Economic Theory Going In and Out of Fashion

Here is an interesting post by Mark Dow on the Council of Foreign Relations web site. I'm extracting the bit about the slow pendulum of fashion in economic theories:

At the time of the Great Depression the prevailing ideology was the Austrian Business Cycle School, a variant of the classical school of economics. (This school of thought was responsible for the useful term “creative destruction”). As the Depression took hold, the policy response was to allow the system to purge itself of its excesses. In retrospect, the mainstream view is that this policy response—or lack thereof—severely exacerbated the length and depth of the downturn.

Economists of every stripe have their own pet reasons as to what caused the Great Depression and what got us out of it. Leaving this debate aside, it is not controversial to say that Keynesian polices were perceived to have helped lift the US out of the Depression.

As a result of the belief that Keynesian policies ‘worked’, its adherents grew in number. The 50s and 60s were characterized by less faith in markets and more faith in government’s ability to solve problems. One might call this the ‘migration’ phase. By the time the 70s rolled around things had been taken even further, and we began to see wage/price rigidities and activist monetary and exchange rate policy take a serious toll. You could say people took a good thing too far.

The onset of the Reagan era marked the end of this pendular swing. Policies that placed greater faith in markets and considerably less in government, coupled with a more independent central bank, were perceived to have saved the economy from Keynesian excesses. As the economy grew over the course of the 80s, this new ideology—monetarist, supply-side, efficient market hypothesis—saw many new adherents jump on the bandwagon. By the late 90s/early 2000s, this prevailing ideology was scarcely seriously challenged. Markets were believed to be largely infallible and self-regulating, and no one doubted that everything government touched was going to be ruined. Fast forward to 2008: markets did fail, and the pillars of the existing ideological edifice started to crack. You could say people took a good thing too far.

Thus, the pendulum has started to swing again. Why does this matter? In short, we are going to be facing a lot of policy issues in the coming years, and many in markets, policy circles, and in the population at large are having a hard time getting off the paradigm. A lot of the baby boomers who learned their economics reading the Wall Street Journal editorial page in their formative years are still stuck in 1982. The high degree of residual ideology in the system is impeding, in my view, the fundamental rethink that the US needs at this juncture to get ahead and stay ahead of the rapidly moving global curve. In other words, with so many people still looking in the rearview mirror it increases the chances of car wrecks.

In my experience there is little room for ideology in economics. No set of rules or principles can fit all of reality for all points in time. The world to too complex and moves too quickly for this. The ‘perfect’ mix of markets and government is not a static concept. It is dynamic, and highly contextual. Again this post is not ideological. It is more a cautionary tale about human nature and the way we follow trends.

This captures my viewpoint very nicely. Fixed ideologues are a danger. The real world is complex and it requires new thinking to properly confront it. The idea of a left-right pendulum swing is a nice mental picture, but it is too simplistic. In human affairs almost nothing goes simply back and forth. In fact, to think that political/economic/social views can be characterized by a simple one dimensional representation is generally too simplistic (despite Krugman's very intriguing posting on "dimensionality").