Financial Times, 13 April 2010
A remarkably distinguished
group of economists gathered last weekend for the inaugural conference of
the Institute for New
Economic Thinking, an initiative of George Soros. They were
soul searching over the failures of economics in the recent crisis. Such
failures are most evident in two areas: the inadequacies of the efficient
market hypothesis, the bedrock of modern financial economics, and the
irrelevance of recent macroeconomic theory.
The central idea of the
efficient market hypothesis is that prices represent the best estimate of the
underlying value of assets. This thesis has recently taken a battering. The
boom and bust in the money markets was precipitated by a US housing bubble. That
bubble followed the New Economy fiasco and was preceded by the near-failure of
Long Term Capital Management, a hedge fund designed to showcase sophisticated
financial economics.
The macroeconomics taught in
advanced economics today is largely based on analysis labelled dynamic
stochastic general equilibrium. The unappealing title gives the game away: the
theorists are mostly talking to themselves. Their theories proved virtually
useless in anticipating the crisis, analysing its development and recommending
measures to deal with it.
Recent
economic policy debates have not only largely ignored DSGE, but have also been
remarkably similar to the economic policy debates of the 1930s, although they
have been resolved differently. The economists quoted most often are John
Maynard Keynes and Hyman Minsky, both of whom are dead.
Both
the efficient market hypothesis and DSGE are associated with the idea of
rational expectations – which might be described as the idea that households
and companies make economic decisions as if they had available to them all the
information about the world that might be available. If you wonder why such an
implausible notion has won wide acceptance, part of the explanation lies in its
conservative implications. Under rational expectations, not only do firms and
households know already as much as policymakers, but they also anticipate what
the government itself will do, so the best thing government can do is to remain
predictable. Most economic policy is futile.
So is
most interference in free markets. There is no room for the notion that people
bought subprime mortgages or securitised products based on them because they
knew less than the people who sold them. When the men and women of Goldman Sachs perform “God’s work”,
the profits they make come not from information advantages, but from the value
of their services. The economic role of government is to keep markets working.
These
theories have appeal beyond the ranks of the rich and conservative for a deeper
reason. If there were a simple, single, universal theory of economic behaviour,
then the suite of arguments comprising rational expectations, efficient markets
and DSEG would be that theory. Any other way of describing the world would have
to recognise that what people do depends on their fallible beliefs and perceptions,
would have to acknowledge uncertainty, and would accommodate the dependence of
actions on changing social and cultural norms. Models could not then be
universal: they would have to be specific to contexts.
The
standard approach has the appearance of science in its ability to generate
clear predictions from a small number of axioms. But only the appearance, since
these predictions are mostly false. The environment actually faced by investors
and economic policymakers is one in which actions do depend on beliefs and
perceptions, must deal with uncertainty and are the product of a social
context. There is no universal economic theory, and new economic thinking must
necessarily be eclectic. That insight is Keynes’s greatest legacy.
John Kay is a member of the advisory board of the Institute for New Economic Thinking
