What is Wrong With Us?

The editorial leader in this week's Economist examines "what went wrong with economics." As an economist, I regularly encounter misperceptions about what we do - when I tell people what my job is, they often ask me for predictions and investment advice. And if that's what people believe we do, than its not surprising if the financial crisis has diminished their respect for economists.

In reality, the things we know tend to be somewhat different and more specialized (for example, I'm really not sure what you should do with your 401-K, but I can tell you that intersectoral adjustment costs may contribute to real exchange rate volatility). The Economist has a better handle than most on what economists do, and is careful not to throw out the baby with the bathwater:

In its crudest form—the idea that economics as a whole is discredited—the current backlash has gone far too far. If ignorance allowed investors and politicians to exaggerate the virtues of economics, it now blinds them to its benefits. Economics is less a slavish creed than a prism through which to understand the world. It is a broad canon, stretching from theories to explain how prices are determined to how economies grow. Much of that body of knowledge has no link to the financial crisis and remains as useful as ever.

Separately, they consider two areas of economics that may be due for a little self-criticism, financial economics and macroeconomics. On macroeconomics, the leader says:

Macroeconomists also had a blindspot: their standard models assumed that capital markets work perfectly. Their framework reflected an uneasy truce between the intellectual heirs of Keynes, who accept that economies can fall short of their potential, and purists who hold that supply must always equal demand. The models that epitomise this synthesis—the sort used in many central banks—incorporate imperfections in labour markets (“sticky” wages, for instance, which allow unemployment to rise), but make no room for such blemishes in finance. By assuming that capital markets worked perfectly, macroeconomists were largely able to ignore the economy’s financial plumbing. But models that ignored finance had little chance of spotting a calamity that stemmed from it.

There is some truth in that, but the tendency to ignore the "plumbing" reflects the fact that writing an economic model - reducing the behavior of six billion crazy people on a stochastic planet to a system of equations - is, by nature, an exercise in simplification. Simplication is useful, and many of the most important insights come from the simplest models (e.g., the Solow growth model and the Krugman trade model). The goal of economic model is to gain insight into how the world works, which is not the same thing as making theory "realistic."

That said, I think they are right, in the separate macroeconomics article, to warn: "Economists can become seduced by their models, fooling themselves that what the model leaves out does not matter." However, the solution is not - as they seem to think - in introducing more complexity, but in keeping a proper perspective on the inherit limitations of the economic modeling exercise.

The articles have drawn some reactions from notables, such as Brad DeLong and Paul Krugman (seconding DeLong) and DeLong again (seconding Krugman, or third-ing himself). They both take issue with the Economist's portrayal on the disagreement within the profession over fiscal policy (the stimulus bill):

Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.

Among the passionate are Mr DeLong and Mr Krugman. They turn for inspiration to Depression-era texts, especially the writings of John Maynard Keynes, and forgotten mavericks, such as Hyman Minsky. In the humanities this would count as routine scholarship. But to many high-tech economists it is a bit undignified. Real scientists, after all, do not leaf through Newton’s “Principia Mathematica” to solve contemporary problems in physics.

They accuse economists like Mr DeLong and Mr Krugman of falling back on antiquated Keynesian doctrines—as if nothing had been learned in the past 70 years. Messrs DeLong and Krugman, in turn, accuse economists like Mr Lucas of not falling back on Keynesian economics—as if everything had been forgotten over the past 70 years. For Mr Krugman, we are living through a “Dark Age of macroeconomics”, in which the wisdom of the ancients has been lost.

The article goes on to sketch the evolution of the divide between the "freshwater" new classical "purists" and the "saltwater" Keynesian "pragmatists." Krugman responds: "The Economist reaches, I think, for a false symmetry, and glosses over too easily the sheer ignorance that has become obvious in the debates over fiscal policy." Of those purists, DeLong says:

In my view, when you have Nobel Memorial Prize-caliber economists like Arizona State's Edward Prescott, Chicago's Robert Lucas and Eugene Fama, and Harvard's Robert Barro claiming that there are valid theoretical arguments proving that fiscal stimulus simply cannot work, not even in a deep depression--even though they cannot enunciate such theoretical arguments coherently--it is entirely fair for outsiders to conclude that academic economics as a profession is useless.

The lasting legacy of the new classical economists is the methodological shift towards models based on microeconomic foundations, such as contemporary Dynamic Stochastic General Equilibrium models. However, the "policy ineffectiveness proposition" which seems, still, to reflexively guide some of the "purist" new classical thinking reflects the mistake of taking models too literally, forgetting about the simplifying assumptions made along the way. While Keynes (and the "textbook" distillation of Keynes into the IS-LM diagram) is full of methodological holes from a today's point of view, the crisis has provided numerous reminders us of how brilliantly insightful he was.

See also the reactions of Menzie Chinn and Mark Gertler, who both believe macroeconomics is doing better than some of the critics give it credit for.