Enlightening economics
The financial crisis has exposed the weaknesses of many traditional economic models, yet economists still appear reluctant to venture out of their comfort zone. Sheila Dow makes the case for a broader approach to a complex discipline
The relationship between the economy and society has come to the fore again as a result of the financial crisis. The conventional wisdom had been that the economy best served society if it was allowed to operate as much as possible under free competition, with minimal interference from the state. Even with the current focus on reregulation of the financial sector, there is a common view that some aspects of state involvement were an important factor in creating the crisis. Many people, including Bank of England governor Mervyn King, have therefore argued that the expectation that banks would be bailed out if they got into difficulties has reduced the beneficial discipline of the market (the ‘moral hazard’ problem).
There has, however, been a strong countervailing view that markets simply did not serve society’s best interests. Indeed, Adair Turner, chairman of the Financial Services Authority, has questioned the social usefulness of the financial sector.
This debate is an old one. In his 1776 text, The Wealth of Nations, Adam Smith set out to consider the emerging economic system of commercial relations, which encouraged large-scale production through specialisation, financed by capital. He argued that this system, through competitive markets, would in general serve individual needs, and serve them better as a result of growth and thus an increase in the standard of living. 
It is important to realise, however, that he was making this argument in response to widespread concern that commercialism would erode morals, and against the backdrop of his Theory of Moral Sentiments. Here he had argued that humans are inherently social and other-regarding, and thus guided by social convention, including moral conventions, without which commercial society could not function. In fact, along with Hume, Smith saw organised production as a mechanism for improving social relations. He did warn, though, that competition in a market economy tended to be eroded by producers seeking to increase their market power and factory workers tended to become alienated; this meant that there was a need for access to education. He also pointed out that a driving force behind capitalism was the self-delusion that riches brought happiness.
Individualism in economics
Since the late 19th century, economics has evolved from being seen as a moral science to being seen as an objective science like physics. Attention shifted from the macro issues of growth and the distribution of its benefits to questions of market allocation in a fully employed economy. Although the Great Depression refocused attention on macro issues, macroeconomics was increasingly organised by methodological individualism: the requirement to build up all theory from assumptions about individual behaviour, using increasingly sophisticated mathematical models. Although there have been some attempts to move away from this, it is a trend that persists in current mainstream economics.
Individuals are assumed to promote their own preferences rationally, being guided by monetary incentives. These preferences might include altruism – the benefits to others of individual choices – but this can only logistically be incorporated into economic theory in a limited way, referring to other specific individuals, such as family members.
The most common assumption is that individuals are self-regarding, and much recent theory has argued that apparently other-regarding behaviour is in fact selfish. For example, it is shown to be rational to trust another person if there will be a reciprocal benefit to oneself. This is the Adam Smith of the popular reading of The Wealth of Nations without all the groundwork done in the Theory of Moral Sentiments. There is no society other than the aggregation of individuals.
Another assumption underpinning this approach is that individuals have either certain knowledge, or knowledge limited in specified ways, and can predict the future within a probability distribution. This assumption drove the creation of the quantitative models that are increasingly used in the financial sector, with portfolio strategies based on the assumption that risk can be quantified in relation to objective economic ‘fundamentals’.
The role of judgement was downplayed relative to apparently objective quantitative guidance for portfolio strategy. Governments gave in to pressure from the financial sector for deregulation from the 1980s to allow more free play to market forces.
Mainstream economics has evolved over the years. A recent development of note has been the willingness to incorporate input from other disciplines. Psychology, for example, has been used in the development of behavioural economics as a way of understanding behaviour in financial markets.Thus individuals may be modelled as having biased expectations, or being unwilling to translate theoretical losses into real ones.
While psychologists may see such behaviour as the normal interplay between emotion and reason, mainstream economics can only define such behaviour as irrational. This suggests one possible policy response: to aim to 'nudge' individuals into being more rational.
The trouble with mainstream economics is that theory is ideally built on axioms of rational individual behaviour and expressed in formal mathematics. Accordingly, the mainstream aim is to find the ‘best’ model of this form, with other theories effectively ruled out. This is reflected in the mainstream response to the financial crisis. Following an initial period of bemusement at a crisis that conventional theory had deemed impossible, mainstream economists formulated several possible explanations for the crisis that fit their framework. The first is that information was concealed, preventing fully rational behaviour; the second is that incentives (including the confident expectation of central bank bailouts) distorted rational behaviour; and the third is that behaviour was irrational.
There is, of course, an element of truth in each of these explanations. Nonetheless, there is further scope for debate about whether this is the most helpful framework in which to analyse these factors, and whether there are other factors behind the crisis that the framework precludes. This is important for policy. What if there is something inevitable about financial instability? This would mean that regulation to make financial products more transparent, or changes to incentives through, for example, the structure of bonuses, can improve matters to some extent, but cannot address the root causes of the potential for instability.
Some alternative approaches to economics include theories that suggest it is in the nature of financial markets to harbour the potential for instability. This is particularly the case for Post-Keynesian theory. Keynes is back on the agenda in the form of the argument for using fiscal expansion to stimulate the economy, an approach that he advocated in the 1930s. This was not all Keynes had to say, however. His views about the nature of financial markets and financial behaviour in a world of uncertainty continue to be relevant.
A multidisciplinary approach
Institutional economics and social economics also have theories about the relationship between the economy and society and the relationship between economics and ethics. Students are not in general exposed to such material, however, since the emphasis of economics education is mainstream economics, something reinforced by textbook-focused teaching.
There was, in fact, a student protest in France in 2000 against an exclusive focus on mainstream material and mathematical methods. This gained support from students internationally and was echoed, for example, in a petition from PhD students
in Cambridge.
Since then, an increasing amount of literature has been devoted to the educational benefits of ‘teaching through controversies’. One of the main advantages of this type of teaching is that students themselves learn how to address different possible approaches to analysing the economy, which teaches them to make their own judgements. While mainstream models may appear to offer direct answers to policy questions, in practice judgement is required. For example, various Monetary Policy Committee publications refer to the need to apply judgement to the diverse arguments and pieces of evidence that they must use to reach a policy decision. Similarly, quantitative models are clearly not the final answer in financial markets; some players perform better than others on the basis of their exercise of judgement.
In addition to learning about different ways of approaching economic problems, students would benefit from learning some of the history and philosophy of the discipline. The history of economic thought gives students an idea of how economics evolved to address problems in different historical contexts, while the philosophy of economics illuminates the scope and rationale for building knowledge in different ways. The importance of knowing some history is evident from the fact that, for many, it seemed to be news that there had been a succession of financial crises in the past. Yet these areas are all gradually being squeezed out of the economics curriculum by the increasingly demanding requirements to learn technical skills.
Much of the discussion about changes to the economics syllabus has come under the umbrella of pluralism. This is the recognition that there is a range of legitimate approaches to theorising about the economy, and that diversity can benefit the discipline. The starting point is the view that the socio-economic system is so complex and evolves in such a non-deterministic way that no one formal model can either explain everything or be capable of precise prediction. Such a view challenges the assumption underlying much of mainstream economics that individuals make their choices on the basis of similar predictions to the models themselves. Different approaches focus on some aspect of that complex reality and provide partial illumination. For example, neo-Austrian economics is particularly helpful in the analysis of entrepreneurship, while institutional economics is particularly helpful in the analysis of the nature and role of institutions. Just as biological diversity provides protection against environmental change that threatens one species or another, diversity in theoretical approaches in economics provides policymakers with the means to address a range of economic challenges.
It is important to have not just theoretical diversity, but also different ways of building up theory. For some approaches, the appropriate unit is the individual, while for others it is social groupings, and for yet others it is the interplay between the two. For some approaches, mathematical modelling is a useful tool, while for others it is to be avoided altogether. For some, there will be a focus on a particular method of enquiry, while for others pluralism is applied at the level of methods. When graduates go into the workplace, they will need to exercise judgement about which approach to adopt, as well as which theories to use.
For pluralists, perhaps the most problematic assumption underpinning mainstream theory is that individuals are calculative: they seek quantitative information on which to base their rational choices in order to maximise personal benefit relative to costs. Happiness literature, however, suggests that happiness is more the result of good relationships and processes than of monetary reward: for example, it is not the absolute value of bonuses that is critical to behaviour in the financial sector, but rather the relative size of bonuses as an indicator of esteem.
There is also the question of knowledge. Since pluralists understand the socio-economic system to be complex, they recognise that individuals in the economy also behave in a complex way. This is what explains the evolution of institutions and conventional understandings of behaviour, as mechanisms to provide support and stability for decision-making. They are also a mechanism for limiting the need for individuals to calculate. A good inflation policy is one that means we do not have to think about inflation, rather than meeting some inflation target that will always be spuriously precise given the tenuous connection between any inflation index and individuals’ experience. A good system of bank regulation and supervision is one that allows us to continue treating our bank account as a means of payment without having to think about it.
It is therefore important in designing policy to understand what underpins behaviour, including the socio-institutional environment. If policymakers are to have good foundations for judgement about such things, economics training needs to be broader and encompass difference of opinion. Then policymakers and their advisers would have a better sense of the inevitable limitations of any one economic approach, given the complexity of the evolving economic system, as well as of the range of different approaches on offer. They would also have a better grounding in how to exercise judgement when choosing how best to approach, understand and address new economic problems as they arise.
Sheila Dow is emeritus professor of economics at the University of Stirling
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