The Public Responsibilities of the Economist

The Tanner Lectures on Human Values are given at selected universities around the world. This year's lectures, 'On the Public Responsibilities of the Economist', were given at Brasenose College, Oxford, on May 18-19 by Diane Coyle.1 This is an edited version of the first of those lectures.2

The following words, written in the New York Times by a departing Goldman Sachs executive, confirmed what many people already believed about the financial markets, if not before the crisis that started in 2008, then certainly afterwards.

These days, the most common question I get from junior analysts about derivatives is, 'How much money did we make off the client?' ..... I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It's purely about how we can make the most possible money off of them. It astounds me how little senior management gets a basic truth: If clients don't trust you they will eventually stop doing business with you.3

These markets are widely seen as having become fundamentally anti-social. So too, by extension, all markets, and economists in general as the principal advocates of markets as the organising structure of modern society. While this is an exaggeration of popular views, evidence from opinion surveys suggests there has been a reappraisal of the pro-market philosophy dominant in public policy since the early 1980s. Although majority public opinion continues to support a market-based economy, there is little popular enthusiasm for how actual markets have been behaving.4 Markets have brought inequality, unemployment, and austerity. Dissatisfaction with actually existing capitalism has been strong enough to get a fair number of people out onto the streets to ‘Occupy’ the commanding heights of the global economy in the City and on Wall Street. Liberal intellectual opinion has become shrill in its denunciations of economics. In fact, there is a long tradition of writers seeing economics as conflicting with more important values or cultural traditions.

It is no surprise that the deepest and longest economic downturn since the Great Depression has encouraged a revival of this kind of criticism. If economists are supposed to help prevent or alleviate economic crises, we have obviously not been doing a good job. While plenty of economists insist there is no fundamental problem with the subject, and many more would reject the hyperbolic attacks from novelists and protestors, many other economists are reflecting seriously on the lessons of the crisis for their intellectual framework and for the practical role they play in the world of public policy. Keynes famously said economists should be ‘humble, competent people’ like dentists, fixing things that go wrong and making modest improvements in people’s lives.5 Instead we have turned out to look more like Dr Frankenstein, unleashing an idealistic experiment that has run monstrously amok, causing devastation.

Have economists created a monster?

I am going to start by looking at the case that economists have created a monster, and that economics has shaped the world in its own dysfunctional image. There is some truth in this, in my view, especially when you get beyond the literary exaggerations. My profession does bear some responsibility for what has happened, in a way I will explain below. But I will go on to argue that this is most true of a particular approach to economics, one which has been in retreat for some time and will turn out to have been finally discredited by the great crisis. The economic catastrophe could indeed be the making of a stronger economic science, re-rooted in the natural sciences, as it was at its birth in the Enlightenment.

It should not really be controversial among economists — although it will be — to suggest that economics as an intellectual discipline and professional practice has actually helped shape the economy. Beliefs about the way the economy works and expectations about the future have a central role in every approach to our theorising, or modelling as it is referred to in our own jargon. In particular, the orthodox macroeconomic models — algebraic summaries of the whole economy at an aggregate level — assume that agents (as we call people) have more or less correct beliefs or ‘rational expectations’ about the economy. At one level this is a reasonable assumption that you can’t fool all of the people all of the time: if they are systematically proven wrong, they will change their beliefs. In practice, it becomes a strong assumption about the information and powers of calculation that millions of real people actually have. However, the key point about the assumption that behaviour today depends on more or less correct beliefs about tomorrow is that it opens the door to self-fulfilling outcomes. Whenever expectations matter, ideas have the power to shape reality. Keynes’s insistence on the importance of ‘animal spirits’ for investment and consumer spending is captured and pinned down in these formal rational expectations models, albeit not in a way he would appreciate.6 Even asset price bubbles can be rational in this way: as long as most investors expect the price to continue rising, it will do so.7

Economics owes the terminology of the self-fulfilling outcome to the sociologist Robert K Merton, although there are many earlier examples of the idea.8 One classical self-fulfilling prophecy is found in the Oedipal myth; Laius’ reaction to the prophecy is what brings about the tragedy it foretells. As soon as the formal economic models that were developed from the late 1970s on incorporated a central role for expectations in decisions, almost everything became self-fulfilling — indeed, instantaneously so in economists’ unearthly world of perfect information and no frictions. However, economists have never given much thought to the theoretical possibility this opens up, namely, that the way economics thinks about the economy can become self-fulfilling too, that the principle works outside the models as well as inside them. If mainstream global economics models the economy or the financial markets in a certain way, and that enters the thoughts of public officials or financial market traders and shapes their beliefs and expectations, couldn’t reality change to reflect the model?

This is the strong version of self-fulfilling prophecy, now often described as ‘performativity’. The canonical example is the model for pricing financial options. Robert K Merton’s son, Robert C Merton, was jointly awarded the Nobel Memorial Prize in Economics in 1997 for devising this model (with Myron Scholes - Fisher Black, the other co-author of the original Black-Scholes model, having died earlier). The investment company he co-founded to put it into practice, Long Term Capital Management, went bankrupt with losses of $4.6 billion in 2000, in a kind of practice run for the later financial crisis. It is hard not to see some strange echo of the Oedipal story in this, especially as his father is rumoured to have invested in LTCM.

How did the options pricing model of Merton fils alter financial reality in its own image, ultimately bringing about his catastrophic financial downfall? The sociologist Donald MacKenzie has traced the massive growth of derivatives markets since the 1970s to the availability of a practical model for pricing these financial instruments. Merton’s contribution was to provide a simple version of the pricing formula for options, one that was more intuitive for traders in the markets than competing approaches because it related the option price to the volatility of the price of the underlying asset from which it was derived. What’s more, Fisher Black, a co-inventor of option pricing along with Merton and Myron Scholes, also provided a commercial service to the financial markets in Chicago. His business calculated various options prices using the Black-Scholes-Merton model on computers away from the market and circulated as single sheets of paper that a trader could roll up into a cylinder for ease of reading a specific column. MacKenzie presents evidence that over a few years options prices observed in the US financial markets converged to those predicted by the model, the discrepancies between the model and the reality declining decade by decade as an ever-larger proportion of traders in the market used the same model for pricing their transactions. He also argues that the intellectual status of an economic theory born in the University of Chicago helped encourage the regulatory authorities not to ban options trading as a form of gambling.9 The combination of a trader-friendly model (subsequently greatly extended as the computer revolution made it easier for others to calculate prices according to the model), the successful commercial provision of pricing sheets, and sympathetic regulators brought into being a global derivatives market from almost nothing in 1970 to a notional value of $1,200 trillion by 2010.10

There is clearly more to this story than the intellectual act of creating and publishing an economic model. However, the argument that the Black-Scholes-Merton model played the Dr Frankenstein role in creating modern derivatives markets seems quite strong, although it is only with hindsight that the case for regulatory prohibition in the early years seems so strong.

Important as they are, culpable as they are in causing the crash, financial markets are not the whole of the economy, and the Efficient Markets Hypothesis is not the whole of economics. The computers trading in financial markets are not economists, nor embodiments of economics in any way. Many, probably most, economists would not regard finance theory and the Efficient Markets Hypothesis as the pinnacle of their subject, to say the least. The out-of-control financial markets need to be tackled, but to do so will do no violence to economics.

A number of economists have objected to my suggestion that the excesses of the financial markets have anything to do with economics at all. They note that many economists were in fact warning of unsustainable asset bubbles in the run-up to the Crash (albeit that few specifically predicted a major banking crisis). This is absolutely correct. Political philosophy, the power of financial institutions, their lobbying of government, and sheer greed all bear much greater responsibility than does economics, or even options markets. If politicians and regulators had really been listening to economists, the crisis might have been averted. There is also a strong defence of the potential for financial markets to improve society. A well-ordered financial system helps individuals and businesses manage risk, and channels savings to the most productive investments. Robert Shiller, famous as one of the economists who predicted the crash, has also argued for an for example, to help countries insure each other against the costs of natural disasters.11

But those offering these defences overlook two points. First, other people believe financial markets and economics are the same thing. Secondly, economics did play a fundamental role in giving birth to the modern financial markets. Economists cannot plausibly disinherit the financial monster without a clearer account of the separation.

There are some other examples of economics shaping the world, although I do not think the claim of ‘performativity’ has nearly the same force outside finance. Indeed, there are some areas of economics where we might like it to operate, but it does not. One example is monetary policy, where policymakers would like their models to convince everyone that inflation will stay on target, but unfortunately they have imperfect credibility.

Still, since the governments of Ronald Reagan in the United States and Margaret Thatcher in the United Kingdom, a specific kind of economic approach has become quite widespread in public policy. This approach puts an emphasis on markets as the organising principle for the economy and in particular advocates the merits of free markets’. The role of the state should be confined to specific ‘market failures' or the provision of certain ‘public goods’; textbooks give standard examples such as pollution, congestion, or the state provision of basic education. It is important to appreciate that the ideology of a minimal state and expanded ‘free markets’ only gained such enormous political traction because of the experience by the 1970s of profound ‘government failure’. Like many Britons of my age, I have powerful memories of doing homework by candlelight and walking past rubbish piling up on the streets. The subsequent privatisation of nationalised industries and deregulation of markets delivered better services and greater choice. We were finally allowed to take spending money freely on foreign holidays and could get a telephone line without months of waiting.

The economic theories embraced by the Thatcher and Reagan revolution were not the mainstream approach at the time; but the contemporary rational expectations revolution, at its high tide in the early 1980s, was successfully melded to the then-unfashionable economics of Friedrich von Hayek and economists such as Milton Friedman who admired him. Although academic and professional economists gradually moved away from the abstractions of the rational expectations models, this took many years and has been a particularly slow process in some important respects. This includes macroeconomics, the study of the aggregate economy, which even now remains wedded to simple ‘dynamic stochastic general equilibrium’ models even though the evidence of recent events demonstrates their inadequacy.12

It also, crucially, includes the standard economics applied to questions of public policy. Adair Turner, Chair of the Financial Services Authority, highlighted this in a post-crisis speech:

The neoclassical approach does tend to dictate a particular regulatory philosophy, in which policymakers ideally seek to identify the specific market imperfections preventing the attainment of complete and efficient markets, and in which regulatory intervention should ideally be focussed, not on banning products or dampening down the volatility of markets, but on disclosure and transparency requirements which will ensure that markets are as efficient as possible.
These propositions, and the strongly free market implications drawn from them, have played a somewhat dominant role in academic economics over the last several decades, though with dissenting voices always present. But they have been even more dominant among policymakers in some of the finance ministries, central banks and regulators of the developed world.13

Academic economics has moved on substantially, but under Conservative and Labour governments for more than a quarter of a century, the scope of markets as a means of organising public as well as private economic activity has been extended. The privatisation of formerly nationalised industries is one example. Even though these industries are still regulated by the government, the intellectual framework for this regulation is, as Lord Turner describes, the correction of a well-defined ‘market failure’, a specified reason such as an externality or information asymmetry for a breach in the general principle of the desirability of markets. The boundaries of the economic activities that take place in the public rather than the private sector vary from country to country, suggesting there is room for debate about whether the market can and should organise the supply of water and electricity, or rail and air services, or even health care in part or as a whole — although it should be emphasised that the share of government spending in the economy has been on an upward trend
everywhere over long periods of time, so it is hard to sustain the argument that markets are displacing government extensively.

However, the market mindset has also been applied to the business of government itself, under the rubric of New Public Management. The logic of rational choice was first applied to politics and administration by James Buchanan and Gordon Tullock in their 1962 book, The Calculus of Consent: Logical Foundations of Constitutional Democracy. This first introduction of the idea that incentives determine administrative or policy decisions as well as economic choices in the marketplace paved the way a generation later for the much wider introduction of the calculus of incentives in public life. This approach, like the donning of market failure spectacles to circumscribe the government’s role in economic management, is still very much with us — probably too much so. There has been a backlash against some manifestations of it, including the use of quantitative performance targets that clearly divert the behaviour of public sector workers towards the achievement of their specific targets rather than the fulfilment of their underlying purposes. However, the philosophy of using incentives rather than ethos or values or professionalism to extract a better performance from the public sector is as live as ever in the current political debate. So too is the use of competition (or ‘contestability’) in the delivery of public services.

Unease about the growing scope of markets pre-dates the financial crisis, however, not least because the distorting effects of target-setting indicate that creating incentives for desired behaviours is a subtler and more difficult matter than the architects of public service reform imagined. Michael Sandel has revisited in a new book the subject of his 1998 Tanner Lectures at Brasenose.14 In What Money Can’t Buy: The Moral Limits of Markets, Sandel argues that economics is to blame for the extension of markets and market-like thinking into wholly inappropriate spheres of life. His argument is that markets have led to a degradation of moral and civic goods, because they introduce an inappropriate mode of valuation. Marketisation of areas such as prisons and even war (through the use of commercial security firms) has corrupted the democratic ideal of citizenship.

Post-crisis, the critics of economics have plenty of new ammunition to lob at the subject. However, mainstream economists tend to be dismissive of the critics, either the non-economists or the economists who identify themselves as ‘heterodox’, content with a rapidly-growing body of empirical research suggesting that in many contexts ‘markets’ do lead to more desirable outcomes than direct government management of the economy. However, economists know — as non-economists generally do not — that the character of economics itself has changed substantially during the past 25 years.15 In many areas of economics the free market version that has shaped so much public policy is long, long gone, replaced by a modern mainstream version that combines the classic emphasis on the power of incentives and the inevitability of choice with a more recent evidence driven understanding of human psychology, the effects of technology, the importance of institutions and culture, and the long hand of history. So, for example, economists have been eager adopters of so-called ‘behavioural’ models and findings from cognitive science that demonstrate without any doubt that the standard rationality assumptions of conventional economics are invalid in some circumstances. Similarly, institutional economics incorporates collective decisions as being more than the sum of separate individual decisions. It recognises that people have different interests and that politics — with either a small or a large ‘p’ — will have an important effect on economics.

In other words, much of the economics that academic economists now do bears surprisingly little relation to the everyday economics debated in politics and applied in public policy. Paradoxically, the leading economists practising the eclectic modern mainstream (whether their field is behavioural or institutional economics, or the economics of ‘happiness’, or political economy) are often celebrated by commentators who at the same time are very critical of ‘economics’. By the latter, these critics seem to mean the narrow, abstract version of economics adopted by Mr Reagan and Mrs Thatcher. That has been taken too seriously for too long outside the profession.

Equally, though, economists have kept too quiet about its slow but steady decline within the profession. For example, historian and philosopher Jonathan Rée recently wrote a glowing review of a new book by Paul Seabright, a leading economist at the University of Toulouse. But Rée asserted that Seabright is regarded by other economists as an ‘oddball, even a miscreant’.16 This is so wide of the mark that it is baffling, and I think Rée simply cannot imagine that an economist interested in psychology and anthropology is a reasonably mainstream and highly respected member of the profession. Many of us have long known that economics as it is actually practised has become much subtler than the public version, but few have said so, prolonging the misperception that we are all free market ideologues. I think the explanation might be a kind of professional courtesy to just one branch of economics, albeit an important one. That is macroeconomics, a specialism of relatively few professional economists, but absolutely dominant in the public eye. Normal people think that macroeconomics, forecasting inflation and growth, setting interest rates or the level of government borrowing, is what all economists do. Macroeconomic forecasting is indeed an important function, and is covered by the media constantly, so people must be forgiven for thinking this is the most important part of economics. Unfortunately, macroeconomics is one of the last specialisms within the subject to cling to the narrowness of perspective our critics habitually attribute to us. At least until the crisis, pointing this out from within the profession felt a bit like admitting to the mad wife in the attic, a guilty secret to be kept inside the family. It should be added that macroeconomists by and large disagree with this statement. Many would argue just that their area of the subject needs reform, not revolution.


1. Diane Coyle is Chairman of Enlightenment Economics and Visiting Professor, Institute for Political and Economic Governance, University of Manchester. Diane has also served on the Council of the Royal Economic Society.

2. The full text of the lectures can be read at Details of the Tanner Foundation can be found at

3. Greg Smith, former Executive Director, Goldman Sachs, New York Times 14 March 2012
Accessed 14/3/12

4. ‘Wanted: A Better Capitalism’, YouGov, May 2011. Accessed 16/3/12

5. ‘The Future’, Essays in Persuasion, London: Macmillan, 1931.

6. J M Keynes, The General Theory of Employment, Interest and Money, London: Macmillan, 1936.

7. Santos, Manuel S and Michael Woodford (1997): ‘Rational asset Pricing Bubbles,’ Econometrica, 65(1), 19-57.

8. Robert K Merton, Social Theory and Social Structure, New York: Free Press. 1968

9. Donald MacKenzie ‘Option Theory and The Construction of Derivatives Markets’, Chapter 3 in Do Economists Make Markets?, MacKenzie, Muniesa and Siu (eds). Princeton NJ: Princeton U P, 2007

10. Bank for International Settlements, December 2010

11. Robert Shiller, Irrational Exuberance (2000); The New Financial Order: Risk in the 21st Century (2003), Finance and the Good Society (2012), all Princeton N J: Princeton U P

12. Mainly Macro: ‘Microfoundations and Central Banks’, Simon Wren-Lewis.
Accessed 27/3/12

13. ‘After the Crises: Assessing the Costs and Benefits of Financial Liberalisation’, Speech by Lord Adair Turner, Chairman, UK Financial Services Authority, at the Fourteenth C. D. Deshmukh Memorial Lecture on February 15, 2010, Mumbai. Accessed 30/4/12 The General Theory of Employment. Interest and Money, Chapter 24.

Accessed 17/2/12. What Money Can’t Buy: The Moral Limits to Markets, London: Allen Lane, 2012.

15. See my book The Soulful Science: What Economists Really Do and Why It Matters, Princeton N J: Princeton U P

16. ‘The War of the Sexes – review’ Guardian, April 12 2012, Accessed 4/5/12

From issue no. 158, July 2012, pp.15-19

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