Keen’s claim that ‘virtually every model’ used by economists assumes the economy is always in equilibrium is nonsense. A workhorse of open economy macroeconomics for over thirty years has been Dornbusch’s overshooting model, which is about asset-market disequilibrium.
The financial crisis in the US and UK is, as Steve Keen says, related to the inner-workings of a credit-based market economy. This is well known to economists. The latest Nobel laureate, Paul Krugman, has a well-known analysis of the 1997 Asian Crisis, emphasising the problem of moral hazard in the credit-based Thai economy.
Economists recognized a bubble before 2007, even though they did not predict when and how a financial crisis ensued in the US, UK, Iceland and elsewhere (but not everywhere). As Greg Mankiw says in the article cited by Keen, to blame economists for this predictive failure is like criticising doctors for not predicting that swine flu would originate in Mexico. Steve Keen didn’t predict the timing either.
In Australia, the advice of economists led to reforms in the 1980s that produced two decades of stellar economic growth. Not only do we have more goods, but we have better goods and choice.
There is a risk/return trade-off to opening the economy and liberalising the financial sector. The OECD countries with the most dynamic financial sectors (the US, the UK, Ireland and to a lesser extent Australia and Spain) had the fastest growth in the 1990s and 2000s and were more exposed to financial crises than say Italy, Germany or Japan – but the reformers are much better off over the two decades, even allowing for the current financial crisis, than the others.
To say that performance is good does not mean that all is perfect. There is need for regulatory reform in the financial sector, but it is difficult to achieve the right balance between competing goals (protecting small depositors and ensuring prudential lending, while encouraging efficient intermediation with a degree of risk-taking).
Similarly, to say that economists provide good advice that has raised material living standards in Australia does not mean that there is no room for improvement. Economics is not dead, it is living. Our understanding of economic forces continues to improve over the decades. It is much better than it was eighty years ago, and in consequence the economic downturns have been smaller.
Key to Keen’s article is the belief that we are in a Depression – and this is a ‘regular’ state for market economies. In his language: bollocks. This is not the 1930s with mass unemployment. Australia is in a recession due to reduced global demand. It will not turn into a 1930s depression, because economists have a much better understanding of the macroeconomy in 2009 than in 1929 and politicians listen to them. The regular state of the Australian economy over the last quarter century has been positive growth, not Depression.
If, by 2015 or so, GDP has dropped by a third (as it did by Butlin’s estimates from 1924 to 1932 or from 1889 to 1895), then Steve Keen will have the last laugh. On the other hand, if we suffer no more than a one-digit decline in GDP, then we can dismiss Minsky’s claim, cited approvingly by Keen, that ‘the true test of the relevance of a macroeconomic theory is its capacity to generate a Depression, since market economies have regularly found themselves in such a state’. Predicting the future is risky, but in this test I would not put money on Minsky and Keen.
Why is there such a market in Australia for writers who create a straw man of ‘neoclassical economics’ or, in the 1990s jargon, ‘economic rationalism’? It may reflect the low level of economics literacy across the population as a whole.
Unfortunately that is a vicious circle: people do not want to study economics because it is irrelevant, and they believe it is irrelevant because they have not studied economics. Or perhaps they studied under one of the iconoclasts who told students that neoclassical economics is dead.
Although I studied some economics, my economics is really rusty. So to engage in a debate among professional economists, especially academics, is a little over reach for me. It seems that all the people on both sides can be supervisors for me to do another PhD in economics (and one was actually my supervisor when I did one in the early 1990s, although I won’t say who). But I am encouraged by the ongoing economic crisis and may act like a venture economist (capitalist) in the debate. Forgive me if I am too naïve or wrong.
It is probably a fact and normal to have economists who may often disagree among themselves. In fact, some jokes on economists include one like that if you have N economists in a room you may have N or more different opinions.
Some economists tend to develop their own new theories (and some may withstand tests) by killing or wounding existing theories. Yes, it is perfectly normal to find the shortcomings of existing theories to progress and advance. But history of economics appears to suggest that the birth of new theories do not necessarily mean the death of existing ones. They may all live and thrive well under particular conditions, that is they may have their usefulness and suitable for some cases.
There have been debates between monetarists and Keynesians. The rational expectations revolution in the 1970s produced the famous result of policy ineffectiveness. But when times of crises, policy makers have no other tools but the two main ones: fiscal and monetary policies, though expectations have become an important part in modelling.
From these limited (but fairly famous ones) episodes of economics, it is not too difficulty to see that both monetary and fiscal policies as well as expectations, both rational and adaptive are useful. It is seldom the case in economics that one theory will always replace another, irrespective whether the proponents of new theories may tend to say otherwise.
So let’s move beyond formalities, though useful they may be, and focus on advancing economics. If the debate can provide some new useful insights into the current economic crisis, it will be good. It will be even better if some policy solutions can be found in the process.
I don’t mean to criticise Richard Pomfret. But I do wish to comment on a more specific point in Richard Pomfret’s article. I agree with Pomfret that economics is living and well. However, economists should not pretend current economics is very particularly effective or sufficiently able to deal with the current economic challenges.
I only comment on one particular point. Pomfret says the following, to quote:
The financial crisis in the US and UK is, as Steve Keen says, related to the inner-workings of a credit-based market economy. This is well known to economists. The latest Nobel laureate, Paul Krugman, has a well-known analysis of the 1997 Asian Crisis, emphasising the problem of moral hazard in the credit-based Thai economy.
It appears that many main stream economists, especially from the west, are eager to find what is “wrong” with developing economies or countries, but not necessarily equally critical to industrialised, especially the US economies. Paul has been a well known economist for many years. Has he done a similar well-known analysis of the American credit problems? Has he done a similar well known analysis on the Japanese problems in the 1990s? If not to both, then why not done for an earlier one and for a later one? Further, notwithstanding Paul’s excellent work on Thailand’s problem in the 1990s, has he been able to provide an effective policy prescription to the current economic crisis in the US by now?
Further, there are so many well known economists including many Nobel laureates. Why do we still have problems of financial and economic crises, and a world synchronised one? Why will it take so long to successfully deal with the current crisis, and why are we still in the process of unknown length to know when the economy will recover, given that we have Keynesian economics, or neoclassical synthesis?
What this suggests that the current economics is insufficient to deal with the current crisis, although economics has been able to deal with many economic challenges.
Economists need to deal with real economic challenges. They need, at least collectively, to have a focus on real economic issues. Otherwise, what is economics for?
As I said, I this is not a criticise, but to show that economics needs not only to be living, but also to live up to the real challenges such as the current economic crisis.
Excellent piece. But I think introductory economics textbooks have done students a disservice by oversimplifying the monetary system and not discussing issues such as moral hazard in that context. As such, such students who have completed introductory economics are poorly equipped to understand what is going on. This gap may even be one reason why some are tempted to incorrectly conclude that neoclassical economics is dead.
This piece by Pr. Pomfret is very agreeable. The problem with the economics is the stagnant nature of the way academics oversee the way it is taught. As the first comment on this piece states “students who have completed introductory economics are poorly equipped to understand what is going on.” The fault of this is not merely with the textbooks available, but with the teaching staff that often portray reality through stale models that have been shown to be empirically incorrect. The most common is Keynes income-expenditure model. This has not only been a model used to justify recent government handouts, but is celebrated by teaching staff that often live by the statement “never let the truth get in the way of a good story.” If introductory economics students are not shown how these models correspond with reality, economics will remain a pseudo-science, a tool for ideologues to justify their agendas.