Self-righting markets and other shibboleths

The global financial crisis has revealed major weaknesses in conventional economics. Economists will need to face up to these if their discipline is to recover its reputation and relevance.

Many of these shortcomings arise from the belief that markets and economies are inherently stable. That is, the market system is self-righting. It's usually in ''equilibrium'' (balance) and, should some external event push it into disequilibrium, this sets off a process that returns the system to equilibrium quickly and easily.

Economists hold to this belief for various reasons. One is that it makes economics nice and neat, providing simple explanations and predictions (the predictions may not be very accurate, but who's counting?). It makes it easier to conduct economic analysis using maths rather than words, which makes academic economists feel scientific and intellectually high-powered.

But the belief in self-righting markets also fits nicely with the political philosophy of libertarianism - the supremacy of freedom of the individual, the minimal need for governments and taxes.

And it suits business interests, who want maximum freedom to make a buck in any way they see fit.

One of the many implications of the belief that markets are inherently stable is that there's no such thing as a business cycle. The economy is almost always at full employment because supply creates its own demand.

But surely, you may object, the whole discipline of macroeconomics is the study of how to stabilise the economy as it moves through the business cycle. Well, it used to be. Increasingly, however, it's been about trying to prove that governments are incapable of influencing the course of the macro economy and that what seems to be a cycle of deficient or excessive demand isn't really.

One notion is that the ups and downs are caused by people taking a bit of time to adjust to new advances in technology. Another is that unemployment is voluntary. Workers are so well off that when they consider the wage rates they're being offered are insufficient they take an unpaid holiday.

To the extent that some academic economists still believe in the existence of the business cycle, they study the concrete factors that cause it - the ups and downs in business inventories, for instance - not the more ephemeral, psychological factors such as optimism and pessimism, greed and fear.

But if the business cycle doesn't exist then it surely must also be the case that sharemarket crashes and financial crises don't happen.

Once again, you may think that the evidence of crashes and crises is readily apparent from the historical record. It is, but the dominant stream in academic economics has become adept at ignoring it.

Although on the one hand the study of economic history has fallen out of fashion in university economics courses, on the other some academics have sought to prove that the Dutch Tulip Bubble of 1624 and the South Sea Bubble of 1720 were really examples of wrong-headed government intervention in markets, not market failure.

Do you see what all this means? It means academic economists tend to focus their attention on what happens when everything is going right - when markets are in equilibrium - and give little thought to the circumstances in which things could go wrong.

Now do you see why so few economists could see the global financial crisis coming? They didn't see it because they weren't looking for it.

(Even those who now contrive to believe that the problems we've seen in the past year and more were caused by faulty government intervention in markets, rather than any fault on the part of markets themselves, weren't warning that these interventions could lead to disaster. No, markets were getting their way and the anti-government brigade was content that all would be well.)

This is the charge made by David Colander, of Middlebury College in Vermont, and six other American and European academics in a much-quoted paper, The Financial Crisis and the Systemic Failure of Academic Economics, that's come to be known as the Dahlem report.

One implication of this is that, despite its pretensions to the contrary, economics isn't very scientific. Like the rest of us, economists suffer from what psychologists call ''confirmation bias'' - they look for evidence that confirms their prior beliefs.

They tend to interpret evidence in ways that favour their beliefs. They remember evidence that goes their way and forget evidence that doesn't. We all do this, it's part of our lack of rationality - and economists are just as irrational as the rest of us.

In contrast, the scientific method involves trying to falsify your hypothesis, not confirm it.

Milton Friedman argued in a famous paper that it didn't matter if a model was built on unrealistic assumptions (such as human rationality). What mattered was whether the model led to accurate predictions.

You wouldn't believe it, but there are still economists who draw comfort from this pragmatic doctrine. You say economics produces inaccurate predictions? Not that I've ever noticed, it doesn't.

Another consequence of the assumption that markets always work well is that economists put a lot of effort into arguing for the removal of small inefficiencies caused by government intervention - restrictive shopping hours, for instance - while academics do little to study or help prevent the gross inefficiencies caused by having thousands of workers lying idle as a result of financial crises and recessions.

Now, economists are terribly defensive people and they'll be able to think of exceptions to every charge I've made. It's true that not all academic economists doubt the existence of the business cycle or asset-price bubbles. There are even some who study our lack of rationality. And economic practitioners, including econocrats, don't all share the extreme views of the academics.

But what I've described is the dominant view prevailing among academic economists. Behavioural economists, for instance, are a fringe minority. And it's surprising how much influence the doctrines of the high priests have on the beliefs and behaviour of practitioners.

The trouble with economics is that the conventional theory has come adrift from the real world and taken on a life of its own. The answer is for academic economics to become less theory-driven and more empirical.

There needs to be a lot more emphasis on testing theories against empirical evidence - and looking for falsification - and on simply seeking to identify empirical relationships and regularities.

With enough of these, economists could search for new theories to explain those relationships. But we also need more study of how markets and economies come unstuck.

Ross Gittins is the Herald's Economics Editor.
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