The economy doesn't work

I'm not an economist. I'm a journalist. But macroeconomics has played a very important role in my professional life. Academic macroeconomists have influenced the way I think about economics. They have also influenced politicians such as Gordon Brown in the 1990s. His first move as Chancellor of the Exchequer was to make the Bank of England independent. He followed to the letter the manual of orthodox macroeconomics. Bill Clinton, when he was elected president of the United States in November 1992, gathered a group of academic economists at a congress to advise him on his future economic policy. In the 2000s, academic economists became star central bank governors, such as Ben Bernanke in the United States or Mervyn King in the United Kingdom. In the television series The West Wing, the president of the United States was portrayed as a Nobel Prize-winning economist.

This is unthinkable today. The macroeconomist's light has gone out. Just as its rise influenced politics, so will its downfall. Virtually all of our economic policy regimes are based on orthodox macroeconomic models that have developed from the late seventies to the present day. Central bank independence, inflation targeting, and fiscal rules owe their existence to ideas deeply rooted in these models.

The problem is that these models stopped working a long time ago.

This news has also reached central banks. Christine Lagarde, president of the European Central Bank, recently made a revealing comment about "changes in economic relations and ruptures of established balances." What he meant was that orthodox economic models, on which the ECB and other central banks have become dependent, no longer capture what is happening.

If you look at central banks' inflation forecasts, you'll see why. Over the past decade, these forecasts almost always pointed to inflation returning closer to the central bank's target. In the UK and the Eurozone, this target is 2%. But inflation has not matched predictions. It was stuck well below target for the past decade, and is now stuck well above. The problem is not that the forecasts are wrong, but that they have an optimistic bias. They don't tell central bankers what they need to know, but what they want to hear.

A dart-throwing monkey or an impartial astrologer would have been more accurate than central banks' economic models. I'm not recommending that central banks start hiring monkeys or engaging in the dark arts. But there are many ways they can improve the results of their forecasts without turning to economists. If a monkey can do better than the model, many humans can too.

Bad forecasts are just the tip of the iceberg. Behind it is a much deeper problem: the inability to understand what is happening. The Queen of England once asked why economists didn't see the global financial crisis coming. The answer, perhaps surprising, was that finance was underrepresented in their models. They also make questionable assumptions about human behavior. They assume that human beings are rational. Behavioral psychologists have proven beyond reasonable doubt that this assumption is wrong. But as an economist friend of mine joked, "No economist has ever given up his model just because the evidence meddled."

Readers could be forgiven for asking why economists don't change their models. The answer is that they have dedicated their professional career to developing them. It's like being a German car manufacturer in a world of electric cars.

My theory is that computer scientists and mathematical statisticians will be the ones who will develop the next generation of models. The methods of Artificial Intelligence and deep learning will play a more prominent role to the detriment of traditional macroeconomics. Personally, I still find some elements of macroeconomics useful. But it's the usual stuff, the parts that went out of fashion in the 1980s.

However, those who will most feel the impact of all this will be governments and central banks. Before the 1990s, central banks did not have inflation targets. These goals only existed because the models indicated so. Before, price stability fell into the category of "I'll know when I see it." We could come back to this.

The whole idea of central bank independence was based on the notion that models work better than political ones. This claim is difficult to sustain when monkeys outperform models. I wouldn't be surprised if the Bank of England was the first of the big central banks to raise the white flag when it comes to inflation. Wouldn't some politicians like to at least wrest control from a dysfunctional central bank?

Or look at fiscal targets. They also come from the depths of modern economic orthodoxy. A specific problem with these models is their concept of potential output, the output that an economy can generate when it is at full capacity. One of the reasons we all ended up suffering from austerity was a misappreciation of how the financial crisis affected potential output.

Here, too, there is a warning to the Labour Party. Gordon Brown broke with the past when he made the Bank of England independent and when he introduced a new tax regime. It laid the foundations for 13 years of Labour government. But it was the period during which the model worked. It cannot be extrapolated to a period when it no longer works.

If they cling to today's economic orthodoxy, politicians risk falling under the influence of what John Maynard Keynes called "defunct economists." The jackpot of British politics will go to the politician who finds a way to break with the existing order. Liz Truss failed for reasons we all know. But clinging to a dysfunctional orthodoxy is not sustainable either.

Wolfgang Münchau is Head of www.eurointelligence.com
Translation at News Clips.

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