Published in Policy Magazine (Sydney), 12 September 2010
Economists need to know history as well as maths, writes Oliver Marc Hartwich
Many groups have had to share the blame for the financial crisis that gripped the world economy in 2007, including commercial banks for unsustainable lending practices; rating agencies for flawed assessments; and central banks for misguided monetary policies.
There is one group, however, whose reputation has perhaps suffered even more than those mentioned above: the economics profession. Few, if any, economists saw the crisis coming. Worse still, before the crisis many economists thought that their tools and methods made such a series of events almost impossible.
Looking back at the state of economics in the pre-crisis years, it is hard not to feel a sense of complacency. The Great Depression had become a distant memory, and the experience gained from handling the comparatively minor economic setbacks—such as the 1987 stock market crash, the 1997 Asian financial crisis, and the end of the dotcom boom—only seemed to demonstrate that economists and policymakers had acquired the necessary knowledge to deal with such challenges in a way that would prevent minor economic setbacks from becoming global catastrophes.
Prime Minister Gordon Brown has rightly received a great deal of ridicule for a promise he had made as Britain’s Chancellor of the Exchequer. At the time, he had predicted an end of boom and bust cycles. Unfortunately for him, the British boom turned to bust almost immediately after Brown became Prime Minister.
It is unfair to blame Brown alone for his unjustified smugness. He could have taken it straight out of the economics textbooks of the time. It is almost embarrassing to read economists’ statements from the pre-crisis years now because, in hindsight, they look dangerously naïve. In January 2003, for example, economist and Nobel laureate Robert E. Lucas delivered the Presidential Address to the American Economic Association and began with this bold statement:
Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.(1)
Although the events of 2007 to 2010 have not been a rerun of the Great Depression, it is equally clear that they are far from the steady-state that Lucas thought had been achieved. If anything was absent during the recent crisis years, it was the kind of stability that macroeconomists thought they had created.
In a sense, it is hardly surprising that economists, or macroeconomists for that matter, had not foreseen the most severe economic crisis for more than 70 years. The elements that triggered the 2008 crisis are virtually absent from macroeconomics. Subprime lending, rating agencies, financial derivates, and the like are not the variables economists use in constructing their modeling exercises.
Laypeople were shocked to discover that many economists were largely ignorant of the developments in financial markets that ultimately caused the greatest economic disruption in decades. To these economists, the crisis was an ‘exogenous shock.’ Translated into ordinary English, this means an event which resulted from forces working outside the world of economists’ models. In other words, neither they nor the governments they advised had anything to do with the crisis. The category ‘exogenous shock’ is usually reserved for events such as floods, earthquakes or political crises. That an intrinsic development in the financial markets could be thought of as ‘exogenous’ must appear ironic to observers of the economics profession.
However, in a sense it is not ironic at all. Economics often takes leave from reality, and some economists have become used to inhabiting a world in which they can play with assumptions, graphs, equations and formulas—but this world does not necessarily have much to do with the real, messy world outside their universities.
The limits of models
To be clear, there is nothing necessarily wrong with economic models or theoretical abstractions. However, it is vital that the economists who apply them are aware that they are dealing with models and that these models have limitations. They must be willing to subject their models to a reality check from time to time. In order to do this, economists need a sound knowledge of the economy. This is where economics has gone wrong.
A few opinion polls among economists are quite revealing in this regard. In a working paper for the Institute for Empirical Research in Economics at the University of Zurich, Bruno S. Frey, Silke Humbert, and Friedrich Schneider presented the results of opinion polls among German, European and American economists.(2) The results should be taken with a pinch of salt because the surveys were not representative and suffered from a high non-response rate. However, they give us an indication of the state of mind of the economics profession.
In the surveys Frey et al. mention, the economists were asked the question ‘What makes a good economist?’. One of the options was ‘Being very knowledgeable about one particular field.’ Ninety-nine percent of German economists, 83% of European economists, and 81% of US economists agreed.
Although this may not sound too surprising at first—after all, specialisation occurs in most professions—it does hint at the degree of specialisation occurring in economics. If the economist’s preferred field of research then happens to be something like abstract general equilibrium theory, you should not expect this economist to have much to say about the state of the US housing market or the political design of the European monetary union.
Of course, economists could choose to specialise in practical subjects closely linked to economic policy. However, other answers in the above-mentioned surveys do not suggest that this is likely. ‘Excellence in mathematics’ was seen as an important requirement to be a good economist by 92% of German economists, 91% of European economists, and 81% of US economists.
Perhaps even more telling was the fact that quite a large minority of economists did not believe that ‘a thorough knowledge of the economy’ was needed at all in order to be a ‘good economist’: 9% of German economists, 24% of US economists, and a staggering 42% of European economists found this unimportant. Compared to other potential qualities, practical knowledge of the economy was seen as one of the least important requirements.
As mentioned before, these results should be treated with a degree of caution. Nevertheless, they suggest that economics has indeed become a technical discipline with a high degree of specialisation and only a moderate ambition to take part in day-to-day discussions of economic policy. Of course, there are economists who do take part in policy debates, but it is safe to say that the great majority of their colleagues do not.
We can only speculate why economists inhabit their own theoretical world with limited links to real life. A few years ago, Philip Mirowski argued that economics bore more than just a superficial resemblance to physics and that it had lifted some of its core elements such as utility and value from nineteenth century physics textbooks.(3) And it tried to emulate the methods of physics for its own enquiries.
Modern economic research makes it hard to disagree with Mirowski. Economic papers now contain few verbal expressions and an increasing amount of dense mathematics (that most real mathematicians would find trivial). Economists are dealing with high abstractions that are based on numerous assumptions and whose relevance and realism appear questionable. Here is a typical abstract from such a paper:(4)
This paper develops and estimates a dynamic stochastic general equilibrium model of a closed economy which approximately accounts for the empirical evidence concerning the monetary transmission mechanism, as summarized by impulse response functions derived from an estimated structural vector autoregressive model, while dominating that structural vector autoregressive model in terms of predictive accuracy. The model features short run nominal price and wage rigidities generated by monopolistic competition and staggered reoptimization in output and labour markets. The resultant inertia in inflation and persistence in output is enhanced with other features such as habit persistence in consumption, adjustment costs in investment, and variable capital utilization. Cyclical components are modeled by linearizing equilibrium conditions around a stationary deterministic steady state equilibrium, while trend components are modeled as random walks while ensuring the existence of a well defined balanced growth path. Parameters and trend components are jointly estimated with a novel Bayesian full information maximum likelihood procedure.
Whatever the intellectual merits of such papers, they have to make a large number of assumptions to design their physics-like models. In the theoretical worlds like the one described above can be found ‘representative infinitely lived households,’ ‘large numbers of perfectly competitive firms,’ and ‘a continuum of intermediate good firms.’ A cursory look outside the economist’s window may have suggested that no such things exist.
Historical knowledge
If economists believe they are engaged in some kind of social physics, then it is only too easy to understand why they are so strangely uninterested in fields that other social scientists regularly deal with. Physicists, for example, do not have to know the biographical details of Albert Einstein to deal with his theory of relativity. Nor do they need to know the historical context in which Isaac Newton developed his concept of gravity.
Economists often pretend that they can afford similar historical ignorance. Today’s economics students may know of Keynes but only few would be able to locate him in time and place. Fewer still would know who Keynes’ great contemporary rival was (Friedrich August von Hayek), and don’t bet on any of these students knowing that Keynes had developed his theory against the backdrop of the Great Depression.
Is this really an appropriate way to learn economics? How much richer would economics be (and how much more interesting) if students were introduced to the history of economics and its leading exponents, because only then would they see how few things in economics today are genuinely new. The current generation of economists were stunned by the global financial crisis the way they were because they were not properly aware that such crises had been happening again and again for centuries. Carmen Reinhardt and Kenneth Rogoff have presented details of past financial crises under the wonderfully ironic title This Time Is Different, and if there is one lesson to be learnt from their examples then it is that (a knowledge of) economic history matters.
One of the fundamental differences between economics and the much admired science of physics is that history matters in economics but not in physics. In the same way, eternal constants and equilibria may exist in physics but not in economics. The extent of their shocked reaction to the global financial crisis may have also been because they had mistakenly believed that an economy was manageable and plannable just like a physics experiment. This was why Lucas believed that macroeconomics had solved its central problem. Once the last equations were written and the final calculations were made, he had basically written a quod erat demonstrandum (that which was to be demonstrated) under his model and declared victory. This may be how to conduct experiments in the natural sciences, but such a method is simply inappropriate in the social sciences. People are not atoms, groups are not molecules, and societies are not biological organisms. Such analogies with physics, chemistry and biology are of limited use in economics and should be questioned.
There may be a reason why economists are hesitant to admit that they are a true part of the social sciences. Currently, economists enjoy a reputation as the most rigid, most precise and, therefore, (they believe) most authoritative social scientists. Other social scientists such as lawyers or sociologists often complain about ‘economic imperialism,’ which is based on the notion that economics possesses the sophisticated toolkit lacking in other disciplines. If economists suddenly admitted that some of their fancy models had been severely flawed, where would this leave economists’ authority to tell others what to think and do?
Learning from the financial crisis
Such understandable fear should not stop economists from offering their mea culpa. There is no use denying the fact that economics has not been as successful as it hoped it could be. It was not as accurate, either. Economists are not the scientists of the new age!
The lesson economists should learn from the wake-up call that was the global financial crisis is that 234 years after the publication of Adam Smith’s The Wealth of Nations, economics as a discipline desperately needs an open and honest debate about its current state, its future, and its methods: How much mathematics is appropriate? What are the limitations to model-building? Where are the blind spots of its theories? What are its relationships to neighbouring disciplines such as law, psychology, sociology, philosophy, and history?
Despite these questions, there is no reason to throw the baby out with the bathwater. Economics can still teach us a lot about how markets and governments work and where both can and do fail. However, economists should be much more upfront in admitting wherever there are uncertainties. There is no point in pretending to have solved problems only to blame ‘exogenous shocks’ when things go wrong.
Such a new economics requires openness and modesty—neither of which seems to have been great strengths of the profession.
Economists should take the time to ask themselves what they can learn from the events of the past three years. If they were honest with themselves, they would come to the conclusion that many of them had been too optimistic about their abilities to predict the future with certainty. They would have to confess that the world is too messy a place to be expressed in models of ‘general equilibrium’ or ‘perfect competition.’
And, hopefully, they would also conclude that you cannot be a good economist unless you actually show a great interest and curiosity in the chaotic and complex world in which we live. As Hayek said: ‘An economist who is only an economist cannot be a good economist.’
Endnotes
