One of the many fall outs from the international financial crisis, as is
being increasingly widely recognised, is that it has produced a deep,
and hopefully terminal, crisis in the type and the ethos of economics
that largely dominated university economics faculties for the last
thirty years. George Soros has put up $50 million for an
Institute for New Economic Thinking. A series of
articles, of which a number are noted below, have discussed this issue.
The type of economics that has been struck a devastating blow by the
financial crisis is the one of ‘rational expectations’, ‘efficient
markets hypothesis’ etc. This school had many of the outward features of
a strange and fanatical religious grouping. It was deeply
self-satisfied and cult like - trying to cut itself off from reality
with an 'in-crowd' pretence no ideas other than its own possessed any
merit and therefore were not even worth discussing (the real purpose of
this approach, of course, being that discussion might have revealed the
fatal flaws in the cult's theology). As Paul Krugman wrote: ‘Back in 1980, [Robert] Lucas,
of the University of Chicago, wrote that Keynesian economics was so
ludicrous that “at research seminars, people don’t take Keynesian
theorizing seriously anymore; the audience starts to whisper and giggle
to one another.”’ This school, as with similar theological groups, was
also engaged in an obsessional hunt for heresy. It had its own
Inquisition to try to get it rooted out. As Anatole Kaletsky noted in The Times this was
an era of: ‘theories based on assumptions of rational and efficient
markets. These concepts became increasingly dominant from the 1980s and
gradually acquired a virtual monopoly on senior university appointments
and research funding. This intellectual monopoly has ended up not just
crushing the competition but also destroying itself from within.’
Nevertheless there was a more fundamental sense in which this trend
of economics acted like a theological and religious cult. This was its
steadfast refusal to base itself on the real facts of the world economy.
In other fields of economics and related disciplines major advances
in genuine knowledge were made – it is sufficient to mention Angus
Maddison or Dale Jorgenson in econometrics, or Alfred D Chandler Jr in
theoretical studies regarding the history of business and oligopoly, to
see the quality of what was produced. Still more practically important,
on the other side of the world, in Asia, the most spectacular economic
growth in world history was achieved by countries that did not at all
base themselves on the theories of the dominant schools of academic
Anglo-Saxon economics, with their proposed exclusive reliance on the
‘invisible hand’ of the market. These economies used a different Asian
growth model, of which the foundations were resolute insertion into the world
economy fed by entirely consciously decided upon, and massive,
mobilisations of investment and labour that were not at all achieved by
pure free market mechanisms.
But the dominant teaching in university economics department
resolutely ignored all these real steps forward in economic policy
making and real factual understanding of the economy. As the world did
not correspond to the theory the world was evidently at fault - it was a
trivial intrusion on theory.
All this was, of course, blown apart by the factual reality of the
international financial crisis, whose sheer scale succeeded in
shattering the theology largely dominating university economics
departments . Not only was this crisis not foreseen by the theories
developed by Muth, Fama, Lucas, Barro, and others but no one crucial in
practically dealing with the economic chaos threatened by ‘efficient
markets’ either paid any working attention to their theories or had the
slightest intention of acting on them – for which the world can be
grateful. It was Keynes, Minsky, and for those prepared to consider radicalism, even Marx who were looked to for
explanations, while more spectacularly in China the most successful
policy response to the financial crisis in the world was carried out by a
government which wisely ignored the 'Anglo-Saxon' criticisms of its
policy response - which relied on a huge programme of state investment
coupled with instructions to banks to ramp up their lending programmes.
China’s practical reply, the proof of the pudding in the eating, was
11.9% year on year GDP growth registered to the first quarter of 2010 –
by far the fastest economic growth in any major economy in the world.
While the dominant fraction of the university economics departments
remained locked in ‘dogmatic slumbers’, to take the phrase Kant used
about a similar crisis in philosophy, the real world proceeded with
complete disregard to their theories.
How, therefore, are the schools of ‘rational expectations’,
‘efficient market hypothesis’ etc economics that have were dominant in
academic economics departments for the last thirty years to be
characterised? One phrase, still utilised by Paul Krugman, is the distinction
between ‘saltwater economics’ and ‘freshwater economics’ – the latter
being a reference to the leading role of the University of Chicago and
others situated near the US Great Lakes in creating the prevailing
academic trend. But that is a purely geographic description. It does not
deal with the essence of the issue.
There is a better analogy. Prior to 1453, the year of the death of
Copernicus and the publication of his On the Revolutions of the
Heavenly Spheres, complex and highly sophisticated mathematical
systems existed demonstrating that the sun circled round the earth –
indeed they had to be very complex given the theory they were trying
to rationalise! Copernicus just showed, based on actual astronomical
observations, that in reality the earth went round the sun. A theory had
to fit the reality - the reality was not obliged, and could not be
compelled, to fit the theory.
The type of economics that has been the dominant university orthodoxy
of the last thirty years is perhaps best described as ‘pre-Copernican
economics’. It was a set of elaborate theories that ignored the facts.
It did not follow the fundamental rule of science that theory must
correspond to reality. It frequently acted as though the test of logical
and mathematical consistency were sufficient to establish something
as true. Unfortunately, the mathematics of Ptolemic pre-Copernican
astronomy was logically consistent. It was just the facts were
otherwise.
The fact that this theological pre-Copernican economics is now
increasingly discredited is greatly to be welcome. It opens up the way
for real empirical studies on the economy, in which there have been huge advances in the last thirty years, to shape
economic theory
* * *
A note on some of the best descriptions of pre-Copernican economics
A whole series of writers have recently pointed out the flaws of
'rational expectations', 'efficient markets hypothesis' economics. Some
are worth particular attention as dealing with the most important issue -
the school's lack of accord with, and in the worst cases even apparent
lack of interest in, economic facts. A few salient examples have been
taken from these analyses but the articles should be read as whole to
understand them fully.
Anatole Kaletsky in The Times on the
dominant academic economics of the last period
‘ unrealistic theories based on assumptions of rational and
efficient markets. These concepts became increasingly dominant from the
1980s and gradually acquired a virtual monopoly on senior university
appointments and research funding. This intellectual monopoly has ended
up not just crushing the competition but also destroying itself from
within. ‘
‘These may seem obscure academic issues, but they had enormous
practical and political relevance. The assumption that a market economy
is always automatically self-stabilising led to some very controversial
policy prescriptions that almost any attempt by government to interfere
with market forces would damage economic efficiency…. the economic
theories blown apart by the financial crisis have had strong ideological
appeal.
‘The Efficient Market Hypothesis, for example, asserted that
while markets might not always be right in predicting the future, they
were informationally efficient, making the best judgments possible on
the basis of publicly available information.
‘It was, therefore, taken for granted that regulators or
accountants should never try to second-guess market judgments, whether
about the true risks of mortgage investments or the real value of bank
assets or the appropriate level of oil prices. When governments did
intervene to override market decisions with their own judgments, such
intervention inevitably would make the economy less efficient.
‘The idea of rational expectations, another assertion with no
empirical backing, had even greater political and financial impact. The
principle of rational expectations asserted that in any model of
economic behaviour, every participant in the economy had to share the
same view about the mathematical laws of motion that determined how
inflation, unemployment and other economic variables would evolve.
‘If this were not the case, it was claimed, some people would be
acting in a grossly irrational manner by believing in economic
principles known to be false by other participants in the economy.
‘Rational expectations allowed theoretical economists from the
early 1970s onwards to prove, with apparently mathematical certainty,
that government policies designed to boost economic activity in a
recession would not work…
‘While governments went ahead with large-scale deficit spending
to pull their economies out of recession, many traditional academic
economists continued to argue that such measures were doomed to failure
on the basis of mathematical theorems derived from such doctrines as
efficient markets, rational expectations and the natural rate of
unemployment.
‘Such doctrines have now been comprehensively disproved by
experience. The question is whether academic economists will respond by
developing new theories or try to defend their existing positions by
sticking to theories they know to be false.’
John Kay in the Financial Times on George
Soros's Institute for New Economic Thinking
‘A remarkably distinguished group of economists gathered last
weekend for the inaugural conference of the Institute for New Economic
Thinking, an initiative of George Soros. They were soul searching over
the failures of economics in the recent crisis. Such failures are most
evident in two areas: the inadequacies of the efficient market
hypothesis, the bedrock of modern financial economics, and the
irrelevance of recent macroeconomic theory.
‘The central idea of the efficient market hypothesis is that
prices represent the best estimate of the underlying value of assets.
This thesis has recently taken a battering. The boom and bust in the
money markets was precipitated by a US housing bubble. That bubble
followed the New Economy fiasco and was preceded by the near-failure of
Long Term Capital Management, a hedge fund designed to showcase
sophisticated financial economics.
‘The macroeconomics taught in advanced economics today is largely
based on analysis labelled dynamic stochastic general equilibrium. The
unappealing title gives the game away: the theorists are mostly talking
to themselves. Their theories proved virtually useless in anticipating
the crisis, analysing its development and recommending measures to deal
with it.
‘Recent economic policy debates have not only largely ignored
DSGE, but have also been remarkably similar to the economic policy
debates of the 1930s, although they have been resolved differently. The
economists quoted most often are John Maynard Keynes and Hyman Minsky,
both of whom are dead.
'Both the efficient market hypothesis and DSGE are associated
with the idea of rational expectations – which might be described as the
idea that households and companies make economic decisions as if they
had available to them all the information about the world that might be
available. If you wonder why such an implausible notion has won wide
acceptance, part of the explanation lies in its conservative
implications. Under rational expectations, not only do firms and
households know already as much as policymakers, but they also
anticipate what the government itself will do, so the best thing
government can do is to remain predictable. Most economic policy is
futile.
'So is most interference in free markets. There is no room for
the notion that people bought subprime mortgages or securitised products
based on them because they knew less than the people who sold them.
When the men and women of Goldman Sachs perform “God’s work”, the
profits they make come not from information advantages, but from the
value of their services. The economic role of government is to keep
markets working…
‘The standard approach has the appearance of science in its
ability to generate clear predictions from a small number of axioms. But
only the appearance, since these predictions are mostly false.’
Larry Elliot in the Guardian
‘ It is possible to construct beautifully precise models if you
start from the assumption that rational economic agents with perfect
information are operating in free markets that always return to
equilibrium. But since none of these assumptions holds true in the real
world, this is a classic case of "rubbish in, rubbish out".
‘Even more worryingly, there has been no room in this view of the
world for the heterodox. The prestigious economics journals have been
cleansed of all but the purveyors of highly technical algebra. Economic
history has been removed from the syllabus, because those who yearn for
economics to be a hard science believe the past can teach them nothing.
Truly, the lunatics have taken over the asylum.
‘The financial crisis has provided Stiglitz, Akerloff and the
others with an opportunity to strike out in a new direction… Speaking at
a Greater London Authority conference last month, economist Paul
Ormerod said a lesson from physics is that there is kudos to be had from
empirical discoveries. In other words, you don't have to construct an
elaborate model of the economy to be considered good; you could draw
important conclusions from the available data.
‘An empirical assessment of 250 years of industrial capitalism
showed that violent movements in asset prices and credit markets of the
sort seen in 2007 and 2008 were relatively frequent; those who used
models to assess risk said the chances of a crash were infinitesimal.’
Paul Krugman in the New York Times
‘Few economists saw our current crisis coming, but this
predictive failure was the least of the field’s problems. More important
was the profession’s blindness to the very possibility of catastrophic
failures in a market economy. During the golden years, financial
economists came to believe that markets were inherently stable — indeed,
that stocks and other assets were always priced just right. There was
nothing in the prevailing models suggesting the possibility of the kind
of collapse that happened last year [2008]… macroeconomists were divided
in their views. But the main division was between those who insisted
that free-market economies never go astray and those who believed that
economies may stray now and then but that any major deviations from the
path of prosperity could and would be corrected by the all-powerful Fed.
Neither side was prepared to cope with an economy that went off the
rails despite the Fed’s best efforts.
‘‘By 1970 or so… the study of financial markets seemed to have
been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in
the best of all possible worlds. Discussion of investor irrationality,
of bubbles, of destructive speculation had virtually disappeared from
academic discourse. The field was dominated by the “efficient-market
hypothesis,” promulgated by Eugene Fama of the University of Chicago,
which claims that financial markets price assets precisely at their
intrinsic worth given all publicly available information…
‘To be fair, finance theorists didn’t accept the efficient-market
hypothesis merely because it was elegant, convenient and lucrative.
They also produced a great deal of statistical evidence, which at first
seemed strongly supportive. But this evidence was of an oddly limited
form. Finance economists rarely asked the seemingly obvious (though not
easily answered) question of whether asset prices made sense given
real-world fundamentals like earnings. Instead, they asked only whether
asset prices made sense given other asset prices. Larry Summers, now the
top economic adviser in the Obama administration, once mocked finance
professors with a parable about “ketchup economists” who “have shown
that two-quart bottles of ketchup invariably sell for exactly twice as
much as one-quart bottles of ketchup,” and conclude from this that the
ketchup market is perfectly efficient….
‘Yet recessions do happen. Why? In the 1970s the leading
freshwater macroeconomist, the Nobel laureate Robert Lucas, argued that
recessions were caused by temporary confusion: workers and companies had
trouble distinguishing overall changes in the level of prices because
of inflation or deflation from changes in their own particular business
situation. And Lucas warned that any attempt to fight the business cycle
would be counterproductive: activist policies, he argued, would just
add to the confusion.
'By the 1980s, however, even this severely limited acceptance of
the idea that recessions are bad things had been rejected by many
freshwater economists. Instead, the new leaders of the movement,
especially Edward Prescott, who was then at the University of Minnesota…
argued that price fluctuations and changes in demand actually had
nothing to do with the business cycle. Rather, the business cycle
reflects fluctuations in the rate of technological progress, which are
amplified by the rational response of workers, who voluntarily work more
when the environment is favourable and less when it’s unfavourable.
Unemployment is a deliberate decision by workers to take time off…
‘And so Chicago’s Cochrane, outraged at the idea that government
spending could mitigate the latest recession, declared: “It’s not part
of what anybody has taught graduate students since the 1960s. They
[Keynesian ideas] are fairy tales that have been proved false. It is
very comforting in times of stress to go back to the fairy tales we
heard as children, but it doesn’t make them less false.”...
‘Economics, as a field, got in trouble because economists were
seduced by the vision of a perfect, frictionless market system. If the
profession is to redeem itself, it will have to reconcile itself to a
less alluring vision — that of a market economy that has many virtues
but that is also shot through with flaws and frictions. The good news is
that we don’t have to start from scratch. Even during the heyday of
perfect-market economics, there was a lot of work done on the ways in
which the real economy deviated from the theoretical ideal. What’s
probably going to happen now — in fact, it’s already happening — is that
flaws-and-frictions economics will move from the periphery of economic
analysis to its centre.’
