The Observer, Sunday 14 October 2012
With its intimidating Washington headquarters and teams of crack young policy wonks jetting into troubled countries to read the riot act, the International Monetary Fund has a reputation as a bastion of economic orthodoxy.
But Christine Lagarde's intervention last week at the fund's annual meetings in Tokyo, where she warned the world's finance ministers against slashing public budgets too far, too fast, showed that in the topsy-turvy world of economics after the crunch, the most conservative institutions have sometimes been in the vanguard of the intellectual revolution.
In the midst of the deepest and longest-lasting economic malaise since the Great Depression, you might expect practitioners of economics to be wracked with self-doubt, academic departments from California to Cambridge sweeping away the old thinking that gave intellectual heft to the claims of City investment firms to be spreading risk and making the financial world a safer place.
But as the Nobel committee prepares to announce this year's winner of the economic sciences laureate tomorrow, David Blanchflower, the US economist and former member of the Bank of England's monetary policy committee, says most people in the profession have sailed on unperturbed: "Economics proceeds as if nothing has happened since 2008. Everybody's going on doing exactly the same things they always did, teaching the same classes."
As for the forecasting record of many of the world's most eminent economic institutions, not least the Bank of England, he says, "In many ways, we would have been better off to hire a monkey to throw darts at a dartboard."
The Bank, as well as the independent office for budget responsibility established by George Osborne, and the vast majority of thinktanks and City forecasters, failed to anticipate the severity of the Great Recession, and the painstaking nature of the recovery.
Yet many economists persist in clinging to their cherished mathematical constructions of the world, simply postponing the upturn each quarter when confronted with the reality that it has failed to materialise. And few have conceded that some of the fundamental tenets of their work – that individuals are perfectly rational, or markets always clear at the right price – need to be junked.
There are islands of resistance. Two former winners of the economics Nobel, Paul Krugman and Joseph Stiglitz, have used their prominence as public intellectuals over the past five years to issue repeated rebukes to policymakers for failing to grasp the scale of the crisis, and take sufficiently radical action to protect the economy from the worst ravages of the downturn.
Maverick thinkers such as Nassim Nicholas Taleb, the author of Black Swan, whose latest book, Antifragile, on the fragility of systems, was cited by Sir Mervyn King in a speech last week, have sought to popularise the fact that model-based, mathematised economics is based on fundamental misunderstandings of the world.
But Krugman and Stiglitz were already well-established as radicals, with strong sympathies for the Keynesian analysis that premature public spending cuts would inflict untold damage.
The IMF's shift, from cheerleading for austerity to advocating a gentler approach, shows just how much old orthodoxies are crumbling in the face of the facts. Five years after the onset of the crisis, the eurozone is on the brink of collapse and the UK is mired in a double-dip recession, despite embracing drastic deficit cuts.
Eric Beinhocker is the executive director of Oxford's Institute for New Economic Thinking, part of a transatlantic effort to rethink the basic tenets taught to students over recent decades. He says: "The crisis has revealed enormous gaps in economists' understanding of the linkages between the financial system and the broader economy. Before the crisis, few economists would have predicted that trouble in an obscure corner of the US mortgage market could cascade into a global calamity."
He argues that there is lots of work going on to address these shortcomings, but "some advocate tweaking existing models, while others feel a more radical rethink is needed".
Jonathan Portes, director of the National Institute for Economic and Social Research, falls into the latter camp. He's a fierce critic of the government's deficit-cutting strategy. But he says that in microeconomics – the bottom-up study of individual firms and markets – it would be wrong to throw the baby out with the bathwater.
"I don't think the crisis tells us much about the fundamental underpinnings of microeconomics," he says. However, he believes where economists failed was in assuming that finance worked just like any other market: "When it came to financial companies, it turned out we needed to think about them completely differently. More markets are not necessarily better."
He adds that one lesson economists may need to learn is to be more humble about the predictive power of their economic models, however neat and precise the mathematics that underlies them. Complex mathematical equations have replaced what Blanchflower calls "the economics of walking about," as the foundation of the modern subject.
Lord Skidelsky, economic historian and biographer of Keynes, agrees: "It may be that there's no perfect model, and that the quest for one is an error. Maybe we need different models, different theories, for different situations, and that's the best we can do. Keynes said economics was a moral science, not a natural science – by which I mean that it has to take into account the variability of human situations."
In other words, economics is not physics, because people are by their nature unpredictable. No one is going to discover an economic "God particle" that explains why someone decides to sell their house, hire an extra worker or buy a new car. "There's no new paradigm; and perhaps the search for one is a bit misguided."
As for tomorrow's Nobel prize, Skidelsky says it may tell us more about passing intellectual fads than fundamental truths about the economic world. "My general feeling is that Nobel prizes in economics very closely follow current fashions in the discipline."
NOBEL FAVOURITES If the Nobel committee wants to reward an economist whose work has shed light on contemporary events, it could opt for Kenneth Rogoff, the Harvard economist who did a stint at the International Monetary Fund. Rogoff, with co-author Carmen Reinhart, published the seminal study into debt crises, This Time is Different, which brought together evidence on 800 years of crashes and crunches. They found, among other things, that once a country reaches a debt-to-GDP ratio of about 90%, there's trouble brewing — an insight borne out recently by the experience of Greece, among others.
Rumours in academic circles have suggested that Angus Deaton, a Brit based at Princeton, and Sir Tony Atkinson, of Nuffield College, Oxford, may be in the frame, for their work on inequality. Atkinson has been carrying out painstaking work into who earns and owns what in Britain, what that means, and what can be done about it, since the 1970s. Separately, Deaton uses survey evidence to examine the link between income, health and wellbeing around the world. Studying the (widening) gap between rich and poor was a relatively unfashionable corner of economics for many years. But income distribution has recently come to be seen - by the OECD and the IMF - as a bar to economic recovery, and perhaps even a cause of the crisis.
Yale's Robert Shiller, one of the few economists who can claim to have foreseen both the bursting of the dotcom bubble and the US housing crash – predicted in his book Irrational Exuberance – is also frequently mentioned. Unlike many ivory tower economists, Shiller has turned some of his theories into cash, designing a house-price index with colleague Karl Case. The widely cited Case-Shiller index, which uses repeat sales of the same properties to track price changes, was snapped up by ratings agency Standard and Poor's. Shiller is regularly quoted as an expert on the housing market, which he believes still hasn't bottomed out. His most recent book, Finance and the Good Society, is about the benefits of financial innovation - a tough message to sell in the current climate.