I was approached by Bloomberg to write an 800-word feature on “The Future of Economics” for the World Economic Forum, which starts today in Davos. Here is the Bloomberg newsletter, with my commentary on page 5.
For its entire history, macroeconomics has been dominated by mathematical models that ignore the existence of money, debt and banking, and that perceive the economy’s movement through time as transitions from one state of equilibrium to another.
At any point in history, these would be heroic assumptions. Could it really be true that models without either money or instability are provably superior at predicting the economy’s future course than models in which money and banking exist, and in which the model economy can be out of equilibrium? If not, is it the case then that such models are simply too difficult to construct—that the best we can do is pretend that the economy doesn’t have banks or money, and that it’s always in equilibrium, even if we know these assumptions are false?
Before the crisis of 2007, few non-economists even asked those questions, because there seemed to be no need to challenge what economists did. The economy, after all, was going gangbusters. Professional economists, using the very latest mathematical models of the economy, took credit for its sterling performance, and predicted more of the same for the foreseeable future.
Robert Lucas, the father of “Rational Expectations Macroeconomics”, asserted that the “macroeconomics … has succeeded. Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”[1] Ben Bernanke lauded “improved control of inflation” as the cause of “the Great Moderation”, which he described as “this welcome change in the economy.” [2] In June 2007, the OECD, guided by its macroeconomic model, opined that “the current economic situation is in many ways better than what we have experienced in years… Our central forecast remains indeed quite benign”. [3]
Then all hell broke loose, and almost five years later, it shows no signs of abating. Now non-economists are challenging what economists do, and finally realizing what a minority of dissidents within economics have long known: these assumptions are not merely heroic, they are both false and unnecessary. Money, debt and disequilibrium dynamics play crucial roles in the actual behaviour of the economy, and it is relatively easy to develop mathematical models which include money and banks, and in which the economy is always in disequilibrium. I should know: it’s what I do, and it’s why I was one of two mathematical economists who saw this crisis coming, and warned of it publicly before it happened (the other was the late Wynne Godley). [4]
For economics to have a future, it has to abandon the obsession with equilibrium modelling, and realistically incorporate money, banking and finance into macroeconomics. Both things are, as I’ve said, not hard to do.
The starting point for modelling any process in a true science is a position of disequilibrium—Newton, after all, modelled gravity by considering a falling apple, not one at rest! Economists have to abandon their fetish with “comparative statics” and instead model processes of change. Dynamics has to be the core of economic analysis, not equilibrium.
Money is also easily modelled by borrowing the basic tool of the accountant, double-entry bookkeeping. [5] Money and debt are created by bookkeeping entries, and the same paradigm can be used to derive dynamic models of the flow of money in one direction, propelling the movement of goods and financial assets in the other.
The difficulty in developing a monetary dynamic macroeconomics comes not from the tools themselves, but from the beliefs that have to be abandoned to employ them sensibly—from other assumptions that Neoclassical economists have made to “simplify” analysis that instead have made it almost impossible to understand the real world. There are enough of these to literally fill a book—to whit, my Debunking Economics [6]—but I’ll single out just three:
- “Rational” expectations—which really means assuming that everyone can accurately predict the future (and therefore avoid any calamities like the one we are in right now);
- Representative agents—which really means assuming that there’s only one person in the economy, who produces and consumes just one commodity; and
- Perceiving macroeconomics as applied microeconomics
This last false belief, and not a quest for greater realism, was the driving force behind the development of macroeconomics since WWII. It was a fool’s errand, since as physicists realized decades ago, “More Is Different”—to quote the title of a famous paper from Physics Nobel Laureate Philip Anderson. [7] Biology cannot be treated as merely applied chemistry, even though the elementary building blocks of living entities are chemicals, because properties emerge from the interactions of these chemicals that can’t be explained from the chemicals alone.
We call one of these emergent properties “Life”. We know a great deal about chemistry, but no chemist has as yet created life. The attempt to reduce macroeconomics to applied microeconomics was as futile a quest.
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[1] Robert E. Lucas, Jr, “Macroeconomic Priorities”, his 2003 Presidential Address to the American Economic Association, January 10, 2003. http://oldweb.econ.tu.ac.th/archan/chaiyuth/New%20growth%20theory%20Review%20in%20Thai/macro%20perspectives_lucas.pdf.
[2] Bernanke, B. S. (2004). Panel discussion: What Have We Learned Since October 1979? Conference on Reflections on Monetary Policy 25 Years after October 1979, St. Louis, Missouri, Federal Reserve Bank of St. Louis. http://www.federalreserve.gov/boarddocs/speeches/2004/20041008/default.htm.
[3] Cotis, J.-P. (2007). Editorial: Achieving Further Rebalancing. OECD Economic Outlook. OECD. Paris, OECD. 2007/1: 7–10. http://www.scribd.com/doc/43756565/Oecd-Economic-Outlook-2007
[4] Fortunately Godley (http://en.wikipedia.org/wiki/Wynne_Godley), has many young followers carrying on his work. For the list of economists who warned of the crisis, see Bezemer, D. J. (2009). “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models. Groningen, The Netherlands, Faculty of Economics University of Groningen. http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf.
[5] For an example of modelling a simple 19th century paper money system, see http://www.economics-ejournal.org/economics/journalarticles/2010–31.
[6] Steve Keen (2011), Debunking Economics: the naked emperor dethroned?, Pluto Press, London. http://www.amazon.com/Debunking-Economics-Revised-Expanded-Dethroned/dp/1848139926/ref=sr_1_1?s=books&ie=UTF8&qid=1326839803&sr=1–1
[7] Anderson, P. W. (1972). “More Is Different.” Science 177(4047): 393–396. http://www.andersonlocalization.com/pdf/more_is_different.pdf.
