Reflections on Economics from a Non-Economist

I have only been seriously interested in economics for the past two years - despite having been a student, majoring in physics, at the University of Chicago for most of the 1960s, - the home of the Chicago School, one of the most influential schools of economics in the world over the last sixty years.

My new interest was sparked in part by the work I have been doing over the past few years on complex systems, especially in market-facing complex systems involving people and services; and in part by my attempts to understand the underlying causes of the global financial crisis, the worst since the Great Depression.

What caused the crisis?  There are clearly no simple answers.  There is plenty of blame to go around.  But, while not condoning it, it is not difficult to understand the greed, temptations and short-term pressures of those in the financial industry, as well as the anti-government ideology of regulators and government officials over the last few decades.  But I have higher expectations from the research and academic communities, and continue to ask myself how so many of our best and brightest, including a number of Nobel Prize winners, could have failed to anticipate a crisis of this magnitude.

Then a few weeks ago I read an excellent article by Paul Krugman in the NY Times Magazine, “How Did Economists Get It So Wrong?,” that directly addresses this question.  In the article’s tag line, Krugman writes: “The Great Recession was the result not only of lax regulation in Washington and reckless risk-taking on Wall Street but also of faulty theorizing in academia.  Can economists learn from their mistakes?”

Professor Krugman believes that few economists, saw the financial crisis coming because of their conviction that markets are inherently stable with no possibility for the kind of catastrophic collapse that we saw last year.  He writes that “the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”  They are in love with an “idealized vision of an economy in which rational individuals interact in perfect markets . . .gussied up with fancy equations.” 

“Unfortunately,” he adds, “this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong.  They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets - especially financial markets - that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.”

Krugman’s article offers a very good tutorial about the two main 20th century schools of macroeconomics - the study of the behavior and decision-making of entire economies. 

One school was championed by British economist John Maynard Keynes.  Keynesian economics, first formulated in the 1930s during the Great Depression, advocates a predominantly private sector economy but with a large role for government and the public sector, as required - a mixed economic model.  Prof Krugman says about Keynes:

“He wanted to fix capitalism, not replace it.  But he did challenge the notion that free-market economies can function without a minder, expressing particular contempt for financial markets, which he viewed as being dominated by short-term speculation with little regard for fundamentals.  And he called for active government intervention - printing more money and, if necessary, spending heavily on public works - to fight unemployment during slumps.”

Of particular relevance to our present crisis, Keynes criticized those in financial markets whose key objective is short-term speculation in order to make as much money as possible, as opposed to investing in the real economy, that is, the economy of production capital, long-term investment and job creation.  “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”    

The other major school is neoclassical economics, first formulated in the 19th century.  It is based on the premise that given all relevant information, people will make rational decisions to maximize their utility and profits.  It believes that markets on their own will just about always achieve the right results, and that government intervention in markets is almost always a bad idea. 

Faith in neoclassical economies and its theories were shattered in the 1930s by the Great Depression.  This gave rise to the more pragmatic, mixed-model Keynesian economics, which dominated economic thinking for the next forty years or so.  But starting in the 1970s, Keynesian economics started to fall out of favor, with the return to neoclassicism led by Milton Friedman and the Chicago School, with its advocacy of a nearly universal trust in markets and a very limited, circumscribed role for government. 

This anti-Keynesian counterrevolution took hold not just in academia, but in governments around the world, especially in the UK, when Margaret Thatcher became prime minister from 1979-1990, and in the US, when Ronald Reagan became president from 1981-1989.  The mood of the times is perhaps best captured by President Reagan’s famous phrase in his first inaugural address:  “Government is not the solution to our problem; government is the problem.” 

Over the next thirty years, this phrase became ingrained in a large segment of our country, including its political leadership.  It was supported by the intellectual foundation and respectability of the Chicago School and its disciples around the world.  Alan Greenspan, the Chairman of the Federal Reserve from 1987-2006, presided over this new economic order. 

Even when the financial system was showing signs that perhaps all was not well, Greenspan continued to hold on to his beliefs that derivatives and other financial instruments were extraordinarily useful in distributing risks, thus lessening the need for regulating the increasingly complex financial markets. “Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient,” he said in 2004.  It wasn’t until October of 2008 that, in Congressional testimony, Greenspan finally acknowledged that he was partially wrong in opposing regulation. He said: “Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity - myself especially -  are in a state of shocked disbelief.”

The most recent issue of the University of Chicago Magazine examined the role of the Chicago School in the financial crisis and ensuing global recession.  Is Chicago School Thinking to Blame?, asks the article written by Chicago alumnus Michael Fitzgerald.  In a nicely balanced article, Fitzgerald writes that the old pillars of the Chicago school have a “near disdain for government.”  He cites a meeting this past May in which Professor Kevin Murphy said, talking about the remaking of General Motors: “Who in their right mind would put the government in charge of that task?”  Murphy’s remark elicited applause from the audience.  Fitzgerald then adds:

“Another crowd might have booed - say, at Columbia University, current home of economist Joseph Stiglitz, who won the 2001 Nobel Prize for work on how markets misfire.  Stiglitz threw this bomb via a Bloomberg News article last winter: ‘The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self-adjusting and the best role for government is to do nothing.’”

Fitzgerald also cites comments by Andrew Leonard in an April 29 column in Salon: “The direction in economic thought pioneered by Milton Friedman and enthusiastically adopted by Ronald Reagan and his Republican successors helped to get us where we are today - in the worst economic contraction in 50 years, characterized by an increasing concentration of wealth in the top tiers of society.”

It is important to point out that while University of Chicago economics has been best known for its Chicago School, it is also the home of some of the most eminent behavioral economists, including Richard Thaler and Steven Levitt.  Behavioral economists like Thaler and Levitt take a much more pragmatic, empirical approach to the field, including research on human, social, cognitive and emotional factors to better understand how people make economic decisions.  Perhaps there is a changing of the guard underway.

Let me offer my own comments about these cosmic battles in the field of economics - from the point of view of a non-economist.

I have been involved in complex systems throughout my professional career - first as a physics student in Chicago in the 1960s; later as a computer scientist focused on very large computer systems, including parallel supercomputing and the Internet; and now with my work in highly complex problems like Cloud Computing, Smart Cities and organizational, people-oriented systems.  I have learned that complex systems are non-linear and dynamic, with emergent, unpredictable behaviors, some potentially catastrophic.  Therefore, such systems, while not susceptible to rigid or hierarchical control, nonetheless need to be very carefully managed.

I am therefore much more comfortable with the messy Keynesian view, which seems to me more reflective of the realities of the world we live in, than with the elegant neoclassical view.  The notion that human beings always make rational financial decisions, which is at the core of most neoclassic economic models, feels naive to me.  Looking at those same humans from the point of view of evolution and natural selection, you can appreciate that primal forces like survival and reproduction will trump rational, logical behavior most of the time.  This is what behavioral economists are now studying.

We should also keep in mind that these discussions are all centered on the evolution of capitalism beyond the crisis and into the 21st century.  As Michael Fitzgerald writes in his Chicago article: “Markets are like Churchill’s view of democracy: a flawed way to run an economy, except for all the other ways we know.”  Few advocate the extremes, either state-directed socialism at one end, or laissez-faire capitalism at the other. 

Most reasonable people are working along a wide spectrum with free markets at its center.  The key question then is to find the right checks and balances between letting markets perform their magic on their own, and intervening when the interests of the larger society require it, so we can end up with a more decent and humane economic world.  As I have learned over the last two years, this is one of the most exciting challenges for us all to think through over the next several decades.  

Comments

[Steve Flinn]

In my view many of the current crop of market critics are actually falling into the same trap as the economists of the past that they criticize -- they are artificially bounding their "models," ignoring the exogenous variables as if they don't exist, but still exuding confidence that the models have reasonable predictive power.

This error in thinking is manifested by on the one hand rightly viewing markets as a complex adaptive system, but then somehow viewing government as a fixed, exogenous variable that will constitute that eminently rational "economic man" that we desire. That's foolhardy thinking. The reality is governments are also complex adaptive systems, and it cannot be predicted exactly how they will evolve any more than we can predict business cycles with any accuracy (although couched in different terms, this was Friedman's key issue).

Rather than artificially focusing just on the economy per se, and on short-term events, I think history is much more instructive when looking holistically at the dynamics of government plus economic performance over long periods of time. So throw in the experiences of the Soviet Union, Latin America, Britain, Sweden, etc., as well the USA, and over a century or more to get a sense of the relative merits of combined complex adaptive system of government plus markets.

[dblwyo]

That's as good a summary, interpretation and presentation of Krugman's article and the debates as I've read. Well done. That's both as someone with an MA in economics and who's been publishing a newsletter which covers the economic situation for almost five years now with a track record of being reasonably accurate. Forgive the ad hominem appeal to authority but at the end of the day the question is what works. The key here is understanding business cycles and the the role of financial markets therein. Unfortunately while a rich area of research the profession came up to the cusp point in the late '70s where it was recognizably dealing with a complex, dynamic system that was out of equilibrium and needed new concept,tools and math to analyze. After trying, failing and giving up they fell back on pure micro-foundations and stunted macro to fit aggregable models; which don't work. One of the pillars of Keynes thinking was that macroeconomies don't follow the simple rules of local behavior - an insight which dates back to Marshall, Robertson, et.al. Marshall in fact compare economics to a biological science. Some good, pragmatic reading is Ellis' Ahead of the Curve, Mike Lehman's Guide to Being Your Own Economist and Mankiw's Intermediate Macro text is outstanding. And a saltwater synthesis for students. My bittersweet joke about economics and its mothership is that they are the largest experimental sciences around because they use whole societies for field test; a sort of agricultural experiment station. The implicit point is that getting this right is important.
NB: on Steve's point about institutional arrangements cf. Douglas North, particularly his earlier work on Structure and Change combined with Mancur Olson's Power and Prosperity.
Keep up the good work and keep proselytizing - we are literally debating the future course of society on the planet, at least IMHO.

[Kymus Ginwala]

Having studied economics only as an engineering student with Samuelson as the textbook, I became a fan of the subject after after I read Levitt. It seems that the subject should be taught as "behaviorial economics" or no other?

[Henry Engler]

Irving,

Thanks very much for your insightful thoughts and summary of economic thinking over the years.

In this latest episode I think what is at stake is an understanding of what our financial system should and should not do -- in other words, as a key service sector of our economy, it's primary role should be to faciliate the flow of capital between those who have it and does who need it. This is a very traditional -- some might say antiquated view of modern finance -- but in essence the intermediary role of finance, bringing owners of capital with borrowers is the core of this business.

Unfortunately over time, as technology has made this intermediary role less profitable -- computers can now match buyers and sellers almost immediately -- the traditional "agency" role of financial firms, particularly among the larger ones, became less attractive.

What emerged was a diversification strategy into more speculative, or shall we say, proprietary business models. Put simply, many large institutions diversified their business models into areas where both leverage and risk was enhanced and allowing their fiduciary responsibilties to take a back seat.

I think one of the core lessons in this latest crisis is perhaps understanding why there was a Glass-Steagall Act to begin with -- the separation of banking from these more risky activities.

I also think, and would certainly welcome your thoughts, on what role you think non-financial institutions should play in lobbying Congress for better regulation of this important sector. We have heard time and again of the influence of Wall Street because of its deep pockets and ability to steer legislation to its liking.

What we do not hear, however, is how large and small non-financial firms, who ultimately bear a cost from such financial engineering, might have a voice if they acted together. Let's not forget that this current recession was manufactured largely by the business decisions on Wall Street. It's ramifications to non-financial companies has been considerable and I believe collectively they should make their case before Congress, underscoring the need for a financial system that is there for the collective good of the larger economy.

Best regards

Henry Engler

[kiramatalishah]

Small Business owners are largely forgotten. Thats why I only focus on them. I have experience several members of my family file bankruptcy due to small business failures. I also I suffered through 2 destroyed businesses due to failure however, in my failings I have learned some of the secrets to success. (Who can say they know it all?)

www.onlineuniversalwork.com

[cabernet reserve]

A year's output is the value of goods and services produced over that year, while equity values reflect the (discounted) value of all future streams of profits. If you are comparing the two, you must at least have a sense of what a decent benchmark for comparison would be.

So if, say, half of GDP originates in the corporate sector and profits are one-third of value added, the present value of profits discounted at a continuous rate of 8% amounts to 208% of GDP (=0.5x0.33/0.08). This suggest that the value of stock markets should be more than double that of annual output, not the mere 10 percent extra that the above numbers suggest. Planet Finance is not all that huge after all--at least given the numbers we are presented.