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The gist of the matter is in the interconnections

Nicky Pouw | 16 September 2011

If there is one primary reason why economists failed to predict the current financial crisis it is because of a gross underestimation of the destructive forces of what I call ‘propelling risks’. Financial risks that were taken at the lower end of the income distribution built up, led to welfare losses, and very quickly affected income groups across the board and in multiple countries. Articles addressing the underlying causes of this misconception always mention one or more of the following three reasons: (i) a foolish belief in perpetual economic growth; (ii) a wrong use of economic models; or (iii) a lack of ethics and morals, not in the least on the side of the financial sector. The gist of the matter however is in the inter-connections. Paul Krugman discusses them in a recent article in which he blames himself too, by the way [i]. So how exactly are these factors interconnected, what do they teach us about economic realities on the ground, and how should we study them?

Economic growth is generally considered an important driver of human development. Economists disagree about whether it is just one aspect of it or the crucial ingredient. To believe that growth is perpetual is foolish though. Even the early Solow-model shows the possibility of a ‘steady-state’. At the moment, economic growth in many advanced economies is slowing down with unemployment rising. Michael Spence describes this in his latest book [ii]: in fifty years time, the US and Europe will earn 10% of global per capita income instead of 60% today. Alternatively, the emerging economies of China, India and Brazil will earn 60%, not in the least because of the size of their populations. Economically speaking, they will soon dominate. The benefits of globalization are swopping owners. Psychologically speaking, people in advanced economies should make sure to be prepared for that. Focusing on growth alone will not pay off. We clearly need to think about distribution and sustainability of growth, too.

Different economic models are needed to capture the increased interconnectedness of uncertainties and risks across borders. The ‘New Growth Models’ and Markowitz-type capital asset pricing model have gone out of fashion. Their underlying assumptions no longer resonate with reality. For example, it is a fallacy of financial models to average out risks and to assume invariance across incomes: we all know that an unemployed family runs a much higher risk of losing their home as compared to an affluent family, let alone the impact of that loss on their lives.

This brings me to my last point: the lack of ethics and morals in economics. In terms of financial practices, bankers have lost sight of it altogether. In terms of discourse, economists should not be so reluctant to take an ethical or moral stance. In the end, it is only a small step from advocating ‘good governance’. How much inequality are we prepared to accept? To the extent that people and countries grow disconnected forever? This is an ethical point that should steer our development policies nationally and globally. If we can’t live together, we are going to die alone.

[i] Paul Krugman. (2011) ‘The Profession and the Crisis’: http://www.palgrave-journals.com/eej/journal/v37/n3/pdf/eej20118a.pdf

[ii] Michael Spence. (2011) The Next Convergence. The future of economic growth in a multi-speed world

Photo credit main picture: Image by Epsos.de

Comments

Something Old, Something New

The specialty training of economists, combined with understanding and experience of individuals and communities, provides all the groundwork for innovative solutions. However, after reading both Pouw's and Krugman's articles, I can't help agree that at least the loudest voices in the economics communities failed to serve their public purpose. In addition to Pouw's poignant question of ethics in the banking communities, the question raised in Krugman’s article of what to do next is staggering.

As global ecologies (social, environmental, political, etc.) evolve, change or are disrupted, so must the economics directing the finances and patterns of exchange. It is easy to forget, especially in times of crisis, that economics, as a whole is half description and half innovation. It is not only what we exchange, but how we do so and to what end. Economists need to adapt and re-evaluate what people have to exchange and how to properly valuate it. Krugman makes a valid argument that to adapt to changing circumstances, economists need to first remember (or learn) the history of economics. As stated by Krugman, an important question is “what constitutes a ‘bank’ (309). While Krugman searches for the answer in existing establishments, it is just as important for each of us to re-evaluate what assets we can trade with a ‘bank’. As Ness pointed out, individuals and communities experiencing global and local changes are in an excellent position to describe, if not innovate as well, exchangeable assets that can contribute to an economy.

The answers to Pouw’s and Krugman’s questions, as alluded to by Nass, are among us already but it will take historically-minded economists and actively involved citizens. A recent article in the New York Times exemplifies the concept of combing historic models with current experience to create an innovative solution: the Time Bank started in the 1980s by Edgar Cahn[i]. The Time Bank is perfect example of an observation-based innovation on an existing economic model: with high levels of unemployment the money economy shrinks, but peoples skills, knowledge and other non-tangible assets are slower to respond [ii].

[i] Tina Rosenberg. (2011, 15 September). “Where All Work Is Created Equal.” The New York Times. Available from http://opinionator.blogs.nytimes.com/2011/09/15/where-all-work-is-created-equal/?scp=2&sq=time%20bank&st=cse

[ii] NPR Staff. (2011, 19 July). “Beyond Bartering: Banking On Community Connections.” National Public Radio. Available from http://www.npr.org/2011/07/19/138510242/beyond-bartering-banking-on-community-connections

Katherine Zobre | October 07, 2011 | Respond

Interdisciplinary approach

Great read and I fully encourage the endeavor to make economic models more inclusive. However the article makes it seem as if there were not broader, more inclusive approaches around. This is not only being easy on the economists and other social scientists, but also denies a huge body of research that does provide some useful answers and theoretical frameworks – one of them being Political Economy.

Some mayor theories within the field of PE take into account the influence of heterodox economic understandings. In fact, some of them critique more traditional theories (like realism, liberalism) which lean on the same assumptions of rationality and parsimonious models that underpin modern economics as well. Take for example Keohane and his incorporation of ideas or the more radical critique by Robert W. Cox explaining the neo-liberal cultural hegemony through the concept of social forces.

What’s more, political economy in itself encourages a broader approach and more possibilities for ‘inclusiveness’ since it presumes that economics is politics, in the way that the allocation of resources is a political choice (i.e. you can make a different one as well). Hence, the intradisciplinary debate is useful, but an interdisciplinary discussion would be very welcome as well.

Wouter Kleijn | September 29, 2011 | Respond

Economics and Social change sciences

I had a look at Paul Krugman's article, and he suggests that economists may need the help of the social sciences. I'm not an economist, although I read a magazine with the same name, but yes as a sociologist/agronomist I often think the same. We really need to learn to better balance 'hard' and 'soft' sciences.

Social change sciences might help economists to understand disparities from a human perspective. Not in a touchy-feely sort of way, but by deepening understanding of societal complexities, like the ones Nicky feels economists should devise models for.

Another thing I have learned from over 20 years development work, is that the best solutions come out of meaningful interactions among varied groups who all care about finding a solution, a way forward. It's not about defining that solution for them, but it's about supporting them on the way to finding a solution that works for all. Nobody has the solution, but if we catch the net a bit wider, we can create better solutions together (e.g. ethics and morals in economics). This requires leadership capacities to:

1) Lead in complex systems
2) Achieve results in the face of unpredictability and uncertainty
3) Continue to learn, and guide others with their ongoing learning
4) Act through others by understanding their values, motives and behaviours
5) Provide vision, meaning and direction

The good news is that such capacities can be developed.

Lucia Nass | September 20, 2011 | Respond

Models, Systems and People

An overly reliance on models and systems can indeed be tricky if the models no longer apply and systems turn wild. Much effort in non-heterodox economics has gone in studying models and systems. Yet, societal and economic change is ultimately fostered by people. We ought to pay much more attention in economics to people's cultural identities, social-political relations, and underlying motivations and how these shape economic processes and outcomes. This will put economists in a much better position to link-up the micro to the macro; something that no model has ever achieved thus far.

Nicky Pouw | September 22, 2011 |