Aditya Chakrabortty writes:

Economists didn't just fail to spot the financial crisis ' they helped create it. They provided the intellectual framework and drew up the policies that helped caused the boom ' and the bust.

He gives the example of how (some) academics made the case for big bosses' pay.

What he's getting at here is the concept of performativity. Academic economics does not merely describe the world, but also helps create it. Markets in options, and index tracker funds, for example, are academic creations; see the work of Donald Mackenzie, such as his book, An Engine Not A Camera.

However, economics is not always performative.

Let's take Aditya's example - that economists have described 'how markets work best when they are left alone.'

There is a large, old and powerful body of theory which shows that, under some (restrictive) conditions, this is true. Back in the 1950s, Gerald Debreu (pdf) and Kenneth Arrow showed that a set of complete state-contingent markets can be Pareto optimal. The converse is also true. As Greenwald and Stiglitz showed (pdf), an economy with incomplete markets will be sub-optimal.

If economics were always per formative, you would therefore expect there to be at least widespread markets in major contingencies.

And there are not. There's a market for my labour (I hope), but not a market for my labour, contingent upon there being a great depression. Although I can insure my house losing value because of fire, I cannot insure against it losing value because of a fall in demand for houses in Rutland. I can insure against inflation, thanks to index-linked gilts, but not against recession or inequality. As Robert Shiller pointed out in his wonderful books, Macro Markets and The New Financial Order, markets for coping with major economic risks are lamentably under-developed.

This poses the question. How come economics is performative in some regards (option pricing, bosses' pay) but not in others, such as contingent markets?

It's certainly not because Arrow-Debreu theory is new or marginal. It is much older, and far more widely taught in universities than the work of Jensen and Murphy cited by Aditya.

Nor is it because state-contingent markets would be an obviously bad idea. Yes, we know from the theory of the second best that it is not necessarily efficient to remove a single market distortion, so it's theoretically possible that the introduction of a few such markets would be sub-optimal. But whether this would be the case in practice takes some proving. And anyway, plenty worse ideas than these have been turned into economic reality.

There is, of course, a simple answer to this question. Economics is performative when it serves private interests, but not (necessarily) when it serves public ones. Traders immediately saw the usefulness of the Black-Scholes option pricing formula, and bosses quickly saw the use of Jensen and Murphy's work. But the benefits of better state-contingent markets accrue to millions and cannot so easily be captured privately. They are an example of a Nordhausian innovation - one with high social benefits and low private benefits and which do not therefore exist. Paradoxically, markets are incomplete because of a market failure - that there's a positive externality to creating complete markets.

I could, of course, put this more crudely. Economics is performative when it serves the interest of the powerful, and not performative when it doesn't. In this sense, the problem is not with economics, but with a class structure that causes the 'real world' to be a corrupted and perverted form of a market economy.