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Adam Smith is considered the founding father of modern economics.
Adam Smith is considered the founding father of modern economics.

Economics has met the enemy, and it is economics Add to ...

The confusion is understandable, and deliberate, according to Philip Mirowski, an economic historian at the University of Notre Dame. “It's part of the PR trick,” Prof. Mirowski argues. Awarding the economics prize immediately after the prizes for physics, chemistry and medicine helps to place economics on the same level as those other natural sciences.

The prize also has helped to transform one particular ideology into economic orthodoxy. Prof. Mirowski, who is co-writing a book on the history of the economics prize, notes that throughout the 1970s and 1980s, economists whose work supported neoclassical, pro-market, laissez-faire ideas won a disproportionate number of those honours, as well as support from the increasing numbers of well-funded think tanks and foundations that cleaved to the same lines. People who rejected those ideas, or were skeptical of the natural sciences model, were quickly marginalized, and their road to academic advancement often blocked.

The result was a homogenization of economic thought that Prof. Mirowski believes “has been pretty deleterious for economics on the whole.”

The road to hell is paved with good intentions,

rational expectations and efficient markets

Many critics of neo-classical economics argue that it has a powerful pro-market bias that's provided an intellectual justification for politicians ideologically disposed to reduce government involvement in the economy.

The rational-expectations model, for example, assumes that consumers and producers all inform themselves with all available data, understand how the world around them operates and will therefore respond to the same stimulus in essentially the same way. That allows economists to mathematically forecast how these “representative” consumers and producers would behave.

During a recession, say, a well-meaning government might want to enhance benefits for the unemployed. Prof. Sargent, for one, would caution against that, because a “rational” unemployed worker might then calculate that it's better to reject a lower-paying job. He's blamed much of the chronically high unemployment in some European countries on the presence of an army of voluntarily unemployed workers, and spoken out against the Obama administration's recent efforts to extend unemployment benefits.

Indeed, under the rational-expectations model, most market interventions by governments and central banks wind up looking counterproductive.

Meanwhile, the efficient-markets hypothesis, developed by University of Chicago economist Eugene Fama in the 1970s, has dominated thinking about financial markets. It posits that the prices of stocks and other financial assets are always “efficient” because they accurately reflect all the available information about economic fundamentals.

By this reasoning, there can be no speculative price bubbles or busts in the stock or housing markets, and speculators with evil intentions cannot successfully manipulate markets. Conveniently, since markets are self-stabilizing, there's no need for government regulation of them.

Critics point out that both these theories tend to ignore what John Maynard Keynes called the “animal spirits” – playing down human irrationality, inefficiency, venality and ignorance. Those are qualities that are hard to plug into a mathematical equation that purports to model human behaviour.

These models also have failed to take into account the profound changes wrought by globalization, and the growing importance of banks, hedge funds and other financial institutions. Yet they have successfully provided a “scientific” cover for an anti-regulatory political agenda that is popular on Wall Street and in some Washington political circles.

Inside jobs: Pay no attention to that banker behind the curtain

The Great Depression of the 1930s led many economists of the day to question some of their discipline's most fundamental assumptions and produced a decades-long heyday for Keynesian economics. So far, the Great Recession has led to less of a fundamental shift.

Notre Dame's Prof. Mirowski believes that more rethinking is necessary. “Everyone thought the banks would have to change their behaviour, but they got bailed out and nothing changed. The economics profession has also been bailed out because it is so highly interlinked with the financial profession, so of course they don't change. Why would they change?”

Indeed, economics may be the dismal science, but there is nothing dismal about the payoffs for those at the top of the heap serving as advisers and consultants and sitting on various boards. Unlike some disciplines, economics has no guidelines governing conflict of interest and disclosure.

In 2010, the Academy Award-winning documentary Inside Job exposed several disturbing examples of academic economists calling for deregulation while working for financial-services companies. And in a study of 19 prominent financial economists, published last year by the Political Economy Research Institute at the University of Massachusetts Amherst, 13 were found to own stock or sit on the boards of private financial institutions, but in only four cases were those affiliations revealed when they testified or wrote op-eds concerning financial regulation.

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