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.
The 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.
”Krugman argued that the macro-economics of the past 30 years was ’useless at best and positively harmful at worst’ “
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.
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).
”We’re at the end of an era of market triumphalism”
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 EMERGENCE OF THE NEW
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).
”Many of the core ideas were widely discussed as far back as the 1970s”
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.
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.
- Economic growth should be subject to limits
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.
”Lord Richard Layard has achieved a high public profile by arguing for happiness as the key goal of public policy”
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.
- Economics should place less emphasis on rationality
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.
- There should be a pragmatic acceptance of state intervention
The new economics is usually counterposed to a supposed free market orthodoxy. It is argued that until the advent of the crisis in 2008 the discipline was dominated by doctrinaire market liberals. The supposed orthodoxy is known by many different names despite representing the same core outlook: market fundamentalism, market triumphalism, neo-liberalism, Thatcherism, Reaganomics, economic rationalism, the Chicago school, freshwater economics, zombie economics, plutocratic capitalism and (in relation to the developing world) the Washington Consensus.
Often financial institutions, and Wall Street in particular, are portrayed as the power base for these ideas. They are also often linked to the political right in America.
The peculiar thing about this is that, even before 2008, the world economy was nothing like the one favoured by traditional advocates of the free market, such as Milton Friedman and Friedrich Hayek. They favoured a minimal role for the state. In their view it should confine itself to functions such as law and order, defence, administering justice and maintaining key public works.
”For the critics, the notion of an infallible market played a key role in the crisis”
In reality, as Ha-Joon Chang, a reader in development economics at Cambridge University, argues in his book 23 Things They Don’t Tell You About Capitalism, every market economy is underpinned by a complex web of regulations. This is also reflected in levels of state spending that are hugely in excess of anything envisaged by Adam Smith back in the 18th century.
Even in America, often seen as the exemplar of free market economics, total state spending accounted for about 35% of GDP in 2007. Since then, with the advent of economic crisis, it has reached nearly 44%. In contrast, back in 1792, only 16 years after the publication of Smith’s The Wealth of Nations, total public spending was only 2.3% of GDP.
Indeed, Krugman, one of the most trenchant critics of free market economics, wrote in Peddling Prosperity, published in 1994, about how the outlook had lost most of its influence. He said that “by the mid-1980s, indeed by the end of Ronald Reagan’s first term [in 1984], conservative macroeconomics had run aground”. Elsewhere in the book he wrote: “By 1992, monetarist and rational expectations theorists had lost virtually all influence over actual policy, in the United States and elsewhere”.
Yet despite Krugman’s accurate observations in 1994, they were apparently either ignored or forgotten 14 years later. Many of the purveyors of the new economics still insisted on the peculiar claim that free market economics represented the orthodoxy.
It should be clear that the new economics goes way beyond the rejection of free market thinking or the rehabilitation of Keynesianism. It represents at least a partial rejection of the basic norms of the market economy: that the goal should be the pursuit of economic growth through maximising profits.
It is also a retreat from the project of developing economics as a science to enable an understanding of the material world. Time and again the new economists warn that economics must be more modest in its aims. They seem to be suffering from a profound lack of confidence in their own discipline.
”The new economists seem to be suffering from a profound lack of confidence in their own discipline”
Their broad conclusion almost inevitably leads to a demand for more extensive state intervention in the economy and in society more generally. Only the demand is put in pragmatic rather than ideological terms. The state needs to be strengthened to curb the damaging destabilising excesses of market power.
Ultimately the new economics can be seen as a desperate attempt to rehabilitate the discipline. Its exponents not only recognise that economics failed to predict the crisis of 2008 – a relatively unimportant charge since capitalism is inherently uncertain; they also recognise that the subject is widely derided as a way of understanding the world.
Rather than probe the fundamental weaknesses of the discipline, the new economists often prefer to criticise a caricatured version of free market economics. They constantly attack ideas that are marginal in academia and even less influential in practice. Yet many of the proponents of the new economics, supposedly a radical approach, are pillars of the establishment.
Developing a new economics might well be a worthwhile task, but attacking straw men is not a good way to achieve it. In any case, it would be naïve to expect anything genuinely subversive to come from the heart of the economic elite.