The Economists' Bailout

Early on, Americans blamed rapacious bankers, reckless borrowers, lax regulators, compro­mised politicians, and greedy CEOs for the financial crisis. Now, with the recession midway through its second year, the onus is spreading to economists. The financial crisis has destroyed the fiction that economics is a science, contends Moisés Naím, ­editor ­in chief of Foreign Policy. The profession needs an intellectual ­bailout.

According to one economist, the problem with his discipline is that false theories developed a stranglehold on academia.

First to go should be the perni­cious concepts of “rational” investors and “efficient” markets, says economist Anatole Kaletsky, editor at large of the ­London-­based Times. On the backs of these two adjectives, “aca­demic economists erected an enormous scaffolding of theoretical models, regulatory prescriptions, and computer simula­tions which allowed the practical bankers and politicians to build the towers of bad debt and bad policy” that have come thundering down. While it was always known that not every market was perfectly efficient, failures were chalked up to such problems as a lack of competition or tax distor­tions. Absent proof of collusion, fraud, tax distortions, or other anom­alies, it was taken as axiomatic that competitive markets would deliver rational and efficient ­results.

The scandal of modern econ­omics, according to Kaletsky, is that false theories developed a stranglehold on academia. The rational expectations hypothesis asserted that a market economy should be viewed as a mechanical system governed by clearly defined economic laws, immut­able and universally understood. It allowed the con­struction of precise mathematical models for economic behavior. The efficient market hypothesis ex­plained that financial markets, because they were populated by a multitude of rational and competitive players, would always reflect available information in the most accurate possible way. Such theories flourished because they “justified whatever outcomes the markets happened to decree—­laissez-­faire ideology, big salaries for top executives, and billions in bonuses for traders.”

Kaletsky argues that economics must be revolutionized or aban­doned as an academic discipline. Instead of using oversim­pli­fied assumptions to create mathematical models that pur­port to reach precise numerical conclusions, economics must return to its roots in the all-too-human imprecision of the real ­world.

Economic giants such as Adam Smith, David Ricardo, and John Maynard Keynes could nev­er land a university job today, he writes. They failed to produce precise econometric forecasts. Their analytical tools were mere words, not mathematics. They studied real human behavior in markets that actually existed and drew insights from history, psychology, and ­sociology.

Harvard political scientist Harvey Mansfield writes that while individual economists are generally sober and cau­tious, when they get together they give way to boyish, irrational exuberance over the accomplishments and prospects of their discipline. Yet they “failed to predict a crisis that has wiped out nearly half the wealth invested in the stock market and elsewhere.”

Economics, like all sciences, per­haps, aims at the reduction and control of risk. Who among us, asks Mansfield, now believes that risk has been diminished and control over our lives vindicated by ­economics?

THE SOURCES: “Missing Links: An Intellectual Bailout” by Moisés Naím, in Foreign Policy, Jan.–Feb. 2009. “Goodbye, Homo Economicus” by Anatole Kaletsky, in Prospect, April 2009.  “A Question for the Economists” by Harvey Mansfield, in The Weekly Standard, April 13, 2009.

Photo courtesy of The University of Salford Press Office