of the purview of macro-economists. But deficits matter only because they add to debt levels, and if it's not your practice to take much interest in debt (because it's a stock) you face a great temptation not to worry too much about deficits, not to be aware of how they're starting to mount up.

Economists didn't cause the public debt build-up. It was caused by politicians pandering to electorates that want more and more government spending, but don't want to pay higher taxes. But economists, with their focus on annual flows, failed to raise the alarm over mounting debt levels.

Then you have a global financial crisis that threatens to bring down the banking system and the real economy with it. You have no choice but to borrow heavily to prop up the banks and borrow again to try to get the economy moving.

One small problem: put all that borrowing on top of already high levels of public debt and suddenly everyone in the financial markets is worried about "sovereign risk" and whether you'll be able to repay your debts.

(That some of the people now carrying on about governments' huge debts were the same people whose reckless behaviour - and accumulation of huge levels of private debt - required the government to bail them out, allows you to call them rude names but not to ignore their ability to bring down those governments.)

Urged on by financial-side economists, governments in Europe are seeking to stave off a possible loss of financial market confidence in those governments' ability to repay their debts by slashing their spending and raising taxes, even while their economies are weak and the austerity programs will make them weaker.

But Keynesian macro-economists are appalled by this and locked in a furious debate with the financial economists. The financial guys are saying it's stocks (of public debt) that matter most and they must be cut at whatever cost; the macro guys are saying it's flows of spending and production that matter most, and to cut them now is madness.

Thankfully, our Liberal Party's obsession with budget deficits and debts has left us in the clear.