Human nature, however, is such that we crave certainty. When we discover something that looks like a feasible theory, we stick to it doggedly, until something proves us wrong. This was our collective error a few decades ago, when economics was hijacked by something called the efficient markets hypothesis, a seductive theory that both tied in with Adam Smith (postulating that most asset prices would always be a fair reflection of supply and demand) and seemed able to predict the future with more than occasional accuracy.
No, that ain’t the EMH. It says pretty much nothing about supply and demand. Actually, in the weaker version it says that markets process all the publicly available information. Sure, some of that info is about supply and demand but the point is in the processing of the information. There’s a stronger version, which states that the results arrived at as a result of such processing are “right”.
The EMH is thus not about supply and demand, it’s about the processing of the information we have about it. Sounds like a small difference but it isn’t: for if the FMH was about s and d then, if they could just find out what they were then bureaucrats could do as well as markets. But if it’s the market doing the processing of the information, then you can’t effectively short circuit markets by the use of bureaucrats, for you need the markets to process the information.
Whether the EMH is actually correct is another matter (to me it seems simply axiomatic that the weak version is correct, the strong one, well, I dunno).
But in a strange way, the by-product of this financial collapse has been to free economics of this burden. In the corridors of the Bank of England and Treasury, there is a distinct whiff of excitement. For the first time in decades, economists have been able to throw away their textbooks and go back to first principles; to exhume once-sacrilegious figures such as John Maynard Keynes or Friedrich Hayek. It is unsettling, no doubt, but this is a fertile moment, an opportunity from which may be born a better model of how to run an economy.
We are already seeing the consequences. In the future, markets will be less free; there will be more regulation; the state will be more interventionist. Taxes may become more redistributive. But from the ashes of the crisis may come a new understanding of how to run an economy that is both more successful, and more stable, than the failed models of the past.
That outcome really rather depends upon whether people read more Hayek than Keynes or vice versa, doesn’t it?
It also rather depends on which bits of Keynes they read: it would certainly be an advance if they absorbed two of his points about fiscal stimulus: the first being that when you’ve growth above trend you should in fact be doing fiscal contraction, saving money for the bad times which will inevitably come. As Brown so famously didn’t. The other is that the best method of fiscal stimulus, the easiest to implement, the fastest and the one that best accords with microeconomic incentives as well as macro desires, is to cut national insurance payments.
If those are the two things that the Treasury takes away from a rereading of Keynes then I for one would be happy….