Behind the cupidity of bankers, the weakness of regulators and the myopia of macro-policy stood a set of dominant ideas about the proper relationship between the state and the market. This amounted to two propositions: that markets–and in this context financial markets–were efficiently self-regulating, and that government intervention in the macro-economy should be confined to the single point of maintaining the value of money. Provided these two conditions were satisfied, a market economy would be cyclically stable and stay close to its production frontier. Collapses of the kind we have just experienced were off the radar screen. Not surprisingly, the chief intellectual casualty of the Great Recession has been this benign view of markets. As George Soros put it, “The crisis was generated by the system itself” (New York Review of Books, 4 December 2008). The economic crisis was thus also a crisis in economics. Soros has endowed a new foundation, the Institute for New Economic Thinking (INET), which held its inaugural meeting at King’s College, Cambridge, in early April.
Notable by their absence were representatives of the “new classical economics”, centred on the universities of Chicago and Minnesota, because theirs was the paradigm that was being attacked as the explanation of our economic woes. Since the 1980s Chicago economics has been the dominant influence on the way economics is done and taught throughout the world. At its heart is the rational expectations hypothesis (REH). In its hardline version, this holds that economic agents have perfect information about all possible future states of the world, so that expectations are always fulfilled on average. A direct application of hardline REH is the efficient market hypothesis (EMH). This claims that risks are always correctly priced and that therefore financial markets need little or no regulation. Chicago economics excludes the possibility of large-scale collapses. Chicago economists have been relatively silent in the last two years, since their theories have robbed them of plausible explanations of what went wrong. Professor Robert Lucas did indeed remark that “everyone is a Keynesian in the foxhole”, without explaining that his model had no foxholes in it. The INET conference brought together the dissenting schools, of which three may be picked out.
1. The New Keynesians, sometimes known as “sticky price” Keynesians from their early work on labour markets. New Keynesian economists accept rational expectations, but drop the assumption of perfect information. At the INET conference, New Keynesian Nobel Laureate Joseph Stiglitz explained that you can have rational expectations without common knowledge. Markets are not in general efficient even when all market participants have rational expectations and all markets are competitive. Whenever risk markets are incomplete and information is imperfect, or asymmetrical, threats from so-called externalities become pervasive. Whenever there are externalities there is a scope for government intervention. Professor Mark Brunnenmeier of Princeton explained that if it’s commonly known that a bubble will burst on a certain day, the bubble will never get off the ground. But we don’t know that everyone knows. You can have a “rational” bubble if everyone knows that the price is too high, but no one knows that everyone knows that either. New Keynesians are not in general committed to “new economic thinking”, they just want their thinking to become the mainstream once more, as it was in the 1950s and 1960s.
2. The post-Keynesians drop the rational expectations hypothesis completely. They believe that uncertainty– symmetric ignorance, not asymmetric information–is what explains why markets fail. At the INET event, George Soros outlined his theory of reflexivity. There are two elements. We are fallible in our understanding of reality, and our thinking about reality changes it. His first fallibility may be called “epistemological uncertainty”, the second “ontological indeterminacy”. In the first case, the future is in principle knowable, but unknown. In the second, it is genuinely unknowable, because we create it each time we act. As a result of this double fallibility we may easily get “super bubbles”. Soros believes the one which collapsed in 2007 may have been germinating since the mid 1990s, with each rescue operation confirming a false trend.
Professors Roman Frydman and Michael Goldberg put forward their Imperfect Knowledge Economics, which enables qualitative, rather than quantitative, predictions by developing a “non standard probabilistic formalism”. As an alternative to efficient market hypothesis, Goldberg suggested a contingent market hypothesis, which recognises that change is affected by unforeseen causes and conditions. The causal processes underpinning price movements can’t be specified by any over-arching model.
A third post-Keynesian contribution came from Tony Lawson. His central point was that you need to use different kinds of models for different situations. Maths isn’t neutral: it is a particular way of structuring reality. It requires what Lawson called “event regularity”. But social reality is not typically like that. It is open, not closed, it is emergent, it is meaningful, it is “valuey”. Economics should not give up maths, but should understand the limits of its applicability to economic problems.
3. Behavioural Economics was represented at the INET conference by Nobel Laureate George Akerlof. Best known for his 1970 article, “The Market for Lemons”, a pioneering study in asymmetric information, he and coauthor Robert Shiller have dropped rational in favour of psychological (i.e. “irrational”) explanations of behaviour in their recent book, Animal Spirits. Economic agents rely not on rational calculation but on confidence, snake oil and stories to motivate their actions. Economics as a system of story-telling is common ground to the Post-Keynesians and the behaviourists. But whereas Post-Keynesians explain conventional behaviour as a rational, or at least reasonable, response to the existence of uncertainty, behaviourists argue that it is an ingrained aspect of human psychology. Behavioural economists expect that in time neuro-analysis will discover behavioural patterns as predictable as those assumed by the rational expectations hypothesis, thus confirming the scientific status of economics.
Practical people may wonder what all these professors have to tell them. The answer is: quite a lot. The common conclusion of the INET weekend was that the self-regulating market is a myth, and that various forms of government intervention are required to make the market system stable and efficient. There is as yet no agreed “new paradigm”, perhaps there will never be. But from the ferment of ideas produced by the crisis is sure to come the next generation of regulation and policy.
*Lord Skidelsky is author of a prize-winning biography of John Maynard Keynes.
Financial Services Authority (2009), The Turner Review: A regulatory response to the crisis in global banking, available at www.fsa.gov.uk
Skidelsky, Robert (2009), Keynes: The Return of the Master, Penguin Books, Ltd., UK. Smithers, Andrew (2009), Wall Street: Imperfect Markets and Inept Central Bankers, John Wiley & Sons, Ltd, UK.
©OECD Observer No 279 May 2010