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I raise this question having spent last weekend in Toronto at the annual conference of the Institute for New Economic Thinking, a foundation created in 2009 in response to the failure of modern economics in the global financial crisis (whose board I currently chair). Unfortunately, the question raised above is as troubling today as it was in November 2008, when Britain’s Queen Elizabeth famously stunned the head of the London School of Economics by asking faux naively, “But why did nobody foresee this [economic collapse]?”
As John Maynard Keynes observed in 1936, when he challenged the economic orthodoxies that were aggravating the Great Depression: “The ideas of economists, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.”
This remark is as relevant today as in 1936. Joseph E. Stiglitz, the Nobel laureate, asked rhetorically in Toronto: “Why are central banks and governments still trying to predict the effects of their policies with an economic model that is manifestly absurd?”
His answer was that the economic models studied in universities and published in leading academic journals are still largely based on a simplifying concept, known as the Representative Agent, which effectively assumes that “everyone in the economy is the same.” So these models have nothing to say about lending or borrowing, ignore the existence of banks and treat bankruptcies as unimportant because “when the borrower does not repay, he only defaults on himself.”
Amazingly, these economic models with no banks are still the main analytical tool used by most central banks. Peeling away further layers of the theoretical onion reveals something even more bizarre: an inbuilt assumption that the economy is self-stabilizing. This means that virtually any policies the central bank may choose to follow will lead automatically to full employment — in the forecasts, if not in the real world.
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