The Public Discourse recently published my article, Rethinking Economics in the Post-Crisis World. Text follows:
In the wake of the financial crisis, we need an economics with greater humility about its predictive power and an increased understanding of the complicated human beings who, when the discipline is rightly understood, lie at its center.
Apart from bankers and politicians, few groups have received as much blame for the 2008 financial crisis as economists. “Economists are the forgotten guilty men” was how Anatole Kaletsky, former economics editor and current editor-at-large for the London Times, put it earlier this year when explaining why “a bank with just $1 billion of capital [would] borrow an extra $99 billion and then buy $100 billion of speculative investments.”
Greed and sheer imprudence played a role, but so too, Kaletsky argued, did those (unnamed) economists who posited that their models proved that events such as the collapse of Lehmann Brothers in 2008 or Long Term Capital Management in 1998 were mathematically likely to happen once every billion years.
Kaletsky’s broader point was that contemporary mainstream economics had been sufficiently discredited by the financial crisis that the entire discipline required what he called an “intellectual revolution,” or it risked being dismissed as a rather suspect sub-branch of statistical analysis and mathematical modeling.
Kaletsky is hardly alone in arguing that economists need to rethink key aspects of their discipline. Though unwilling to call for a total paradigm shift, the Economist recently opined that the financial crisis has raised profound questions of coherence about two areas of economics: macro-economics and financial economics. “Few financial economists,” the Economist observed, “thought much about illiquidity or counterparty risk, for instance, because their standard models ignore it.” Likewise, the Economist commented, “Macroeconomists also had a blindspot: their standard models assumed that capital markets work perfectly.”
All this is certainly true. But the key expression to note here is “their standard models.”
Since John Maynard Keynes’s time, mainstream economics has undergone a steady process of mathematization. Anyone doubting this need only peruse their nearest copy of the American Economic Review and observe the plethora of algebra, mathematics, and abstract modeling that is central to most mainstream economists’ argumentation—regardless of whether they are committed neo-Keynesians or proponents of the efficient markets hypothesis.
Of course there is, as Nobel Prize economist Myron Scholes notes, a difference between the academic economists creating the models and the Wall Street financial engineers applying these models in the marketplace. Indeed many economists who support the efficient market hypothesis have introduced numerous qualifications—based, for example, on their willingness to import insights from other disciplines—to explain apparently irrational economic behavior by individuals and institutions.
Much of this work will bear fruit over time. It is telling, however, that there appears to be little inclination on the part of some contemporary economists to ask some searching questions about their heavy reliance on mathematical logic and argumentation. This may well be because doing so would raise some rather profound questions about the very nature of post-Keynesian economic science.
One who posed precisely these questions was the German economist Wilhelm Röpke (1899-1966). Röpke is well-known as an intellectual architect of post-war West Germany’s path from collectivist economic oblivion to market-driven economic miracle in the ten years following its economic liberalization in 1948.
Less attention, however, has been given to Röpke’s fierce critiques of the post-war Keynesian consensus. On one level, this was driven by Röpke’s belief that Keynesian policies would inexorably reduce political and economic freedom. But another source of Röpke’s angst was his conviction that Keynes and his disciples had corrupted economics as a social science.
In Röpke’s view, Keynes was “a representative of the geometric spirit of the 20th century” and “an exponent of positivistic scientism,” for whom “economics was part of a mathematical-mechanical universe.” While Röpke assigned more blame to Keynes’s disciples, he insisted that Keynes’s approach to economics had created an “old economics” and a “new economics” in which the sense of one was nonsense in the other.
According to Röpke, the neo-Keynesian new economics was inclined to reduce economics to mathematical and statistical formulas and analyses. Röpke may have been thinking of Paul Samuelson’s 1947 effort to reconfigure economics on the basis of mathematical language. For Röpke, such efforts conflated the object of economics with one tool of economic analysis. Opening a post-Keynes economic textbook, Röpke suggested, made readers wonder if they had stumbled upon a chemistry curriculum.
Mathematics is a form of language based upon symbols. Its origins lie in facilitating the study of the natural sciences. But mathematics is less adequate when it comes to analyzing things which are unquestionably real and have implications for economic life such as traditions, institutions, and values. Röpke believed that mathematical formalism addressed these realities by generally ignoring them. Economics thus became a quantitative exercise that “teems with equations in ever-increasing profusion” and focused upon developing models and patterns of aggregate behavior by whole populations.
While accepting that the new economics enhanced the use of macroeconomic concepts, Röpke complained that Keynes had effectively “declared the method of thinking in aggregates to be the only one, both now and in the long run.” Economics consequently lost sight of its essence which is not macro-aggregates but the choices of individuals and institutions. On this basis, Röpke believed that the “new economics” was destroying economics as “a ‘moral science’ in the sense that it deals with man as an intellectual and moral being.”
In Röpke’s view, sound economics certainly allows the use of mathematics to explain certain relationships that have quantitative characteristics. Nevertheless the more economics drifted in a mathematical-statistical direction, the less attention it paid to that which is un-mathematical and which does not always behave predictably—human beings. Though Röpke believed that mathematics can help describe relatively stable and uncomplicated economic relationships, he was unconvinced it could handle the full complexity and instability of actual economic life. The eventual result, Röpke stated, was not only that “with all our cleverness, we have become decidedly less wise, while knowing more and more about less and less,” but also the “dehumanization of economic science.”
Worries about these developments were not confined to convinced free marketers. One of Keynes’s earliest followers and first biographer, Sir Roy Harrod, commented that many economists’ effective replacement of attention to basic economic principles with an immersion in mathematics and aggregates had led him to conclude that “we should be better off with the old political economy.”
Reflecting upon the expression political economy might not be a bad place to start for those interested in rethinking economics’ foundations in a post-crisis era. In Adam Smith’s Wealth of Nations, the term acquires three meanings.
The first is the commonly accepted positive sense of political economy as the scientific study of “the nature and causes of the wealth of nations.” More broadly, however, Smith’s political economy also embraces the study of the interrelationship between economic theory and the political ideas and movements of a given time. Lastly, there is the sense in which Smith understood political economy in terms of what we today call economic policy: “a branch of the science of the statesman or legislator” whose objective was “more properly to enable [people] to provide such a revenue or subsistence for themselves; and . . . to supply the state or commonwealth with a revenue sufficient to the public services.”
On one level, the Wealth of Nations does involve abstract analysis of economic life. Smith carefully dissects the claims of prevailing economic thought, presents a fresh theory about how wealth is created, and elaborates on what should be done in policy-terms if wealth creation and society’s overall material enrichment are deemed desirable. But in doing so Smith also attempts to develop a powerful normative argument for an economy based around private property, free competition, and limited government over and against the mercantilist systems that dominated eighteenth-century Europe.
As the economic historian Emma Rothschild reminds us, Smith sees economic liberty as something to be approved and pursued partly because of its capacity to liberate people from many forms of oppression. For Smith, the move from mercantilist to market economies was not only a matter of following the promptings of scientific economic reasoning focused on wealth-creation. Smith also regards market economies as superior to previous economic arrangements on grounds of the greater efficiency and liberty they accorded to ever-widening numbers of people to seek human fulfillment.
Unfortunately, with some notable exceptions, this Smithian conception of political economy did not persist after Smith’s death in 1790. By John Stuart Mill’s time, political economy was being defined as studying the behavior of homo economicus, a creature whose nature is far removed from that of the more complex, not-always rational being found in Smith’s writings. From here, it was only a short step towards the reduction of much economics to a branch of applied mathematics, however valiantly this trend has been resisted by the Austrian and Public Choice schools.
Obviously there are many aspects and tools of modern economics with which we would not want to do without. But a renewed focus upon political economy in Smith’s three senses might provide a rich starting point for economists interested in the deep rethinking advocated by Kaletsky. It would maintain economics’ strong empirical-positive dimension, but blend it with a deeper appreciation for human complexity, and thus engender more humility about economics’ predictive power—a virtue all of us could use more of in our post-crisis era.