Tuesday, January 8, 2013

Can economics be re-established as a relevant social science?

In an interesting post, Lars Syll, a Swedish economist, looks at what it would take to re-establish economics as a realist and relevant social science.
Economics – and especially mainstream neoclassical economics – has as a science lost immensely in terms of status and prestige during the last years. Not the least because of its manifest inability to foresee the latest financial and economic crisis – and its lack of constructive and sustainable policies to take us out of the crisis....
Please re-read the highlighted text as Professor Syll has nicely summarized both the failure of economics to foresee the crisis and, much more importantly, the failure of economics to present constructive and sustainable policies to get us out of the crisis.
Neoclassical economists, however, have wanted to use their hammer, and so decided to pretend that the world looks like a nail. Pretending that uncertainty can be reduced to risk and construct models on that assumption have only contributed to financial crises and economic havoc....
Please  re-read the highlighted text as Professor Syll has nicely made the critically important point that the economics profession has contributed greatly to the financial crisis.
How do we re-establish credence and trust in economics? Five changes are absolutely decisive.  
(1) Stop pretending that we have exact and rigorous answers on everything. Because we don’t. We build models and theories and tell people that we can calculate and foresee the future. But we do this based on mathematical and statistical assumptions that often have little or nothing to do with reality. By pretending that there is no really important difference between model and reality we lull people into thinking that we have things under control. We haven’t! This false feeling of security was one of the factors that contributed to the financial crisis of 2008.
Your humble blogger has frequently said that the every economist who offers their opinion about how to respond to the financial crisis should first say whether they publicly predicted the crisis or not.

Everyone knows that if you didn't see the crisis coming it is highly doubtful that your analysis of the crisis will be accurate.  After all, leading up to the financial crisis you had no insight into what was wrong with either your models or the financial system.
(2) Stop the childish and exaggerated belief in mathematics giving answers to important economic questions. Mathematics gives exact answers to exact questions. But the relevant and interesting questions we face in the economic realm are rarely of that kind. Questions like “Is 2 + 2 = 4?” are never posed in real economies. Instead of a fundamentally misplaced reliance on abstract mathematical-deductive-axiomatic models having anything of substance to contribute to our knowledge of real economies, it would be far better if we pursued “thicker” models and relevant empirical studies and observations.
A classic example of where the models haven't worked is the Fed's models of the economy.  The Fed models neither predicted the financial crisis nor have they predicted the subsequent economic performance that has occurred.

I have previously noted on this blog how economists get upset that consumers and savers are not responding in the way that their mathematical models suggest.  Perhaps the consumer or saver is not wrong, but rather the mathematical model is wrong.
(3) Stop pretending that there are laws in economics. There are no universal laws in economics. Economies are not like planetary systems or physics labs. The most we can aspire to in real economies is establishing possible tendencies with varying degrees of generalizability....
Actually, there is one law in economics.  For the invisible hand to operate properly, buyers must have all the useful, relevant information in an appropriate, timely manner so they can assess and make a fully informed decision.

Where this isn't true is an example of an imperfect market.
(5) Stop building models and making forecasts of the future based on totally unreal micro-founded macromodels with intertemporally optimizing robot-like representative actors equipped with rational expectations. This is pure nonsense. We have to build our models on assumptions that are not so blatantly in contradiction to reality. Assuming that people are green and come from Mars is not a good – not even as a “successive approximation” – modeling strategy.

From the IMF.

A session at the annual American Economic Association conference in San Diego January 4–6 heard that debt levels have exploded across the advanced economies since the financial crisis, and are now at unprecedentedly high levels. High debt levels are a potential drag on growth, the session was told. 
At the conference, economists from the IMF, academia, and a broad range of other institutions acknowledged that, five years after the start of the Great Recession, economists are still struggling to find solutions to the mounting debt and high unemployment the crisis has triggered....
“The past few years have highlighted how little we actually know,” stressed Donald Kohn, a former Vice Chair of the U.S. Federal Reserve who is currently at the Brookings Institution. 

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