The English economist John Maynard Keynes was famously quoted as saying “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.” Since mainstream economics did not predict the global financial crisis of 2007/08, nor explained well the phenomenal rise of China, there is ample justification for a new economic thinking.
It is useful to recall that the current generation of central bankers and policymakers, who steered us all into and through the global financial crisis, are supposed to be the finest and best economic professors of their generation, such as former Fed Chairman Ben Bernanke (Princeton) and Bank of England Governor Mervyn King (Oxford and London School of Economics), as well as the top investment bankers who understood markets (US Treasury Secretary Henry Paulson and European Central Bank President Mario Draghi, both from Goldman Sachs).
Both the theory and the markets failed them all. Solving the debt crisis by creating more debt, or quantitative easing, is not theory but bad economics that has created more problems for future generations to solve.
Indeed, with rapid changes in technology, increasing evidence of climate change, rising social inequality and growing polarisation, including stressful geopolitical rivalry that may push us to a third World War, we cannot look at 21st century issues without 21st century thinking, rather than “some defunct economics” that is at best incomplete and, at worst, offers them wrong policy options.
John Maynard Keynes wrote his General Theory of Employment, Interest and Money in 1936, seven years after the Great Crash of 1929. Eleven years after the global financial crisis, which began with the US subprime lending crisis of 2007, and after official enquiries and thousands of academic articles and books on the causes and solutions, no convincing theory has emerged that offers a coherent model on how to deal with the recurrent financial crises and social inequities/climate change in the 21st century. Thomas Piketty’s best-seller, Capitalism in the 21st Century, identified the roots of inequality, but did not offer any solutions that even border on consensus.
The issue is that the world has become much more complex than it is possible to explain through very simplistic, reductionist general equilibrium models that dominate the current generation of quantitative economists. Theories are simply theories — they are not reality and the real world is clearly far too complex to be explained by overly reductionist but elegant economic theories. The theoreticians were too obsessed by the beauty of their models and simply ignored the fact that the facts did not fit their models.
We may need to search outside economics to other disciplines for better approaches going forward.
Indeed, it is important to ask whether, like physics in natural science, it is possible at all to have a single, unified theory of human behaviour?
I asked one of the most respected social psychologists in the field, who answered that there is no such thing as a complete, unified theory of human psychology. One can have different theories about different aspects of human behaviour, but there is no such thing as a universal theory.
It was his answer, during a trek up the Peak District in the UK together, that convinced me that I had to go back to the foundations of economic theory. Of course, many economists were already moving into behavioural economics, using experimental techniques from psychology to study economic behaviour. Many also understood that the study of the history of economic thought and also meta-economics — the deep thinking behind economic theory — would be helpful. But so far, there has been no satisfactory complete explanation of why economics as a discipline went wrong.
There are certainly many partial explanations.
The first is that if the assumptions are wrong, then the theory or its predictions are logically wrong. Clearly, the assumptions of perfect information, rational man or expectations, are theoretical assumptions which do not hold in practical life, where there is huge uncertainty and behaviour can often be irrational. But economists seeking for elegance in their theory often made further bold assumptions (not verified by evidence) that in near-perfect conditions, such as very large and liquid financial markets, the basic theories would hold.
Indeed, one of the assumptions became an accepted “fact” that few people questioned — the financial system would revert back to equilibrium naturally if disturbed by an external shock. Many economists were shocked when the shocks were endogenous (internal) to the financial system, rather than external shocks.
The second is that in the absence of perfect information, any partial explanation of systemic behaviour would be wrong. In the search for the “pure science” that is close to physics, economists would assume away as “other things being equal”, factors such as politics or social inequality”. The scientific paradigm of breaking down a complex problem into its parts and studying the parts in depth was not wrong. What was wrong was not to fit the different parts together to see if they are still consistent with the whole.
The economics profession branched into many sub-disciplines that studied phenomena in more and more depth, without understanding how the parts are inter-related and fitted together. It is the classic problem of “silos”, where every specialist operating in a silo (or specialised area) thinks that given more resources, he would have the right answer to any problem. Economists then became blind men feeling different parts of an elephant and thinking that they understood what an elephant looks like.
In other words, to explain human behaviour and its complex interaction with nature and each other, we need complex theories that draw from many disciplines. Just as mathematicians and physicists are still searching for the grand theory of everything, economists are undertaking the same search, but have (until recently) ignored the lessons from other disciplines. It is an open question whether it is even logically possible to have a universal theory of human behaviour since human beings think and are not inanimate natural material that interact according to predictable natural laws.
The third (which follows from the reductionist elegance of simple models) is to ignore or underestimate, the crucial importance of human organisations — institutions or bureaucracies — in their impact on policies and outcomes. In their simplest form, economic theory makes policy predictions, based on fundamental assumptions and basic data that are causal — running from cause to effect. More complex models would take into consideration feedback effects where there are leads and lags. But by and large, human bureaucracies are very complex institutions that may not even execute policies designed to solve social problems, because it may be against the interests of the bureaucracy itself.
This weakness is more evident in Anglo-Saxon (English or American) economists than those from the European schools, which always emphasised the importance of institutions. European socologists, anthropologists and philosophers have made progress in this area, but their influence on mainstream economics has so far been limited.
The failures of the economics profession are known, but the profession still remains very influential in policymaking.
This series of articles seeks to understand the deep thinking that lies behind economic theory, beginning with in Western economic theory. It argues that Chinese economic policies have been influenced by Western economic theory but, by and large, have remained pragmatic and practical, within Chinese classical thinking that accepts uncertainty, imperfection and complex institutions.
The thesis is relatively simple. It argues that Western economic thinking drew from its Greek and Christian-Judaic philosophy that sought perfection, leading to linear reductionist models that “stalled” at Newtonian physics, so that what emerged was a mechanical model of the world, with rational man being robot-like in behaviour. Indeed, the revolution in physics since Einstein and discoveries in biology, ecology and other fields suggest that uncertainty, complexity and interactivity and interdependence are critical elements for understanding systemic behaviour of humans and nature. Quantum theory is all about uncertainty, relativity and entanglement,
To put it crudely, mainstream economics thinking remains in Newtonian terms, when the real world and advanced scientific theories have moved beyond Newton into theories that incorporate uncertainty, radical change and evolution and complex, non-linear interaction between systems.
These elements are inherent in Chinese classical thinking, but for various reasons that will be explained, Chinese science and technology evolved in a different direction from the West. It remains essentially pragmatic and flexible, but lacks theoretical elegance and empirical verification. However, with many more Chinese studying, learning and absorbing Western science and technology, a convergence in thinking is emerging, creating exactly the integration of different schools of thought into, hopefully, a better school of economic thinking that fits 21st century challenges and problems.
Only by accepting that our current thinking is flawed or incomplete can we evolve to the next step of better theory and better policy formulation. This is the objective of this series of articles, not on reforms, but on the theory of reforms and economic development.
Andrew Sheng writes on global issues from an Asian perspective