A year ago the world economy faced almost total collapse. We have stepped back from the brink and now it is appropriate to try to understand the causes of the failure. I put a lot of the blame at the door of the economics profession.
My PhD supervisor first introduced me to the economics of walking about. You ask people what's going on in their lives and take seriously the answers they give you. And you pay close attention to the data. This follows a long tradition in my field of labour economics, dating back to John Dunlop, Clerk Kerr, Al Rees, Richard Lester, Sumner Slichter and H Gregg Lewis, that emphasises the importance of observation.
Unfortunately, many fields in economics have been taken over by a bunch of mathematicians who have little or no interest in what is happening inside factories, banks, hedge funds, shipyards, building sites and small firms. Practical experience of the real world has been lacking, and that has been a costly error.
Economics has long been dominated by what Paul Krugman refers to as freshwater economists (from Chicago) and saltwater economists (from Princeton and Harvard). Unfortunately, neither school was much interested in looking into the muddy waters of the data. Untested theory dominates. Shame on them.
Many policy failures of the past few years are the result of large parts of the field of economics becoming more like theology than science. Science moves forward by testing theory against data, but not in economics in general and macroeconomics in particular. I recall a conversation with one extremely well-known economist who, when confronted with the fact that his model did not fit the data, asserted that he simply preferred his model to a "reduced-form correlation", ie, the real world. Sadly, policy was made on the basis of such mindless absurdity.
Indeed, the Nobel laureate Bob Solow argued recently in the Journal of Economic Perspectives that "modern macro" has been "notable for paying very little rigorous attention to data . . . there is nothing in the empirical performance of these models that could come close to overcoming a modest scepticism. And more certainly, there is nothing to justify reliance on them for serious policy analysis."
I sat for many hours at the Bank of England listening to one unsubstantiated assertion after another, trotted out as if it were truth. I remember being especially bemused by the frequent arguments that there was no relation between house prices and consumption, despite there being a pretty strong one in the data for the previous hundred years. But in any case, the proponents argued that both variables were determined by something else, permanent income, which unfortunately is unobservable in the real world. A further practical difficulty is that there is very little empirical evidence to suggest that the permanent income hypothesis - which links an individual's consumption at any point in time to the total income earned by that individual over his or her lifetime - is true. So that doesn't seem like a great basis on which to make policy. But policy was made on it. Painful.
The problem with the training of young economists is the emphasis on the need to be able to write down complicated mathematics, as if that told you anything about the world. Assume this, maximise that, assume rational expectations, add a further twist of this and a dash of that, and, hey presto, you have a set of (bad) policy prescriptions. This has been a cul-de-sac.
The Bank of England has 12 "Agents" who produce monthly scores of how the economy is performing based on intelligence they receive from walking around the country talking to businesses. At our Monetary Policy Committee (MPC) briefing meetings, the agents usually had ten minutes at the end of a three-hour session. Nobody paid any attention to what they said. Wrongly, it turned out. Their scores picked up the onset of recession very early. This can be seen from the chart above, which plots the agents' scores on capacity constraints within firms in both manufacturing and services, compared to the average. It is clear that these data started to turn down in mid-2007. There are numerous other examples, including the agents' scores for turnover, output, investment and recruitment difficulties, which all started to drop off a cliff around the spring of 2007. The MPC ignored these data, and as late as August 2008 the majority were arguing that there was not going to be a recession. Economics of walking about = 1, macroeconomists = 0. Home win.
The Bank of England missed having practical folk in charge who had the mobile telephone numbers of bankers and lawyers who could have helped to ease the pain of the crisis. Bleating moral hazard - the idea that a party insulated from risk may behave differently than it would if fully exposed to risk - didn't help Northern Rock much. Deals in (non-)smoke-filled rooms would have helped. Where were the lawyers who understood that the European law was not designed to prevent banks being rescued? They were let go years earlier, along with the market intelligence folk, the small-firm specialists and the regulators, to name but a few. They were replaced with lots of economists who had no idea what to do on Saturday at midnight, as the next bank was about to fail. For goodness' sake, banking crises are as old as the hills.
Old-style central banking, please come back. Central bankers need to be people with experience of the real world, rather than academic economists who live in what Larry Summers has called the stochastic pseudo-world. People who understand the economics of walking about are what we need going forward.
Economists should surely take only one seat at the policy table, not all of them. We would all be better off if folks with experience of the real world took their place at the table. It's time for practical people to stand up and say those darned economists who thought they knew so much have no clothes. They messed up. It's time to move over. The economics of walking about has returned.
David Blanchflower is professor of economics at Dartmouth College, New Hampshire, and at the University of Stirling