Is This the Future of Economics?

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By Mark Thoma

I hear frequently that economics needs to change, and it has, at least in the questions we ask. Twenty years go, the dominant conversation in economics was about the wonder of markets. We needed to free the banking system from regulations so it could do its important job of turning saving into productive investment unfettered by government interference. Trade barriers needed to come down to make everyone better off. There was little need to worry about monopoly power, markets are contestable and the problem will take care of itself. Unions simply get in the way of our innovative, dynamic economy and needed to be broken so the market could do its thing and make everyone better off. Inequality was a good thing, it created the right incentives for people to work hard and try to get ahead, and the markets would ensure that everyone, from CEOs on down, would be paid according to their contribution to society. The problem wasn’t that the markets somehow distributed goods unfairly, or at least in a way that is at odds with marginal productivity theory, it was that some workers lacked the training to reap higher rewards. We simply needed to prepare people better to compete in modern, global markets, there was nothing fundamentally wrong with markets themselves. The move toward market fundamentalism wasn’t limited to Republicans, Democrats joined in too.

That view is changing. Inequality has burst onto the economics research scene. Is rising inequality an inevitable feature of capitalism? Does the system reward people fairly? Can inequality actually inhibit economic growth? Not so long ago, the profession ignored these questions. Similarly for the financial sector. The profession has moved from singing the praises of the financial system and its ability to channel savings into the most productive investments to asking whether the financial sector produces as much value for society as was claimed in the past. We now ask whether banks are too big and powerful, whereas in the past that size was praised as a sign of how super-sized banks can do super-sized things for the economy, and compete with banks around the world. We have gone from saying that the shadow banking system can self regulate as it provides important financial services to homeowners and businesses to asking what types of regulation would be best. Economists used to pretty much ignore the financial sector altogether. It was a black box that simply turned S (saving) into I (investment), and did so efficiently, and there was no need to get into the details. Our modern financial system couldn’t crash like those antiquated systems that were around during and before the Great Depression. There was no need to include it in our macro models, at least not in any detail, or even ask questions about what might happen if there was a financial crisis.

There are other changes too. Economists now question whether markets reward labor according to changes in productivity. Why is it that wages have stagnated even as worker productivity has gone up? Is it because bargaining power is asymmetric in labor markets, with firms having the advantage? What’s the best way to elevate the working class? In the past, an argument was made that the best way to help everyone is to cut taxes for the wealthy, and all the great things they would do with the extra money and the incentives that tax cuts bring would trickle down and help the working class. That didn’t happen and although there are still echoes of this argument on the political right, the questions have certainly changed. Much of the current research agenda in economics is devoted to understanding why wage income has stagnated for most people, and how to fix it. We’ve moved beyond “technology is the problem and better education is the answer” to asking whether the market system itself, and the market failures that come with it (including political influence over policy), has something to do with this outcome.

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Fiscal policy is another example of change within the profession. Twenty years ago, nobody, well hardly anyone, was doing research on the impact of fiscal policy and its use as a countercyclical policy instrument. All of the focus was on monetary policy. Fiscal policy would only be needed in a severe recession, and that wouldn’t happen in our modern economy, and in any case it wouldn’t work (not everyone believed fiscal policy was ineffective, but many did). That has changed. Fiscal policy is now an integral component of many modern DSGE models, and — surprise — the models do not tell us fiscal policy is ineffective. Quite the opposite, it works well in deep recessions (though near full employment its effectiveness wanes).

Monetary policy has also come under scrutiny. In the past, the Taylor rule was praised as responsible for the Great Moderation. We had discovered the key to a stable economy. But the Great Recession changed that. We now wonder if other policy rules might serve as a better guidepost (e.g. nominal GDP targeting), we ask about negative interest rates, unconventional policy, all sorts of questions that were hardly asked or even imagined not so long ago. We wonder about regulation of the financial sector, and how to do it correctly (in the past, it was about how to remove regulations correctly).

I don’t mean to suggest that economics is now on the right track. The old guard is still there, and still influential. But it’s hard to deny that the questions we are asking have gone through a considerable evolution since the onset of the recession, and when questions change, new models and new tools are developed to answer them. The models do not come first — models aren’t built in search of questions, models are built to answer questions — and the fact that we are asking new (and in my view much better) questions is a sign of further change to come.

Originally published here.

2016 February 4

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  • JeffMowatt

    20 years ago, it was almost heresy to suggest that capitalism was flawed. Bill Clinton, then US president was warned

  • X-7

    I argue that economists, and most of the populace don’t understand code, including monetary code, in a physics / evolution context.
    This is a young thought-structure.

  • Chuck Willer

    Mark, You write that 20 years ago “The move toward market fundamentalism wasn’t limited to Republicans, Democrats joined in too” in order to suggest that the events of the current period are calling into question economics. Yet, my copy of the Crisis of Vision in Modern Economics by Heilbronner and Milberg is dated 1995 and in 1989 Philip Mirowski’s More Heat Than Light was published. So powerful was Mirowski’s attack on mainstream economics that Duke University hosted an entire conference on Mirowski’s book and the proceeding were subsequently published as an Annual Supplement to Volume 25 History of Political Economy. (1993).

    In the Supplement, E. Roy Weintraub argues “there is danger in an important book” and “More Heat Than Light is an important book.” Weintraub goes on to say “Mirowski’s book is a remarkable frontal attack on this entrenched historiography [of economics]. His interweaving of mathematics with physics, his understanding that the mathematics of the neoclassical revolution was the formally instantiated energetics of the earlier time, and his construction of a narrative to encompass the interrelated fields of scholarship which shared language, formalism, and imagery (albeit with incommensurability problems, and translation failures) make a history of economic thought which cannot be ignored. Once a connection is demonstrated, and argued, and seen, it cannot be unseen.”

    I write these words not to urge anyone to read Mirowski, but to note that the warnings to economics go back decades. The rise of Econophysics in the 1990s must be noted. Joseph McCauley’s 2004 book Dynamics of Markets: Econophysics and Finance reflects much of the prior periods econophysics insights into finance. McCauley is adamant that neoclassical economics is empirically invalidated.

    All of the above work sounded an alarm about economics years before the 2008 financial crisis left egg on the profession’s face. Yet, the economics profession heard none of it. The issues go far beyond the topic of inequality. Perhaps today’s economics graduate students have little time or interest in econophysics or to learn the history of economics but there is disquiet in many departments. Economists like Steve Keen are increasingly being heard.

    You ask “Is rising inequality an inevitable feature of capitalism? Does the system reward people fairly? Can inequality actually inhibit economic growth” and than you note “Not so long ago, the profession ignored these questions.” Arguably, the profession has ignored much more than inequality, It has been stuck in a theoretical crisis for three or more decades grasping after one research palliative after another.

    Debt, banks and money are a good starting point for formal inclusion in a new economics – one that is modeled empirically and dynamically. Then finance, capitalism and inequality might begin to be appreciated and understood by economists. Who knows, it might even be an economics amenable to an evolutionary theory.