The most important thing that the global financial crisis has done for economic theory is to show that neoclassical economics is not only wrong – it’s dangerous.
Neoclassical economics has contributed directly to the crisis by promoting a faith in the innate stability of a market economy, a false faith that has actually increased the financial system’s tendency to instability. Touting the dubious claim that all instability in the system can be traced to market interventions rather than the market itself, neoclassical economics championed the deregulation of finance and the dramatic increase in income inequality. Its equilibrium vision of the functioning of finance markets has led to the development of the very products that are now threatening the existence of capitalism itself.
At the same time, neoclassical economics was distracting economists from the obvious signs of an impending crisis: the asset market bubbles and the mounting private debt that was financing them. Paradoxically, as capitalism’s “perfect storm” began to gather, neoclassical macroeconomists were absorbed in smug self-congratulation over their apparent success in taming inflation and the trade cycle, a feat they like to call the “Great Moderation.” In 2004 Ben Bernanke, now the Chairman of the Federal Reserve, said:
“The low-inflation era of the past two decades has seen not only significant improvements in economic growth and productivity but also a marked reduction in economic volatility, … a phenomenon that has been dubbed the ‘Great Moderation.’ Recessions have become less frequent and milder, and … volatility in output and employment has declined significantly … The sources of the Great Moderation remain somewhat controversial, but … there is evidence for the view that improved control of inflation has contributed in important measure to this welcome change in the economy …”
It is all very well to have economic theory dominated by an innate faith in the stability of markets when those markets are forever gaining – either by growth in the physical economy or rising prices in the asset markets. In those circumstances, neoclassical dissenters who align themselves with the post-autistic economics movement (paecon) can rail about the logical inconsistencies in mainstream economics all they want. During the good times, the government, business community and most of the public ignore their concerns because they don’t appear to matter. Dissenters are, in fact, often dismissed as critics of capitalism or proponents of socialism because it seems to neoclassical economists – and to those outside academia – that they are attacking capitalism itself and not economic theory. “You think markets are unstable? Shame on you!”
The story is entirely different when asset markets crash beneath a mountain of debt, and the ensuing fallout threatens to take the physical economy with it. Now, in light of the global financial crisis, it should be possible to appreciate the critics of neoclassical economics for what we really are: critics of a fundamentally false theory and tentative developers of a new, realistic analysis of the nature of capitalism – warts and all.
Given the present severity of the crisis, the urgent need to reform economic theory and education should be obvious. But though the “irresistible force” of the global financial crisis is indeed immense, so is the inertia of the “immovable object” of economic belief.
Despite the ways in which the crisis has affected our everyday world, academic neoclassical economists will continue to teach from the same textbooks in 2009 and 2010 that they used in 2008 and earlier (laziness will be as much a factor here as ideological commitment). Rebel economists will be emboldened enough to proclaim, “I told you so” in their non-core subjects, but in the core micro, macro and finance units it will be business as usual. Many undergraduate economics students in the coming years will sit gobsmacked as their lecturers recite textbook theory as if nothing extraordinarily different is taking place in the real economy.
The same will happen in the academic journals. The editors of the American Economic Review and the Economic Journal are unlikely to convert to post-Keynesian economics, evolutionary economics or econophysics anytime soon, let alone be replaced by editors who are already practitioners of such unorthodox thought. The battle against entrenched neoclassical economic orthodoxy within academia promises to be long and hard, even though the discipline’s failure is glaringly obvious to those in the outside world.
It will be a difficult struggle mainly because neoclassical economists are genuinely naive about their role in causing the crisis. Instead they will attribute any failures to poor regulation and government intervention in the markets. Any aspects of the crisis that cannot be solely attributed to these causes will be covered by embellishing basic neoclassical theory. The subprimes scam, for example, will be easily explained by the theory of asymmetric information.
Neoclassical economists seriously believe that far from the crisis calling for the abolition of their discipline, it actually calls for the theory to be more widely propagated. The idea that this financial crisis could require any change in what they do, let alone necessitate the rejection of neoclassical theory altogether, will strike them as completely incredible.
In this sense, they are like the Maxwellian physicists about whom Max Planck remarked, “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”
But physics is charmed in comparison to economics, since it is inherently an empirical discipline. Planck’s confidence that a new generation would take the place of the old was therefore well founded. But in economics, the neoclassical old guard will not only resist change, they may – if economic circumstances stabilize – give rise to a new generation that faithfully accepts their interpretation of the crisis. That’s exactly how the Keynesian counterrevolution came about, and it’s the reason we are facing this crisis with an even more rabid neoclassicism than that which confronted Keynes in the 1930s.
It is crucial that this crisis galvanizes student protest against the lack of debate within academic economics. Dissident academic economists will be unable to effect change without student bodies exerting massive pressure on the old guard. I was one of many students who protested against neoclassical economics in the early 1970s at Sydney University and campaigned for the establishment of a Political Economy Department. Were it not for student protests, the non-neoclassical staff at Sydney University would have had no chance at all of changing that department.
And though we won that battle at Sydney University, we lost the war. The economic downturn of the mid-1970s allowed for the defeat of what Joan Robinson aptly called “Bastard Keynesianism” and ushered in its replacement: Friedman’s “monetarism.” Our protests were also wrongly characterized as being essentially anti-capitalist. Though there were indeed many anti-capitalists within the political economy movement, the real target of student protest was a poor theory of how capitalism operates, not capitalism itself.
Similar observations can be made about the paecon movement, which began when student dissatisfaction with neoclassical economics in France spilled and ignited a worldwide movement. Though the movement’s initial impact was substantial, neoclassical dominance of economic pedagogy continued unabated. paecon persisted, but its relevance to the real economy wasn’t appreciated because that economy appeared to be booming. Now that the global economy is in crisis, students need to regroup and pounce – they need to apply massive pressure in order to ensure that real change to economic pedagogy occurs.
Pressure from business groups is also essential. To some degree, these groups naively believe that those who herald the virtues of the market system and argue on the side of business in disputes over income distribution are their allies while market critics are their enemies. I hope that this financial catastrophe will convince the business community that its true friends in the academy are those who understand the market system, whether they criticize or praise it. As much as we need students to revolt over the teaching of economics, we need business to bring pressure on academic economics departments to revise their curricula.
The pedagogic pressure from students and the wider community has to be matched by the accelerated development of alternatives to neoclassical economics. Though we know much more today about the innate flaws in neoclassical thought than was known at the time of the Great Depression, the development of an alternative is still a long way off. There are multiple alternative schools of thought extant – from post-Keynesian economics to evolutionary economics to behavioral economics to econophysics – but they’re not yet developed to the point of providing a fully fledged alternative to neoclassical economics.
But the fact that we do not yet have a viable alternative shouldn’t dissuade us from dispensing completely with the neoclassical approach. We have to accept a period of turmoil and uncertainty in order to overcome flawed theory. Hanging on to parts of a failed paradigm simply because it has components that other schools lack would be a tragic mistake. It is from precisely such relics that a neoclassical vision could once again rise when (or if) the market economy emerges from this crisis.
We need a rejection of neoclassical microeconomics in its entirety. An all-encompassing rejection was precisely what Keynes’s revolution was missing. While Keynes tried to overthrow macroeconomic shibboleths like Say’s Law, he continued to accept microeconomic concepts (such as perfect competition) and their unjustified projection into macroeconomic areas. He believed, for example, that the marginal productivity theory of income distribution, which is fundamentally a micro concept, applied at the macro level of wage determination.
From this failure to expunge the microeconomic foundations of neoclassical economics from post-Great Depression theory arose the “microfoundations of macroeconomics” debate, which ultimately led to a model in which the economy is viewed as a single utility-maximizing individual blessed with perfect knowledge of the future.
Fortunately, behavioral economics provides the beginnings of an alternative vision of how individuals operate in a market environment, while multi-agent modeling and network theory give us foundations for understanding group dynamics in a complex society. These approaches explicitly emphasize what neoclassical economics has evaded: that aggregation of heterogeneous individuals results in emergent properties of the group, which cannot be reduced to the behavior of any “representative individual.” These approaches should replace neoclassical microeconomics completely.
The changes to economic theory beyond the micro level involve a complete recanting of the neoclassical vision. The vital first step here is to abandon the obsession with equilibrium.
The fallacy that dynamic processes must be modeled as if the system is in continuous equilibrium is probably the most important reason for the intellectual failure of neoclassical economics. Mathematics, science and engineering developed tools long ago to model outside of equilibrium processes. This dynamic approach to thinking about the economy should become second nature to economists.
An essential pedagogic step here is to relegate the teaching of mathematical methods in economics to mathematics departments. Any mathematical training in economics, if it occurs at all, should come after students have at the very least completed course work in basic calculus, algebra and differential equations (the last being one about which most economists are woefully ignorant). This simultaneously explains why neoclassical economists obsess too much about proofs and why non-neoclassical economists, like those in the Circuit School, experience such difficulties in translating excellent verbal ideas about credit creation into coherent dynamic models of a monetary production economy.
Neoclassical economics has effectively insulated itself from the great advances made in science and engineering over the last 40 years. This self-imposed isolation must come to an end. For while the concepts of neoclassical economics appear difficult, they are actually quaint in comparison to the sophistication evident in today’s mathematics, engineering, computing, evolutionary biology and physics. In order to advance, economics must humbly submit to learning from disciplines that it has studiously ignored for so long. Some researchers in outside fields have called for the wholesale replacement of standard economics curricula, using at least the building blocks of modern thought inherent in other disciplines. In light of the catastrophe economists have visited upon the real world, those calls carry substantial weight.
In response to a paper critical of trends in econophysics, for example, physicist Joe McCauley responded that, though some of the objections were valid, the problems in economics proper were far worse. He suggested that: “… the economists revise their curriculum and require that the following topics be taught: calculus through the advanced level, ordinary differential equations (including advanced), partial differential equations (including Green functions), classical mechanics through modern nonlinear dynamics, statistical physics, stochastic processes (including solving Smoluchowski and Fokker-Planck equations), computer programming (C, Pascal, etc.) and, for complexity, cell biology. Time for such classes can be obtained in part by eliminating microeconomics and macroeconomics classes from the curriculum. The students will then face a much harder curriculum and those who survive will come out ahead. So might society as a whole.”
The economic theory that should eventually emerge from the rejection of neoclassical economics and the basic adoption of dynamic methods will come much closer to meeting Alfred Marshall’s dictum that “the Mecca of the economist lies in economic biology rather than in economic dynamics.” As Thorstein Veblen correctly surmised over a century ago, the failure of economics to become an evolutionary science is the product of the optimizing framework of the underlying paradigm, which is inherently antithetical to the process of evolutionary change. This is the primary reason why the neoclassical mantra that the economy must be perceived as the outcome of the decisions of utility-maximizing individuals must be squarely rejected.
Economics also has to become a fundamentally monetary discipline – from the consideration of how individuals make market decisions through to our understanding of macroeconomics. The myth of “the money illusion” (which can only be true in a world without debt) has to be immediately dispelled, while our macroeconomics have to reflect a monetary economy in which nominal magnitudes matter, precisely because they are the link between the value of current output and the financing of accumulated debt. The dangers of excessive debt and deflation simply cannot be comprehended from a neoclassical perspective.
The discipline must also become fundamentally empirical, in contrast to the faux empiricism of econometrics. By this I mean basing itself on the economic and financial data first and foremost – the collection and interpretation of which has been the hallmark of contributions by econophysicists – and by respecting economic history, a topic that has been systematically expunged from economics departments around the world. It, along with a non-Whig approach to the history of economic thought, should be restored to the economics curriculum. Important names that are conspicuously absent from modern economics courses – Karl Marx, Thorstein Veblen, John Maynard Keynes, Irving Fisher, Michal Kalecki, Joseph Schumpeter, Hyman Minsky, Piero Sraffa and Richard Goodwin – should echo throughout the halls of universities around the world.
Steve Keen is the Associate Professor of Economics and Finance at the University of Western Sydney and the author of Debunking Economics. Check out his blogs at debunkingeconomics.com and debtdeflation.com/blogs.