Three cheers for the death of old economics

The orthodox mathematical model took no account of reality. The new George Soros institute should bring back some sanity

Anatole Kaletsky

One of the few benign consequences of last year’s financial crisis was the exposure of modern economics as an emperor with no clothes. In February I argued that economists deserved as much blame as bankers, regulators and politicians. Quite a number of others, including Nobel laureate economists, made the same point that economics had to be urgently reinvented. These ideas have borne fruit much sooner than anyone expected with yesterday’s announcement of an Institute for New Economic Thought.
INET, funded with an initial commitment of $50 million from George Soros and backed by a phalanx of distinguished academic economists, could lead to a flowering of original thinking in a profession whose creativity has been stifled by the intellectual monopoly of orthodox academic funding bodies. It could promote a much more serious debate about what governments can and cannot do to regulate the market. Eventually it could re-create an academic discipline capable of explaining reality and offering useful advice to policymakers facing unexpected events.

The dirty little secret of modern economics is that the models created by central banks and governments to manage the economy say almost nothing about finance. Policymakers who turned to academic economists for guidance in last year’s crisis were told in effect: “The situation you are dealing with is impossible: our theories prove that it simply cannot exist.”

New economic thinking could have an important political impact. For economics is not just the desiccated study of abstract equations. It is the foundation of all politics in capitalist nations. As Keynes wrote: “Practical men who believe themselves to be quite exempt from any intellectual influence are usually the slaves of some defunct economist.”

The defunct economists today are the people who took control of the subject in the 1980s, with theories that closely coincided with the spirit of the Thatcher-Reagan revolution. Their three main ideas transformed the politics, as well as the economics, of the next 20 years. The first idea, known as “rational expectations”, maintained that capitalist economies with competitive labour markets do not need stabilising by governments.
The second idea — “efficient markets” — asserted that competitive finance always allocates resources in the most efficient way, reflecting all the best available information and forecasts about the future.

The third idea stated that economics, previously a largely descriptive study of human behaviour, had to become a branch of mathematics, using assumptions on human behaviour that were clear enough to be expressed in algebraic formulae. Economic problems that could not be analysed with mathematics were deemed unworthy of consideration.

Between them, these three ideas had huge political effects. “Rational”, “efficient” and mathematically inexorable economics seemed to legitimise whatever political results were decreed by markets: income inequalities, industrial dislocation, vast bonuses for top executives could all be presented as the impersonal result of scientific forces, rather than political issues.

Nobody seemed to notice that all this mathematical flummery left out the most crucial step of true science. Physics, chemistry and biology use mathematical models to draw conclusions that are then tested against reality. If reality contradicts these tests, then scientists reject the models. Today’s academic economics reverses this process: if models disagree with reality, it is reality that economists want to change.

It is not surprising that the whole scaffolding of theorems, models and computer simulations came crashing down, along with the towers of bad debt and bad policy it supported. Today’s academic approach prevented economists from thinking about a world that is, by its very nature, unpredictable and inconsistent — as Keynes and Hayek, at opposite ends of the political spectrum, both understood.

To gain a genuine understanding of unpredictable reality, some unorthodox economists may employ new mathematical techniques of non-linear dynamics and chaos theory. Others may revive the literary and anecdotal traditions of the great economists of the past, building on the work of sociologists, psychiatrists, historians and political scientists disdained by the present orthodoxy. INET will try to support these new schools of thought.

A good test of whether this venture proves successful will be to ask a simple question: Was Adam Smith an economist? Were Keynes or Hayek? By the standards of what is taught as economics today, the answer is “no”. They may have explained some of the deepest mysteries of human life: why the pursuit of individual self-interest increases the wealth of nations; why market economies suffer prolonged slumps; why central planning never works.

Yet Smith and Hayek produced no real mathematical models. Their eloquent writing lacked the “analytical rigour” demanded by modern economics. And none of them ever produced an econometric forecast. If any of these giants applied for a university job today, they would be laughed out of court and their written works would not have a chance of acceptance in The American Economic Review.

This is the mentality INET hopes to overcome. If the next generation of academic economists aspire to succeed Smith, Keynes and Hayek, rather than ineffectually aping Euclid, Newton and Einstein, then the venture will have been worthwhile. (Anatole Kaletsky, The Times)


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