For economics, it’s like Britain’s Glastonbury music festival, only with better food and no mud. King’s College, Cambridge will host the biggest happening for the dismal science’s counterculture in decades when it hosts the inaugural conference of the George Soros funded Institute for New Economic Thinking this weekend.
It’s a big gig, spread over four days and with plenty of headline acts. Joe Stiglitz, George Akerlof, Michael Spence and Sir James Mirrlees are the four Nobel prize winners performing, along with Dominique Strauss-Kahn, managing director of the IMF, Lord Adair Turner of the Financial Services Authority and Bill White, former chief economist at the Bank for International Settlements.
The choice of venue is symbolic and deliberate. The great and the good believe that what has happened over the past three years is both an economic crisis and a crisis in economics. They want to see new thinking of the sort provided by John Maynard Keynes the last time there was such a systemic shock to the global economy. King’s was Keynes’ college.
The crisis has yet to throw up a new Keynes and is unlikely to do so, according to my friend and fellow commentator, David Smith of the Sunday Times, who has just published a thought-provoking book on the crisis and its likely consequences.
In reality, though, there is no need to reinvent the wheel. It’s more important to strip away the layers of complexity that gave big-picture economics a spurious and dangerous exactitude in advance of the crisis. The big lesson in economics from Keynes is that we know less than we think we do, and that there is a vast difference between the output of economic models and the actual behavior of individuals. He was unimpressed by the argument that decisions were “the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”
This, though, is where mainstream economics has ended up. 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 “garbage in, garbage 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.
As Smith puts it in his book: “Economists, like bankers, discovered they were more fallible than they thought and for some that was a humbling experience. Occasionally, that is no bad thing.”
There are plenty of suggestions for where the profession should be heading. Speaking at a Greater London Authority (GLA) 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.
Nick Parsons, head of strategy at National Australia Bank, says he learns a lot by talking to his bank’s clients and by simply observing what people are up to. Sir Alan Budd, chief economic adviser to the British Treasury during the recession of the early 1990s, once said that he had been surprised at how poor the official figures were for consumer spending given that the shopping malls appeared to be full of people. Only when he looked more closely and saw that most were empty-handed did he realize the truth: People were reluctant to part with their money but still liked to window-shop.
The Bank of England also sees the merits of the economics of walking around. It has a model of the economy but interest rate decisions are also influenced by the reports from regional agents who act as the eyes and ears of the monetary policy committee.
At the same GLA conference, Neil Stewart, a psychologist at Warwick University, said that people make economic decisions using general-purpose psychological tools. He used the example of the minimum payments required by credit card companies. The idea behind these is to protect the minority who otherwise would make no repayment, but Stewart said there was evidence that they made other consumers less likely to pay off their bills in full. The perception of consumers was that the minimum payment reduced the chance of them getting seriously into debt, and increasing the minimum payment from 2 percent to 5 percent resulted in fewer and fewer people paying off their bills in full.
As the Bank of England governor, Mervyn King, noted in a recent lecture, economists can learn about how to cope with instability from other disciplines, such as ecology or epidemiology. The approach of engineers to limiting the damage caused by avalanches or forest fires could be imitated to make economies more resilient to shocks. Questioning the idea of a rational “homo economicus,” he added that there was evidence that perceptions of risk were affected by recent experience; actions were influenced by what other individuals were doing; and that people had excessive faith in their own judgments.
Like those gathering in Cambridge tomorrow, King is wary of the notion that economics can be boiled down to hard and fast rules.
“Beliefs adapt over time in response to changes in the environment; and this in turn affects how economic systems behave,” he said. “Because the surrounding environment can affect economic decision-making, there are probably few genuinely ‘deep’ [and, therefore, stable] parameters or relationships in economics.”
Is it worrying that the governor of the Bank of England freely admits that economists don’t have all the answers? Not a bit. There are things we know and things we don’t. Understanding that there is a difference is the path to wisdom.
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