Did Capitalism Fail?

But, to put it bluntly, the belief that an economist can fully specify in advance how aggregate outcomes – and thus the potential level of economic activity – unfold over time is bogus. The projections implied by the Fed’s macro-econometric model concerning the timing and effects of the 2008 economic stimulus on unemployment, which have been notoriously wide of the mark, are a case in point.

Yet the mainstream of the economics profession insists that such mechanistic models retain validity. Nobel laureate economist Paul Krugman, for example, that a back-of-the-envelope calculation on the basis of textbook macroeconomics indicates that the $800 billion US fiscal stimulus in 2009 should have been three times bigger.

Clearly, we need a new textbook. The question is not whether fiscal stimulus helped, or whether a larger stimulus would have helped more, but whether policymakers should rely on any model that assumes that the future follows mechanically from the past. For example, the housing-market collapse that left millions of US homeowners underwater is not part of textbook models, but it made precise calculations of fiscal stimulus based on them impossible. The public should be highly suspicious of claims that such models provide any scientific basis for economic policy.

But to renounce what Friedrich von Hayek called economists’ pretense of exact knowledge is not to abandon the possibility that economic theory can inform policymaking. Indeed, recognizing ever-imperfect knowledge on the part of economists, policymakers, and market participants has important implications for our understanding of financial instability and the state’s role in mitigating it.

Asset-price swings arise not because market participants are irrational, but because they are attempting to cope with their ever-imperfect knowledge of the future stream of profits from alternative investment projects. Market instability is thus integral to how capitalist economies allocate their savings. Given this, policymakers should intervene not because they have superior knowledge about asset values (in fact, no one does), but because profit-seeking market participants do not internalize the huge social costs associated with excessive upswings and downswings in prices.

It is such excessive fluctuations, not deviations from some fanciful true value – whether of assets or of the unemployment rate – that Keynes believed policymakers should seek to mitigate. Unlike their successors, Keynes and Hayek understood that imperfect knowledge and non-routine change mean that policy rules, together with the variables underlying them, gain and lose relevance at times that no one can anticipate.

That view appears to have returned to policymaking in Keynes’s homeland. As Mervyn King, the former governor of the Bank of England, put it, Our understanding of the economy is incomplete and constantly evolving….To describe monetary policy in terms of a constant rule derived from a known model of the economy is to ignore this process of learning. His successor, Mark Carney, has come to embody this view, eschewing fixed policy rules in favor of the constrained discretion implied by guidance ranges for key indicators.

Rather than trying to hit precise numerical targets, whether for inflation or unemployment, policymaking in this mode attempts to dampen excessive fluctuations. It thus responds to actual problems, not to theories and rules (which these problems may have rendered obsolete). If we are honest about the causes of the 2008 crisis – and serious about avoiding its recurrence – we must accept what economic analysis cannot deliver in order to benefit from what it can.

Roman Frydman is a professor of economics at New York University. Michael D. Goldberg is a professor of economics at the University of New Hampshire. They are co-authors of and .

Copyright: Project Syndicate, 2013.

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