Learning lessons from the crash: how the study of economics can move on
By Rob Hayward
With economics students in Manchester in revolt and economists gathering in London to launch an alternative to the traditional teaching of economics, it is clear that there is widespread dissatisfaction with the state of the subject. Many, including the Queen, blame economists for not anticipating the financial crisis and the credit crunch. There are calls for universities to put greater emphasis on alternative economic ideas.
At the heart of mainstream macroeconomic forecasting that is used by government and central banks is the Dynamic Stochastic General Equilibrium Model (DSGE): it is dynamic because it moves through time, it is open to stochastic shocks but everything is in equilibrium and there is progression from one balanced state to another. There is little scope for financial market friction as this world is populated by representative agents.
The whole idea of equilibrium in economics is controversial. Many argue that it is a confusing concept and even if it is useful, many would argue that it is the messy adjustment from one state to another that is the most interesting. As Keynes wrote in 1923 in A Tract on Monetary Reform.
“Long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”(p. 80, Keynes 1923)
When economic conditions are calm, the DSGE model can provide a guide to the way that the economy will drift; when there is a financial storm, other tools are needed. There is no equilibrium. Fortunately, many of these tools already exist and just need to be dusted off and given more prominence: political economy and the connection between economic and political power; agency theory and the inability of thousands of diverse and remote pension funds to have any meaningful control over investment or conventional banks; the importance of information and the way that markets can freeze when it is impossible to distinguish the reliable from the unreliable (whether that is used cars or banks); the role of uncertainty in economic decision-making.
The latter is particularly important. The DSGE are Keynesian models based on sticky prices that allow fluctuations in economic activity. However, most of those gathering at the Treasury were calling for more emphasis to be placed on Keynes’s’ work on long term expectations and the role of uncertainty. Keynes, Shackle, Simon and Hayak are amongst those whom have argued that economic decision-making in many cases cannot be approximated by mathematical formula and probabilities but should be based on simple rules (heuristics in the psychologists’ jargon) that can cause consistent or extreme divergence from standard utility theory.
The Institute for New Economic Thinking are preparing a set of on-line materials that will be available for all schools and universities to use. These materials put a much greater emphasis on the history of economic thought, fundamental economic questions, the role of the government and the way that institutional features of particular markets change the way they operate. A pilot of the new materials shows that they match the slick, professional appeal of the sort of sites that have been prepared by the publishing companies to encourage students to buy textbooks. However, it is clear that it will be possible to incorporate this material into the curriculum more easily and ethically as they will not require students to purchase the textbook or an access code.