The Economic Crisis and the Need to Rethink Economics

Many of the criticisms people now make of economics have been made in the past. The Post-Autistic or Real World Economics Movement has been gaining prominence, but it has been around for a long time. The difference now is that the crisis seems to be proof that the criticisms are true. They are not so easy now for the mainstream of the economics profession to shrug off. In fact, many economists are taking the critique very seriously.

So I would like to present a paradox. Economics is both in crisis — and experiencing an extraordinarily fruitful renaissance. There is already a new approach emerging from the pre-crisis framework, like a butterfly hatching out of its chrysalis. It is much less tied to a particular theoretical approach — it is both more pragmatic and more empirical. It is rooted in a lot of existing work that has been more or less hidden from public view, but is what most economists actually do. It is vital for the contribution of economics to the real world that we don’t throw this baby out with the bathwater.

Yes, it is true that practitioners and policy makers acted as if the strong form of the Efficient Markets Hypothesis held true — in other words that prices instantly reflect all relevant information about the future — even though this clearly defies reality. The computer and communications technologies fed the trend as well, by making more and more financial transactions possible.

I think an honest, conventionally-trained economist has to at least acknowledge that we grew intellectually lazy about this. Although we all knew at some level that the rational choice assumption was being made to bear too much weight, very few economists openly challenged its everyday use in justifying public policy decisions. Very few of us put this weight on it in our own work. But not all that many economists challenged its pervasive use in the public policy world.

One result has been that many critics think all economists are right-wing free marketeers. The “Occupy” movements would blame economics for much more than just the financial crisis, in particular the much greater income inequality in almost all OECD economies now. Meanwhile, the evidence from surveys is that left-of-center economists outnumber right-of-center economists, although by much less than in the other social sciences.

Critics also dislike what they see as the reductionism of economics, the philosophy that the economy can be understood as the aggregation of individual profit- or income-maximizing decisions by independent economic agents. I think economists would acknowledge that there are definitely circumstances where this assumption is not valid, and it has been used as a matter of practicality, of simplicity. Again, though, it was very much taken for granted. The crisis, so strongly marked by herd behavior, firmly underlines its limitations.

For all these reasons, the financial and economic crisis also spells a crisis for certain areas of economics, or approaches to economics. Financial economics and macroeconomics are particularly vulnerable. They are the subject areas where the consequences of the standard assumptions have been most damaging, because they are actually least valid.

There is a good reason for using these models, though. Because understanding and forecasting the aggregate behavior of millions of businesses and individuals is an impossibly hard task. It is much harder than long-range weather forecasting because it ought to incorporate the effects that individual decisions have on each other, and because it ought to incorporate expectations of the future into today’s decisions.

Another problem is the economics curriculum in universities. In most cases, students are taught one macroeconomic worldview as if it were true, with no intellectual context, no history of economic thought. They learn almost nothing about economic institutions such as the banking system. They have little sense of economic history, which is usually not required now (although it used to be in many Ph.D. programs).

Economists have also come to have a particularly influential role in public policy, compared to other social scientists. (We have chief economists in most departments in the UK, but not chief anthropologists or chief psychologists.) Other social scientists of course give policy advice as well, but unlike economists they do not have specific roles in the administration.

It would be ironic, and regrettable, if the crisis causes people to distrust economics at exactly the time when it has more to offer. This is one reason that we economists have to put our house in order now, and acknowledge our collective faults. It’s no good making criticisms without suggesting solutions, so here are a few reforms the discipline of economics needs:

1. You can predict a macroeconomist’s political views from the confidence of his statements about the economy. They are bringing all of us into disrepute, and instead of going on TV to criticize the government or the opposition, they need to become more humble about what they know.

2. Economists who are genuinely interested in how the economy functions in the aggregate will need to open their minds to different approaches, as there is nothing like a consensus on this part of the subject.

3. Academics in general do not have strong incentives to teach well, so it would be good to see that improved. I would also like to see universities and research funders encourage disciplinary innovation and fresh thinking to ensure that academic economists do not simply draw up the barricades against their critics and resist any change.

I hope that the crisis will strengthen economics by stimulating reform from within. Most economists are actually very practical, not just abstract theoretical people. They are passionate about using their knowledge to improve the world and keen to test their theories against the evidence. That is true even if the evidence sometimes needs knocking into shape before it confirms that the theory is correct.

In the end, the data explosion and the vast increase in computing power is what makes me most optimistic that we will see the subject evolve in important ways. Rather than just relying on instincts and preferences covered up as theories, we now have the wherewithal to use a lot of data to make real progress in understanding the world.

When I was a Ph.D. student, access to both data and computer time was very costly. Sometimes, data had to be loaded by threading a big reel of magnetic tape into the computer. I had to write regression programs in Fortran, as the only commercial software available was quite limited. Each regression had to be run, one by one, overnight. One had to choose a thesis subject depending on whether or not any data would be accessible.

It wasn’t until 1980 that there was data for a significant number of countries dating back at least half a century. (Previously, there had been about 30 annual measurements for a handful of countries.) It is hard to find definitive empirical results from so little data. No wonder economists have been overly focused on abstract models.

The situation has changed spectacularly in the past 20 years or so, thanks to the availability of new databases, the computer power to use them, and the statistical techniques to make valid inferences from different types and structures of data.

The revolution of using computers to process economic data and information, then, is transformational. But it is still in its infancy in terms of its eventual impact on the state of economic knowledge and the science of economics. And although there’s no doubt that political ideology colors economists’ work, fundamentally economics remains the same discipline it always was — the application of Enlightenment empiricism to human societies in order to understand how they allocate and use resources.