Does mainstream economics have any relevance today given its poor performance in the Great Recession? In a new book, Cal professor George Akerlof and Yale's Robert J. Schiller claim that it does.
The recent economic crisis has been the "emperor has no clothes" moment for the dismal science. Mathematical models that claim to predict economic activity, the crown jewels of the profession, have proven to be of little value in explaining what happens in an economy tossed in stormy seas. These theories were declared to be as unassailable as E = mc2, but have proven to be spectacular failures and maybe even frauds. Nor has the profession been able to propound a system or plan that allows one to arrange or even to understand an economic life with any certainty — surely a crucial requirement of a relevant economics profession.
You have to give some in the profession credit. At their recent professional convention in January, the poobahs of the American Economics Association sanctioned a humor section featuring the "stand-up economist" Yoram Bauman. My favorite joke of Bauman's is, "How do you tell the difference between macroeconomists and microeconomists? Microeconomists are wrong about specific things and macroeconomists are wrong about things in general."
Various non-humorous attempts are now being made by economists to try and resuscitate their profession. One of the most important of these CPR efforts comes from two "liberal" mainstream economists who take the Reagan/Thatcher free-market theories to task and claim to explain the current mess and tell us "what we need to do to get out of it." In their new book, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, Cal professor and Nobel laureate George A. Akerlof, and Yale's Robert J. Schiller, the co-creator of the Case/Schiller index of housing, try to make mainstream macroeconomics relevant in the post-crisis period. The Internet rumors say this is a favorite book at 1600 Pennsylvania Avenue.
Akerlof and Schiller admit that their profession has strayed far off the mark. Employing a theory of "behavioral economics," the authors argue that the current model of how the economy works must be altered to make room for so-called "animal spirits." This term from the writing of John Maynard Keynes refers to the common actions of people that have an important effect on economic activity.
It would seem obvious that our emotions play large parts in our personal economic activity, and in the economy as a whole. Heretofore, however, classical economics downplayed or ignored these spirits, claiming that those involved in economic activity nearly always act in economically "rational" ways. For a half century or more, such free-market economics have been dominant in the profession and in practice. As the world steadily forgot the lessons of the Great Depression, countries throughout the globe, including the formerly socialist China, adopted the policies that solidified under Reagan in the United States and Thatcher in the U.K. But Humpty Dumpty has had a great fall.
Akerlof and Schiller argue that mainstream economists have been seriously mistaken to dismiss the human element in their explanations of the past and forecasts for the future. Models that simply modeled a scientific and rational market failed because they did not take into account the reality of human beings. For example, the authors argue that the current economic crisis was not caused primarily by capital flows, overproduction, or a low savings rate, but instead by psychological factors such as "our changing confidence, temptations, envy, resentment, and illusions — and especially by changing stories about the nature of the economy." It is these animal spirits that caused the housing bubble to form, various financial firms to fail, the Dow to drop more than 40 percent, and the unemployment rate to rise.
This book seeks to reassure us that their profession really can predict future economic activity, or at least understand it in time to ward off catastrophes. The authors hope such reassurance can calm the fears that make economic actors reticent to act "normally." This attempt is laudatory. Their attempt to reassure us that proper understanding of animal spirits will tame the violent economic swings of market capitalism is off the mark, however. Occasional earthquakes are the real scientific reality of capitalism.
The book is must reading for those who follow the minutia of Washington's economic battles, as it argues for a strong hand from government to keep these spirits controlled. This claim has inspired a furious counterattack from their neo-classical compadres.
But partisan wrangling aside, this book misses the point of what the profession should be doing. The problem in macroeconomics is not our failure to discover some magic formula that will explain all economic activity. The problem is that the profession is not addressing how it can assist in building an economy filled with good, productive, and fulfilling jobs. It has succeeded at creating a McDonald's/Wal-Mart economy, but it is clear that this will not support a vibrant and humane society for all. When faced with the need of all people for decent health care, the lens of this profession focuses on the supposed harm such costs do to the "reasonableness" of our wage demands.
Unfortunately, Akerlof and Schiller do not dispute this current "blame the people" attitude of mainstream economics or challenge the underlying sins of their profession. The underlying assumption of their profession remains that we are all individually acting irrationally, and our sinning is causing today's economic problems. I guess we should emulate the penitentes of Northern New Mexico and southern Spain, whipping our backs to excoriate our sins as we trod our economic highway.
But the book is an important milestone in this academic/policy dispute. And maybe these fights between mainstream economists are a good thing. As the Bauman joke goes, when considering your economic health the three most terrifying words in the English language are "macroeconomists agree that ... ."
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