Economists Fighting

Economists have at last noticed that there is something wrong with their science and they are beginning to fight about it. A new group of economists has emerged to tell a story that counters the version of the financial crisis of 2007-8 that is typically presented by mainstream economists.

The problem within economics is not trivial but neither is it complicated. It comes down to faith in the power of markets. Orthodox neoclassical economists believe in the efficiency of markets and the inefficiency of government. Their opponents in this confrontation, Keynesians of one sort or another, claim that pervasive market failure can only be remedied through the regulatory power of government.

In the workaday world, the market economists have successfully marginalized anyone who opposes them. You bow before the God of markets or you do not get a job in academic economics.

The people who are presently challenging the entrenched market economists, principally Paul Krugman and Joseph Stiglitz, are themselves Nobel Laureate economists. They and the other leaders of this group have all of the honors, awards and credentials necessary to be taken seriously. They are supported and cheered on by a following of heterodox economists who occupy the fringe and range from the merely disgruntled to radical leftists.

The dispute around the 2007-8 crisis arose from the American choice of stimulus versus the IMF and European Union choice of austerity as their response to the present economic slowdown and crisis. For the mainstream economists, the appropriate policy in a recession is to put up with unemployment because it lowers wages and to pay off debts because it will keep the interest rate low and thereby avoid inflation. These choices are expected to generate confidence and job creating investment.

Keynesian economists, on the other hand, note that recessions by their nature reflect inadequate demand so that austerity, i.e.unemployment, lower wages, and paying off of debts, just makes the lack of aggregate demand even worse. A generous government social safety net and deficit spending is expected to restart the benevolent cycle that rebuilds the economy.

Mainstream austerity economists base their policy recommendations on a widely cited study by Ken Rogoff and Carmen Reinhart that found high debt associated with low growth, paired with a sharp drop in growth when the debt-to-GDP ratio went past 90 percent.

An independent group of heterodox economists reviewing the Rogoff study found statistical errors, confusion about the direction of causation and generally sloppy research in a non-reviewed journal. Rogoff and Reinhart vigorously defended the findings in their paper. They admitted the statistical errors but treated them as trivial and easily cleaned up. They fudged the causation discussion. Krugman and Stiglitz entered the fray to note how these flaws undermined the austerity theory. Rogoff accused them of uncivil behavior. Others, from both sides, jumped in and the battle was joined.

Rogoff and Stiglitz have a history of less than civil discourse on this topic. Insults are being carefully crafted and accusations are getting personal.

This is the first serious challenge to mainstream economics since Keynes. It came to notoriety based on the failures of the IMF and US austerity policies in dealing with recent financial crises. In 1995, the U.S. Treasury bailed out US banks in Mexico but not Mexican banks. Austerity devastated the Mexican economy. The IMF austerity program for Asia in 1997 undermined the finances of strong, well-managed economies. In the wake of these failures, the IMF is reconsidering its position.

This confrontation will hopefully change the nature of economics. Economics has pretended, since the 19th century, to eschew politics, claiming a mathematics-based neutrality. Paul Krugman has now changed all that, injecting a political model into the discussion. Krugman cited a Polish leftist, Michal Kalecki, on how the wealthy would use a demand for confidence to maintain their political agenda. In the 1930s, Kalecki predicted exactly what is happening now.

Economics, through this confrontation, are pointing out the failures oftheir science. In macro, mainstream economists have never explained why they failed to predict the biggest downturn since the Great Depression. Nor do they seem to think any explanation is necessary. The onset of the financial crisis had Treasury Secretary Paulson and Fed Chairman Bernanke picking a $700 billion stimulus number out of the air and improvising after that. Even today, Fed Chairman Ben Bernanke is making it up as he goes along with his quantitative easing.

Micro is just as bad. Maximization of profit is the bedrock of the theory of the firm but the corporate version, maximizing quarterly stockholder wealth, has been called the "dumbest idea ever." The attempt by America to impose its corporate structure on the world is being seriously challenged by the somewhat/maybe socialist/communist economic structure of China.

All of this boils down to that same question about the efficiency of markets. Let us hope that the economists go at it vigorously and and honestly. Eventually, economists might become as useful as dentists.