Can America Become the New Phoenix?

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In mythology, Phoenix rose from the ashes to lead to a new direction. This article(via Manan Shukla) makes the point that a new direction is needed in economic thinking in order to solve our global economic problems. We have learned that our financial system is subject to recurrent crises that were not predicted by economic theory. Moreover, the dominant free market ideology led to the deregulation of the financial markets that contributed to the latest crisis. We also know that global warming is changing global weather patterns and causing recurrent cycles of bad weather events to be more extreme. The cost benefit analysis used by economists stress the cost of lost economic growth that might result from efforts to reduce greenhouse gases. We have also learned that unemployment and increasing income inequality are endemic to our system and that economic growth does not fix either problem. We need new ways of thinking in economics to deal with our major problems and the US, which is still the world's dominant economic force must assume a position of leadership in setting the new directions. The key question is whether America will become the Phoenix that is needed or whether it will continue in its role as the center of free market ideology that describes an economy that has never existed.

Adair Turner, an aristocrat who makes policy for England's central bank, made the keynote address at the recent Bretton Woods Conference which should challenge the profession and inform our politicians. He stated that employment stability, financial stability, climate stability and inequality were our most important problems and that they could be solved without a focus on economic growth. Banks should be required to hold enough capital to forestall problems even if it resulted in less lending and economic growth. Furthermore, countries should pay whatever is necessary to improve energy efficiency, and to transition from fossil fuels, even if it stunts economic growth by 1% of GDP as many models predict.

Unfortunately, economics is still engaged in a debate between those who argue that free markets can fix all of our problems, and that government intervention only makes things worse, and those who argue that government is essential to deal with market failures. Rational expectation theory, which is the outgrowth of free market ideology, still dominates macroeconomic modeling despite its failure to predict market failures. This is not surprising since one its assumptions is that markets don't fail unless an external event disrupts their normal operation. Financial markets are not accounted for in the theory. They are external to the economy.

The article describes some of the new efforts to improve economic forecasting and to incorporate irrational behavior into economic thinking. The financial crisis should make the case for a collective funeral for the old ideas that do not describe reality and which contribute to the market failures that have always been characteristic of the way in which markets really work.