Innovation Nation

Neo-classical economics is bunk. Keynes is dead. What comes next?

In 1964, when Alan Greenspan was still worshiping at the altar of objectivist Ayn Rand, he wrote that “[regulation’s] sole ‘contribution’ is to substitute force and fear for incentive as the ‘protector’ of the consumer…the basis of regulation is armed force…What collectivists refuse to recognize is that it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product.” Presumably Greenspan could not envision the flock of loan originators, packagers, and underwriters involved in the mortgage-financing fiasco, who didn’t care if they had a quality product or reputation for honest dealings as long as they could pass off financial junk to the next buyer. Today, thanks to the Treasury’s $700 billion bailout plan, that next buyer is the U.S. taxpayer.

How did we get into such a mess? While the causes are many, at the core there is one: Washington’s belief in the primacy of unfettered markets. This belief is not just some random notion that happens to be in vogue. Rather, it lies at the heart of the prevailing doctrine of neo-classical economics, with its focus on stable markets driven by rational actors responding to price signals. Whether the question is how to respond to global warming, address the record trade deficit and declining U.S economic competitiveness, or put in place regulatory oversight to limit financial improprieties, the answer from the neo-classicists is largely the same: The market will take care of it, and if there is a role for government it should be strictly delimited, so as not to “distort” the workings of the “market.”

Neo-classical economics pervades the thinking of both parties’ establishments. On the right, supply-side economics is the anthem of the American Enterprise Institute, the Heritage Foundation, and the Cato Institute; on the left, “Rubinomics,” referring to the policies of Clinton Treasury Secretary Robert Rubin, dominates the Brookings Institution, the Peterson Institute, and the Council on Foreign Relations. Staffers at all these places float in and out of top spots in the federal government, meaning that neo-classicists not only shape but also enforce the Washington consensus on economic policy.

It wasn’t always this way. Before the late 1970s, U.S. economic policy was grounded in a different doctrine–Keynesianism economics–which prioritized high employment as the best way to grow the economy. Government’s job was to stimulate spending for goods and services, particularly during slowdowns when consumers and businesses might be cutting back their spending, and regulate key sectors to prevent the kinds of excesses that led to the Great Depression. But Keynesianism lost its dominance in the late 1970s, when the emergence of high unemployment with high inflation (termed “stagflation”), coupled with a dramatic slowdown in productivity growth, led many to question it as an adequate guide.

Now the tables are turned, and the prevailing neo-classical economic doctrine is being called into question. When the private sector acting on its own can single-handedly be responsible for the losses of over $2 trillion dollars and require the federal government to save both it and the economy, the notion of leaving things to the wisdom of the market rings hollow at best. And yet a return to Keynesianism, with its inflexible emphasis on employment markets, is hardly the answer, either. We know we are on the wrong path, but how do we reach the right one?

Even with these tectonic changes in the markets, unless there is new thinking that not only calls into question the prevailing doctrine but lays out a compelling new doctrine, old doctrines have a way of hanging on. In the 1930s, the Depression put to rest old notions of laissez-faire, but without John Maynard Keynes’s 1936 book The General Theory of Employment, Interest, and Money, the old doctrine might have managed to muddle through. In the 1970s, without Jude Wanniski’s 1978 supply-side bible The Way the World Works (coupled with a revival of neo-classical economics scholarship), Keynesianism might have had time to renew itself. Today, without a compelling new approach, we risk falling back on the neo-classical response once again, or even turning back even further to a revived Keynesianism.

Fortunately, new work is not only questioning key tenets of neo-classical economics, but also articulating a compelling alternative doctrine: “innovation economics.” This theory, promulgated in two new books, holds that the major goal of economic policy should be to spur higher productivity and greater innovation, and that policy should rely not just on price signals alone to get there, but on smart public-private partnerships.

In The Origin of Wealth, McKinsey Global Institute Fellow Eric Beinhocker challenges the notion of homo economicus, the idealized rational actor that underlies neo-classical economics. Research in an array of fields, including the new disciplines of behavioral economics and complexity theory, has called into question this faith by showing how people often fail to act rationally when making economic decisions. Relying on advanced computer modeling and simulations, researchers have found that many economic systems act less like well-structured systems in equilibrium (as neo-classical economics holds) and more like chaotic, complex systems whose outcomes are unstable and can vary widely based on seemingly minor changes. These models bring us closer to the way things actually work: In the traditional neo-classical view, stock market bubbles don’t exist because markets are rational and always reflect full costs and benefits. But in a chaotic, complex-system model, bubbles and their bursting are not out of the ordinary.

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