The financial crisis and the real economy recession have now been with us for months. Tremendous mountains of asset values have been wiped out. Big banks and broker houses have gone from a billion dollar equity to nothing overnight. Why did no one anticipate this ? Even if some institutions?IMF and the Bank of International Settlements?may have issued warnings, why did no one take them seriously? Who can we blame for this fiasco ?
The suspicion is now focussed on economics and economists. It is said that economic theory over the last 30 or so years has focussed exclusively on perfect and efficient markets. They have forgotten the legacy of Keynes. It is the theorists who taught generations of students about markets being self adjusting which biased the regulators and policymakers against any intervention. Hence when the disaster came, the theorists still said it was not supposed to happen. Does economics need a cure? Do we need a new economics ?
Many people think that it is not new economics but merely a revival of Keynesian economics which the world needs. Of course, even the Keynesians have their own differences as to what Keynes meant but the main idea is that since the economy cannot adjust to achieve full employment automatically there is a strong argument for state intervention. Indeed whatever they may have believed in till September 2008, all governments are now plunging for the Keynesian solution. There are differences among them as to whether the danger of inflation outweighs the fear of a depression. Yet when push came to shove, governments were Keynesians in policy.
My view is that this is a false battle. Both Keynesians and the New Classical economists believe in equilibrium economics. They both have static or at most dynamic steady state equilibrium models in mind. The economy may be at less than full employment or at full employment, but these are both equilibrium notions. Keynes is in this sense a neoclassical economist. After all, the notion that markets can efficiently allocate resources as well as the idea that there may be market failure both emanate from a neoclassical tradition. After all, it was Pigou, the Cambridge professor, and rival of Keynes, who pioneered the notion of market failure.
Markets are theoretical constructs for neoclassical economists and even their critics to grasp the complexity of how economies work. There is an older tradition?a classical including a Marxist tradition which treats capitalism as a disequilibrium system. Markets in this way of thinking are not allocation systems, but signalling mechanisms where profit opportunities are and where accumulation would be fruitful. Marx, Wicksell, Schumpeter and Hayek all theorised capitalism as a system in which cycles are endemic . For Marx a crisis is not a disease, but the way capitalism cures its own problems. Wicksell also theorised about cumulative dynamics of booms and slumps. Schumpeter is of course famous for his idea of creative destruction and Hayek was at the forefront of analysis of capitalism in the years before Keynes wrote his General Theory.
Keynes replaced this dynamic disequilibrium theory by an under-employment equilibrium one. This was more ?general? than the neoclassical full employment equilibrium idea, but it was not general in the sense of encompassing both equilibrium and disequilibrium in one theory.
No classical economist would be surprised by asset bubbles and financial crises. They would think of these as part of the way the system works. A crisis is not a sign of market failure; it is part of the way markets work. This kind of thinking has been so completely forgotten that we have a false battle between those who argue for efficient markets and those who complain about market failure.
So, if economic theory has to be reconstructed it needs not just a revival of Keynesian economics, or a refashioning of new classical economics. It needs a rethinking of the nature of capitalism. Capitalism mind you, not some bloodless notion of markets. It is the dynamics of profit-seeking innovators and entrepreneurs who scour the world for new niches and gaps in the demand structure and supply opportunities. This is how globalisation has transformed the world in the last 25 years. Economics in the meantime is still tied up in single national economy models and still uses linear rather than non-linear mathematics.
Keynes famously wrote about how policymakers are influenced by the scribblings of some madmen in the past. Alas we are today influenced by far too sober economists Keynesian and new classical who cannot do justice to the nature of reality. They have their followers but then people could sail around the oceans even thinking that the earth was flat.
The author is a prominent economist and Labour peer