Big ideas - Our economists are no longer autistic

Economics - "Monetarism lite" may rule the world, but "the dismal science" has begun a renaissance b

In economics the intellectual cold war, the clash between monetarists and Keynesians, right and left, reached its bitter climax in the late 1970s and early 1980s. The electoral victories of Ronald Reagan and Margaret Thatcher offered monetarists in the US and UK an opportunity to put their theories about how to manage the economy into practice. Past policies had failed: both inflation and unemployment were unacceptably high, contrary to the textbook Keynesian view that if one went up, the other should go down. Monetarism solved the inflation problem, but at a price in lost jobs and outputs that its advocates had not foreseen.

This titanic battle of big ideas was as much of its era as bell bottoms and platform shoes. There is now a firm professional consensus on how to manage economies. It says that fiscal policy (the government's plans for overall levels of tax and spending) should keep budget deficits low and cannot be used to steer the business cycle without dire consequences. (Almost every professional economist is alarmed about the size of the current US deficit.)

Monetary policy (the level of interest rates and credit) is accepted as a much more effective tool for stabilising the level of output and jobs - but should be set according to clear rules and kept largely out of the hands of politicians. Political pressures make for overreactions, like people who are too impatient for the water temperature to adjust when they turn the gauge on the shower and end up alternately freezing and scalding.

There are still debates in macroeconomics, but mainly about the global economy. Should exchange rates be fixed or flexible? What kinds of capital controls work best? These are pragmatic rather than ideological debates. "Monetarism lite" rules.

Despite this, and although few have noticed it, economics has begun an intellectual renaissance. Prompted by the availability of extremely cheap computer power and the development of statistical techniques for drawing conclusions from large amounts of economic and social data, it is enjoying one of its most exciting eras since the days of Adam Smith and David Ricardo. In two of the past four years the Nobel Prize has gone to econometricians, who specialise in the application of statistical theory to economic data.

In other words, for the first time since the birth of economics, it is possible to live up to the promise of a scientific assessment of human society. Take some recent examples from the academic journals. Do extra police on the streets cut crime rates? (Yes, in the immediate local area.) Would it be cheaper for the NHS to run a simple, "no fault" medical compensation scheme such as the one operated in Sweden, rather than the present scheme based on proving negligence in complex court cases? (No, because the number of claimants would rise so much.) Do state pensions reduce private savings for old age, as some conservatives claim? (Yes, except for those on low incomes who never earn enough to save.)

Specific hypotheses such as these, bearing on important policy decisions, are increasingly being confronted with evidence and properly tested. Economics is becoming more like natural sciences such as epidemiology, geology or biology.

There is also a growing interest among economists in the overlap between their own subject and other sciences which investigate human behaviour, notably psychology and evolutionary biology. One of the strands of research involves laboratory experiments, seeking to understand how people react in all kinds of contexts, from tipping cab drivers to negotiating over water rights. Again, the work has led to Nobel prizes. Behavioural economics - which hit the bestseller list in the shape of Robert J Shiller's Irrational Exuberance - has had a big impact on research into financial markets.

This renaissance in economics has also been assisted by the loosening of the straitjacket of the "neoclassical" version still taught in universities. The defence of conventional methodology rests on its analytical rigour. Economists rightly see many critics of their "reductionism" as being in fact hostile to some of the conclusions - for example, that markets are usually the best way to allocate scarce resources - or even to applying the scientific method to human society at all.

At the same time, more students and more professional economists would welcome a richer approach. There is a "post-autistic" economics movement, and free-market economists such as Deirdre McCloskey of the University of Illinois have offered a very powerful critique of the narrow conventional framework. More economists are using techniques such as game theory, computer simulation or experiments, rather than writing down conventional analytical models. It adds up to a quiet, and welcome, methodological revolution.

An overarching intellectual framework is slowly forming from this swirl of applied research and interdisciplinary work. Its shape can be seen most clearly in the study of economic growth. Since the dawn of capitalism, this has been the big question. Why do capitalist economies grow? What can people do, collectively, to encourage economic growth, given that it brings benefits such as longer life expectancy, better health and improved opportunities for personal development? What are the most helpful forms of government intervention? And, increasingly, how can growth be linked to our well-being and quality of life?

The profession is little closer to a big answer than it was in Adam Smith's time. However, it is taking some steps forward. The classical economists understood the importance of social institutions for the effective operation of markets. Now we can augment that with insights from anthropology or game theory, and also - crucially - empirical evidence. One example is a new book by Alberto Alesina and Edward Glaeser, Fighting Poverty in the US and Europe: a world of difference (Oxford University Press, 2004), which measures differences in social attitudes to welfare in Europe and the US, and links those differences to the ethnic composition of the population and the history of race relations in each case. The implication that racial diversity undermines support for welfare makes uncomfortable reading for woolly liberals such as myself. The problem with evidence is that it challenges cherished beliefs.

To give another example, the Nobel laureate James J Heckman recently demonstrated to a Scottish audience that the highest returns on the use of public money in education come from spending on the early years. Yet Scotland, even more than England, subsidises tertiary (post-16) education, although there is next to no evidence that society needs to intervene in order to persuade individuals to invest more in this educational stage. The policy conclusion is clear: redirect public funds substantially to children under eight. But the politics remains problematic.

So "evidence-based policy" is the current buzz phrase. And who, you may ask, would want any other kind of policy? Well, "prejudice-based policy" still has a strong grip. Virtually every piece of applied economics falls foul of the dilemma Daniel Bell identified 30 years ago in The Coming of Post-Industrial Society: that governing a complex society needs technical expertise, but technical decision-making conflicts with increasingly participatory and even populist politics. The dilemma becomes all the sharper as technocrats become better-informed about what works.

Economics remains a very Anglo-Saxon discipline, a tendency reinforced by the new empiricism. Can we describe what is emerging as a big idea? Perhaps it is best characterised as the belief that social outcomes depend on the interaction of millions of individual decisions. Those decisions are shaped by our history and geography, and by the psychology and physiology of human beings.

That the leading economies have achieved such high levels of prosperity is something of a miracle, as Paul Seabright points out in his important new book, The Company of Strangers (Princeton University Press, 2004). Perhaps we should not be surprised that so many societies outside the industrialised world have never achieved the same levels of economic growth.

Yet their failure has become one of the most pressing challenges of the age. The new "what works" agenda of economics may help to meet that challenge.

Diane Coyle is the author of Sex, Drugs and Economics and Paradoxes of Prosperity (Texere)