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Neo-classical economics led us into a cul-de-sac. Now we must find a way out

Neo-classical economics led us into a cul-de-sac. Now we must find a way out Ian Fraser

The so-called “Washington Consensus” ought to have been consigned to the scrapheap of history by now. The consensus – sometimes known as neo-classical economics – underpinned macroeconomic policy, including financial (de)regulation and central bank policy, for most of the past three decades. But the Panglossian assumptions about financial markets that underpinned ultimately gave rise to the global financial crisis from which many economies have yet to recover.

So why do so many people – including global leaders who still believe the best way to promote recovery in massively over-leveraged and bankrupt economies is to inject further leverage – adhere to this intellectual wrong-headedness?

It seems that a great many people in business and finance, the media, economics faculties, politics, and government just want an easy life. Most are thinking about the short term, towards the next election or annual results presentation, and a change of 'religion' might imply deeper short term pain. At a country level this sort of thing has traditionally required revolutions and bloody civil wars. Perhaps they just feel safer thinking along similar lines as before (albeit perhaps with a bit of austerity and fiscal rectitude thrown in) in the hope that things will just keep chugging along until they retire?

The BBC documentary maker Adam Curtis summed up the situation in a recent blog called "The Curse of TINA":

"Nobody – not just from the left, but from anywhere – has come forward and tried to grab the public imagination with a vision of a different way to organize and manage society. It's a bit odd. [Why do] we find it impossible to imagine any alternative; why have we become so possessed by the ideology of our age that we cannot think outside it?"

Professor Richard Werner, director of the Centre for Banking, Finance and Sustainable Development at the
University of Southampton, has described the bizarre intellectual contortions 21st century economists must go through in a viewpoint published in the first edition of QFINANCE in October 2009. Werner wrote:

"Economists are obliged to pretend that the emperor is not naked, that markets clear, that there is equilibrium, and, even more preposterous, that markets deliver the best possible outcome for society."

I won’t summarize Professor Werner’s entire piece here, but he concludes with several entirely workable recommendations including that private sector banks should be relieved of their credit creation responsibilities. We need more people like Werner to help us identify the big weaknesses in neo-classical economics (sometimes also known as neo-liberalism) and to suggest workable alternatives.

So when did the rot set in? Russell Napier, a consultant for CLSA Asia Pacific Markets and founder of the Practical History of Financial Markets course, believes the real “intellectual disaster” took place in the 1960s. It was then that economists with high ambitions for their profession found a way of transforming what had been at best a social science into a 'hard' science. Napier believes that economists and policymakers’ faith in the market’s superior ability to allocate resources became entrenched because the state had done this so spectacularly badly in the post-World War Two years.

“The woeful misallocation of resources by governments in the post war era didn’t exactly set a high hurdle: it was not difficult to demonstrate that the market could allocate resources more efficiently than politicians and civil servants.”

Gradually this morphed into the widespread belief that fictions like “perfect markets” and Eugene Fama's “efficient market hypothesis” were real. And it wasn't long before groupthink set in. Neo-classical economic thinking became entrenched inside finance ministries, economics departments, banks and other financial institutions. Alan Greenspan was one of its high priests, and Britain's Labour Prime Minister Gordon Brown one of his most ardent disciples.

Then, as Napier (whose viewpoint article Urgent Need to Retool Business Faculties with Financial Historians and Eject the Financial Engineers is published in the third edition of QFINANCE) writes, having built our financial system on what turned out to be fraudulent intellectual foundations (i.e. sand), the whole thing was damn near swept away in the global financial crisis of 2007-09. As Napier writes:

"The economic rubble from that new era of certainty lies all around us … We have paid a very high price for the journey up this particular intellectual cul-de-sac."

One of the most tragic and perturbing things about all this, also emphasized in a viewpoint by the prominent reformist chartered accountant Richard J Murphy, is that university economics and finance departments became one-party states -- and remain so despite the bankruptcy of their ideas. No one who is not willing to worship at the shrine of neo-classical economics, or who is not willing to pretend to do so, had much chance of becoming an economist in the UK at the moment. As Napier puts it.

“Incredibly, though, our universities continue to lead their students up the same blind alley. The same equations are being taught today as were taught before. The next generation of certain economists and financiers are entering the real world with the same unshakable belief that their equations can explain and thus manage risk. Unless this production line can be halted, the whole thing is going to happen

It's depressing. Clearly there's a huge appetite for alternative approaches to economics right now, especially ones that are empirical and rooted in the realities of the world and how it actually works. Unfortunately, however, the prevailing orthodoxy means that proponents of such alternative models invariably struggle to get funding, and some struggle to get a fair hearing. Some are marginalized as "pinkos" and "lefties".

But there again there are signs of hope. People who are prepared to break out of the confines of neo-classical thinking were arguably given real impetus by the global Occupy movement which kicked off in New York's Zuccotti Park last September.

My own, far from exhaustive, list of people and organizations who are working towards the discovery of more sustainable economic models includes Nouriel Roubini, Steve Keen, Ha-Joon Chang, Yves Smith (main author of the Naked Capitalism blog), the Capital Institute, the Institute for New Economic Thinking, the New Economics Foundation, and the US investor Jeremy Grantham. Such themes have also been comprehensively addressed in Financial Times’ Capitalism in Crisis series and by Richard Murphy in The Courageous State

With the widespread ostrich-like tendency in high places and, in the light of the eviction of Occupy, there is a danger that the search for more sustainable ways of organizing economies might lose steam. We must not let this happen.

Further reading on the future of economics:

Tags: Adam Curtis , Alan Greenspan , BBC , CLSA , economics , economics faculties , financial crisis , Financial Times , free-market economics , Ha-Joon Chang , Jeremy Grantham , Naked Capitalism , neo-classical economics , Nouriel Roubini , Occupy Wall Street , Richard Murphy , Richard Werner , Russell Napier , Steve Keen , universities , Yves Smith
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  1. Anonymous Comment says:
    Wed Jun 20 15:13:07 BST 2012

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  2. Ian Fraser says:
    Mon Mar 19 22:25:19 GMT 2012

    I just found Thomas Frank's Too Smart to Fail ( in the Baffler. In the excellent article Frank writes:- What happens when the experts are fools? What happens when their professions are corrupted, their jargon has become a shield against outside scrutiny, their process of peer review has been transformed into a device by which a professional faction can commandeer the discipline, excommunicate rivals, and give members of the “us” group endless pardons for their endless failures? The economist James K. Galbraith, who was right about many of the disasters of our age but who is neither “mainstream” nor “Wall Street,” once wrote that something very much like this had happened to his discipline: Leading active members of today’s economics profession . . . have formed themselves into a kind of Politburo for correct economic thinking. As a general rule—as one might generally expect from a gentleman’s club—this has placed them on the wrong side of every important policy issue, and not just recently but for decades. They predict disaster where none occurs. They deny the possibility of events that then happen. . . . No one loses face, in this club, for having been wrong. No one is dis-invited from presenting papers at later annual meetings. And still less is anyone from the outside invited in. Where does this leave the premature market skeptics, the ones (like Galbraith) who were right all along? The answer is, by and large, nowhere. These people have remained at the out-of-the-way universities, the do-it-yourself blogs, and the impotent think tanks where they began... Extraordinary.
  3. clindinger says:
    Fri Mar 09 18:47:24 GMT 2012

    Guess this is mainly a problem of selective perception; especially scholars suffer from this kind of cognitive bias. Ideas outside their conception of the world are percieved automatically as impossible or simply wrong. This attitude can be observed in poltics, economics, science, etc. However, I agree with George Bernard Shaw: "The possibilities are numerous once we decide to act and not react." Most of the time it is just our own narrow mindset that limits our possibilities.

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