PR VA Wis) 110s One iain PMLCL The evolution of Economics and the evaluation of what happens in the world econorny oround us, have been beautifully summed up in an arlicle by Justin Fox, published in Fortune (March 15, 1999). We reproduce below an edited version of that article for the reader to reflect on the state of Economics and the Economists in the perspective of revalving history of economic thought. The science of economies has growin in terms of the atternpt of the economists to explain the contemporary problerns which they have eyperienced in their own age and stage of development of economics asa discipline. Initially, ottempt was fo explain the problem of an individual econornic unit; eventually th ottempt was to explain the problem of an aggregate economy. At each phase explonations, not only was the problem analysed, but their policy implications were also worked out, In the process of executing the policies either at the rnicro corporate level or at the macro notional level or even at the global level, the inade inappropriateness of the policies and principles underlying them, were det: attempt was made to improve upon the existing explanations and/or predictions This is how history of economic thought forged ahead to bring the discipline of economics to its current state. a a a 3 a The extract from the article reproduced below is a very concise treatment of the economists’ contribution to the understanding of the contemporary economic problems. Economists rule the world. This is not o new phenomenon. "The ideas of economists ond political philosophers, both when they are right and when they are w more powe: han is commonly understood,” John Maynard Keynes wro in the famous conclusion to his Generol Theory of Employment, Inte “Indeed the world is ruled by litile else, Practical men, who believe them: guite exempt from any intellectual influences, are usually the slaves of some defunct economist.” The world went on to prove Keynes right: His General Theory becaine the basis of economic policy making in the US and Europe for decades after his decth Now the undisputed rule of Keynesianism is long past, but work of econoimecs professors sill rules. When we talk about emerging markets currency cn3es, Japanese stagnation, about European unemployment, about US prosperty, words we use and the framework thats Adam Sth, trom Keynes, {rom Millon Friedman, from other academics we may never have head ot apes our thinking come fro. The field of economics 3 hke oF at least macreeconamics, the study af big 584 inflation, unemployment and the business cycle has been the scene af some +2") public battles over the past hall century Also, the world economy 1s ui a seeiry NE the days. Palticans don't know what ta do about it, the hedge tund may who a couple ol years ago seemed to be running the show don't have a due. Ds economists have an answertNo, and no again, The pitcheg battles of Academic economists have indeed en 1°" but they have done so by diminighi tools and come up with similar gy ‘ é artow ques erolening the behaviour of he stab} economy, oe eat: But wheniteomare restofhem ne longer soem behave hen so hese e8tee=in fact tule the world, but they aren't Quite sure what ie dowiha - Economists it, ltwasn’t always this way, of course, To und dead certainties to peacefy| contusion, one hes to go bac! the 1960s, when almost everybody wos sv, ‘ e there wo: explanation for the workings of the economy. And back ‘mies went form waning ka few decades. Back, Ss one obviously correct even further, to when the were allowed to work their magic, everything would tur into the messy reality of the Great Depression, Inthe US in the 1930s, the financial system essentially stopped functioning, the market for real estate and other assets dried up and unemployment remained stubbornly high. “Nothing in what | was Jaught from nine o'clock to ten o'clock in economic theory had any room to explain that”, says Paul Samuelson, then an undergraduate at the University of Chicago and now one of Lorry Surimers’ Nobel laureate uncles. “Finally, | heard Chicago professor Frank Knight say normal economics applies in normal times, but when it comes to really pathological times, it doesn't apply.” The job of designing an economics for pathological times fell to none other than John Moynard Keynes. Keynes —a lecturer at England's Cambridge University os well as c journalist, an adviserto governments, an insurance company executive, a commodities speculator and husband of a famous ballerina — had, like every other economist of his time, internalised the “classical” truisms that the laws of supply and demand interact to set prices at the appropriate level ond that something colled Say’s low decrees that every penny saved is automatically converted into investment. In the aliernative economics, Keynes proposed in the mid-1930s, however, nnd sometimes gets stuffed in mattresses, prices and wages don't always adjust " fo na demand and it’s perfectly possible for an economy to get stuck in a slump unless 99vernment acts to stimulate demand. —with first By the 1950s this Keynesian economics had become the new cathode Combsridge University in England and then the Cambridge, Moss, whee best selling ord MIT as its temples. At MIT the high priest was Samve eae ‘ Keynesion ides introductory textbook, Economics, first published in 1948, tthe US economy wos JP generations of college students. Of course, by the 1950s ' oo eggs, Bt ©nger the pathological wreck that Keynes was frying 7 ish economic down Samuelson and his fellow Keynesians figured they cou fiscal ond monetary policy. ‘ums and moss Unemployment by tweaking government fiscal26 In the early 1960s, Samuelson and encther MIT stor and future Nobelist; Robert Solow, were able to put their ideas into practice as advisers to President Kennedy. The US economy responded with the longest expansion in history.” Itseemed an economies as free of ideological difficulties as, say, applied chemistry or physics, promising a straight forward expansion in economic possibilities”, wrote economists Robert Lucas and Thomas Sargent years later. “One might argue about how this windfall should be distributed, but il seemed a simple lopse of logic to oppose the windfall itself.” Afew economists weren't so sure. The most notable dissenter was Milton Friedman of the University of Chicago. Friedman had been a graduate student at Chicago during the same troubled times that Samuelson was, there as an undergrade, but he never shared Samuelson’s conviction that the Chicago economics they learned had failed. In the epic Monetary History of the United States he co-authored with Anna Schwartz in 1961, Friedman argued that the best explanation for the Great Depression was not market pathology but the failure of the Federal Reserve to keep the money supply from shrinking in the early 1930s. Friedman's emphasis on monetary policy-which had been deemed by Keynes to be impotent in limes of true economic crisis and was thus long ignored by his disciples— had o big impact on economic discourse. But at first most economists adopted monetary policy os a way to keep the economy running on high employment overdrive. Samuelson and Solow had brought to the US the empirical evidence, first complied by a British economist named A W Phillips, that there was c trade-off between inflation and unemployment — thot is; higher infliction meant lower unemployment. Allowing prices to rise seemed the only humane thing to do. Friedman argued that the unemployment/inflation trade-off was temporary and he also pointed out that using fiscol and monetary policy to avert recessions was a lot harder than it looked. These orguments weren't ignored: For years Friedman and Samuelson wrote duelling columns for Newsweek; in 1967 Friedman was the President of the American Economic Association. But his thinking wasn't mainstream, either among Americans at large or within the economics profession. That changed in the 1970s when the Mideast oil crisis hit the US with both high inflation and high unemployment, Friedman won the Nobel Prize (six years after Somuelson) ond became a best selling author, TV personality and revered adviser to free market oriented politicians around the world. Within the economics profession, however, the deathblow to the old ways came from the above-mentioned Robert Lucas, Friedrnan student at the University of Chicago who had gone on to leach at what is now Carnegie Mellon University, Lucas wrote a series of articles in ithe 1970s hammering away al the theoretical underpinnings of Keynesian thought. He argued that if people are rational - a basis lenet of economics that we'll discuss in more depth loter - they con form rolional expectations of predictable fulure events. So if the government gels in the habil of boosting, spending or increasing the mong supply every time the economy appears headed for a downturn, everybody wiApe eventually [20° thet ond ediug tH regulor government efforts heir behovi 597 to. control ‘eviCUr accordingl ay 1980, Lucas wos able to elo Ol the business cycle simppea en means thot good, under-40 economistewi ah Some istics, work, For a while it looked as if Lucey identity themselves orien ore Scrnsitind i "S™ Was the w. work a5 'Keynesion’ Chicogo to which lucas retuned in 1974 ed, Of the future and the University of wails eens of economic thought, Bur th di Planted MIT ond Harvard Bul the da classical” economists led them Ia tng ° or lobel Prize for his crit i i MS criti * come up with a viable alternative acto theory, One othie ncn, hosnevar ler students, Edward Prescott of the University of Minnes: ota, has pro, ¢ explained Propesed that recess) could be explaine ha 288 On sors ol technoiegicl ea eae - But this “rea business cycle” school has yet to deliy, er anything of much use to economi nomi licy- makers. So Cambridge, Mass., home of the discredited Keynesian orthedovy gotthe opportunity to come up with a credible replacement. And ino way, it did, ‘seins et lured to MIT. Fischer had been s, its own newly minted Ph.D.s, so he ended up ot he Unecrs Behe el tine MIT called with o job offer severl years late, Fischer hod eomast beg appreciation for Friedman's real world approach to ®conomics and an interest in Lucas’ theoretical critique of Keynesianism. Fischer brought over another Chicagoan, international economist Rudiger Dornbusch and the Pair came to dominate MIT economics for two decades. "They were bringing the latest thinking in,” recalls Columbia professor Frederic Mishkin, one of Fischer's lirst students ot MIT, “They had absorbed a lot of the Chicago approach, but had very open minds”. They also had open doors and before long Fischer and Dornbusch hod become MIT’s dissertation advisers of choice Across town at Harvard, the agent of change was Martin Feldstein. Feldstein, an Oxford Ph.D. who joined the Harvard faculty in 1967, specialised in investigating how the incentives created by government toxing and spending change the behaviour of people and firms ~ on area that had been given short shrift by the Keynesians but that became, in cruder form, the heart of Reagan-era supplside economics His biggest impact on the study of economics, though, may have been his ronsformation i |, a private think tank, had ofthe National Bureau of Economic Research. The bureau, a p' auld been founded in 1920 by one of he most prominent economies & te Columbia's Wesley Mitchell, to offer “scientific semi oe Our interpretation of facts bearing upon economic, socclond ding Millon Friedmor's the years it had sponsored some landmark research — 1"monetary history - but by the Icte 1970s it was fusty place known mainly as the official arbiter of when recessions start and end. Upon being named president of the NBER in 1977, Feldstein moved it from New York to Cambridge and brought in lop academics like Fischer and Dornbusch and their students, to churn out working papers using cutting-edge theory to examine real world problems The products of this atmosphere include a disproportionate number of the world’s mest prominent economists. There are the policy makers listed above; the chairmen of three top economics departments, Olivier Blanchard of MIT, Maurice Obstfeld of Berkely, and Ben Bernanke of Princelion; the many Romers: Staniord growth-theorist Paul (who started his Ph.D. training ot MIT but finished at Chicago). Berkeley economic historian Christina (no relation to Paul) and Berkeley macroeconomist David (married to Christina, not related to Paul); Columbie’s Mishkin, the former chief economist of the New York Fed; industrial organisation guru Jean Tirole of the University of Toulouse; and, most familiar to readers of this magazine, FORTUNE Columinists Greg Mankiw of Harvard and Paul Krugman of MIT, The members of this group don'Hitinto any neat ideclogical or doctrinal category, but they are generally skeptical of both unfettered capitalism and government effors to fetter it. They share Keynes’ conviction that markets can ge wrong (some of the younger ones even call themselves new Keynesians) but have also accepted the criticisms of Friedmen and Luces. To. a casual observer this may sound like plain old common sense and to certain extent that's what it is. But when these economists communicate with one another, it’s not in the langucge of common sense but in a jargon that has its roots in the work of 18" century Scotsman Adam Smith, Smith’s masterpiece, An Inquiry into the Noture and Causes of the Wealth of Notions, introduced the then radicol notion that selfish, greedy individuals, if allowed to pursue their interests largely unchecked, would interact to produce a wealthier society as if guided by on “invisible hand.” Smith never worked out a proof thal this invisible hand existed and not all subsequent economists agreed with his optimistic ossessment— Thomas Malthus thought people would have too many children ond cverpopulate the world; Kor! Marx thought capitalists would be so greedy they would bring down the system. But they all shared Smith’s view of economics as the study of people trying to maximise their materiel well-being. This assumption of rational, maximising behaviour wen out not just because it often reflected reolity but because it wos useful. |! enabled economists to build mathematical medels of behaviour, to give their discipline a rigorous, scientific air. This process started in the mid-1800s, evolving by the erid of the century into the approach known today as neoclassical economics (Marx having assigned the term “classicol” to Smith and his immediate successors). And while 20" century critics like the University of Chicago’s Thorstein Veblen and Harvard's John Kenneth Galbraith argued that people are also motivated by altruism, envy, panic and other emotions, they failed to come up with a way to fit these emotions into the models that economists had grown accustomed fo —and thus had little impact.Keynes, to get at his explanation for slumps, did have to assume that ie ociidns were sometimes motivated by “animal spirits” rather than by ore fafondlie puihe never tried fo work this ino afl. blown behavioural heone Aker Kevea foct, economics come to be split into two parts, Theré was macroeconomics which used broad strokes to depict the big things that Keynesians cared about: semplaymen’, inflation and the business cycle. Then there wes micro seonon ies virich examined how the interactions of rational in " dividuals led ic market outcomes. Macroaconomics described how economics malfunctioned; micro-economics described how they worked, These two sides of economics coexisted uneasily in the same academic depariments, sometimes in the same people. In his advice to President Kennedy and in his undergraduale textbook, MIT's Samuelson offered thoroughly Keynesian explanations of macroeconomic phenomena; meanwhile, landmark 1947 book Foundations of Economic Analysis, taught generations of graduate students how to approach micro- economics as set of mathematica! models featuring rational actors. One of those students was Robert Lucas, wno worked through Foundations, calculus textbook in hand, he summer before he staried grade school at Chicago. Lucas’ subsequent theoretical work essentially forced Keynes’ (and Samuelson’s) macroeconomics to submit to the some relentless mathematical logic as Samuelson’s micro-economics — ctest it couldn't pass. Micre-econamics, however, was beginning to change. The neoclassical tradition . feached an apotheosis in 1951 when future Nobel lourecies Kenneth Arrow (another Summers uncle) and Gerard Debreu published an article that in essence mathematically proved the existence of Adam Smith's invisible hand. This” general equilibrium’ proof has been a mainstay of graduate level economics training ever since, But Arrow soon moved on; he and other economists began working our ways in which rational behaviour could lead to less than optimal market outcomes. The most important tool in this analysis wos game theory — the study of situations, like poker or chess games, in which players have to make their decisions based on guesses about what the other player is going to do next. Game theory was first odapted to economics in the 1940s by mathematician John von Neumann (the same von Neumann whose theoretical insights made the computer possible) and economist Oskar Morgensiern. But it ook a while to catch an. 'n 1963, Arrow wos first to hint at the game theory implications of situations in which different porties to a transaction possess different parties lo a transaction possess differen! amounts of information, But “asymmetric information” really came into its ©wn in the 1970s 0s 0 woy to explain the behaviour of financial markets ~ which ore tremely susceptible to informotion difficulties. lis leading theorist wos probably Joseph Stiglitz, 0 1966 MIT Ph.0., now the World Bank's chiel economist. Arotherlong neglected aspect of microeconomics that Stiglitz and others began to Study in the 1970s was increasing relurns. To work oul to equilibrium, models of‘6UU, economic behaviour always had to assume that at a certain point makers of a product would be faced with diminishing returns; the mere they produced, the less profit per piece. It had long been clear that this didn’t always reflect reality, but new math techniques and the growth of the software industry — a business in which making additional copies of a product costs virtually nothing — led economist to finally take increasing returns seriously. : This was the context in which the young scholars of Harvard and MIT learned economics in the late 1970s and early 1980s. Keynesian macroeconomics was dead, but nothing had sprung up in its place. Micro-economics, meanwhile, had moved away from the dead certainties of the past into a much more interesting thicket of research possibilities. The mathematical models that had come to form the basis of academic economics were shifting from general equilibrium, in which everything worked out for the best, to multiple equilibriums, in which it might net. “That was kind of a golden age fer economic theorising,” says, Krugman. Different people took to the atmosphere in different ways. Larry Summers became a master debunker, using theory and data to poke holes in new classical certainties. Paul Romer moved macroeconomics away from its business cycle orientation to devise a new theory of long-term economic growth. And Krugman, whose academic work probably best represents the direction economics has taken, built lots of mathematical models of real-world economic phenomena. The models, Krugman says, are constructed upon a couple of basic principles; “self- interested behaviour and interaction — $100 bills don't lie in the street for very long, and you don’t have sales that aren't purchases.” Beyond that there are no clear rules. “What.you end up looking for is a specific set of strategic simplifications,” he says. . i The two models that made Krugman's name in the late 1970s both involved international economics. One concluded that currency crises were rational, inevitable reactions to untenable government policies. The other overturned the conventional economic wisdom that countries could gain an advantage in trade only because of better technology or greater resources — by showing that the increasing returns inherent in making huge quantities of o product can lock in an advantage. These two models shared no grand theme or ideology and matters got even murkier when Krugman tried to draw policy conclusions from them. He gradually came over to the view that currency collapses can also result from self-fulfilling investor panics thot overrun even countries with sensible economic policies. This has led him to conclude tha! controls on capital flows sometimes make sense, But he does not believe in restricting trade, even though his increasing relurns model seems to suggest adventages for the sort of protectionist, volume building tactics used by Japanese industries in the 1980s,= ae rein lies the dilemma of modern econo, eer more sophisticated, but itis looking ever less likely thot they’! ioacoherent, reliable science of economies, “Ifyou cat, rand ou seer theory you come up with garbage,” says David Colander a ater econore thought at Middlebury College. Most economists have com open em they are stoving away ftom grand questions and sickingte vero eo eeu es. I's not that economists can’t agree on ony bi us the articles of Robert Lucas, oppears Inainstreom all honkering for inflationary Fe whether the optimal inflation rate is 3% or 2% or 0. There's al what facilitates long-term growth: transparent financial mork sey wal enn fal wall regulated banks, free trade; educeted vlan orkers; 0 reliable but not inflexib| en ; ‘ notinflexible legal systern; toxe! re benefits low enough fo avoid disincentives to work Thetrouble comes when there's trouble. In dealin on the real economy, with downturns in the busin nations, the mathematical models of mode mics. Analytical techniques are becoming 1g with the impact of financial crises less cycles, with interactions between ; ice ™ economics come up short. So economists make substitutions: guesswork, judgement, experience, ideology which leads to large differences of opinion. Witness the response to the recent emerging markets economic crises. Economists who use the same techniques, believe in the some principles and studied under the same teachers are coming up with wildly different responses. Summers and Fischer have backed a tough love policy of advancing IMF loans te countries in crisis but demanding that those countries shut down reckless banks, raise interest rates and cut government spending. Stiglitz wants more generous lending and regulation of global capital flows. Sachs favours creation of an international bankruptcy code under which troubled countries could seek protection. Krugman has urged countries to impose capital controls. Dornbusch, who taught Krugman international economics, says that’s nuts. Abig help, these economists are. Says Krugman: "I've got a guess, Jeff Sachs hes a guess and Larry Summers is ruling the world.” Summers has slightly more reassuring take: “Ultimately there’s no alternative to judgement — you con never get the answers out of some model, But the reason there are many, many more good economists in positions of influence in the world is that one con understand the issues more sharply and clearly and can pose the trade-offs and can make more accurate judgements within a clear analytic framework.” That's a long way from saying economics has all the answers. But it’s obout all any economist can honestly claim. Source: Fortune, March 15, 1999