BACK in October 2008, just after the investment bank Lehman
Brothers collapsed, the International Monetary Fund unveiled its
forecasts for growth in 2009. The IMF is the global lender to national
governments; its economic pronouncements are highly respected. So what
did it predict? The US would grow 0.1% in 2009, countries in the euro
zone 0.2% and the world as a whole 2.6%. The actual outturns were
declines of 3.5%, 4.2% and 2.6% respectively.
This lamentable short-sightedness was not unique. Economists have regularly failed to predict recessions and were completely caught out by the recent financial crisis, as the Queen famously noticed.
The shortfalls of the profession are old news. All the way back in 1994, Paul Ormerod wrote a book called The Death of Economics, lamenting the failure to forecast the Japanese recession or the collapse of the Exchange Rate Mechanism, from which Britain was turfed out in 1992. “The ability of orthodox economics to understand the workings of the economy at the overall level is manifestly weak (some would say it was entirely non-existent)” Ormerod wrote.
To be fair to economists, there are two reasons why their forecasts are often likely to be wrong. The first is that humans are not inanimate objects; we change our behaviour and we watch the news. If every economist forecast a recession for 2013 and the predictions were widely publicised, businesses would cancel their investment programmes and consumers would start saving, not spending, for fear of losing their jobs. The recession would occur now, not next year.
Second, the economy is a complex mechanism with many working parts. Economists cannot run real-time experiments in the same way as scientists; operating one version of the economy with high interest rates and another with low rates, as a pharmacologist can offer one patient a new drug and another a placebo. There is no way of isolating the various factors that affect growth.
But there are more fundamental questions about the nature of the subject beyond the failure of economists to make accurate forecasts. Do economists have an accurate model of human motivation? Or do they assume that our motives are entirely mercenary?
In his excellent book, “The Assumptions Economists Make” Jonathan Schlefer tries to go back to first principles. Economists, he writes, “make simplified assumptions about our world, build imaginary economies based on those assumptions – otherwise known as models – and use them to draw practical lessons.” This is, as he admits, inevitable; the economy is too complex for any other approach to work. Simplified models can be manipulated mathematically to produce answers to economic problems. But it is easy to get carried away by the elegance of the model, and to forget the short cuts that were taken when the simplified assumptions were made.
Even the most basic assumptions of economics turn out to have exceptions. Take one law that most people can grasp – supply and demand. As supply rises, relative to demand, the price falls; while if demand rises, relative to supply, the price rises. But this is not true for housing; when prices are rising, demand increases as more people want to become homeowners. And it is not true of so-called Veblen goods, luxury items such as designer clothes whose appeal is driven by their higher price.
Modern economists are often accused of “physics envy”, filling their papers with complex equations to make them look like “real” science. But in one important sense, the subjects are similar; they can be divided into two. There is sub-atomic physics which deals with the tiny particles that make up matter, and then there is classical mechanics, which deals with the effect on bodies of forces like gravity. Marrying the two has not always been easy. Similarly, there is micro-economics which deals with how individuals and companies behave; and macroeconomics, which deals with the overall economy.
There are various ways of dividing modern economic thought, but one divide is the way they marry the micro and the macro. The Chicago/neoclassical school tends to build up from the micro level, looking at the way that rational individuals will respond to incentives. The Keynesian school sees that the aggregated response of rational individuals might have perverse outcomes, as in the paradox of thrift, so calls on the government to take action in response. The two sides have also accumulated political baggage with the Chicago school reluctant to see that governments can do nay good and the Keynesians reluctant to acknowledge that there may be a limit to the effectiveness of government intervention.
Take the idea that individuals seek to “maximise their utility”, to buy the combination of goods that best satisfies us, to smooth our consumption over our lifetimes, to balance work with leisure and so on. This led the Chicagoans to argue that workers and businesses would see through the effect of government policies and adjust their behaviour accordingly; for example, that a big budget deficit today would inevitably lead to higher taxes in a few years’ time.
This “rational expectations” approach has the benefit of treating people as thinking individuals rather than elementary particles. But the rational expectations model requires the average citizen to make complex calculations that seem, well, irrational for anyone but an economist to expect.
As Schlefer writes, these models “say that employment rises or falls because actors choose to work more when productivity is high and less when it’s low. This idea is nuts.” As Paul Krugman has quipped, the logical conclusion of this approach is that workers created the Great Depression by taking an extended holiday. This other-wordly mentality is reminiscent of Catherine the Great’s aphorism about political ideas which “work only on paper, which accepts anything, is smooth and flexible and offers no obstacles either to your imagination or your pen.”
A related criticism is that economists tend to think that most problems can be created by designing the right incentives. If there is a shortage of blood, making payments to blood donors might seem a brilliant idea. But studies show that most donors are motivated by an idea of civic duty and that a monetary reward might actually undermine their sense of altruism. A related example involves giving $100 to a participant and asking him to share it with another member of the group; the catch being that, if the donee rejects the deal, neither person gets anything. A rational donee (in economists’ terms) would be happy to accept $1, since it is better than nothing; however, a sense of fairness means that donees expect something much closer to a 50-50 split. If the donor is too mean, the donee is happy to punish him by rejecting the ideal outright.
In short, many economists seem to neglect the importance of non-financial motivation, although the school known as “behavioural economics” is starting to remedy this. People have an idea about how they should behave, derived from social norms, which may not fit the profit-maximising model. Thus employers may be reluctant to slash the wages of their employees in a recession, not least because workers will resent such cuts and lose motivation. Workers will resent a 5% wage cut at a time of zero inflation far more than a wage freeze at a time of 5% inflation, even though the effect on their standard of living will be the same.
The history of economics can be viewed rather like the regular sequence in the Peanuts cartoon strip, whereby Lucy snatches the football away every time that Charlie Brown tries to kick it. Just when economists have reached a consensus, events in the real world proved them wrong. Classical economists assumed that, left to itself, an economy would find its way back to balance; in a downturn, wages would fall and workers would price themselves back into jobs. Then came the Great Depression and the subject was changed irrevocably by John Maynard Keynes.
In the 1930s, worried citizens decided to save, not spend, their income; the resulting fall in demand caused workers to lose their jobs, causing an even greater level of caution. The “paradox of thrift” was that the rational decision to save could make the entire economy smaller. Keynes argued that, in such circumstances, governments (which can borrow more cheaply than individuals) should spend money and support demand.
After 1945, the Keynesian school assumed that with careful tweaking of government policies, the economy could be managed successfully. If there was unemployment, then the government could put its foot on the accelerator; if there was inflation, then it as time to touch the brakes. Then came the 1970s, when both inflation and unemployment were high, and economic thinking changed again.
The Keynesian consensus was overturned in the 1970s by Milton Friedman, who asserted that the apparent trade-off between joblessness and inflation was an illusion. Workers responded to Keynesian policies by demanding higher wages, so the net result was higher inflation with no reduction in unemployment. Instead, governments should focus on by controlling the money supply, which would prevent inflation from rising. But the Chicago school’s attack on Keynesianism was much broader than the monetarist label which became attached to it; indeed, it turned out that the nature of money was very hard to define and monetary targets were largely abandoned within a decade or so of their adoption.
The Chicago school was inspired as much by its dislike of big government as by its views on inflation; Keynesian policies had caused the state to play a much bigger role in the economy than it did before the Second World War. Industries were nationalised; welfare spending soared. Taxes crept higher and higher; the 95% top rate prevailing in the 1960s even inspiring an attack by the Beatles in the song Taxman (“Should 5 per cent appear too small, be thankful I don’t take it all”). The Chicagoans argued that the state was an inefficient allocator of resources; that high taxes and welfare spending had a deadening effect on incentives.
The time was right for these theories to gain adherents. The 1970s was a period of crisis; of strikes, power cuts and higher oil prices. The political tide turned; in California, a referendum, Proposition 13, heralded a revolt against high property taxes. In Britain, Mrs Thatcher came to power followed shortly after by Ronald Regan in America. It was the age of the “ations” – deregulation, liberalisation, privatisation and crucially the Great Moderation, a period of steady growth, falling inflation and lower unemployment that marked the 1990s and early 2000s.
It was a return to the thinking of the classical school and free markets appeared to deliver on their promise. In his Presidential address to the American Economic Association of 2003, Robert E Lucas (a doyen of the Chicago School) said that ““macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” Just five years later, the worst economic downturn since the 1930s occurred; a downturn from which the world is still struggling to emerge.
In response to the financial crisis, governments and central banks have tried all manner of policies; cutting taxes, slashing interest rates to historic lows; buying assets with newly-created money (the process known as quantitative easing or QE); raising government spending and then cutting it again. Which of these policies have worked and which have failed? No-one really knows.
That doesn’t stop economists from having very strong opinions on the subject and about each other. Gone are the days when President Harry Truman demanded a one-armed economist, rather than his wishy-washy advisers who said “On the one hand, this” but “On the other hand, that”. Frequent blogger Brad DeLong, writes of his opponents that they are “a bunch of rather lazy ideologues who haven't done and won't do their homework talking bullshit and trash”. John Cochrane, of the opposing school, writes that the other side is talking “absolute hogwash”.
The long-suffering public is a puzzled observer to these disputes, hoping that some bright politician will come up with a winning formula. To the historian, it is all a matter of cycles. The financial sector gets liberated, then constrained; enthusiasm for government intervention waxes, then wanes; consumers, companies and governments take on debts, then cut back. We elect politicians and appoint central bankers and expect them to manage these cycles but they cannot, any more than they can halt the progress of the seasons.
The best we can say about economics is that we know what not to do; we have plenty of modern examples from African kleptocrats to totalitarian North Korea. A functioning modern economy needs respect for property rights; a government that is able to collect taxes and offer a social safety net; banks that allow the payment system to function; markets that allow businesses to raise capital and so on. Once those essentials are in place, whether the right top tax rate is 40% or 50%, the right interest rate is 1% or 5% is largely a matter of trial and error, and of political acceptability.
Much is made of the difference between Britain’s “Anglo-Saxon” model and of France’s dirigiste approach, between the British government’s austerity drive, and France’s pro-growth approach. But for all the rhetoric, Britain’s GDP per head in 2011 was $36,090, according to the IMF, while France’s was $35,156, almost identical. Britain plans to balance its budget by 2017, and so does France.
Despite the small differences in outcome, economists will continue to debate the merits of the competing systems as vigorously as Reformation clerics debated the difference between transubstantiation and consubstantiation. Mr Schlefer’s book, which is deeper and richer than this (already long) blog note can elucidate, is a very valuable addition to the debate.
This lamentable short-sightedness was not unique. Economists have regularly failed to predict recessions and were completely caught out by the recent financial crisis, as the Queen famously noticed.
The shortfalls of the profession are old news. All the way back in 1994, Paul Ormerod wrote a book called The Death of Economics, lamenting the failure to forecast the Japanese recession or the collapse of the Exchange Rate Mechanism, from which Britain was turfed out in 1992. “The ability of orthodox economics to understand the workings of the economy at the overall level is manifestly weak (some would say it was entirely non-existent)” Ormerod wrote.
To be fair to economists, there are two reasons why their forecasts are often likely to be wrong. The first is that humans are not inanimate objects; we change our behaviour and we watch the news. If every economist forecast a recession for 2013 and the predictions were widely publicised, businesses would cancel their investment programmes and consumers would start saving, not spending, for fear of losing their jobs. The recession would occur now, not next year.
Second, the economy is a complex mechanism with many working parts. Economists cannot run real-time experiments in the same way as scientists; operating one version of the economy with high interest rates and another with low rates, as a pharmacologist can offer one patient a new drug and another a placebo. There is no way of isolating the various factors that affect growth.
But there are more fundamental questions about the nature of the subject beyond the failure of economists to make accurate forecasts. Do economists have an accurate model of human motivation? Or do they assume that our motives are entirely mercenary?
In his excellent book, “The Assumptions Economists Make” Jonathan Schlefer tries to go back to first principles. Economists, he writes, “make simplified assumptions about our world, build imaginary economies based on those assumptions – otherwise known as models – and use them to draw practical lessons.” This is, as he admits, inevitable; the economy is too complex for any other approach to work. Simplified models can be manipulated mathematically to produce answers to economic problems. But it is easy to get carried away by the elegance of the model, and to forget the short cuts that were taken when the simplified assumptions were made.
Even the most basic assumptions of economics turn out to have exceptions. Take one law that most people can grasp – supply and demand. As supply rises, relative to demand, the price falls; while if demand rises, relative to supply, the price rises. But this is not true for housing; when prices are rising, demand increases as more people want to become homeowners. And it is not true of so-called Veblen goods, luxury items such as designer clothes whose appeal is driven by their higher price.
Modern economists are often accused of “physics envy”, filling their papers with complex equations to make them look like “real” science. But in one important sense, the subjects are similar; they can be divided into two. There is sub-atomic physics which deals with the tiny particles that make up matter, and then there is classical mechanics, which deals with the effect on bodies of forces like gravity. Marrying the two has not always been easy. Similarly, there is micro-economics which deals with how individuals and companies behave; and macroeconomics, which deals with the overall economy.
There are various ways of dividing modern economic thought, but one divide is the way they marry the micro and the macro. The Chicago/neoclassical school tends to build up from the micro level, looking at the way that rational individuals will respond to incentives. The Keynesian school sees that the aggregated response of rational individuals might have perverse outcomes, as in the paradox of thrift, so calls on the government to take action in response. The two sides have also accumulated political baggage with the Chicago school reluctant to see that governments can do nay good and the Keynesians reluctant to acknowledge that there may be a limit to the effectiveness of government intervention.
Take the idea that individuals seek to “maximise their utility”, to buy the combination of goods that best satisfies us, to smooth our consumption over our lifetimes, to balance work with leisure and so on. This led the Chicagoans to argue that workers and businesses would see through the effect of government policies and adjust their behaviour accordingly; for example, that a big budget deficit today would inevitably lead to higher taxes in a few years’ time.
This “rational expectations” approach has the benefit of treating people as thinking individuals rather than elementary particles. But the rational expectations model requires the average citizen to make complex calculations that seem, well, irrational for anyone but an economist to expect.
As Schlefer writes, these models “say that employment rises or falls because actors choose to work more when productivity is high and less when it’s low. This idea is nuts.” As Paul Krugman has quipped, the logical conclusion of this approach is that workers created the Great Depression by taking an extended holiday. This other-wordly mentality is reminiscent of Catherine the Great’s aphorism about political ideas which “work only on paper, which accepts anything, is smooth and flexible and offers no obstacles either to your imagination or your pen.”
A related criticism is that economists tend to think that most problems can be created by designing the right incentives. If there is a shortage of blood, making payments to blood donors might seem a brilliant idea. But studies show that most donors are motivated by an idea of civic duty and that a monetary reward might actually undermine their sense of altruism. A related example involves giving $100 to a participant and asking him to share it with another member of the group; the catch being that, if the donee rejects the deal, neither person gets anything. A rational donee (in economists’ terms) would be happy to accept $1, since it is better than nothing; however, a sense of fairness means that donees expect something much closer to a 50-50 split. If the donor is too mean, the donee is happy to punish him by rejecting the ideal outright.
In short, many economists seem to neglect the importance of non-financial motivation, although the school known as “behavioural economics” is starting to remedy this. People have an idea about how they should behave, derived from social norms, which may not fit the profit-maximising model. Thus employers may be reluctant to slash the wages of their employees in a recession, not least because workers will resent such cuts and lose motivation. Workers will resent a 5% wage cut at a time of zero inflation far more than a wage freeze at a time of 5% inflation, even though the effect on their standard of living will be the same.
The history of economics can be viewed rather like the regular sequence in the Peanuts cartoon strip, whereby Lucy snatches the football away every time that Charlie Brown tries to kick it. Just when economists have reached a consensus, events in the real world proved them wrong. Classical economists assumed that, left to itself, an economy would find its way back to balance; in a downturn, wages would fall and workers would price themselves back into jobs. Then came the Great Depression and the subject was changed irrevocably by John Maynard Keynes.
In the 1930s, worried citizens decided to save, not spend, their income; the resulting fall in demand caused workers to lose their jobs, causing an even greater level of caution. The “paradox of thrift” was that the rational decision to save could make the entire economy smaller. Keynes argued that, in such circumstances, governments (which can borrow more cheaply than individuals) should spend money and support demand.
After 1945, the Keynesian school assumed that with careful tweaking of government policies, the economy could be managed successfully. If there was unemployment, then the government could put its foot on the accelerator; if there was inflation, then it as time to touch the brakes. Then came the 1970s, when both inflation and unemployment were high, and economic thinking changed again.
The Keynesian consensus was overturned in the 1970s by Milton Friedman, who asserted that the apparent trade-off between joblessness and inflation was an illusion. Workers responded to Keynesian policies by demanding higher wages, so the net result was higher inflation with no reduction in unemployment. Instead, governments should focus on by controlling the money supply, which would prevent inflation from rising. But the Chicago school’s attack on Keynesianism was much broader than the monetarist label which became attached to it; indeed, it turned out that the nature of money was very hard to define and monetary targets were largely abandoned within a decade or so of their adoption.
The Chicago school was inspired as much by its dislike of big government as by its views on inflation; Keynesian policies had caused the state to play a much bigger role in the economy than it did before the Second World War. Industries were nationalised; welfare spending soared. Taxes crept higher and higher; the 95% top rate prevailing in the 1960s even inspiring an attack by the Beatles in the song Taxman (“Should 5 per cent appear too small, be thankful I don’t take it all”). The Chicagoans argued that the state was an inefficient allocator of resources; that high taxes and welfare spending had a deadening effect on incentives.
The time was right for these theories to gain adherents. The 1970s was a period of crisis; of strikes, power cuts and higher oil prices. The political tide turned; in California, a referendum, Proposition 13, heralded a revolt against high property taxes. In Britain, Mrs Thatcher came to power followed shortly after by Ronald Regan in America. It was the age of the “ations” – deregulation, liberalisation, privatisation and crucially the Great Moderation, a period of steady growth, falling inflation and lower unemployment that marked the 1990s and early 2000s.
It was a return to the thinking of the classical school and free markets appeared to deliver on their promise. In his Presidential address to the American Economic Association of 2003, Robert E Lucas (a doyen of the Chicago School) said that ““macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” Just five years later, the worst economic downturn since the 1930s occurred; a downturn from which the world is still struggling to emerge.
In response to the financial crisis, governments and central banks have tried all manner of policies; cutting taxes, slashing interest rates to historic lows; buying assets with newly-created money (the process known as quantitative easing or QE); raising government spending and then cutting it again. Which of these policies have worked and which have failed? No-one really knows.
That doesn’t stop economists from having very strong opinions on the subject and about each other. Gone are the days when President Harry Truman demanded a one-armed economist, rather than his wishy-washy advisers who said “On the one hand, this” but “On the other hand, that”. Frequent blogger Brad DeLong, writes of his opponents that they are “a bunch of rather lazy ideologues who haven't done and won't do their homework talking bullshit and trash”. John Cochrane, of the opposing school, writes that the other side is talking “absolute hogwash”.
The long-suffering public is a puzzled observer to these disputes, hoping that some bright politician will come up with a winning formula. To the historian, it is all a matter of cycles. The financial sector gets liberated, then constrained; enthusiasm for government intervention waxes, then wanes; consumers, companies and governments take on debts, then cut back. We elect politicians and appoint central bankers and expect them to manage these cycles but they cannot, any more than they can halt the progress of the seasons.
The best we can say about economics is that we know what not to do; we have plenty of modern examples from African kleptocrats to totalitarian North Korea. A functioning modern economy needs respect for property rights; a government that is able to collect taxes and offer a social safety net; banks that allow the payment system to function; markets that allow businesses to raise capital and so on. Once those essentials are in place, whether the right top tax rate is 40% or 50%, the right interest rate is 1% or 5% is largely a matter of trial and error, and of political acceptability.
Much is made of the difference between Britain’s “Anglo-Saxon” model and of France’s dirigiste approach, between the British government’s austerity drive, and France’s pro-growth approach. But for all the rhetoric, Britain’s GDP per head in 2011 was $36,090, according to the IMF, while France’s was $35,156, almost identical. Britain plans to balance its budget by 2017, and so does France.
Despite the small differences in outcome, economists will continue to debate the merits of the competing systems as vigorously as Reformation clerics debated the difference between transubstantiation and consubstantiation. Mr Schlefer’s book, which is deeper and richer than this (already long) blog note can elucidate, is a very valuable addition to the debate.
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