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
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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.’
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