This One Economic Theory is Killing the Economy

Robert Atkinson and Michael Lind have recently written a piece on how the simplifications made in introductory economics classes help spread wrong beliefs about how an economy works in practice. The criticisms they make against "orthodox" or "neoclassical" economic theory are standard ones: unrealistic assumptions, lack of practical relevance, unfounded claims of being a science, and an implicit normative bias. All together, these problems have contributed to make professional economists unaware of the developments leading to the 2008 financial crisis and unable to respond with effective policies to heal the economy.

How fair are these criticisms? And how are these perceived shortcomings affecting the recovery of the global economy after the financial crisis?

Atkinson and Lind’s comments may be relevant when discussing the way economics is taught at universities and how perhaps students should be exposed to some of the high-level debates in economics from an earlier stage. However, critics of neoclassical economics are unfair when they base their opposition to an entire academic discipline on a caricature of it that is offered at the introductory level. Meanwhile, they ignore some of the most exciting developments that economics has undergone recently, developments which have tried to move beyond the traditional assumptions of rational decision-makers, full information, and complete markets, as well as addressing the importance of political institutions in economic decision-making. Plus it’s important to remember the oft-repeated Friedman quote, that models should be based on their predictive power, not on their assumptions.

The real problem with orthodox economic theory, what has really affected the economy and millions of people’s lives, is the unjustified authority vested in its leading exponents. Modern economies are incredibly complex systems. The idea of being able to model such systems, made up of millions of different individuals, by thinking about the behavior of a "representative agent" in the face of an external shock or policy change is just silly. Still, this is exactly what modern macroeconomics tries to do through the development of DSGE (Dynamic Stochastic General Equilibrium) models. As Willem Buiter rightfully puts it: “Most mainstream macroeconomic theoretical innovations since the 1970s… have turned out to be self-referential, inward-looking distractions at best…So the economics profession was caught unprepared when the crisis struck.”

The reality is that we know very little about how financial markets actually work. And the people who know the most probably are those with practical experience of these markets rather than macroeconomic theorists. Economists might say that they are scientists, but in that case, they are a strange species of scientists: a species that forgets about the existence of the real world. How else can you justify the disappearance of economic history, that is, the story of how economies actually work, from most graduate schools’ curricula? Instead, the preferred method of argument is abstract theorization, with each side arguing on the behavior of hypothetical agents, while rarely giving concrete examples.

The crux of the problem is not our lack of a complete understanding of the economy. It is obvious that no science can claim to know everything about its subject matter, otherwise there would be no research. What is actually worrying is the authority given to economists’ opinions on matters that have everything but a consensus. In this sense, it makes sense to characterize some economic theories as "atomic bombs." The most prominent recent example of such hazardous behavior is, of course, Reinhart and Rogoff’s computational errors in a paper that suggested economies started shrinking after public indebtedness rose above 90%.

This same paper had been used many times in conservative politicians’ defenses of austerity, a policy that even the IMF has admitted doesn’t work.  And this is exactly how economic theory is killing the economy. It is not the theory itself. We cannot blame honest, hard-working economics researchers for the shortcomings in the recovery of advanced economies in the post-crisis world. But we can blame those who make selective use of the evidence to justify mistaken policies, even getting to the point of denying the most basic economics. They represent a triumph of ideology over science, an ideology that has close connections with the supposedly positive axioms of neoclassical economic theory. Even Joe Stiglitz, no heterodox economist himself, is critical of the overwhelming preeminence of neoclassical economics:

"One might ask, how can we explain the persistence of the paradigm for so long? Partly, it must be because, in spite of its deficiencies, it did provide insights into many economic phenomena. ...But one cannot ignore the possibility that the survival of the paradigm was partly because the belief in that paradigm, and the policy prescriptions, has served certain interests."

So, how can this situation be fixed? After all the effort that has been put into fixing their budgets, and the unchanged stance of the European troika, we wouldn’t expect austerity-afflicted European countries to undergo a radical change of course. Meanwhile, the U.S. economy gives positive signs of recovery. This recovery, though, is happening despite, rather than because, of the post-crisis response.

So although change seems unlikely, economists should start by reforming the way the subject is taught, but also the way it is thought. Luckily, there has been an awakening of the economics world towards this matter. One of the most interesting new initiatives is the George Soros-funded Institute for New Economic Thinking. This project seeks to promote innovative ways of thinking about economics, ways which have actual policy relevance. It has also promoted a wide-ranging inquiry of how economics is currently taught at universities, so as to correct the pedagogical deficiencies and avoid the pitfalls of Econ 101. Although there still hasn’t been much reform in graduate economics programs, especially at the influential top American universities, one is left to hope that economists eventually come to their senses, allowing the discipline to evolve towards a so-called post-autistic framework.