What's wrong with economists?

This is a question not easily answered, but Noah Smith, a candidate for a Ph.D. in economics, makes a really good effort here in his Noahpinion blog. He discusses both clearly and at length the scientific deadend of deducing theories that don't fit real-world data and the equally sterile pursuit of mining data but inducing no explanatory theories. An economist--or other scientist--who does only one or only the other is stuck, which is what economics has been for a long time.  Smith points to some green shoots he hopes mean economists may be getting unstuck.

Why we should pay no attention to the macroeconomists behind that scientific curtain

Economist Peter Radford argues that much of modern macroeconomics is deliberately divorced from reality and does more harm than good in addressing current issues of political economy. For me, this evokes the Wizard of Oz.

There is an economist to defend any hair-brained policy proposal. Anything a politician cares to suggest can be given a well argued, and reasonable defense by a well respected and tenured professor from somewhere.

And when economists are hopelessly wrong? Are they fired? Are they pilloried and thrown out of their tenured positions to suffer the voluntary unemployment lines they condemn others to? Dean Baker has recently thrown a hissy fit over this. Of course not. Failed economists are a dime a dozen in our best schools. They are still teaching whatever they first thought. No amount of empirical data threatens their prestige. Why? Here’s the great scam: because economics is a self-contained, self-referential pursuit disconnected, very deliberately and carefully, from the dangers of having to be useful. It is thus immune from disproof. All that Popperian conjectures and refutations mumbo-jumbo is not applicable to economics. Economists have constructed their world so as not to have to be practical. Instead they are quasi-philosphers, quasi-mathemeticians, quasi-physicists, quasi-psychologists, and quasi-sociologists. By so being they can dodge between the bullets of practical questioning and never have to improve their art. Being quasi-everything is a great defense. You can confuse all the specialists and answer to no one. Except yourself.

These people should have the moral decency not to advance their theories as useful political policies, Radford says.

You’d think that, at the very least, they would stress test their advice. That they would check their theories against some evidence of their efficacy. That they would have the ethical decency to do no harm. Before, that is, and not after, they urge policies whose consequences, both intended and unintended, we all have to live through.

Radford says 19th Century economists began developing the cloak of pseudoscience (when science and respect for science were booming) to attempt to counter Marx's charge that they were merely mouthpieces for heartless and rapacious capitalism. 

No one doubts that the study of economies is a very serious and potentially socially valuable pursuit. Most of its great advances have been at times when there were big political and social upheavals and dangers that required insight into the way in which an economy works. A real one. Not a made up one. Early economists were intrigued and influenced by the processes and challenges of industrialization. Prior to that they had been embroiled in arguments over taxation and trade, both of which were contentious and relevant topics to the newly emerging nation states of the 1600 and 1700′s.

Then along came Marx, who thundered away at the disruptive issues of early capitalism and its satanic mills. His critique was sufficient to demand a right wing response, which came in the form of marginalism and Walrasian systemic thinking. Those advances were an attempt to make economics scientific and thus immune to the implied Marxist charge that the early theories were simply justifications for capitalist favoring policies.

That attempt to shift economics from being politically motivated towards being scientific, and thus cleansed of political taint, gathered momentum and led to even greater discord in the 1930′s and later. One part of economics wandered off into the supposed safety of the self referential community I mentioned above, content to manipulate ever more abstract models until it ended up with people like [Nobel laureate] Lucas openly calling his analysis utopian. The other channel was filled with people trying to engage a more “realistic” set of theories that recognized the vagaries and complexities of the world. But because those vagaries are intractable, or have been, to the tools economists inherited from their political economy origins, and because much of the subject’s key topics are still framed in 1800′s terminologies these realists have made less of an impression. They don’t appear as scientific. Their models are kluge-like and not filled with impressive mathematics. So the so-called scientists won. They invented “positive” economics, where theoretical discussions disdained empirical proof, and where math wizardry counted for more than connection with practical policy.

Which is why a recent poll of economics post-graduate students showed a belief that being good in math is more important to being a good economist, than knowing anything about the economy. Abstraction for abstraction’s sake is the watchword of modern mainstream economics.

Read the whole article in Real-World Economics Review Blog.

Krugman-Einstein Trade Theory

How did we miss this?  Nobelist in international trade theory, Paul Krugman, has published a paper laying out a theory of interstellar trade that deals, inter alia, with the difficulties of general relativity. Hat tip to Steve Keen, who posts some key excerpts here (the most accessible way to start reading it) and wonders if possibly Krugman is trying to embarrass somebody. 

Where do I sign?

An international student movement to free standard economics curriculum from its neoclassical straightjacket was launched last week at UC Berkeley. Courtesy of Real-World Economics Review, here it is: 

Kick It Over Manifesto 

We, the undersigned, make this accusation: that you, the teachers of neoclassical economics and the students that you graduate, have perpetuated a gigantic fraud upon the world. 

You claim to work in a pure science of formula and law, but yours is a social science, with all the fragility and uncertainty that this entails. We accuse you of pretending to be what you are not.

You hide in your offices, protected by your mathematical jargon, while in the real world, forests vanish, species perish and human lives are callously destroyed. We accuse you of gross negligence in the management of our planetary household.

You have known since its inception that one of your measures of economic progress, the Gross Domestic Product, is fundamentally flawed and incomplete, and yet you have allowed it to become a global standard, reported day in, day out in every form of media. We accuse you of recklessly projecting an illusion of progress.

You have done great harm, but your time is coming to a close. Your systems are crumbling, your flaws increasingly laid bare. An economic revolution has begun, as hopeful and determined as any in history. We will have our clash of economic paradigms, we will have our moment of truth, and out of each will come a new economics – open, holistic, human‑scale.

On campus after campus, we will chase you old goats out of power. Then, in the months and years that follow, we will begin the work of reprogramming your doomsday machine.

Sign the manifesto at
www.kickitover.org

Update on Tuesday, October 26, 2010 at 06:55AM by Skeptic

This is getting personal at Berkeley. The Manifesto was nailed to the door of a Nobel laureate, and an adjunct professor sends an email denying he's irrelevant.  Link.

"Identity economics" explains why people don't always make selfishly rational economic decisions.

Nobel laureate in economics George Akerlof and Rachael Kranton have a new book, Identity Economics: How Our Identities Shape Our Work, Wages, and Well-Being, which they summarize here.  They note that real people in large numbers often confound mainstream economists by making decisions contrary to obvious economic incentives measured in money. That basic insight is not new; it is central to “behavioral economics” and assumed by sociologists, psychologists, and political scientists. Still, it’s interesting when one of the high priests of economics joins in pulling away the homo economicus foundations of the mainstream economics theory temple.  This paragraph encapsulates the authors’ explanation for these common but economically irrational behaviors: 

When we examine people’s decisions from the perspective of their individual identities and social norms, we get new answers to many different economic questions. Who people are and how they think of themselves is key to the decisions that they make. Their identities and norms are basic motivations. We call this approach identity economics.

They provide several examples of behavior that cannot be explained by mainstream economic theory and then suggest how to get employees and students to be productive and successful without traditional economic rewards. 

Men and women in the United States smoked cigarettes at vastly different rates at the beginning of the twentieth century, but these rates largely converged by the 1980s. Women now smoke just as much as men. 

Overall military pay is relatively flat—that is, it does not go up and down depending on performance, and it is also lower than for comparable positions in civilian firms. Nothing in standard economic analysis can make sense of such a pay structure—or of the rituals that are central to military tradition.

. . . .

In organizations that function well, employees identify with their work and their organizations. If employees feel more like insiders—a key purpose of military rituals—there is little need for incentive pay or pay-for-performance schemes. The military changes the identity of its recruits, inculcating in them values such as duty and service. In the civilian world, too, the most important determinant of whether an organization functions well is not the monetary incentive system, as standard economic models would imply, but whether its workers identify with the organization and with their job within it. If they do not, they will seek to game the incentive system, rather than to meet the organization’s goals.

Likewise, good schooling occurs not as a result of monetary rewards and costs—the stock-in-trade of conventional economics—but because students, parents, and teachers identify with their schools, and because that identification is associated with learning. Moreover, whether students identify with being in school becomes the major determinant of whether they stay or drop out.

Given this, education policy should look at what some successful programs have done to establish a school identity that motivates students and teachers to work according to a common purpose. If we focus on training teachers in how to inspire their students to identify with their school—rather than teaching students to take standardized tests—we just might be able to reproduce these schools’ great results.

Update on Saturday, June 19, 2010 at 03:23PM by Skeptic

This NYT article from Mumbai Deciphering the Cause of Human Motivation draws on the work of other authors arguing that there is an over-emphasis on rewards and accountability, which is based on a misunderstanding about what motivates humans. Hat tip to Christine for the link.

Too many hedgehogs and not enough foxes among economists

The Global Financial Crisis and the Great Recession have created an intellectual crisis among economists. Essentially their question among themselves is, "What's wrong with the way we do our work that made us fail to predict this?" It helps to keep their attention focused that the Queen of England asked the same question while visiting the London School of Economics in November 2008 and that many others inside and outside the economics priesthood won't let them forget this colossal failure of mainstream economics.

Mark Thoma says part of the problem is that courses in the history of economic thought and economic history have largely disappeared from undergraduate and graduate education in economics. He reports in this review of Simon Johnson and James Kwak's new book, 13 Bankers: 

I was at a conference a few weeks ago at King's College in Cambridge, England hosted by the Institute for New Economic Thinking. Simon Johnson was there as well. The topic of the conference was "The Economic Crisis and the Crisis in Economics." During one of the sessions, a speaker asked the audience -- most of whom were economists from the top schools in the world -- if their departments included the history of economic thought as core part of their graduate curriculum. Nobody raised their hand.

The number of economics programs offering history of thought as a field, or as part of the core program, has diminished over time. Some programs still teach the history of thought (though not always at the graduate level), so it's not gone altogether, but it has become rare.

The situation is even more dire for American economic history which has all but dropped off the map in many programs. That is unfortunate. If economists had studied U.S. financial history in depth, they might have been able to recognize that past patterns were repeating themselves. They might have foreseen that we were headed for trouble. Instead, we missed some fairly obvious similarities between events prior to the crisis and events of the past that should have alerted us to the potential danger ahead. To a large degree, we have lost our historical perspective.

Why have these classes been dropped from graduate programs? I tried to answer that question here by arguing that the technical demands of modern economics crowded these courses out of graduate programs, but it was more than that. There was also a sense that we had solved the macroeconomic problem using a highly mathematical, scientific approach, or at least made enough progress to bring about a "Great Moderation." There was little to learn from macroeconomists of the past, or so it seemed, and that overconfidence turned out to be costly when the crisis hit. Many of the hard learned lessons of the past had to be relearned once again.

Thus, one answer to the problem of regulating the financial sector is to make sure that economists know the history of their field, including US economic history and all of the financial turmoil of the 1800s and early 1900s. That is where 13 Bankers is so valuable. The book begins with an overview of U.S. financial history, and it includes a readable explanation of the economics and politics behind the financial events of the past. This is essential reading for any economist who wants to understand what triggered financial panics in the past, what policies worked or failed and why, and how it relates to today.

Paul Krugman says the "freshwater" economists deliberately purged all knowledge of what went before and what isn't in their paradigm.

For when freshwater macro took over a good part of the field, its leaders gleefully dismissed all the work Keynesian economists had done over the previous few decades, often with sneers and sniggers.

And that same adolescent quality was evident in the reactions to the Obama administration’s attempts to deal with the crisis — as Brad DeLong points out, people like Robert Lucas and John Cochrane (not to mention Richard Posner, who isn’t a macroeconomist but gets his take from his colleagues) didn’t say that when serious scholars like Christina Romer based policy recommendations on Keynesian economics, they were wrong; the freshwater crowd declared that anyone with Keynesian views was, by definition, either a fool or intellectually dishonest.

So the freshwater outrage over finding their own point of view criticized is, you might think, a classic case of people who can dish it out but can’t take it.

But it’s actually even worse than that.

When freshwater macro came in, there was an active purge of competing views: students were not exposed, at all, to any alternatives. People like Prescott boasted that Keynes was never mentioned in their graduate programs. And what has become clear in the recent debate — for example, in the assertion that Ricardian equivalence rules out any effect from government spending changes, which is just wrong — is that the freshwater side not only turned Keynes into an unperson, but systematically ignored the work being done in the New Keynesian vein. Nobody who had read, say, Obstfeld and Rogoff would have been as clueless about the logic of temporary fiscal expansion as these guys have been. Freshwater macro became totally insular.

And hence the most surprising thing in the debate over fiscal stimulus: the raw ignorance that has characterized so many of the freshwater comments.

Whether it's from time constraints, intellectual arrogance, and/or something else, it seems clear that too many economists know too little about the context of their narrow knowledge bases. In Isaiah Berlin's metaphor, they are "hedgehogs" who know one big thing, when what we need to guide public policy are "foxes" who know many things.

Whither macroeconomics?

I have posted several times on the intellectual crisis in macroeconomics.  I have been following closely what Mark Thoma has to say about this, and today he posted a really good summary of some of the possible future directions for macro. 

The session I moderated at the INET Conference was called "What Kind of Theory to Guide Reform and Restructuring of the Financial and Non-Financial Sectors?" (the panel was Franklin Allen, Sheila Dow, Axel Leijonhuvfud, and Joe Stiglitz). During the introduction, I made (or meant to make) the following points:

... If you believe, as I do, that macroeconomics needs to change, there are three possible ways to proceed.

First, we could try to reform the DSGE model used widely today. How much would it help to do one or more of the folowing: (i) Within the DSGE model, develop better connections between the real and financial sectors. In particular, the model should allow for the endogenous collapse of financial intermediation. Recent models of financial frictions and endogenous leverage cycles give an indication of how to proceed. (ii) Replace rational expectations (and the efficient markets hypothesis) with a better approximation of how expectations are actually formed. One possibility along these lines is to added learning to the models. Another is behavioral economics. (iii) Replace the representative agent assumption with heterogeneous agents. It's hard to have realistic financial markets with one agent. However, adding heterogeneity is not as simple as it might seem. Generically, having heterogeneous agents in a model makes it difficult to aggregate across individuals – once the representative agent assumption is dropped you cannot, for example, guarantee that uniqueness or stability will appear at the aggregate level even if individual agents are well-behaved neoclassical agents. There are clever ways to allow for heterogeneity without sacrificing the ability to aggregate, but they aren’t fully satisfactory. If we are going to go this route, then more cleverness is needed. (iv) You may be surprised to learn that regulations such as capital requirements have very little theoretical backing -- they are largely ad hoc (see the talk by Franklin Allen). If the problem wasa failure of regulation and not a failure of the model more generally, then perhaps better models of regulation are all that is needed (or, if you believe the crisis was caused by the Fed's pursuit of low interest rates, perhaps all we need is a better model of monetary policy). However, this brings up the question of whether the DSGE structure is an adequate foundation for models of regulation, and I am not convinced that it is. (v) This wasn't part of my remarks, but a physicist spoke at the conference and one of his main points was that financial markets are dictated by power laws, not the Gaussian distributions that are commonly assumed in theoretical work (often for analytical convenience). Is addressing this problem all that is needed?

The second way we might proceed is to adopt new models. Possibilities along these lines are: (i) To develop network (complexity) models and their associated measures of network characteristics such as centrality and degree distribution that can be used to estimate the risk of network failure. (ii) There is George Soros' Reflexivity theory, and (iii) there is the theory developed by Frydman and Goldberg, Imperfect Knowledge Economics. (Both of these had been discussed in earlier sessions.) (iv) We could begin the modeling process at the aggregate level and give up the insistence that the models be microfounded. This would, among other things, avoid the problems associated with aggregating from realistic microfoundations discussed above.

Third, take a whole new approach to theory. (i) The call for pluralism that Sheila Dow will talk about falls into this category (see here for more on this). (ii) Economics could give up trying to model itself after physics as it existed a century or more ago, drop the "natural" language, and embrace the methods of the "softer" sciences. These disciplines have already successfully addressed many of the problems that economists face. ...

Read Thoma’s whole post and comments.

Update on Monday, April 12, 2010 at 09:24AM by Skeptic

Rebecca Wilder, who says much of what she learned to get her recent Ph.D. in economics is now obviously wrong, attended the INET conference at Kings College Cambridge (funded by George Soros), provides some additional details, and links to some conference materials here.

Update on Thursday, April 15, 2010 at 09:16AM by Skeptic

Mark Thoma provides links to Joseph Stiglitz's presentation on video and his paper here. 

Realistically, economics is an art, not a science.

David Brooks' high-level historical overview of economics concludes it's not a science at all and eventually economists may realize that. 

In Act IV, in other words, economists are taking baby steps into the world of emotion, social relationships, imagination, love and virtue. In Act V, I predict, they will blow up their whole field.

Economics achieved coherence as a science by amputating most of human nature. Now economists are starting with those parts of emotional life that they can count and model (the activities that make them economists). But once they’re in this terrain, they’ll surely find that the processes that make up the inner life are not amenable to the methodologies of social science. The moral and social yearnings of fully realized human beings are not reducible to universal laws and cannot be studied like physics.

Once this is accepted, economics would again become a subsection of history and moral philosophy. It will be a powerful language for analyzing certain sorts of activity. Economists will be able to describe how some people acted in some specific contexts. They will be able to draw out some suggestive lessons to keep in mind while thinking about other people and other contexts — just as historians, psychologists and novelists do.

At the end of Act V, economics will be realistic, but it will be an art, not a science.

In addition to dismissing much of modern economic science as virtual reality games, I have noted that economic theories are as far from the complexity of real economies as cell biology is from physicians diagnosing and treating real human patients.  The cell biologist may know a great deal that is useful, but he doesn't know nearly enough to be entrusted with patients. Cell biologists seem much better than macroeconomists at knowing their own limits. 

Update on Sunday, March 28, 2010 at 07:38AM by Skeptic

To be fair to economists, many of them are aware of the problem, according to Tim Hartford here.  For example, in a 1983 article, Let's Take the Con Out of Econometrics, Edward Leamer pointed out that econometricians often have great difficulty teasing out cause and effect.

This is the “identification problem” – trying to work out whether a statistical pattern is caused by what we think it has been caused by. It muddies any statistical analysis of data that have not been generated by a controlled experiment, and it particularly plagues econometricians, the statistical wing of the economics profession. But, complained Leamer, throughout the 1970s they too rarely cared, and much of their work was dubious at best. Leamer was not alone. David Hendry showed in 1980 that by using the standard methods of the day, he could demonstrate that rainfall caused inflation. Or was it that inflation caused rainfall?

Hartford says progress has been made.

Update on Friday, April 2, 2010 at 10:34AM by Skeptic

Commenting on the same Brooks column, economist Justin Fox says economics is too important to be left to the economists.

[T]he ways in which scholars interpret the world can (with a time lag and a lot lost in translation) have a big influence on the way the rest of us see things. Over the past half century, economists have come to utterly dominate thinking about economic matters, and begun to insinuate themselves into lots of other fields too. Business education, and business advice, has certainly become much more economics-oriented. Which isn't all bad. But even an economist would agree that we could use more competition in the marketplace of ideas. Right?

Update on Friday, May 14, 2010 at 06:30AM by Skeptic

Arnold Kling says there are too many things going on in the real world to be represented by one model applied to one data set.

Fifty years of macroeconomic thought—scientific and political gains but engineering failure

One way to understand the feud among macroeconomists is that some of them are "engineers" focused on solving real world economic problems and some are "scientists" focused on improving mathematical models of their theories, according to Harvard professor Greg Mankiw in this very interesting paper from 2006. [Please see 6/26/2020 update for a working link.]  Mankiw says the "engineers" trace their roots to MIT (Samuelson and Solow), while the "scientific" tradition is rooted in the University of Chicago (Friedman, Barro, and Lucas). (This is often referred to as the "saltwater-freshwater" schism.) He notes that many prominent economic engineers have taken senior positions in government under both Democratic and Republican administrations, as he did in George W. Bush's first term as chair of CEA, but that he cannot think of a single prominent economic scientist who has done that.

After a fascinating summary of the main research threads and theories since the 1930s, he surprised me by concluding that almost none of the developments in economic science since WWII has affected how the economist-engineers in Washington do their jobs.

The real world of macroeconomic policymaking can be disheartening for those of us who have spent most of our careers in academia. The sad truth is that the macroeconomic research of the past three decades has had only minor impact on the practical analysis of monetary or fiscal policy. The explanation is not that economists in the policy arena are ignorant of recent developments. Quite the contrary: The staff of the Federal Reserve includes some of the best young Ph.D.'s, and the Council of Economic Advisers under both Democratic and Republican administrations draws talent from the nation's top research universities. The fact that modern macroeconomic research is not widely used in practical policymaking is prima facie evidence that it is of little use for this purpose. The research may have been successful as a matter of science, but it has not contributed significantly to macroeconomic engineering.

Nor has there been a great effect on college textbooks, which still bear strong resemblance to Samuelson's 1948 Economics, according to Mankiw who is author of today's most widely used introductory college economics textbook. The most prominent alternative textbook, introduced by Chicago's Robert Barro in 1984, failed to catch on.

Although Mankiw doesn't discuss it, many of the ideas that have not been implemented by the engineers and have been largely abandoned by the scientists nevertheless had, and continue to have, great political influence. For that reason, I summarize below Mankiw's history of the evolution of mainstream economic thought since the Great Depression. Among the theories and concepts that flash across the screen are the neoclassical-Keynesian synthesis, an economy stuck in a suboptimal equilibrium, sticky prices, animal spirits, fiscal stimulus, Phillips curve, monetarism, rational expectations, real business cycle theory, short run and long run behavior, imperfect competition, dynamic stochastic general equilibrium theory, and the new neoclassical synthesis. Clearly, this is my wonkiest post ever.

Although the word "macroeconomics" first appears in the scholarly literature in the 1940s, economists had been paying attention for at least 200 years to the main concerns of macroeconomics—inflation, unemployment, economic growth, the business cycle, monetary policy, and fiscal policy. The Great Depression brought the realization that economists did not understand why there was no spontaneous recovery until John Maynard Keynes explained in General Theory (1936) that markets can get stuck in an unfavorable equilibrium because of a general pessimism and lack of confidence or animal spirits and because prices, especially labor prices, tend to be sticky. When an economy was stuck in a depression, Keynes prescribed massive government spending with borrowed money (fiscal stimulus) to generate personal incomes that would boost aggregate demand which would stimulate hiring and investment, turning stagnation into a resumption of growth.

Many who had the life-changing experience of living through the Great Depression and later became prominent economists seized on these ideas and became leaders of the "Keynesian Revolution." They undertook to turn Keynes' grand vision into a simpler, more concrete and precise model.

One of the first and most influential attempts was the IS-LM [Investment/Saving-Liquidity preference/Money supply] model proposed by the 33-year-old John Hicks (1937). The 26-year-old Franco Modigliani (1944) then extended and explained the model more fully. To this day, the IS-LM model remains the interpretation of Keynes offered in the most widely used intermediate-level macroeconomics textbooks. . . .

[Meanwhile] . . ., econometricians such as Klein were working on more applied models that could be brought to the data and used for policy analysis. Over time, in the hope of becoming more realistic, the models became larger and eventually included hundreds of variables and equations. By the 1960s, there were many competing models, each based on the input of prominent Keynesians of the day, such as the Wharton Model associated with Klein, the DRI (Data Resource, Inc.) model associated with Otto Eckstein, and the MPS (MIT-Penn-Social Science Research Council) model associated with Albert Ando and Modigliani. These models were widely used for forecasting and policy analysis. The MPS model was maintained by the Federal Reserve for many years and would become the precursor to the FRB/US model, which is still maintained and used by Fed staff.

Although these models differed in detail, their similarities were more striking than their differences. They all had an essentially Keynesian structure. In the back of each model builder's mind was the same simple model taught to undergraduates today: an IS curve relating financial conditions and fiscal policy to the components of GDP, an LM curve that determined interest rates as the price that equilibrates the supply and demand for money, and some kind of Phillips curve that describes how the price level responds over time to changes in the economy."

. . . .

Yet the Keynesian revolution cannot be understood merely as a scientific advance. To a large extent, Keynes and the Keynesian model builders had the perspective of engineers. They were motivated by problems in the real world, and once they developed their theories, they were eager to put them into practice. Until his death in 1946, Keynes himself was heavily involved in offering policy advice. So, too, were the early American Keynesians. Tobin, Solow, and Eckstein all took time away from their academic pursuits during the 1960s to work at the Council of Economic Advisers. The Kennedy tax cut, eventually passed in 1964, was in many ways the direct result of the emerging Keynesian consensus and the models that embodied it.

The Phillips curve, based on a 1958 paper, was incorporated into the Keynesian model in the 1960s. It purported to describe a fixed relationship between the unemployment rate and the inflation rate—if one was high the other would be low and vice versa, supposedly making it possible for policymakers to choose among various combinations of unemployment and inflation. It underpins the Congressional mandate to the Fed that it must consider both inflation and unemployment in policy making, unlike some other central banks that are mandated only to limit inflation. Although modified versions of a Phillips curve are still used in econometric models today, the 1970s versions could not explain the coincidence of high inflation and high unemployment ("stagflation") of that decade [See 4/16/11 Update], and that opened the door (at ix) to rival theories being developed and taught in Chicago.

In their article After Keynesian Macroeconomics, Sargent and Lucas (1979) wrote, "For policy, the central fact is that Keynesian policy recommendations have no sounder basis, in a scientific sense, than recommendations of non-Keynesian economists or, for that matter, noneconomists." Although Sargent and Lucas thought Keynesian engineering was based on flawed science, they knew that the new classical school (circa 1979) did not yet have a model that was ready to bring to Washington: "We consider the best currently existing equilibrium models as prototypes of better, future models which will, we hope, prove of practical use in the formulation of policy." They also ventured that such models would be available "in ten years if we get lucky.

Although Sargent and Lucas admitted their models were not ready for Washington (and were then indeed as scientifically flawed as the Keynesian models) some of the ideas behind the Chicago models were nevertheless kidnapped from the cradle and taken to Washington where they quickly became and remain hugely influential on policy decisions and public discourse about economics. In large part this was because their escalating attacks on the Phillips curve at a time when it pretty clearly wasn't working discredited the whole Keynesian model, including its valid ideas about the possibilities for stagnation, sticky prices, and fiscal stimulus of aggregate demand. The Chicago ideas were also successful because they supported existing political preferences for reduced government spending and laissez faire markets and because Milton Friedman was a weekly Newsweek columnist from 1966 to 1984, an advisor to Ronald Reagan, the host of a TV series about political economy, and generally a prominent public intellectual. During this period, Chicago launched three big macroeconomic ideas emphasizing the virtues of markets and the failings of government.

The first wave of new classical economics was monetarism, and its most notable proponent was Milton Friedman. Friedman's (1957) early work on the permanent income hypothesis was not directly about money or the business cycle, but it certainly had implications for business cycle theory. It was in part an attack on the Keynesian consumption function, which provided the foundation for the fiscal policy multipliers that were central to Keynesian theory and policy prescriptions. If the marginal propensity to consume out of transitory income is small, as Friedman's theory suggested, then fiscal policy would have a much smaller impact on equilibrium income than many Keynesians believed.

Friedman and Schwartz's (1963) Monetary History of the United States was more directly concerned with the business cycle and it, too, undermined the Keynesian consensus. Most Keynesians viewed the economy as inherently volatile, constantly buffeted by the shifting "animal spirits" of investors. Friedman and Schwartz suggested that economic instability should be traced not to private actors but rather to inept monetary policy.

Although the Keynesian models dealt with the money supply among other factors, the monetarists said "only money matters." In its turn, strict monetarism was quickly displaced in academia by "rational expectations" theory, also developed in Chicago.

In a series of highly influential papers, Robert Lucas extended Friedman's argument. In his Econometric Policy Evaluation: A Critique, Lucas (1976) argued that the mainstream Keynesian models were useless for policy analysis because they failed to take expectations seriously; as a result, the estimated empirical relationships that made up these models would break down if an alternative policy were implemented. Lucas (1973) also proposed a business cycle theory based on the assumptions of imperfect information, rational expectations, and market clearing. In this theory, monetary policy matters only to the extent to which it surprises people and confuses them about relative prices. Barro (1977) offered evidence that this model was consistent with U.S. time-series data. Sargent and Wallace (1975) pointed out a key policy implication: Because it is impossible to surprise rational people systematically, systematic monetary policy aimed at stabilizing the economy is doomed to failure.

The third wave of new classical economics was the real business cycle theories of Kydland and Prescott (1982) and Long and Plosser (1983). Like the theories of Friedman and Lucas, these were built on the assumption that prices adjust instantly to clear markets—a radical difference from Keynesian theorizing. But unlike the new classical predecessors, the real business cycle theories omitted any role of monetary policy, unanticipated or otherwise, in explaining economic fluctuations. The emphasis switched to the role of random shocks to technology and the intertemporal substitution in consumption and leisure that these shocks induced.

As a result of the three waves of new classical economics, the field of macroeconomics became increasingly rigorous and increasingly tied to the tools of microeconomics. . . .

This commitment to rigorous mathematical scientific modeling and to microeconomic foundations had become the hallmark of new classical economics. The methodology was more important than the particular postulates modeled.

Today, many macroeconomists coming from the new classical tradition are happy to concede to the Keynesian assumption of sticky prices as long as this assumption is imbedded in a suitably rigorous model in which economic actors are rational and forward-looking. Because of this change in emphasis, the terminology has evolved, and this class of work now often goes by the label "dynamic stochastic general equilibrium" theory.

Meanwhile, the Keynesians had not gone away or been converted. They too had been troubled by the absence of micro-foundations for their macroeconomics. While the freshwater economists had rejected Keynes outright and set about building their own theories and models, the saltwater economists tried to improve the neoclassical-Keynesian synthesis by incorporating micro-foundations.

All modern economists are, to some degree, classical. We all teach our students about optimization, equilibrium, and market efficiency. How to reconcile these two visions of the economy—one founded on Adam Smith's invisible hand and Alfred Marshall's supply and demand curves, the other founded on Keynes's analysis of an economy suffering from insufficient aggregate demand—has been a profound, nagging question since macroeconomics began as a separate field of study.

Early Keynesians, such as Samuelson, Modigliani, and Tobin, thought they had reconciled these visions in what is sometimes called the "neoclassical-Keynesian synthesis." These economists believed that the classical theory of Smith and Marshall was right in the long run, but the invisible hand could become paralyzed in the short run described by Keynes. The time horizon mattered because some prices—most notably the price of labor—adjusted sluggishly over time. Early Keynesians believed that classical models described the equilibrium toward which the economy gradually evolved, but that Keynesian models offered the better description of the economy at any moment in time when prices were reasonably taken as predetermined.

Mankiw describes (at 10-12) specific problems that were worked out between about 1971 and about 1990 and concludes—

In my judgment, these three waves of new Keynesian research added up to a coherent microeconomic theory for the failure of the invisible hand to work for short-run macroeconomic phenomena. We understand how markets interact when there are price rigidities, the role that expectations can play, and the incentives that price setters face as they choose whether or not to change prices. As a matter of science, there was much success in this research (although, as a participant, I cannot claim to be entirely objective). The work was not revolutionary, but it was not trying to be. Instead, it was counterrevolutionary: Its aim was to defend the essence of the neoclassical-Keynesian synthesis from the new classical assault.

In the late 1990s a new synthesis between the freshwater and saltwater approaches emerged, although it may have been only an uneasy truce (which broke down in the wake of the global financial crisis).

Like the neoclassical-Keynesian synthesis of an earlier generation, the new synthesis attempts to merge the strengths of the competing approaches that preceded it. From the new classical models, it takes the tools of dynamic stochastic general equilibrium theory. Preferences, constraints, and optimization are the starting point, and the analysis builds up from these microeconomic foundations. From the new Keynesian models, it takes nominal rigidities and uses them to explain why monetary policy has real effects in the short run. The most common approach is to assume monopolistically competitive firms that change prices only intermittently, resulting in price dynamics sometimes called the new Keynesian Phillips curve. The heart of the synthesis is the view that the economy is a dynamic general equilibrium system that deviates from a Pareto optimum because of sticky prices (and perhaps a variety of other market imperfections).

. . . .

With the benefit of hindsight, it is clear that the new classical economists promised more than they could deliver. Their stated aim was to discard Keynesian theorizing and replace it with market-clearing models that could be convincingly brought to the data and then used for policy analysis. By that standard, the movement failed. Instead, they helped to develop analytic tools that are now being used to develop another generation of models that assume sticky prices and that, in many ways, resemble the models that the new classicals were campaigning against.

The new Keynesians can claim a degree of vindication here. The new synthesis discards the market-clearing assumption that Solow called "foolishly restrictive" and that the new Keynesian research on sticky prices aimed to undermine. Yet the new Keynesians can be criticized for having taken the new classicals' bait and, as a result, pursuing a research program that turned out to be too abstract and insufficiently practical. Paul Krugman (2000) offers this evaluation of the new Keynesian research program: "One can now explain how price stickiness could happen. But useful predictions about when it happens and when it does not, or models that build from menu costs to a realistic Phillips curve, just don't seem to be forthcoming." Even as a proponent of this line of work, I have to admit that there is some truth to that assessment.

This post would not be complete without mentioning that the "mainstream economics" described by Mankiw above omits many important economics ideas and ongoing work. For example, the work of Hyman Minsky and his followers on asset price bubbles and crashes has gained recent prominence as people try to understand why the mainstream economists were blindsided by the global financial crisis (which hadn't happened yet when Mankiw wrote this paper). Whereas the mainstreamers had accepted the Keynesian lesson that prices could be sticky and had mathematical models to study the resulting effects, they were not considering—and their models did not accommodate—the opposite problem that asset prices can be very volatile. Now, 18 months after the collapse of Lehman Brothers, we still don't seem to have a mainstream answer about how to model and make policy decisions about asset price volatility or what textbooks should say about this.

Another area of economics that is floundering is understanding what policy changes could stimulate growth and prosperity in undeveloped countries. Mankiw explains that the "Great Moderation" of the 1990s caused mainstream economists to think business cycles were a problem of the past and not worth studying, and they turned their attention to growth models, which inspired (in my words, not Mankiw's) other half-baked policies like the Washington Consensus about development, which is already being abandoned by the economist-engineers. There were other reasons for this diversion of attention, including this one:

There is also a fourth, more troublesome reason why budding macroeconomists of the 1990s were drawn to study long-run growth rather than short-run fluctuations: the tension between new classical and new Keynesian worldviews. While Lucas, the leading new classical economist, was proclaiming that "people don't take Keynesian theorizing seriously anymore," leading Keynesians were equally patronizing to their new classical colleagues. In his AEA Presidential Address, Solow (1980) called it "foolishly restrictive" for the new classical economists to rule out by assumption the existence of wage and price rigidities and the possibility that markets do not clear. He said, "I remember reading once that it is still not understood how the giraffe manages to pump an adequate blood supply all the way up to its head; but it is hard to imagine that anyone would therefore conclude that giraffes do not have long necks.

Update on Saturday, March 13, 2010 at 09:08PM by Skeptic

Peter Radford, writing Whither Economics? What do we tell the students? in Real-World Economics Review, has this to say about Mankiw's dichotomy:

I prefer a slightly different division to Mankiw’s. There are economists who study economies, and there are economists who study economics. Both theorize. Both search for regularities. Both offer what they think is practical advice. Both develop technologies based upon their theories. There are engineers and scientists in both camps. The difference is more fundamental than Manikiw suggests.

Those who study economies are naturally drawn to real world economics, whether they think of themselves in that camp or not, because of their attention to the world around them. If the real world and its variety, its institutions, cultures, religions, its diversity and even its geography influence a theorist’s starting point then they are studying economies in a real world sense.

Those who prefer to investigate the properties of equilibrium, rational expectations, and efficient markets are studying economics. They are dealing with abstraction since their starting point is an artefact created from assumptions, axioms and the like. Their hope is that they can elicit useful statements transferable to the real world, but yet not study the real world.

The problem with this split is that it implies that economics over the years has come to represent something other than the study of economies, and this is the source of the conflict that now rages. The realists complain about the irrelevancy of orthodoxy now that it has become little more than a self-referential series of models whose major value resides in their elegance and sparseness. Theirs is a feeling that economics should engage the real world rather than resist it. It is a feeling that a true ‘science’ should not view so much of reality as a failure to conform with theory. Rather it should explain the texture of reality, albeit through the prism of mathematics and models.

Update on Monday, April 26, 2010 at 03:26PM by Skeptic

Paul Krugman explains here the time and the issue that created the freshwater-saltwater schism. Robert Lucas and Robert Barro (Chicago) advanced the "rational expections" model and when it became clear that it didn't work they went on to "real business cycle" theory while the saltwater folks became "New Keynesians."

Update on Tuesday, June 29, 2010 at 08:52AM by Skeptic

Paul Krugman links to some current criticisms of modern freshwater macro and gives his summary of what went wrong  here. 

Update on Saturday, October 9, 2010 at 01:48PM by Skeptic

More in the same vein and a complaint by saltwater economists about how hard it became to get published unless they disguised their models to look like fresh water "modern macroeconomics."

Update on Friday, November 26, 2010 at 12:36PM by Skeptic

Paul Krugman's narration here is less granular but similar, as he considers whether forgetting the economic policy lessons of the Great Depression was perhaps inevitable because of an instability of intellection moderation. 

Update on Monday, November 29, 2010 at 08:36AM by Skeptic

Peter Radford points out that all the major strains of modern economics have failed to resolve the internal contradictions between their respective micro and macro theories.

Update on Saturday, March 19, 2011 at 04:48PM by Skeptic

Krugman says he was a pretty conventional neoclassical economist who thought that monetary policy could stablize the economy without any fiscal help, but he changed his mind and became more Keynesian when the Asian financial crisis of the late 1990s demonstrated clearly that monetary policy was insufficient. 

He also says that when powerful political interests have settled on their preferred policies and want economic analyses and arguments to influence voters, many economists who are politically aligned find ways to reject their own prior professional opinions and back their preferred political positions.

Update on Saturday, April 9, 2011 at 10:38AM by Skeptic

Larry Summers, until recently chief economic policy advisor to President Obama, said in a recent interview by Martin Wolf that in addressing the debt crisis and Great Recession, they considered the basic Keynesian IS-LM model supplemented by liquidity trap considerations and paid no attention to DSGE models and micro foundations papers.  Mark Thoma, who was present, reports it here and quotes a bit from The Economist's writeup and links to it. 

His broader point—reinforced by his mentions of the knowledge contained in the writings of Bagehot, Minsky, Kindleberger, and Eichengreen—was, I think, that while it would be wrong to say economics or economists had nothing useful to say about the crisis, much of what was the most useful was not necessarily the most recent, or even the most mainstream. Economists knew a great deal, he said, but they had also forgotten a great deal and been distracted by a lot.

Update on Saturday, April 16, 2011 at 09:58AM by Skeptic

A series of graphs plotting inflation rates vs. unemployment rates from 1948 to 2007 is presented by Catherine Mulbrandon at VisualizingEconomics. Her interpretation is that the Phillips relationship held only in the 1960s. 

Update on Monday, July 18, 2011 at 03:02PM by Skeptic

Peter Radford identifies the 1930s as a time of great political ferment that created schisms in economic doctrines rather than the other way around.  The doctrines of that time are all incomplete, very much alive, and serve different political interests.  An excerpt:

The divisions that carve economics apart are extraordinarily deep. But very often they are political in their origins. They creep into economics only after having been formed in politics. Economics is hopelessly ideological.

Thus the Austrian school agrees with the neoclassical camp that government intervention in an economy is almost always a negative effect. The Keynesians adamantly disagree.

But the Austrians also embrace uncertainty. That splits them part from the neoclassicists who build their theories on presumptions of varying degrees of certainty. The Keynesians have uncertainty at the core of their ideas, so they agree on this with the Austrians.

Money disappears from neoclassicism which is, essentially, a theory of barter, while Keynes brings money into the center. But he, rather curiously, ignores banks.

The Austrians, via Hayek, have a great deal to say about the centrality of knowledge and its evolution which makes them close to evolutionary economics and more comfortable with behavioral economics, yet they have a naive view of production and entrepreneurial activity which means they fall short of embracing complexity and thus have nothing much to say about the modern firm.

Which is odd, since institutions play a greater role in Austrian theory than in either Keynes or neoclassicism. This leaves new institutional economics straddling the gap between neoclassicism and the Austrian school.

Update on Friday, April 6, 2012 at 02:44PM by Skeptic

Mark Thoma explains New Classical, New Keynesian, and Real Business Cycle Models.

Update on Saturday, April 7, 2012 at 10:29AM by Skeptic

Unlearning Economics lays out the implicit assumptions he thinks all neoclassical economists (freshwater and saltwater) make and then never discuss. 

(1) Methodological individualism – the economy is modeled on the basis of the behaviour of individual agents.

(2) Methodological instrumentalism – individuals act in accordance with certain preferences rankings, to attain some end goal that they deem desirable.

(3) Methodological equilibration – given the above two, macroeconomics asks what will happen if we assume equilibrium. Note that this doesn’t  necessarily posit that the system will end up in equilibrium (although that is often the case), but rather seeks to find out what will happen if we use equilibrium as an epistemological starting point.

This foundation makes it hard for them to credit the work of other schools whose work starts with different assumptions. Unlearning sees this talking-past-each-other problem in the current argument between Keen and Krugman.

Update on Friday, June 26, 2020 at 02:50PM by Skeptic

The link to Mankiw's paper has rotted away.  The official citation is Mankiw, N. G., The Macroeconomist as Scientist and Engineer. Journal of Economic Perspectives. 2006; 20 (4) :29-46.  The link to a PDF is working today.

Shouting at the deaf

Yesterday I described Marxist economists as one of several groups that predicted the financial crisis and pointed out that Marxists do not think about policy prescriptions to prevent, ameliorate, or recover from such crises because their belief system assumes our economic system is inherently unsustainable and will collapse and be replaced. They say a crisis proves their fundamental beliefs and brings us another step closer to the inevitable.

Today, in an exchange with some folks who seem to be strict anti-government free-marketeers, I realized they too are uninterested in policy prescriptions to prevent, ameliorate, or recover from crises because their belief system assumes that whatever happens in a totally unregulated market system is the very best possible result by their only criterion—it is the result of a free market system. If the results seem bad by some econometric or human measure, that can't be considered because they know free markets produce the most "efficient" results, and any undesirable effects must be due to government interference.

Both groups are functionally deaf (and illiterate too) to discussions about making governments and markets work better, and it's no use shouting. Now that I've taken the trouble to write that down, it seems too obvious to waste electrons on. But how does one communicate effectively with ideologues?

Five heterodox groups of economists who should be brought out from under the shadow of the orthodox economists who have no answers for financial crises

If you are as interested as I am in the fact that the most prestigious groups of economists were totally surprised by the recent financial meltdown, have no models or theory to explain it after the fact, and are continuing their virtual reality games as though nothing happened, you'll want to read this paper by Jamie Galbraith in the NEA Higher Education Journal. My summary:

While the two mainstream schools, Chicago (or freshwater or neoclassicists) vs. MIT (or saltwater or new Keynesians), have contended vigorously with each other over details, they remain united in a commitment to an all-encompassing theory expressed in mathematics.  They are in the same "gentlemen's club" in which nobody loses face for predicting things that don't happen, failing to predict things that do happen, or maintaining positions that outsiders can clearly see are goofy. Galbraith describes five heterodox groups that did predict the recent crisis and similar crises in the past and says we would be better off if they had more resources and influence.

The hoariest are the "American Marxists" who believe the economic system is fundamentally flawed by conflicting power relationships and that its eventual collapse will be triggered by one of several events (they don't all agree on the specific type) like a collapse in the dollar, accumulating current account deficits, overextension of debt in the financial system, etc. Since these economists are "habitual Cassandras" and are uninterested in policy adjustments for what they think is a unsalvageable system, it's hard to see how they are helpful, but they did predict the financial crisis.

Dean Baker and others have predicted asset bubbles by observing large deviations from their means of relationships such as P/E ratios, home ownership prices to rents, etc. Critics complain that it relies on the assumption that the chosen relationship will revert to a mean not because there is a theoretical reason why it should but only because it always did in the past. The lack of theory is troubling to other economists, but these folks were right about the financial crisis and have a methodology that predicts reasonably well the sizes of adjustments.

Another group in Cambridge (UK) and the Levy Economics Institute studies relationships in the National Income and Product Accounts (which generate GDP) and argue, with some theoretical underpinnings, that large increases or decreases in Consumption, Private Investment, Government Spending, or Net Exports must induce opposite changes in certain other accounts and that at some point these shifts are unsustainable and must reverse. They too were right about the financial crisis.

Hyman Minsky and his followers like Barkley Rosser and Ping Chen developed a theory that stability in markets breeds instability and that self-generated boom-bust cycles are inevitable unless government intervenes to prevent hedging, which normally morphs into speculation (the obvious need to refinance in the future), from passing into the Ponzi phase (where ever-increasing amounts will have to be refinanced). This group warned against the policies of Alan Greenspan and Larry Summers that not only facilitated but actively encouraged what was obvious Ponzi financing, and they predicted the financial crisis.

The economics of John Kenneth Galbraith in The New Industrial State (1967) sought to focus less on markets and more on institutions (big corporations, labor unions, governments, etc.) and how those institutions function internally and in relation to each other. The mainstream economists hated and marginalized it. Jamie Galbraith followed this tradition in The Predator State (2008), arguing that after about 1970 there was a withering of internal controls in corporations, less governmental oversight, and other pressures that led to managements running amok, often blindly. As several financial crises (S&L, Dot.com, Enron/Worldcom, Sub-prime) were autopsied, a lack of control and irresponsible behavior is at the center of all. Other economists studying these institutional dynamics have pointed out recurrent patterns not only of irresponsibility and chaos but of fraud and looting and warned of recurrences if the institutions were not reformed. This group also predicted the financial crisis.

Finally, Galbraith argues that the "gentlemen's club" must be circumvented by university administrators, foundations, students, and others outside the mainstream economics departments to create academic space and public visibility for these versions of economics.

Animal spirits and what else is wrong with neoclassical economics

A much discussed book this year has been Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George Akerlof and Robert Shiller. One of the best discussions is by John Gray in the London Review of Books. Link. He credits Akerlof and Shiller for their evisceration of neoclassical economics for assuming at its core rational behavior of human beings—conceiving them to be a species, homo economicus, that is not us. Gray goes beyond this and points out that even if we all were homo economicus, important parts of the future are always unknowable and cannot be quantified and factored into market decisions as probabilities. A third theme of the review is the hubris of the neoclassical school in assuming that the magic beans they had discovered would work in any environment and that, indeed, no other doctrine would lead to economic abundance. Unaccountably and regrettably, these ideologues appear not to have noticed in the real world the massive contradictions to that view. A few excerpts:

. . . . The trouble with prevailing theories, in Akerlof and Shiller's view, is that they assume human beings are more rational than they actually are. 'This book, which draws on an emerging field called behavioural economics, describes how the economy really works,' they claim. 'It accounts for how it works when people really are human, that is, possessed of all-too-human animal spirits.'

. . . .

. . . . If economists have failed to explain repeated crises, it is because they have interpreted economic activity through an unreal model of rational decision-making. Thinking of human behaviour in this way allows them to claim a high degree of precision for their discipline, which is presented as a kind of applied mathematics. But they have left psychology out of their equations.

. . . . The fact that markets are flawed seems novel only in the context of the economic orthodoxy that prevailed between the wars, and in the run-up to the recent crisis. It is wrong to imply, as Akerlof and Shiller do, that the classical economists believed otherwise. 'Just as Adam Smith's invisible hand is the keynote of classical economics,' they write, 'Keynes's animal spirits are the keynote to a different view of the economy – a view that explains the underlying instabilities of capitalism.' Here they are endorsing the caricature of Smith propagated by neoliberal ideologues anxious to confer a distinguished patrimony on an illegitimate intellectual offspring. . . .

If Akerlof and Shiller's grip on the history of economic thought is shaky, they also fail to grasp why Keynes rejected the idea that markets are self-stabilising. . . . [I]n his canonical General Theory of Employment, Interest and Money (1936) he concluded that there was no way anyone could make forecasts. Future interest rates and prices, new inventions and the likelihood of a European war cannot be predicted: there is no 'basis on which to form any calculable probability whatever. We simply do not know!' For Keynes, markets are unstable less because they are driven by emotion than because the future is unknowable. To suggest that the source of market volatility is unreason is to imply that if people were fully rational markets could be stable. But even if people were affectless calculating machines they would still be ignorant of the future, and markets would still be volatile. The root cause of market instability is the insuperable limitation of human knowledge.

. . . .

The central flaw of the economic orthodoxy against which Keynes fought in the 1930s was to imagine that an insoluble problem – human ignorance of the future – had been solved. The error was repeated in the 1990s, when economists came to believe that complex mathematical formulae could tame uncertainty in the murky world of derivatives. . . .

. . . . Hayek said that governments could never know enough to plan the economy successfully – a claim vindicated by the miserable record of central planning in Communist countries. At the same time, he attributed near omniscience to markets, and never doubted that if left to its own devices the economy would liquidate mistaken investments and return to equilibrium. Against this, Keynes had shown that there is no market mechanism that ensures revival; economic contraction can be self-reinforcing, and only government action can then create a way out.

. . . .

Akerlof and Shiller claim that their account of the role of psychology helps to explain the financial crisis. 'Our theory of animal spirits,' they say, 'provides an answer to a conundrum: why did most of us utterly fail to foresee the current economic crisis? How can we understand this crisis when it seems to have come out of the blue with no cause?' They are right that part of the answer lies in an intellectual default within economics, but they seem oblivious of the role of ideology in producing this default. The deformation of economics was not the result only of factors internal to the discipline, it was also part of the short-lived Western triumphalism that followed the end of the Cold War.

Those were the years when slackers throughout the world were enjoined to submit themselves to the rigours of 'the Washington consensus' – a mix of dogmatic policy prescriptions and hypocritical rhetoric that enjoyed the support of the great majority of economists. According to that consensus, the market regime that was installed in Britain, the US and a few other countries from the 1980s onwards could not only ensure stability and promote steady growth there but was a model – the only possible model – for countries everywhere. The one truly rational economic regime, free market capitalism, was also the most productive. As such it was bound to drive every other system out of existence, and would eventually be adopted worldwide. This faith in the universal spread of free markets animated much of the thinking of the American-led institutions overseeing the world economy, such as the IMF. Along with economists in university departments in much of the world, these institutions succumbed to a quasi-religious belief that the free market was the germ of a single, universal economic system.

Not everyone swallowed this creed. It was not accepted in China, which then as now displayed a well-founded contempt for Western advice – an attitude that has much to do with its astonishing economic success. Whether in the face of global recession China can continue to grow at the same rate is unclear – as Keynes would have put it, we simply don't know. Nonetheless, its emergence as an economic superpower poses questions for economics that are harder to answer than is generally recognised. Economists do not always take the neoliberal party line, according to which growth can be sustained only in a regime of deregulated capitalism; the evidence of history precludes any such simple-minded view. Liberal capitalism has achieved striking results (though in the US, often against the background of trade protection), but so have many varieties of dirigisme, from rapid growth in late tsarist Russia to Asian market economies in the decades after 1945. Economic historians whose minds are not befogged by ideology accept that there are many routes to growth. At the same time, nearly all Western-trained economists insist that sustained growth is impossible in the absence of a legal system that allows the independent rule of law and secure rights to private property. Without this framework, they believe, there will not be the incentives required for long-term saving and investment.

But China has achieved the largest and fastest industrialisation in history without having such a legal system. Until recently, Western economists, along with other Western observers, were adamant that China would continue to be successful only to the extent that it mimicked Western practice. Now that Western economies are in trouble this confidence has been shaken, and China is once again being perceived as alien and dangerous. There is no real attempt to try to understand the sources of its success. Like other branches of the study of society, economics remains culturally parochial, and its underlying concepts based on a few centuries of Western experience.

. . . .

Akerlof and Shiller intend their analysis to contribute to an intellectual reformation in economics, as a consequence of which the discipline will become more useful to policy-makers. It must be doubted, though, that the authors will succeed in persuading economists of the inadequacy of the conception of rational action. The profession is one of the few areas of human activity in which that conception is applicable. In its intra-academic varieties, at any rate, economics is insulated from the world not only by its narrow explanatory methodology but also because it rewards the mathematical modelling that resulted in nearly all of its members failing to anticipate the financial crisis. As institutionalised in universities, the notion of rational decision-making is self-perpetuating. Economics as currently practised may have only a slight grip on market behaviour, but it seems to be powerfully predictive of the behaviour of economists.

Thanks to Mort for bringing this piece to my attention.

Update on Saturday, December 19, 2009 at 07:37AM by Skeptic

Gavin Kennedy reposted parts of this and added his comments on Adam Smith's Lost Legacy. (Scroll to November 26, 2009.) Kennedy is an economic historian and an expert on Adam Smith, about whom he has written extensively, including two books. 

Irving Kristol, the midwife of supply-side economics before he became the Godfather of neo-conservatism

David Warsh summarizes Irving Kristol's contributions to supply-side economics and other tenets of 1980s conservatism here.

The side he picked in economics was an odd one. A 1975 issue [of The Public Interest founded and edited by Kristol] featured a pair of articles: "The Social Pork Barrel" launched the career of a young Michigan Congressman, David Stockman, who would become budget director for Ronald Reagan; and "The Mundell-Laffer Hypothesis – a New View of the World Economy," by Wall Street Journal editorial writer Jude Wanniski, introduced the world to economists Arthur Laffer and Robert Mundell, and their newly-invented brand of "supply side economics."

The striking thing about Wanniski's article was its anti-establishment tone, anti-Chicago as well as anti-Cambridge, Mass. The new hypothesis might be as transformative as the Copernican Revolution, he averred – or at least that of John Maynard Keynes. Mundell and Laffer's enthusiasms for a gold standard, fixed exchange rates, large tax cuts and tight money were picked up and greatly amplified by the editorial page of The Wall Street Journal. The Republican Party was divided – insouciant economic populists in one wing, sober technocrats in another.

In the neo-conservative firmament, the stars of ordinarily first-magnitude conservatives Milton Friedman and Martin Feldstein dimmed, while Laffer and Wanniski brightened. The success of The Way the World Works, Wanniski's 1979 book for editor Midge Decter, nearly ripped apart the boutique social science publisher Basic Books, where Kristol worked as an editor as well.

By then The Public Interest was losing its force. As James Q. Wilson wrote the other day in The Wall Street Journal, "It began to speak more in one voice and the number of liberals who wrote for it declined." Daniel Bell quietly resigned, in 1980. It didn't matter. The Republicans were in power; and Kristol was ready for a second act. He would become widely known as "the Godfather" of neo-conservatism, dispensing favors and advice as a political activist operating out of the American Enterprise Institute in Washington.

In its obituary last week, The Economist summed up this second act of Kristol's career: "American conservatism, before he began to shake it up, was dour, backward-looking, anti-intellectual and isolationist, especially when viewed from the east coast. By the time Mr. Kristol … had finished with it, it was modern and outward looking, plumped up with business-funded fellowships and think tanks and taking the lead in all policy debates."

Economist Brad DeLong found and posted this quotation showing Kristol was interested in political messages, but economic science—not so much.

Among the core social scientists around The Public Interest there were no economists.... This explains my own rather cavalier attitude toward the budget deficit and other monetary or fiscal problems. The task, as I saw it, was to create a new majority, which evidently would mean a conservative majority, which came to mean, in turn, a Republican majority - so political effectiveness was the priority, not the accounting deficiencies of government...

A comment on Mark Thoma's blog supplies the link to the original source of this quotation. 

Update on Friday, May 7, 2010 at 07:03AM by Skeptic

Bruce Bartlett has posted the contents of Jude Wanniski's influential 1976 National Observer article here.

At the bottom of the financial crisis--powerful minds with strange ideas

Keynes' biographer, Robert Skidelsky, echoes Keynes' assertion that ideas are more powerful than vested interests:

"The root cause of the present crisis lies in the intellectual failure of economics,” Mr. Skidelsky writes. “It was the wrong ideas of economists which legitimized the deregulation of finance, and it was the deregulation of finance which led to the credit explosion which collapsed into the credit crunch. It is hard to convey the harm done by the recent dominant school of New Classical economics. Rarely in history can such powerful minds have devoted themselves to such strange ideas."

(From Dwight Garner's NYT book review.)  Yes, and Alan Greenspan admits his powerful mind held some of these strange ideas. 

Orthodox economics has failed, and Notre Dame ousts the heterodox professors.

In 2003, Notre Dame imprisoned its teachers of economic history, "saltwater economics," and economic theory compatible with Catholicism in a department of economics and policy studies.  A new department of economics and econometrics was organized and staffed to do orthodox, mathematically sophisticated, "freshwater" economics.  As the culmination of several moves crippling to the heterodox department, it is reported that Notre Dame will dissolve it and scatter the professors into other departments.  They are no longer allowed to teach introductory or intermediate level courses.  The orthodox types have consolidated their power just at the moment of the most spectacular failure of their theories in the real world. Apparently, the Catholic Church learned nothing from that Galileo affair. 

Update on Saturday, September 19, 2009 at 07:59AM by Skeptic

Commenter SS on Mark Thoma's blog highlights here the inconsistency between the Notre Dame choice and papal encyclicals. 

Update on Wednesday, January 6, 2010 at 07:02AM by Skeptic

Notre Dame economics students have a blog, and this is what one posted about the crisis in economics and the missed opportunity at Notre Dame. The post is mostly excerpts from Jamie Galbraith's paper for the NEA Higher Education Journal.

The battle to discredit orthodox macroeconomics is getting interesting.

The sub-prime mortgage meltdown and the Great Recession have unleashed a tremendous battle among macroeconomists over the almost complete failure of orthodox economics to predict and prevent these calamities, or even to allow for the possibilities that they could occur. Paradigm shifts have occurred several times in economics in the last 100 years, and we seem to be witnessing another. For a really good historical perspective as well as layman-friendly descriptions of some of the disputed doctrines, read Paul Krugman's NYT magazine piece How Did Economists Get It So Wrong? I've been a more-than-casual reader in the history of economic thought for the last 4-5 years and this is by far the best read-in-one-sitting piece I know of.

Krugman describes the schism between the "freshwater" economists and the "saltwater" economists and explains key concepts like the "Chicago School," neo-classicism, monetarism, free market fundamentalism, efficient market hypothesis, rational expectations, behavioral finance, general equilibrium models, "real business cycles" theory, mathematical vs. "literary" methods, monetary vs. fiscal stimulus, supply-siders and Keynesians, asset price bubbles (including the belief that they can't happen), and "zero-bound" interest rates. He discusses the influential contributions and views of individuals like Olivier Blanchard, Robert Lucas, Ben Bernanke, John Cochrane, Brad DeLong, Adam Smith, John Maynard Keynes, Joseph Schumpeter, Milton Friedman, Anna Schwartz, Eugene Fama, Michael Jensen, Larry Summers, Robert Shiller, Alan Greenspan, Raghuram Rajan, Edward Prescott, Greg Mankiw, David Romer, Andrei Shleifer, Robert Vishny, Mark Gertler, Nobuhiro Kiyotake, John Moore, Casey Mulligan, and even H. L. Mencken. The article concludes this way:

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: "There is always an easy solution to every human problem — neat, plausible and wrong."

When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won't be neat; but we can hope that it will have the virtue of being at least partly right.

The arguments among economists in the blogosphere are more detailed, more intense, and often bitter. For example, John Cochran blasts back at the Krugman article, and Krugman replies on his blog with language that probably wouldn't pass NYT standards for gentility in the print version. David Warsh, who has done a lot of fine writing about the history of economic thought, has a different take here and a link to a recent paper by Robert Gordon with his version of recent history and what should come next. Warsh reminds us that the last big paradigm shift 30 years ago involved discrediting the dominant Keynesian view by associating it with the "Phillips curve" (which claims a tight inverse relationship between unemployment and inflation). Mark Thoma has collected here links to very diverse sources who have weighed in on the future of macro, and Mark has been otherwise very active in the discussion.

Below, strictly for my own convenience, are links to other Realitybase posts on the pending (I hope) paradigm shift.

http://www.realitybase.org/journal/2009/4/1/my-kind-of-economist.html

http://www.realitybase.org/journal/2009/3/15/blame-the-economists-not-economics.html

http://www.realitybase.org/journal/2009/2/11/economic-theory-in-crisis-another-view.html

http://www.realitybase.org/journal/2009/1/28/orthodox-economics-is-in-crisis-or-maybe-not.html

http://www.realitybase.org/journal/2009/1/25/economics-professors-are-training-virtual-reality-gamers.html

http://www.realitybase.org/journal/2009/1/15/liberal-and-libertarian-economists.html

http://www.realitybase.org/journal/2009/1/7/how-many-pinheads-can-dance-on-a-virtual-austrian.html

http://www.realitybase.org/journal/2009/1/6/the-financial-theory-king-is-dead-now-what.html

http://www.realitybase.org/journal/2008/12/6/theyre-baaaack-keynesians-to-the-rescue.html

http://www.realitybase.org/journal/2008/10/24/two-economists-views-on-whats-wrong-with-their-profession.html

http://www.realitybase.org/journal/2008/6/13/rubinomics-in-crisis.html

http://www.realitybase.org/journal/2008/5/23/even-milton-friedman-has-said-mainstream-economics-does-not.html

Update on Saturday, September 19, 2009 at 07:21AM by Skeptic

Krugman focuses here on the time (1980-81) and issue (the failure of the Lucas rational expectations modification of the Phelps employment model to account for stagflation) that split the "freshwater real business cycle" types and the "saltwater new Keynesians." 

Even Milton Friedman has said mainstream economics does not deal with real economic problems.

What's wrong with "neoclassical" or "mainstream" economics as it is taught, practiced, and widely believed today? Here are the words of six winners of the Bank of Sweden Prize (Nobel Prize) for Economics saying, in essence, that the subject is simply irrelevant to the real world.

[E]conomics has become increasingly an arcane branch of mathematics rather than dealing with real economic problems. Milton Friedman

[Economics as taught] in America's graduate schools . . . bears testimony to a triumph of ideology over science. Joseph Stiglitz

Existing economics is a theoretical [mathematical] system which floats in the air and which bears little relation to what happens in the real world. Ronald Coase

We live in an uncertain and ever-changing world that is continually evolving in new and novel ways. Standard theories are of little help in this context. Attempting to understand economic, political and social change requires a fundamental recasting of the way we think. Douglass North

Page after page of professional economics journals are filled with mathematical formulas. . . . Year after year economic theorists continue to produce scores of mathematical models and to explore in great detail their formal properties; and the econometricians fit algebraic functions of all possible shapes to essentially the same sets of data. Wassily Leontief

Today if you ask a mainstream economist a question about almost any aspect of economic life, the response will be: suppose we model that situation and see what happens. . . . Modern mainstream economics consists of little else but examples of this process. Robert Solow

Mainstream economics is under (well-deserved) attack. There are even heterodox economics journals like my favorite, real-world economics review, an exclusively-online journal that was until this year named the post-autistic economics review. (It is the source of the above quotations.) Although it is militantly heterodox, it has attracted submissions from many leading economists including Kenneth Arrow, James Galbraith, Robert Heilbroner, Jeffrey Sachs, and Joseph Stiglitz.

But the mainstreamers still control the high academic ground and are fighting fiercely. In 2004, Notre Dame renamed its economics department the Department of Economics and Policy Studies and brought in new professors to create a neoclassical Department of Economics and Econometrics. The recently-ghettoized professors have posted a petition that describes the situation and seeks support for the idea that their group should not be eliminated and that required economics courses not be exclusively neoclassicist orthodoxy. The petition is worth reading because it describes how economics is taught in other major schools, which is, of course, why Notre Dame created the new department.

Also worth reading is the home page of real-world economics review, which features short essays on, inter alia, A Brief History of the Post-Autistic Economics Movement, The Strange History of Economics (about how mainstream economics came to divorce itself from reality), and Policy Implications of Post-Autistic Economics, and links to several books.

Meanwhile millions of us have graduated believing neoclassical economic theory instead of our own lying eyes. How long will this go on? As a junior officer Colin Powell asked a mentor how long the US would stick with a certain weapons system that had some obvious vulnerabilities; the answer was, "Until it fails in war." It seems neoclassical economics will continue to be our conventional wisdom until it suffers a spectacular failure. Are we there yet?

Update on Saturday, May 24, 2008 at 10:16AM by Skeptic

Thanks to John (Comment #1) for pointing out that I have been laboriously reinventing the Austrian School of economics. I was familiar with some of the tenets of the school—that planned economies cannot work because price discovery information is critical but unavailable, and the extreme libertarian, absolute property rights philosophy. But I had not noticed the school’s rejection of the scientific pretensions of what has become mainstream economics. According to information in the links John provided, mainstreamers have sneered at Austrian School types as being mere “literary economists.”

Be sure to watch this space for an announcement of my work on something I call the “wheel.”

Economic Science is to Science as Fantasy Football is to Football

This week three gents won the Nobel Memorial Prize for "Economic Science."  The idea that the study of political economy is a science is misleading to the general public and, apparently, to a great many economists.  To call the field a "science" is to imply that it employs the "scientific method," developing hypotheses about cause and effect or other relationships in the physical world and attempting to disprove or confirm them empirically.  To the contrary, economists, especially macro-economists, are not able to test anything because the real world has a vast number of uncontrollable variables (including populations who refuse to cooperate). 

Wise economists recognize this and properly regard their ideas as merely insights or arguments in the legitimate (but unscientific) field of "political economy."  Economic "scientists," on the other hand, seem to deal with the real world by ignoring it when it does not agree with their beliefs.  The latter often develop mathematical models and run them through computers as though their field can be explained as simply and elegantly as Isaac Newton explained the laws of motion.  Unfortunately for them, the real world of macro-economics has a complexity more like that of the life sciences.  A principal focus of this blog is likely to be exposing the unreality of their views, which can do great damage when promoted by influential people. 

On the bright side, the recent Nobel prize was for work on "mechanism design theory."  That this sub-field exists is a challenge to free market fundamentalists who purport to believe that free markets yield the best solutions to all problems.  The fundamental tenet of this sub-field is that all markets have rules and that the particular rules chosen can have great influence on transaction outcomes.  For a brief and useful summary, see John S. Irons. 

Update on Saturday, October 20, 2007 at 10:15AM by Skeptic

"Carping from time to time over the unworthiness or politics of a particular Nobel peace or literature laureate is expected.  But when it comes to economics, it's the award itself that sometimes comes in for sneers; even a couple of its winners have suggested it be abolished."  Today's New York Times.  The story quotes James K. Galbraith, "They're not engaged in the problems of the actual world."  1974 winners Gunnar Myrdal and Freidrich von Hayek were the two laureates who suggested there should be no prize for economics.  Myrdal "rejected the idea that the field of economics could claim a Nobel on the basis of its scientific rigor."  But they're still doing it, so I'll continue "carping."