It's time for economic theory to evolve

We need an economic theory that is more relevant to a modern capitalist economy, one that embraces uncertainty and disequilibrium.

By Kevin Kaiser, Hedgeye

FORTUNE -- I graduated with a degree in economics from Princeton University; looking back at old textbooks and syllabi, and listening to former professors debate current economic issues, I can't help but feel like I "dropped a hundred and fifty grand on an education [I] could've gotten for a dollar fifty in late charges from the public library," to quote one of my favorite movies, Good Will Hunting.

But it seems that I'm not alone. Last month, seventy freshmen at Harvard walked out of Gregory Mankiw's introductory Economics 10 lecture; they wrote to the well-known economist that his course "espouses a specific – and limited – view of economics that we believe perpetuates problematic and inefficient systems of economic inequality in our society today." And that, "As your class does not include primary sources and rarely features articles from academic journals, we have very little access to alternative approaches to economics."

Post-Keynesian economist Steve Keen wrote that "Economics is too important to leave to the economists." If you've never heard of him it's because he doesn't write for the New York Times or dine in Davos, though in 2010 he did win the Revere Award for Economics for being "the economist who first and most cogently warned the world of the coming Global Financial Crisis."

Keen, author of Debunking Economics, is a harsh critic of mainstream economists. While he warned as early as 2001 that "economic theory has been complicit in encouraging America's investing public to once again delude itself into a crisis," neoclassicists like Alan Greenspan, Ben Bernanke, and Tim Geithner were our economic leaders that empowered the private sector to lever up to an unsustainable level (private sector debt to GDP of 300%) and gave no warning of imminent danger. Even today they fail to apply appropriate policies to lift us out of the recession because they don't understand what caused it.

Like those Harvard freshmen, Keen isn't afraid to say that today's 'Emperors of Economics' aren't wearing any clothes. He's right.

The economists that make the world's crucial monetary policy decisions are the same economists that I listened to in lecture halls and who authored my textbooks. While superficially appealing, their theories lack empirical evidence, are riddled with internal inconsistencies, and are based upon tenuous assumptions. Specifically, their models are built on downward sloping demand curves, upward sloping supply curves, perfect competition, rational consumers, benevolent dictators, and general equilibrium; there is no dynamic analysis, no consideration of disequilibrium, and no role of private sector debt.

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What real-world, market economy adheres to the principles defined by our leading economists?

There isn't one. That's why Milton Friedman argued that a theory cannot be judged by its assumptions, but only by the accuracy of its predictions. But that defense doesn't hold up so well after every neoclassical economist failed to predict the financial crisis and ensuing recession. In fact, in August 2008, Olivier Blanchard, professor at MIT and now chief economist at the IMF plainly stated that, "The state of macro is good." Somehow, even when groupthink's policy resulted in turmoil the world over, economic leaders failed to judge modes of economic thought by the accuracy of their predictions. As a result, the same actors – Geithner, Bernanke et al. – remain in systemically-important roles even after being proved wrong pre- and post-2008.

As Keen puts it, neoclassical economists are "wedded to the belief that capitalism is inherently stable. They cannot bring themselves to consider the alternative perspective that capitalism is inherently unstable, and that the financial sector causes its most severe breakdowns."

Rather than expanding the range of phenomena that economics can explain, the leading edge of neoclassical theory focuses on defending the core beliefs from the attacks of ancillary views. It is truly a degenerative science, if economics can be considered a science at all. True sciences expand and evolve: genetics, psychology, quantum mechanics, astronomy. Economics defends itself – it is an ideology.

On scientific progress, German physicist Max Planck said that, "Science advances one funeral at a time." And Keen concurs: "You cannot persuade people who believe a mythical vision of reality and their whole lives are dedicated to believing that way."

As it pertains to the leadership of our globally-interconnected economy, we're more optimistic. The American people's frustration demands a faster rate of change than "one funeral at a time." Whereas academic economists move at a glacial pace (if they are moving at all), the people are unafraid of change – they will fold a losing hand. Public opinion polls have shown for some time the dissatisfaction of the American people with Bernanke's performance, for instance.

Americans want to stop playing with perennial losers, while potential winners are left on the bench.

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Including concepts from complexity theory, evolutionary economics, Austrian economics, Post-Keynesian economics, and other alternative economic schools – all shunned by today's monetary and fiscal policy leaders – would be a positive change on the margin. What we need is an economic theory that is more relevant to a modern capitalist economy – one that embraces uncertainty and disequilibrium, is grounded upon realistic assumptions, is judged by the accuracy of its predictions, and where debt and money are implicit, important factors.

Like Wall Street 1.0, Economics 1.0 is broken and has to evolve.  Keen aptly states, "If economics is to become less of a religion and more of a science, then the foundations of economics should be torn down and replaced." We are on the way.