With the first decent US employment figures since 2007 published on Friday, we can all breathe a sigh of relief. The greatest financial crisis in history has not turned into an equally catastrophic economic crisis.
Now that a repeat of the 1930s has been averted, it is a good time to take stock of the lessons from this near-death experience for the world economy. While everyone is aware of the mistakes made by bankers and financial regulators, the economic theories that encouraged and justified these blunders have not received the attention they deserved. This is about to change.
On Thursday, a galaxy of academic economists, including half a dozen Nobel laureates, current or former departments heads from leading universities and top policymakers from institutions such as the IMF, will gather at King’s College, Cambridge, alma mater of John Maynard Keynes, to launch the Institute for New Economic Thinking.
Funded with an initial grant of $50 million from George Soros, Inet has already had pledges of millions of dollars in additional matching funds from other donors to create research institutes in leading universities in Britain, America and around the world.
Their purpose will be to reopen many of the debates closed down by unrealistic theories based on assumptions of rational and efficient markets. These concepts became increasingly dominant from the 1980s and gradually acquired a virtual monopoly on senior university appointments and research funding. This intellectual monopoly has ended up not just crushing the competition but also destroying itself from within.
These may seem obscure academic issues, but they had enormous practical and political relevance. The assumption that a market economy is always automatically self-stabilising led to some very controversial policy prescriptions that almost any attempt by government to interfere with market forces would damage economic efficiency.
Probably the most important of these abstract theories leading to far-reaching political consequences was Milton Friedman’s assumption of a natural rate of unemployment, which was at the heart of the monetarist counter-revolution against Keynesian economic policies in the 1970s.
Friedman asserted that in any economy there was a particular unemployment rate, set by structural factors such as skills and welfare safety nets, and that the economy would automatically converge to this level of unemployment. Any attempt to push unemployment below this natural level with monetary or fiscal stimulus would merely create higher inflation.
Before monetarism, economists had believed that unemployment could be reduced by accepting somewhat higher inflation, as illustrated by the so-called Phillips Curve, which linked levels of inflation and unemployment observed every year. Monetarists asserted, however, that the Phillips curve was vertical — at least in the long run.
This vertical Phillips Curve became an unquestionable assumption, built into every economic model and even into the legal mandates of the Bank of England and the European Central Bank, which implicitly assume the monetarist theory that central banks can do nothing to affect the level of unemployment.
In reality, the assumption of a vertical Phillips Curve has turned out to be false. The Phillips Curve in Britain has been virtually horizontal for the past 18 years (see second chart). Exactly contrary to the theory, interest rates have had a very large impact on unemployment and almost no effect on inflation.
Why have economists had almost nothing to say about such issues for the past 20 years? The answer is that the economic theories blown apart by the financial crisis have had strong ideological appeal.
The Efficient Market Hypothesis, for example, asserted that while markets might not always be right in predicting the future, they were informationally efficient, making the best judgments possible on the basis of publicly available information.
It was, therefore, taken for granted that regulators or accountants should never try to second-guess market judgments, whether about the true risks of mortgage investments or the real value of bank assets or the appropriate level of oil prices. When governments did intervene to override market decisions with their own judgments, such intervention inevitably would make the economy less efficient.
The idea of rational expectations, another assertion with no empirical backing, had even greater political and financial impact. The principle of rational expectations asserted that in any model of economic behaviour, every participant in the economy had to share the same view about the mathematical laws of motion that determined how inflation, unemployment and other economic variables would evolve.
If this were not the case, it was claimed, some people would be acting in a grossly irrational manner by believing in economic principles known to be false by other participants in the economy.
Rational expectations allowed theoretical economists from the early 1970s onwards to prove, with apparently mathematical certainty, that government policies designed to boost economic activity in a recession would not work.
Instead of creating additional employment or investment, Keynesian policies of fiscal stimulus could be shown in a rational expectations model merely to increase inflation or to force consumers to save a larger share of their incomes because of the additional taxes they would face in future to repay government debts.
This argument about the alleged ineffectiveness of government stimulus measures must be familiar to anyone who followed the debates in America, Britain and Europe about the appropriate policy response to the crisis.
While governments went ahead with large-scale deficit spending to pull their economies out of recession, many traditional academic economists continued to argue that such measures were doomed to failure on the basis of mathematical theorems derived from such doctrines as efficient markets, rational expectations and the natural rate of unemployment.
Such doctrines have now been comprehensively disproved by experience. The question is whether academic economists will respond by developing new theories or try to defend their existing positions by sticking to theories they know to be false.
Max Planck observed, in the context of the revolution in physics that occurred 100 years ago with the discovery of relativity and quantum mechanics, that science progresses one funeral at a time.
The achievements of modern economics are too meagre and its ideological importance is too great to allow such slow progress. Either economics will reform itself quickly or the funeral will be for the discipline as a whole.
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