New Classical Economics

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Time Warp Economics

One of my ongoing complaints about economics is that it seems hidebound and horribly out of date. It seems stuck in the steam age with its references to land, labor and capital. Its models conjure up images of the titans of industry forging new railways across open plains and building vast steel works or cotton mills in once pristine valleys. There are landlords preying on peasants, while workers labor away in Dickensian conditions. Words straight from those bygone years litter its lexicon. The very notion of the margin was born from the forced usage of the worst farmland as the population grew, and from the distances wagons had to travel to market towns in northern Germany.

Not that there’s anything wrong with this, as long as we add more modern stuff along the way.

And that’s the problem.

Even reading the 1950’s work on pricing is an adventure back into an archaic world. Nowhere, or at least not very prominent, are concepts drawn from all the advances of the last couple of decades. It may be useful to talk about production functions and cost plus prices, but they remind me of astrolabes while I live in an era of GPS devices.

Leafing through an average economics paper or book I am left imagining a world largely bereft of mega banks; international companies managed by large self serving bureaucracies; internet sales; digital transmissions; or computer use. Very little seems to be made of the vastly more rapid flow of information, or that many of our products nowadays are entirely information based. It’s as if we never left the industrial era.

This may not matter. But I suspect it does. I suspect that a finer breakdown of labor would reveal very different influences on wage patterns and inequality. Models that treat labor as one big glob probably miss this detail. The same goes for capital.

It may well be that the basic 1800’s categories are sufficient to explain a 21st century economy. But I would like to be sure.

We are often told that capitalism adapts. If so, why are we looking at it through the same old lens? Land, labor, capital. Is that it?

It seems to me that the economy moves from one state to another. Each state being the result of some vastly complex computation based upon a massive set of variables. The space of those states is thus practically infinite. Yet the movement of the economy from one state to another is heavily constrained. We made it thus. We set boundaries by establishing institutions and cultural norms. Its movement is constrained by geography and the resource limits that are associated with location. Our ability to exploit those resources hinges on our knowledge and technology. The networks through which we communicate limit the flow of knowledge and capital. Society with its classes and other fractures gets in the way of smooth operation. And, of course, each configuration of the economy limits the possibilities for the next. Then we must account for the feedback between our current activity and each of these constraints.

It is tempting, in that face of this complexity, to simplify. We build models to explore pieces that interest us. Sometimes we dare to encompass the entire economy in one such simplification, and impute properties like equilibrium to tame the beast sufficiently for our imaginations to explore. We imagine that properties at one level of granularity flow untouched onto other levels either above or below. We remain faithful to the foundations of the discipline.

But if we don’t update our thinking, if we ignore progress, we run the risk of becoming anachronistic. Our models look quaint next to the reality they are supposed to explicate. We are condemned to add ever more sophisticated spheres to our Ptolemeic systems in order to keep up with emerging knowledge. We scramble for ever more ludicrous assumptions, and when all else fails we simply assert axiomatically that the world is the way we need it to be for our steam driven models to remain in touch with the electronic age. It is flat if we only have the tools to examine flat worlds.

One example: it is odd that it took such an effort to insert technology into our models as a driver of growth. In our zeal to cut the problem down to manageable size we eliminated most everything resembling an actual economy, and ended up focusing on allocation or heavily constrained optimization. That is pointless, because we are no longer examining anything that exists. Anyone familiar with complexity, self-organization and evolution is comfortable with systems that mutate, adapt and change from within. Technology is an obvious component of such change. It is entirely ordinary to consider it. Not extraordinary.

The mechanistic, individualistic, reductionist time warp that orthodox economics is trapped in does a disservice to our future. It is inappropriate. It is inaccurate. It is dated. So is the reliance on the same set of alternatives. Kalecki, Keynes, Sraffa, Robinson, the entire lot need to be freshened up. With them we moved from a goods based analysis to one inclusive of credit, money and finance. Now we need to embrace information. We need to move on and not keep arguing over the same time worn issues that occupied our forbears.

Here’s an idea: the information content of the economy has exploded. The products we make now are information intense. The algorithm needed to explain those products is more complicated and lengthy than that needed to explain the average product made seventy years ago. Our thinking about what an economy is needs to keep up.

And that goes for all you DSGE fans too.

Then again I may be wildly wrong. After all an astrolabe would still help you navigate the world. Sort of.

But I know it’s not flat.

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Krugman Fails To Take Up The Challenge

Sifting amongst the debris left after the recent collapse of economic orthodoxy is not easy. The big guns of the academy are clinging on for all they are worth to the idea that a few fixes and we are all back on track. They have the most to lose in reputation and standing, so I suppose this stubborn refusal to admit the extent of the defeat is understandable. But it is not acceptable. Things have to change in a more dramatic way for economics to rehabilitate itself as a credible body of thought upon which policies can be based. It is simply not enough to continue the old “freshwater” versus “saltwater” debate – that please recall is the argument between various grades of orthodoxy, the former ensconced in Chicago and other universities far from the coasts, and the latter based primarily on those two coasts.

Paul Krugman is a great example of the problem.

He presents a strong argument and defense of a Keynesian approach to macroeconomics. This is the part of economics that deals with the big issues that occupy policy makers, especially in times of recession. In this he finds himself ranged against the more orthodox ideas of the Chicago style thinking that has invaded and taken over most of the high ground in the discipline. So he thinks of himself as an insurgent of “heterodox” thinker, and likes to do combat as a rebel.

This is curious since the rebellion is simply an attempt to reinstate the Keynesian theoretical constructs that were so successful in the immediate post war years until they were dethroned by monetarist and then hyper rationalist versions of what is called neoclassical economics. That neoclassical set of ideas was largely initiated by Paul Samuelson in 1948, when he published his enormously successful textbook and sought to incorporate Keynes within the pre-existing classical tradition.

The problem this melding produced as its legacy is that there is an inherent and implacable break between Keynesian and classical economics. Keynes spoke to aggregate issues: before him there was no notion of “aggregate demand” as a concept to be studied, managed, or fitted into policy. He argued that uncertainty was axiomatic and that the classical notions of perfect competition and so on were thus invalid. Unfortunately Keynes did not follow through and give us a full replacement for the old classical system. He was a practical and conservative person dealing only with the larger issues: indeed he invented what we now called “macroeconomics” so he could propose solutions to those larger issues, especially the devastation wrought by the Great Depression.

To put it bluntly: economics became a mess.

At the big picture level the emergence of Keynesian thinking split the subject apart. The saltwater versus freshwater fight is the result of this division.

But at the lower level much of the classical tradition survived untouched. The magic of markets; the workings of rational agents making perfectly rational decisions; the possibility of a “Pareto Optimum” – that mystical point at which an economy reaches its most efficient allocation of resources; and the other paraphernalia of classical “microeconomics” remained supreme.

So economics was cleft in two. The Keynesian constructs at policy level were based upon a worldview at odds with the micro analysis economists still relied on to understand the workings of the marketplace.

One response within economics was to replace Keynesian macro with a cobbled together version based upon classical micro. The mantra became “macro built upon a micro foundation”. This new classical tradition is the basis for freshwater thinking.

The other response was simply to ignore the contradictions between Keynesian macro and classical micro. This was the basis for saltwater macro.

Krugman falls into the second group. He voices little concern about the contradictions. Indeed he accepts them.

The obvious parallel is with physics, where the physics of very small things, known as generally as quantum mechanics, is incompatible with the physics of very large things, which is the relativity of Einstein. If physics can exist with a great divide, Krugman argues – I am putting words in his mouth – so too can economics.

This, frankly is rubbish.

Why?

For two reasons:

One, is that physics at each level is supported by empirical testing to an extraordinarily high degree of accuracy.

Two, is that physicists the world over are striving to connect to the two traditions. they do not find it acceptable to have deep contradictions within their thought, and so have set out to look for the necessary theoretical breakthroughs needed to reconcile them.

Not so in economics,according to Krugman. We, apparently will have to make do with the odd supposition that aggregate constructs are subject to inherent, and axiomatic, uncertainty. While our understanding of the deeper workings of the markets, firms, and consumer behavior from which those aggregates are composed are subject to no such thing. On the contrary those lower order objects behave supremely rationally in a world admitting of no uncertainty at all.

Talk about a muddle.

That this muddle persists is indefensible. It is time to eliminate the error left in the aftermath of the Samuelson synthesis. If Krugman won’t take up the challenge, then others will. Building a new micro based on the acceptance of uncertainty as its central axiom is the work we now need to undertake. Much has been done, much is yet to be done. One thing is clear: the challenge must be met.

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It’s Love “Schumpi” Day

When last I wrote here I repeated a quote by Joseph Schumpeter, that Paul Krugman used to lambast the classical opposition to government interference in the economy.

True to form, I was immediately set upon by the one man Austrian economist defense force – Stephan – who managed to dig out the original text from which the quote was cut. His purpose being to draw my attention to the softer tones used elsewhere in that document.

I agree. Schumpeter was not as clear cut a terror as Krugman made him out to be. While we all know Schumpeter as the inventor of the phrase: “the gales of creative destruction of capitalism”, he was so much more.

His influence was muted by the fact that his long career always seemed to leave him out of the limelight, he was eclipsed by Keynes for instance, and never part of a dominant school of thought. He was a teacher, at Harvard, of a number of subsequent “Nobel” prize winners, but his books and papers put him outside of the emerging mainstream of American economic theory.

In many ways Keynes was more orthodox than Schumpeter.For instance, Keynes, for all his rebellion against classical theory, was still committed to static equilibrium style thinking. That in his system equilibrium could imply less than full employment was startling, and controversial. But his thinking was focused on the properties of economies as they tend toward or away from such equilibrium. It was Patinkin who pointed out that Keyne’s great innovation was to locate the equilibrating force within his novel conception of “effective demand”. Everything else in The General Theory flows from that idea, and the tools Keynes used were borrowed and adapted from others, such as theeconomist Fisher.

By contrast, Schumpeter was never interested in equilibrium. He saw the economy as in perpetual flux and never in the kind of static equilibrium that has come to dominate orthodox economics since the mid-20th century. This is why he was led to discuss “creative destruction”. The central actor in his conception of an economy was the capitalist innovator driven by profit to search for new products and new methods of production. It was this innovation that, in Schumpeter’s view, provided the engine driving wealth creation and social welfare generally. Along the way capitalists make mistakes, they over produce or over invest, this leads to periods of adjustment and the need to revalue assets. These periods are what we call recessions or depressions, and are the times when those mistakes are wiped away. Hence the destruction. Naturally once the adjustment has been made and past mistakes expunged, the now chastened capitalist class powers forward again, driven once more by the profit motive, only this time free of the encumbrance either over valued assets or ill advised investments. Hence the creative aspect to Schumpeterian economics.

Drucker draws the difference between Schumpeter and Keynes nicely. Keynes, he said was merely a heretic. Schumpeter was a full blown infidel.

Unfortunately for Schumpeter his notion of an economy being dynamic and subject to cyclical upheaval flew directly in the face of classical theory whose goal was to place economics firmly into a Newtonian firmament both mechanical and determinist. This misfortune was compounded by the success of people like Arrow and Debreu who, a few years after Schumpeter’s death, were able to create the mathematics necessary to articulate a model of general equilibrium and thus obviate the need for younger theorists to explore the seeming chaos of the Schumpeterian world.

Oddly, sixty years after his death, Schumpeter seems more relevant than before. His ideas could be re-cast as being evolutionary, and the great theme of evolution is one possible way in which economics can regain the relevance and connection with reality it lost after Arrow-Debreu. His importance to current events is even more significant when we consider his long view for capitalism. It was a system, he thought, that would choke itself on its own success. Not through the results posited in the Marxist critique, but because of something altogether more mundane: he feared that capitalism would spawn a great bureaucracy populated by elitist “hangers-on” to the entrepreneurial machine. These elitists would be highly educated workers like lawyers, accountants, and bankers who would eventually sap the system of its vitality through their ability to impose non-productive costs on the innovative process. They would rent seek, draw off funds, and starve capitalists of the means to keep the engine running.

This scenario sounds eerily familiar. It also accords with the work of a protege of his nemesis. It was Minsky, a follower of Keynes, who correctly developed a theory describing the instability within finance – one of Schumpeter’s feared bureaucracies. So, perhaps, within a Minsky moment we can detect the imprint of Schumpeterian creative destruction.

If so, there is hope for a conjunction of the theories of two of greatest non-classical thinkers of twentieth century economics.

And we need all the new ideas we can get.

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The State of Economics. Hint: Bad.

This next weekend Paul Krugman has an article in the New York Times that I think it is well worth your time reading. It is called: “How Did Economists Get it So Wrong?”.

I have inveighed here, in my own inadequate way, many times about how I see the failure of economics as a body of both theoretical and practical thought as one of the main causes of our recession. Krugman, naturally doesn’t go that far, but that’s because he’s knee deep in the intellectual mire.

“It wasn’t simply greed: it was intellectually sound and risk adjusted greed.”

The simple fact is that economics as a body of thought has let us down with a thump still resounding around the hallowed halls of the University of Chicago [and Minnesota] whose intellectual tradition in the subject has now collapsed. Or rather has self-immolated.

This may seem to most of you to be a peripheral and dull thing to talk about, but I would urge you to reconsider.

Most people who are engaged enough to discuss the state of the economy bring with them a set of unstated assumptions or ‘truths’ about it. I hear statements every day such as ‘markets self correct’ or ‘markets are more efficient than government’ and so on. These are ideas bedded in a particular economic theory. They are the result of hard fought intellectual battles that extend back through time all the way to the pre-capitalist years of the late 1600’s and early 1700’s. They are not infallible, yet they are kicked around carelessly as if they were eternal truths.

They are not.

And the thrust of the Krugman article is to describe the more recent aspects of the fight between two major competing schools of thought within economics: the ‘New Classicals’ and the ‘Keynesians’. Never has an academic bun fight been more important to the public. The outcome may well determine the next thirty years of public policy.

So get involved. At least read Krugman’s side of the argument.

There is no point in my hiding my allegiance in this battle: I am firmly on the side of Krugman, although I think he has only just begun to understand the trajectory needed: he is steeped in the old way of thinking and is only now emerging into the brighter light of progress. Nonetheless he gets it. I cannot name an instance at the University of Chicago where I would say the same. Indeed they now all appear to be astrologists rather than academics.

So what?

Well, the issue before us can be boiled down to simple terms: are markets efficient?

I say no. There is no practical way of meeting, in the real world, the necessary conditions that underpin an ‘efficient’ market. So none – absolutely none – of the properties so valued by efficient market economists can be discovered out here on planet earth. That is not to say that the mathematics of the efficient market folks isn’t the apogee of elegance and rigor. It’s just that is has no earthly application or relevance.

The heroes of this school of thought – Lucas et al – represent the ‘who’s who’ of economics over the past three or four decades. To them have gone the preponderance of Nobel Prizes and awards. To them have gone the best contracts and the bulk of the recognition.

So well established did they become that they came to dominate the formation of public policy. And it is here that you all ought to pay attention. For decades the guiding ‘worldview’ of our legislative process and of the elites in business and public policy has been driven by the New Classical paradigm. Within which the notion that markets are efficient reins supreme. Flowing logically from this are the practical ideas of deregulation and limited government intervention – indeed to a Lucas influenced central banker or policy maker any kind of government action is, at best, self defeating, and at worst damaging. This viewpoint dovetails nicely with libertarian style Republicanism of the Reaganite mold – indeed it provides that form of Republicanism with a gloss of intellectual virtue.

You can see the effects all around you: deregulated banking is a primary cause of the recent debacle; weakened government institutions fail to respond to Katrina effectively; and the current health care debate is largely forged in those terms.

So to argue that the current dispute within economics is simply an academic spat of no consequence to the wider world is just not true. The outcome is essential.

The good news, as Krugman indicates, is that the lost knowledge acquired at such cost in the Great Depression, has been resurrected and used. In the nick of time we re-learned the lessons of the 1930’s. Keynesian economics is back in full force.

That is good news.

But is also just a beginning.

Financial firms all across the world are replete with analysts brought up inside the New Classical tradition. Our colleges still use text books written by New Classical heroes. The flood of PhD graduates going from the top schools to Wall Street to model, wrongly, derivatives and other arcane aspects of our financial world is unabated. Every time one of these highly educated and well meaning people run a model based upon the efficient market hypothesis they propagate a falsehood. They bake in an error. Every time a talking head on TV speaks breathlessly about the ‘market’ they, perhaps unknowingly, spread the meme that markets are good things we should pay attention to and leave well alone. The error spreads in all these small ways. It will be very difficult to root out.

The truth, such as we now see it, is very different and much more nuanced. An economy has properties that exhibit regular behavior, but markets are ’emergent’ from a group of individuals – you cannot simply sum up the various individual behaviors and get a market. So the properties we must use in our models and in finance are far deeper than the simple mechanisms taught us by the likes of Samuelson, Friedman, and so on. Complexity intrudes at every stage. This is the great lesson of the financial crisis: the very mathematics upon which we based, in good faith, our understanding of market behavior, is wrong. The point is that even wrong theories can produce good results for a time: Ptolemaic astronomy served well in the limited seas of the Mediterranean for centuries. The notion that risk is always clustered at the center of a normal curve, and that those, now famous, ‘long tail’ events are so improbable as to be sensibly ignored , is such a theory. Wrong, but useful enough to dominate thinking for a while. And it was responsible in large part for the collapse of the derivative market and hence the big banks. Cleared headed, textbook economics, perfectly executed and properly implemented destroyed the financial system. It wasn’t simply greed: it was intellectually sound and risk adjusted greed.

And it sank like a stone when the real world’s complexity intruded.

So now it’s time to import fresh ideas to buttress the Keynesian vision.

Mandelbrot, Prigogine, Minsky, and others have all something to add.

This is why Krugman is at the start not the end. He asks where does the profession go from here? I respond by saying: into complexity theory, information theory, statistical dynamics, agent based modeling and evolution. All these great traditions are inter-twined. From their nexus we will create the new economics.

What fun we will have. For those of you who have a practical bent: agent based modeling is the tool that I see as having the most immediate impact on things like risk management and portfolio analysis.

Meanwhile, remember this: markets are flawed. They work well sometimes, but there are moments when they hit barriers and need help. The one thing we know is that they are not efficient. Learning that has cost 6.7 million people their livelihoods. Perhaps one or two professors should join them.

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Economists Go to War

Well sort of. One of the wonderful aspects of the current crisis is that economists are having to confront reality for a change. That might sound odd, but when you consider that most academic economists have not one whit of experience in the messy goings on of a real economy it takes on a delicious meaning. Most economists nowadays spend their life sublimely cut off from reality and instead inhabit an alternative world of mathematical models. It is a world stripped of all the awkwardness introduced by nasty things like people. In this alternative world you and I could not exist, we are far too limited. No. That world is ruled by ‘agents’ who are supremely gifted, far sighted, and have incredible powers of both memory and computation. While you and I might fumble over the addition in a simple shopping list, these denizens of the economist’s utopia are veritable cognitive gods. Nothing eludes them. Nothing fools them. And above all else nothing shakes them from their determined march towards the idyllic perfection of something called equilibrium.

That none of this resembles, in the slightest way, what goes on in a real economy is of no interest or relevance to academic economists. Indeed they get self righteously indignant whenever someone, an amateur like me for instance, throws cold water on their ‘science’. Call economics voodoo and wait for the hissing from the tenured crowd who preach that market interferences like, well tenure, are a ‘bad thing’.

“If economists are akin to astrologers, which most of them are in my opinion, why should we be interested?”

Of course there are exceptions. Those among them who ‘get it’. These rarities realize that economic theory is, at best, a very weak ‘first approximation’ for reality, and that the outcomes of the models that so enthrall the profession are most often of absolutely no relevance to practical problem solving.

Now I know some of you might be wondering why I bring this all up. If economists are akin to astrologers, which most of them are in my opinion, why should we be interested?

Because they screwed your life up. That’s why. This economic crisis has at its roots an ideological conflict. A war. Between a more realistic economics and the utopian version that has held sway for the past few decades. Had the utopians not won the early battles of the war we may well not have arrived at the mess we find ourselves in.

The Reagan/Bush era is the era also of the triumph of ‘New Classical Economics’. Boring and arcane though it may appear this pernicious and almost entirely useless intellectual construct has permeated into everyday conversation. Anyone one of us who talks of the ‘self-righting capacities’ of markets, or of the ‘proven’ superiority of market allocations over centrally planned allocations of wealth, or of the ‘meddlesome and inefficient’ nature of government, or of the ‘obvious’ inability of government to manage GM, and, in particular, of the ‘need’ to deregulate to set business ‘free’ is aping the New Classical agenda.

The fact is that none of these statements is scientifically correct. Not one. For those of you who remember Econ 101 at college: there is actually no scientific ‘proof’ that supply and demand behave in those nice curves we all drew back then. Behind the scenes there has to be a lot of assumption, guessing, and then leaps of blind faith to make the whole machinery work. Yes it makes intuitive sense. But can it be ‘proved’? Nope. Life is far too complex. Even simple things like that fact that people change their minds about what they like throws the machinery into chaos. The economist’s response? Disallow such things. In the models they use, people, sorry ‘economic units’ to use Milton Friedman’s revealing nomenclature, are not able to change: what they want at seventeen years old is what they want when they are seventy. Bill Gates used to order pizza in his garage while he tinkered with Windows, and he still, according to the models, orders pizza – exactly the same pizza -while he tinkers with Microsoft and his various charitable trusts.

Whoops. As I said: a rough ‘first approximation’ at best.

You might have noticed the recession. It almost slipped into depression. Something evidently went wrong in the economy. One of those things that went wrong was economic theory. Markets apparently foul up now and again. They do not relentlessly focus in on optimal solutions, and then magically and inevitably produce perfection. Sometimes they seem to spin wildly out of control. Heck people even cling onto silly notions like trying to keep their wages high despite rising unemployment – that doesn’t happen in the models.

So economists are going to war.

Not with the intent of developing a new theory that incorporates the messiness of the real world. No. They are going to war with each other. Today’s Financial Times acknowledges as much: it carries an article by Lord Skidelsky trumpeting the behind the scenes violence that has flared up.

The point is this: there are many camps within the world of theoretical economics. Some are more accepting of the real world than others. Some actually tolerate the foibles of real people. Some even allow businesses to make profits – another thing that doesn’t happen in the standard models.

Given the obvious failure of the New Classical system those economists who have been marginalized for the past few decades have suddenly seized the opportunity to grab the headlines. Sometimes they are not even that iconoclastic. Economics is a very gentlemanly world so calling someone, Robert Lucas say, a jerk, is not very nice and therefore not tolerated. Academics being the intensely respectful folk that they are do not go as far as I would. Some would even defend Lucas still for his ‘contribution’.

But let me not pick on Bob.

I should pick on the whole lot of them.

The war that now rages is of great importance to us all. We need economists to understand the economy. It helps us to make policy. If they don’t get their theories right we are left making policy in an intellectual vacuum. This is not trivial. Millions of jobs and livelihoods depend upon the theories that flow from places like the University of Chicago which became the epicenter of the stupidity known as New Classical economics, and which, therefore needs to issue a public apology. Or at least show a little contrition.

Manning the front lines in the war, on the behalf of reality, are a variety of schools of thought. ‘Behavioral’ economists are trying to inject real people idiosyncrasies and psychological fallibilities into economics. Evolutionists are trying to get history and change to be part of the system we examine. There are many others.

But most of all, in the context of the current fight, it is the Keynesians who are emerging as the ‘new wave’. Which means that this war over theory is a re-match. Keynes got it right. The essential observation that sets him apart is his acceptance of the limitations of markets. In his world markets can go wrong. In fact they inevitably will go wrong. This is such an anathema to the New Classicists that they waged war against Keynes for decades until the fortuitous convergence of the 1970’s stagflation, Reaganism, and the collapse of the Soviet Union seemed to hand them the victory. Keynes, with his monetary roots in Wicksell, and his criticism of market purity, along with others with unacceptable ideas, like Fisher, slipped from the textbooks and subsequent generations of students were brainwashed with the notion that markets are inevitably the best solution to all economic problems. The Keynesian tolerance for government intervention was thrown overboard and a strict ‘government is the problem’ dogma took over.

This process of expunging the heretics was covered up and called a ‘merging’: the good ideas from everywhere were brought into the warmth under the covers of the New Classical rubric.

But the ‘synthesis’ looks an awful lot like a deletion. The lessons and theories of the previous era were quietly removed from the curriculum as being quaint or, according to Johnny Cochran, simply ‘fairy tales’. New Classical purity took over. Which is good for the heretics since there is a straight line to be drawn connecting the victory of New Classicism and today’s crisis.

Why?

Because economists were not content with producing theories. They also produced technologies.

Once markets are enshrined as all knowing and supreme the door is opened for all sorts of mischief. Markets must also be ‘efficient’. They must deliver the best solutions. If that is so then the solution we are observing must be optimal since it is an outcome of a market process. This may sound tautological, but it is a summary of something called the Efficient Markets Hypothesis [‘EMH’] which provides the intellectual undergirding for the derivatives market. So economics not only sought to explain the market, but it went further: it provided the techniques, or technology, for running the market. Without EMH the derivatives markets would have remained an arcane backwater. AIG would still be an insurance company and not a failed casino. You and I would never have heard of TARP. Joe Nocera in last weekend’s New York times wrote about the mess that is EMH: this war is going public.

New Classical economists became so sure of themselves that they believed they could shape reality to conform with their models. The application of EMH to options trading is an example of their hubris. And their failure.

Not only this but they declared the mysteries of the business cycle over. As recently as this decade Lucas and his ilk called the days of downturns done with. Alan Greenspan was a true believer. As were most economists with any public stature: it was not possible to attain public stature without bowing to the gods of the market.

This is the extent of the intellectual clean up we are now engaged in. There are years of falsehoods to undo. And huge intellectual reputations to undo as well.

The world has been massively misled by economics. We should all treat it with disdain as it sorts itself out. The New Classicists will not go without a fight: witness the recent public spat, courtesy of the New York Review of Books, between Niall Ferguson and Paul Krugman. But they are in retreat. That’s good news for realists.

And how ironic that New Classical economics may have arrived at its ‘Minsky moment’. Minsky was a Keynesian whose theory talked about asset price bubbles and the inevitable instability of financial markets. That his voice was unknown to so many players in the market is a shame, and may have cost us billions of dollars.

So we can be encouraged: the economists are at war. Sometime in the future they will be worth listening to again.

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