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Joseph Stiglitz: New economic paradigm Joseph Stiglitz, whose work on information asymmetries won the Nobel Prize for economics, has just published a good summary of what whet wrong with economics. The full article can be found at this link, below I summarize his main points in his own words: The blame game continues over who is responsible for the worst recession since the Great Depression – the financiers who did such a bad job of managing risk or the regulators who failed to stop them. But the economics profession bears more than a little culpability. It provided the models that gave comfort to regulators that markets could be self-regulated; that they were efficient and self-correcting. The efficient markets hypothesis – the notion that market prices fully revealed all the relevant information – ruled the day. Bad models lead to bad policy: central banks, for instance, focused on the small economic inefficiencies arising from inflation, to the exclusion of the far, far greater inefficiencies arising from dysfunctional financial markets and asset price bubbles. Fortunately, while much of the mainstream focused on these flawed models, numerous researchers were engaged in developing alternative approaches. Economic theory had already shown that many of the central conclusions of the standard model were not robust – that is, small changes in assumptions led to large changes in conclusions. Even small information asymmetries, or imperfections in risk markets, meant that markets were not efficient. Celebrated results, such as Adam Smith’s invisible hand, did not hold; the invisible hand was invisible because it was not there. Changing paradigms is not easy. Too many have invested too much in the wrong models. Like the Ptolemaic attempts to preserve earth-centric views of the universe, there will be heroic efforts to add complexities and refinements to the standard paradigm. The resulting models will be an improvement and policies based on them may do better, but they too are likely to fail. Nothing less than a paradigm shift will do. But a new paradigm, I believe, is achievable. What is at stake, of course, is more than just the credibility of the economics profession or that of the policymakers who rely on their ideas: it is the stability and prosperity of our economies. This article brings a few questions to mind: 1. Why did economic science veer so badly off course? Firstly, economists overly simplified economics in order to turn it into a more mathematical discipline. The economy is a complex system, economics will always be an imperfect science. Rational expectations and invisible hand were approximations which economists began to treat as axiomatic truths from which flawless concrete structures could be constructed. Psychologically attached to flawless mathematical structures, economists turned a blind eye to criticism and empirical failures. Secondly, politics coloured economics because rational expectations and invisible hand underpin laissez-faire economics. Just as Ptolemaic physicists resisted Galileo's theory of the earth revolving around the sun for religious reasons, economists resisted critics of rational expectations and invisible hand for political reasons. 2. What will the new paradigm look like? The key to economics is utility, economists needs to find other ways to measure utility, they can no longer rely on market prices and competition automatically delivering it. With economic support for laissez-faire undermined, economics is going to be increasingly at odds with business, increasingly suspicious of private sector activity, increasingly focused on social gains. The new paradigm is also going to be less theoretical and more statistical, philosophical, psychological and political. It's also going to be a lot more exciting and controversial. It's also going to have major implications for democracy - if laissez-faire is not the way forward we need much better government. The idea of irrational consumers and perfidious produces also raises big questions about the desirability of individual freedoms. 3. What books can I read about this? I think the economist Ha-Joon Chang is pretty good. His books include "Bad Samaritans" and "23 Things They Don't Tell You About Capitalism". Also, Stiglitz is about to release a book called "Freefall: America, Free Markets, and the Sinking of the World Economy". In term of internet links, I suggest: Credit Crisis Lessons, Rent Seeking, Apple. |