According to billionaire George Soros, co-founder of the Institute for New Economic Thinking, proving the bankruptcy of traditional economic theory is “mission accomplished” and it is now time to determine the foundations of a new economic model.
Soros is, without a doubt, a powerful and influential voice: he is articulate, savvy in his understanding of trends, and able to push through ideas with energy and funding. His ideas are worth heeding – even when they are wrong - because they provide new insights. But his claim that the bankruptcy of economic theory is “well-established” has to be taken with a grain of salt simply because it represents a narrow, stylised, strawman view of what economics is and how it relates to the nature of human behaviour.
However, Soros’s attack does reveal the problems with our understanding and application of economic thinking. First, there is a tendency to believe that economics is a homogeneous field in which “free market” “rational expectations” thinking is pervasive. This is not the case at all.
The field of economics is strewn with theories, many of which are not based on rationality assumptions or completeness in markets. There are economic theories of incomplete information, biased decision-making, contracting and so on, all of which work to expose the importance of fundamental assumptions to the outcomes seen in markets. Indeed, many Nobel-Prize winners – such as Michael Spence, Ronald Coase, Daniel Kahneman and Herbert Simon, to name a few – made their claims to fame by questioning the fundamentals of standard economic modeling and building new theoretical ideas.
Second, there is a tendency to think that economics is monolithic: if individuals working in the “real” world do not set things straight, we as academics will just continue to ignore the failure of our theories to work. However, this too is not correct. There is no doubt that self-correction in science is slow. But it is slow on purpose, particularly in the social sciences.
Building theories
The idea is not to come up with grand theories comparable to Newtonian Physics, like Soros says, but to work more like builders of a complex of buildings. Some academics are like experts working on one building, for example labour economists or those concerned with international trade. Others work as specialists in techniques and therefore across projects. Econometricians who do technical modeling are akin to bricklayers or masons who work across different buildings.
In doing this we create not a single theory of everything but a collection of theories that are far more eclectic than in the physical sciences. Overtime some buildings become disused and fall down (Marxian economics) while others continue to be used (Keynesian economics) and others might be neglected for a period but get renovated and resurrected (Austrian economic models of entrepreneurship).
Third, Soros is confusing the creation of economic models by economists with the application of those models by practitioners. What he really should be saying is that we need to educate people about the limits of the models they use to justify decisions. I would never claim to have the business acumen of Soros, but what has always amazed me when dealing with corporate leaders and individuals who believe they understand economics and markets is how little they do understand them.
Knowledge base
In this case, what is at issue is not that individuals use what little knowledge they have but that they believe they know more than they do. Indeed, as strange as it may seem, there are behavioural economic models of overconfidence that have shown that the most biased individuals are those who are the most overconfident based on limited information. Ironically, there are economic models that highlight exactly the problem that Soros argues is the fundamental problem with economics.
Finally, in all science it is easier to tear down an edifice than it is to know what to replace it with. I am an editor of a top business journal, I have been an editor of many publications, and I sit on over a dozen editorial boards. A sure fire way to get your work rejected is to: a) set up a strawman and then set it on fire, b) tear down a theory but have no replacement readily at hand, and c) argue based on anecdotes without substantive and replicable evidence.
If Soros’s initiative is to be successful, then it must avoid a) and b) while working to achieve c). In all areas of science, even the social sciences, contestation of ideas is the lifeblood of advancement. But ultimately what matters is whether or not what replaces old thinking is functionally and empirically better than what exists. According to Richard Feynman, Nobel Prize-winning physicist: “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with experiment, it’s wrong.”