Fundamental Problems in Economics

Is Donald Trump a populist?
A famous national populist, former US President Donald Trump

The economy is not an understandable and controllable machine as assumed by conventional macroeconomic theory. Rather, the economy is a complex, adaptive system, like many others in nature and society, in which policies can have significant, unintended consequences. 

Former BIS Chief Economist William R. White

We are dealing with an intellectual problem—a profession that has been absorbed by theoretical constructs abstracting from human behaviour. We are dealing with ingrained ways of thinking. The challenge is to raise questions about accepted approaches, in drawing lessons from recent experience. We need to pull economics back into the real world of political economy.

Former Federal Reserve Chairman Paul Volcker

We also have to recognize that good economics cannot be divorced from good politics: this is perhaps a reason why the field of economics was known as political economy. The mistake economists made was to believe that once countries had developed a steel frame of institutions, political influences would be tempered.

Former IMF Chief Economist and University of Chicago Professor Raghuram Rajan

Leonard’s Curiosity in Economics

My interest in the political dimensions of economic policy began while I was still an undergraduate student at the University of Auckland. I was intrigued by the rise of Bernie Sanders in the United States and Donald Trump in 2015. They both represented movements against the status quo of government. Meanwhile, in my Economics courses, I was learning about macroeconomic models of endogenous growth, the Solow-Swan theory of technological progress, Paul Krugman’s liquidity trap theory, Milton Friedman’s monetarist theory, among other frameworks. An intense interest in both Political Science and Economics led me to major in both disciplines (History and International Business were later added in 2018).

Theoretical economic models were fascinating. Yet, in my mind economists have been missing the mark.

I was particularly intrigued by the global financial crisis (GFC) of 2007-2008. What caused it? The greed of Wall Street, easy monetary policy, or institutional corruption? Globalisation? Are there political influences at play? Exactly how can geniuses from Ivy League universities make such an error? I was perplexed by the global financial crisis and remained keenly interested in it (so much so that I even co-authored a report on the potentials for the next financial crisis in 2021).

The failure of world-renowned economists – in the likes of Larry Summers – to identify the fundamental causes of the GFC (and the aggregated political effects of that crisis) convinced me that the discipline required fundamental reform.

My education at the University of Auckland contributed to my intellectual framework. However, the models and theories that I learned in my economics classes were insufficient to prepare me to be an excellent economist. I believe that the study of Political Science, Psychology and Economic History should become complementary areas for students studying Economics.

As someone who also holds a degree in History, the economic topics within all of the courses I took always intrigued me. Among these themes are, for example, the role of hyperinflation in the fall of the Weimar Republic and the rise of Hitler; the rise of Keynesian economics and the New Deal; the rise of the Bretton Woods system and its effects on international affairs; the revival of Communist China under Deng Xiaoping; and the experience of New Zealand under Rogernomics and Ruthanasia. In contrast to my colleagues who were studying other topics, I was fascinated by economic problems and how they affected the political system in general. As I see it, Economics is a hybrid of the humanities and the sciences – a social science. I was told by my history lecturer, Dr Paul Taillon, that I had more of a ‘political economy’ bent. I fully concurred with his assessment.

My involvement in Economics as a discipline was motivated by this experience. An overview of my obsession with the subject is presented in this section. It is fascinating to me and I intend to continue my studies in the future. In the next section, I will explain the fundamental causes of the GFC and why many economists got their predictions completely wrong.

The Failures of Economists: Predicting GFC

Many economists, including Nobel laureate Paul Krugman, admitted they were wrong in the wake of the first major economic catastrophe since the Great Depression. Most mainstream economists failed to predict the onset of the financial crisis in 2007-2008 (with notable exceptions such as William R. White, Niall Ferguson, Raghuram Rajan and Kenneth Rogoff). There was a great deal of hubris and arrogance in the profession.

By the beginning of the 1960s, mathematicians and engineers were becoming increasingly involved in the economics discipline, leading to the development of econometric models as a dominant source of policy analysis. One of the main reasons this occurred is the rise of mathematical economics. Paul Samuelson and other ‘technical’ economists popularised this sub-discipline. Prior to this disciplinary revolution, the subject was called ‘political economy’, not economics as we all understand it today. Through mathematic economic modelling, increasingly more experts have become almost certain that modelling meant that it will be reflected in the real world. In many ways because of what the numbers told them, many determined that the risk of financial collapse has been eliminated. Financial markets are supposedly safer as a result of the ‘Great Moderation’ and technocratic management of the economy. Francis Fukuyama’s End of History did not help. It created further arrogance and complacency among western elites, believing that they were destined to spread free markets and liberal democracy globally. However, with the bursting of the housing bubble in 2007, the Great Moderation of 1987-2006 proved to be a myth as it led to the collapse of the global economy.   

The GFC taught me that economics was not an entirely objective or empirical discipline in the same vein as mathematics, chemistry, and physics. In the words of former Bank of England Governor Mervyn King, “Economists have brought the problem upon themselves by pretending they can forecast. No one can predict the unknowable future and economists are now exception”. Economists forgot a very important concept called ‘radical uncertainty’.

In terms of quantitative predictions, in many ways they are correct in the modelling. But it is correct in real life? No. The models are not perfect. Individuals are not fully rational. Statistical formulas and mathematical equations can get manipulated to provide the authors of a particular research paper with data that supports their hypothesis.

I do not claim, however, that empiricism does not matter – it does matter to a considerable degree. Using models, we can obtain an understanding of what is happening throughout our economic system. We would struggle to solve problems without the aid of hypotheses testing and quantitative methods. But it does become problematic when economists strictly rely on models, as fundamentalist beliefs, akin to the scientific fact of gravity.

Pricing for options is an example of this. The Nobel Prize in economics was awarded to Robert Merton of Harvard University and Myron Scholes of Stanford University for their contribution to calculating stock options (a form of derivatives). In the financial world, it was believed that ‘rational’ calculations of these risky investments were feasible. But this was utter nonsense. It is nearly impossible to determine the value of these complex financial instruments. Analysts have devised numbers to create an impression of credibility. It was just a bogus form of quantification. There was a quasi-religious belief among people in the financial sector that risk had virtually disappeared following the introduction of these objective models. This legitimized financial gambling. This intellectual debacle was caused by the dogmatism of belief in ‘market perfection’ and ’empiricism’. Economist Raghuram Rajan questioned this dogma of the financialisation of the world economy in his 2005 research paper. He showed that actually banks and financial institutions were making more money via more risk, not less risk as shown by these models for derivatives. As shown in the documentary ‘Inside Job’ by Charles Ferguson, to some degree it was a form of intellectual and moral corruption where economists across elite institutions brought the idea that risk was eliminated.

The failure of economists told me a few things. There needs to be a fundamental restructure in the education of future economists. Economics as a discipline needs to combine both the ‘economic history’ and empirical methods to explain and understand complex systems like the global economy. More emphasis needs to be placed on the ‘humanity’ aspect of economics. The classical scholars in the likes of Adam Smith, David Ricardo, David Hume, John Maynard Keynes and even Hayek were not entirely mathematically driven economists. All of them were experts in the political economy. Excess objectivity within the field of economics led to financial disasters and hubris.

The GFC should have been a wake up call, but have there been some changes? Not necessarily. Economists still buy into their DSGE models and macroeconomic equilibrium hypotheses. Although some economists in the likes of Dani Rodrik, Raghuram Rajan and Joseph Stiglitz have been warning others for some time about the continued failure of their fellow colleagues to diagnose the problem. What we witnessed instead were significantly political consequences in the form of both left wing and right wing populism.

Backlash against the Technocrats – Western Populists

While the mainstream neoclassical economists continued to repeat their talking points to the world, the world was shifting to a more polarised society. The GFC did not help the cause. With millions of ordinary people losing their life savings and wealth. Simultaneously, big banks and financial institutions were bailed out without any jail time for many of the financial executives that created the problem. Injustice and economic corruption led to a growing mistrust towards public institutions.

Politically, people became very angry across the world and manifested to resentment.

As shown by Charles Murray’s ‘Coming Apart‘, much of the political discontent had to do with offshoring of manufacturing and the decline of communities in former manufacturing hubs such as Detroit. These states and regions are nicknamed Rustbelt states for a reason. These same white-working class folks lost their jobs and their livelihoods through free trade agreements and offshoring of their jobs into developing countries. The rise of opioid addiction, rising divorce rates, crime, social disintegration, declining social mobility, and educational regression led to an intergenerational downward cycle. J.D. Vance’s ‘Hillbilly Elegy’ does a wonderful job illustrating the extent of the social decay. The richer urban class in states such as California and New York saw their wages increase exponentially with more households and families in these areas getting more educated, while those in the former stronghold manufacturing states such as Michigan, Wisconsin and Pennsylvania failed to see rising incomes. As mentioned by Raghuram Rajan, the premium on College education and demand for skilled work led to growing economic inequality. Social decay and free market prescriptions were a recipe for social disintegration and political discontent.

Globalisation and international economic integration was the correct policy subscription, but the short turn effects were devastating. Although globalisation and free flow of capital and labour led to overall net-positives for the world economy (3.8 billion people in the middle class as of 2018). Economists and policymakers failed to consider these people’s livelihoods. Trade adjustment subsidies and social insurance were insufficient.

Consequently, across the western world, we saw more politicians going against these mainstream orthodoxies. Anti-European Union politicians in the likes of Nigel Farage and Boris Johnson became increasingly popular, meanwhile the US saw the rise of an anti-liberal demagogue in the form of Donald Trump. Simultaneously, left-wing populists such as Bernie Sanders and Jeremy Corbyn shocked the world with their relatively successful campaigns for President and Prime Minister (and UK Labour’s leadership).

In my eyes, a healthy dose of populism is important for liberal democracies. It provides people with the sense that something is fundamentally wrong in society and that policy adjustments were warranted. But, extreme and excess populism can lead to bad consequences as we’ve seen with the rise of Hitler and Soviet Communism post-Great Depression. Economic stability and growth is significant for a stable liberal democratic system. Systems can break down and cause revolutions if it gets out of hand. This is why understanding the root causes of contemporary populism and dealing with the problems raised is crucial. However, I’m yet to see any western politician hoping to resolve the anti-establishment populist sentiment. Nor are economists willing to provide a new approach to this ongoing political economy problem.

Conclusion

“Almost every political question has an economic aspect and almost every economic question has a political aspect”.

Charles P. Kindleberger

As the prominent international political economy scholar Charles Kindleberger states in this quote, economics cannot be separated from politics and vice versa. The rise of mathematical economics and econometrics are crucial to policy evaluation and analyses, but by ignoring economic and political history, we fail to learn our lessons from what really happened. Economics is not just about models – it’s about people’s livelihoods. Humans are not just rational utility maximising robots. We are complex and we cannot rely simply on microeconomic theory, presumptions and calculations as a basis for effective economic policy making.

This opinion piece was to inform readers about understanding and staying skeptical about the economics profession. I have been heavily involved in this field and public policy in the early stages of my career and even though I don’t know much in comparison to many professionals globally, I hope this piece was relatively informative. As Kenneth Rogoff mentioned before, economics should still stay relatively objective and mathematical, but we must not ignore economic history and incorporate other aspects of social science into the equation.

I am a political economy person, and I think more economists should move in this direction.

Happy New Year.

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