The Great Debate

from Anatole Kaletsky:

Time to stop following defunct economic policies

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.”

Five years after recession, we still can’t agree on what causes joblessness

Although the Fed announced months ago it is considering pulling back its purchase of assets, unemployment remains historically high. What, if anything, can the government do to get people back to work?

In order to determine the right policy prescription, first we must diagnose what’s causing unemployment. Is the high unemployment due to low demand from the recession, known as cyclical unemployment, or has the world changed and jobs are not coming back, known as structural unemployment? Most likely it’s both. It is impossible to know precisely how much new unemployment is structural and how much is cyclical. This uncertainty has sparked a contentious debate about the nature of unemployment that has been raging since the start of the recession, and lately seems to be hardening into absolutism. The cyclical camp fears that acknowledging an increase in structural unemployment will be used as an excuse to support tightening monetary policy, and gives the government a pass on fixing unemployment. But actually, saying all unemployment is cyclical is what lets the government off too easy. Structural unemployment can be helped with policy, but the solutions take more political will, creativity and leadership. We can lower the structural rate by changing tax incentives to encourage mobility, both job and location, and building a wealth cushion to finance productive job transitions.

If unemployment is cyclical then all the government has to do is reignite demand. For example, if people aren’t buying much then firms don’t produce or sell as many goods, and therefore employ fewer people. Typically to compensate for recessions, monetary policy makers lower interest rates. This encourages people to buy more or firms to expand. That creates more demand and firms hire again. If the Fed creates more inflation, which lowers real wages, then firms can hire more cheaply.

Why economists are part of the problem


Charles Ferguson is the director of Inside Job, a documentary about the financial crisis. The opinions expressed are his own.

Both Glenn Hubbard and Laura Tyson (pictured above, left to right) have played major roles in American economic policy, and both also, unfortunately, exemplify the disturbing, opaque conflicts of interest that pervade the economics discipline.

Over the last thirty years, academic economics has been penetrated by special interests, particularly financial services, in the same way that America’s political and regulatory systems have been compromised by campaign contributions and the revolving door.  In fact, the “revolving door” is now a triangular trip between industry, government, and academia.