Economists stung by criticisms of their failure to foresee the financial crisis have reacted by advocating a new economics. Daniel Ben-Ami attempts to pin down its core ideas and asks whether they really address the world's problems.
T?he financial turmoil of 2008 and the subsequent economic downturn have led to a profound intellectual crisis in economics. Critics, from the Queen downwards, have demanded to know why economists did not predict the recession. At the same time, many prominent economists have presented a dim view of their chosen profession.
Economists of all shades have expressed intense anxieties. Alan Greenspan, for a long time the chairman of America's Federal Reserve and an arch free marketeer, acknowledged in 2008 that he was "in a state of shocked disbelief"? at the financial crisis. He also made the admission - almost unheard of from an economist - that he had been "partially"? wrong in relation to his views on regulation.Meanwhile, among Keynesian economists, Paul Krugman, a Nobel laureate and New York Times columnist, has launched a searing attack on economics. In a 2009 lecture he argued that the macroeconomics of the past 30 years was "spectacularly useless at best, and positively harmful at worst"?. (article continues below)
In response to such criticisms, many economists, finance professionals and central bankers have advocated a new economics. The best-known initiative is the Institute for New Economic Thinking (Inet), an organisation established with $50m (£31m) from George Soros and listing five Nobel laureates among its advisers. Alongside that are economists advocating shifts in economics to give greater priority to human psychology and happiness.
Although such critics typically favour a different kind of economics, it is not clear what it will involve. They disagree with a lot of free market economics, which they portray as the conventional wisdom, but there is no definitive statement of their alternative. Although there are many common themes, there is nothing like universal agreement on the components of the new economics.
For some participants in the debate it represents a Keynesian resurgence against an until recently dominant free market outlook. For example, Lord Robert Skidelsky, the author of a three-volume biography of John Maynard Keynes, has achieved a high profile for his project of rehabilitating the mid-20th century economist.
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But many of the arguments fall outside the traditional division between Keynesians and free marketeers. Popular themes among new economists include a discussion of whether humans can be seen as generally rational, the importance of happiness and the redefinition of third world development in terms of "capabilities"? (basic entitlements). Yet none of these can be found, for example, in Keynes' masterwork, The General Theory of Employment, Interest and Money (1936).
In addition, problems that were central to Keynes, and to traditional Keynesianism more generally, have a low priority in the contemporary discussion. For instance, unemployment features only as a sideshow in the current discussion, whereas achieving full employment was central to the Keynesian consensus after the second world war.
Given that economics is meant to offer a framework for understanding the material world, it would help greatly if the nature of the new economics is clarified. What prompted emergence of the new economics? Why is there a widely perceived need among economists for a new approach to their discipline? What are its core beliefs? What are the consequences of this approach?
Each of these questions will be examined in turn.
The discussion of the need for a new approach to economics was clearly given a boost by the financial and economic crisis of recent years. From the collapse of Lehman Brothers in September 2008 onwards, it seemed likely that the severe problems the financial sector was already suffering were likely to have a damaging economic spin-off.
This development in turn gave added impetus to the call to rejuvenate economics.
Michael Sandel, a professor of political philosophy at Harvard, put this trend into context in his first BBC Reith lecture in June 2009:
"One way of understanding what's happened is to see that we're at the end of an era, an era of market triumphalism. The last three decades were a heady, reckless time of market mania and deregulation. We had the free market fundamentalism of the Reagan-Thatcher years and then we had the market friendly neo-Liberalism of the Clinton and Blair years, which moderated but also consolidated the faith that markets are the primary mechanism for achieving the public good.
"Today that faith is in doubt. Market triumphalism has given way to a new market scepticism."?
Of course, it took time for the unease about the state of the global economy to be formalised into calls for a new economics. But it was already a clear trend within a year. For example, Inet grew out of informal discussions in the first half of 2009, although it was not officially founded until October 2009. Its inaugural conference was held at King's College, Cambridge, in April 2009. Among the many luminaries speaking were Dominique Strauss-Kahn (the managing director of the International Monetary Fund), Joseph Stiglitz (a Nobel laureate) and Adair Turner (the Financial Services Authority chairman).
Meanwhile, Krugman had a substantial article published in the New York Times magazine in September 2009 entitled "How did economists get it so wrong?"? He has built on the theme many times since, with virulent attacks on those he derides as "freshwater economists"? - free market economists who are generally based in universities away from coastal states. Other prominent economists, including Stiglitz and Bradford DeLong of the University of California, Berkeley, made similar attacks.
The same general trend was apparent in Britain. In mid-October, Turner gave a series of three lectures at the London School of Economics on economics after the crisis. In the first he argued that his goal was to reject the "dominant conventional wisdom"? while still supporting market economics and liberal capitalism in principle. He went on to argue that: "economics, to be most useful, must be rooted within a wider discipline of political economy, a philosophical, empirical, historical and ethical discipline, as well as a rigorously mathematical one"?.
Turner's call followed similar arguments by many other authorities. Rowan Williams, the Archbishop of Canterbury, has also recently co-authored a book calling for a more moral form of capitalism. Willem Buiter, a former member of the Bank of England's Monetary Policy Committee, has written of the "unfortunate uselessness"? of orthodox economics. Anatole Kaletsky, the principal economics commentator for The Times (London), wrote a book, Capitalism 4.0, calling for a shift to a less doctrinaire economic outlook (for my review see "Case for new era is out of proportion"?, Fund Strategy, August 16, 2010).
However, it would be a mistake to see these ideas as coming out of nowhere in response to the crisis. Many of the core ideas were widely discussed as far back as the 1970s. For example, an examination of the Nobel prizes in economics shows that key elements of "new economics"? were widely recognised well before 2008 (see box, below). But the financial and economic crisis of the past two years gave added impetus to the reshaping of conventional economics.
?Nobel prizes in economics: free market dominance??One way to gauge the influence of different sets of economic ideas is to look at the winners of the Nobel prize for economics each year. The awards do not reflect just the quality of the work but also the influence of particular sets of ideas at particular times.The most striking thing about the table (see below) is how many critics of free market economics it contains. Five laureates are closely associated with the Institute for New Economic Thinking: George Akerlof, Michael Spence and Joseph Stiglitz (all 2001), Amartya Sen (1998) and James Mirrlees (1996). Others are critical of free market economics but are not associated with the organisation. Paul Krugman is probably the most vocal in this category. Others many not have high-profile opinions but their approach runs counter to the free market orthodoxy. For instance, the work by Daniel Kahneman and Vernon Smith on behavioural economics.There are some free market Nobel laureates but not nearly as many as might be expected from the rhetoric of the new economists. The most high profile include Robert Lucas (1995), Gary Becker (1992), Robert Merton and Myron Scholes (both 1997), and Edward Prescott (2004).This year's winners are not in the free market tradition.
Underlying the emergence of this critique is a profound lack of confidence in economics and indeed the market economy itself - although there is insufficient space here to explain why this emerged. Even staunch advocates of capitalism nowadays tend to see it as a highly destabilising and risk-laden system.
Perhaps the most striking expression of this lack of confidence was a statement by Nicholas Stern, a former chief economist at the World Bank, in his report for the Treasury on the economics of climate change in 2006. He stated that "climate change is a result of the greatest market failure the world has seen."? In other words, from his perspective the market system had created a potentially fatal threat to humanity. Whatever the merits of his report, it embodied a profoundly gloomy view of the dangers of unfettered markets.
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Although there is no universally accepted definition of the new economics there are three propositions that would be widely accepted by critics of free market thinking. To the extent it is possible to talk about a canon of new economics, this is probably the closest that exists.
Central to the new economics is what I have dubbed "growth scepticism"?. This is the outlook that supports growth in principle but says it should be subject to numerous caveats. Typically, this takes the form of suggesting that it is necessary to respect environmental, moral and social limits to growth. It also often means redefining prosperity from material terms to a focus on emotional well-being.
Growth scepticism has many forms but the most importance include:
The idea of natural limits to economic growth. It has become widely accepted that the fragility of the planet means that economic growth should be restrained. Not only is there a risk of depleting resources but climate change, in this view, necessitates curbs on prosperity. Growth has to be sustainable.
The need for more emphasis on equity rather than efficiency. From this perspective any growth should be fair. In the present economic crisis in particular there is a need for everyone to be ready to make sacrifices.
The new economics should be moral. It needs to have a vision of "the good life"? rather than simply focusing on the maximisation of economic output.
Rather than being preoccupied with maximising GDP, the emphasis should be on wellbeing. This was the focus of a 2009 report of eminent economists, including Amartya Sen and Stiglitz, sponsored by President Nicholas Sarkozy of France. In Britain, Lord Richard Layard, now an emeritus professor at the London School of Economics, has achieved a high public profile by arguing for happiness as the key goal of public policy.
Third world development should be redefined in terms of realising various "capabilities"? to allow for individual "flourishing"? rather than promoting growth. Sen, a Nobel laureate in economics, is the key exponent of this argument. It has been adopted by influential organisations such as the United Nations Development Programme.
The pursuit of maximised profits also needs to be restrained. For this reason corporate governance, corporate social responsibility and business ethics are seen as far more important than they were in the past. Financial institutions in particular are seen as in need of restraint because of their potential dynamism.
The new economists are often highly critical of the idea of the rational economic man. No doubt it is true that not everyone acts entirely rationally in every situation - that would be a caricature of free market economics in any case. But in their vehement criticisms of rational economic players, the very idea of rationality ends up being called into question. It raises doubts about the project of developing a social science that is capable of understanding the material world. These doubts are expressed in several different ways:
Economic and financial models are highly problematic. Proponents of economics tend to be critical of economic models as unrealistic. Those that relate to the financial markets are viewed with particular hostility.
The Efficient Market Hypothesis (EMH) is frequently viewed as both theoretically wrong and politically dangerous. Many proponents of the new economics lambast the strong version of EMH which contends that financial markets discount all available information. In other words, prices in developed markets such as America and Britain, are by definition correct. For the critics, the influence of the notion of an infallible market played a key role in the financial crisis. Practitioners and politicians conveniently defined away any potential problems and therefore missed the messy reality of the financial markets. Other models, such as the Black-Scholes pricing model for derivatives, have also come under attack.
Conventional economics puts too much emphasis on mathematics and too little on history. This is an extension of the argument about models. The argument is that the emphasis on elegant mathematical models is at the expense of incorporating a messy reality. Far better, it is argued, for economists to bolster their knowledge of history.
Human psychology, rather than rationality, provides the best basis for understanding economic behaviour. Although rational man has been criticised by others, Keynesian and free marketeers, in the past, the current emphasis is behavioural. They try to understand the financial markets and the economy by examining human psychology rather than assuming individual rationality. Daniel Kahneman, Robert Shiller and Richard Thaler are among the key movers in this project. The behavioural view even rejects the project of rationally understanding the economy as hubristic. If anything the financial and economic crisis has strengthened this school of thought.
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