The crisis in economics

Economists didn't predict the 2008 crisis - George Soros' new institute, which seeks to understand why, has its task cut out, writes Sumati Mehta.

The recently launched Institute for New Economic Thinking, promoted by thinker and philanthropist George Soros, has a tough mandate - to provide fresh insights and thinking, with a view to promoting changes in economic theory and practice.

This is likely to be a tough task because the modes of thought, in respect of our current economic system, have got embedded in the psyches and mindsets of the very same folks, who now have to attempt to change these mindsets.

Notwithstanding the terrain which is likely to be arduous and uphill, the task has to be achieved and credibility restored to the profession, the discipline and the body of knowledge, which embodies the discipline. Where does one begin?

Naturally, one needs to begin by seeking clarity on the question: What exactly is the crisis in economics? The crisis in economics has come about because of the failure of economists as a body of professionals, and economics as a field of knowledge, to provide advance warning regarding the economic and financial crisis which the global and national economies witnessed in 2008.

Advance warning from the custodians of knowledge could have enabled timely action to avert the crisis. This did not happen. Instead, a full-blown global economic tsunami hit the global and individual economies across the world in the September of 2008 after the collapse of Lehman Brothers.

The free fall of economies could be arrested only after a massive coordinated effort by world leaders from the G-20 nations. The aftermath of the crisis is still continuing.

Why and how did the crisis occur?

The factual answer to this question, is well documented. What is crucial to understand is the fact that the crisis in economies and economic institutions was only an outward manifestation of a deeper crisis in economics as a body of knowledge or discipline.

Economics and economists are charted with the task of attempting to explain how economic agents interact and how economies work. This they could not, or did not, do as they should have to be effective practitioners of their discipline.

Why did this happen?

The answer to this question was recently deliberated upon at the inaugural conference of the Institute for New Economic Thinking held at King's College in Cambridge. Most of the presentations zeroed in on one or more of the following reasons for the inability of economics to predict/avert the crisis:

Firstly, it was pointed out that the model of Rational Expectations, on which most or all of economic theory is premised, has proved to be an inadequate or imperfect guide to understanding economic behaviour.

Secondly, the Market Efficiency Hypothesis has also been found to be more absent, than present, as economists themselves have discovered and elaborated on, for different reasons, and on different counts.

Thirdly, the representative agent models which assume that all economic agents function in like manner also does not hold true in the real world, even though it is most often the assumption when moving from micro to macroeconomics.

Juxtaposing these realities of economic behaviour which belie some of the basic assumptions of economic theory, against the economic theory and theories which rested on this foundation and pillars of the very same assumptions, and building fancy mathematical models, on this fragile base, is enough to explain why the crisis occurred. In addition, there is one more reason, which is still more fundamental and which gives a better idea of where the fault lines actually lie.

A large part of the world has witnessed, in the last few years, a mindset which has emphasised "self" interest and glorification of the self even at the expense of social or community well-being. This has been based on a kind of blind faith in the philosophy and thinking promoted by intellectuals of the kind of Ayn Rand and others.

There has been a disproportionate emphasis on individual self and personal freedom which, therefore, has, as a natural outcome, led to a society epitomising those very same values, which ultimately manifest in a culture of greed and blatant selfishness, regardless of all else. The consequences of such a mindset are now being witnessed.

This takes one logically to the next question. What should be done so as to let a crisis become an opportunity? An opportunity to think, correct, modify and transform, which is what the dictionary meaning of crisis also suggests.

The answers to this question flow from the analyses in the preceding paragraphs.

Firstly, there is a need for a change in societal "mindset", away from one promoting greed and blatant selfishness, and towards one based on respect for community and larger whole. This is not an impossibility. It only requires a conscious promotion of the values of selflessness and sacrifice.

Secondly, there is a need to search for an alternative hypothesis which is a better fit in explaining human and economic behaviour, than the Rational Expectations Hypothesis hitherto believed in, even if partially. Again, this will have to be based on deeper thinking, which attempts to understand the process of decision-making in human beings and models it only subsequently, after adequately understanding the process of thought.

Thirdly, since the Efficient Markets Hypothesis does not hold, at least most of the time, it is time for the profession and practitioners of the craft of economic systems to accept the role of responsive, responsible and stable governments as an essential requirement of miracle economies, and work towards designing common elements, if any, of the role that such governments can and should play.

In fact, a next step, which is a little premature at this juncture, would be to see how a mindset of trust and cooperation can be fostered. Surely, this too is possible as understanding about the human brain, mind and consciousness increases over a period of time.

Fourthly, and finally, for the purposes of this particular article, though not for the future of new economic thinking, where an ocean of new knowledge waits to be mined for oysters and pearls, future aversion of crises will hinge on having in place a framework of global governance, designed specifically to meet the specific requirements of the highly interconnected and technologically advanced world of the 21st century.

While the G-20 and international financial institutions are moving in the right direction, there is a need for greater speed in thought and action if events are not to overtake us as we passively watch the world race by. The time to act is now, before it is too late, once again. The Institute for New Economic Thinking has its tasks laid out. Its hands should be more than full.

The author is a civil servant. The views expressed are personal.