Should economists be seen as biologists instead of wannabe physicists?

Renee Courtios Haltom of Richmond Fed writes a superb paper/article on the intellectual crisis in economics. Like Krugman’s amazingly candid piece – How Did Economists Get It So Wrong? this one is as refreshing and candid as well.

Haltom says the crisis in economics is not accepted by all:

The sense is not unanimous, mind you, or probably even the majority view. But there is the uncomfortable fact that the profession was largely surprised by the largest economic event in several generations. Some have taken it as a sign that economists are, decidedly, studying the wrong things. The specific complaints are varied: Economists were so focused on unrealistic, highly mathematical models that they missed the problems developing before their very eyes.  They were so complacent with the idea that markets usually get things right that they ignored a housing bubble and  securitization mess in the process. Overall, critics say,  policymakers shouldn’t listen to a profession so lacking in consensus and out of touch with reality.

Did the research and beliefs of economists leave them ill-equipped to foresee the possibility of a major financial crisis? And if so, what drove the profession to such a myopic position?

Haltom then wonderfully (rather magically) presents the evolution of economic thought from Smith to Ricardo to Keynes and to current Lucas/Chicago School thoughts. (Though she misses out Friedman!)

The theme in this evolution of thought is how economics increasing became mathematical and wanting to become scientific. The only social science which kind of became independent science in the process (atleast wannabe). 

She says it all started with Ricardo who showed comparative advantage using elegant maths. The use of maths went to a different with start of marginal revolution.

Then came the Great depression and arrival of Keynes when marginal/classical economics failed to give answers. As economies recovered and Keynesian became mainstream, economists took the crude Keynes ideas and turned into maths and equations. Philips curve further led to the belief that Govt could tweak the economy – if want low inflation then tolerate high unemployment and vice versa. 

Then came stagflation with both high inflation and unemployment. This led to weakening of Keynes and arrival of Friedman/Lucas revolution of monetarism/rational expectations. Since then we have lived with these ideas and then came this crisis bringing Keynes back in fashion. By 2007, it seems maths became master of economics and was not the servant anymore.

She says in 1970s two paradigms emerged which led to saltwater and freshwater divide:

Two, not one, replacement paradigms emerged, both emphasizing microfoundations. First, the new classicals, whose models included fewer market imperfections, were able to incorporate a “general equilibrium” view that demonstrated how separate markets affect each other as they might in the actual macroeconomy. Their brand of macroeconomics  looked more like microeconomics, with a focus on the power of markets to allocate resources most efficiently.

Second were the new Keynesians, who wanted to tweak, not replace, the Keynesian models by using microfoundations to explain aggregate imperfections that the government might be able to fix via judicious monetary and fiscal policy. The models generally were unable to study more than one market at a time, a “partial equilibrium” perspective.

This is the famous “freshwater” and “saltwater” divide that has caused much controversy (and occasional name calling)  within the economics profession. The monikers describe the geographic locations where the economists in those camps have tended to be located. Saltwater economists (centered at universities around the two coasts) have  been accused of assuming policymaker omniscience and ignoring the bad incentives that government intervention can create, while freshwater economists (centered at universities around the Great Lakes) have been accused of operating with blind faith in the unfailing power of markets to self-regulate.

The differences still exist but there is more convergence over years thanks to computing power. Read how she explains DSGE model in English:

Those caricatures still exist, but for the most part the camps have converged over time to crea te a hybrid of general  equilibrium, microfoundational models that include imperfections and a potential role for government intervention. “The new tools developed by the new classicals came to dominate. The facts emphasized by the new Keynesians forced imperfections back into the benchmark model,” wrote Blanchard in 2008. The Economist magazine described the convergence in vision as “brackish” macroeconomics. 

Even more striking has been the convergence in methodology.   Because of advancements in econometrics and  computer power, economists today can combine the  strengths of various  theories better than before. What models today have in common is not so much any one school of  thought, but the type of mathematical tools that are used — so, in a way, mathematics is the new reigning paradigm of economics. The quintessential example are DSGE models, which stands for “dynamic stochastic general equilibrium” (a fancy way of saying they include decisions made over time and under uncertainty, and that the decisions made by policymakers, consumers, and firms affect each other).

As economics became more specialised, economists just failed to capture the linkage of housing with finance with economics. THis is something which Rajan and Shiller have made recently as well

Coming back to the title of the post. This is really fascinating:

It may partially be the quantitative nature of modern economics that causes it to be mistaken for the certainty and precision that natural sciences can offer, George Mason University economist Russ Roberts wrote recently on his blog, Café Hayek. He argues macroeconomics should be viewed more like biology than physics. “We do not expect a biologist to forecast how many squirrels will be alive in 10 years if we increase the number of trees in the United States by 20 percent. A biologist would laugh at you. But that is what people ask of economists all the time.

 

This is how it should be. Economists are asked to predict anything under the sun (and best part is they do it as well!)

Then she looks at way forward. Reviewing a few economists views, she says not much changes expected. Economists are paid well to see their forecasts and do they it with a lot of confidence. A code of ethics as proposed alone would not help:

The AEArecently considered adopting a code of ethics to induce economists to disclose any paid consultancies that could  potentially sway their research conclusions. A better move, Colander says, would be for economists to have a culture that discourages people from purporting undue certainty in their predictions and explanations.  If there’s a bottom line to recent criticisms of what economists study, Whaples says, it is that the fundamental dispute dates back at least a century.

Finally, economics keeps oscillating between markets and government.  This crisis shows both extremes are wrong and there is middle path.

The consensus vacillates between those who say markets don’t work well and that we need to put regulations on them, and those who point out the unintended side effects of government intervention and the fact that smart people will exploit regulations. “That basic argument goes back and forth, around in a circle, forever,” Whaples says. “When we haven’t had any crises for a while, the ‘markets work’ group will get stronger. And when we have a crisis the ‘markets don’t work  so well’ group will get stronger.” Nobody can say which is right, he says; there are valid points to be made on both sides. “But there’s always going to be that middle ground. The problem is, it’s kind of wide.”  The crisis may have helped narrow the question some: In what situations do markets work, and how does policy affect how markets function?

Economics is about the journey, not the destination; economists will never be “done” understanding the economy and human behavior. But the constant drive toward better understanding can only be a good thing for future economic thought.

Amazing essay. I have missed many other interesting ideas there. Like this amazing anecdote on how economists converse:

In 2001, economist Robert Lucas described working with Edward C. Prescott in the early 1970s on research that applied the rational expectations concept that would eventually win him a Nobel Prize. (Prescott would also become a Nobel Prize winner for related ideas.) The two economists were struggling to crack how labor markets are likely to respond to monetary policy.

Lucas said: Some days, perhaps weeks, later I arrived at the office around 9 and found a note from Ed in my mailbox. The full text was as follows:  ÒBob, This is the way labor markets work:  v(s,y,) = max {_,R(s,y) + min[_,§v(s«,y,_)Ä (s«,s)ds«]}. EdÓ

The normal response to such note, I suppose, would have been to go upstairs to EdÕs office and ask for some kind of explanation. But theoretical economists are not normal, and we do not ask for words that explain what equations mean. We ask for equations that explain what words mean.

🙂

Must must read.