Neo-classical economics led us into a cul-de-sac. Now we must find a way out

By Ian Fraser

Published: QFINANCE

Date: March 9th, 2012

The “Washington Consensus” ought to have been consigned to the scrapheap of history by now. The consensus – also known as neo-classical economics – supported global macroeconomic policy including financial (de)regulation and central bank policy, for most of the past three decades. But the Panglossian assumptions about financial markets that underpinned it ultimately gave rise to the banking and financial collapses of 2007-09 from which many economies have yet to recover.

So why do so many people – including global leaders who still believe the best way to promote recovery in massively over-leveraged and bankrupt economies is to impose strict austerity and inject further emergency leverage – adhere to this intellectual wrong-headedness?

It seems that a great many people business and finance, the media, economics faculties, politics, and government just want an easy life.

Most are thinking about the short term, towards the next election or annual results presentation, and a change of ‘religion’ might imply deeper short-term pain. At a country level, abandoning one faith and replacing it with another traditionally requires revolutions and bloody civil wars. Perhaps the powers that be just feel safer thinking along similar lines as before (albeit with a bit of austerity and fiscal rectitude thrown in), in the hope that things will just keep chugging along until they retire?

The BBC documentary maker Adam Curtis summed up the situation in a recent blog called “The Curse of TINA”:

“Nobody – not just from the left, but from anywhere – has come forward and tried to grab the public imagination with a vision of a different way to organize and manage society. It’s a bit odd. [Why do] we find it impossible to imagine any alternative; why have we become so possessed by the ideology of our age that we cannot think outside it?”

Professor Richard Werner, director of the Centre for Banking, Finance and Sustainable Development at the University of Southampton, described the bizarre intellectual contortions 21st century economists must go through in a viewpoint published in the first edition of QFINANCE in October 2009. Werner wrote:

“Economists are obliged to pretend that the emperor is not naked, that markets clear, that there is equilibrium, and, even more preposterous, that markets deliver the best possible outcome for society.”

I won’t summarize Professor Werner’s entire piece here, but he concludes with several entirely workable recommendations including that private sector banks should be relieved of their credit creation responsibilities. We need more people like Werner to help us identify the big weaknesses in neo-classical economics (sometimes also known as neo-liberalism) and to suggest workable alternatives.

So when did the rot set in?

Russell Napier, a consultant for CLSA Asia Pacific Markets and founder of Edinburgh Business School’s Practical History of Financial Markets course, believes the real “intellectual disaster” occurred in the 1960s. It was then that economists with high ambitions for their profession found a way of transforming what had been at best a social science into a ‘hard’ science.

Napier (whose excellent and inspirational course I attended in April 2010 and is pictured right) believes that economists’ and policymakers’ faith in the superior ability of the market to allocate resources may have become entrenched because the state had done this so spectacularly badly in the years immediately after World War Two. He writes:-

“The woeful misallocation of resources by governments in the post war era didn’t exactly set a high hurdle: it was not difficult to demonstrate that the market could allocate resources more efficiently than politicians and civil servants.”

Gradually this morphed into the widespread belief that fictions like “perfect markets” and Eugene Fama’s “efficient market hypothesis” were real. And it wasn’t long before groupthink set in. Neo-classical economic thinking became entrenched inside finance ministries, economics departments, banks and other financial institutions. Alan Greenspan was one of the delusional creed’s high priests, and Britain’s Labour Prime Minister Gordon Brown was one of his most ardent disciples.

Then, as Napier writes (his viewpoint is published in the third edition of QFINANCE and already available online courtesy of Quantum Magazine – see pp 60-64 of PDF), having built our financial system on what turned out to be fraudulent intellectual foundations (i.e. sand), the whole thing was damn near swept away in the global financial crisis of 2007-09. As Napier writes:

“The economic rubble from that new era of certainty lies all around us … We have paid a very high price for the journey up this particular intellectual cul-de-sac.”

One of the most tragic and perturbing things about all this, also emphasized in a QFINANCE viewpoint by the prominent tax campaigner, reformer and chartered accountant Richard Murphy, is that university economics and finance departments became one-party states — and remain so despite the apparent bankruptcy of their ideas.

Unless they are willing to worship at the shrine of neo-classical economics, or at least not willing to pretend to do so, noone has much chance of becoming an economist in the UK at the moment. As Napier puts it:-

“Incredibly, though, our universities continue to lead their students up the same blind alley. The same equations are being taught today as were taught before. The next generation of certain economists and financiers are entering the real world with the same unshakable belief that their equations can explain and thus manage risk. Unless this production line can be halted, the whole thing is going to happen

It’s depressing. Clearly there’s a huge appetite for alternative approaches to economics right now, especially ones that are empirical and rooted in the realities of the world and how it actually works.

Unfortunately, however, the prevailing orthodoxy means that proponents of such alternative models invariably struggle to get funding, and some struggle to get a fair hearing. Some are marginalized as “pinkos” and “lefties”.

But there there are signs of hope. People who are prepared to break out of the confines of neo-classical thinking were arguably given real impetus by the global Occupy movement which kicked off in New York’s Zuccotti Park last September.

My own, far from exhaustive, list of people and organizations who are working towards the discovery of more sustainable economic models includes Nouriel Roubini, Steve Keen, Ha-Joon Chang, Yves Smith (main author of the Naked Capitalism blog), the Capital Institute, the Institute for New Economic Thinking, the New Economics Foundation, and the US investor Jeremy Grantham.

Such themes have also been comprehensively addressed in Financial Times’ Capitalism in Crisis series (summary from New Atlanticist) and by Richard Murphy in his new book The Courageous State

With the widespread ostrich-like tendency in high places and, in the light of the eviction of Occupy, there is a danger that the search for more sustainable ways of organizing economies might lose steam. We must not let this happen.

This article was first published on QFINANCE  on Friday 9th March, 2012

Further reading on the future of economics:

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