Time to stop following defunct economic policies

By Anatole Kaletsky
April 19, 2014

Can economists contribute anything useful to our understanding of politics, business and finance in the real world?

I raise this question having spent last weekend in Toronto at the annual conference of the Institute for New Economic Thinking, a foundation created in 2009 in response to the failure of modern economics in the global financial crisis (whose board I currently chair). Unfortunately, the question raised above is as troubling today as it was in November 2008, when Britain’s Queen Elizabeth famously stunned the head of the London School of Economics by asking faux naively, “But why did nobody foresee this [economic collapse]?”

As John Maynard Keynes observed in 1936, when he challenged the economic orthodoxies that were aggravating the Great Depression: “The ideas of economists, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.”

This remark is as relevant today as in 1936. Joseph E. Stiglitz, the Nobel laureate, asked rhetorically in Toronto: “Why are central banks and governments still trying to predict the effects of their policies with an economic model that is manifestly absurd?”

His answer was that the economic models studied in universities and published in leading academic journals are still largely based on a simplifying concept, known as the Representative Agent, which effectively assumes that “everyone in the economy is the same.”  So these models have nothing to say about lending or borrowing, ignore the existence of banks and treat bankruptcies as unimportant because “when the borrower does not repay, he only defaults on himself.”

Amazingly, these economic models with no banks are still the main analytical tool used by most central banks. Peeling away further layers of the theoretical onion reveals something even more bizarre: an inbuilt assumption that the economy is self-stabilizing. This means that virtually any policies the central bank may choose to follow will lead automatically to full employment — in the forecasts, if not in the real world.

The pernicious effects of such stilted thinking are most visible in Europe. As Adair Turner, former chairman of Britain’s Financial Services Authority and now an INET Senior Fellow argued, the rules for the eurozone agreed in 1991 were based on the belief that “economists had cracked the problem of macroeconomics  – that low and stable inflation was not just necessary, but sufficient for economic success.”

Making matters worse for Europe, this hubris among economists was combined in the Maastricht Treaty with the German concept of “ordo-liberalism,” which asserted that government’s only legitimate role was to set clear rules for competition and price stability and then strictly enforce them.

“This was why the Bundesbank’s legal department became as powerful as its economic department,” Turner noted, “and why Germany has been so unbending in its interpretation of the euro rules. We now know that ordo-liberalism does not work in macroeconomics. But the entrenchment of these old economic ideas, even after they have been proved wrong, is so great that any change will be very slow.”

As a result, Turner concluded, Europe “could look remarkably like Japan in the 1990s, with many years of very low growth — but probably much greater social tension, because Europe’s immigration-based societies are much less uniform and consensual than Japan’s.”

How could economists break this pernicious grip of old ideas? The obvious answer is by developing new ideas and many were presented at Toronto: Forecasting currencies with a new technique called Imperfect Knowledge Economics developed in New York and Copenhagen; understanding the role of government in technological innovation through work in Cambridge and Massachusetts; analyzing the role of self-fulfilling “reflexive” expectations in boom-bust cycles; applying the mathematics of complex systems to economic problems ranging from financial instability to housing and the competitiveness of developing countries in Oxford and Rome; funding work in Paris and Berkeley on income distribution that is attracting worldwide attention; researching the economics of education and childhood development through a global network led from Chicago; developing new undergraduate courses on subjects neglected by the traditional curriculum with an international team of professors run from University College London and Bangalore; restoring the study of economic history through workshops in Italy and the United States.

But despite such initiatives, the “old ideas that have been proved wrong,” including inflation targets, self-stabilizing markets, and rigid separation of monetary and fiscal policy, remain dominant where they are most dangerous — in the macroeconomic analysis of finance ministries and central banks. Overcoming these old ideas will require new thinking about politics and not just economics.

As Michael Sandel, the Harvard philosopher, told the conference: “Over the past three or four decades, the public life of our societies has been animated by a faith that market mechanisms can answer all questions and solve all problems. This era of unquestioned faith in markets coincided with the time when political life lost the sense of morality or public purpose. Market reasoning seems to offer a non-judgemental way of allocating goods and incomes, but in many cases we have to make moral judgements. The new economic thinking that is now required has many affinities with old economic thinking. Classical economists, going back to Adam Smith, did not view economics as a value-neutral science or even as an autonomous discipline. They all understood economics to be a sub-field of moral and political philosophy.”

In other words, economics always operates in a specific political context. Market mechanisms must be judged by social outcomes, government and business must work in concert, not in opposition. As a new phase of global capitalism emerges from the 2008 crisis, these are the key ideas that economists will have to discover — or rediscover.

Anatole Kaletsky is chairman of INET’s board of governors, co-chairman of Gavekal Dragonomics, and author of Capitalism 4.0, which develops many of these ideas.

 

PHOTO (TOP): German Chancellor Angela Merkel addresses the Bundestag, the lower house of parliament, at the Reichstag in Berlin, March 13, 2013. REUTERS/Tobias Schwarz

PHOTO (INSERT 1): Columbia University Professor Joseph Stiglitz speaks during The Economist’s Buttonwood Gathering in New York, October 24, 2012. REUTERS/Carlo Allegri

PHOTO (INSERT 2): International Monetary Fund Managing Director Christine Lagarde gestures as she speaks about the global economy at the Johns Hopkins School of Advanced International Studies in Washington, April 2, 2014. REUTERS/Kevin Lemarque

 

19 comments

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The failures of economics can be traced to economists’ stubborn refusal to give any consideration whatsoever to what is arguably the most dominant parameter affecting economics today – population growth. When economists were mocked for endorsing Malthus’ theory that mankind would be doomed to a life of misery constrained by food shortages, they completely capitulated to the criticism and vowed never again to consider the subject. Now they dismiss the subject entirely with the claim that mankind is ingenious enough to overcome any and all obstacles to growth – something obviously impossible in a finite world.

While Malthus may have been proven wrong (thus far?) by technology that boosted crop yields faster than the growth in the population, the ramifications of population growth don’t end there. They are many and far-reaching. Most importantly, economists have been blind to the inverse relationship between population density and per capita consumption, and its role in driving unemployment and the global trade imbalances that nearly collapsed the global economy and continue to threaten it today.

If the other sciences had caved in to criticism so easily, we’d all still be living on a flat earth at the center of the universe, cooking on wood stoves, reading by candlelight and seeking treatment from witch doctors for our maladies.

Pete Murphy
Author, “Five Short Blasts”

Posted by Pete_Murphy | Report as abusive

One must follow what worked in past in very similar conditions over the long term and not untested academic models or political economic ideology.

One must also deal with foreseeable real world conditions. For example there really are very dangerous things that can go into the use of things. Bad buildings collapse, without traffic lights cars crash, X-rays have use but can kill, Therefore there a need for all sorts or regulations. Since there are bad guys with arms and armies there is a need for an army. Long term growth depends on education and a new generation. All of the above cost money and require taxes. Free trade punishes the nation that taxes in the short term. Therefore, any free trade zone will need a central taxing and standards for the above.

Posted by SamuelReich | Report as abusive

nothing new here. No matter how smart they are all any borrower has to do is default once as they have done so many times throughout history. Video series called “ascent of money” covers this in great detail, commented on by Neil Ferguson of the London school of economics.

Posted by mountainrose | Report as abusive

nothing new here. No matter how smart they are all any borrower has to do is default once as they have done so many times throughout history. Video series called “ascent of money” covers this in great detail, commented on by Neil Ferguson of the London school of economics.

Posted by mountainrose | Report as abusive

Only @Pete Murphy focuses on the real problem, the neutron bomb of economics: population growth coupled with globalization.

Every four and one-half days (4.5 days) the world population grows by 1 million people. I expect this article by Anatole Kaletsky will be on Reuters for about 4.5 days, starting today. During that short time, millions of babies will be born and millions of people will die of old-age or disease, but the increment will be a one-million-persons increase in the world population. Most of the 4.5 days increase, this coming Monday, Tuesday, Wednesday, will occur in poor countries, and further fuel the unprecedented, mass immigration to developed countries of Europe and the United States.

That is one million more people, in 4.5 days, driving the furnace of mass immigration, flooding the labor markets of Europe and the United States, where mass-unemployment already reigns.

In the United States or in Europe, go out into the public and look around you, look at the people. The middle class is degrading, disintegrating.

Although corporate profits are up, wages have gone drastically down, and are accelerating downward even faster, in virtually all professions in Europe and the United States.

– Carpenter? Down
– Store clerk? Down
– Engineer? Down
– Scientist? Down
– Architect? Down
– Pharmacist? Down
– Electrician? Down
– Plumber? Down
– Fisherman? Down
– Accountant? Down
– Computer programmer? Down
– Mathematician? Down
– School teacher? Down
– Agricultural worker? Down

Globalization, to the media mantra of free-trade, free-trade, free-trade, is destroying the vast middle classes of Europe and the United States.

The greatest enemy of the people of Europe and the United States is the WTO, the World Trade Organization, which is made up of the world’s wealthiest companies.

@Pete Murphy is the only one in this thread who is focusing on the real problem, an exploding population growth and its connection with poverty and destruction.

Every 4.5 days, another one million mouths.

Posted by AdamSmith | Report as abusive

How many ‘bubbles and busts’ does it take for economists, financial and political people to realize that models aren’t precise enough? They persist in leaving out the human factor in all three areas.

The Housing bubble and subsequent Recession was due to a human factor – Fraud in the US housing market (not regulated enough by the US laws) that expanded into the financial sector and went global.

We must consider the laws of a country in regards to the money flow. If the laws are lax or not enforced, both in taxation enforcement and banking regulations, there will be a distortion and an inability to forecast any economic gains or losses with any accuracy. Both are reflected in employment of a population also.

@AdamSmith, Population is a huge part of the problems that will be back and forth. The other is weather, drought, flooding etc. which effects the ability to feed that population which leads to political unrest.

The idea that the larger population of a country should bear the most in taxation or lesser gov’t services in order to ‘float’ a gov’t GDP is ridiculous. The larger population is the foundation of a country. Not the smaller richer sector. Without the larger population being educated and in well being, the country implodes. It is historical and current.

One has only to look at the beginning of Syria’s civil war – drought and the inability or refusal of Assad to ensure that the people would not have difficulty in procuring the most basic of needs – food.

There are many examples of all types of issues that affect GDP and the flow of money. Each part seems small but when taken as a whole, the global effect is apparent.

Posted by mstan4408 | Report as abusive

Pete Murphy and AdamSmith are both wrong because they have no facts just opinions… see http://www.gapminder.org/

World population growth rate is reducing and population may stabilise, possibly even decrease.

I find it rich that those who hate welfare and socialised education blame the illiterate and in poverty for having bigger families. If good education were universal the progeny of the privileged would have to truly fight for a chance in the economy (even playing field). Educated people tend to have smaller families, start families later and make more money.

The total number of live births are less than halved when going from 3 children per couple to 2 children per couple over a hundred and fifty years. Better education, job opportunities (something to do besides procreation or being idle), better healthcare, better law and order, among possibly many other things will bend the curve towards this. Heck it is already happening.

The Malthusians are not wrong only because of innovations in agriculture (the area under agriculture also increased in huge proportions as the population has increased), but also because the real growth rate is going down.

Posted by juggernaut | Report as abusive

BTW, as an engineer, speaking to my personal anecdote, salaries have almost doubled over the last 8-10 years, where I work for people who started working with me.

You have to keep adding to your skill-set to get raises and experience is one of those things.

Posted by juggernaut | Report as abusive

Humans are not fungible. “Good education” and “equal opportunity” will not make impact any less disparate.

This needs to be worked into any economics framework.

Of course, any economist taking an honest view of this will find their career somewhat truncated, to say the least.

Posted by Zeken | Report as abusive

Boy you said it Anatole! We certainly need to change our view of economics. Globalization and automation in the 21st century demand this. The Chinese have the wisdom to see this and the discipline to act on it. I hope their leadership will save the west from destroying itself.
@Pete_Murphy, AdamSmith, juggernaut and many others are correct. Though I think they tend to try and simplify the complexities down to a few comprehendible issues.
We the people of the world need to begin planning a transitional form of economics that takes into account that the bulk of the population will not need to work. This is completely contrary to virtually all current forms of economics and forms of government. It is going to be very difficult as we will need to change many of our basic human instincts and social teachings.
Technology is advancing far faster than people realize. If just a few short decades we will replace the human worker with intelligent android workers. If you don’t believe that you are not paying attention. How will we handle that? When only 30% of the current working population “works”, how will they support the rest? When these numbers are world wide in 2050?

Posted by tmc | Report as abusive

Put an economist, sociologist, social psychologist, anthropologist, political scientist, and historian in a room and they will be discussing a subject with a HUGE number of variables and extremely complex modelling that yields results based on statistical probabilities that will be often inaccurate, misquoted, and misunderstood. Unfortunately that subject is the weather because nobody in that room likes each other and they all think the others are in the “soft sciences”.

Posted by notnews | Report as abusive

Anatole, I just heard your position has been outsourced and you have been replaced by an East Asian who will pontificate for a third of your rate.

Posted by rikfre | Report as abusive

First: Anatole states that: ‘…So these models have nothing to say about lending or borrowing, ignore the existence of banks and treat bankruptcies as unimportant’… Now I don’t know what brand of economics is taught in the EU, but economics courses in US universities, in fact do teach about lending, borrowing, the existence and reason for having banks, how banks created money, bankruptcies and their importance. So I don’t know where this comes from….
As far as the commentors go: they are mostly ignorant of economics, from what I’ve read.

Posted by edgyinchina | Report as abusive

“The letter explains that as low interest rates made borrowing cheap, the “feel-good factor” masked how out-of-kilter the world economy had become beneath the surface”. This is a quote from a letter by eminent economists to the Queen of England in 2009 explaining why the crisis happened and no-one saw it coming.

Since then we have had low rates provided by central banks and encouraged by various governments as the prescription for a normal economic recovery. You just cannot make this stuff up – they must be idiots.

Posted by keebo | Report as abusive

@edgyinchina
It seems that Anatole is still paraphrasing Stiglitz in that portion of the article. He does assert that Stiglitz is correct in that central banks use these models. I have no knowledge as to whether that is true or not, but you and I may agree that it seems unlikely. What ‘brand of economics’ is taught in the EU doesn’t seem to have anything to do with it as Stiglitz teaches in the Ivy League. As to us commentors, I suppose we could all stand to use a more Socratic approach to our pontifications, but calling us ignorant without elucidating any particulars is immaterial and evokes shamanism.

Posted by notnews | Report as abusive

@edgyinchina
It seems that Anatole is still paraphrasing Stiglitz in that portion of the article. He does assert that Stiglitz is correct in that central banks use these models. I have no knowledge as to whether that is true or not, but you and I may agree that it seems unlikely. What ‘brand of economics’ is taught in the EU doesn’t seem to have anything to do with it as Stiglitz teaches in the Ivy League. As to us commentors, I suppose we could all stand to use a more Socratic approach to our pontifications, but calling us ignorant without elucidating any particulars is immaterial and evokes shamanism.

Posted by notnews | Report as abusive

@edgyinchina
It seems that Anatole is still paraphrasing Stiglitz in that portion of the article. He does assert that Stiglitz is correct in that central banks use these models. I have no knowledge as to whether that is true or not, but you and I may agree that it seems unlikely. What ‘brand of economics’ is taught in the EU doesn’t seem to have anything to do with it as Stiglitz teaches in the Ivy League. As to us commentors, I suppose we could all stand to use a more Socratic approach to our pontifications, but calling us ignorant without elucidating any particulars is immaterial and evokes shamanism.

Posted by notnews | Report as abusive

So I now understand how the repeated post thing happens via a frozen browser.I apologize and must say that is annoying.

Posted by notnews | Report as abusive

Juggernaut, I’m afraid you missed the beginning of Rosling’s lecture, and maybe the beginning of your science lectures too.

The population will grow to 9 billion by 2050: 9 billion. As Rosling said, nothing short of a nuclear war can stop the poorest 2 billion people from doubling in 40 years.

Your opinion is that: World population growth rate is reducing [sic] and population may stabilise, possibly even decrease. The rate *may* stabilize and *possibly* even decrease. The rate is not going down yet, and wishing won’t make it so.

Better education is not a fact in Africa or the Middle East, and India is lagging far behind than other developing nations. Hell, the U.S. education system ranks 14th or 15th now. Job opportunities are not increasing in the areas above, nor in places like Indonesia. Better healthcare…maybe more expensive in the U.S., but infectious disease resistance is increasing. Better law and order, like in Syria, Pakistan, North Korea, Ukraine…? You say, many other things will bend the curve towards this. And they are, what?!?
Your optimism is frighteningly naive.

Posted by Andvari | Report as abusive