Today’s established economics – the economics dominant in classrooms, boardrooms, banks and governments – misconceives the keys to prosperity. That has consequences for how we understand history, how we make policy and how society views business and economic life. Its explanations fail and mislead at important junctures in modern history.
At the end of the previous decade, an enormous bubble in housing prices finally broke, leading to massive defaults on mortgages andinsolvency of banks in the U.S. and U.K. But, even if we tweak them to make room for "poorly designed incentives" or "securities fraud," the established models of asset prices and investment decisions can explain neither the towering rise nor the shuddering fall in the price of houses. In those models there are no expectations that could spark a 60 per cent rise in housing prices. The explanation of the asset price bubble is lacking in microeconomic foundations.
In recent decades, the idea of rational expectations made most participants believers in the magic of the market: The price is always right. Judgment is not needed. Expertise is no longer required. These notions are based on the premise that market participants possess complete knowledge of how the economy works and use that to form "rational expectations." But this theory is inapplicable to a modern economy, since its innovating makes its future largely unknowable.
Since 2000, the U.S. economy has shown signs of a decline in “dynamism” – its capacity and urge to make indigenous innovations. Neglect of business by banks, neglect of the long term by companies, and a drying up of venture capital all point to such a decline. The established theory cannot address that concern since it fails to incorporate indigenous creativity, exploration of the unknown and discovery.
By the 1980s, it became obvious that continental western Europe lacked the dynamism it had displayed in the 1800s. The continent’s postwar “miracle” was mostly catch-up, not dynamism. In contrast, the U.S. retained its dynamism, as innovation surged in the 1920s and 1930s, 1960s and 1990s. Adherents of the established theory say that the rise of the welfare state reduced after-tax wages, cutting the supply of labor. But this story is defective. When take-home pay moved to a lower growth path, reducing the incentive to work, private wealth gradually sank to a lower path, increasing the incentive to work.
In the early 1800s, the U.S. economy of Alexander Hamilton enjoyed a phenomenal “take-off” – without railroads or steam power to speak of. In Europe, one country after another sooner or later experienced the same. The established body of economic theory offers no explanation of why this explosion occurred then or at all. The theory makes no room for any creative internal forces that may have powered it.
Until economics is grounded on the basic character of modern economies – the ignorance, the uncertainty, and the new ideas for speculation and innovation – it limits and distorts our view.
In response, the Center on Capitalism and Society is endeavoring to build a modern economics of the workings of modern economies – how they get their dynamism, how they promote economic inclusion and how the imperfect knowledge on which they operate opens them to healthy booms yet also to unhealthy booms and ensuing slumps. (See our Mission statement.) On these questions, work at the Center has already produced insights over this decade.
In its early years, following America's brilliant innovation and joyous boom of the late 1990s, the Center saw modern capitalism to be the exemplar of economic dynamism. The recent crisis may not alter that judgment yet it has cast light on ways in which the financial sector may have diminished the economy’s dynamism and exacerbated the economy's speculative excesses. The Center has been studying a restructure of the financial sector that would make it less accommodative and less vulnerable to speculative swings and make it once again a key contributor to the dynamism and inclusion of the business sector.