6 February 2009

Economists are the forgotten guilty men ~ Anatole Kaletsky

hese two theories - called “rational expectations” and “the efficient market hypothesis” - essentially assume that the economy is a predictable, comprehensible machine with a defined set of instructions. That in itself may seem preposterous, but the theory goes farther and assumes that every “rational” participant in economic life knows these instructions and assumes that everyone else knows them too. To make matters worse, it is then applied to financial markets so that any economically inexplicable gyrations that do occur are explained a way as purely random, like tossing a coin. This leads to the conclusion that financial prices, although they may fluctuate randomly in the short term, are highly predictable in the long term, in the same way that the takings of a casino are.

Why did these implausible theories defeat more realistic ones? Partly it was the ideological mood of the 1980s and partly the ease with which rational expectations theories could be turned into mathematical models. By using these models, bankers and policymakers could be “blinded with science” - and even better from the standpoint of academic economists, their discipline could be elevated to the scientific status of physics.

The impact on both economics and public policy has been dire. The obvious effect has been the reckless behaviour of bankers and regulators, who were told by reputable-sounding economists that the bankruptcy of Lehman Brothers could be expected only once every billion years or so even though similarly “impossible” events - such as the collapse of the LTCM hedge fund and the 1987 stock market crash - had occurred twice in the previous 15 years.

Equally pernicious has been the stifling of intellectual debate among academic economists, who have spent the past 20 years arguing about the properties of their imaginary mathematical models rather than the behaviour of the real economy these models were supposed to describe.

The question, not only for professional economists but for all those in politics and business who have relied on these ideas, is what will happen to economics now that its fundamental assumptions and mathematical models have been totally discredited by events.

There seem to be only two options. Either the subject has to be abandoned as an academic discipline and becomes a mere appendage of the collection and analysis of statistics. Or it must undergo an intellectual revolution.

The prevailing academic orthodoxy has to be recognised as a blind alley. Economics will have to revert to a genuine competition between diverse intellectual approaches - such as behavioural psychology, sociology, control engineering and the mathematics of chaos theory.

So economics is on the brink of a paradigm shift. We are where astronomy was when Copernicus realised that the Earth revolves around the Sun. The academic economics of the past 20 years is comparable to pre-Copernican astronomy, with its mysterious heavenly cogs, epicycles and wheels within wheels or maybe even astrology, with its faith in star signs.

The academic Establishment will resist such a shift, as it always does. But luckily economists understand incentives. They should now be given a clear choice: embrace new ideas or return their public funding and Nobel prizes, alongside the bankers' bonuses they justified and inspired.

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