What’s Wrong with Economics, by Robert Skidelsky, Yale University Press, 223 pp, €11.88, ISBN: 978-0-300-25749
When Queen Elizabeth visited the London School of Economics in November 2008 soon after the global financial crisis had exploded she asked the assembled economists why nobody had seen the crash coming. The assembled economists did not have time to answer Her Majesty’s very pertinent question on the day of her visit, but in June 2009 the British Academy convened a group of leading economists, politicians and policy makers for a roundtable discussion on the subject. In a letter to the queen, Professors Tim Besley, an economist, and Peter Hennessy, an historian, both Fellows of the academy, summarised the views expressed in the discussion. They wrote that “some of the best mathematical minds” were involved in risk management but “they frequently lost sight of the bigger picture”. In summary, they concluded, “the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole”.
The banking crisis of 2008 focused public attention on the dismal failure of most economists to foresee the risk of crash and raised questions about the usefulness of the “models” used by economists to analyse the economy, and indeed about the validity of economics as a soi-disant science. In What’s Wrong with Economics Robert Skidelsky argues that the economics taught in universities and practised by economists in the private and public sector, based as it is on mathematical models, is incapable of explaining economic activity, much less forecasting future economic events.
The area of economics with which most people are familiar is macroeconomics, which uses models to analyse and predict growth in output, prices and interest rates. Microeconomics is concerned with analysing individual markets and the main insight of the greatest economist of the twentieth century, John Maynard Keynes, was that the overall economy cannot be understood by applying microeconomic principles. Keynes developed a model to explain how overall output and employment are determined. Yet, as Skidelsky shows, most economics textbooks such as Harvard professor N Gregory Mankiw’s Principles of Economics (now in its ninth edition), emphasise the primacy of microeconomic principles. The first “principles” a reader of Mankiw encounters are not the fundamentals of growth or employment but rather “opportunity cost, marginal decision making, the role of incentives, the gains from trade, and the efficiency of market allocations”, all of which are microeconomic ideas.
Skidelsky targets what he sees as the three main weaknesses of economics as currently researched and practised: its reliance on mathematical models, its very limited understanding of human psychology and its isolation from and even hostility to the other social sciences. The mathematical models reduce the enormous complexity of economic life to an absurdly oversimplified set of variables about which assumptions are made and on the basis of those assumptions predictions are formulated. Less attention is paid to the usefulness of the model than to its logical rigour or the level of mathematics needed to prove it. Economists could be said to suffer from “physics envy” in that they assume there are fundamental regularities that characterise economic phenomena similar to the laws of physics that govern the natural world. Skidelsky argues that the so called “laws” of economics are ideology rather than science. The “law” that markets are the most efficient way of allocating resources inevitably leads to the conclusion that governments should not intervene in markets and should even create them in areas where they do not exist.
The second major weakness of contemporary economics is its absurd caricature of the human beings as an individualistic utility-maximising homo economicus. The Nobel Prize-winning US economist Thomas Sargent has defined a person as a “constrained, intertemporal, stochastic optimization problem”. Skidelsky wonders whether this “unlovely creature” is a theoretical tool or an ideal to which people should aspire in their decision-making.
Keynes wrote that the economist must be “mathematician, historian, statesman and philosopher”, yet as Skidelsky shows in his third main criticism, the subject has since the mid-twentieth century sedulously separated itself from philosophy, sociology, political science and anthropology. It is surely significant that Gillian Tett, a financial journalist who predicted the 2008 banking crash, trained as a social anthropologist before becoming a journalist.
Economics purports to be superior to the other social sciences because its use of mathematical models makes it more “scientific”. As a subject it emerged from political economy after WWII. In a vain attempt to make it a science, all reference to history and the evolution of institutions was abandoned ‑ to the great impoverishment of the discipline. Most introductory textbooks present an abstract model of capitalism with no reference to the role of institutions. The USA, Germany and Sweden are all market economies but differ radically in terms of the roles of government and labour in their economic models. All introductory textbooks in economics gives the satisfaction of limitless individual wants as the goal of an economic system. Skidelsky suggests that an economics informed by ethics would consider the elimination of poverty as a fundamental goal of an economic system.
If economics were a purely theoretical subject its deficiencies would matter little, but as Skidelsky argues, its laws and models, despite their fatuity, are imposed on the world, with often disastrous consequences for many people. The ideolog-as-science idea that free markets always give the best outcome resulted in the privatisation of many publicly owned utilities, including water supply, in the UK under Margaret Thatcher’s governments. This has resulted in water supply companies making large profits and paying dividends to shareholders while supply is restricted to households during droughts despite the loss of millions of gallons of water every day because profits are not reinvested in water infrastructure. Even when evidence shows a theory to be wrong it is often retained for ideological reasons. Free market economists argue that a minimum wage always leads to higher unemployment. In the USA states with minimum wages have lower unemployment than those without, yet the unemployment argument continues to be cited against minimum wages. When real world evidence shows the models of the free-market ideologues to be wrong, their response is to blame the world not the models.
Another instance of the disastrous consequences of applying an economic model to the real world was the role of the Black-Scholes model of stock pricing, for which its originators won the Nobel Prize in Economics in 1997. As traders acted according to the model, the resulting prices seemed to validate the model’s predictions, leading to ever more complex and risky transactions. Regulators who believed in the model’s assertion that stock markets could eliminate risk ignored the ever-inflating financial bubble which culminated in the crash of 2007-2008. Myron Scholes had put his theory into practice in the 1990s when he co-founded Long Term Capital Management (LTCM), a bond trading company which attempted to make money by identifying and trading in “incorrectly priced” assets. The company invested heavily in Russian government bonds and collapsed when the Russian government defaulted on its debts. LTCM had to be bailed out by the US Federal Reserve using public money in a classic example of what the eminent US economist Joseph Stiglitz called socialism for the rich and markets for the poor.
The application of an economic model called the Washington Consensus has had dire negative consequences for millions of people in developing countries. When many Latin American and African countries in the 1980s found themselves unable to repay the vast loans advanced to them irresponsibly by rich countries a conference of economists was held in Washington where the IMF and World Bank are based to devise a rescue package for the indebted countries. The conference agreed that in order to be rescued from their debt crisis the countries must implement a set of pro-market reforms. The governments of the poor countries must reduce government spending on health and education (but not arms bought from rich countries), open up to trade and foreign investment, deregulate economic activities and privatise state-owned enterprises. This set of policies was described by Naomi Klein as “a clear effort to halt all discussion and debate about any economic ideas outside the free-market lockbox”.
Proponents of the Washington Consensus argued that the policies would create short term pain but in the long run would lead to economic growth. By the mid-1990s it was clear that they had failed to generate the promised economic growth but had led to fiscal crises and growing inequality. The response of the IMF economists was to add more “reforms” to the list required for rescue packages. Meanwhile China had grown spectacularly and lifted 400 million people out of poverty by implementing policies which were the opposite of the Washington Consensus, including imposing tariffs, subsidising industries and employing massive state intervention in the economy. The proponents of the Washington Consensus had failed to understand that countries did not become rich by liberalising their economies but liberalised when they became rich.
A more recent example of economists clinging to their models even when they fail to predict economic events is the assertion by Philip Lane, chief economist of the European Central Bank, in March 2022 that inflation in the Eurozone would decline later this year and be a lot lower next year. When some governors of the ECB expressed scepticism about the model Lane was using for his inflation predictions, he stoutly defended it, arguing that he would stick with it until a better model was proposed. It takes a model to beat a model. Inflation is now (August 2022) 8.9 per cent, almost twice what Lane’s model predicted and it is expected to continue increasing for the rest of 2022.
Skidelsky calls for “radical modesty, transparency and pluralism” in economics, but it is very unlikely that the practitioners of the dismal science will heed this call as their careers depend on promoting and implementing their discredited models. If a physicist employed by NASA made calculations which caused a spaceship to explode on take-off it is likely he would be dismissed, yet all the economists whose theories contributed to the banking crisis remain honoured and highly remunerated. More disturbingly, the dubious theories of microeconomics are now coded in algorithms which are used in much public and private economic decision-making. The world may have irritatingly failed to behave according to the models, but the models still rule.
Sean Byrne is lecturer emeritus in economics at Technological University Dublin.