Paradigms Lost? Cowboys and Indians in the Battle Over Economic Ideas

One of the most interesting organizations to come out of the crisis is the Institute for New Economic Thinking (INET), which is dedicated to “fresh insight and thinking to promote changes in economic theory and practice.” I attended its first conference in April 2010. The mood was optimistic. Rational expectations theories, the efficient markets hypothesis, capital account openness, Ricardian equivalence, were all on the chopping block. The book of the conference was Skidelsky’s The Return of the Master. We were all Keynesians now, again…for about eight months.

Then came the ECB June 2010 Monthly Report that raised the specter of ‘Ricardian consumers’ and ‘expectation effects,’ while the G20 meeting that same month (coincidence?) focused attention upon ‘Growth Friendly Fiscal Consolidation’ and the overwhelming need to reduce debt. Led by the UK (whose net debt-to-GDP ratio was at that time was below the Maastricht threshold) the voices of orthodoxy quickly regrouped and triumphed. Austerity and belt-tightening gained traction as the advocates of a reinvigorated Keynesianism shifted their sights from dismembering the neoclassical corpus to simply maintaining the legitimacy of spending under any circumstances.

By the time the G20 met in Paris last weekend only the degree of fiscal rectitude was up for grabs, Obama having joined the consolidators. And as for the lofty goals of INET, it is significant that their next meeting will be held at the Bretton Woods hotel where the post-war Keynesian order was assembled. These new economic thinkers seem to be searching for ‘Paradigms lost.’

All of which makes me wonder about the conditions under which the economic ideas that, as Keynes put it, “dominate the economic thought, both practical and theoretical, of the governing and academic classes of this generation” change? As I argue in a new piece for the journal Governance, if one views the problem of paradigm shift as one where some series of events act as anomaly generators that undermine the theory, leading to its eventual and ultimate collapse and replacement, then the 2008 crisis was as close to a perfect natural experiment as you can get. To list some of the howlers: prices were not right in any sense, liquidity turned out to be a social property after all, VaR and associated techniques of risk management proved to be worse than useless, and the whole experiment cost (so far) around $2-3 trillion dollars.

You might then think that given such large losses and red faces we really should now be living in a post-neoclassical world. Yet we are not. Here are two reasons why this is the case: one that I don’t buy and one that I do buy.

“There is (still) no Alternative” – There is No New Paradigm.

This is a very odd but powerful form of argument. Odd, when you consider that this blog, INET, and hundreds of other sources are actively building one. Powerful, in that by saying that ‘unless you replace one complete integrated mathematically perfect theory with another one you should stick with the one you have got.’

I have always been suspicious of this form of argument for three reasons. First, part of the pathology of the old paradigm was precisely its perfectly integrated general form, which made it quite useless for acting in the world. Any new paradigm should be robust to the world, which means partial and revisable in the light of experience. Economists tend not to like that idea.

Second, there is a new paradigm, it’s the old paradigm that seeks to put finance in a box unless it aids in the production of things you can buy, sell and drop on your foot. It’s just that with 40 percent of US and British corporate profits coming out of this sector one or two folks might be resistant to such a paradigm shift.

Third, in terms of not chucking out babies with bathwaters: the last ‘theory’ we had linking biology and behavior until the rise of modern genetics and neuroscience was Eugenics. Getting rid of that and doing without a ‘new and better model’ for some forty years was probably a good idea.

Or – Kuhn’s Conundrum: The Politics of Authority

Thomas Kuhn, the originator of the ‘paradigm shift’ model of intellectual change, argued that the process of change was as much sociological as scientific. As such, who gets to speak authoritatively becomes a critical determinant of paradigm change as much or more than what the ‘facts’ say.

Contrasting Peter Hall’s brilliant examination of paradigm change from Keynesianism to Monetarism in the UK in the 1970s and 1980s with the current crisis gives us some insight for why there has been no paradigm shift in this crisis. In Hall’s case of the UK, the locus of authority, who gets to speak about how the world works, was the Treasury and the Cambridge Keynesians. Surrounding them and shooting arrows of dissent, like so many Hollywood Indians in a Western movie, were a panoply of organizations; think-tanks, the conservative party, the financial press, the City of London, all pushing against the dominant paradigm. One locus of authority, many challengers, each ‘failure’ amplified and distributed, discrediting the source: outgunned and outflanked.

Now consider the 2008 crisis, when all the liquidity in the world dried up as every equity dealer in every bank had to become a credit analyst such that the system as a whole ground to a halt. Saving the global payments system from itself was essential, and so the unreconstructed brute Keynesianism of output gaps and stimulus was wedded to an enormous redistribution of wealth from taxpayers to rentiers, as financial bailouts became the order of the day. But once the system was stabilized, this time around the critics would have a hard time being heard.

In this case the Indians were few and the cowboys were many and distributed. Thirty years of spectacular returns and not blowing up (at least in the Western core states) had convinced everyone from the OECD to the ECB, from the BIS (with a few exceptions) to the IMF, from the Swedish central bank to the US Federal Reserve, that markets were rational, prices were right, and policies were optimal. Those invested in selling ‘the Great Moderation’ could hardly be expected to turn around and tear it all down so easily. With so many distributed authorities invested in ‘paradigm maintenance’ the forces for paradigm change had to spread their fire over such a wide area that their effect was dissipated. That’s one reason, among many, why there was no Paradigm Lost.

Authority, as deeply social a construct as one can imagine, trumps mere facts where the correlation of forces is against reform. Mere facts, even two trillion dollar facts, seldom triumph over a good ideology.