Just where do we go from here?

Letter from an Economist – 9th February 2010
Just where do we go from here?

Some of your students may not realize this but it’s not that long ago that economist’s were congratulating themselves over the success of their theories on macroeconomics! For some it was a golden era for the profession.

The International Monetary Fund declared that “the state of macro is good.” And there was a “broad convergence of vision.” Put in simple terms most of the advanced economies were following policies that would deliver sustainable growth, low inflation and high employment. For those in work consumption was ‘exciting’, whilst for those without a job benefits were paid, credits given and re-training offered. Few, if any, of the problems that had plagued the 1970’s and 80’s were visible – then it all went wrong.

We have to be honest and admit that few economists saw the current crisis coming. To compound this failure to predict events the practitioners of the subject actually began to believe that market volatility was something of the past and that stability was a fact of free-market life! To support these view experts stated that shares, assets, commodities etc were all accurately rewarded by the interchange of information within markets.

But we awoke to find that the majority of the world’s largest economies were in a mess. Students, politicians, journalists and most of the general public wanted to know how we could have made such an enormous error.
The economics profession had lost its golden image and where does it go now?

I just wonder if economists were seduced by beauty, clad in impressive-looking mathematics, as being the answer to all the complexities of human interaction. We fell for a similar game of ‘smoke and mirrors’ in the time just before the Great Depression, when most economists perceived capitalism as a perfect or nearly perfect system. The Great Depression dispelled those myths and yet we continued to teach successive generations of students that, and I quote ‘rational individuals interact in perfect markets etc’ – indeed, some of those who had listened to this went out and designed business models that represented the very opposite of what they had been taught! In fairness the majority of western politics came to embrace the free market system and the arrival of The European Union which saw a concerted effort to promote liberal capitalism ( and democracy, peaceful co-existence, justice and human rights – the latter was not part of pre-Depression thinking) as the best way forward for those who had remained loyal to the western way of life and those who apparently wanted it once released from the confines of Communism post the fall of the Berlin wall and the collapse of The Soviet Union. The mathematicians won and formulas reigned, that is until human behavior interfered with this utopian dream of just how we interact, especially where money is concerned.
It is the very irrationality that we all admit exists that led to bubbles and busts, to large institutions causing problems and, of course, the imperfections of markets — especially financial markets. Crashes arose, regulators wondered why and those who had pestered for less regulation and the deliberate consolidation of banking sectors suddenly went very quiet!

We will have to accept the importance of irrational and often unpredictable behaviour, acknowledge the imperfections of markets and accept that a “theory of everything” is just not possible.
The last 100 years or so have were based on the presumption of “neoclassical” economics and that was that we should have faith in the market system.

Then came the Great Depression and economists turned to the insights of John Maynard Keynes for both an explanation of what had happened and a solution to future depressions.

Keynes wanted to fix capitalism, not replace it. But he did challenge the notion that free-market economies can function without a regulatory framework – he was particularly aware of the financial markets, dominated by short-term speculation. He called for active government intervention — printing more money and, if necessary, spending heavily on public works — to fight unemployment during slumps. He wanted regulation but not draconian and he wanted economists and politicians to accept that humans could create amazing things but they could also destroy, especially when personal greed enters the equation!

What the next generation of economists have to answer is – can we improve on Keynes and if so where?

John
9th February 2010.