Cogs and Monsters

What Economics Is, and What It Should Be

Diane Coyle

• Publisher: Princeton University Press
• Year: 2021
• ISBN:
  9780691231037
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

How economics needs to change to keep pace with the twenty-first century and the digital economy Digital technology, big data, big tech, machine learning, and AI are revolutionizing both the tools of economics and the phenomena it seeks to measure, understand, and shape. In Cogs and Monsters, Diane Coyle explores the enormous problems—but also opportunities—facing economics today and examines what it must do to help policymakers solve the world's crises, from pandemic recovery and inequality to slow growth and the climate emergency.Mainstream economics, Coyle says, still assumes people are "cogs"—self-interested, calculating, independent agents interacting in defined contexts. But the digital economy is much more characterized by "monsters"—untethered, snowballing, and socially influenced unknowns. What is worse, by treating people as cogs, economics is creating its own monsters, leaving itself without the tools to understand the new problems it faces. In response, Coyle asks whether economic individualism is still valid in the digital economy, whether we need to measure growth and progress in new ways, and whether economics can ever be objective, since it influences what it analyzes. Just as important, the discipline needs to correct its striking lack of diversity and inclusion if it is to be able to offer new solutions to new problems.Filled with original insights, Cogs and Monsters offers a road map for how economics can adapt to the rewiring of society, including by digital technologies, and realize its potential to play a hugely positive role in the twenty-first century.

1

The Public Responsibilities of the Economist

My 2007 book The Soulful Science: What Economists Really Do and Why It Matters was born of my frustration with the kind of straw man criticisms of economics described in the Introduction. Some of those criticisms—the overuse and abuse of mathematics, the extreme assumptions about rational, individual choice, abstractness from the real world, the merits of markets over government intervention—had been truer in 1985 than in 2005, when frustration drove me to the keyboard to start writing. The critics were ignoring the fact that economics had changed a lot in two decades.

I knew this because I had lived it. The period from 1981 to 1985 when I did my PhD at Harvard was the high-water mark in the academic profession of what might now be described as neoliberal economics. These were the Reagan and Thatcher years, both of whom were elected in reaction to the shortcomings of economic management by the state during the crises of the previous decade. I was as swayed by the intellectual tides as any other eager young economist, impressed by those who could wield the algebra and calculus more adeptly than I, and inclined to give market solutions to problems the benefit of the doubt. Still, my good luck with my teachers and mentors—Peter Sinclair at Oxford, Ben Friedman at Harvard—meant I was somewhat inoculated against the extremes of the ‘rational expectations revolution’. It was also still the case then that the Harvard economics department required its graduate students to take two economic history courses along with the usual micro and macro theory and econometrics. In another stroke of luck my professors of these courses were the economic historian Barry Eichengreen and the heterodox economist Steve Marglin. While I rather naïvely disagreed with the latter, who was out of tune with the intellectual tides in Reagan’s America, the readings and discussions certainly made me think.

In 1985, though, when I started my first job back in the UK as an economist at the Treasury, I would have defended the kind of economics most deserving of the frequent criticisms. Indeed, my job, in the grand Whitehall building just across the square from Parliament, was in the division responsible for monetary policy (this was before the days of central bank independence). The monetarism originating with Milton Friedman’s work in the 1960s and implemented during the inflationary economic crises of the 1970s was the policy orthodoxy. We were also closely involved in the preparations for ‘Big Bang’, the removal of long-standing regulations governing the financial markets in the City of London. These 1986 deregulatory changes gave birth to the financial system that eventually delivered the Great Financial Crisis (GFC) of 2008–9, including the explosive growth of derivatives markets. (One of my tasks in the Treasury was writing an explainer about derivatives for senior officials and ministers, which was certainly an education for me too.)

By 2005, the orthodoxy had changed substantially—at least in the academic world. The Soulful Science is a description of what had changed. For example, the intervening twenty years had seen the introduction of endogenous growth theory (Romer 1986a), which linked economic growth to education and intellectual property rather than taking it as due to unexplained technical progress; and a broad appreciation of the role of institutions, or in other words historical and political context, in growth and in economic development (Acemoglu and Robinson 2012). Importantly, a constellation of computer power, new data sources, and improved statistical techniques had made empirical work both easier and more widespread. What The Soulful Science omitted—reflecting my own gaps in knowledge—was finance.

Of course, soon after the book was published, the GFC happened, taking the financial system literally to the brink of collapse, and causing a significant recession. This was not as bad as it might have been, as economists had learned from the 1930s—and one expert on the Great Depression, Ben Bernanke, was in a key role as chairman of the US Federal Reserve Board. Yet how had this cataclysmic event happened, after a long period some people had taken to calling the Great Moderation, with low inflation and steady growth? Her Majesty the Queen famously asked a group of economists at the London School of Economics why on earth they had not seen it coming. Macroeconomists were widely condemned for not having forecast the crisis, for many of the models used for forecasting at that time ruled out such events. Financial economists were mocked for their ‘efficient markets hypothesis’, the claim that asset prices captured all currently known information about future returns, so that their future movements could only be random.

Needless to say, I revised Soulful to acknowledge these shortcomings (Coyle 2010). But the GFC has cast a long shadow. We have been living with its consequences ever since, particularly the way central banks’ use of ‘quantitative easing’—buying (mainly) government bonds to put money into the economy—has kept interest rates ultra-low, pumped up other asset prices to the delight of financial markets and rich asset owners, and plunged many pension funds into crisis. Having started ruminating on the role of finance and on the culpability of policy mistakes for what had happened, this became my subject when I was invited to give the 2012 Tanner Lectures on Human Values in Oxford.¹ What was the role of academic economics in creating and unleashing Frankenfinance—could its ideas have given birth to the monster? What were the responsibilities of policy economists, who had grown increasingly powerful in government since the mid-twentieth century, in allowing the financial crisis to happen? How should they apply economic research when faced with the roughness and messy complexity of the real world? Economics has moved on since 2012, but can we be sure something similar could never happen again?

Part I: Dr Frankenstein, I Presume?

These days, the most common question I get from junior analysts about derivatives is, ‘How much money did we make off the client?’ I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them. It astounds me how little senior management gets a basic truth: If clients don’t trust you they will eventually stop doing business with you (Smith 2012).

These words, written in the New York Times by a departing Goldman Sachs executive a few years after the GFC, confirmed what many people believed then and still believe to be true about the financial markets. These markets are widely seen as having become fundamentally harmful to society. So too, by extension, are all markets and economists in general, since they are the principal advocates of markets as the organising structure of modern society. While this is perhaps an exaggeration of popular views, evidence from opinion surveys suggests there has been a reappraisal of the pro-market philosophy dominant in public policy since the early 1980s. Although majority public opinion continues to support a market-based economy, there is little popular enthusiasm for how the players in these markets have been behaving (YouGov 2011). Thanks to them, capitalism in the early twenty-first century has brought inequality, unemployment or precarious jobs, and austerity. Public dissatisfaction was strong enough by 2012 to get a fair number of people out onto the streets to ‘Occupy’ the commanding heights of the global economy in the City of London and on Wall Street. In 2019 polling in the United States by RealClear Opinion found more than a quarter of respondents saying capitalism and free markets are broken and another 15 percent saying they would like more government regulation of the economy.² Liberal intellectual opinion has been shrill in its denunciations of economics. Here is one example, from the American novelist Marilynne Robinson:

It is this supranational power, Economics Pantocrator, that failed us all in fairly recent memory. It has emerged from the ashes with its power and its prestige enhanced even beyond the status it enjoyed in the days of the great bubble. The instability and the destruction of wealth for which it is responsible actually lend new urgency to its behests (Robinson 2012).

She is not alone in regarding economics as a malign social force, rather than a useful practical discipline. There is a long tradition of writers seeing economics as conflicting with more important values or cultural traditions. It dates back to the Romantic backlash against the rationalist Enlightenment view of improvable Nature (Porter 2000). John Ruskin (1860) would have approved of Robinson’s rant (there is no other word for it), having fulminated against industrial capitalism in a similar way in Unto This Last: whereas craft production created wealth, modern economics spawned ‘illth’, he claimed.

It is no surprise that what was then the deepest and longest economic downturn since the Great Depression—the pandemic probably will not take that title now—encouraged a revival of such criticism. If economists are supposed to help prevent or alleviate economic crises, it showed we have obviously not done a good job. While plenty of economists insist there is no fundamental problem with the subject, and many more would reject hyperbolic attacks from novelists and protestors, many others have been reflecting seriously on the lessons of the crisis for their intellectual framework and for the practical role they play in the world of public policy. Keynes famously said economists should be ‘humble, competent people’ like dentists, fixing things that go wrong and making modest improvements in people’s lives (Keynes 1931). Esther Duflo, a recent Nobel Laureate, opted instead for a comparison with plumbers, another practical profession (Duflo 2017).

Instead we have turned out to look more like Dr Frankenstein, unleashing an idealistic experiment that has run monstrously amok, causing devastation. Have economists created a monster? Has economics shaped the world in its own dysfunctional image?

There is some truth in this, in my view, when you get beyond the literary exaggerations. My profession does bear some responsibility for what has happened, in a way I will explain. But it is most true of a particular approach to economics, which has been retreating for some time and will eventually turn out to have been finally discredited by the GFC. The economic catastrophe could indeed be the making of a stronger economic science, re-rooted in the natural sciences, as it was at its birth in the Enlightenment. In the second part of this chapter, I will discuss how the struggle between old and new economics is playing out in the arena of public policy, where economists have for decades had a privileged status in influencing decisions.

This is my claim: economics as an intellectual discipline and professional practice has helped shape the economy it analyses. Beliefs about the way the economy works and expectations about how it will work in the future have a central role in our theories, or ‘models’. In particular, many models—summaries of the relationships in the economy as a whole in the case of macroeconomics, or of a subset—assume that ‘agents’ (as we refer to people) have more or less correct beliefs or ‘rational expectations’ about the economy. At one level this is a reasonable assumption that you can’t fool all of the people all of the time: if they are systematically proven wrong, they will change their beliefs. In practice, it becomes a strong—unrealistic—assumption about the information and powers of calculation of millions of real people.

However, the key point about the assumption that behaviour today depends on beliefs about tomorrow in any way, rational or not, is that it opens the door to self-fulfilling outcomes. Whenever expectations matter, ideas have the power to shape reality. Keynes’s insistence on the importance of ‘animal spirits’ for investment and consumer spending is captured and pinned down in these formal rational expectations models, albeit not in a way he might have anticipated (Keynes 1936). Even speculative asset price bubbles can be rational in this sense: as long as most investors expect the price to continue rising, it will do so (Santos and Woodford 1997).

Economics owes the terminology of the self-fulfilling outcome to the sociologist Robert K. Merton, although there are many examples of the idea to be found before he coined the phrase (Merton and Merton 1968). One classical self-fulfilling prophecy is found in the Oedipal myth; the protagonists’ expectations shaped by the prophecy are what bring about the very tragedy it foretells. As soon as the formal economic models that were developed from the late 1970s onwards incorporated a central role for expectations in decisions, almost everything could become self-fulfilling—indeed, instantaneously so in economists’ unearthly world of perfect information and no frictions.

However, economists have never given much thought to the theoretical possibility this opens up, namely that the way economists think about the economy can become self-fulfilling too, that the principle works outside the models as well as inside them. If mainstream global economics models the economy or the financial markets in a certain way, and that enters the thoughts of public officials or financial market traders and shapes their beliefs and expectations, could reality change to reflect the model? If economists reflect a narrow slice of society and think in a distinctive way—and we are as a group demonstrated to be more selfish and individualist than average (Gerlach 2017)—then perhaps the models we use can shape the economy in the image conceived by the model-makers.

This is the strong version of self-fulfilling prophecy. It is often described as ‘performativity’, although this usage has travelled some distance from the word’s origins in linguistic philosophy. John Austin used it for statements such as ‘Sorry!’ or ‘I now pronounce you husband and wife,’ in which the words themselves form the action (Austin 1962). Economic sociologists now use it for economic models that build their own reality, rather than merely describing an external reality. The canonical example of performative economics is the model for pricing financial options. Robert K. Merton’s son, Robert C. Merton, was jointly awarded the Nobel Memorial Prize in Economics in 1997 for devising this model (along with Myron Scholes; Fisher Black, the other co-author of the original Black-Scholes model, had died earlier).³ The investment company Robert C. Merton co-founded to put the model into practice, Long Term Capital Management (LTCM), went bankrupt with losses of $4.6 billion in 2000, in a kind of trial run for the later financial crisis. It is hard not to see some strange echo of the Oedipal story in this, especially as his father Robert K. is rumoured to have invested in LTCM.

How did the options pricing model of Merton fils alter financial reality in its own image, ultimately helping to bring about his catastrophic financial downfall? Sociologist Donald MacKenzie has traced the massive growth of derivatives markets since the 1970s to the availability of a practical model for pricing these financial instruments. Merton’s contribution was to provide a simple version of the pricing formula for options, one that was more intuitive for traders in the markets than competing approaches because it related the option price to the volatility of the price of the underlying asset from which it was derived. What’s more, as MacKenzie (2007) describes, Fisher Black also provided a commercial service to the financial markets in Chicago (at that time open outcry markets with traders shouting their deals in the various pits). His business calculated various options prices using the Black-Scholes-Merton model on computers away from the market and circulated them as single sheets of paper that a trader could roll up into a cylinder for ease of reading a specific column.

MacKenzie presents evidence...