The Future of Economics

flattr this!

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.

—————————————————–

[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.

About Steve Keen

I am a professional economist and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous debts accumulated in Australia, and our very low rate of inflation.
Bookmark the permalink.

51 Responses to The Future of Economics

  1. Pingback: Time for a Copernican revolution in economics | Pennsylvania Conservative Review

Leave a Reply