The Australian’s Australian Literary Review will be publishing an issue next month with views from various people speculating what their field would be like in 2020. I was asked to do the economy and economics piece but alas editorial differences coupled with too difficult to manage time constraints have meant that it won’t be in that issue. Nonetheless, I don’t want to let some work go to waste and so over the fold is my ‘author’s cut’ of the piece for any who are interested.
Economics and the Economy in 2020
Sitting here in 2010, it is very tempting to write that economics faces considerable challenges in dealing with the next decade. After all, while Australia escaped it, the North Atlantic (Europe and the United States) is still suffering from the Financial Crisis of 2008. A litany of books has been written about how economics, particularly, macroeconomics and financial economics, are essentially out-dated, at best, and dangerous, at worst. This is perhaps best encapsulated by John Quiggin’s Zombie Economics that traverses economic standard after economic standard and tears the head off each. But truth be told, those issues have more to do with economic discourse and how these translate into policy than on the core of economic research. To be sure, there are issues there too but they are far more long-term and far more challenging than anything we face as a result of our recent economic turmoil.
In this light, I will, therefore, divide my commentary into two parts. In the first, I will explain why economics actually did passably well in the last two years and, indeed, its failures were the result of the previous decade of ill informed translation of economic ideas. In the second, I will look forward and identify where I think core economic research needs to move to address newer challenges.
The passing grade and prior failure
Much has been written about the failure of economists to predict the recent financial crisis although when it comes down to it, this is the same criticism that arises with every financial crisis. Economists are no better in predicting those than anyone else. Despite that, when the chips were down, economists’ prescriptions won the day. While we might be concerned that policy was being made a frenetic pace, in Australia, the moves to guarantee banks, sure up the mortgage backed security markets, stimulate targeted areas where jobs were in most immediate peril and loose monetary policy were straight out the economics textbook. You have to work hard to find violent opposition to all that. Pass marks all around.
While we might applaud the fire fighters, it is surely incumbent upon us to ask how the fire started in the first place? And here is where Quiggin and many others including Nobel Laureates, Paul Krugman and Joseph Stiglitz, point the finger correctly: at the core idealistic ideas that gave intellectual foundation to hands-off deregulatory policies in the financial sector. Those ideas are (1) financial economics that views markets as operating frictionlessly to generate price signals and weed out inefficiencies in capital allocation in a timely manner and (2) a version of macroeconomics that inflation as an accident of government money management and unemployment as leisure chosen while workers wait for better wage opportunities. These ideas make government policy an easy choice: leave all this to itself and get out of the way. And the result was deregulation and monetary policy to ensure a healthy supply of ‘risk free’ options for investors. The result was poor policy requiring a collapse for politicians to realise the mess that had been created.
Reassessments of those idealistic notions are important because they can remind us of their very unreality. We will do it now for the economics of recent decades just as we did it in the 1980s for the heavy-handed microeconomic interventions that left so many sectors rigid and inefficient. But the broader issue is why the ‘reasonable middle’ of economics so often fail to find a voice. I write from personal experience when I say that striking a balanced view in economic debates is a challenge and it is not clear it is something anyone has successfully traversed.
Consider our recent debate over the National Broadband Network. This is one of the most ambitious public investments in many decades. But we have a Government that continues to sell it as infrastructure that will earn it a commercial return; seemingly appealing to a need for a ‘market judgment’ as to its value. That leads to an Opposition, armed with the true knowledge that the market, by its very inaction on such investment, has already rendered its judgment to call for an expensive cost-benefit analysis for which the answer is already known. Thus, we have this policy being judged on the very idealistic market ideas that recent experience should have steered us away from. And in the end, we neglect the textbook ideas of public investment to correct market failure (in this case, universal access and competition in telecommunications) and so do not do the hard work of ensuring our public dollars will be spent in a way that maximises social return. So again the victory of the easy over the hard sows the seeds of future waste.
And we are not yet free of the easy with regard to the financial system either. Australia lucked out of a recession despite everyone thinking we would have one in 2009. As an economist, frankly, I do not know why our financial system survived. To explain my ignorance would require another essay. But my point here is that policy-makers lack that knowledge too. What we know is that our banks and larger financial institutions are “too big to fail” and so have an implicit government guarantee. That very fact and the lack of evaluation and thoughtful consideration of the evidence should give us pause. Good long-term policy requires continual deliberation and challenge to our own beliefs but currently such evidence-based consideration is politically unattractive. This failure will be what historians point to when the next crisis arises.
The future knowledge we need
Despite the failure of the ‘reasonable middle’ to find a voice, there are many areas where economic researchers, such as myself, need to direct their efforts to at least generate long-term policy options for governments.
Let me highlight just one. While recently economists have embraced psychological knowledge of how people make choices, we are increasingly finding that the social dimension of interaction is critical. This year, the Nobel prize was awarded for the development of a theory of unemployment based on how hard it is for employers and employees to find each other. But on that very topic, sociologists have made great progress in understanding how important individual relationships – who you know and who they know – are in understanding what jobs people take as well as other important economic transactions such as who knows what and how knowledge is shared. Indeed, Andrew Leigh has recently published a book on this very topic, Disconnected.
This social psychological and sociological dimension to the economy is important but our understanding of what it means for economic policy and its conduct is in its infancy. But if I had to guess, in a decade’s time, we will be talking commonly about how the ‘social dimension’ can help us in traditional economic areas such as how to change people’s behaviour with respect to the environment, how to improve the efficiency of education, how to diffuse good health options, how scientists come up with useful ideas and maybe even to understand why financial markets fail.
Joshua Gans is an economics professor at Melbourne Business School and a visiting scholar at Harvard University.