The financial crisis has underlined fundamental conflicts in academia, especially amongst economists who spend their days typing Greek symbols on paper. Ostensibly, the work economists do improves our understanding of the economy. But as long as major economists continue to disagree, our understanding remains incomplete.
The lack of consensus is particularly striking in light of the overwhelming agreement on the methodology of economic research. This methodology is straight forward: write a simple mathematical model of economic behavior; check if the model is consistent with real-world data; if so, use the model to make predictions and shape policy. The fact that a common methodology yields divergent conclusions is particularly demoralising when we need economists to clarify the prevailing financial mess.
For the purposes of this article, mainstream economists can be divided into three groups: the strict neoclassicists of the Chicago school, the liberal neoclassicists, and the behavioral economists. This is an admittedly whimsical categorisation, and the term ?Chicago school? is perhaps a misnomer given that much of its opposition also resides at the University of Chicago.
The Nobel laureate Robert Solow, writing in the New York Review of Books, describes the Chicago school as ?libertarian, monetarist, sensitive to even small matters of economic efficiency, dismissive of large matters of equity.? Solow?s description of the intellectual dichotomy reveals where his own sympathies lie.
How can a neutral methodology lead to distinct and opposing conclusions? There are two possibilities. First, since we often lack the data to validate just one model of the economy, multiple models can coexist. Second, as Solow suggests, economists have legitimate disagreements about normative goals.
It is useful to illustrate this in the context of the financial crisis. The US government?s proposed solution involves regulation of financial markets and massive borrowing from the future to stimulate investment and consumption today. Some commentators have started muttering about the impending demise of capitalism. This is far-fetched, but the administration?s plans have certainly reignited the academic debate about appropriate government intervention in a capitalist economy.
Let?s start with Kevin Murphy, a superstar of the Chicago school and one of its most articulate defenders. At a recent forum in Chicago, Murphy offered a provocative critique of the stimulus plan. He argued that temporary tax rebates will not increase consumer spending since they have little impact on ?permanent income?. Rather, consumers? incentives to spend could be adversely affected by the prospect of higher tax rates in the future. Murphy also pointed out that government investment could be inefficient since it will be directed at hard-hit cities like Detroit rather than areas that provide the highest returns.
Murphy?s arguments reveal his choice of model and, to some extent, his beliefs about what outcomes matter. First, in his model of the economy, individuals are rational, well-informed, and capable of responding vigorously to present and future financial incentives. Second, his measure of outcomes is rooted in the concept of efficiency, or the size of the economic pie.
On a normative level, many liberal neoclassicists would take issue with the focus on efficiency. It can be argued that the size of the pie is inadequate as a measure of well-being?where is the ethical justification for valuing efficiency above inequality, poverty rates, and health? Amartya Sen and Joseph Stiglitz are heading a commission that seeks to replace GDP with a more descriptive and ethically satisfying notion of national well-being. Bhutan?s claim that it leads the world in gross national happiness may yet be validated.
Critics of the Chicago school sometimes accuse it of caring only about efficiency. That is a mischaracterisation. Murphy and his mentor Gary Becker have elsewhere defended capitalism on broader grounds, like its ability to raise living standards of the poor. Nevertheless, the Chicago school?s zest for efficiency does fuel the charge that it is indifferent to distributional concerns.
Additionally, liberal neoclassicists use a different model to analyse the crisis. Economists like Roger Myerson (last year?s Nobel laureate) argue that the economic universe should be modeled as one with a serious problem of asymmetric information. If people are ill-informed about borrowers? trustworthiness or firms? fundamentals, unfettered free market outcomes can be inefficient. Then, there is a need for intelligently designed regulatory institutions that encourage revelation of information. Under this model, one cause of the crisis was that financial products were complicated and obscured private information.
In the liberal neoclassical world, individuals may be uninformed but they are still rational. Though no economist claims that real people are entirely rational, this premise has long been accepted as a reasonable approximation. In contrast, many behavioral economists argue that human foibles must be taken seriously. They claim that the assumption of rationality hides fundamental insights that matter for welfare.
In a recent book, George Akerlof and Robert Shiller reinterpret Keynesianism using the vocabulary of behavioral economics. Economic decisions are influenced by psychological factors beyond the reach of financial incentives?people are more prone to take risks in good times than in bad times. This immediately suggests that governments need to be more than mere enforcers of contracts.
Behavioral economists also remind us that people are not as forward-thinking as rational models suggest. A truly rational individual would indeed not adjust consumption in response to a tax rebate with a negligible effect on lifetime wealth. But as Richard Thaler argues, people are prone to mental accounting, whereby they divide their lifetime wealth into several independent ?mental? accounts. As a result, they are in fact quite likely to head to the shops once the rebate cheques arrive.
The profession remains undecided about the best way to distil a system as complex as the global economy. I urge Mr Obama to send me a large tax rebate so I can analyse my response and thus contribute to the greater common good.
?The writer teaches economics at the University of Chicago