Anti-Keynesians win the Nobel prize

Allister Heath
THERE are two kinds of non-Keynesian economists these days. The first category includes those such as Thomas J Sargent, a member of the new classical school of economics, who yesterday was awarded the Nobel Prize in economics, jointly with Christopher Sims, a econometrics guru who among other achievements demolished the traditional graphical Keynesian construct taught to all economics, finance and MBA students.

Their mathematical models took the economic profession by storm, with a renewed focus on expectations and the microeconomic foundations of economic fluctuations and growth. I still remember studying Sargent’s textbook – you needed years of advanced mathematics to be able to get to grips with it.

Both economists warned that profligate governments usually cause inflation; when budget deficits are massive, there is no difference between fiscal and monetary policy as governments simply print money to pay for spending. Sargent (together with others) also brilliantly helped to show that policymakers cannot fool everybody all of the time by increasing inflation (and tricking people into thinking that demand has genuinely increased). Those findings have been forgotten by many governments and central bankers.

Nobody listened to Sims when he almost exactly predicted the Eurozone crisis: in 1999, he argued the euro’s fiscal foundations were “precarious” and that a problem in one member state “would likely breed contagion effects in other countries”. A few years later, he warned the ECB would have problems with its balance sheet, another forecast which has come to pass.

Fiscal stimulus advocates keep citing left-wing Nobel laureates such as Paul Krugman or Joseph Stiglitz – but they won’t find much that pleases them in Sargent’s work. He has savaged Barack Obama’s stimulus packages, warned that his social policies would actually increase unemployment and has explained why deposit insurance and other forms of government guarantees made it rational for bank shareholders (and depositors) to condone excessive risk-taking.

Yet while many of Sargent and Sims’ contributions were fascinating, the methods they pioneered took thinking down a dangerous blind alley and towards ever more extreme mathematical approaches to economics. Part of the problem was that it was the wrong kind of maths: the system portrayed was too deterministic and insufficiently chaotic. It was also easy to disastrously misuse their models, which is what many banks and regulators ended up doing during the crisis.

While a lot of the new classical economists’ conclusions were right, and they did actually warn about bubbles, the way they reached them and their methodology and philosophical understanding of the limitations to knowledge were flawed. People aren’t as rational as they assumed. They also wrongly downplayed the role of the money supply in causing cycles.

Hence why I find the second category of non-Keynesian economics more interesting: the latest incarnation of the more traditional classical school, including the better Austrian thinkers, whose conclusions are similar but whose approach is much more realistic. Keynes was wrong, as yesterday’s Nobel prize winners rightly point out, a lesson many need to rediscover. But he wasn’t always wrong for the reasons Sargent and Sims thought.
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