The Myth of the Rational Market
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"Economics is revealed to have no more clothes than other social science."
"The reconstruction of economics needs to start with the universities."
Robert Skidelskys kommande bok Keynes: The Return of the Master
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Keynes: The Return of the Master
“Why did no one see the crisis coming?”, Queen Elizabeth asked
A seminar at the British Academy tried to answer and the FT has taken up the discussion.
Robert Skidelsky, FT, August 5 2009
Lord Skidelsky’s Keynes: The Return of the Master will be published by Allen Lane in September
Ever since modern economics started in the 18th century it has presented itself as a predictive discipline, akin to a natural science. Since the future a year ago included the present slump, it is natural that the failure of the economics profession – with a few exceptions – to foresee the coming collapse should have discredited its scientific pretensions.
Karl Popper produced a famous argument against the possibility of prediction in human affairs: one cannot anticipate a new invention because, if one could, one would already have invented it. However, this objection can be overcome if one assumes a stable and repetitive universe in which rational actors make efficient use of the information available to them. In this environment, uncertainty disappears to be replaced by calculable risk. Shocks and mistakes may occur but these will cancel each other out, so that, on average, people get what they expect.
An important implication of this view is that shares are always correctly priced. This is the basis of the so-called efficient market hypothesis that has dominated financial economics. It led bankers into blind faith in their mathematical forecasting models. It led governments and regulators to discount the possibility that financial markets could implode. It led to what Alan Greenspan called (after he had stepped down as chairman of the US Federal Reserve) “the underpricing of risk worldwide”.
It has also led to the discrediting of mainstream macroeconomics. The efficient market hypothesis is simply an application of the recently triumphant New Classical school, which preaches that a decentralised market system is always at full employment.
In their obsession with getting government out of economic life, Chicago economists claimed that any consistent set of policies will be learnt and anticipated by a population, and will therefore be ineffective. Since people – apparently including the 10 per cent or so unemployed – are already in their preferred position because of their correct anticipations and instantaneous adjustment to change, “stimulus” policies are bound to fail and even make things worse. Recessions, in this view, are “optimal”.
Most of those unversed in New Classical economics assume that John Maynard Keynes exploded these fallacies 70 years ago. Their re-emergence is not just the result of the failure of Keynesian macroeconomic policy to anticipate or deal with “stagflation” in the 1970s. It reflects a persistent bias in economics towards an idealised account of human behaviour; what Joseph Schumpeter called the “Ricardian Vice” of excessive abstraction.
The reconstruction of economics needs to start with the universities.
The obvious aim of such a reconstruction is to protect macroeconomics from the encroachment of the methods and habits of the mathematician. Only through some such broadening can we hope to provide a proper education for those whose usefulness to society will lie as much in their philosophical and political literacy as in their mathematical efficiency.
For 30 years or so Keynesianism ruled the roost of economics – and economic policy.
Harvard was queen, Chicago was nowhere.
But Chicago was merely licking its wounds. In the 1960s it counter-attacked.
The new assault was led by Milton Friedman and followed up by a galaxy of clever young disciples.
What they did was to reinstate classical theory. Their “proofs” that markets are instantaneously, or nearly instantaneously, self-adjusting to full employment were all the more impressive because now expressed in mathematics.
Adaptive Expectations, Rational Expectations, Real Business Cycle Theory, Efficient Financial Market Theory – they all poured off the Chicago assembly line, their inventors awarded Nobel Prizes.
No policymaker understood the maths, but they got the message: markets were good, governments bad. The Keynesians were in retreat. Following Ronald Reagan and Margaret Thatcher, Keynesian full employment policies were abandoned and markets deregulated.
Then along came the almost Great Depression of today and the battle is once more joined.
Robert Skidelsky, Financial Times June 9 2009
On a visit to the London School of Economics last November, the Queen asked why no one saw the financial crisis coming.
For if people with enough authority and influence had foreseen it, some preventive action would have been taken and either the crisis would not have occurred, or it would at least have taken a different form.
Samuel Brittan, FT, August 6 2009