A crisis of economics

One of the primary criticisms of International Monetary Fund (IMF) stabilisation programmes is the imposition of stringent conditionality, often characterised by austerity measures. According to the IMF’s own research, such measures can lead to short-term economic contraction and social unrest. A 2015 paper titled “The Role of Fiscal Policy in the Post-Crisis Economic Recovery” suggests that austerity can deepen recessions, as public spending cuts reduce demand and hinder growth.

The economics profession stands at a pivotal crossroads. Failures during the 2008 financial crisis, the inflation surge of 2022, and the rise of populism have exposed the limitations of conventional economic thinking. Economists have clung to outdated models, often ignoring the complexities of the real world. Prominent voices like Gita Gopinath, Thomas Piketty, Angus Deaton, and Dani Rodrik argue that the discipline must evolve. This discontent, reflected in the rise of populism, is rooted in economic alienation and the failure of traditional economic prescriptions.

The 2008 financial crisis shattered the economic orthodoxy that had dominated for decades. Economists had long championed deregulation, market self-correction, and the belief that markets would stabilise on their own. When the crisis struck, these assumptions proved dangerously naïve. Financial models, rooted in rational behaviour and efficient markets, failed to predict or prevent the collapse.

In the aftermath, economists implemented bank bailouts, stimulus packages, and ultra-low interest rates to stabilise the economy. However, these measures did little to address the deeper structural issues. Thomas Piketty’s Capital in the Twenty-First Century critiqued how mainstream economics ignored wealth inequality, a key factor in financial instability. While his proposals for global wealth taxes are contentious, his broader argument — that the economic system is inherently flawed — remains compelling.

Increasingly rising populism driven by financial crises reflects growing discontent with traditional economic models that fail to capture real-world intricacies

Mr Piketty notes, “The discipline of economics has yet to get over its childish passion for mathematics and for purely theoretical and often highly ideological speculation, at the expense of historical research and collaboration with the other social sciences. Economists are all too often preoccupied with petty mathematical problems of interest to themselves only. This obsession with mathematics is an easy way of acquiring the appearance of scientificity without having to answer the far more complex questions posed by the world we live in.”

The inflation crisis of 2022 further exposed the limitations of traditional economic frameworks. After decades of low inflation, central banks assumed that inflation was under control. However, when the pandemic disrupted global supply chains and geopolitical tensions escalated, inflation surged to levels not seen in decades.

Initially, inflation was dismissed as “transitory,” only for it to persist, forcing central banks into a reactive stance. The models, designed for an era of low inflation, failed to account for global supply shocks. Ms Gopinath, in her role at the IMF, called for central bankers to adopt humility, acknowledging the limits of their models and underscoring the broader need for economic flexibility in an increasingly interconnected and complex global economy.

Angus Deaton’s work further emphasises this need for humility. In his contributions to the IMF, Mr Deaton has highlighted the critical intersection of economic policy and real-world outcomes, particularly in his analyses of poverty and inequality. He argues for policies that are informed by empirical evidence and that address the underlying issues of economic distress rather than relying solely on traditional economic models.

The failures of mainstream economics have also fuelled the rise of populism. Leaders across the world, capitalising on discontent with globalisation and free-market policies, have drawn support from those who feel economically abandoned. Populism, driven by economic frustration, finds fertile ground where neoliberal policies — focused on deregulation, market liberalisation, and free trade — have resulted in stagnant wages, growing inequality, and job displacement. These issues, laid bare during the 2008 crisis and exacerbated by the Covid-19 pandemic, have further deepened divisions.

Economists have long fixated on aggregate growth, often at the expense of wealth distribution. This neglect of inequality has contributed to the alienation of the working class, which in turn fuels populist rhetoric. Dani Rodrik has argued that Western economic models, which prioritise deregulation and market liberalisation, often overlook the importance of state intervention and tailored economic policies.

Mr Rodrik’s critique of Western economic orthodoxy offers a vital perspective. In contrast to the neoliberal consensus, he stresses that economic development is not a one-size-fits-all process. He points to China’s rise as an example of successful state-led development, where the country ignored Western advice and embraced selective global integration, infrastructure investment, and state control over key industries. This challenges the prevailing assumption that liberalisation and free-market policies are the only paths to growth.

Yuen Yuen Ang’s work further supports this notion. In her book, How China Escaped the Poverty Trap, she underscores that successful development is not merely about adopting Western prescriptions but about tailoring policies to local conditions. Ms Ang illustrates how state-driven development can yield more inclusive growth than reliance on markets alone, emphasising the need for context-specific strategies that consider cultural and institutional realities.

One thing is clear: traditional economic models must evolve. Mr Piketty’s focus on wealth inequality and Mr Deaton’s work on poverty suggest that policies must address the political, social, and economic dimensions of economies — issues that mainstream economics has often overlooked.

As Joseph Stiglitz has argued, “The failure to recognise the imperfections of markets has led to unnecessary crises, which could have been avoided had the economic models been more realistic.” This critique of market fundamentalism is particularly relevant today, as economists continue to rely on outdated models that fail to capture the intricacies of the global economy.

The writer is former head of Citigroup’s emerging markets investments and author of ‘The Gathering Storm’

Published in Dawn, The Business and Finance Weekly, November 25th, 2024