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12 September 2023

Economics is broken

I am not an economist. I am a journalist. But macroeconomics has played a huge role in my professional life. Academic macroeconomists have influenced the way I think about the economy. They also influenced politicians like Gordon Brown in the 1990s. His first act as chancellor was to make the Bank of England independent. He followed the playbook of orthodox macroeconomics to the letter. When Bill Clinton was elected US president in November 1992, he gathered a group of academic economists in a conference to advise him on his future economic policy. In the 2000s, academic economists rose to become star central bankers, like Ben Bernanke in the US or Mervyn King in the UK. In the TV show The West Wing, the US president was portrayed as a Nobel-prize winning economist. 

This is unthinkable today. The light of the macroeconomist has faded. Just as their rise influenced policy, so will their fall. Virtually all our economic policy regimes are based on the orthodox macroeconomic models that were developed from the late 1970s until today. Central bank independence, inflation targets and fiscal rules all owe their existence to ideas deeply embedded in those models. 

The trouble is that these models have ceased to work some time ago.

This news has arrived in the central banks too. Christine Lagarde, president of the European Central Bank, made a revealing comment recently about "shifts in economic relationships and breaks in established regularities". She is saying that the orthodox economic models, on which the ECB and other central banks have become reliant, are no longer capturing what is going on. 

If you look at central bank inflation forecasts, you can see why. Over the last decade, these forecasts almost always suggested that inflation would revert close to the central bank's target. In the UK and the eurozone, this is 2 per cent. But inflation did not follow the forecast. It got stuck well below the target in the last decade, and is now stuck well above it. The problem is not that the forecasts are wrong - but they are biased towards optimism. They don't tell central bankers what they need to know but what they want to hear.

A dart-throwing monkey or an unbiased astrologer would have outperformed the central bank economic models. I am not recommending that central banks should start hiring monkeys or engage in dark arts. But there are many ways they can improve their forecasting performance without involving economists. If a monkey can outperform the model, so can many humans.  

Bad forecasts are only the tip of the iceberg. Behind it lies a much deeper problem - the failure to understand what is going on. The Queen once famously asked why did economists not see the global financial crisis coming? The perhaps surprising answer was that there is no substantial representation of finance in their models. They also make questionable assumptions about human behaviour. It assumes that we humans are rational. Behavioural psychologists have demonstrated beyond any reasonable doubt that this assumption is wrong. But as an economist friend of mine once joked: "No economist has ever given up on their model simply because evidence intruded."

You might be forgiven for asking: why do economists not change their models? The answer is they have invested their professional careers into developing them. It is similar to being a German car maker in a world of electric cars. 

My own expectation is that computer scientists and mathematical statisticians will be the ones that develop the next generation of models. Methods from artificial intelligence and deep learning will play a more prominent role at the expense of traditional macroeconomics. I personally still find elements of macroeconomics useful. But it is the old stuff, the bits that went out of fashion in the 1980s. 

But the really big impact of all of this will be on governments and central banks. Before the 1990s, central banks did not have inflation targets. These targets only exist because the models suggested so. Previously, price stability fell into the "I know it when I see it" category. We might go back to this.

The whole idea of central bank independence was based on the idea that models perform better than politicians. The claim is hard to sustain when monkeys outperform the models. I would not be surprised if the Bank of England became the first of the large central banks to hoist the white flag on inflation. Would at least some politicians not want to take back control from a dysfunctional central bank? 

Or take fiscal targets. They too derive from the vaults of modern economic orthodoxy. One specific problem with those models is their notion of potential output, the output an economy can produce when it is at full capacity. A misjudgment of how the financial crisis affected potential output was one of the reasons we all ended up with austerity. 

Herein also lies a warning to the Labour Party. Gordon Brown broke from the past when he made the Bank of England independent, and when he introduced a new fiscal regime. He laid the foundation for 13 years of Labour government. But it was the period during which the model worked. You cannot extrapolate this to a period when it no longer does.

By clinging on to the current economic orthodoxy, politicians risk coming under the influence of what John Maynard Keynes called a defunct economist. The big prize in UK politics will come to the politician who will find a way to break with the existing order. Liz Truss failed for reasons we all know. But clinging to a dysfunctional orthodoxy is not sustainable either. 

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