Thursday, 29 March 2012

Economists and the Crisis: a story of denial and opportunism

It is now generally understood that our present economic crisis was not caused by external factors but by dynamics internal to the system. Economists as a profession - in academia, government, international institutions, and the financial industry - failed to grasp the fundamental instability of the system they are all, in one way or another, paid as experts to understand and help us master. Furthermore they have largely failed to predict each iteration of the crisis as it has mutated from investment bank liquidity crunch to general financial sector insolvency, to a credit crisis on main street, to an economic recession on everyone’s street, to a threat to government solvency and the international political crisis in the Eurozone. This is not only because prediction is very difficult in social sciences, but because the situation in the real economy has fallen outside orthodox (neo-classical) economics’ standard models and theories (which excluded such extraneous elements as the banking system). Their theoretical expertise has been painfully irrelevant throughout the crisis, and we have been saved from a second Great Depression rather by the informal arts of political economy than by economic theory per se. 

It is not only the economy, but also the study of the economy which is in crisis. How have economists responded? A mixture of denial and opportunism.

Denialism

Eugene Fama, the guru of the Efficient Market 'Hypothesis', and a number of other neoclassical economists have responded to the economic crisis by resolutely denying that it has anything to do with economics. See for example the astonishing Panglossian metaphysics espoused by Fama in this recent New Yorker interview. But this response has internal contradictions.

First these neoclassical economists generally accept that economics has ...ahem... not completely understood the working of the economy. (Fama: "We don’t know what causes recessions..... Economics is not very good at explaining swings in economic activity.") This is because the economy is very complicated and economics is very humble. They are good and responsible scientists, they claim, and always acknowledge the limitations of economic theory, with its deliberately ideal assumptions, in the attempt to abstract out and analyse the most important economic relationships. The message here is that economists are not actually experts about the economy, but rather experts about 'economics', and never claimed the former. This makes them sound more like mathematical philosophers than social scientists, and naturally leads to the question, why the hell are we paying these people?

This is where the contradictions start, since economists naturally enough want to justify their existence (and retain their institutional positions and status). After appearing in the first response to retreat to a citadel of pure theory impenetrable to empirical falsification, the economist – sometimes in his very next breath – performs a rhetorical pirouette and now asserts the value of economic theory for the real world. (Although it may seem to the reader that this is an absurd caricature, I assure you this account is all too familiar to those who have struggled to get a clear and consistent answer to criticism from a neoclassical economist!) For example they will say that macro-theory allowed the 'Great Moderation', of sustained growth and low interest rates and stability of the 2 decades in the West leading up to the crisis; EMH based models that assumed prices moved in a random walk were central to the profitable innovation and expansion of financial markets leading up to the crisis; and so on. This is a transparent effort to deal with criticism by changing the subject, even though in this case it doesn't change it enough to help them.

The next phase is casual empiricism. Most orthodox economists assert that the crisis was caused by external factors, generally "the government". In a sense it is true that it was caused by factors outside their mathematical models, but that is more a reflection of the arbitrary narrowness of the models than the unpredictable or non-economic nature of the causes. In any case, since so much of the real world economy was left outside those models, orthodox economists have struggled to give non-anecdotal explanations of the crisis. One factor particularly singled out (though not by all) is that the US had passed laws encouraging companies to provide mortgages to ethnic minorities who lacked standard credit histories. (See Kessler in the Real World Economics Review). Supposedly such government interventions forced companies to behave irrationally and caused the sub-prime loan implosion.

This kind of thing is bad science because it consists of a search for evidence to confirm (not test) an existing belief: that the macroeconomy - like markets in general - is efficient and self-correcting unless someone (government) interferes. In that particular example it doesn't work at all because the numbers don’t remotely add up: the delinquency of a few tens of thousands of 'ethnic' loans could not have caused the subprime loan crisis, and didn't even correlate with its occurrence. But even considered at a more general level, whatever the particular government intervention named, one can ask, Why would banks behave irrationally just because of the government? Or rather, given that there always is a government - and it is never included in your models - when in this understanding of the economy could actors ever behave rationally? Basically what this defence comes down to is that when the economy works, that's because of how brilliant economists are; when it breaks, someone else did it.

Finally the denouement. Economics is claimed to be a real science and this is how science progresses. First you make a model. Then you see how it matches up with the real world. Then you go back and put an error factor into the model so it fits. Hey presto, your theory is now a better fit with the world. For example option pricing models seemed successful, then crashed in 1987, and have since been reborn with more caveats: a success for neoclassical economic science.

But this is a parody of science. Science seeks to understand the world as it really is. That means that when scientists realized that the sun didn’t really go around the earth, they changed their whole theory (eventually). On the economist’s view, it would have been fine to stick with the Ptolomeic model of the universe and just add error factors all over the place to account for the discrepancy between where the model said heavenly objects should be, and where our telescopes say they really are. This is perfectly possible to do - let us call this Ptolomeic Economics - but real scientists wouldn’t do it if they had better options available.

And this seems to be the real problem: orthodox economics doesn't have any better options to give us. You can tell when a scientific research programme is not only stagnating but actually rotting from the inside out when the quality of the excuses for empirical failure become this weak.

As one of my personal heroes, the eminent historian and philosopher of economics Mark Blaug, once put it:
Modern economics is sick. Economics has increasingly become an intellectual game played for its own sake and not for its practical consequences for understanding the economic world. Economists have converted the subject into a sort of social mathematics in which analytical rigour is everything and practical relevance is nothing. To pick up a copy of The American Economic Review or The Economic Journal these days is to wonder whether one has landed on a strange planet in which tedium is the deliberate objective of professional publication. Economics was once condemned as “the dismal science” but the dismal science of yesterday was a lot less dismal than the soporific scholasticism of today.
It's not only philosophers who say this. A large-scale survey of US economics graduate students more than 20 years ago found that while 57% considered mathematical proficiency "very important" to successful careers as economists, only 3% thought knowledge of the economy was "very important" and 68% thought it was "unimportant"*.  Even the superstars of the profession, its Nobel Prize winners, have been criticising its real-world relevance for decades. For example:
Existing economics is a theoretical system which floats in the air and which bears little relation to what actually happens in the real world. (Ronald Coase 1997)
Economics has increasingly become an arcane branch of mathematics rather than dealing with real economic problems (Milton Friedman 1999)
As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. (Krugman 2009)


Opportunism

One of the ironies of the crisis in orthodox economics is that economics itself is perceived as more important and more interesting than it has been for decades. Numbers are up: more undergraduates, more research funding, more jobs, more attention from media and governments. Unsurprisingly therefore, the crisis in economics has also been characterized by a number of efforts at opportunism – at presenting other theoretical options that are claimed to be better than the orthodoxy – by economic schools both in and out of the mainstream. Many of the papers, books, op-eds, etc. being written about the crisis by practising economists are best understood not only as strategies to distance themselves from the failures of economics present, but also as part of an ongoing struggle to redefine the future of economics, one way or another. 

Heterodox economists, like the Marxists, took early advantage of the economics crisis to bask in the unusual level of attention for radical alternatives, particularly from the public (Das Kapital shot up the bestseller lists). The Austrians have enjoyed more sustained success in promoting their species of right-wing common-sense moralism in op-eds and the speeches of populist politicians. Some heterodox economists even managed to gain the attention of the powers that be, most notably the reasonably sensible Keynesian school(s) that had carried the torch of Keynes' macro-economic theory through its long night since the 1970s (when stagflation ruined their own reputation for expertise). Given the abject failure of the contemporary macro-economic theory available to policy makers to base their decisions on, the old-fashioned Keynesians were well-placed to be listened to in high places and even to make new converts (for example Richard Posner's road to Damascus conversion moment). However, none of these schools have any real chance of redefining the discipline of economics since they will never acquire the necessary  academic dominance. Despite the efforts of Paul Krugman, they have almost no power base in the important universities and mainstream economists sniff at their shaky theoretical foundations and grasp of mathematical tecnhique. Also decades of exclusion from the mainstream have eroded their academic quality and self-confidence [previously].

But there has also been a struggle for power within mainstream economics, between the younger alternatives to orthodox neo-classical economics, such as game theory, behavioural economics, experimental economics, evolutionary economics, neuroeconomics, and complexity economics. They have scented the vulnerability of the orthodoxy in its combination of ridiculous complacency and theoretical incoherence in the face of the crisis. These schools had been preparing for the end of the neo-classical hegemony for some time - carefully laying the foundations for their future rise by building up their academic power base: their own department chairs, research rankings, graduate schools, associations, conferences, research budgets, journals, media profiles, etc. The feeling now is that this crisis has brought the gentle decline of orthodoxy to a head: the stench of decay is obvious to all in the economics profession, and even to governments and the wider public.

The future of economics is wide open and the sense of excitement in the profession is obvious. The battle is already underway but the outcome is still unclear. To me the more important questions include:-
  • Who will be the winners and losers? What will happen to neo-classical economics, the old orthodoxy?
  • Will we enter an extended period of pluralism in academic economics or see a rapid return to the 'equilibrium state' of a single orthodoxy, perhaps a synthesis of existing mainstream schools? 
  • Will the rift between macro and micro economics become re-entrenched, like the rift between quantum and relativity level theory in physics?
  • Will the relationship between media, government, and academic economics change? For example, will financial economics come to seem less important to the public's perception of economics?
What do you think the future of economics will look like? Share your ideas with the rest of us in the comments section.


*Arjo Klamer and David C. Colander, The making of an economist (Westview Press, 1990). 

10 comments:

  1. I had the impression that the prediction by Austrian economics, that bubbles and busts must necessarily occur in an economy into which capital is continually being injected, fits nicely with the phenomena observed. I know most main stream economists don't agree with this view, but I think it makes a lot more sense than the "it just happens"-approach to crises.

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    1. Austrians take money seriously (it's not -neutral), and I like that. But I don't see them taking over the commanding heights of economic theory anytime soon, partly because they are seen as dogmatic and unrealistic about the role of government.

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  2. I took a few introductory econ classes in college and read a smattering around the field.
    It sounds like you're saying that economists are divorcing themselves from the real world, so that their mathematical models don't really represent anything or enough.
    The issue revolves around quantities versus qualities- numbers on their own measure nothing. They only make sense by meaning something- and that seems at least one part of the problem of modern economics- you speak of an emphasis on ecology, that is, attentiveness to what the math is speaking of.Is that part of your point?
    Thans

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    1. Yes, I think orthodox economics has systematically neglected interaction effects between real world mechanisms - the core of serious social science - in favour of the identification of abstract logical relationships amenable to mathematical representation. This relates I think to economics' self-identification with mathematical physics, rather than with say ecology, or perhaps medicine, which would seem a much more appropriate (and humbler) perspectives from which to consider an economy. What we want from economists is not answers to esoteric questions about the ideal of efficiency, but an actionable understanding of how economic order arises, works, and can be sustained. (Alan Kirman is particularly good on this.)

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  3. Despite occasional imprecise and sloppy language, the common argument is not that government mandates caused irrational behavior, but that rational responses to perverse incentives created negative externalities. And people recognize that this was true throughout the financial sector - it applied, for example, to the underpricing (relative to balance sheet risk) of credit to TBTF banks, since creditors expected (rightly, for the most part) that the government would make them whole if the bank couldn't.
    And speaking of casual empiricism, is government housing policy really the single most commonly named factor? My guess would be that low interest rates (due to Fed policy or excess savings from China and the rest of the world), TBTF, financial complexity, and credit ratings are named about as often. And even if it is the most commonly named factor, I don't see how it's "bad science" to cite it as a likely contributing factor as long as one's claim is appropriately qualified, and one recognizes that there were lots of other contributing factors.
    I'm a huge fan of your blog, and you make some sound points in this post, but (imo) you're cherry-picking some weak arguments.

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  4. Just one other point while I'm at it: the EMH, to the degree it applies (and most financial economists accept the idea that markets may be *relatively* more or less efficient based on the speed with which new (public) information is incorporated into prices - it's hard to know what "fundamental" efficiency could even mean), has force in liquid secondary markets. This does not describe the markets at the center of the crisis (mortgages and mortgage-backed securities). There's no reason to think the EMH would have had force in these markets.

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    1. Great points, Anon! I've revised the post to try to take the sting out of them, but may have to revise further as I think more on what you said.

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  5. Good to hear that economists want change. For too long many of them have sought the safety of reading, publishing, and meeting on noncontroversial topics with the 49 other economists in the world of the same micro-specialty.

    I'm not sure a great new economic idea would be noticed or accepted now, regardless of what young economists do. Most educated people still confuse moral nostrums (debt is bad, savings is good) with macroeconomics. Even most economists I know sneer at, and are completely ignorant of, macroeconomics.

    To change the environment, I suggest economists make the following reforms:
    1) PhD comps require a fluency in macroeconomic understanding, and not just micro and math.
    2) Chase the "economists for rent" out of universities. If they want to sell their credentials to lobbyists, then let them do it in a consulting firm and not in a school where they have to contort their curriculum to agree with paid propaganda.
    3) Write survey textbooks that teach understanding of a few essential macroeconomic ideas (money, investment, lending, business cycles) rather than a laundry list of theories, graphs, and algebra that very few novices would understand or remember. And please, teach MBA's something accurate about money and banking.

    Maybe even economists (including in Europe) will learn something from Spain's coming collapse and stop blaming everything on excessive government spending and loose central banks.

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    1. I think much of what you say would be covered by a professional code of ethics for economists. Only a minor part of that would address the headline 'conflicts of interest' so well portrayed in Inside Job . The greatest ethical problems are hubristic. Economists claim deep and actionable knowledge about a significant public domain. But they often do not know whereof they speak (no interest in/training in understanding the real economy). And they do not make clear to the public or policymakers the uncertainties involved in both their theoretical knowledge and how it may be applied. (George DeMartino has an excellent book on this, The Economist's Oath

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  6. The only professional authority that economists (macro-economists) can legitimately claim is to understand the meaning and quality of national and international economics data. Few, however, are genuinely able to do that!
    Above all, calling oneself ane economist ought to mean knowing intimately about economic data accounting, what is primary data and what is derived from national income accounting standards i.e. as an accounting system.
    Economics philosophers can recompose definitions and useful phrase-making but not if out of context or disconnected to actual data, and then only if comprehensively organised.
    This is what we shoud mean by empiricism.
    Unfortunately, teaching economics first and foremost as an accounting system is not how it is taught except in the three deacdes after WW2, not how it any longer analysed by models so-called, or speculated about as political philosophy, or dogmatically expressed by politicians etc. Hence, academic economists and their students today mainly indulge in a huge variety of algorithmic equations and narrowly defined correlations that is no better than games-playing with a few jigsaw pieces, with bits of headline data out of context, outside of relationships that only work imbedded in a complete double-entry book-keeping system that constrains extreme assumptions.
    But, who is to say that if economics was better practised with more completness and integrity this would have changed the extreme 'animal-spirits' of recent decades.
    Moreover, had OECD countries not over-indulged speculative risk-taking in rich trade deficit countries the rest of the world (developing, emerging, who rely on export surpluses) would not have gained an impressively prolonged boost to income, investment and more sustainable wealth creation?

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