The next step for economists
These are strange times for macroeconomists. The subject has been shot to the forefront of CEO concerns and economists have emerged from their backroom status to find themselves blinking in the spotlight. Topics previously discussed only among the cognoscenti at earnest conferences are now debated enthusiastically in the media. Macro has gone mainstream among the business community. Participating in this process as a macroeconomist, Andrew Scott asks what next for the discipline of economics?
Some commentators argue that this is not just a crisis for the economy, but for economists. There seem to be two strands to this argument. The first is that the economics profession did not forecast such a serious downturn. The second is that canonical models have been shown to fail and the conceptual cupboard in economics and finance is bare. Economics has much to learn from this crisis and research will be clearly refocused as a result. What we teach as mainstream economics will undoubtedly shift substantially. But is it really a crisis?
We didn't see it coming
The criticism over the forecasting failure of economists rests on two assumptions. The first is that it wasn't forecast; the second is that economics should be judged by its predictive ability. It's certainly true that only a few individuals - Nouriel Roubini and Bill White of BIS are two that spring to mind - predicted such a devastating downturn. From my experience (and my own views), a majority of economists thought that asset markets were overvalued, there would be a correction, and this would cause serious financial pressures and a downturn. But few predicted correctly how badly the financial sector would be affected by declines in real estate or how large the impact of financial distress would be on the real economy.
There seem to be two reasons for this. The first is a natural problem in forecasting. When forecasting the future, it seems natural not to take extreme positions. Put simply, if something bad is expected to happen, do you think it will be as bad as usual, not as bad as usual or the worst outcome you can think of? The rational perspective is to expect the average outcome. The result is that forecasters will inevitably tend to underestimate the strength and duration of really sharp recessions, just as they will underestimate very strong booms.
The second issue is whether economics should be judged by its predictive ability. Here there seems a big divide between producers and consumers of economics. Among economists, forecasting is not held in high renown and is a minority occupation. However, among people who want to listen to economists, it is predictions they expect.
To my mind, economists are similar to my doctor in terms of predictive ability. When I go to my doctor, I tell him my symptoms and he diagnoses an illness and recommends an intervention. If I push my doctor, say that I have an important talk to make in three days and ask if he can guarantee that I will be well enough to participate, I get the following response: "I think you have X and these drugs work in three or four days. You should be okay. But if you aren't, come back and we will try something different."
Economists are very similar. The government comes to us and says, "Here are my symptoms." We diagnose a recession and recommend cutting interest rates, increasing fiscal deficits and banking sector bailouts. The government then says, "But I have an election in 12 months; will things be better?" We reply that the measures take 12-18 months to work, that it should be OK, but, if it isn't, then come back and we will try something else. In other words, the medical profession isn't particularly good at prediction, but we still find it useful and helpful. The fact that the medical profession was unable to pinpoint swine fever as the next pandemic or that it would occur in Mexico and is unable to give us reliable forecasts of how it will develop in terms of cases and time span has not lead to widespread criticism of academic medicine or calls to banish sophisticated mathematical models and read Malthus. Yet economics and finance has experienced this backlash and much exhortation to re-read Keynes, Minsky and even Marx.
I don't wish to say that economics is as advanced as the medical profession in terms of knowledge or the reliability of its interventions. I am sure many would say we are more like witch doctors than doctors. But an inability to predict extreme and unlikely events is not grounds to dismiss a body of knowledge. Economics will never be able to reliably predict such events; nor is it alone in this failing. More needs to be done to educate consumers of economics on how to interpret forecasts, and, undoubtedly, the economics profession needs to be more modest in how it presents its forecasts.
Intellectual bankruptcy
Another widespread criticism of economics and finance is that we have been dominated by irrelevant textbook theories and that our belief in them has led the world to the brink of destruction. The usual culprits mentioned here are efficient markets and the theories of rational expectations and equilibrium, and mention is made of Nobel prizes awarded to Lucas, Merton and other academics who have articulated the insights of these theories.
The truth is, of course, that economics is a broad field with many research agendas. After all, the usual criticism of economics is that we are two-handed and can't commit to one view of the world. Those who criticise the work of Lucas and Merton seem to conveniently ignore Nobel Prizes awarded to Akerlof and Stiglitz, who believe that markets are characterised by many fundamental failures. Even before the crisis, some of the liveliest and most interesting macro research was in the areas of how agents have imperfect information about the world, how they learn and sometimes make mistakes in their learning, and how risk and incomplete markets have serious macroeconomic implications. It is for their work in this area that many suspect that Sargent and Shiller may receive Nobel prizes in the future.
I make the case that economics is not bankrupt or has not ignored key themes. But there are many areas that need much more focus - imperfection information, extreme events, liquidity, financial-real interactions and the importance of behavioural factors to name but a few. The academic world of finance tends to view financial markets as separate from the economy. This has proved nearly economically fatal as pricing formulae, risk diversification strategies and risk assessment have been proved woefully inadequate, since a weak financial sector causes a weak economy that in turn creates further financial weakness. Macroeconomists tend to do better at realising how financial markets interact with the economy, but they have poor models of this interaction. We are still reliant on black box models of how money and credit is created and have no effective model of the banking sector and the wider financial system.
The near-term future remains uncertain. Recovery may not be in place and, if it occurs, may well be very anaemic. In the wake of such a serious financial crisis and deep recession, there will be changes going forward. Capitalism has been extremely flexible throughout its history in how it responds to shocks and challenges, and once again the tug of war between markets and regulation will resume with a shift towards greater regulation. The rise of behavioural theories provides increased intellectual justification for government intervention to protect individuals from their own decisions. The financial crisis will result in substantial reregulation in the financial sector. The growing political support for government intervention also bodes badly for globalization.
Further, whereas the past decades have seen deregulation in an effort to bring out the best from globalization and technology, the major future trends that governments will have to deal with are environmental issues and an ageing population. Solutions to these problems will require substantial government regulation and intervention. Capitalism therefore evolves and will continue to mutate. It is not just in the West that changes will occur. China and the Middle East and a host of emerging markets will realise that they need to develop their own financial markets and their own capacity to absorb domestic investment to avoid a recurrent pattern of savings gluts, capital flows, bubbles and crashes. This will have major implications for the magnitude and direction of capital flows as well as critical issues connected with what currency acts as an international reserve and the whole global financial architecture.
Business will also face a whole series of major risks - regulatory risk, tax threats, threats of deflation and inflation (although the experience of Japan suggests deflation may be the most prominent) and uncertainty about the strength and sustainability of recovery. This may be, after all, the biggest change that corporations have to respond to - the return of aggregate risk and uncertainty. After a period of stable and sustained growth that meant markets and firms focused on internal issues of leadership and corporate finance, they are once more facing the challenge of external uncertainty. No one knows for sure what the future will bring. Dealing with that uncertainty, factoring it into decision-making processes, and being flexible enough to survive whatever events occur, has risen up the corporate agenda.
Although the macroeconomists will retreat from the spotlight, every CEO will want to make sure they aren't banished too far into the back room.
Andrew Scott (ascott@london.edu) is Professor of Economics and Joint Chair of Economics at London Business School.