Financial meltdown exposes inadequacy of traditional economics

The crisis of 2008 turned the global economy upside down, taking the orthodoxies of economics along with it. Now it is up to ‘radical’ economists to put the discipline back on its feet

By Heather Stewart  /  The Observer

Wed, Oct 17, 2012 - Page 9

With its intimidating Washington headquarters and teams of crack young policy wonks jetting into troubled countries to read the riot act, the IMF has a reputation as a bastion of economic orthodoxy.

However, IMF Managing Director Christine Lagarde’s intervention last week at the fund’s annual meetings in Tokyo, where she warned the world’s finance ministers against slashing public budgets too far, too fast, showed that in the topsy-turvy world of economics after the crunch, the most conservative institutions have sometimes been in the vanguard of the intellectual revolution.

In the midst of the deepest and longest-lasting economic malaise since the Great Depression, you might expect practitioners of economics to be wracked with self-doubt, academic departments from California to Cambridge sweeping away the old thinking that gave intellectual heft to the claims of financial sector investment firms to be spreading risk and making the financial world a safer place.

However, David Blanchflower, a US economist and former member of the Bank of England’s monetary policy committee, says most people in the profession have sailed on unperturbed: “Economics proceeds as if nothing has happened since 2008. Everybody’s going on doing exactly the same things they always did, teaching the same classes.”

As for the forecasting record of many of the world’s most eminent economic institutions, not least the Bank of England, he said: “In many ways, we would have been better off to hire a monkey to throw darts at a dartboard.”

The bank, the UK’s independent Office for Budget Responsibility established by British Chancellor of the Exchequer George Osborne, and the vast majority of thinktanks and financial sector forecasters failed to anticipate the severity of the Great Recession, and the painstaking nature of the recovery.

Yet many economists persist in clinging to their cherished mathematical constructions of the world, simply postponing the upturn each quarter when confronted with the reality that it has failed to materialize. Few have conceded that some of the fundamental tenets of their work — that individuals are perfectly rational, or markets always clear at the right price — need to be junked.

There are islands of resistance. Two former winners of the economics Nobel, Paul Krugman and Joseph Stiglitz, have used their prominence as public intellectuals over the past five years to issue repeated rebukes to policymakers for failing to grasp the scale of the crisis, and take sufficiently radical action to protect the economy from the worst ravages of the downturn.

Maverick thinkers such as Nassim Nicholas Taleb, the author of Black Swan, whose latest book, Antifragile, on the fragility of systems, was cited by Sir Mervyn King in a speech last week, have sought to popularize the fact that model-based, mathematized economics is based on fundamental misunderstandings of the world.

However, Krugman and Stiglitz were already well-established as radicals, with strong sympathies for the Keynesian analysis that premature public spending cuts would inflict untold damage.

The IMF’s shift, from cheerleading for austerity to advocating a gentler approach, shows just how much old orthodoxies are crumbling in the face of the facts. Five years after the onset of the crisis, the eurozone is on the brink of collapse and the UK is mired in a double-dip recession, despite embracing drastic deficit cuts.

Eric Beinhocker is the executive director of Oxford’s Institute for New Economic Thinking, part of a transatlantic effort to rethink the basic tenets taught to students over recent decades.

He says: “The crisis has revealed enormous gaps in economists’ understanding of the linkages between the financial system and the broader economy. Before the crisis, few economists would have predicted that trouble in an obscure corner of the US mortgage market could cascade into a global calamity.”

He argues that there is lots of work going on to address these shortcomings, but “some advocate tweaking existing models, while others feel a more radical rethink is needed.”

National Institute for Economic and Social Research director Jonathan Portes falls into the latter camp. He is a fierce critic of the British government’s deficit-cutting strategy. Yet he says that in microeconomics — the bottom-up study of individual firms and markets — it would be wrong to throw the baby out with the bathwater.

“I don’t think the crisis tells us much about the fundamental underpinnings of microeconomics,” he said.

However, he believes where economists failed was in assuming that finance worked just like any other market: “When it came to financial companies, it turned out we needed to think about them completely differently. More markets are not necessarily better.”

He adds that one lesson economists may need to learn is to be more humble about the predictive power of their economic models, however neat and precise the mathematics that underlies them. Complex mathematical equations have replaced what Blanchflower calls “the economics of walking about,” as the foundation of the modern subject.

Lord Skidelsky, economic historian and biographer of Keynes, agrees: “It may be that there’s no perfect model and that the quest for one is an error. Maybe we need different models, different theories, for different situations, and that’s the best we can do. Keynes said economics was a moral science, not a natural science — by which I mean that it has to take into account the variability of human situations.”

In other words, economics is not physics, because people are by their nature unpredictable. No one is going to discover an economic “God particle” that explains why someone decides to sell their house, hire an extra worker or buy a new car.

“There’s no new paradigm; and perhaps the search for one is a bit misguided,” Skidelsky said.” My general feeling is that Nobel prizes in economics very closely follow current fashions in the discipline.”