Economic theory must wake up to the real world of unpredictable behaviour
Andrew Sheng says any search for new solutions has to confront the problems of market failure
Last weekend, more than 400 people - including three Nobel laureates and many top economists and thought leaders - gathered in Hong Kong for the annual Institute for New Economic Thinking conference, co-hosted by the Fung Global Institute.
So what was new? In the opening session, Dr Victor Fung, founding chairman of the institute, quoted Henry Kissinger as saying, "Americans think that for every problem, there is an ideal solution. The Chinese, and Indians and other Asians, think there may be multiple solutions that open up multiple options." This summed up the difference between mainstream economic theory being taught in most universities and the need for a new curriculum that teaches that there is no flawless equilibrium in an imperfect world and that there is no "first-best solution".
The aspiring economist must be taught to ask the right questions and find the missing pieces in our analysis. After all, theory is not reality.
Nobel laureate Friedrich Hayek, a leading thinker on open societies and free markets, explained why the practice of mainstream economics is flawed. Over three decades ago, he wrote that "a whole generation of economists have been teaching that government has the power in the short run, by increasing the quantity of money rapidly, to relieve all kinds of economic evils …
"Unfortunately this is true so far as the short run is concerned. The fact is that such expansions of the quantity of money which seems to have a short-run beneficial effect become in the long run the cause of a much greater unemployment. But what politician can possibly care about long run effects if in the short run he buys support?"
In today's age of "quantitative easing", does this sound familiar? In his 1974 Nobel lecture, Hayek said "this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences - an attempt which in our field may lead to outright error."
Hayek understood what is today recognised as quantitative-model myopia. What cannot be easily measured can be ignored. Then it is a small step to assume that what can be ignored does not exist. But it is precisely what cannot be measured and cannot be seen - the "Black Swan" effect - that can kill you.