In the past 6 months, there have been three serious, full-scale indictments of neoclassical theory. The authors and the publications are mainstream enough so that many people—inside and outside the discipline—are having to take notice. The first is Patricia Cohen’s “Ivory Tower Unswayed by Crashing Economy”; the second, “The Last Temptation of Risk,” was penned by Barry Eichengreen; and the most recent, and probably the most read, is Paul Krugman’s “How Did Economists Get It So Wrong?”
While all three authors fundamentally challenge, and call for an alternative to, the way mainstream economics has been practiced in recent years—and therefore the way the discipline of economics and economic policymaking have been organized—they have different analyses and solutions.
Let’s start with Cohen. She recognizes that economists who did not fit within the neoclassical orthodoxy were marginalized:
For years economists who have challenged free market theory have been the Rodney Dangerfields of the profession. Often ignored or belittled because they questioned the orthodoxy, they say, they have been shut out of many economics departments and the most prestigious economics journals. They got no respect.
And while the crises of capitalism have led many to question the usefulness of neoclassical theory, the discipline itself has been slow to change:
Yet prominent economics professors say their academic discipline isn’t shifting nearly as much as some people might think. Free market theory, mathematical models and hostility to government regulation still reign in most economics departments at colleges and universities around the country. True, some new approaches have been explored in recent years, particularly by behavioral economists who argue that human psychology is a crucial element in economic decision making. But the belief that people make rational economic decisions and the market automatically adjusts to respond to them still prevails.
But she does recognize that there have long been alternatives to the neoclassical orthodoxy:
There are a handful of departments that have welcomed alternative theorists, like the University of Massachusetts, Amherst; the University of Massachusetts, Boston; the University of Utah; and the University of Missouri, Kansas City (where the Heterodox Economics Newsletter is published).
The same, unfortunately, cannot be said of Professors Eichengreen and Krugman. Perhaps that makes their indictments even more compelling for the mainstream, in the sense that neither of them even deigns to recognize the existence of heterodox economics or of departments where such theories are taught and practiced. What this means is the alternatives they offer are narrowly circumscribed by the pendulum swings that have long characterized mainstream economics—between (for Eichengreen) more rationalist and more empiricist approaches and (for Krugman) more neoclassical/”freshwater” and more Keynesian/”saltwater” approaches.
For Eichengreen, the “great credit crisis” caught mainstream economists unaware:
We now know that much of what we thought was true was not. The Great Moderation was an illusion. Monetary policies focusing on low inflation to the exclusion of other considerations (not least excesses in financial markets) can allow dangerous vulnerabilities to build up. Relying on institutional investors to self-regulate is the economic equivalent of letting children decide their own diets. As a result we are now in for an economic and financial downturn that will rival the Great Depression before it is over.
But the problem is not with the discipline of economics but, rather, with the way mainstream economics was appropriated:
One interpretation, understandably popular given our current plight, is that the basic economic theory informing the actions of central bankers and regulators was fatally flawed. The only course left is to throw it out and start over. But another view, considerably closer to the truth, is that the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking.
The solution he offers is to move away from mathematical modeling and turn in a more empirical direction:
The twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.
Krugman also indicts mainstream economists’ fascination with mathematical modeling:
As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. . .the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.
This physics-envy led them to fetishize free markets and forget about all other factors:
Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.
While Krugman puts most of the blame on the Chicago School/freshwater/neo-neoclassical economists, he argues that even New Keynesian/saltwater/neoclassical economists must shoulder part of the blame:
Their framework, unlike that of the Chicago School, both allows for the possibility of involuntary unemployment and considers it a bad thing. But the New Keynesian models that have come to dominate teaching and research assume that people are perfectly rational and financial markets are perfectly efficient. To get anything like the current slump into their models, New Keynesians are forced to introduce some kind of fudge factor that for reasons unspecified temporarily depresses private spending.
So, if both sets of neoclassical models are fundamentally flawed, where does Krugman see the solution? In a bit of tinkering around the edges:
Here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.
All three authors therefore recognize that neoclassical economics, in the way that it has been developed and practiced over the course of the past 30 years or so, is fundamentally flawed. The mainstream discipline, beholden as it has become to neoclassical theory, stands indicted. But only Cohen has the ability to see beyond neoclassical economics and to understand that there are many different approaches to economics—Marxian, Post Keynesian, feminist, institutionalist, and so on—that did not blind their practitioners to the real possibility of capitalist crises.