Economic ideas matter. For two centuries political debates have been framed by economic arguments – markets versus states; right versus left. But economic thinking is changing, and it is paramount that policy and politics change along with it. Yet few politicians are even aware of these economic developments, although their implications for politics are potentially transformative.
New economics can offer us a better toolkit to analyse and develop policy. In 2006, economists at the Federal Reserve analysed what would happen if the then-growing US housing bubble burst. The answer that came back was ‘not much’. The traditional economic model they used assumed that everyone would behave rationally, markets would function efficiently, and the system would smoothly self-correct.
We all know what happened. When the bubble burst it wiped out $10.8 trillion in wealth in the US alone. In Europe, the President of the ECB remarked, ‘I found the available models of little help. In the face of the crisis, we felt abandoned by conventional tools’. Yet a crisis is exactly when a model should be at its most helpful.
So what would new economics have done differently? A team of researchers at Yale and several other universities have constructed a detailed bottom-up model of the housing market which shows the bubble in a new light. Unlike conventional top-down models, which show gentle self-correction, the team’s ‘agent-based model’ showed the bubble bursting and markets crashing. The team modelled various policy responses to the housing bubble using real data. Conventional wisdom has been that sustained low interest rates following the 2000 dot-com crash were the primary cause of the housing bubble. But in the model raising the interest rates did not prevent a bubble forming, but tighter regulation of banks almost completely eradicated it.
This suggests better ways to frame economic policy in relation to the housing market. But, in coming years, similar work will undoubtedly highlight ways to improve policy in other areas. For example, the European Commission has funded a similar modelling effort to better understand and prevent financial crises, and these techniques are being applied to areas ranging from climate change, to health policy, to better understanding how economies grow.
Second, in addition to providing new models for understanding specific issues like the financial crisis, new economics offers a different way of thinking about policy more broadly.
Traditional economics views the economy in a fairly mechanistic way, ignoring what George Soros calls the ‘reflexivity’ of the economy: a two-way interplay between perceptions and actions which can send the economy off on a course very different from that predicted by traditional models.
New economics can take account of some of the complexity, unpredictability and reflexivity of the economy to take us beyond a mechanistic view of policy. Rather than finding a specific problem and following one policy to solve it (or not), we should create portfolios of small-scale experiments, building on those that work whilst rejecting those that don’t. Policies and institutions should be made as adaptable as possible. California’s building codes have succeeded in reducing energy consumption by setting standards which automatically ratchet up as technology improves. This allows regulations and state-of-the-art building practices to co-evolve. Policy-makers must begin to see themselves as ‘system stewards’ rather than social engineers. They should aim to provide the conditions which allow socially favourable outcomes can emerge from the interactions of the system’s stakeholders.
Finally, new economic thinking could provide the foundations for an entirely new species of politics which does not correspond to a left-right framework. This isn’t merely a centrist compromise. Rather it is a different frame work that agrees with the right on some things, with the left on others, and neither on still others.
New economic work shows that Hayek was ahead of his time in his insights into the power of markets to self-organise, efficiently process information, and innovate. But new economic work also shows that Keynes was ahead of his time in his concerns about inherent instabilities in markets, the possibility that markets can fail to self-correct, and the need for the state to intervene when markets malfunction. New economics offers the promise of a new synthesis that goes beyond the insights of figures such as Keynes and Hayek and re-frames historic left-right debates.
A new narrative of politics could develop out of such a shift. For example, Eric Liu and Nick Hanauer, in their book the Gardens of Democracy advocate a move from mechanistic ‘machine-brain’ narratives in politics towards a ‘gardener’ mind-set, with the state playing the role of a gardener, helping create the conditions in which the private sector and civil society can flourish.
New economics still has some distance to go to mature as a body of economic theory, and no doubt it will take time to further develop the policy and political implications of these ideas. This journey may not end our political debates, but it has the potential to make them far more productive for society.