By George M. Georgiou and Les Manison
The financial crisis of 2007–2009, referred to as the Great Recession, which afflicted most of the advanced capitalist economies and beyond, triggered a debate among commentators, economists and policy makers about the relevance of academic economics. Critics were drawn from across the ideological spectrum.
Despite the avalanche of criticisms following the Great Recession, it seems academics buried their heads in the sand hoping that the problem would go away. And to a large extent it has. Neoclassical economics is alive and thriving and the deeply flawed dynamic stochastic general equilibrium (DSGE) models so beloved by policy makers, such as the European Central Bank, continue to be used albeit in modified forms. Academics continue to build their careers on the basis of how many articles they can publish in a handful of abstruse journals that very few people read other than fellow academics, and even then only by those who share similar research interests. Publishing a policy-oriented book is considered suicide for those young academics hoping to climb the career ladder.
Neoclassical economists contend that competition leads to an efficient allocation of resources with the forces of supply and demand creating market equilibrium. However, the abuse and poor allocation of financial resources by banks and other financial institutions was mainly responsible for the Great Recession. And it can be argued that the exuberant activity in the financial sector resulted, in large part, from policy makers being influenced by neoclassical economic theory which asserts that market excesses can be largely dealt with by self-correcting mechanisms and minimum government regulatory interference.
Unfortunately, in the aftermath of the Great Recession the sway of neoclassical mainstream economics has continued to prevail. Although important regulatory reforms have been undertaken by central banks, it is open to question whether these are robust enough. Radical policies are needed to ensure that another financial crisis can, if not prevented, at least be minimised in terms of its impact.
In the United States, for example, a return to the Glass-Steagall Act requiring the separation of investment and commercial banking to deter, among other things, the over-zealous use of bank deposits in speculative investments would seem warranted. Furthermore, there is a need for regulations to ensure that the taxpayer will not be burdened unduly with the bailing out of banks, shadow banks or other large financial players, should another financial crisis take place. In this context a lowering of the high priority assigned to owners of financial derivatives in claiming the assets of distressed institutions, surely is necessary.
It’s not all doom and gloom. Given that economics is essentially the study of human behaviour, economists Samuel Bowles and Wendy Carlin in 2017 set out a proposal for the teaching of undergraduate economics which would take into account the contributions of psychologists, historians, political scientists, biologists, philosophers and legal scholars (one may also include sociologists and anthropologists). This can be seen as an extension of what John Maynard Keynes believed was necessary for an economist to master his discipline. In his obituary of Alfred Marshall in 1924, Keynes wrote that a good economist:
“….must be mathematician, historian, statesman, philosopher–in some degree….. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must lie entirely outside his regard. He must be.… as near to earth as a politician.”
Ironically, Marshall was the founder of British neoclassical economics. We have to turn to the great political economists of earlier eras to find those who satisfied Keynes’ criteria. Writers such as Adam Smith, David Ricardo and Karl Marx certainly did.
Bowles and Carlin also advocate replacing some of the unrealistic assumptions, often used for mathematical convenience, that undergraduates are taught with an approach that better captures economic relationships in the real world.
We believe that as an important first step to reconnecting economics with the real world, state-owned universities across the globe, including here in Cyprus, should adopt the Bowles and Carlin proposals. However, in the long run a more fundamental overhaul of economics is needed.
George Georgiou is an economist who for many years worked at the Central Bank of Cyprus in various senior roles. Les Manison served as a senior economist with the IMF, an adviser at the Cyprus Ministry of Finance and as a senior adviser at the Central Bank of Cyprus. We would like to thank Savvakis Savvides for valuable comments.