Starting afresh with new economics

The following is my comment from this week’s Fund Strategy on the intellectual crisis of economics. I also wrote a news analysis piece on the first anniversary of the financial crisis.

The economic crisis of the past year has engendered a parallel crisis of economics. Economists from Nobel laureates downwards have engaged in soul searching about their profession.

Considering their record it is not surprising. Not only did they fail to predict the crisis but the vast majority argued that a Great Moderation had set in. By this they meant that the business cycle was likely to be muted as long as central banks and governments behaved prudently.

There was, as I discussed last week, a small minority of economists who argued that a crisis was imminent. But many of them were permanent doomsters while others had the causes of the crisis wrong.

Broadly speaking there are two reactions to the crisis of economics. One is to argue that the basic ideas of conventional economics are right, but its implementation should be improved. Another is that economics needs to move in a behavioural direction. Sometimes the two arguments are combined.

Those who take the first line argue that economists should take finance more seriously. They bemoan its lack of understanding of the financial markets. Others call for a more subtle understanding of risk.

Those who take the second line appear to be more radical. They argue that economics should throw out the assumption that individuals generally behave rationally. Instead they should build models based on psychological insights about how humans behave.

Neither set of criticisms is convincing. Arguably economic discussion is too obsessed with the financial markets. The crisis has largely been understood in relation to the behaviour of financial institutions while the weakness of the real economy is ignored.

Behavioural economics has also long been a mainstream approach. It got the ultimate official endorsement in 2002 when Daniel Kahneman and Vernon Smith, two exponents of the approach, were awarded the Nobel prize.

Yet behavioural economics also has serious weaknesses. Like mainstream economics it tends to attach too much importance to the financial markets. Economic crises should not simply be understood in relation to “irrational exuberance”.

Rather than tweak conventional economics it would be better to start afresh. Many insights from classical economists, such as Adam Smith and David Ricardo, remain valid, including their emphasis on the real economy and the need for economic growth.

Among the key features of the new economics more importance should be attached to production, an understanding of the indirect relationship between finance and the economy, and a more historically specific approach. Above all, economics should be seen as a system humans can reshape rather than as a natural science.