Economics' Newest Thinking Comes from the Old Masters

Economists, John Maynard Keynes wrote in 1931, should be more like dentists—"to get themselves thought of as humble, competent people." It's a goal more urgent than ever today, since economists, especially those who purport to understand the workings of the macroeconomy, have been kicked in the teeth during the past few years. Their intricate mathematical models largely failed to predict the 2008 financial crisis. Some economists have been assailed for having financial ties to the big banks that did so much to precipitate the crisis. And now they are divided about how to get out of the slump and worried that U.S. employment won't return to normal for years.

No wonder the annual meeting of the American Economic Assn. (AEA), held on Jan. 6-9 in Denver, was a scene of much soul-searching and little mirth. Keynes didn't speak to this point, but we can stipulate that dentists have more fun. The American Dental Assn.'s annual meeting is in Las Vegas; the AEA's top entertainer in Denver was "stand-up economist" Yoram Bauman, who teaches at the University of Washington and favors wisecracks about marginal utility.

As macroeconomists grope for new ideas to reinvigorate the profession, they're looking past the one-liners and harking back to the old masters. In Denver, Stanford University economist Robert E. Hall, concluding his one-year term as president of the AEA, introduced an economic model that leans heavily on Keynes' Depression-era insights about the ineffectiveness of central banks when interest rates hit zero. (The federal funds rate target has been stuck at 0 percent to 0.25 percent for two years.) Meanwhile, the liberal billionaire investor George Soros hosted a talk last year on the economic theories of Keynes' archrival, Friedrich Hayek (1899-1992), a hero of the Tea Party movement. The profession is in such tumult that some thinkers are being to drawn to their ideological opposites.

The ferment calls to mind Thomas Kuhn's 1962 book The Structure of Scientific Revolutions, which posits that when one scientific paradigm breaks down and another hasn't yet taken its place, all hell breaks loose. In Denver, it was clear that the decades-long project to weave different strands of macroeconomic thought into a "neoclassical synthesis" had run into an intellectual cul-de-sac. But it was far from clear what new approach might emerge to replace it.

Economists can't even agree on whether they disagree. Hall, who also chairs the committee that dates the beginnings and ends of recessions, insists that disputes within the profession are a media concoction. "Modern macro doesn't have schools [of thought] anymore," he said at another session. "Only the press thinks it's interesting to talk about schools." Yet doors away, other economists were enthusiastically poking holes in the so-called consensus from the perspective of Minskyites, Austrians, Institutionalists, and on and on. John Quiggin of Australia's University of Queensland argued that the economic ideas most discredited by the crisis were those of the "sensible center of the profession"—such as Federal Reserve Chairman Ben Bernanke's mistaken assertion before becoming chairman that the U.S. economy had achieved an enduring "Great Moderation."

Bottom line: No consensus. But no dentist-like humility, either. "If you ask 1,000 economists what's wrong with economics," says Scott Sumner of Bentley University in Massachusetts, "they'll all tell you the same thing—which is that other economists don't believe what they believe." Benjamin M. Friedman, a Harvard University economist, said that many economists seem to be returning to theories that have been discredited. Says Friedman: "A large amount of the old complacency has crept back."

The renewed investigations into the thinking of Keynes and Hayek may seem to signal that the profession hasn't advanced much in the past five decades. Yet it is heartening in a way, since it shows that at least some of today's economists are willing to reassess their theories in light of new data. Stanford's Hall, for instance, is a senior fellow of the free-market Hoover Institution, which is hardly a hotbed of belief in Keynes' bedrock notion of expanding government to solve economic problems. Still, Hall thinks Keynes was right that more government spending on infrastructure would boost economic growth. His objection is tactical, not theoretical. For whatever reason, Hall says, "government is incapable of executing a rapid and large increase in purchases."

Equally surprising is that Soros, the bane of the Tea Party, has taken an interest in Hayek, the author of the libertarian manifesto The Road to Serfdom. Last year the Institute for New Economic Thinking, which Soros launched in 2009 with a 10-year, $50 million pledge, invited one of the world's leading Hayek scholars, Bruce Caldwell of Duke University, to speak at its inaugural conference at King's College, Cambridge. (Caldwell is the editor of the new, definitive edition of The Road to Serfdom.)

Soros clearly doesn't share Hayek's politics, though both opposed communism. Still, in a video on the INET website, Soros praises Hayek for understanding that economics, unlike the hard sciences, cannot make strong predictions because its subjects (people) are so elusive. "Somehow, in the last 25 or more years, this has been forgotten, and I think it's time to remember it," Soros says.

The wisdom that's been lost since Hayek and Keynes engaged in friendly battle is that uncertainty is both unavoidable and potent. Errors in forecasting that lead to mismatches of savings and investment are crucial to both men's theories of booms and busts, albeit in different ways. The modern macro "synthesis"—now under repair—tended to give uncertainty only a bit part. Economist L. Randall Wray of the University of Missouri at Kansas City argues that "most of mainstream macroeconomics is dead. It's a zombie. They don't know they're dead yet, but they're dead."

To be fair, Wray's is an extreme view. There are a lot of smart economists who understand the field's problems and are working to fix them. Harvard's Friedman, despite his criticisms, says that in the past two years more economists have incorporated "credit-market frictions" into their models—in other words, they have finally acknowledged that not all consumers and businesses can borrow at reasonable rates at all times. Numerous sessions at the Denver conference were devoted to understanding the instability of the financial system. Harald Uhlig, chairman of the University of Chicago's economics department, who attended one of Soros' INET conferences, says groundbreaking work on financial failures and their consequences is being done by the likes of Xavier Gabaix of New York University's Stern School of Business, Roger E.A. Farmer of the University of California at Los Angeles, and Nobuhiro Kiyotaki of Princeton University.

The gloomiest forecast about economics is that the profession's progress will occur only funeral by funeral, as people entrenched in outdated thinking pass from the scene. But it doesn't have to be that way. For one thing, it's not just young people who are looking at things afresh—Hall, the outgoing AEA president, is 67. The newfound interest in the likes of Keynes and Hayek makes sense, too—their ideas were shaped by the Great Depression, which is the last time things were worse than they are now (for the U.S., anyway). That's why the newest thinking in economics is decades old.

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