Not Just a Failure of Economists

I agree with everything Peter Dorman has to say in this post at EconoSpeak. A couple key points:

First, economic theory, taken as a whole, is culpable. The core problem is that each theoretical departure, whether it is a knotty agency problem or a behavioral kink, is inserted into an otherwise pristine general equilibrium framework. The only way you can get an article published in a mainstream economics journal (and therefore reproduce the conditions of your existence as an academic economist) is to present your departure piecemeal, showing that it exerts its effects even in an otherwise pristine universe. According to the standards that rule the profession, a GE model with one twist is theory’s version of the controlled experiment.

And

Second, the shift toward empiricism is not an unalloyed gain. Yes, much of this work is refreshingly open-minded, allowing the data to lead. An honest tally of the published literature, however, particularly in the top journals, will show that a majority of quantitative articles are concerned to calibrate existing theoretical models.

In summary

…economics in both its theoretical and empirical modes is implicated in the current debacle. Making the funding of economists more transparent would help, and attention should be given to the institutional structures that favor conformism within the profession, but economics itself needs to be reformed.

Bingo. And this is why a provost or dean who simply quotes top-twenty journal publishings as a criteria for “serious” research is not taking his/her own job seriously.

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“Irrational everything”

Via Mark Thoma, this interview with behavioural economist Daniel Kahneman talks, among other things, about the failure of models:

“In the last half year, the models simply didn’t work. So the question arises: Why do people use models? I liken what is happening now to a system that forecasts the weather, and does so very well. People know when to take an umbrella when they leave the house, or when it will snow. Except what? The system can’t predict hurricanes. Do we use the system anyway, or throw it out? It turns out they’ll use it.”

On prediction:

“The problem is there were other economists who predicted this crisis, like Nouriel Roubini, but he also predicted some crises that never came to be.”

“Ten out of three is a pretty good record, relatively. But I conclude from the fact that only five people predicted the current crisis that it was impossible to predict it. In hindsight, it all seems obvious: Everyone seemed to be blind, only these five appeared to be smart. But there were a lot of smart people who looked at the situation and knew all the facts, and they did not predict the crisis.”

When asked why people didn’t simply use the right economic models, Kahneman, drawing on an earlier metaphor, said,

“Look, it’s possible that there simply is no map of the Alps, that there is nothing that can predict hurricanes.”

That’s not an admission you hear every day.

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Soros against Equilibrium

This headline is striking for its elegance: “Revise regulation, the theory of market equilibrium is wrong”. Obviously this speaks directly to a major criticism of neoclassical theory by heterodox economists. An article in the Real World Economics Review (formerly PAER) identifies methodological equilibration as one of three axioms intrinsic in neoclassical theory. Soros’ criticism strikes a chord with me.
Now, like any eager economics student, I was first entranced by equilibrium in micro when we drew our supply and demand curves and saw where they crossed- the equilibrium point. I’m naturally attracted to lines that cross at a point. Even better when intermediate macro taught me that in the AS-AD model, the point of intersection was self-reinforcing. Move away from it, and you just go right back; it’s so elegant proving it to yourself.

But, things like the financial crisis throw the notion of equlibrium off kilter:

We are in the midst of the worst financial crisis since the 1930s. The salient feature of the crisis is that it was not caused by some external shock like OPEC raising the price of oil. It was generated by the financial system itself. This fact – a defect inherent in the system – contradicts the generally accepted theory that financial markets tend toward equilibrium and deviations from the equilibrium occur either in a random manner or are caused by some sudden external event to which markets have difficulty in adjusting. The current approach to market regulation has been based on this theory, but the severity and amplitude of the crisis proves convincingly that there is something fundamentally wrong with it.

Even better, Soros explains that when you go away formt he intersection, neat little arrows don’t lead you back:

I have developed an alternative theory which holds that financial markets do not reflect the underlying conditions accurately. They provide a picture that is always biased or distorted in some way or another. More importantly, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect.

I call this two-way circular connection between market prices and the underlying reality “reflexivity.” I contend that financial markets are always reflexive and on occasion they can veer quite far away from the so-called equilibrium. In other words, financial markets are prone to producing bubbles.

What then to do about it? Regulate. This is not the heterodox solution, but no one expects Soros  to call for the nationalization of the financial system, although he oes acknowledge that regulation within the current system is limited by lack of information, another good assumption to start with. It’s encouraging to see another prominent voice approach the financial system with correct premises.

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