Those in the field "have relatively little to say about dynamic processes, about change"by Paul Ormerod / January 9, 2017 / Leave a comment
Groupthink culture in the economics profession led the Bank of England’s Chief Economist, Andy Haldane, to admit last week that economic forecasting is in crisis.
The notorious projections by “Project Fear” of the immediate impact of a Brexit vote have been shown to be completely wrong. But, as the Treasury document which produced the forecasts states, they were based on a “widely accepted modelling approach” [my italics].
GDP growth in the third quarter of 2016—July through September—was projected by the Treasury to be negative with a Brexit vote, between -0.1 and -1 per cent. The Office for National Statistics now estimates growth was +0.6 per cent, and comments: “Since the result, growth in gross domestic product (GDP) has been in line with recent trends. This suggests limited effect so far from the referendum.”
The reasons for the views of mainstream economists rest on two important underpinnings of the discipline. The first is the belief in the benefits to society of free trade. The basic theory was developed by the great English economist David Ricardo, almost exactly 200 years ago.
Economists are aware that free trade can destroy jobs. For example, a paper in the July 2016 issue of the American Economic Review by Justin Pierce and Peter Shott shows that the sharp drop in US manufacturing after 2000 can be attributed to a change in US trade policy that eliminated potential tariff increases on Chinese imports.
But trade, by increasing the efficiency of production, benefits industries by reducing the cost of their inputs, and benefits consumers by reducing the price of goods and services in the shops (and online!).
There is a large amount of empirical evidence which supports economists’ views on free trade. The elision which they make is to go on to believe that the UK leaving the EU will necessarily lead to our trade becoming less free. This is a judgement about political economy, on which standard economic theory is silent. The Brexiteers believe that we can negotiate better trade deals on our own, the Remainers think not.
The Cambridge economist Bob Rowthorn points out “There has already been a sharp fall in the size of the euro area economy as a proportion of the world economy, and it is hard to see how this trend will not continue.” The deals we need are with India and China. Whether we can get a better deal in or out of the EU is a matter of judgement, not theory.
The rapidly declining importance of the EU brings us to the second key reason why most economists find it hard to see the potential benefits of Brexit. This is the more important of the two.
Economic theory is in essence about equilibrium. It is about how best to allocate a fixed amount of resources in a static world. This became the dominant theme in economics in the late 19th century. It was a very strange problem for economics to focus on. It was strange because by the late 19th century, the Industrial Revolution was a century old. For the first time in human history, a social and economic system had emerged in which the total amount of resources available was being continually expanded.
Economics has relatively little to say about dynamic processes, about change, about disruption, evolution, innovation, about behaviour out of equilibrium.
This emphasis on equilibrium, on a static world, leads many of them to be blind to the serious failings of the EU, both actual and potential. Their mindset is as if—a favourite phrase of economists—the EU is a great economic success story. On the contrary.
The growth rate of GDP fluctuates from year to year, over the so-called business cycle. But if we average growth rates in an economy over a period of, say, 20 years, we smooth these out. The 20 year average gives a good heuristic measure of the sustainable growth rate, the rate at which living standards might reasonably be expected to increase, averaging them out over the cycle.
The 20 year average in the main EU economies—Germany, France and Italy—peaked in 1970. Growth in the 1950s and 1960s had been rapid. It has fallen ever since, and now is barely 1 per cent a year. In contrast, although growth in the UK was not as high in 1970, it has fallen only very marginally since then, and remains well over 2 per cent.
Innovation in the EU is grinding to a halt, as the fall in the sustainable growth rate shows. A specific example is biotechnology, one of the key industries of the 21st century. The US and the UK lead the world, with the EU lagging far behind.
Almost incredibly, GDP in Portugal, Italy, Greece and Spain (the PIGS) remains well below the previous peak levels, reached in 2007, the year immediately prior to the financial crisis. This is an exceptionally long period.
The fault lines within the EU economies lie not just with the euro. On the Transparency International corruption index, some of the PIGS rank with countries like Ghana. The financial crisis exposed the inherent weaknesses caused by rampant corruption, and they are unable to evolve and recover.
The static, equilibrium world of economic theory seems to hamper the ability of the profession to recognise change. The ability to innovate is the key to long term growth, as America has shown with Microsoft, Google, Facebook and others. Economic theory has very little to say about innovation. And this blinds the economics profession to the failings of the EU.
On the 17th of January 2017, Prospect hosted a roundtable discussion with the contributors to: Brexit Britain: the trade challenge. This report is designed to act as a guide for parliamentarians, officials and businesses with a stake in the UK’s changing relationship with the world following Brexit. The discussion was chaired by Tom Clark, Editor of Prospect. Participants included Tasmina Ahmed-Sheikh MP, Miriam González and Vicky Pryce.
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