Economic theory must wake up to the real world of unpredictable behaviour

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.

In other words, economists must deal with what we call today the "unknown unknowns". They arise not just from accidents of nature, but also from the unpredictability of human behaviour, such as market disorder. If unknown unknowns are common in real life, then a lot of the economic models that appear to give us precise answers may be wrong. In other words, for every question, there is no unique answer and the solutions are "indeterminate".

The trouble is that positive feedback can happen. The fluctuations get larger and larger until the system breaks down. Nineteenth-century Scottish scientist James Maxwell discovered that steam engines can explode if there is no governor (or automatic valve) to control the steam building up.

At about the same time, English bankers learnt that banks can go into panic regularly without the creation of a central bank to regulate the system. Markets therefore need a third party - the state - to be the system "governor".

Free market believers think that the market will take care of itself. John Maynard Keynes was the first to recognise that when free markets get into a liquidity trap, the state must step in to stimulate expenditure and get the economy out of its collective depression.

In the 21st century, we have evolved beyond Keynes and free market ideology. Belief in unfettered markets has created a world awash with liquidity and leverage, but the capacity of advanced-country governments to intervene Keynesian-style has been constrained by their huge debt burden.

Larry Summers has pointed out that Keynes invented not a General Theory, but a Special Theory for governments to intervene to get out of the liquidity trap. The fact that we are still struggling with that trap means economists are searching for new solutions, such as borrowing from psychology to explain economic behaviour.

The Hong Kong conference introduced the thinking of French literary philosopher Rene Girard to explain how social behaviour more often than not gets into unsustainable positive feedback situations - either excessive optimism or pessimism. How do you get out of such situations? Girard introduced the concept of sacrifice. We will have to wait for the next conference to explore this new angle.

Intuitively, all life is a contradiction. The sum of all private greed is not a public good. It does not add up. Someone has to sacrifice.

Joseph Schumpeter's great insight about capitalism is that there is creative destruction. He only restated the old Asian philosophy that change is both creative and destructive. Out of change comes new life.

Andrew Sheng is president of the Fung Global Institute