What Kind of Theory to Guide Reform and Restructuring? A focus on theoretical approach

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The economic crisis has exposed shortcomings in standard economic theory and provided an impetus for new economic thinking. But the theoretical debate in the wake of the crisis has been unduly constrained by the terms of the mainstream approach to economic theory. Like any approach, it is characterised by a way of framing reality, giving meaning to terms and setting criteria for good argument. It also determines how any economic theory is understood, whether from the history of economic thought or from the contemporary literature. But there are other approaches to economics which would open up the field to a much wider range of possibilities for new economic thinking. Addressing the challenge that any reader bases her understanding on her own approach, the purpose of this paper is to attempt to explain what it means to consider different approaches. This is done by discussing two features of the financial crisis which pose particular problems for economic theory. These are the role of changing market sentiment in driving asset prices on the one hand and the breakdown of trust relationships in banking on the other (the moral hazard issue). We will see how these are addressed by mainstream theory and by alternative approaches. First, market sentiment is discussed within the mainstream rational-optimising framework, where risk is quantifiable, and compared with the Keynesian approach based on the general uncertainty of knowledge, where reason, evidence and sentiment are integrated. The moral hazard issue is then discussed in its mainstream form in terms of rational opportunism and in its institutionalist form in terms of the foundation of social relations (including relations between institutions) in trust. It is shown that different ways of approaching theorising in each case imply different policy measures. It is argued further that a deductive mathematical approach to analysis of market sentiment and trust is unduly limiting, and that a more pluralist approach would more fully address the issues.

Posted for comments on 13 Jan 2012, 9:35 am.

Comments (2)

  • Stuart Birks says:

    As might be expected from Sheila Dow, this is a useful discussion on the limitations of mainstream economic theory, with valuable alternatives suggested. She stresses the importance of framing and usefully draws on Tony Lawson’s concerns about atomism and closed systems.

    I could not help noting a quote from Keynes that she includes in the paper.

    [I]n ordinary discourse, where we are not blindly manipulating but know all the time what we are doing and what the words mean, we can keep ‘at the back of our heads’ the necessary reserves and qualifications and the adjustments which we shall have to make later on, in a way in which we cannot keep complicated partial differentials ‘at the back’ of several pages of algebra which assume they all vanish. (Keynes 1936, pp 297–8)

    To me, this suggests a way in which her argument could be developed a step further. The key words are “reserves”, “qualifications” and “adjustments”. Framing involves “selection emphasis, exclusion and elaboration” (Weaver, 2007, p. 143). These aspects apply to any analysis, including theoretical perspectives. Hence, as Dow acknowledges, theoretical approaches require abstraction.

    Dow uses two examples to show how mainstream theory falls short due to the exclusion of some key phemonena. She then presents a Keynesian alternative for one example and an institutionalist one for the other, thereby including consideration of these phenomena. This goes part of the way towards addressing the problem, but it should be noted that the alternatives are also abstractions, or frames. It is equally important to note their reserves, qualifications and adjustments, what is emphasised and what excluded.

    This means that, rather than just presenting alternative theories, it should be recognised that theories only take us part of the way towards an understanding of real world events. If all theories have shortcomings, the solution cannot be simply to change theory, or even to adopt a plurality of theories. Instead, the way forward may be to recognise the abstract nature of theories, such that they may, on occasion, serve as analogies (or metaphors) for the real world, but nothing more.

    Any application of theory would then require consideration of its limitations. For mainstream theory, this may involve concerns about atomism and closed models, and also the focus on static analysis and equilibria, along with infinite divisibility required for marginalism and many more limiting requirements. There will also be limitations associated with Dow’s alternatives, and these should be recognised.

    I also have some specific comments:

    In the first paragraph in “The role of market sentiment”, it may be worth mentioning the difficulties of forecasting turning points when discussing transition between euphoria and fear.

    In the third paragraph of that section, in the discussion of uncertainty, there may be some value in considering the distinction between market uncertainty and environmental uncertainty as posited by Meade (1970, p. 3).

    In the last paragraph of that section, it may be worth mentioning the private sector’s switch in favour of debt reduction, which would have slowed the expansionary effects of stimulus packages, resulting in pressure for further stimulus and resulting sovereign debt problems.

    At the bottom of p.9, with reference to lender-of-last-resort, note (emphasis added) “advances should be made on all good banking securities” (Bagehot, 1896, p. 199).

    Bagehot, W. (1896). Lombard Street: a description of the money market. London: Kegan Paul, Trench, Trubner.
    Keynes, J.M., [1936] 1973, The General Theory of Employment, Interest and Money ,
    Collected Writings vol. VII, London: Macmillan, for the Royal Economic Society.
    Meade, J. E. (1970). The theory of indicative planning: lectures given in the University of Manchester. Manchester: Manchester U.P.
    Weaver, D. H. (2007). Thoughts on Agenda Setting, Framing, and Priming. Journal of Communication, 57(1), 142-147.

  • Stephen Pratten says:

    Sheila Dow provides a powerful argument in favour of opening up the discipline of economics. She shows how the dominance of mainstream approaches constrains the development of economics and undermines its ability to offer theoretical insight and policy guidance. Her call is for alternative approaches to be recognised as legitimate forms of enquiry and allowed to inform policy discussions alongside mainstream contributions. Dow’s argument is not developed at a purely methodological level rather she focuses in on the financial crisis as a way of illustrating the core issues. She shows how mainstream contributions approach the analysis of financial markets in a highly constrained fashion so that those aspects of the social world that cannot be modelled in the way viewed as acceptable are effectively filtered out. Dow points out how alternative approaches developed by Post Keynesian and institutionalist authors offer genuine theoretical insight and provide a basis for approaching policy in a quite different and potentially more productive manner. Her contribution is a timely one and useful for all those seeking to move economics in a more relevant direction.

    There are two aspects of Dow’s analysis I would like to draw attention to. The first concerns whether Dow takes the consistency and coherence of alternative approaches too much for granted. Her own strategy is exemplary in that she compares the constraints imposed on the relevance of mainstream approaches to financial markets by the rigid insistence that certain methods be adopted with the explanatory powerful accounts developed by certain alternative approaches. However, many heterodox economists, perhaps because only partially aware of the ontological grounding of their own rejection of mainstream approaches, seem to assume that the implausibility and failure of mainstream economics is just a contingent feature of the dominant set of models currently in place and that the elaboration of a properly specified collection of heterodox models will constitute a sufficient response. This, of course, is where sustained ontological elaboration can provide assistance. Replacing one set of mathematical models with another, even if labelled heterodox, would not constitute progress at all – they would likely be equally limited. By seeking to elaborate on the nature of the material being approached ontological analysis can facilitate more informed judgements about which methods to deploy.

    The second observation concerns Dow’s depiction of a transformed discipline as one in which alternative and mainstream approaches co-exist but where the value and insights/limitations of each are more fairly assessed. What Dow means by mainstream economics or mainstream approaches perhaps requires further clarification in this context. One can certainly imagine circumstances where individuals and groups in a radically and progressively transformed discipline of economics pursue projects that seriously examine what insights into the social realm can be gleaned by experimenting with various forms of mathematical analysis. However, at least some see a constituting feature of the current mainstream in economics as being precisely its insistence upon mathematical modelling as the only legitimate approach. If this is an essential feature of mainstream economics then it is by directly opposing it (rather than by reserving a space for it) that pluralism can most effectively be promoted.

    Stephen Pratten
    King’s College London