The Crisis in Economic Theory

The Crisis in Economic Theory

Dr. Asad Zaman [850 words]

In 2003, Nobel Laureate Economist Robert Lucas proclaimed that the central economic problem of depression prevention had been solved. These words came back to haunt him in the aftermath of the global financial crisis of the 2007, which not only ruined functional economies, but also created a crisis in economic theory. Many leading economists made remarks similar to Paul Krugman, who said that the profession as a whole went astray because they mistook the beauty of mathematics for truth. Not only did economists fail to foresee the greatest economic catastrophe of the new millennium, but even worse, conventional macroeconomic theories contain no hint of the possibility of such an occurrence. Our goal in this article is to explain why.

One of the key guiding principles of economic theories is the famous “invisible hand,” widely attributed to Adam Smith. A leading economics textbook by Mankiw explains it as follows:

“Smith is saying that participants in a market economy are motivated by self-interest, and that the ‘invisible hand’ of the market place guides this self interest into promoting general economic well-being. … One of our goals in this book is to learn how this invisible hand works its magic. … Prices guide (the market) to outcomes that maximize the welfare of the society as a whole.”

Recently, scholars of economic history have pointed out Mankiw and other modern economists have misunderstood Adam Smith. The name of Adam Smith is invoked to give prestige to an interpretation of the “invisible hand” which has nothing to do with how he himself used this metaphor. Whereas modern economic theory claims that selfish behavior leads to economic welfare, Adam Smith gave several examples of how selfish behavior harms society in his classic Wealth of Nations.

One of the central claims of modern economic theory, emphasized by Mankiw, is that prices guide the market to outcomes which maximize the welfare of society. This is because prices are accurate indicators of scarcity and value, and provide the right level of incentives to produce socially desirable quantities of the relevant products. The collapse of financial markets in 2007 destroyed this central pillar of modern economic theory. The average stock value declined by 50% over a period of 18 months. Which price accurately reflected values? The pre-crash price or the post-crash price?

The global financial crisis suggests that free market prices may actually provide the wrong signals, encouraging socially harmful activities and suppressing socially useful activity. George Soros and many other famous analysts have attributed the financial crisis to excessive greed on Wall Street. This is a nightmare for mainstream economics since it contradicts the invisible hand principle. Instead of maximizing social welfare, the free market guided selfish participants to outcomes which have led to the highest levels of homelessness and hunger in the USA seen since the Second World War.

Despite the crisis, it continues to be widely believed that financial markets have led to a tremendous amount of wealth creation in the west. In fact, there is a great deal of evidence to suggest that financial markets create an illusion of wealth, rather than the real thing. An overheated financial sector led to the collapse of banks and created the Great Depression of 1929, which lasted till the Second World War. The US government intervened massively to prevent banks from collapsing during Savings and Loan crisis of 1980’s. Financial experts have estimated that the costs of the intervention wiped out all profits from the banking industry made in the twentieth century. Similarly, bailout in trillions of dollars to the financial industry in 2007-2008 show that in the long run, the financial industry has destroyed wealth, instead of creating it.

What difference this make to economic theory? As already discussed, it is a central idea of economics that prices are accurate guides to values, and lead the market to produce things of social value. Before the collapse of 2007, the value of financial derivatives was ten times the world GDP. Thus the financial markets were tremendously overvalued. Executives in the finance industry were earning (and continue to earn, thanks to the bailouts) massive salaries. Thus market prices led to substantial investment of human and other resources in the finance industry, and reductions in investment in the real sector which produces goods and services. This has proven to be a big mistake, in the aftermath of the financial crash. The current prolonged depression in the USA is due to under-investment in real productive capabilities and over-investment in financial wizardry.

The current crisis in economic theory is closely parallel to the one created by the Great Depression of 1929. It is on the record that leading economists forecast continued prosperity just before, and a quick recovery just after the Great Depression. To explain it, Keynes created an entirely new theory, which denied some central principles of previous economic theories, such as the validity of supply and demand in the labor market. We are still waiting for a modern Keynes to resolve the theoretical problems created by the financial crisis.

Great Depression Statistics - Very useful statistics for the post Great Depression Period