Thursday, January 24, 2008

An End to Magical Thinking

The last two weeks on global stock markets have been a roller coaster ride with which no theme park could compete. And, while many people saw it coming, what is most remarkable is that the so called best and brightest didn't. The question is why?

In the last thirty years of his life, the economist John Kenneth Galbraith saw the Keynesian consensus, which he had helped build, crumble. A new generation of economists, in an attempt to transform economics into a natural science, tried to build a set of mathematical models which could predict the future. It was, in fact, Milton Friedman -- Galbraith's academic antagonist -- who claimed that any theory should be judged, not on its realism, but on its predictive capacity.

The problem was that, at the heart of the new economic models, lay the bedrock assumption that human beings are rational creatures who make rational decisions. If one buys that assumption, mathematical economic models work. Galbraith contended that economics existed as part of a matrix which included politics and history, both of which offered a plethora of evidence that human beings often make irrational decisions. He claimed that any attempt to turn economics into a rational, self regulating system was, in effect, to believe in magic.

What the current gyrations on the world's financial markets proves is that Galbraith was right and Friedman was wrong. And, if there is any lesson to be taken from recent and future financial turbulence, it is that -- as Richard Gywn wrote this week in The Toronto Star -- we need to relearn that "when governments leave the marketplace to itself, as has been the prevailing ideology for the past couple of decades, the result is both an outburst of entrepreneurial energy and creativity but also a thundering great smashup."

The markets have taken some hope from the coordinated cutting of interest rates by central banks and from the American Congress's promise to cobble together a stimulus package. But, as Robert Reich wrote this week in his blog, "As a practical matter our only real hope for avoiding a deep recession or worse depends on loans and investments from abroad -- some major U.S. financial firms have already gotten key cash infusions from foreign governments buying stakes in them -- combined with export earnings as the dollar continues to weaken." Reich concluded that, "We're going to need the rest of the world to bail us out." We have been reminded again that, whether the subject is global finance or global warming, we are all in this together.

And we have been reminded that, whether the movers and shakers sat in the executive offices of Enron, or the White House, or City Bank, the story ended the same way. The new technocrats know a lot about statistical analysis. It's a shame they know so little about Sophocles, Aeschylus or Euripides. The Greeks could have told them that this was going to happen. Their predictions were based on a thorough knowledge of human nature -- not magic.

1 comment:

Jack Payne said...

Gailbraith went radioactive, when was it? I believe sometime not long after WW II. Freidman's theories drove to the forefront, and seemed to become the rallying cry of supply-siders.

I find it eerie how these fads run in cycles, and wonder what's coming next?