Zombie economics: how dead ideas still walk among us

John Quiggin interviewed by Viv Davies, 03 December 2010

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<p><em>Viv Davies interviews John Quiggin for Vox</em></p>
<p><em>November 2010</em></p>
<p><em>Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5879]</em></p>
<p><strong>Viv Davies</strong>: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Centre for Economic Policy Research. It's the 30th of November, 2010 and I'm in London talking to John Quiggin, Professor of Economics at the University of Queensland in Australia. Professor Quiggin has recently published a book entitled<em>, Zombie Economics: How Dead Ideas Still Walk Among Us</em>. The book examines a number of economic theories and ideas that, in the author's opinion, should have been killed off by the financial crisis. Yet, like zombies, they refuse to die. I began by asking Professor Quiggin to outline the thinking behind the book and to explain why it needed to be written.</p>
<p><strong>John Quiggin</strong>: Well it's about ideas in economics, some theoretical and some empirical, that, in my view, should have been killed by the global financial crisis, but remain influential in one form or another. It started just with some posts on the Crooked Timber blog where I tried to list some of those ideas, why I though they didn't stand up anymore. And people wanted more of it, so that's how it eventually turned into this book.</p>
<p><strong>Viv</strong>: So maybe you can elaborate a little on each of these zombie ideas, as you call them, in turn. The first idea that you think is dead and should be buried once and for all is the idea of the so called Great Moderation, that many suggest began in 1985 and initiated a period of unparalleled macro economic stability. You question whether the Great Moderation was a real phenomenon or whether, as you put it, it was an over optimistic interpretation of the data.</p>
<p><strong>John</strong>: Yes. Well, focusing on the US, it really comes down to the fact that they had two cycles in which the recessions around about 1990 and in 2000, were relatively mild, certainly in terms of GDP growth. That's a relatively weak lead, I would say, to build such a story on. It really rested on the belief, of course, that that was going to continue for a long period in the future. And that the policies of the US Federal Reserve were stabilizing in the long run. Whereas, in retrospect, I think it's clear that what they were doing, particularly after 2001, was staving off the crisis in the short term, but producing an even more severe crisis in the long run.</p>
<p><strong>Viv</strong>: Do you believe that, a significant number of economists are of the opinion that the global financial crisis was just a blip, and that we'll soon be back to business as usual?</p>
<p><strong>John</strong>: Well of course I cite in the book a couple of economists writing on VoxEU precisely using that term - a transitory volatility blip. I suspect relatively few people believe that in quite such strong and explicit terms, but if we see the way the economics profession is going on, and particularly the way in which central banks are pursuing policies, they really are on the assumption that we can put this episode behind us and then go back, essentially, to the policies of that period from the early '90s to 2007 when interest rate targeting was the chief instrument of policy, and when the job of fiscal policy was to keep deficits down, just to get out of the road of monetary policy.</p>
<p><strong>Viv</strong>: Your second zombie is the efficient markets hypothesis, which many considered to be the central doctrine of market liberalism. You maintain in the book, the efficient markets hypothesis created the climate that produce the global financial crisis. Can you explain this in some more detail for us? In particular perhaps outline what you consider maybe the implications for the future of financial regulation.</p>
<p><strong>John</strong>: Yes. Well, the efficient markets hypothesis is more properly, I guess, the complete efficient financial markets hypothesis. So it's the argument that really the prices generated in financial markets are the best possible estimate of the value of any asset, given all the available information. If you believe that then there can never be things like bubbles or panics, the kinds of things that, in fact obviously, for anybody not ideologically committed to that hypothesis, we saw in 2000 and saw again in the global financial crisis. Once we accept that that hypothesis is false, we come back to the older view that large and unregulated financial markets are not a stabilizing force in the economy, as was implied both by efficient markets hypothesis and by the theories of global moderation, but are in fact much more likely to destabilize the economy. And that, in turn, suggests an approach to regulation which is much more devoted to constraining the size of the financial sector, much more suspicious of financial innovation. Seeing financial innovation in the majority of cases not as being new and better ways to spread risk, but newer, better ways to hide risk from regulatory constraints. So you certainly have a view that would suggest a smaller financial sector, one that was more tightly regulated in the kinds of offerings it made and one that didn't generate the kind of outsized returns and incomes that the current financial sector does.</p>
<p><strong>Viv</strong>: By far the biggest chapter in the book focuses on the established economic theory of dynamic stochastic general equilibrium, or DSGE. You suggest that the underlying micro foundations of DSGE are of little us in understanding the macro economy.</p>
<p><strong>John</strong>: Yeah, that's right. This was the most challenging chapter of the book to write, because it's not an area I'm a real specialist in, but it certainly struck me for a number of observations. We have developed, over the past 30 years and I go over the history of that, a very elegant and elaborate macro theory. But in practice, if we look at the kind of debates that are being conducted about macro policy now, they aren't drawing on that theory at all, to any significant extent. We're really talking about questions like the size of the multiplier, the existence or otherwise of crowding out, the role of animal spirits. All the kinds of things that really we were talking about in the last big episode of macroeconomic disruption back in the 1970s. And part of the story, I think, is precisely the micro foundations, which is the essential demand that led to the creation of this intellectual structure was...following on from the 1970's, the Lucas critique of Keynesian policy and so forth, was the idea that we needed to base macroeconomics on the same micro foundations as had been relatively successful in microeconomics. I think that's mistaken for a number of reasons.</p>
<p>One, I think it's not at all clear that even in microeconomic contexts, people behave in the way that the textbooks suggest. Instead it's more reasonable that abstractions that work reasonably well in the micro context - things that you don't really need to worry about, for example if there was animal spirits whether they found trusting or not &ndash; people are still going to choose between apples and oranges in much the same way. When it comes to macroeconomics I think those issues become a great deal more important.</p>
<p><strong>Viv</strong>: And you suggest that, if we were to develop a macroeconomic theory that can help us understand economic crises and improve probable responses, then we have to look in a very different direction.</p>
<p><strong>John</strong>: I think we do. I think the big difficulty with the DSGE approach is not that it gives a range of answers from broadly New Keynesian to Classical. But it can never go very far from that starting point of general equilibrium. And so if the economy is far away from general equilibrium, we're really not likely to achieve adequate modeling by doing what Olivier Blanchard, as I quote in the book, says is &ldquo;general equilibrium with a twist&rdquo;.</p>
<p><strong>Viv</strong>: There's a section in each of the chapters in the book that considers current attempts to re animate these dead ideas. But one concept that you consider to be very difficult to kill off is trickledown economics. Why do you consider trickledown economics to be a zombie and why should it be such a worthy candidate for immortality?</p>
<p><strong>John</strong>: Well it certainly, as I mentioned, has been around essentially as long as there are rich people and poor people. Rich people will find it convenient to encourage other people to say that this is all for the best. Aesop's Fables has a whole bunch of examples, all of which inculcate the lesson that the poor should not grumble about the rich. The bible, in most of the standard interpretations, the one's that are taken popularly, typically tells that same story. Quote the hymn All Things Bright and Beautiful, which includes the line, &quot;The rich man in his castle, the poor man at the gate. God made them high and lowly and ordered their estate.&quot;</p>
<p>So that kind of view has, I think, been around and is unlikely ever to go away. Nonetheless, I think empirical evidence of the last 30 years has been that...the spectacular growth in the incomes of the ultra rich, particularly in the US, hasn't been accompanied by a corresponding improvement in the standards of living of people, particularly in the bottom half of the income distribution.</p>
<p><strong>Viv</strong>: Your final zombie is privatization and this has been a highly political issue, particularly in the UK, for a number of years. And, paradoxically, as you point out in the book, with more privatization of ownership, one might have expected less regulation. But in the UK, the opposite has been the case. I wonder if you could comment on that and also talk about the benefits of real mixed economy, as opposed to the so called &quot;third way&quot; that was offered by political leaders like Blair and Clinton.</p>
<p><strong>John</strong>: Sure. The striking thing is, of course, that if you look at the early advocates of privatization under Thatcher... I'm thinking particularly of people like Littlechild and Beesley, their assumption was that the only reason we had large monopolies in those eras was because the government had created them. That if only we would get the government out of the way, we would soon have a thriving, inventive industry. But in fact the realities that led to public ownership were typically that those were industries which had substantial tendencies to monopoly, substantial network effects, substantial externalities. All of which require regulation in one form or another. In abandoning public ownership, you abandon one form of regulation in which ownership and control are together and you have to have separate one which is one where you have a set of owners looking to maximize their profits and set up external regulators trying to keep those profits to a reasonable level and also to steer the enterprise in a socially desirable direction. Now, you can toss around different views of the relative merits of those models, but they're clearly not nearly as far apart as the advocates of privatization had hoped.</p>
<p>And furthermore, I think, what we see is that the difficulties of pushing that model have been greater and greater, the further that reform is pushed into the traditional areas of the public sector. The Third Way, I think a lot of it...There are a bunch of things, of course, wrapped up under that label, but a significant thrust of it was the belief that we could make much more use of market forces in core public serves like health and education if we did it in clever kinds of ways.</p>
<p>And my view is that really those things haven't come to very much. The fundamental difficulties which economists have long pointed to in making markets work haven't gone away and can't be wished away by the kinds of rhetoric that was characteristic of the Third Way.</p>
<p>And that, I think, says that we really...looking at future economic organization, clearly of course, there was until the 1970s a widespread belief that private ownership withered away and disappeared. I think very clearly that we now have a very good understanding of why public ownership doesn't work at all well in large sectors of the economy. The subsequent 30 years ought to have told us that in other areas we need substantial regulation, with or without public ownership. And in other areas, the cost of trying to set up a regulated framework around a private profit-making provider are too great.</p>
<p>And we really need some combination of public provision or perhaps publicly-funded NGO provision, is another model at that end of the spectrum. But there's a wide range of economic situations, some of them conducive to the successful operation of the profit motive and some not.</p>
<p>And of course another really huge question, which I didn't raise here, but essentially is the role of the financial system. And indeed the extent to which a largely unregulated profit-making financial system is in fact a desirable social institution.</p>
<p><strong>Viv</strong>: So where do we go from here? Are you optimistic that you can kill of the zombie ideas that led us into the financial crisis?</p>
<p><strong>John</strong>: Well certainly...although we seemed to be making more progress a year ago than I would say we are now, we really have seen these ideas come back in various forms in both the US and Europe. Even without any obvious rationale, but we're just seeing people doing the same things as they were doing before the crisis on the assumption, apparently, that they're going to work better this time. And so it is clearly a big need to keep on hammering the point that the ideas have been discredited by experience. But the other thing that's lacking, which I try and make some pointers towards in the book., clearly in a situation unlike the 1970s and unlike the period after the Depression, there's no readymade alternative that people can point to and say, &quot;Well I'm going to adopt this body of theory to replace the old body of theory.&quot; Keynes was there after the Depression and the vast majority of the profession became Keynesian. In the 1970s there was first Milton Friedman and monetarism and then more broadly the resurgence of free market economics in micro and macro that seemed to offer an answer, certainly, to the values of the Keynesian social democracy of that period. We don't have that now and I think the economics profession has a long way to go to deliver the kinds of alternatives we need.</p>
<p><strong>Viv</strong>: That's very interesting. You suggested in the book that one of the difficulties facing academics right now is that they're locked into their syllabus and they're teaching commitments. Those are long term and it's hard to turn the ship around in many ways and so there's a resistance to even thinking through these implications of all this.</p>
<p><strong>John</strong>: Absolutely. I think if you use a facility like Google Scholar, look at things like DSGE or the efficient markets hypothesis. First, yeah, there are vast numbers of papers being turned out. While some of those, to some extent at least, are critical reflections or attempts to modify those theories in the light of the crisis, there's also a vast body of what Kuhn might have called normal science. Stuff going on, really as if the crisis never happened, just continuing projects that really tend to reflect very much pre crisis thinking.</p>
<p><strong>Viv</strong>: Yeah. So there's no Keynes around now, there's no Friedman. But there is a really vibrant community on the internet of economists just like you. You're a major blogger at Crooked Timber and you say in this book that the book couldn't have been written without significant contributions from other bloggers. Do you think that the new age Friedman or the new age Keynes is actually a collective?</p>
<p><strong>John</strong>: I suspect so. I think perhaps the days of the great man, I guess, probably are behind us. Certainly I think, looking at the kinds of things that need to be done, I don't see it being a single bold theoretical stroke, like Keynesianism or even the repetition of an eternal variety, which roughly speaking is what Friedman did of course. He made his own sophisticated contributions, but broadly speaking, his primary message was, the good old quantity theory of money is true and always has been. I don't think either of those kinds of messages, for which a single prophet perhaps decides what we need... We really need lots of movement in lots of different directions to an economics that's more realistic and more concerned with the actual facts and with the impacts on people. And, I guess, also less prone to the kind of professional hubris that we certainly were displaying as a profession during the latter years of the Great Moderation.</p>
<p><strong>Viv</strong>: So given that, there are no hard and fast solutions in the book. But in terms of general direction of economics, what are your thoughts on that?</p>
<p><strong>John</strong>: Well I think we really need to move beyond the kind of ultra rational individual, possibly with some other twists that populates the micro textbooks and is the basis of DSGE macro. There's a whole field, some of it under the brand &ldquo;behavioral economics&rdquo; and some other work that's fairly similar might not use that brand, but things that take a more general view of the kinds of decisions people make. And things that recognize that people cannot be unboundedly rational. Not because people are dumb, but because the world is an incredibly complex place. Even the most sophisticated financial trader, all the time must be unaware of some relevant possibilities. Sometimes those possibilities come in and bite people. If enough people suddenly realize a new possibility at once, we can have a panic or perhaps a euphoric bubble emerging as people discover these new things. So that, I think, gives us a more promising approach to account for things like the Minsky's Financial Instability Hypothesis, than attempts to explain all these things with ultra rational individuals during their infinite time optimization process.</p>
<p><strong>Viv</strong>: An interesting last word that you leave us with in the book, where you talk about what is needed in economics...To summarize, you say, we need more on realism, less on rigor, more on equity, less on inefficiency, more on humility and less on hubris.</p>
<p><strong>John</strong>: Certainly. And I fear we are seeing efficiency and rigor and particularly hubris re emerging in the kind of policy responses we're now seeing under the banner of austerity.</p>
<p><strong>Viv</strong>: John Quiggin, thanks very much for talking to us today.</p>
<p><strong>John</strong>: Thank you. <br />

Topics:  Frontiers of economic research Global crisis

Tags:  financial crisis, economic theory, economic policy

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John Quiggin

Australian Research Council Federation Fellow in Economics and Political Science, University of Queensland


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