New economic thinking

LAST weekend, over 400 top economists, thought leaders, three Nobel Laureates and participants gathered in Hong Kong for the fourth Annual Institute for New Economic Thinking (INET) conference, co-hosted by the Fung Global Institute, entitled “Changing of the Guard?”



So what was new?

In the opening session, Dr Victor Fung, founding chairman of Fung Global Institute, quoted Henry Kissinger as saying, “Americans think that for every problem, there is an ideal solution. The Chinese, and Indians and other Asians think there may be multiple solutions that open up multiple options.”

That quote summed up the difference between mainstream economic theory being taught in most universities and the need to build up a new curriculum that teaches the student to realise that there is no flawless equilibrium in an imperfect world and that there is no “first-best solution”.

Instead, what is important is to teach the aspiring economist to ask the right questions, and to question what it is that we are missing in our analysis. It is important to remember that theory is not reality, it is only a conceptualisation of reality.

Nobel Laureate Friedrich Hayek, one of the leading thinkers on open societies and free markets, explained why the practice of mainstream economics is flawed. In 1977, he said, “A whole generation of economists have been teaching that government has the power in the short run by increasing the quantity of money rapidly to relieve all kinds of economic evils, especially to reduce unemployment.

Unfortunately this is true so far as the short run is concerned. The fact is that such expansions of the quantity of money, which seems to have a short-run beneficial effect, become in the long run the cause of a much greater unemployment. But what politician can possibly care about long-run effects if in the short run he buys support?”

Sounds familiar on present day quantitative easing?

In his 1974 Nobel Laureate Lecture entitled “The Pretense of Knowledge”, Hayek showed healthy scepticism: “This failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences an attempt which in our field may lead to outright error.”

Hayek understood what is today recognised as quantitative model myopia. What cannot be easily measured quantitatively can be ignored. Then it is a small step to assume that what can be ignored does not exist. But it is precisely what cannot be measured and cannot be seen the “Black Swan” effect that can kill you.

In other words, economists must deal with the real world of asymmetry information, that there exists Knightian uncertainty, named after University of Chicago economist Frank Knight, what we call today unknown unknowns.

Unknown unknowns arise not just from accidents of Mother Nature, but from the unpredictability of human behaviour, such as market disorder, which is clearly complex and ever-changing.

If unknown unknowns are common in real life, then a lot of the economic models that appear to give us precise answers may be wrong. In other words, for every question, there is no unique answer and the solutions are “indeterminate”.

George Soros, who helped found INET, explained his theory of reflexivity based on the complex interaction between what he called the cognitive function (human conception of reality) and the manipulative function (the attempt by man to change reality).

His theory of reflexivity in markets differs from mainstream general equilibrium theory in one fundamental aspect. General equilibrium models assume that market systems are self-equilibrating, going back to stable state. Borrowing from engineering systems theory, we now know that this is a situation of negative feedback a system that gets disturbed fluctuates smaller and smaller till it returns to stable state.

The trouble with nature and markets is that positive feedback can also happen. The fluctuations get larger and larger until the system breaks down. Nineteenth century Scottish scientist James Maxwell discovered that steam engines can explode if there is no governor (or automatic valve) to control the steam building up.

At about the same time, English bankers learnt that banks can go into panic regularly without the creation of a central bank to regulate the system. Markets therefore need a third party the state to be the system “governor”. Free market believers think that the market will take care of itself. John Maynard Keynes was the first to recognise that when free markets get into a liquidity trap, the state must step in to stimulate expenditure and get the economy out of its collective depression.

In the 21st century, we have evolved beyond Keynes and free market ideology. Belief in unfettered markets has created a world awash with liquidity and leverage, but the capacity of advanced country governments to intervene Keynesian style has been constrained by their huge debt burden.

Larry Summers has pointed out that Keynes invented not a General Theory, but a Special Theory for governments to intervene to get out of the liquidity trap. The fact that we are still struggling with the liquidity trap means that economists are searching for new solutions, such as borrowing from psychology to explain economic behaviour.

The INET conference introduced the thinking of French literary philosopher, Rene Girard, and his theory of memetic desire, to explain how social behaviour more often than not get into unsustainable positive feedback situations, either excessive optimism or pessimism. How do you get out of such situations? Girard introduced the concept of sacrifice. We will have to wait for the next conference to explore this new angle.

Intuitively, all life is a contradiction. The sum of all private greed is not a public good. It does not add up. Someone has to sacrifice, either the public or a leader.

Schumpeter's great insight about capitalism is that there is creative destruction. He only restated the old Asian philosophy that change is both creative and destructive. But out of change comes new life.

In sum, contradictions are creative. What is new is often old, but what is old can be new.

 
Tan Sri Andrew Sheng is president of Fung Global Institute.