Summertime is often called the media's silly season, for what on earth can journalists write about when Parliament is away? But the holiday season also gives us time to reflect when news - big or small – fills the computer screen leaving us with but a flickering impression of reality.

 

The Economist (17 July 2009), has used the summer break to raise the question: What is wrong with Economics? According to the weekly three major critical issues must be discussed and criticized in connection with macroeconomic theory - in particular such as it is taught by most economic institutes and therefore considered to be mainstream economics. The first critique made is that the conclusions based on this kind of macroeconomics have actively prompted the crisis in the first place. The second critique is that the magnitude of the crisis has not been understood by mainstream economists even when confronted with the facts of the situation. The last critique argues that mainstream theory has no relevant idea of "how to fix it".

 

This is undeniably quite a broadside launched against mainstream economics, but one which is backed up by statements from a number of economists. This year's Nobel prize winner, Paul Krugman, is quoted for saying "that the last 30 years development in macroeconomic theory has, at best, been spectacularly useless or, at worst, directly   

harmful". The Economist does distance itself somewhat from this rather bombastic assertion by concluding on a more sober note, that most mainstream economists knew only too well that their models did not represent the whole truth about recent macroeconomic development. However, the weekly does go on to say that therefore they should have voiced their reservations more loudly about their own analyses, for they have led directly to the comprehensive deregulation of both national and international financial markets experienced over the last 30 years.

 

There is one undisputed yet erroneous assumption which pretty well all modern financial theory has built on up to now: that financial markets function so perfectly well that, if only regulations were lifted, markets themselves would find the socially correct price for trading in financial and 'real' assets. Hence, a number of financial regulations have been lifted to make the financial markets and institutions left to look after themselves. As stated in the conclusion of many mainstream economic textbooks, "no-one knows better than the market itself, because if they did know better, they could earn a fortune!" Quite so, this is precisely what financial managers with specialized knowledge have been doing for years - with catastrophic consequences for less-well informed citizens and the real economy. The politicians made an unforgivable mistake by swallowing this utterly plausible argument wholesale, one that turned out to be totally flawed.

 

On top of this, the central bank managers made yet another mistake when they accepted another of the mainstream economic theories which assumes a close correlation between the development of the money supply and consumer prices. The central bank governors pursued their interest rate policy with one-track minds - inflation targeting so-called. Whether you take American, European, or British central bank governors, they all sang the same song way into 2007, "we don't see any imminent problems" as the annual increase in consumer prices is close to 2 percentages. Any thought that annual price increases of 20-30 percentages on the share and property market should create a macro-economic imbalance was simply not mentioned in the mainstream textbooks. Central banks might have been misled by the mainstream macro-models without any fully integrated financial sector whatsoever. In fact, due to its equilibrium assumptions mainstream macroeconomic theory is alarmingly underdeveloped with regard to the importance of the financial sector. For instance, one textbook in advanced macroeconomics used at University of Copenhagen states that "most macroeconomists assume that money plays no real economic role in the long run".

 

So what can alleviate the crisis? As The Economist points out, mainstream theory has nothing to offer at the moment - apart from letting the market prevail. Economic policy is ineffective according to Nobel Prize winners Robert Lucas, Finn Kydland, John Prescott. Hence, the best answer emanating from this macroeconomic theory developed over the last 30 years is "no policy" - something which Paul Krugman, for example, opposes vehemently. Mainstream macroeconomic theory has but a single reason for the persistent deviation from full employment, and that is a lack of wage and price flexibility. If only monetary wages were fully flexible then persistent unemployment would disappear. The reason for the prolonged nature of the actual crisis, mainstream economists say, must be the sluggishness in price and wage adjustment caused by market imperfections stemming from remaining political regulation of the labour market (minimum wage, generous unemployment benefit, high tax rates or too much market power of the trade unions). So, mainstream macroeconomists are not just talking about political ineffectiveness, but about failures of governmental economic policy which is to blame for these market imperfections. Ergo, best policy is to go on deregulating and cutting back the welfare state which is what lies behind The Economist's assertion that mainstream economists have no serious idea of "how to fix it (the crisis)".

Fortunately, responsible politicians did not listen to mainstream economists. Had they done so, there would have been a risk of the on-going crisis turning into a prolonged recession like the one of the early 1930s. At that time mainstream economics was also dominated by equilibrium theory, which was discarded by Franklin D. Roosevelt when he introduced his New Deal policy. Shortly, the English economist, John Maynard Keynes developed a new macro-economic understanding of why an unregulated market system will be bogged down in high unemployment at regular intervals. This theory became mainstream from the late 1930s up till sometime in the 1970s, when it was put into cold storage under pressure from neo-liberal political currents in the USA ( flourishing in the Reagan era) and in Great Britain (under Margaret Thatcher). It was no longer politically correct to conclude that the state - or the central bank for that matter - could intervene and play an active political role in limiting the scale of unemployment. Equilibrium economics became once again mainstream under the brands of ‘new-classical economics’ and ‘real business cycle theory’.

 

But political correctness took on a new turn in the USA in the aftermath of the attack on the World Trade Centre in 2001 and in Europe after the election of a succession of social democratic governments (Great Britain, Germany, Spain, and Scandinavia). This provided the state with the opportunity - ideologically speaking - to play a bigger role, not only in combating terror but in economic policy as well. This is how fiscal policy, which allocates state income and expenditure, was assigned a more active role than before. This concept of the state being able to act as a counterweight to instability in the private market economy was put to the test in the aftermath of the 2001-event with apparently outstanding success. Economic growth was re-established not least against a background of an impressive interest rate cut, but which actually contained the seeds of the present economic crisis. A crisis, which politicians - for want of a relevant economic theory – have sought to master in most countries by setting an even lower interest rate and even larger public sector budget deficits. To which The Economist asks, if such an expansionary policy - even if it sets the economic wheels rolling again - simply lays the foundations of the next economic crisis?

 

This question cannot be answered for self-evident reasons until the economic textbooks have been rewritten. They may then be in a better position than today to come up with relevant answers about what the determining factors of macro-economic development might be in the future. The macro-economists must descend from their theoretical ivory towers and understand that economics is a social science and their task is to explain the ever changing "real” world, which the financial crisis, if anything, has demonstrated.

 

 

 

 

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