A Call for Radically Rethinking Economic Theory

In the movie Shutter Island, Martin Scorsese's psychological thriller, a U.S. marshal played by Leonardo DiCaprio goes to a mysterious island to investigate the disappearance of a dangerous mental patient only to discover in the end—spoiler alert!—that he is the most dangerous mental patient of all. Something like that plot twist occurred when economists gathered at an important conference at Cambridge University in Britain last week. They showed up intending to discuss the crazies on Wall Street, in Washington, and in academia who were most responsible for the financial crisis only to find that they, the mainstream economists, were probably the most dangerously unbalanced players of all. The question is whether, like Leo in the movie, the economics profession should now be led off en masse to be lobotomized or whether some form of rehabilitation is still possible.

At the conference, as in the movie, there was a grand manipulator behind the scenes, driving the plot. In Cambridge it was economist Robert A. Johnson, the founding father of the Institute for New Economic Thinking. Backed by a $50 million pledge from George Soros, Johnson has begun an ambitious project to overturn the fundamental premises of his profession, which is still dominated by neoclassical thought, or the idea that markets are driven by rational choices and can find equilibrium on their own. It was largely because of this intellectual environment that "financial innovation" of recent years was allowed to run amok—leading to such catastrophic excesses as "naked" credit default swaps and "CDOS squared"—on the theory that the inherent stability of markets would keep things from getting too out of hand.

The inaugural gathering of the Institute for New Economic Thinking, held in the same stately surround at King's College where John Maynard Keynes developed his General Theory in the mid-1930s, was planned as an insurgency against this way of thinking. The conference amounted, in fact, to a kind of tea party of its own—the opening shot in what is certain to be a bitter and drawn-out war for the commanding heights of economics. "This is intended to energize the troops," said Nobelist Joseph Stiglitz, who has spent decades fighting what he calls "free-market fundamentalism" and who chairs the new institute's advisory committee.

In truth, very little is going to change on Wall Street or in the global economy unless Rob Johnson and like-minded insurgents in the economics profession succeed. The deeper policy correction that's now needed in Washington and financial centers around the world simply can't take place without a rethinking of the underlying economic theory. Much as Washington is still captured by Wall Street, the economics profession remains captured by the false idea of rationality—the "religious belief" (as Stiglitz calls it) that science can fully explain human economic behavior. This thinking underlies much of the short-sighted thinking in Washington, the persistence-by-default of the old view that letting market forces rip is invariably the best policy choice, at least when compared to government intervention.

So enduring is this idea that, even in the face of the most serious market failure since the Great Depression, policymakers in Washington are still behaving in scared deference to the old rational-market models. Even with the evidence of massive fraud and manipulation in the mortgage and credit industry before them, Congress is intent on blocking or defanging the new Consumer Financial Protection Agency and providing the scamsters of the derivatives industry with new loopholes. When it comes to health care, a great deal of economics work has shown that the free market, dominated by for-profit insurance companies, simply doesn't work well: people who most want insurance are also the people who are likely to become ill or who are already ill; and for-profit companies, knowing this, work equally hard to eliminate these customers or to minimize the care they can get (a concept called "adverse selection"). Despite that, the first thing to be dropped from the debate in President Obama's recent legislative triumph was the "public option," the idea of a government-run insurance alternative. Never mind that it was probably the only measure that could really bring the insurance companies under control. Johnson, however, stresses that he has no ideological ax to grind. "This is not really about left or right. This is the challenge of reinvigorating a profession that has lost its license of expertise. It has lost the trust of the public."

We have already heard many critiques over the last couple of years about how the "efficient-markets hypothesis" is to blame for much of the havoc wreaked by Wall Street. And indeed, many economists would like to confine their critique to this bizarre, ideologically driven subsection of neoclassical thinking. But again, as in Scorsese's movie, the truth is far deeper and grimmer. Much of the foundation of modern economics needs to be rethought because it laid the groundwork for financial recklessness and the domination of the real economy by financial markets. Again and again, in different ways, the most perspicacious observers at the Cambridge conference drove this point home: rational models don't work because there are too many unknowns to justify them. There is no real equilibrium in the real world. The models don't compute. Literally.

Johnson's eclectic group-therapy session in Cambridge included not just economists but a remarkable array of leading philosophers, scientists, journalists, financial experts, and respected bloggers such as Yves Smith of Naked Capitalism, Mike Konczal of Rortybomb, and Steve Clemons of The Washington Note. During one session, J. Doyne Farmer, a physicist at the Santa Fe Institute, bluntly warned the gathered economists that unless they abandoned their false scientific pretensions—their "physics envy," as some have called it—economics will fail to take advantage of enormous computing power that is now available to it. By using these new technologies, researchers can better map human economic behavior, in somewhat the way we now track climate change or the weather. But for that to happen, the profession has to create "much more complex models," Farmer admonished, and economists can't get there by sticking to the disproved dogma that markets self-stabilize.

In fact, many of the world's best economists, such as Stiglitz, Berkeley's George Akerlof, and Yale's Robert Shiller, have been chipping away at the rationality model for decades. Yet in terms of influence, their work hasn't moved beyond the margins of mainstream thought, at least in the United States. The dominant alternative paradigm, called New Keynesianism, merely grafted Keynesian countercyclical concepts like fiscal stimulus on top of the old rational-markets theory. "We need better theories of persistent deviation from rationality," as Stiglitz summed it up during the conference. Instead, economists are still in love with their elegant equations based on simplistic notions of rational behavior and "a vision of capitalism as a perfect or nearly perfect system," as Paul Krugman wrote in a much-cited essay in The New York Times Magazine last fall: "The economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth," he wrote.

In Britain, the home of Keynes—who was profoundly skeptical of his profession's ability to explain the mysterious "animal spirits" that move market behavior—there is a lot more straight talk about this pathological state of affairs than there is in Washington today. No one has taken up the fight with more brilliance and bravado than Adair Turner, the head of Britain's Financial Services Authority (a government-appointed body that regulates financial markets), who won over the Cambridge audience last Friday with a fierce and witty assault on economics's most sacred tenets. There is a "inherent irreducible uncertainty" in economic behavior that cannot be explained or modeled, said Turner, who has derided most financial innovation as "socially useless." In a recent interview, even Kenneth Arrow, who co-designed the best-known mathematical proof of a market-clearing equilibrium, earning him the 1972 Nobel Prize, told me that his profession had taken the wrong lessons from his path-breaking work. Much of economics was misled by "an implicit omniscience. It was not that economists thought there was no uncertainty, but there was a belief that you could understand the consequences of uncertainty," said Arrow, who is now 88 and is casting a backward glance on the field he did so much to change. But it's just not true: the people who make up the economy—that is, the people who become investors, savers, and consumers—are simply burdened with too much faulty or incomplete information to end up making truly rational decisions most the time.

You won't hear anything like this in Washington or more broadly yet in the American economics profession. And some prominent economists at the conference, like Jeremy Siegel of the University of Pennsylvania, sought to blunt what they saw as overkill by the Johnson counter-revolution. During the period of steady growth after the Cold War, Siegel said, what became known as the Great Moderation, it actually was rational to take more leverage and reduce risk premiums. Beyond that, he argued, the fiscal and monetary measures taken by the Fed and the Bush and Obama administrations to keep the economy from falling off a cliff in the last few years clearly show that economists have learned a few things since the Great Depression. That may well be true, at least when it comes to crisis response. But if we are to understand how badly wrong markets really got things, a much bigger discussion must take place. The market failure of the Depression produced a wholesale rethinking of economics, including Keynes's General Theory. A similar rethinking should be occurring now. Surprisingly, until now it has not. That it has not is testament to the power and ideological influence of the financial sector. Rob Johnson's Cambridge conference is a critical beginning. Let's hope it's the start of something bigger.