New economics: making forecasts after the recession

The financial crisis has dealt a heavy blow to the dismal science which failed to predict it.

by Richard Reeves
Last Updated: 09 Oct 2013

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood,' wrote the economist and part-time political philosopher John Maynard Keynes. 'Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.'

Keynes would have been amused to find himself, more than 80 years after the publication of his great work, The General Theory of Employment, Interest and Money, the economist du jour. The recent decision by the nations of the eurozone to pump half a billion euros into their economy - in an attempt to stop the financial forest fire in Greece igniting the entire continent – is a classic Keynesian measure: using state cash to keep the economy moving in a downturn.

But while books by Keynes are being dusted off again, there is a growing recognition that economics needs a more fundamental rethink. Some of the basic ideas that have underpinned economics for at least half a century have been challenged by the extraordinary events of the past three years. There is a crisis in the economy, but also in economics itself.

Economists have spent much of their time since 2008 scraping egg off their faces. With a few honourable, and now famous, exceptions such as Nouriel Roubini, economists failed to predict the financial meltdown. And among the many casualties of the crash and ensuing recession were the haughty superiority and prized theories of the economics world.

Of course the real losers in all of this weren't the academics but the ordinary people at the front line of the recession – those who have been made redundant, lost homes or watched pensions shrink to nothing. Were governments too easily seduced by the false certainties of the dismal science? Whatever the case may be, economists are now engaged in a mass exercise in professional therapy, atoning for their sins and trying to build a new economics from the rubble of the old.

Last year, Queen Elizabeth went to the London School of Economics to try and understand what had taken so much wealth out of her Commonwealth. 'Why did nobody predict it?' the monarch asked the hapless host, professor Luis Garicano. In response, some of the nation's leading economists gathered at the British Academy and drafted a letter to Buckingham Palace. 'In summary, Your Majesty,' the mea culpa concluded, 'the failure to foresee the timing, extent and severity of the crisis ...

was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.'

The collapse of the financial markets, and the seizing up of credit, resulted from a series of interconnected risks, attaching the failure of a poor black family in the US midwest to the complex financial instruments of a maths PhD in a London hedge fund and to the savings of a Chinese farmer. Historians will point to the collapse of Lehman Brothers in September 2008 as the moment the world's market traders lost their nerve, when the 'animal spirits' that haunt every trading floor mutated into panic and fear.

But it was, as the Queen's correspondents observe, a 'failure of imagination' above all else. The ideas that have been the foundation of economic thinking – that markets will self-correct to an 'equilibrium', that regulation distorts and inhibits growth, and that economic agents act rationally – are all, now, defunct. As Mark Twain said: 'It ain't the things you don't know what gets you into trouble, it's the things you know for sure what ain't so.'

In April 2010, a new movement began, appropriately enough in Keynes' alma mater, King's College, Cambridge. With funding from George Soros, the Institute for New Economic Thinking kicked off its work with an all-star seminar. Four Nobel laureates – Joe Stiglitz, George Akerlof, Michael Spence and Sir James Mirrlees – gave papers, along with Dominique Strauss-Kahn, managing director of the International Monetary Fund and Lord (Adair) Turner, head of the UK's Financial Services Authority, and the man who risked the wrath of the City by describing much of their activity as 'socially useless'.

The common theme of the Institute's inaugural gathering was the failure of the idea that economic activity is driven by rational decision-making. Economics textbooks are still inhabited by 'rational economic man', the fictional character who gathers up all the information available, weighs up which course of action will 'maximise' his 'utility' (ie best satisfy his preferences) and then acts. Stiglitz, who chairs the Institute's advisory board, describes this view as a 'semi-religious' one: 'Market fundamentalism is dead. September (2008) is to market fundamentalism what the fall of the Berlin Wall was to Communism.'

Lord Turner stole the show at the King's conclave with an after-dinner speech on the causes of the crisis. 'There was a dominant conventional wisdom that markets were always rational and self-equilibrating,' he said, 'that market completion by itself could ensure economic efficiency and stability, and that financial innovation and increased trading activity were therefore axiomatically beneficial.'

Of course, there were always those who rebelled against the orthodoxy – and Soros' Institute now provides the refuseniks with a home – but these ideas hardened into ideology, and thence into policy. The most profound political shift of the past two decades has been the acceptance by parties of the centre left of the free-market nostrums of the right. Former PM Gordon Brown has recently castigated the 'risk-takers' of the Square Mile. Rewind just a few years and he was paying homage to them as he cut their taxes and removed the regulations that impeded them.

Brown had accepted the idea that free markets, operating transparently, would tend automatically towards 'equilibrium'. He can hardly be blamed for this. Everyone else had too. The period leading up the credit crunch had been marked by a reduction in volatility in financial markets: indeed it had been labelled by economists as The Great Moderation.

So while some economic indicators were flashing red – negative net savings in the US and UK, massive imbalances between the west and China – on the surface, all seemed calm. And rational economics had an explanation. The innovations of the financial markets – complex 'hedges', credit default swaps and the like – were allowing risk to be offset, and spread. Alan Greenspan, former chairman of the US Federal Reserve, was a leading exponent of this view, along with most of the economists at the IMF. All had studied macroeconomics at the finest universities – where the primacy of 'dynamic stochastic general equilibrium' had been hammered home. Inevitably shortened to DSGE, this view that evolving markets, even subject to shocks (the 'stochastic' bit) would trend towards equilibrium if enough information was available, and actors operated fairly rationally, was the orthodoxy.

In 2006, just a year and half before the crisis broke, the IMF produced a survey of the financial markets, recording that: 'There is a growing recognition that the dispersion of credit risks to a broader and more diverse group of investors ... has helped make the banking and wider financial system more resilient. The improved resilience may be seen in fewer bank failures and more consistent credit provision.' These sentences need to be etched on giant tablets in Wall Street and the City of London.

What the market-equilibrium theorists forgot was that credit relies not just on contracts, but on emotion, hope and trust. The root of the English word 'credit' is credo – Latin for 'I believe'. If the belief that debts would be repaid is shaken, the whole edifice crashes down. And, pre-2008, risk and debt had been repackaged so many times that there was no relationship between the person carrying the risk, and the person carrying the loan. 'In a securitised market,' writes economic historian Niall Ferguson in The Ascent of Money, '(just like in space) no one can hear you scream – because the interest you pay on your mortgage is ultimately going to someone who has no idea you exist.'

Kenneth Arrow, who won the 1972 Nobel Prize in economics for co-designing the best-known mathematical proof of a 'market-clearing equilibrium', now insists economics has misappropriated the insight and has been waylaid by 'an implicit omniscience. It was not that economists thought there was no uncertainty, but there was a belief that you could understand the consequences of uncertainty.'

The market-equilibrium creed was based on an assumption that proved to be fatally flawed: that enough information would be available in free markets for prices and risk to find the right level. Regulators the world over drove financial institutions to be transparent. But the truth was that many of the financial instruments were opaque to most people within the firms trading them. Indeed, some of the whizz-kids who invented them have admitted to not fully understanding them. And by the time debts had been sold across the world, the information about the debtor had been lost.

The risks posed by US 'sub-prime' mortgage-holders were not being assessed and borne by a kindly local banker, but by 22-year-old futures traders in London and Hong Kong. Capital and risk have outrun information in a 24-hour global marketplace. As Turner said, regulators did believe that 'transparency to reduce the costs of information-gathering was essential: but recognising that information imperfections might be so deep as to be unfixable, and that some forms of trading activity might be socially useless, however transparent, was beyond the ideology.'

The second ingredient in the market 'fundamentalist' creed that has been lost in the crisis is the idea of 'rational' economic actors, of Rational Economic Man (REM). The field of behavioural economics has shown that in real life people act out of fear, laziness, habit or desire to be like others – in other words, act like humans, not walking calculators. This section of the economics discipline has gone, almost overnight, from a harmless sub-branch to a major force. Its acolytes, including Akerlof and Daniel Kahneman (another one with a Nobel Prize on his shelf), have examined the ways in which people are averse to loss, poor at valuing the future and prone to following the 'herd'.

Nobody has ever really claimed that people are super-computers maximising their utility – economists have simply said REM was a useful proxy, a stylised version of humanity that was helpful in making economic models work. The trouble is that quite often the economic models did not work, precisely because these starting assumptions were wrong: a case, as The Guardian's economics editor Larry Elliott points out, of 'rubbish in, rubbish out'.

Amartya Sen – yes, he has got a Nobel Prize as well – has criticised rational choice theory as based on an absurdly narrow view of human motivation. The behavioural economist shows that even when we try to rationalise our utility, we screw it up by discounting time wrongly, miscalculating risk and giving in to short-term desires over longer-run investments: as the Hollywood actress once put it, 'nowadays, even instant gratification isn't quick enough'.

Social scientists have begun to push back against the dominance of economic thinking. A decade ago, expansionist economists such as Gary Becker at the University of Chicago were attempting to show that economic laws could explain patterns in marriage, sex and drug use. Now sociologists and anthropologists are turning their attention to economics, showing that stigma, habit, ritual, culture and character all need to be weighed in the economic balance. Rachel Kranton and Akerlof have pioneered 'identity economics', which stresses that self-perception, as a person, churchgoer or parent, hugely influences our economic decisions.

It is not a coincidence that one of the most perceptive analysts of the financial crisis, Gillian Tett, capital markets editor of the Financial Times, has a doctorate in social anthropology. 'If you come from an anthropology background, you also try and put finance in a cultural context,' she explains. 'Bankers like to imagine that money and the profit motive are as universal as gravity. They think it's basically a given and they think it's completely apersonal. And it's not. What they do in finance is all about culture and interaction.

With the toppling, or at least humbling, of the old economics, the appetite for a new economics, a new realism in economics, perhaps, is strong: this indeed is the animating purpose of the Institute for New Economic Thinking, to which Soros has pledged $50m. Nor is the new economics confined to the seminar room: Nouriel Roubini, a professor at New York University, one of the elite handful of economists who can say 'I told you so', having given his warnings before 2007, gets a cameo role in Oliver Stone's Wall Street II.

Apart from canapes at Cannes, what will the new economics consist of? The two biggest implications are the need for a greater range of ideas and approaches, and a fresh emphasis on tracking actual trends and behaviour rather than tinkering with elegant theoretical models: more diversity and more data.

'Good economics is inherently non-monolithic,' was Turner's warning to the Cambridge crew. 'Really good economic thinking will provide multiple partial insights, based on varied analytical approaches.' We don't want a new orthodoxy, but a greater respect for heterodoxy. The new big idea is that there is no big idea. In a series of recent speeches, the economist running the Bank of England, Mervyn King, has sketched a humbler set of aspirations for economic theory. 'Because the surrounding environment can affect economic decision-making, there are probably few genuinely "deep" parameters or relationships in economics,' he said in a speech to the Royal Society in March 2010. 'In contrast, in many settings in the physical sciences there are stable "rules of the game" – for instance, the laws of gravity are as good an approximation one day as the next.'

This is quite a wrench for an intellectual discipline that has aspired to the theoretical achievements of the physical scientist – that has even suffered from what one physicist, J Doyne Farmer of the Santa Fe Institute, has described as 'physics envy'.

The second implication is the need to gather actual data about what is happening and how people actually behave. Economists have historically often been quite snooty about actual data sets, but it seems certain that there will be a new reverence for real facts. The massive data-crunching power available from modern computers and software packages has to be put to better use. Economists will need a little more data and a little less dogma in the years ahead.

Economics will emerge from its own crisis with more humility and a greater openness to a wider range of theories, approaches and sources of data. It will be less scientific and therefore more realistic; less certain and therefore more reliable. Economists themselves will need to return to seeing economics as an art, as well as a science. As Keynes himself wrote, from his study at King's College, the true economist must always be a 'mathematician, historian, statesman and philosopher in some degree'.

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