Edmund Phelps says the silence of economists on the underlying causes of the political ructions and what can be done to restore economic vigour has been deafening, evidence of a refusal to acknowledge the need for change

Edmund Phelps says the silence of economists on the underlying causes of the political ructions and what can be done to restore economic vigour has been deafening, evidence of a refusal to acknowledge the need for change

By Edmund Phelps*

The West is in crisis – and so is economics.

Rates of return on investment are meager. Wages – and incomes generally – are stagnating for most people. Job satisfaction is down, especially among the young, and more working-age people are unwilling or unable to participate in the labour force. Many in France decided to give President Emmanuel Macron a try and now are protesting his policies. Many Americans decided to give Donald Trump a try, and have been similarly disappointed. And many in Britain looked to Brexit to improve their lives.

Yet economists have been largely mute on the underlying causes of this crisis and what, if anything, can be done to restore economic vigor. It is safe to say that the causes are not well understood. And they will not be understood until economists finally engage in the task of reshaping how economics is taught and practiced. In particular, the profession needs three revolutions that it still resists.

The first concerns the continuing neglect of imperfect knowledge. In the interwar years, Frank Knight and John Maynard Keynes launched a radical addition to economic theory. Knight’s book Risk, Uncertainty, and Profit (1921), and Keynes’s thinking behind his General Theory of Employment, Interest, and Money (1936) argue that there is no basis – and could be no basis – for models that treat decision-makers as having correct models with which to make decisions. Knight injected an uncertain future, Keynes added the absence of coordination. But subsequent generations of economic theorists generally disregarded this breakthrough. To this day, despite some important work on formalising Knight’s and Keynes’s insights (most notably by Roman Frydman and his colleagues), uncertainty – real uncertainty, not known variances – is not normally incorporated into our economic models. (An influential calculation by Robert J. Barro and Jason Furman, for example, made predictions of business investment resulting from Trump’s corporate profits tax cut without bringing in Knightian uncertainty.) The Uncertainty Revolution still has not succeeded.

Second, there is still a neglect of imperfect information. In what has come to be known as the “Phelps volume,” Microeconomic Foundations of Employment and Inflation Theory, we brought to light a phenomenon overlooked by economists. Overestimation by workers of wage rates outside their towns brings inflated wages and thus abnormally high unemployment; underestimation brings bargain pay levels and thus abnormally low unemployment. When workers lose their jobs in, say, Appalachia they have little idea – no well-based estimate – of what their wage would be outside their world and how long it might take to find a job; so they might remain unemployed for months or even years. There is a deficiency of information, not “asymmetric information.”

More than that, the volume sees every actor in the economy as being thrown back on whatever sense he or she can make of it, as Pinter depicted, and to do the best they can, as Voltaire urged. But theorists at the University of Chicago created a mechanical location model in which unemployment is merely frictional and thus transitory – the so-called island model. As a result, the Information Revolution has not yet been absorbed.

The last great challenge is the utter omission from economic theory of economic dynamism. While economists have come to recognise that the West has suffered a massive slowdown, most of them offer no explanation for it. Others, wedded to Schumpeter’s early thesis on innovation in his classic 1911 book The Theory of Economic Development, infer that the torrent of discoveries by scientists and explorers has shrunk to a trickle in recent times. Schumpeter’s theory operated on the explicit premise that the mass of people in the economy lack inventiveness. (He famously remarked that he never met a businessman with any originality.)

This was an extraordinary premise. One can argue that the West as we know it – the modern world, we might say – began with the great scholar Pico della Mirandola, who argued that all mankind possesses creativity. And the concerns of many other thinkers – the ambitiousness of Cellini, the individualism of Luther, the vitalism of Cervantes, and the personal growth of Montaigne – stirred people to use their creativity. Later, Hume stressed the need for imagination, and Kierkegaard emphasised acceptance of the unknown. Nineteenth-century philosophers such as William James, Friedrich Nietzsche, and Henri Bergson embraced uncertainty and relished the new.

As they reached a critical mass, these values produced indigenous innovation throughout the labour force. The phenomenon of grassroots innovation by virtually all sorts of people working in all sorts of industries was first perceived by the American historian Walt Rostow in 1952 and described vividly and voluminously by the British historian Paul Johnson in 1983. I discuss its origins in my 2013 book Mass Flourishing.

So it was by no means clear that the Schumpeterian thesis would be incorporated into economic theory. But when MIT’s Robert Solow introduced his growth model, it became standard to suppose that the “rate of technical progress,” as he called it, was exogenous to the economy. So the idea that people – even ordinary people working in all industries – possess the imagination to conceive of new goods and new methods was not considered. And it would have been dismissed had it been mooted. The Dynamism Revolution in economic theory was put on hold.

With the great slowdown and a decline of job satisfaction, however, there now appears to be a chance to introduce dynamism into economic modeling. And doing so is imperative. The importance of understanding the newly stagnant economies has sparked an effort to incorporate imagination and creativity into macroeconomic models. I have been arguing for a decade or more that we cannot understand the symptoms observed in the Western nations until we have formulated and tested explicit hypotheses about the sources, or origins, of dynamism.

That theoretical advance will give us hope of explaining not only the slow growth of total factor productivity, but also the decline of job satisfaction.

America cannot be America again, France cannot be France again, and Britain cannot be Britain again until their peoples are once again engaged in thinking of better ways to do things and excited at embarking on their voyages into the unknown.


This commentary was adapted from a speech given at Paris Dauphine University on January 15, 2019. Edmund S. Phelps, the 2006 Nobel laureate in economics, is Director of the Center on Capitalism and Society at Columbia University and the author of Rewarding Work. Copyright: Project Syndicate, 2019, and published here with permission.

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36 Comments

Very interesting, thanks interest.co.nz for republishing.

Glad to see a prominent economist challenging the discipline's application of its theoretical body of knowledge. Seems to me however that a glaring hole in the application of economic theory is the status quo's seeming reluctance to incorporate/address issues of power, as per a Marxian analysis.

And not sure about his own application of theory with respect to the solution he proposes in this piece he authored linked to above;
http://www.hup.harvard.edu/catalog.php?isbn=9780674026940

Phelps’s solution is a graduated schedule of subsidies to enterprises for every low-wage worker they employ. As firms hired more of these workers, the labor market would tighten and pay levels would rise. Ultimately the program would be largely self-financing, because its cost would be offset by reductions in the cost of welfare, crime, and medical care—as well as by formerly unemployed workers who would then pay taxes.

Kate,

Classical economics has given us such absurdities as Says Law,the Arrow Debreun theorem,the Efficient Market hypothesis and others,all of which have been demolished by Behavioural Economics. This of course,is based on the work of Kahneman and Tversky,Thaler and others.

The problem is theory.......

(and the real world doesn't match theory).

I think the word you’re searching for is dogma - a quasi-religious, very human affliction. Never has the quest for “absolute knowledge” and its pitfalls been more powerfully articulated than by Bronowski in the great BBC series ’The Ascent of Man'

https://www.youtube.com/watch?v=JlDumTPyn00

Kate - by issues of power do you mean the human psychological tendency to seek power and control, manipulate to their advantage, and perpetually defy logic? If so i totally agree.

Sort of, but with less emphasis on the individual. What I think needs greater consideration is the way in which power is exerted over individuals in/by our modern society, as opposed to the power exerted by individuals themselves. Lukes described three faces of power;

https://en.wikipedia.org/wiki/Steven_Lukes

It's a relatively straight-forward/easy model to incorporate when looking at social/political problems. Economics is a social science - yet it seems some who consider themselves professional economists want to "rise above", or distinguish themselves from the other social sciences.

Perhaps that is why the world seems to be so stuck on the present broken-record.

12
up

Many Americans decided to give Donald Trump a try, and have been similarly disappointed. And many in Britain looked to Brexit to improve their lives.

Trump has hardly been given a fair "try" and Brexit hasn't been implemented. Both Trump and Brexit are attempts by people to reestablish some sort of sense of control and destiny for their nation.

The reason we are stagnating is because we are not allowed to feel any sense of glory or purpose in our aspirations as distinct nations. The approved position is cynicism and making sure that people's feelings are never ever hurt. Our highest purpose is consuming stuff and travelling and pointing at things and exclaiming how pretty it is while taking selfies.

I was recently dining at the Stratosfare restaurant in Queenstown. It was full of overweight, ordinary people, indulging in gluttony with magnificent alpine views in the background. It left me feeling that something is not right about all of this.

Your Queenstown dinner reminds me of the great writings by Goscinny and Uderzo. In particular their work 'The Mansions of the Gods'

Disagree Zac. i would suggest that we are stagnating because the total gravy train has been hijacked by the political and powered elite at the expense of the masses. It is the natural consequence. They have created and perptuate a system that entrenches their power and privilege, and only allow those why demonstrate the appropriate psycopathy to rise above everyone else, to enter. The rest is about maintaining control, wealth and privilege. Effectively they have shot themselves in the foot, and us with them.

Yes, that's the kind of thinking that needs to be given legitimacy by way of exposure through proper analysis. This economist seems to completely ignore those aspects of power and status quo as they influence society.

Agreed Kate and this is what I was thinking in my earlier question to you. I do think the current Government's Wellness standard is a step in that direction, but it is clear they are struggling and are getting advice that ultimately seeks to preserve power and privilege.

For the next 2 years, you and the Elysium-dwellers will analyse and talk at length about wellness. It's a deliberate distraction. I call it deception.

The question is are you prepared to march down the street?

I like that Queenstown dinner ob Zachary, have felt the same down there myself.

Zachary,

Why would you give Trump “a fair go”? His record was there for anyone to see who cared to look. His business record? At best patchy. We now know that he inherited much more than he admits to,several hundred million dollars. Go and check out his abysmal business dealings in Atlantic City as just one example. It’s no wonder that he refuses to release his tax returns. Forbes Magazine,hardly a left wing rag,estimates his net worth to be much much less than does Trump. I know that Trump Turnberry is losing money hand over fist.
We know how he treats women and were he not President,there is a good chance that he would be convicted of sexual assault.
Look at his record in the White House where the staff turnover is,to put it mildly,high. We know that he is incapable of reading briefing papers,unless they can be condensed to a single page. His ignorance of the world is legendary. I could go on at some length.

“Many in France decided to give President Emmanuel Macron a try and now are protesting his policies. Many Americans decided to give Donald Trump a try, and have been similarly disappointed. And many in Britain looked to Brexit to improve their lives.” - We need to realise that it isn’t the leaders that make the difference, it’s the system we operate in. If that doesn’t change, the outcomes won’t be that much different regardless of who is in charge. Kind of like house prices dramatically increasing under both labour and national.

The reason we are slowing down across the board begins with Nixon abandoning the gold standard in the early 70’s and certain liberal reforms late 80’s. We have tied our growth to debt creation which inherently produces diminishing returns as we are seeing now. After the GFC, Obama roughly doubled the US national debt as he introduced more or less 10 trillion dollars to the economy and what did it buy them? Not much.

While we create money the way we do we are just trains on a track swapping drivers occasionally. Time to stop the fantasy that economies can be controlled by centralised authorities and return the power to the people so to speak.

That sounds almost Marxist...... " all power to the Soviets!"

(having just finished reading The Russian Revolution: A New History By Sean McMeekin and currently reading Lenin the Dictator By Victor Sebestyen. Some of the quotes seem so clichéd in 2019).

History doesn’t repeat but it rhymes, or something like that... I feel that certain literature has been taken as an instruction manuals rather than the cautionary tales they are meant to be. 1984 by Orwell and China come to mind.

The Ever War concept by the US also comes uncomfortably to mind. Was it a coincidence that America had a lot of unemployed young men when Bush decided to invade Iraq, just because he could? I hope so, but, it was, just, so very convenient.

Hmmm. Food for thought, I never considered that. I thought it was a play for oil and control as Hussein was dropping the USD. And boy oh boy would the US be in trouble if they aren’t the reserve currency anymore. No more printing without consequences.

Edward Gibbon wrote in his Decline and Fall of the Roman Empire about the son of Marcus Aurelius and how he set in motion the collapse of Rome. He wrote of Commodus (177-192AD):

“distinction of every kind soon became criminal. The possession of wealth stimulated the diligence of the informers; rigid virtue implied a tacit censure of the irregularities of Commodus; important services implied a dangerous superiority of merit; and the friendship of the father always insured the aversion of the son. Suspicion was equivalent to proof; trial to condemnation. The execution of a considerable senator was attended with the death of all who might lament or revenge his fate; and when Commodus had once tasted human blood, he became incapable of pity or remorse”

https://www.armstrongeconomics.com/armstrongeconomics101/understanding-c...

Interesting article, maybe I’ll have to change my above statement to “history doesn’t rhyme, it repeats.”

Most pertinent to me in it - “Historically, when the government loses sight of their purpose and sees itself as the embodiment of sovereignty instead of the people, then it begins to abuse the people with regulation and taxation. Once that takes place, the trend of coming together is reversed.”

I feel we are seeing the rise of politicians so self confident in their ideologies that they are happy imposing them on others as “they know best.” And of course, why would the individual need to sovereign when we can be governed so effectively!

What we have is a deficiency of aggregate demand. A problem that sufficient fiscal stimulus could solve if we stopped worrying hysterically about public debt to gdp ratios. Expansion of household debt to maintain growth rates is not feasible. We are close to peak private debt. Governments on the other hand can use overt monetary finance to stimulate the economy debt free if they choose to, the limit being inflation. Surely it's time to give it a try on a modest scale at least? Before we enter a new period of populist fascism brought on by economic stagnation. Humanity, alas, seems to need a period of war and mass destruction before it adopts sensible Keynesian policies and tackles inequality.

No mention of Minsky? Werner? Keen? North?

The trouble with economics is the complete reluctance to recognise ‘credit’ in their modelling. Why is there so little innovation, is it because the system has trapped the young who are too debt strapped to step out and give something a go? Why do Western economies flat-line the minute there is an easing in the 'credit impulse' and how entrenched are the ideas of Keynes and The follow-on Neo-liberals. Ignore 'credit' and you ignore the only driver the West has left.. a driver that is also its biggest weakness.

Thanks for the article though and I agree the mainstream economists are clueless, but how many of them rely on their old ideas to help pay their wages and living costs in an artificially expensive (debt fuelled) system?

Nor any mention of Benoit Mandelbrot or Sir Isaac Newton either (you know the chap who engineered the monetary system that enabled a small, damp, island nation to become a world power, that and creating Physics as we know it, of course).

Darn, forgot Luca Pacioli. Few economists really understand the higher mathematics of double entry bookkeeping, that's why the bankers, who do, can run rings around them. Economists are a bit like lawyers, you hire them as required. Their ideas provide a facade of respectability and lots of intellectual obfuscation to help advance your own interests.

When researching who saw the GFC coming, I came across a paper that found that the few that clearly predicted it all had an accounting basis for their work. That is, they thought that money and debt mattered. They could read a balance sheet.

Can't find that paper, it was from a university in Holland, but these seem similar:
https://voxeu.org/article/no-one-saw-coming-or-did-they
https://mpra.ub.uni-muenchen.de/15892/

Exactly.

Nic,

I would include Bagehot,Kindleberger and surely,Keynes.

I have recently listened to. 5 part BBC radio 4 broadcast on just why economists failed to see the GFC coming. One interview was with a senior figure at the London School of Economics who had written some of the standard textbooks on macro economics and when the crisis blew up,she had students asking her for an explanation,as there was nothing in their textbooks to help them understand. She agreed that she had had to rewrite her own work.
A book I keep going back to is Money,the unauthorized biography,by Felix Martin.

Nic,

I would include Bagehot,Kindleberger and surely,Keynes.

I have recently listened to. 5 part BBC radio 4 broadcast on just why economists failed to see the GFC coming. One interview was with a senior figure at the London School of Economics who had written some of the standard textbooks on macro economics and when the crisis blew up,she had students asking her for an explanation,as there was nothing in their textbooks to help them understand. She agreed that she had had to rewrite her own work.
A book I keep going back to is Money,the unauthorized biography,by Felix Martin.

The reason we are slowing down is that our exponentially-increasing draw-down of resources has met the inability of a finite planet to underwrite it.

Catton (his 'Overshoot' is downloadable on kindle and a must-read) points to the misdirection of blame onto incorrectly-identified 'culprits'.

increased energy cost of energy
increased debt
Financialization of housing, education, art and human history.
loose money printing

Just reading this article should give a hint about why todays economists don't know what's going on they are so busy trying to fit humanity into a model which is just insane.

A noose and pitch fork may be whats needed to bring these people back to the real world.

Simple, just cut off their funding. Organisations tend to work primarily for the benefit of those running them. Governments are a prime example.

Didn't understand it. Recognised a few of the names that were dropped. Was this bit in the conclusion significant to the post: ""the great slowdown and a decline of job satisfaction"" because if so I'd agree about the slowdown and query the job satisfaction. If our economy is now static hasn't it just returned to its typical state for the last 10,000 years? I'm sure young workers do grumble about job satisfaction but that has more to do with social media and TV setting standards. Working in MacDonalds is way more varied and interesting and involving in human interaction than standing on a production line with ear-muffs on tightening the left nut on a partly assembled machine part as they pass by for eight hours on a shift., five days a week, week in and week out.

I think job satisfaction comes down to future prospects. People were traditionally happier with more mundane jobs if they knew it would further their life financially/better their future. With key asset prices like housing becoming increasingly out of reach there is less hope for future betterment and much of the negativity has come from there. The social contract has been broken in a way.

You have a good point. Modern life is much richer in possibilities. In the past young people had a single path ahead of them: the children of miners went down the mines, the children of farmer labourers became farm labourers. Now they have many paths available to them which means many paths not taken and result dissatifaction.

That wasn’t exactly my point but I’m sure it has merit as well, analysis paralysis? What I was meaning is that it now takes a lot longer to achieve the markers in life that help lead to fulfilment. Waiting longer to buy a house, have kids for example, all because price to income ratios have been pushed out so far for no good reason.