This paradigm dominated economic thinking until the 1970s, when Vietnam-era inflation, compounded by exorbitant spending on the war and Great Society programs, left the economy mired in “stagflation,” with inflation rates that reached 15 percent and high unemployment. The double plague of inflation and unemployment, along with excessive government spending, drove an anti-Keynesian rebellion led by Friedman and his University of Chicago school of free-market thinkers, who shaped the Reagan revolution against Big Government.
That era, in turn, produced the next great model, the so-called rational-expectations hypothesis. “It says that people are rational, can see through government policy, and will basically predict what it is that government is trying to do and get around it by other means,” Lo says. It was this framework that underpinned much of the deregulating, free-market approach of recent years. But the concept of a rational, self-equilibrating market has been called into question by the failure of the financial industry to regulate itself. “In fact, that’s a very, very idealized and unrealistic description of the macroeconomy,” Lo contends. “We haven’t spent the time on modeling new theories.”
Still, there’s a lot of disagreement over how much new modeling is necessary. The University of Chicago’s Kashyap counters that it’s wrong to dismiss rational expectations entirely. Instead, he says, the problem is that economists didn’t pay enough attention to the inner workings of the financial system and how it interacts with the real economy. As a theory, Kashyap says, rational expectations isn’t wrong—it’s just incomplete. “The dominant model didn’t have a financial system in it,” he notes. “Lots of people didn’t come to appreciate how much stuff they had swept under the rug.… The big rethink now is that people are not going to say financial arrangements are a second-order detail anymore.”
But Turner and many other economists counter that a deeper remodeling is needed that will acknowledge, at long last, that irrational or quirky behavior drives much of the economy. Rachel Crosen, an economist who works with the National Science Foundation, says that some of the more trailblazing research efforts try “to incorporate sociology that is harking back to days of economics before it was so mathematized.” Among the most exciting new thinkers, she says, is Esther Duflo of MIT, who is using field experiments in economic development to figure out what makes economies grow. Even some mathematical economists are engaged in new inquiries: Lars Hansen of the University of Chicago is doing profound work on evaluating economic models and the uncertainty inherent in them; and Chris Sims of Princeton is rethinking how economics uses data.
New models try to explain the human side of economics. Some incorporate psychology; others, social norms; others still, the power of storytelling.
Other prominent economists, including Nobel laureate George Akerlof of the University of California (Berkeley) and Robert Shiller of Yale, are developing horizons in “behavioral economics” that attempt to map human behavior more realistically, rather than assuming that people are always “rational” economic actors. On the sidelines at Bretton Woods, Akerlof—relaxed in a wool blazer, heavy pants, and hiking boots—outlined his latest theories in “identity economics,” the idea that social norms influence how markets work and should factor in policy, too.
People develop fixed ideas of what they should be doing—at work, at home, over their lifetimes—Akerlof said, and those ideas drive the economic choices they make. Those decisions can confound basic market theory and lead, for example, to the persistently high unemployment we’re seeing in the United States today. Akerlof says that the job market “is like a game of musical chairs” where the players refuse to sit in anything but the seats they’ve come to identify as their own. If Jane sees herself as an engineer meriting a $100,000-a-year salary, because she’s done that for a decade and it makes her happy, then if Jane loses that job to outsourcing, she’ll be reluctant to take a similar one for $60,000 a year—even if the markets suggest that should be the going wage for an engineer. The rational-expectations theory says that Jane should take that job; the identity theory says she won’t. She’ll hold out for a $100,000 job: She won’t sit down until someone puts her rightful chair back in the room. That’s not a problem you can solve just by revving up GDP growth.
New thinkers say they’ve long struggled to break into the policy conversation. Since the late 1980s, researchers at the Santa Fe Institute have worked to bring the idea of complexity back into economics by making use of advanced computing power to map human economic behavior in the same way weather or climate change is tracked. It may sound like science fiction, but it’s the kind of work that might have helped recognize the full magnitude of risk-taking under way during catastrophic housing bubble. Down the road, it could help the Fed recognize “systemic risks” building up in far-flung corners of the financial system.