Smith versus Keynes: economics and political economy in the post-crisis era.

• Author: Gregg, Samuel

INTRODUCTION

Alongside politicians, bankers, and CEOs, few groups have received as much opprobrium for the 2008 financial crisis as economists. "Economists are the forgotten guilty men" was the phrase employed in February 2009 by Anatole Kaletsky, editor-at-large for the London Times, when explaining why "a bank with just $1 billion of capital [would] borrow an extra $99 billion and then buy $100 billion of speculative investments." (1) Self-indulgence and imprudence had a part, but so too, Kaletsky asserted, did those economists who insisted that their models "proved" that occurrences such as Long Term Capital Management's demise in 1998 or Lehman Brothers's collapse almost exactly ten years later were mathematically likely to happen only once every billion years. (2) Kaletsky's wider claim was that mainstream economics had been so discredited by the financial crisis that economics itself required an "intellectual revolution" or risked being reduced to a somewhat suspect sub-branch of mathematical modeling and statistical analysis.

Kaletsky has not been alone in making such arguments. Economic historian Harold James made a similar point, albeit more temperately:

[A]n overwhelming majority of modern economists were misled by treating short-term trends as if they were permanent phenomena that could be used to derive reliable behavioral correlations and extrapolations. There were some exceptions ... but such analysts were dismissed as alarmist or eccentric, not only by the commercially driven economists who worked for financial institutions as de facto salesmen, but also by the overwhelming majority of academic economists, who were also subject to commercial pressures in the forms of peer evaluation and patterns of career development. These economists instilled a false complacency in politicians and other policymakers. (3) In March 2009, Willem Butler, a former external member of the Bank of England's Monetary Policy Committee, likewise referred to "[t]he unfortunate uselessness of most 'state of the art' academic monetary economics." (4) Though unwilling to demand either a complete paradigm change or a defenestration of the economics profession, the Economist suggested that the financial meltdown raised profound questions of coherence about two specific fields of economics: financial economics and macroeconomics. "Few financial economists," it suggested, "thought much about illiquidity or counterparty risk, for instance, because their standard models ignore it." Likewise, "[m]acroeconomists also had a blind spot: their standard models assumed that capital markets work perfectly." (5)

These claims evoked a strong riposte from the Nobel Prize economist Robert Lucas in defense of the Efficient Market Hypothesis (EMH), the claim that the price of a financial asset reflects all relevant, generally available information. "One thing," Lucas wrote, "we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September [2008]." (6) Since the late Paul Samuelson published his proof for one version of the EMH in 1965 and Eugene Fama detailed the theory and evidence for three forms of the EMH in 1970, (7) the EMH had been subject to consistent criticism. But none of these critiques, Lucas maintained, had proved its falsity. Other economists, however, argued that the stock market meltdown demonstrated the EMH's inability to account for the market overpricing assets such as mortgages. On this basis, they conjectured, "the EMH, as applied to the stock market in aggregate, must be discarded or modified." (8)

While these discussions are important, much of the debate about economic theory following the 2008 crisis has focused upon the place of models in economics. Some contemporary economists seem hesitant to question the appropriateness of their heavy dependence on models and mathematical logic. This hesitance may arise because they want to avoid raising difficult questions about the very nature of postwar mainstream economic science.

Since John Maynard Keynes's time, mainstream economics has undergone a steady process of mathematization and immersion in abstraction. One need only glance through their nearest copy of the American Economic Review and observe the plethora of algebra that is now central to most mainstream economists' argumentation. Outside the Austrian school of economics, few economists have publicly questioned this dependence. One economist willing to do so, however, was Wilhelm Ropke (1899-1966). Ropke is well known as one of the intellectual architects of postwar West Germany's path from National Socialist economic collectivism to a market-driven economic miracle in the decade following West Germany's economic liberalization in 1948. Less attention, however, has been given to Ropke's passionate critiques of postwar developments in economics as a social science. On one level, these denunciations were driven by Ropke's belief that policies based upon Keynesian-influenced economics would gradually diminish economic and political liberty. But another source of Ropke's angst was his conviction that Keynes and, more particularly, his many disciples were slowly undermining the integrity of economics as a social science. Though Ropke died over forty years ago, his analysis of trends in economic science following Keynes's General Theory (9) provides useful insights into some of the challenges confronting contemporary economics. It also contains some intimation of a possible direction for post-crisis economics, one closer to the vision of Adam Smith than the legacy imparted by Keynes and his successors.

1. ECONOMICS, POSITIVISM, AND SCIENTISM

   Reflecting on the fortunes of economics in the 1950s, Ropke marveled at the enormously augmented scope for economic research. (10) He contrasted it with the economics profession's situation in prewar Germany as a lowly handmaiden to faculties of law. (11) Postwar economic science enjoyed a stature that had previously eluded the discipline, partly, Ropke thought, because a range of difficulties had emerged since the 1930s that caused many to turn to economics for responses. (12) But, Ropke held, these new realities were actually grounds for considerable concern about postwar changes in economics as a social science.

   "The economist, too," Ropke once wrote, "has his occupational disease: restricted vision." (13) Emphasizing that he spoke from personal experience, Ropke suggested that some economists found it hard to look beyond their own discipline or concede that the economy was part of a larger order about which other sciences had things to say. (14) This provincialism was magnified by the error of "economism," the habit of viewing "everything in relation to the economy and in terms of material productivity, making material and economic interests the center of things by deducing everything from them and subordinating everything to them as mere means to an end." (15) Economic research, Ropke insisted, would not be productive if economists largely ignored the complexity of the world in which economic choices and policies operate. (16) Economism invariably led economists into the trap of what Ropke called "social rationalism," the tendency to regard market mechanisms as value-neutral methods applicable to any economic or social order. One example was the attempt of socialist economists such as Oskar Lange to reconcile the price mechanism with collectivist economies. How, Ropke asked, could a mechanism that assumes human freedom operate in societies premised on the radical subordination of liberty? (17)

   It followed, according to Ropke, that economists should seek to avoid segmenting economic inquiry from the complex character of human nature. Though attentive to utility, Ropke rejected the neoclassical premise of humans as rational utility maximizers: "The ordinary man is not such a homo ceconomicus.... The motives which drive people toward economic success are as varied as the human soul itself." (18) Nor did Ropke consider it reasonable to premise economic theory on an understanding of humans as selfless creatures. (19) Instead, Ropke invoked a rather Smithian understanding of human beings to explain his fondness for market economies over the alternatives:

   There is a deep moral reason for the fact that an economy of free enterprise brings about social health and a plenitude of goods, while a socialist economy ends in social disorder and poverty. The "liberal" economic system delivers to useful ends the extraordinary force inherent in individual self-assertion, whereas the socialist economy suppresses this force and wears itself out in the struggle against it. Is the system unethical that permits the individual to strive to advance himself and his neighbor through his own productive achievement? Is the ethical system the one that is organized to suppress this striving?... It makes virtue appear irrational and places an extravagant demand upon human nature when men in serving virtue in a collectivist economy must act against their own proper interests in ways that, as even the simplest of them can see, do nothing to increase the total wealth. (20) Ropke was also impatient with economic theories that diminished the study of individual human choice and action to relative insignificance. (21) This diminishment, Ropke maintained, was the product of scientism's effect upon economics. He defined "scientism" as the tendency to "understand by science [what] is merely fundamentally the narrow territory of the 'positivist" and 'exact' natural sciences and their technical application." (22) Scientism embodied the notion that there were no limits to the cognitive capacities of positivist methodology and technical analysis. It was usually associated with "an optimistic belief in progress by means of a mechanical leadership of society." (23) The result was "the...