Interview with Economist Edmund Phelps
Kovanda, Lukas, The New Presence: The Prague Journal of Central European Affairs
You have stated that the theoretical models economists employ are partially responsible for the current crisis. How so?
What I meant is that people who applied models to finance did not take into account speculation and therefore unstoppable and unrealistic price increases. Price increases will, sooner or later, crash unless some divine force intervenes and changes everything. Additionally, such models strengthened the idea that any price generated by the market is the correct price. However, this belief is obviously false.
Prices which establish themselves on the market depend on expectations over how the price will change in the next two to three months. If those expectations are proven false, it means that the market prices were false. The property prices were strange; they did not have any backing. If they were supported by models, then those models were just as false as the economic models used by banking professionals.
Do you think we need a radical change in economic model making? has the economic crisis confirmed your reservations toward the rational expectation theory? (the rational expectation theory provides economists with a model which is supposed to determine future human expectations of economic variables).
Yes, I think that the current crisis underlines the impracticality of rational expectation in an economy whose future is unknown. We need models which take into account future uncertainty and the potentiality of unfulfilled expectations.
You have also said that neo-classical textbook economics does not take into account the authentic nature of man. Do you think that a certain paradigm shift will occur after the crisis which will change this?
The problem is not that we do not recognize the authentic nature of man. Rather, those models do not recognize authentic situations which involve people. I believe that most people understand very well that the future cannot be predicted. Nevertheless, they want to and must react; they think in a certain way and form their own expectations. The economists who use rational expectation models do not understand--and this is the trouble--that a good model must also include the option that future expectations might not coincide with reality, that such expectations may be false.
In 1990 you helped create proposals for reforming the collapsing soviet economy. the proposals were created within the scope of a mission under the European Bank for reconstruction and Development. what was your opinion of the economic reform going on in central and eastern Europe? At that time, did you support Joseph Stiglitz's gradual approach or Jeffrey Sachs' shock therapy?
I knew some of Jeffrey Sachs' recommendations, but I was not familiar with the proposals of Stiglitz. Sachs supported opening Eastern European economies to Western goods in order to connect the post-Soviet states' capital and credit markets with those of the West. I was sure that that alone would not be enough. I knew that it would be necessary to establish sound financial structures and promote high quality corporate governance alongside a sound economic policy.
I do not think that I am a gradualist. I simply felt that it would be necessary to build institutional infrastructure in its entirety, that this would be crucial for achieving good results. Perhaps I underestimated how long it would take for the construction to end and for the institutions to function as intended without being abused or circumvented. I undoubtedly underestimated many things, but as I said, I placed particular emphasis on building institutions. Until the new system was entirely completed, I did not say a single word in favor of socialism.
When you look back, how do you evaluate the reform in Central and Eastern Europe and especially in the Czech Republic?
I believe that the Czech Republic was one of the problem states, especially because privatization was not designed well. …