Post-Crisis Economics

A conference last week brought together a variety of economists from academia and policy to discuss what changes the discipline should produce post the financial crisis and what changes should be made to degree studies.


There was probably a consensus that micro economics had made more progress than macro in recent years and that students should be taught more economic history (and possibly the history of economic thought), but beyond this there was perhaps insufficient willingness to engage in setting out the principles of the subject. John Sutton suggested that we would only be able to say we had a proper subject discipline when we could say that 95% of a textbook was true – when I asked the audience later to say whether they thought even 50% was true, no hand at all went up. I hesitated to try and find out whether there was any percentage a majority would have signed up to! I did wonder whether we should run an auction to decide the agreed proportion – an area where there is probably a consensus that progress has been made – but didn’t have any rules to hand.

If teachers and practitioners are unclear what truth there is in basic teaching, what can the subject be about? One teacher suggested it was about ‘thinking like an economist’ which I defined as considering incentives, balancing costs and benefits, asking about market failures. This is certainly how the distinction feels in public policy. Of course, this has nothing to say about whether equilibrium is a useful concept, or whether maximisation is possible.

John Kay stressed that different problems would need different approaches and modelling techniques and that economics was too often a technique in search of a problem. Andy Haldane drew attention to the importance of networks in many markets and how standard economics made no allowance for the impact of one market participant on another. But the group did not really focus on these approaches, and I think largely prefers to consider how adjustments can be made to the existing approaches to maintain as much as possible of the canon – even though it is not true!

Hardly anyone referred to learning from other disciplines, whether anthropology, biology, psychology, philosophy or history, although many of these are making contributions to how economies work. A particular contribution comes from physics as Paul Ormerod pointed out.

Of course there are circumstances in which the standard model of independent market participants, able on average to build a good model of the market, in a rational way, will be a sensible approach. But there are many circumstances when these conditions will not hold. It was noteworthy that innovation, growth, and disruption got little coverage at the conference. What is the model for considering large scale investment which will change connectivity between markets for example? What about technical innovation which disrupts markets? These are the sorts of changes which have been a distinguishing feature of capitalism and which have made possible the standard of living, health and longevity we now enjoy. We didn’t discuss these and we must.

I think that the conference showed that economics continues to have good problems, and it has some good skills. But it still lacks a set of good theories and quite often lacks good data as well.

Bridget Rosewell, Managing Partner, Volterra

Co-operation and Competition

Ed Mayo, ex-head of the New Economics Foundation and now of Co-ops UK, has an interesting blog (read here) on the importance of co-operation in our economic system rather than competition. This is a really challenging and difficult topic.


Co-operation is extremely important to the successful functioning of the market-oriented economies of the West. But this is not because of co-operation as an organisational structure. The dominant form of corporate structure for over 100 years has been the shareholder-based joint stock company, and not organisations based on co-operative lines. But nevertheless, co-operation between firms is essential.

The most important reason for this is very simple. Complex economic systems contain many linkages between the different component parts. In an evolutionary context, we can think of a competitive relationship between two firms being expressed by a negative connection between them. If one does well, the other is likely to lose out, and its fitness is reduced. In contrast, a co=-operative relationship is positive. If one does well, the fitness of the other is increased, and vice versa.

Economic theory focuses exclusively on the competitive links. But these are dominated by the co-oerative ones. The structure of production is the reason why. Most economic activity does not involve the final consumer, the individual. It is business to business. So if a firm learns to produce something more efficiently, or if it innovates successfully, the companies to which it supplies benefit.

More generally, co-operation is needed to agree institutional structures in which economic activity can take place. And it is the basis of most contractual agreements. It is impossible to specify in complete detail most business-to-business contractual relationships – look at the massive difficulties caused by Brownite thinking on this in terms of the relationships between regulators and the regulated in the relevant sectors of the UK economy. A strong element of trust is required.

But all this co-operation, which pervades successful capitalist economies, has nothing to do with the organisational form of companies. It can, and indeed has, shown itself in a system dominated not by co-operative but by joint stock firms.

I have been interested in this for some time, and here is a very technical paper which examines what happens in an evolutionary system when most of the linkages are competitive and not co-operative.

Paul Ormerod, Managing Partner Volterra

The Folly of Wellbeing in Public Policy

The idea that Government policy should focus more on promoting wellbeing has been gaining support. Proponents of this view argue that happiness indicators have stagnated over decades because, they argue, governments have paid too much attention to maximizing a materially-based measure of economic welfare, Gross Domestic Product, rather than a more holistic indicator based on happiness.  This premise is clearly false.   Economics has undoubtedly been important in post-war political life, but it has not always been a decisive factor in determining the outcome of elections. Clinton’s Party lost the election in 2000 despite years of prosperity, Margaret Thatcher led the tories to re-election in 1983 despite the 1980-82 recession, and Tony Blair overwhelmingly defeated the Conservatives in 1997 after several years of strong economic growth. The fact is politicians do exhibit concerns over a wide range of issues where GDP is not the immediate focus.  For instance immigration and crime are two very live issues that no serious politician can afford to ignore. Yes, economics and economic policy matters to voters, but so do other issues, and it is wholly misleading to suggest that policy is focused solely on the maximization of GDP.    GDP as a concept has been criticized as it does not capture wider social and environmental costs and benefits within a society.  But the simple fact is that GDP was never intended to include them in the first place.  The purpose was to measure the value of the output of an economy, as far as possible using market based prices to do so. The question of measuring non-market output is conceptually different to that of happiness and well-being, but it is often confused with them in practice.  Namely:  Should we, and if so how, extend the concept of GDP to include more ‘non-market’ factors?   A wide range of adjustments to the basic measure of GDP have been suggested, such as weighting income by the degree of inequality, deducting the value of ‘bads’ such as time spent commuting, valuing work in the house, and so on.    However, the wellbeing movement goes far beyond tinkering with what is and what is not included in GDP. It suggests replacing it altogether with a measure which purports to describe not the material prosperity of a population, but its happiness.   Surveys on the levels of happiness reported by individuals have been carried out over a few decades in most Western countries. In general there is no apparent trend to be found, either up or down. Over the same period, average material standards of living (GDP per head) have shown a clear upward trend. This seems to support the old maxim ‘money does not buy you happiness’! The fact that measured happiness has not increased over decades is viewed by some commentators as indicating a flaw in our society which must be corrected through government intervention.  Indeed the lack of correlation between happiness and GDP is indicative of a similar non-trend across many other variables: expenditure, life expectancy, racial and gender inequality.  This suggests that attempting to improve the human lot through any policy – not just through pursuing economic growth - is entirely futile. Alternatively, we could conclude that happiness data over time shows little movement because it does not have much meaning.   When happiness is measured, people are asked to register their level of happiness on a scale of n categories (e.g. 1 = ‘not happy’, 2 = ‘fairly happy’ or 3 = ‘very happy’). Discrete categories mean that people have to undergo large discrete change in their happiness in order for this to be registered by the indicator so noticeable changes in average happiness can only come about through substantial numbers of people moving category. Furthermore the happiness data can exhibit no indefinite trend; in answering a survey in which levels of happiness are measured on an n-point scale, the data is therefore bounded between one and n. In contrast, at least as it is presently defined, real GNP can exhibit no upper bound.    More subtle recent work is in fact suggesting that there is a clear and positive connection between life satisfaction and income, and that there appears to be no cut-off point to this.  In a paper published in 2010 in the Proceedings of the National Academy of Science Daniel Kahneman and Angus Deaton distinguished two aspects of well-being.  First, life satisfaction, defined as the thoughts which people have about their life when they think about it.  Second, emotional well-being, which refers to the emotional quality of an individual’s everyday experience, the frequency and intensity of emotions such as joy, anger, sadness. The results of Khaneman and Deaton are striking.  Life satisfaction is unequivocally related in a positive way to income, but emotional well-being is not. In these recent studies, GDP does therefore appear to continue to have wider value as an indicator of a successful society, over and above its direct purpose of measuring material prosperity.   Despite such recent developments happiness advocates continue to insist that a single measure of happiness should be the only way of evaluating policy and progress. The problem is not merely that this lobby wants to replace GDP with a happiness index, it is the belief that by measuring happiness, it then becomes subject to prediction and control by policy makers. Of course, the fact that economics has made little or no progress in its ability to predict and control the macro economy might be seen to suggest that same fate awaits the happiness index and its devotees.  It is simply not possible to obtain systematically reliable predictions of aggregate happiness indices, any more than it is for GDP. We cannot predict with accuracy the next shake of a true dice, and neither can we do so for happiness.    Indeed, government attempts to increase measured happiness, rather than making life better for us, may well actually do the opposite: create arbitrary objectives which divert civil service. energies from core responsibilities; give many people the message that happiness emanates from national policy rather than our own efforts; and create pressure for Government to appear to increase an indicator which has never before shifted systematically in response to any policy or socio-economic change.   These are exactly the mistakes of the target-driven mentality which has come to pervade the British public sector.  We should learn from these rather than replicate them.   By Paul Ormerod. Read Paul’s full chapter on the subject in the recent IEA publication …and the Pursuit of Happiness available here.

Recessions as Collective Action Problems

In a blog on Keynes and Hayek I mentioned that I viewed recessions as collective action problems. In this blog I want to expand on what I mean by this because it makes all the difference for economic policy. It also contextualises our conventional demand management approaches, namely fiscal and monetary policy.

To build up the hypothesis, it is necessary to dip our toes in to a number of fields of study. But let us start with some empirical evidence and build the conceptual framework from there.
In his study of decision-making in the financial system, set out in his book Minding the Markets, Prof. David Tuckett from UCL interviewed 50 investment managers and analysed how they made decisions under conditions of uncertainty. Here I will take Prof. Tuckett’s conclusions and apply them to the phenomenon of recessions.

Prof. Tuckett explained how investment managers used narratives to help them make sense of the past, present and future. The amount and complexity of the information and the high degree of uncertainty they have to deal with can be staggering. So they develop narratives – mostly sub-consciously – to form what seems to be a cohesive pattern of understanding. This is also true of people in everyday life.
This is very different to conventional economics where “rational expectations” dominate. In this conventional approach, people are typically fully informed, have a particular (unchanging) model of how the economy works, and use these to determine their expectation of some variable in some fully predictable future.
By contrast, in reality people use narratives – again, subconsciously most of the time – in complex environments and these narratives can include some expectation of the future. People also typically have a sub-set of the information required to make decisions in their daily lives and, in complex social systems, the future is inherently uncertain.

Narratives form an important part of our framing of some situation or object but that is not to say they displace conscious analyses of the economy. The two are not mutually exclusive: narrative formation can involve a complex interplay of the conscious and sub-conscious aspects of the brain.
Narratives are also formed in part through social interaction. We listen to what others have to say: they influence us and we influence them, both at the same time. This important point means we are compelled to think of social systems as “Complex” (meant in the formal, Complexity theory sense), with people continuously interacting and co-evolving. The concepts of emergence and global cascades are useful for understanding how narratives are “exchanged”, how they spread, and how a particular narrative might become a “consensus” view among a group of people.

With these micro and system-wide points in mind, my argument is that recessions come about when a dominant narrative emerges within society, leading to behaviour that is consistent with a recession subsequently arising. If people believe a recession is likely, or imminent, they tend to behave “prudently” with respect to both consumption and investment. An important point is that the narrative of a recession and how people respond to that narrative make a recession both inevitable and self-fulfilling. In more technical language, there is “time-consistency” between the narrative-expectation and people’s behaviour.
An important difference between a recession narrative, which leads to a recession, and traditional theory is that in the latter, an economy is typically expected to gravitate toward some future full-employment equilibrium. For example, the models used by central banks (the terribly-named Dynamic Stochastic General Equilibrium models) normally show economies necessarily recovering following a recession. But if the consensus narrative is one of recession, and remains there, it is plausible that an economy can remain in that state, i.e. a “depression” narrative could emerge, reinforcing the slump. Alternatively put, a depression could be viewed as a sub-optimal equilibrium in a complex system.

I refer to recessions and depressions as collective action problems because they arise out of the collective action of agents in the system, operating in a way that is consistent with self-interest but which result in outcomes that are detrimental to all. An analogy is the Prisoner’s Dilemma game in game theory. As is famously known, the outcome in the Prisoner’s Dilemma is sub-optimal for both prisoners. If they could collude (a form of collective action), they could achieve a different outcome that is preferable for both. But this outcome is contingent upon the collusion being viewed as credible by both prisoners: some mechanism is required.

Now let’s turn to the policy implications of treating a recession as a collective action problem. In traditional macroeconomics, the mechanisms used to mitigate recessions (fiscal and monetary policy) are viewed as managing the overall level of demand in the economy. But if the narrative approach above is accurate, are these traditional tools of demand management sufficient for bringing about a recovery? Not necessarily.
What is crucial is the impact these policies will have on people’s narratives about the economy, not only their impact on “aggregate demand”. How these changed narratives influence individuals’ behaviour is another important question. A key point is that the overall impact of people’s changing narratives concerning an economy can dwarf demand management policies. A second key point is that narratives seem to be formed through an emergent process, which means prediction and control are highly problematic.
It is for this reason that I am sceptical of orthodox Keynesian approaches that imply a mechanistic view of the economy, whereby people adjust – deterministically – to macro management policies. Narrative formation is much more complex than that. Indeed, my colleague Paul Ormerod noted in November that the US appeared to be enjoying an expansionary fiscal contraction. This is possible if narratives change in favour of a recovery, leading to recovery-consistent behaviour by individuals, despite a fiscal contraction.
However – and this is a big however – demand management policies can and do influence narratives. But they should be viewed as one of a complex set of influences on how people view the economy, including its future.

UK GDP Growth (Source: ONS)

Before concluding, it is worth noting that these points relate to the fiscal policy debates of 2008-2010. During those debates the conventional Keynesian and Conservative perspectives were wheeled out. Keynesians said the fiscal deficit had to be expanded to counter a contraction in private demand; and Conservatives emphasised prudence to inspire “confidence”. A narrative-based framing shows that the Conservative perspective was not as unreasonable as Keynesians argued: we can re-state “confidence” through a narrative framing in stating that a prudent approach might inspire a shift away from a recession narrative to something more optimistic. But there is also a reasonable argument that a fiscal expansion might have inspired a recovery narrative. We will never know. What is clear is that we need to understand better how narratives emerge and perpetuate and how they can be influenced, including (if at all) by governments.
To conclude, I suspect that to those people not trained in conventional economics, this all sounds blindingly obvious. I would like to think that is because I started with a look at research based on empirical evidence, albeit based on the world of finance; and because I mixed this evidence with appropriate and cutting edge concepts from the new field of Complexity theory. But a lot more work needs to be done to deepen this framework, including by the academic community.

By Greg Fisher, Managing Director of Synthesis - associates of Volterra

HS2 gets Traction

Justine Greening has announced this week that HS2 will go ahead – which is enormously welcome. It is still surprising how many people have fallen for the proposition that is will be an expensive white elephant. Even the leader writers of the Financial Times have been captured by the Nimbys and the naysayers.
The fact remains that the long distance rail system is creaking at the seams. The West Coast Main Line is one of the busiest railways in Europe and managing its maintenance, even after its refurbishment, is a nightmare. The southern end, with massive commuter use, already needs more capacity. So we don’t just need HS2 to meet projected growth – we need it here and now.
Running infrastructure too close to capacity is risky, just as we see at Heathrow. This has to operate at 98% capacity, so that the slightest thing that goes wrong means lengthy trouble and hours to get the system back into normal running.
But the extra capacity will generate additional benefits. Accessibility is crucial to modern economies. With globalisation and the fact that cities are the focus of growth, intercity connectivity will be a key element in maintaining the UK’s economic performance. Our work for the Core Cities has shown that city centre growth will both generate and be generated by extra trips.

Bridget Rosewell

Minsky Mania: a Raincheck

The American economist Hyman Minsky is currently very fashionable, especially amongst those who are sympathetic to the idea of more government intervention in the economy.
Minsky argued that financial crises were an inevitable feature of capitalism, unless governments stepped in through regulation and central bank action.
He hypothesised that in prosperous times, when the corporate cash position became strong, exuberance developed which translated into a speculative bubble in asset and property markets. Private sector debt rose as borrowing increased to fuel the speculation, and at the ‘Minsky moment’ a crisis would occur. Following this, banks tighten credit, and even companies which are fundamentally sound may be driven out of business because of an unwillingness to roll over debt.
His theory is very seductive in the light of the experience since 2007.
But the theory does not explain why, over the past 80 years, we have only had two major financial crises, the early 1930s and the recent one from 2007. It is the dog which has not barked which causes fundamental problems for the hypothesis as it stands.
For example, in the United States, private sector debt relative to the size of the economy reached a peak of 2.1 in 1932. From a low point of only 0.4 in 1945, it rose almost without interruption to a new peak of nearly 2.2 in 2001. But there was no crisis. It reached 2.6 in 2006, much higher than its peak in the 1930s Great Depression. But again, no crisis.
The Minsky story is good at telling us after the event what happened in a crisis. It does not tell us why crises do not happen, even when the objective facts suggest they should.

Paul Ormerod

Health Spend At the Blair Benchmark

The Blair milestone has been reached. In a celebrated TV interview in the autumn of 2000 the then Premier Blair committed the government to raise NHS spending up to internationally comparable levels with our European partners or more widely with the OECD. Now our spending is over the OECD average –9.8 per cent of GDP compared to an average of 9.6 per cent. This is more than among others Finland, Australia and Italy. Spending on health per person is also now slightly above the OECD average at $3847 per person compared to the average of $3233.
For decades the problems of the NHS have been blamed on underfunding. It was said that the NHS may not have been the envy of the world but it was the envy of Finance Ministers. Now there are no more alibis. For the future there seems little chance of any large bail out where funds rise faster than inflation. The OBR Report paints a picture of falling tax revenues and might have said more about the forward commitments on public spending especially for an increased number of retired who expect improved public sector benefits and may not get them The NHS has its own forward commitments for PFI schemes and technical improvements.
The NHS and the private health sector are now much more important for the productivity of the whole economy than they were when the health service accounted for 3 per cent of GDP as was the case in 1950. There is also the potential for further drag on the economy as demand expands. Health services have a hidden economic and human opportunity cost in that they employ a large proportion of the most highly qualified personpower. How can we create conditions which would ensure that these abilities are fully used?
The key lies in a new drive for redesign of services. We have to improve quality and patient access for a level of funding which will be at best static in real terms. Yet we have a high cost, high tech model where spending has been growing by 4.8 per cent p.a. in real terms. Volterra is committed to working with health partners to make a creative and effective response to this rather large and threatening challenge.
There is an emerging model of healthcare which can deliver better services for patients. The model has four stages in prevention, early diagnosis, ambulatory treatment and care programmes. There is clear evidence from Scandinavia and from HMOs in the US that such a model can deliver better health for populations while containing costs.
Premier Blair in fact came to realize that his commitment to Euro level of spending was not enough for a good health service—for this were needed incentives and competition and patient choice. The agenda is still there and now inescapable.

(1)OECD Health at a Glance 2011. Key Findings United Kingdom.

By Nick Bosanquet, Director Volterra Health