Hard problems in economics

This is a summary of a presentation I gave in Zurich earlier in June to FuturICT, one of the candidate flagship European Union research projects, each worth 1 billion Euros.

1. Financial markets is a very hard problem, issues of agent heterogeneity, networks, learning, financial innovation, regulation – all these and more are important. Mainstream economics has largely avoided the topic, content to believe in the efficient markets hypothesis. A great deal of distinguished work has already been done by econophysicists.

2. Inequality: where does it come from?

This is not just a matter of the distributions of income and wealth. A major concern of policy makers on say, outcomes in health care or education across hospitals and schools, is that such outcomes are ‘unequal’ in the key sense that they differ at any point in time. This seems inevitable in any complex system of interacting agents, but it is often a major concern to voters and hence to politicians.

3. Shortages: food/water/energy – how do we avoid/mitigate these key social, economic and security-related problems

Both these very hard problems require trans-disciplinary teams. For example, Elinor Olstrom showed how societies evolve ways of dealing with the ‘problem of the commons’ to give outcomes which are quite different to those predicted by economic theory.

4. What does it mean for an agent to be rational in the world of the 21^st century?

We face a stupendous number of choices, many of which are complex and difficult to evaluate and distinguish between them, and we are increasingly both aware of and influence directly by the behaviour and decisions of others across networks. A sub-theme of this is: how do agents cope with the massive explosion in information and turn it into useful knowledge.

The old concept of rationality is no longer in general valid.

This has very deep and widespread policy implications. Almost all existing policy is based on a view of the world in which autonomous agents maximise subject to constraints. In a world of interconnected agents where maximisation does not make much sense, what becomes the basis of policy? How will agents react? What are better ways to get them to react in ways which policy makers want?

This involves matters such as, individual learning, social learning, the evolution of self-image, networks (the relevant topology; how they evolve; who/where/when agents might copy)

So a very hard task is: what is the new paradigm for agent behaviour, one which in principle is general across the social sciences.

The economic recession: where are we now, and how bad has it been?

The world economy as a whole is roaring away. The 5 per cent real GDP growth on 2010 is almost the highest annual growth rate seen over the past 20 years. And even in 2009, world output fell by only 0.5 per cent.

The problems have been almost exclusively in the developed world. Looking at annual growth rates in 17 countries since 1871, the current recession can be placed in the context of 140 years of data.

Quarterly data is now routinely available, but for most of this period, this was not the case. It only started in a few countries in the late 1940s, and gradually spread. But for long term comparisons, we have to rely on annual data.

We can define a recession in two ways. First, the successive periods in which (annual) real growth is less than zero. Second, the periods in which the level of GDP is below that of its pre-recession peak.

I published statistical analysis of recessions 1871-2010 in Risk Management in 2010, which is on the papers section of the website, and I have extended it for a conference in Kiev in honour of Simon Kuznets in the ‘new’ section of the site. So details are available there.

Looking at the economies of Western Europe, Canada, the US, Japan, Australia and New Zealand, the falls in output started to happen in the period from the third quarter of 2007 (2007Q3) to the second quarter of 2008 (2008Q2). In almost all the 20 economies, growth had resumed by 2009Q4, and often earlier in 2009. In Portugal and Spain growth resumed, albeit very haltingly, in 2010Q1, leaving Ireland as the only exception.

So on this conventional definition, the recession was short, entirely in line with historical experience: over 90 per cent of all recessions last no more than 2 years. The size of the recession across the sample of 20 countries varied substantially, but overall it was a pretty big one, with the average fall in output being arouind the third quartile of all recesssions.

Despite the size of the recession and the financial nature of the crisis, in 9 of the 20 countries, by 2011Q1 (the latest data), the level of output had exceeded its previous peak value. This group includes America and Germany.

This perspective indicates that the recession was a serious one. Even on this measure, very few recessions last for longer than 3 years, yet it has already lasted this long. Some economies, such as France and the Netherlands, are close to their previous peak output levels. There is a group (Denmark, Finland, Italy, Japan, Portugal, Spain, UK) where the level of GD remains 3 to 6 per cent below its previous peak – Ireland again is the exception.

But overall, even the economies of the developed world have demonstrated great resilience in the face of a financial shock which had the potential to turn into a repeat of the 1930s.

What a good job Keynes didn’t believe in forecasting

Keynes is in many people’s minds at the moment, as uncertainty about the course of the economic recovery is high.

In May 1933, at roughly the same stage in the cycle as we are today, Keynes wrote in the Times: ‘Confidence has been restored and cheap money established both on long and on short term [the equivalent of zero interest rates and quantitative easing from the Bank of England today]. Yet unemployment has not declined. Where are we to look for the explanation? Not in the international sphere; for our net foreign trade position, though still bad, is much improved [the equivalent of the increase in net exports caused by the 25% depreciation of sterling since 2007].

We can find it nowhere, I suggest, except in the decline in our loan expenditure, as the result of our no longer borrowing for the dole and of our restraining the capital expenditure of all public authorities’.

Keynes made the case for tax cuts and infrastructure spending to boost growth and reduce unemployment. He made it clear he had little time for fiscal masochism, noting : ‘Unfortunately the more pessimistic the chancellor's policy, the more likely it is that pessimistic anticipations will be realised and vice versa. Whatever the chancellor dreams will come true!’.

Here is what happened to growth and unemployment:





So, yes, no sooner had Keynes written these words that confidence was indeed restored. The economy boomed and unemployment nearly halved.