Posts Tagged Economics Education

The Crisis & Economics, Part 4: Masters of the Universe?

This is part 4 in my series on economics and the crisis, which asks whether economics is really responsible for policy, and if so, how these policies may have contributed to the financial crisis. Here are parts 1, 2 & 3.

Argument #4: “Mainstream economics cannot be blamed for politicians inflating housing bubbles/pursuing austerity/deregulating the financial sector; our models generally go against this. Clearly, we do not have that much influence over policy.”

This defence really raises two questions. The first is whether or not economic theory has had a major influence on policy. The second is whether or not this influence, if it exists, is culpable in creating the financial crisis.

The first is, in my opinion, easily answered in the affirmative. While it’s entirely understandable that the majority of academic economists would scoff at the idea that they effect policy, this doesn’t have to be the case for economic theory itself to hold sway among governments. After all, economics graduates are highly sought after and employed in policymaking positions. Famous economists lunch with the president; textbooks and macroeconomic papers are full of policy discussions; prize-winning economists such as Bob Shiller acknowledge that a “problem with economics is that it is necessarily focused on policy, rather than discovery of fundamentals.” It’s hard to imagine powerful institutions such as Central Banks, the World Bank or the IMF functioning with advice from any but economists, and government organisations are even set up based on new ideas coming out of economics. Economics is the language in which the media discuss policy: demand, stimulus, markets, etcetera. I could go on.

However, as economists like to remind us, there’s no reason to believe that advice based on mainstream economic theory should have led to the types of ‘free market’ policies typically implicated in the financial crisis and its aftermath. Even a basic economics education will leave you with an awareness of things like information asymmetry, moral hazard and externalities, and few economists support wanton deregulation of the financial sector. Modern macroeconomics is loosely pro-stimulus,  not pro-austerity. So what’s going on?

First, it should be noted that not only ‘free market’ thinking was implicated in the crisis. Central Banks around the world used inflation targeting, based on the New Keynesian idea that this would be sufficient to achieve macroeconomic stability, which blinded them to problems brewing in the financial sector. What’s more, the approach to regulation favoured by economics was, not atypically, quite narrow and didn’t favour systemic thinking. For example, I have previously spoken about Value at Risk (VaR) regulation, which forces firms to sell off assets when markets are volatile and hence increase their insurance against risk. However, while this looks good from the perspective of individual firms, it worsens systemic risk because the asset sell-offs result in increased volatility. Overall, the reductionist nature of economic theory tended to blind policymakers to systemic problems and made them focus on the wrong variables, things they might not have done if they’d been familiar with more holistic viewpoints.

Having said this, it’s clear that at the heart of the financial crisis were lax regulatory policies, justified by a belief in the self-stabilising power of financial markets. And while a majority of individual economists may not endorse such a view, theoretical frameworks or ‘ways of thinking‘ came out of economics which were used to justify this deregulation. Whether or not efficient markets, perfect competition, rational expectations and other theories which imply financial markets will run smoothly are endorsed by most economists, the fact that they are common knowledge in economics (and usually the benchmark for more complex analysis) is significant. As I’ve argued before, familiarity with economic theory lends itself to a pro-market view, even if a lot of modern work is done pushing the core framework away from this. And as I’ve argued before, the nuances of this work are often lost in popular translation, as the elegance of the most Panglossian theories proves too tempting when economists speak to the public. Alternative theories which use different starting points for analysis, such as input-output matrices, sectoral balances, or class struggle, would help to combat the deeply ingrained nature of the neoclassical theories.

This issue does not necessarily fit into a narrow ‘government versus market’ policy perspective. Instead, the point is that acknowledging different approaches in economic theory can give us a different way of thinking about policy, illuminating rather than obfuscating debates. A key complaint about economics graduates is that they have overly narrow, abstract tools, so the enemy is not so much any particular approach as it is one sided thinking. Providing both economics students and professional economists with an awareness of  different theories, as well as making economics more politically, historically and ethically engaged, would hopefully at least temper the zeal and enthusiasm with which pet policies are recommended, and partially dislodge whatever pedestal economics currently sits on as a rationale for policy.

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Teaching Economics? Start with Key Contested Ideas

How economics is taught has been the subject of a lot of debate recently. Although there have been a lot of good points made, in my opinion Andrew Lainton‘s recent blog post hits the nail on the head: we need to begin economics education with a discussion of key, contested ideas.

Starting with contested ideas has a few major benefits. First, it immediately shows students what economics is: a subject where there is a lot of disagreement, and where key ideas are often not well understood, even by the best. Second, it allows students to grapple with the kinds of critical questions that, in my experience, people generally have in mind when they think of ‘economics’: where do growth, profits come from? How do things ‘work’? Third, it allows us to intertwine the teaching of these concepts with economic history and the history of thought.

Lainton’s key contested idea is savings: how naive national accounting might make you believe that saving instantly create investment; how Kalecki and Keynes showed that it’s closer to the other way around; and onto modern debates that add nuances to these simplified expositions. Naturally, this would also tie in with debates about the banking system, loanable funds and endogenous versus exogenous money. On top of ‘savings’, I can think of quite a few other important economic ideas that are not agreed upon, but are central to the discipline:

Decision making and expectations

How do people make decisions? This question is clearly central to economics, as any economic model that explicitly includes agents must make some assumption about what drives these agents’ decisions. In modern economics, an agent’s decision rule generally rests on seeking some form of ‘gain’, whether subjective satisfaction or simply units of money. Economists themselves have also, to their credit, pushed behavioural and even neurological investigations into decision making. However, much of this has yet to filter down to the main models/courses, even though it should really be at the forefront of economic modelling.

All too often, the most mathematically tractable models such as utility maximisation and rational expectations are simply assumed, perhaps with caveats, but not with any real discussion of whether they represent human behaviour. Well established psychological characteristics and behavioural heuristics/biases are ignored, even though they may alter the analysis of choice in fundamental ways. Public officials are often assumed to follow behaviour that creates their personally preferred outcome, despite important evidence to the contrary. It is assumed the public understands the fundamentals of the economy, even though a lot of evidence suggests this is way, way off. Decisions in the workplace that concern morale, hierarchy and norms are often disregarded, despite evidence that they are of utmost importance.

However, my point isn’t necessarily about which models are right or wrong. It’s that these debates about how people act, and based on which motives and expectations, are not only incredibly interesting but are incredibly important. Such debates could also tie in with a comprehensive discussion of the Lucas Critique – not as a binary phenomenon that can be solved with microfoundations, but as an ongoing problem that requires us to evaluate the way the parameters of the economy change over time and with policy, culture and so forth. This would allow students to see how the economy evolves, and how its behaviour depends on fundamental questions about human behaviour.

Value

Theories of value underlie economic theories, whether economists like it or not –  in fact, it’s pretty difficult (impossible?) to judge the “performance” of the economy without a theory of value. Classical economics was built on the Labour Theory of Value (LTV), and distinguished between the price of an object (exchange-value) and its value to whomever used it (use-value). Marginalist economics is built on the Subjective Theory of Value (STV), which tends to combine use and exchange value into mathematically ordered preferences. GDP calculations simply measure ‘value added’ as a monetary quantity. There are also other, albeit less popular, theories of value, such as those based on agriculture and energy.

A crucial point here is that the concept of ‘value’ is not necessarily well-defined, and each theory of value generally has something slightly different in mind when they use it. For the (Marxist) LTV,value refers to an objective quality: the total productive ‘value’ in the economy, which is expressed as an exchange relationship between commodities, and originates solely from labour. For the STV , value refers to the subjective ‘surplus’ gained from transactions, which neoclassical theory seeks to optimise to maximise social welfare. For theories of value based on the natural sciences, value refers to more physical qualities, such as how energy is transformed in production and the limits to this process. However, the common ground between theories is the question of how we create more than we had – and what to do about it.

I expect a lot of economists would regard the STV as largely obvious and not up for debate, but if it’s so obvious and important that’s even more reason to study it explicitly – after all, Newton’s Law’s are not tucked away underneath classical physics: they are explicit, and their empirical relevance is frequently demonstrated to students. Clearly, we can’t demonstrate the empirical relevance of a theory of value (hey, it’s almost as if economics is not a science!) but we can discuss it in depth and how it is  a relevant and necessary backdrop to formulating theories about utility, surplus and profit.

What is economics?

It’s a testament to how contested the field of economics is that even the definition is not agreed upon. Open a ‘pop‘ economics book and you’ll find a definition such as “the study of how people respond to incentives”. Another popular mainstream definition is “the allocation of scarce resources” or even “satisfying unlimited wants with scarce resources“. Classical economics – and more recently, Sraffians – considers economics the study of how society reproduces itself. Austrians might give you a definition that says something about human action and the market system.  The definition given by Wikipedia is “the study of production, distribution and consumption”. I’m sure there are many more out there.

Agreeing on a definition of economics would put the discipline on surer footing. Right now it occupies a space where it is simultaneously used as an all encompassing worldview, and as a very narrow toolkit that only investigates one or two things at a time (I expect many economists would basically consider themselves applied statisticians or econometricians). I sometimes even find that economists fall back on defining economics by “what economists do”, which is a rather weak (and circular) definition. Given that we are not even sure which problems economic theories are designed to understand and solve, is it any wonder people can’t agree on which ones to use?

This post is by no means exhaustive. Off the top of my head, some other relevant contested ideas might be: capital; money; how to measure the economy; different economic systems; institutions; policy and economists’ relationship with it. This kind of approach is surely better for furthering students’ understanding than simply teaching a set of abstract theories which are labelled ‘economics’, often with little critical engagement. It would open students’ minds to the kinds of difficult and relevant questions that are currently either shied away from, or only open to those who have completed an Economics PHD. I expect many would also leave with an understanding of economics closer to what students currently expect (and do not really get) from an economics education.

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