John Gray on Keynes

The current London Review of Books has an excellent review of Akerlof and Schiller's groundbreaking work on behavioral econcomics, Animal Spirits: How Human Psychology Drives the Economy and Why it Matters for Global Capitalism, by noted political philosopher John |Gray.

While the review is generally positive, the telling point that Gray makes is that the error addressed by Keynes and the one that drove last year's crisis was not psychological, as Akerlof and Schiller would have it, but epistemological. As Gray puts it:

The central flaw of the economic orthodoxy against which Keynes fought in the 1930s was to imagine that an insoluble problem – human ignorance of the future – had been solved. The error was repeated in the 1990s, when economists came to believe that complex mathematical formulae could tame uncertainty in the murky world of derivatives. Steeped in history as they were, this was a delusion that none of the classical economists entertained. It began to shape economics only towards the end of the 19th century, with the rise of Positivism, according to which the natural sciences are the only legitimate repository of human knowledge. It was the formative influence of this philosophy on the Chicago School that enabled the orthodoxy of the 1930s to re-emerge triumphant, and the result was an immense boost to the prestige of economics as a discipline. Economists could claim to be scientists, who with the aid of their mathematical magic could pierce the veil that conceals the future.

The hegemony of Positivism in economics obscured Keynes’s scepticism about probabilistic knowledge, his most important contribution to the discipline.

This was of course the core of Hayek's work -- his insistence that where individual knowledge fails the collective wisdom of markets will succeed. Yet s Gray notes

Hayek said that governments could never know enough to plan the economy successfully – a claim vindicated by the miserable record of central planning in Communist countries. At the same time, he attributed near omniscience to markets, and never doubted that if left to its own devices the economy would liquidate mistaken investments and return to equilibrium. Against this, Keynes had shown that there is no market mechanism that ensures revival; economic contraction can be self-reinforcing, and only government action can then create a way out.

From this Gray draws the obvious inferences that

Keynes and the classical economists before him knew that there is no realm of market exchange that obeys laws of the kind that can be formulated in the natural sciences. Economics and politics are not separate branches of human activity, and economic life cannot be studied independently of social divisions and political conflicts among populations, along with their cultures and religions. Familiar to Keynes and most of the economists of his generation, these truisms have been forgotten, or rejected, by many economists today. The result is an economic imperialism that tries to explain every human activity in terms of a conception of rational action that does not work even when applied to the behaviour of markets.

Thus while behavioral economics may be a useful expansion of the scope of economic analysis,

[i]t must be doubted, though, that the authors will succeed in persuading economists of the inadequacy of the conception of rational action. The profession is one of the few areas of human activity in which that conception is applicable. In its intra-academic varieties, at any rate, economics is insulated from the world not only by its narrow explanatory methodology but also because it rewards the mathematical modelling that resulted in nearly all of its members failing to anticipate the financial crisis. As institutionalised in universities, the notion of rational decision-making is self-perpetuating. Economics as currently practised may have only a slight grip on market behaviour, but it seems to be powerfully predictive of the behaviour of economists.