Mainstream economics was nonplussed by the financial crash of 2007-8 and the subsequent Great Recession of 2008-9. The doyen of the neoclassical school, Robert Lucas, confidently claimed back in 2003, that “the central problem of depression-prevention has been solved”. And leading Keynesian, Oliver Blanchard, now chief economist at the IMF, told us as late as in 2008 that “the state of macro is good”!
But then economic forecasting has not been the strong suit of the mainstream. In March 2001, just as the mild global economic recession of that year began, according to the Economist, 95% of US economists ruled out such a recession. Economists surveyed by the Philadelphia Reserve Bank in November 2007 forecast that the US economy would grow 2.5% in 2008 and employment would rise.
How has mainstream economics rationalised this failure to predict and what explanations has it come up with since for the causes of the Great Recession? Modern vulgar neoclassical economics starts with the assumption (given and not proven) that the market is a perfect reflection of the underlying fundamentals. Asset prices may change, often dramatically, but merely as a rational and automatic response to the arrival of new information.
The price of any given asset at any time is completely correct. It cannot be over or undervalued. It is the right price, nothing more nor less. If all public information is available immediately, it is incorporated into the price. So any movement cannot be predicted because it depends on information that is not yet known. You cannot beat the market.
Thus there is the famous (infamous) efficient market hypothesis (EMH). Financial markets always get prices right given the available information. Eugene Fama from University of Chicago first promulgated the EMT. According to Fama, there was no bubble in housing markets because consumers had all the information they needed to buy, so the price was right.
The usual economic joke about EMH is that an economist and his friend come across a hundred dollar bill lying on the ground. The friend goes to pick it up, but the economist says don’t, it’s not necessary. If it were a real bill, someone would have already picked it up.!
Paul Krugman, the leading US Keynesian economist and columnist of the New York Times, delivered a blistering attack on the failure of neoclassical economics to offer any explanation of the Great Recession (10). Krugman pronounced: “admit that financial markets fall short of perfection; admit that Keynesian economics is the best framework we have making sense of recessions and depressions. Incorporate the realities of finance into macroeconomics.”
The Chicago School responded equally sharply. John Cochrane defended the EMT. “The central prediction of the EMT is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats nor crafty hedge fund managers, nor ivory tower academics. This is the best tested proposition in all the social sciences”. Thus Cochrane tells us that the main thesis of neoclassical economics is that it can tell us nothing about the financial crash! Alternatively, the EMT tells us the bleeding obvious: namely, that if someone makes money doing an investment or activity, then other people will copy him/her and whittle away his/her returns over time (11).
For the neoclassical school, asset prices can move out of line with any reasonable expectation of future cash flows (underlying value). This might because people are prey to bursts of irrational optimism and pessimism. But it might also be because people’s willingness to take on risk varies over time and is lower in bad economic times. We just don’t know, apparently.
Cochrane criticises those who reckon economics needs some theoretical power in predicting crises. “Crying bubble is empty unless you have an operational procedure for identifying bubbles, distinguishing them from rational low risk premiums and not crying wolf too many years in a row”. In effect, Cochrane says that economists don’t know anything about bubbles. Unless you can predict when a bubble will burst, stop complaining about the EMT predicting bubbles are impossible!
Keynesian and behavioural economic theory is no better than neoclassical theory in gauging economic crises, according to Cochrane. “Are markets irrationally exuberant or irrationally depressed today? It’s hard to tell”. Behavioural economics lacks measurable indicators – but then Cochrane has none himself.
Cochrane thus dismisses any attempt to explain market volatility and collapse. For him, “it is the central prediction of free market economics, as crystallised by Hayek, that no academic, bureaucrat or regulator will ever be ably to fully explain market price movements. Nobody knows what ‘fundamental’ value is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism and central planning would have worked”.
So there we have it. The only indicator of value is the market price and no underlying value can be ascertained – this is the ultimate in vulgar economics. But note the disingenuous words “fully explain”. Apparently, we can explain ‘something’ and thus we could even measure perhaps a fundamental value for something (even if we cannot predict market prices at any one time).
For the neoclassical school, “the case for free markets was never that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse”. On this vulgar ideological assumption, Cochrane dismisses the Keynesian attack on the EMT, but also the key Keynesian policy prescription for the slump, namely fiscal stimulus.
But as Nouriel Roubini (see below) points out, “Crisis economics is the study of how and why markets fail. Much of mainstream economics, by contrast, is obsessed with showing how and why markets work – and work well.”
For Cochrane, fiscal stimulus won’t work. It can help employment for a while but only at the expense of weakening consumer demand growth eventually. Cochrane falls back on the neo-Ricardian theorem of Robert Barro. Here Cochrane and Barro are on stronger ground as current empirical evidence of previous fiscal stimulus packages suggests that fiscal multipliers in the Keynesian sense are very weak and even negative.
Cochrane argues mischievously that if you are a Keynesian you would have to support Bernie Madoff’s Ponzi scam, because it took money from rich savers and gave it to thieving spenders. It does not matter what it is spent on or how you get it as long as it spend it and not save it, according to Keynes, says Cochrane.
Paul Krugman’s attack on the failures of the neoclassical school exposed the ‘free marketers’ in Chicago who deny that any frictions or flaws exist in free markets. Krugman tells us that “economics as a field got into trouble because economists were seduced by the vision of a perfect, frictionless market system”. This is why they have nothing to say on the Great Recession. For Krugman, only Keynesian theory can provide light where there is dark.
Krugman is particularly upset that the neoclassical school has become obsessed with substituting beautiful mathematical models for truth and reality. They turned a blind eye to human irrationality, to market imperfections. Economists now have to live with messiness, the importance of irrational behaviour and imperfections in markets.
“ If the profession is to redeem itself it will have to reconcile itself to a less alluring vision – that a market economy has many virtues but it is also shot through with flaws and frictions”.
Monetarist Barry Eichengreen argues that “the development of mathematical methods designed to quantify and hedge risk encouraged commercial banks, investment banks and hedge funds to use more leverage as if the very use of mathematical models diminished the underlying risk. Mathematical rigor has the inherent tendency to conceal the weakness of models and assumptions to those who have not developed them and do not know the potential weakness of the assumptions”.
Tony Lawson argues that the fundamental failing of modern mainstream economics is, as Krugman says, not that it could not predict the recent crisis but that its obsession with mathematical modelling and formalistic models will never produce any successful predictions (12). Mainstream economic is dominated by this failed approach to economic insights.
But are the vulgar economists really saying that maths are not useful in economics. Surely there is not enough maths? Or to be more exact, there is not enough logical analysis as well as empirical data to check theory, namely there is not enough scientific method. Should we abandon the attempt to compare theories quantitatively against data?
The problem is not the maths but that the neoclassical school builds an economic model on the twin assumptions of rational expectations and individual agents. This is a false behavioural model and a false macro assumption. Human beings may not act ‘as expected’ and certainly not at an individual level. The economics profession has a duty to make that clear just as climate scientists have to do today over their models and assumptions. But mainstream economists do not – on the contrary. This shows the vulgar ideological nature of mainstream economics.
More important, the power of the aggregate and history is completely ignored. The aggregate irons out the irrational or the unexpected (even if some wrinkles remain) and history, namely empirical data and evidence, provides a degree of confidence for any theory (the goodness of fit). With the neoclassical EFM, neither part of scientific method is applied.
Carmen Reinhart and Kenneth Rogoff have taken an empirical approach with much more success in revealing the nature of capitalist crises (13). They complain that “Research on the origin of instabilities, overinvestment and subsequent slumps has been considered as an exotic sidetrack from the academic research agenda (and the curriculum of most economics programs). This was because it was incompatible with the premise of rational representative agents.”
“A deeper question is whether economists have any handle on ferreting out dangerous price bubbles. There is much literature devoted to asking whether price bubbles are possible in theory…in theory, rational investors should realise that the chain of expectations driving a bubble is illogical and therefore can never happen. Are you reassured? Back in my graduate days, I know I was. But it all depends on how market participants coordinate their expectations. In principle, prices can jump suddenly and randomly from one equilibrium to another as if driven by sunspots. Any study of stock markets shows that they are much more volatile than the standard models of theory that Cochrane relies on (14)?
David Colander sums up the relative success of the neoclassical and Keynesian schools in explaining the crisis (15): “the failure of economics is not a failure of Classical or Keynesian economics. Instead, it is a systemic failure in the entire economic profession.”
The bankruptcy of mainstream economics is partly because economic models “fail to account for the actual evolution of the real world economy. Moreover, the current academic agenda has largely crossed out research on the inherent causes of financial crises. There has also been little exploration of early indicators of systemic crisis and potential ways to prevent this malady from developing.”
Colander goes on: “systemic crisis appears like an other-worldly event that is absent from economic models. Most models by design offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory.” What we need are models capable of envisaging such ‘exceptional circumstances’. Instead, macroeconomics is confined to models of stable states that are perturbed by limited external shocks and that neglect the intrinsic boom and bust dynamics of our economic system”.
But Colander wants us economists to retreat to the idea that economics is not a really a science, but an art. “It’s not the lack of maths or too much. It is that an economy is a complex system and we don’t know how to analyse it. We must start to rely on ‘common sense”. God help us!
For Colander, the way out, is to admit bankruptcy of mainstream theory and give up on science, although he is not happy with the result. “Economists have had no choice but to abandon their standard models and to produce hand-waving common sense remedies. But common sense advice, although useful, is a poor substitute for an underlying model that can provide much-needed guidance for developing policy”.
This is what vulgar economics has concluded from the experience of the Great Recession: economic theory is useless, scientific method cannot be applied and there are no policy prescriptions that work. Yikes!