COLUMN-Trying to fix broken economics: Kaletsky

Thu Apr 4, 2013 11:19am EDT

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By Anatole Kaletsky

April 4 (Reuters) - Here is a list of economic questions that have something in common. In a recession, should governments reduce budget deficits or increase them? Do zero percent interest rates stimulate economic recovery or suppress it? Should welfare benefits be maintained or cut in response to high unemployment? Should depositors in failed banks be protected or suffer big losses? Does income inequality damage or encourage economic growth? Will market forces create environmental disasters or avert them? Is government support necessary for technological progress or stifling to innovation?

What these important questions have in common is that professional economists can't answer them. To be more precise, economists can offer plenty of answers about government deficits, printing money, inequality, environmental issues and so on, but none of these answers is authoritative enough any longer to persuade other economists, and never to convince the world at large.

Take two examples. On whether government borrowing aggravates recessions or promotes recoveries, the world's most eminent economists fall into one of two violently conflicting schools. The world's most important central banks, the U.S. Federal Reserve and the European Central Bank, hold diametrically opposing views about the effects of quantitative easing.

If economics were a genuinely scientific discipline, such disputes over fundamental issues would have been settled decades ago. They are equivalent to astronomers still arguing about whether the sun revolves around the earth or earth around the sun.

How should politicians and voters who look to economists for guidance respond to this cacophony? Writing this week from Hong Kong, which is hosting a galaxy of economic superstars at the annual conference of the Institute for New Economic Thinking (INET), I can offer a partial answer.

INET is a $150 million foundation created four years ago to support academic research and teaching in economics that break with the assumptions of natural equilibrium, market efficiency and statistical predictability that were largely responsible for the policy mistakes that produced the 2008 financial crisis.

Economics is ultimately a study of politics, psychology and social behavior. It is therefore as close to philosophy or even theology, as to physics, biology or engineering. Just as philosophers and theologians still argue about the same issues that preoccupied Plato, Kant and Descartes, economists see no shame in continuing the debates over budget deficits, monetary policy and full employment launched by Keynes, Wicksell or Walras.

This political and moral aspect of economics suggests a reason for the subject's remarkable prestige and power, despite its obvious failings. Economists have become a secular priesthood, turning the political orthodoxies of their times into comprehensible narratives, thereby promoting social stability and democratic consensus.

In the 40 years since the mid-1970s, the dominant schools of academic economics have preached the virtues of free markets, competition and small government, helping to legitimize widening disparities of wealth and income as economic necessities, dictated by natural laws of market competition that were impervious to political interference or social control.

In the 40 years before that - from the Great Depression and Keynesian revolution to the Great Inflation and monetarist counterrevolution - economists played the opposite political role. Their job was to persuade conservative business interests that active government, fine-tuning of economic cycles, welfare safety nets and redistributive tax systems were indispensable to the success and even survival of capitalist free-market societies.

If we look back to the 19th century, to the origins of the modern capitalist system, we can see economists playing other politically legitimizing roles - establishing respect for private property, competition, free trade and voluntary contracts for mutual beneficial exchange, in a world that was still largely feudal, with wealth distribution justified by heredity, violence or military conquest.

As Keynes famously said, "The ideas of economists, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist."

What makes Keynes's comment so relevant today is that the economic system is again in a process of transformation. It is now fairly clear, as suggested in my book Capitalism 4.0, that a new model of global capitalism is evolving out of the 2008 crisis, just as it did out of the crises of the 1970s, the 1930s and out of the collapse of feudalism in the early 19th century. We are still waiting for the parallel transformation in economic thinking, but some of its features can be discerned.

The first is a recognition that the world is too complex and uncertain to be analyzed with models that assume a natural equilibrium of a future that is predictable, at least in a probabilistic sense. The second is that even competitive and perfect markets can make disastrous mistakes. The third is that a world economy that is highly unpredictable must be managed with fairy broad and flexible tolerance ranges for indicators such as inflation, government borrowing or unemployment, instead of the precise inflation targets of the pre-crisis period.

In short, enlightened economists are starting to recognize that their models must describe a world that is imperfect, unpredictable and unstable. Enlightened policymakers are starting to understand that rigid rules devised many years ago - for example, the Maastricht deficit targets now threatening to destroy the euro - are no longer relevant in the new world.

The next phase will be for politicians to explain to voters that, in a rapidly evolving global economy still struggling to emerge from financial crisis, there is nothing wrong with imperfect solutions - for example, budgetary policies that "kick the can down the road" and "muddle through."

Victor Fung, head of Li & Fung, a company that brought globalization to China, set the tone in his welcome speech to the INET conference, which his Fung Global Institute co-sponsored:

"Americans believe that every problem has one ideal solution. The Chinese believe that every problem has multiple solutions and that each solution will lead to new problems down the road."

That may indeed be the new economic thinking.

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