Economics Fights for Relevancy

Two economists say their profession has forgotten people. But so have they.

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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