June 9, 2010

Many not so casual observers, including Queen Elizabeth II, have wondered why economists did not anticipate the recent Financial Crisis. The reality is most economists were stunned when the Crisis arrived, panicked at its blinding speed and can only recommend ‘the same old, same old’ going forward. There’s two principal reasons they didn’t see it coming. One, economists weren’t looking broadly enough at the economy to see the problems developing in the first place, and second, what evidence was available (and there was plenty) tended to be discounted or ignored for ideological reasons.

The Dismal Science

Economists, despite being highly respected and sophisticated scientists, have been on the defensive for centuries. Truthfully, the study of economics was in difficulty even before Thomas Carlyle leveled his famous ‘dismal science’ charge in 1850. Perhaps the one nagging criticism  that stings most strongly these days is the charge that economists are so infatuated with the wonder of their theory that they ignore practical reality.  

Why should the rest of us care? It’s a serious issue because economics matters. The management of a modern economy, the decisions and actions undertaken by politicians, senior policy advisors, Chairmen of the Federal Reserve Bank, business leaders, Wall Street investment bankers and others, are derived from an underlying body of economic thought; today those underpinnings rest largely on the shoulders of neoclassical economics, the foundation stone of modern capitalism.

Neoclassical Economics

Although neoclassical economics is a foundation, it is by no means a unified body of theory. However modern economists working within the neoclassical paradigm tend to agree on both a quantitative approach to economic analysis and a field of study centered on the exchange process. Neoclassicism is a mathematical system of thought concerned with market related phenomena, particularly the determination of prices, outputs, and income distributions.

This is quite a change from the past. A century ago the great Alfred Marshall could say of economics: “Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing. Thus it is on one side a study of wealth; and on the other, and more important side, a part of the study of man.” These days you’ll find a much less ambitious definition for economics, generally along the following lines: “Economics is the social science that examines how people choose to use limited or scarce resources in attempting to satisfy their unlimited wants.” …a dismal science indeed.

So, where did it all go wrong?

It all happened a long time ago, in the horse and buggy days of the Victorian era. Mid-Victorian capitalism was facing a mountain of trouble. Marxism and the rising working class movement were galloping forward on the left; on the right there was a looming – cataclysmic – breakdown of laissez faire, which eventually launched an era of vicious protectionism and hyper aggressive imperialism. According to economic historian Eric (Lord) Roll, in these confusing times there was a strong desire among classically minded economists to produce a more scientific study of economics and – ideally – find a way to side-step the theoretical challenge of Marxism once and for all.

The Marginalist Revolution of the 1870’s provided just such an opportunity. The marginal utility theories of Jevons, Manger and Walras revolutionized economic thought and with it the entirety of economic study.  Neoclassical economic theory, which emerged as a consequence of the Marginalist Revolution, introduced important new concepts into the economic lexicon, particularly a theoretical perspective that the value of goods is determined subjectively “in use” by the end-user (classical economics had assumed that goods had a hard, objective value, which was equal to the amount of labor applied in its development – the so called labor theory of value).

However, neoclassicism also introduced fundamental changes in the study of economics; its explicitly scientific approach introduced a mathematical bias into economics, which has grown significantly over the course of the past century. Unfortunately, mathematical precision has come with a hefty price tag: the Marginalist Revolution reduced the scope of modern economic analysis considerably. By drawing a ring-fence around the exchange process – forevermore the ‘legitimate’ area of economic inquiry – neoclassical economics retreated into a narrow, quantifiable definition of economics, where the larger (messy) questions were simply ‘out of bounds’. And although economists gained much greater mathematical certainty and logical consistency in adopting neoclassical principles, the Marginalist Revolution placed significant limits on the boundaries of economic study, stifling inquiry of those economic inputs that lay outside the narrow confines of the exchange process.

It was this reduction in scope, this retreat from the larger study of political economy, undertaken over a century ago that created the ‘boundary’, the theoretical wall that defines the limits of economic analysis; the presence of which leaves economists as mere spectators in critical elements of the economy. It is one of the reasons why so many of them didn’t see the storm clouds gathering in the first place and still can’t.

Economist’s counter these charges by pointing out that their market focus is reasonable, given that every meaningful economic activity that takes place outside the boundary eventually winds up in an exchange transaction, which they believe, essentially, brings the outside world to them on their (quantitative) terms.

Yes, economists do consider ‘out of boundary’ inputs, but lumber them into a broad undifferentiated category they call externalities. The practical consequences of this approach, however, distance economic analysis from the primary sources of economic activity. For instance most economics are unconcerned (and presumably unaware) of the nature of new asset classes in an emerging knowledge  economy or more importantly, just how these new assets impact economic risk assessment over time. In other words, economists are left to examine only the derivative (quantitative) effects of economic phenomena rather than their primary causes.

The Ideological Force of Monetarism

Unfortunately, this confusion between cause and effect has been greatly magnified by the late 20th century rise of Monetarism. Like many theoretical considerations in economics, monetarism was controversial and applied carefully within the profession; while outside in the world of finance and business it was swallowed whole, hook, line and sinker. Unfortunately monetarism became more than a new set of economic principals, it morphed into an ideology, a faith like belief in the purity of markets. The practical effect of market purism has been to undermine traditional checks and balances perfected over the ages to preserve the integrity of capital. As a result capital management practices collapsed across the board when it became popular to believe that markets purified the economy of all risk. This ideological sedative infected all aspects of economic decision making, undermining the culture of banking, accounting, credit rating, management and economic policy making.

Modern Economic Thought

Modern economics, despite being an important theoretical advance on the past limits economic thought in several ways. Firstly its dedicated mathematical approach limits the very process of economic analysis, for it implies strongly that anything that is not quantifiable simply doesn’t count. Secondly its constricted focus means it looks at the economy through a microscope rather than a telescope – in other words its missing the capitalist forest for the statistical trees. These reductive forces contribute to the fatal combination that blinded many economists in the run up to the Financial Crisis and are, even now, limiting our ability to put the economy back on a sound footing.

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