Saturday, November 13, 2010

How economists forgot much of what they knew

When I started as an economics writer in the mid-1970s, the Keynesian ideas that had guided macro-economic policy through the postwar Golden Age were judged a failure and economics was in crisis.

But now, as Professor John Quiggin of the University of Queensland reminds us in his new book, Zombie Economics, the global financial crisis and the Great Recession have revealed the ideas that replaced simple Keynesianism as failures that plunged economics back into crisis.

The end of the Golden Age and the loss of faith in Keynesianism were brought about by the advent of "stagflation" - high inflation despite a stagnant economy. Keynesian theory said you could have high unemployment or high inflation but not at the same time. It could fix one or the other but not both together.

There aren't many new ideas in economics, just old ideas tarted up. Keynes's ideas were new, however. The "neo-classical" orthodoxy of his day said recessions couldn't happen, so it couldn't explain the Great Depression of the 1930s and had no policies to end it.

Keynes identified various market "imperfections" that explained the economy's malfunctioning and advocated government spending to stimulate the economy and get it growing again. When economists lost faith in Keynesianism they turned back to the discredited neo-classical orthodoxy. Milton Friedman's "monetarism", for instance, was based on the old "quantity theory of money".

Government policymakers soon gave up on monetarism's targeting of growth in the supply of money - it didn't work - but a lasting consequence of that episode was to switch the primacy in macro-management from fiscal policy (the budget) to monetary policy (interest rates).

Keynesianism was criticised because its approach at the macro (top-down) level didn't fit with the bottom-up approach of micro-economics. Its conclusions about how the whole economy worked didn't fit with the standard conclusions about how individual markets worked.

Building models of the macro economy based on neo-classical micro-economic foundations had various attractions. Giving up Keynesianism's more realistic assumptions about how the world worked made the models more rigorously logical and amenable to mathematics.

Assuming everyone was rational and in possession of perfect information got economics back to its libertarian roots, creating a presumption against government intervention in markets and favouring small government and lower taxes.

One development on the old neo-classical foundation was the "efficient market hypothesis", which Quiggin says is the central theoretical doctrine of the "market liberalism" that replaced Keynesianism.

It says financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production. And coming after the collapse of the Keynesian Bretton Woods system of fixed exchange rates, it provided a rationale for the era of finance-driven capitalism that's ended so badly.

In its "weak form", the hypothesis says movements in the prices of assets such as shares can't be predicted from their past movements as claimed by "technical analysts". Like a drunk, share prices move in a "random walk" in reaction to whatever good or bad news next comes along.

In its "strong form", the hypothesis says the market price of an asset is the best possible estimate of its value, incorporating all the available information.

If this is true, bubbles can't develop in asset markets, causing them to crash when finally the bubble bursts.

You can see how this faith - an amazing triumph of hope over centuries of experience - encouraged the excessive deregulation of banks and the financial system, which had formerly been heavily regulated in response to the banks' key role in the Depression.

At the level of macro-economic theory, monetarism was soon superseded by "new classical" economics, incorporating mathematically (and ideologically) convenient propositions such as "rational expectations" and "Ricardian equivalence".

Rational expectations assumes people's expectations about future events will always be right; everyone has the same views about how the economy works as the economics professors who built the model.

Ricardian equivalence - named after David Ricardo, the classical economist who first thought of the idea, then dismissed it - assumes that when governments engage in deficit spending during recessions this has no stimulatory effect on the economy because everyone knows taxes will eventually have to rise to pay off the debt, so they start saving.

Between them, these ideas rendered ineffective government efforts to manage the macro economy. In practice, the academics were less damning of monetary policy. Predictably, new classical economics was never popular with politicians and treasuries, but it fed the general mood that the less governments intervened in the economy the better.

These "new classical" academics developed "real business cycle" theory to explain why economies move in cycles of boom and bust, even though simple neo-classical theory says they don't and many conservative economists had argued that all unemployment was voluntary. Under this theory all fluctuations in economic activity are caused by "exogenous shocks" (developments outside the economic system) such as changes in technology, the terms of trade or workers' preferences for leisure.

Eventually academics - including those in the "new Keynesian" school, which retained remnants of the old Keynesianism - coalesced around the "dynamic stochastic general equilibrium" model. This did allow for the possibility that wages and prices might be slow to adjust, and for imbalances between supply and demand, but moved the model only a short way towards the real world.

The fact that, following the malfunctioning of the 1970s, the main economies seemed to settle down after 1985 - with inflation back under control and unemployment lower - led many economists to conclude this Great Moderation proved economics was now on the right track and the business cycle had been tamed.

Famous last words. The US housing boom proved to be a giant bubble that eventually burst, we realised what crazy games the global financial markets had been playing, the sharemarket crashed, the banking system tottered on its foundations and the developed world entered by far the worst recession since the Depression, which looks likely to linger for the rest of the decade.

And the people whose unrealistic theories helped to bring the calamity about had no idea it was coming because they were playing "rigorous" mathematical games at the time.

I haven't done justice to Quiggin's book, so if you're interested in a readable exposition of the exploits of academic economists over the past 35 years I recommend it highly. It's the story of how economists forgot much of what they knew. Please, guys, don't do that again.