Financial crash: what's wrong with economics?

It didn't predict the crash—and that isn't its only flaw

December 09, 2014
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President Harry Truman famously yearned for a one-handed economist, in exasperation at their inability to give a straight answer. But economists have long been united about at least one thing—their positive assessment of their own subject. Since the 1980s, at least, economics has accorded itself high professional status, as well as taking an increasingly prominent role not just in shaping public policy, but in shaping many other aspects of public life.

However, that confidence has begun to wane in recent years. Internally, economics is more fractured than perhaps at any time in a generation. The reason for this is not difficult to find: the global financial crisis has made economists’ pre-crisis self-confidence look, in hindsight, more like hubris.

The areas of economics suffering most acutely are those whose shortcomings were exposed by the crisis—the fields of finance and macroeconomics. Although many economists do not work in either of these fields, they are the areas of economics most visible to the wider world. It is talk of recession, recovery, the ups and downs of inflation, Gross Domestic Product and unemployment that fills television and radio programmes. Beyond that, there is a broader public awareness, sometimes concern, that an incomplete economic orthodoxy may have intruded into wider society. And economics is not always a welcome guest there. This concern sometimes manifests itself in fears about rampant consumerism, the erosion of public spiritedness or the emergence of markets in everything from votes to kidneys, from education to clean air.

To the surprise of many, including perhaps the authors themselves, recent books such as Thomas Piketty’s Capital in the Twenty-First Century and Michael Sandel’s What Money Can’t Buy have made the bestsellers list. They succeeded because they examined how and why economics has shaped societies in ways that are not always benign or, indeed, entirely intended. And then there is economics teaching and research. Somewhat paradoxically, the crisis has generated a groundswell of interest in the discipline among both students and scholars from outside economics. This ought to be the chance of a lifetime, a steroid injection of human and intellectual capital. Yet some in the economics profession have treated this interest in the subject as a threat, and have regarded students and scholars from other disciplines as barbarians at the gate to be repelled at all costs.

When describing the state of economics, therefore, we see a complex picture: some economists are in denial, others (often less visible, but no less important) are embracing change, while others still go about their business much as before. Let us try to give a quick (and subjective) tour of the good, the bad and the ugly.

It is a major irony that, in the aftermath of one of the most serious crises since the dawn of capitalism, many areas of economics are now enjoying huge intellectual and public success. Jean Tirole, this year’s Nobel prize winner in economics, in some ways embodies this. His work is highly mathematical—something many non-economists would identify as one of the most acute problems with the discipline. Yet it is also concerned with some very important practical questions: how can competition be safeguarded in the digital industries where the winner takes all? How should we regulate markets in which there is monopoly power? How much should firms choose to invest in patenting their products? And does the introduction of financial incentives undermine the motivation of those working in public services?

Other economists, though they may lack Tirole’s breadth and brilliance, are addressing similarly important questions of market design. Some are working enthusiastically with colleagues in other disciplines, such as psychology, urban studies and epigenetics.

New life is being breathed into empirical research, too. Laboratory experiments and randomised control trials are being used to assess the impact of policy interventions of various types, before they are imposed on an unsuspecting public. And large data sets are being constructed and explored in order to shed light on longstanding problems such as inequalities in health and wealth, and the causes of job market success and financial market failure.

Some of the theoretical foundations of mainstream economics are also being rebuilt. For example, behavioural economics—the fusion of economics and psychology—has become both fashionable and important. Economists are now taking seriously the idea of cognitive limits and lapses which may undermine economic rationality and cause markets to fail. In government, policy wonks are exploiting these imperfections by devising means of “nudging” society into a better place. Sociology, anthropology, neurology and biology are also beginning to form part of some economists’ toolkits. How else to explain how and why people interact and influence each other’s choices and how societies—complex living, mutating systems—evolve over time? Alongside this, there has been a long overdue growth of interest in economic history—largely washed away by the free market high tide—as economists seek both to explain the crisis and to understand how new technologies might transform the economy.

"In certain corners of the economics profession, the frontiers are being rolled back"
In short, in certain corners of the economics profession, the frontiers are being rolled back. More research is being done using realistic assumptions about how humans behave, how they make decisions and how alternative policies might shape economic fortunes. This research rarely makes headlines, but it is thriving.

Economists typically distinguish between microeconomics and macroeconomics. Microeconomics looks at the economic decisions of individuals, households, firms or specific markets—the demand for electricity or concrete blocks, say, or for legal services or The X Factor. Macro-economics involves the study of measures of the whole economy such as GDP, unemployment, government spending and interest rates. The media tend to concentrate on the macro, the day-to-day undulations in the economy. The public’s preference is for news and views on how many people will be out of work or will have to pay higher mortgage rates or whether the euro will collapse. By contrast, new evidence on how publishers’ decisions have affected e-book pricing or how farmers in Mozambique learn improved agricultural techniques—the micro, in other words—do not seem to capture the public imagination.

More’s the pity. For today there is deeper disagreement, and greater uncertainty, about what drives the macroeconomy than at any time in the recent past. These disagreements and uncertainties were made worse by the financial crisis. Few, if any, economists saw it coming. Those who did, such as Raghuram Rajan, now Governor of the Reserve Bank of India, were either criticised or ignored, often both. The models that are the tools of the macroeconomic trade—sets of equations run on computers linking important variables such as GDP, unemployment and inflation—were close to useless in predicting the crisis. More depressingly still, they have also been close to useless in predicting the contours of the economic recovery.

So what went wrong? With hindsight, too few macroeconomists had been thinking the unthinkable and too many missed the unmissable. The latter included the long-term (in economists’ jargon, “secular”) rise in indebtedness among households and the staggering growth in leverage in the banking sector. These features, crucial elements of pretty much all previous financial crises, were missing from pre-crisis models. And the economic actors who did appear in those models were cartoon caricatures: rational agents operating in a bleached-white world. The world described by these models was a fictional construct. In them, a crisis was not just unthinkable, it was impossible.

A few years ago, at a conference on the state of macroeconomics convened in Oxford, it was evident that there were two camps. Some—including at that point many prominent macroeconomists—believed that macroeconomics was basically healthy, but suffering a temporary bout of crisis flu. Administering some mild medication—a slight enrichment of existing models—would return the patient to rude health. Others maintained that macroeconomics was suffering a potentially terminal illness. Intensive surgery was essential.

Many macroeconomists still give the impression that they lean towards the first camp. Reasons are not difficult to find. If economists ever tell you anything, it is usually that incentives matter. With so much human capital invested in pre-crisis models, it was and remains emotionally very difficult for economists to write that capital off and risk intellectual bankruptcy. Meanwhile, many practitioners, employers, students and perhaps most micro-economists probably lean towards the second camp. They see changes to pre-crisis approaches to the macroeconomy as pretty much essential if we are to make the subject relevant again to the questions that shape public discourse.

Then there is finance. This is a highly specialised area, which often uses PhD-level mathematical techniques to understand the minds of financial traders. It is also the area of economics most heavily influenced by free-market orthodoxy. It is where belief in market “efficiency” became an ideology as much as a theory. After the crisis drove a coach and horses through that theory, a long period of convalescence is now in order. Attempts are being made to rewrite finance theory, placing imperfections and irrationalities centre-stage. Models borrowed from psychology—and some from psychiatry—are being used to explore financial traders’ neurological pathways. Whether financial markets practitioners themselves, with their in-built biases, are capable of adapting to this new strain of thinking remains to be seen.

So far, the parties to this debate are easily distinguished. On the one side, noisy critics of economics who condemn the discipline for being overly mathematical and cut off from the real world. On the other, entrenched vested interests man the barricades. Occupying the twilight zone in between is a third species: reform-minded economists who agree with certain aspects of the general critique, but who bridle at the caricature of their colleagues as soulless failed physicists. Both authors of this piece identify with this third tribe.

There are other tribes, occupying more remote regions of economics and other social sciences. They have more fundamental criticisms which predate the crisis. They are often described as “heterodox” economists. Their more fundamentalist factions see themselves as battling a mainstream impervious to change. That image had real force in the early 1980s, when economics was the flag-bearer of Ronald Reagan and Margaret Thatcher’s ideological crusade which saw the triumph, in intellectual life as well as in society, of an unfettered free-market approach to policy-making. That era also spawned the kinds of macroeconomic models which failed so spectacularly during the crash—models based on self-interested individuals, the cumulative consequences of whose choices were necessarily in society’s best interests, thanks to Adam Smith’s “invisible hand.” It was a brave soul who pursued the heterodox path at that time.

But the heterodox economists had a point—economics could not aspire to the condition of a natural science. Economists’ claims to be offering a value-free perspective were either false or naïve. Economic research and teaching inevitably reflect the social and political values of the time, every bit as much as those values have been influenced by economics. For that reason, economic history and the history of economic thought matters in economic policy in ways that the history of physics or chemistry doesn’t trouble your average physicist or chemist. In this respect, economics may be closer in spirit to medicine, psychology, anthropology and other sciences of humanity. The novelist CP Snow, after his famous 1959 lecture on the “two cultures,” had good reason to classify economics and other social sciences as belonging to a “third culture” that combined elements of both the arts and sciences.
"These are young people who have encountered economics for the first time in the context of a macroeconomy enfeebled by crisis"
All of this dispute and debate is bringing about change. And it is change for the better. One manifestation of this is in reform of the undergraduate economics curriculum. One of the surprises at a Bank of England and Government Economic Service conference on the curriculum held in early 2012 was how eager employers of graduate economists were to see students being taught a different sort of economics—an economics imbued with greater awareness of history and methodology and deeper sensitivity to values and politics; more embracing of insights from other disciplines; better attuned to the importance of institutions; readier to acknowledge cognitive uncertainties and more open to the possibility that the economy may be in an almost perpetual state of disequilibrium. Criticism of the existing curriculum is fiercest among some student groups. After all, these are young people who have encountered economics for the first time in the context of a macroeconomy enfeebled by crisis. They are rightly motivated by a desire to shape the future fortunes of the economy so as to avoid another crisis in their lifetimes. There is an international network of student activists, Rethinking Economics. Another group, the Post-Crash Economics Society at the University of Manchester, is forming a pan-university network.

In the aftermath of the crisis, the students’ criticisms have real force. Until now, many may have been taught a bowdlerised version of the subject, remote not just from the real world but from other disciplines whose interests intersect with those of economics. Very little inter-disciplinary research has made it to the textbooks and lecture halls thus far. Pressures on lecturers, in particular the requirement to publish, have played their part. It takes time to adapt lecture notes and to teach material not found in textbooks. Incentives for pupils and teachers are rarely perfectly aligned.

But universities are beginning to respond, albeit slowly. University College London has adopted a pioneering new core undergraduate course developed by Wendy Carlin, in collaboration with the Institute for New Economic Thinking. It combines some fundamental tools of economic analysis with history, real world examples and issues of political economy such as power in the workplace, monopoly and ethics. The University of Manchester has recently launched a review that will lead to a revised curriculum from 2016 and has already included some new courses as a first step towards acknowledging the kinds of change that are needed. Other economics departments are following suit.

Kingston University has gone further and introduced, under the auspices of Steve Keen, a fully heterodox curriculum in which different economic philosophies are taught—Austrian, Marxist, Keynesian and neoclassical. The approach is well described in a recent book by Ha-Joon Chang of the University of Cambridge, another heterodox thinker. The high-profile student groups tend to prefer heterodoxy.

It is healthy to have different departments offering a range of options. You do not need to be Jean Tirole to conclude that, in some settings at least, competition is an unmitigated good. Market forces, in the shape of student numbers, will hopefully reward those offering the most enriching undergraduate experience. Pluralism in this sense—an openness to alternative perspectives and the acknowledgment of different ideologies—should be welcomed with open arms and an open mind. After all, narrative history is every bit as valuable as statistical regression; institutions and politics matter just as much as demand and supply. If students, academics, practitioners and policymakers were to adopt that mind-set, then, with luck, the profession would be better able to explain how the economy shapes society and society the economy. With time, and with due modesty, it might also improve both.