Scepticism about the ability of economists to offer meaningful predictions and prognosis about economic and social phenomenon has heightened in the wake of the global financial crisis
Ten years ago, in August 2007, the French investment bank BNP Paribas SA, which had taken money from investors to buy subprime mortgages in the United States, told those investors that it was suspending redemptions because the bank’s fund managers were no longer sure what those mortgages were worth.
Ripples of panic spread across financial markets, and the resulting financial contagion led to a global credit freeze. The credit crisis culminating in the fall of the iconic American investment bank Lehman Brothers Holdings Inc. in September 2008 plunged the global economy into a recession from which it has not been able to recover till now.
The global financial crisis has also morphed into a social and political crisis, producing mass discontent, and challenging the global neoliberal consensus forged after the collapse of the Soviet system between 1989 and 1991.
Given the pivotal role of economists in forging that consensus, the cracks in the consensus have created a crisis for the discipline of economics itself.
Over the past decade, the economics profession has faced a mounting tide of criticism directed against it, both from within its ranks, and from outside.
There has always been some level of scepticism about the ability of economists to offer meaningful predictions and prognosis about economic and social phenomenon. That scepticism has heightened in the wake of the global financial crisis, leading to what is arguably the biggest credibility crisis the discipline has faced in the modern era.
Some of the criticisms against economists are misdirected. But the major thrust of the criticisms does have bite.
There are seven key failings, or the ‘seven sins’, as I am going to call them, that have led economists to their current predicament. These include sins of commission as well as sins of omission.
Sin 1: Alice in Wonderland assumptions
The basis of the post-1989 neoliberal consensus rested on what economists call the rational expectations revolution of the 1970s and 1980s. The rational expectations revolution provided the intellectual basis for ‘light touch’ regulation by positing that markets will auto-correct left to themselves, and that state or regulatory interventions can only be counter-productive.
This narrative was challenged by dissenters such as the financial economist Robert Shiller of Yale University, who noted the damaging consequences of herd behaviour in markets, and presciently warned about both the dotcom bubble of the early 2000s, and the housing bubble of the mid-2000s.
Shiller won the Nobel Prize in economics in 2013 for his work on behavioural finance, but his warnings were ignored by most macroeconomists till the big crash of 2008 happened.
The edifice built atop the rational expectations model also came crashing down then, and the policy response to the crisis reverted back to old-fashioned Keynesian demand-management policies (read fiscal stimulus packages), which the ‘superior’ and ‘rigorous’ rational expectation model had supposedly supplanted three decades back.
Why did the state-of-the-art rational expectations model fail? The answer lies in its deeply problematic assumptions. The model collapses all distinctions between firms, and homogenises all individuals and commodities.
“If you homogenize all individuals and commodities in aggregate models, it is mathematically easy to build stability into the defining equations as a pure assumption,” wrote the Harvard Business School scholar Jonathan Schlefer in his 2012 book on the subject—The Assumptions Economists Make. “But it is a pure assumption. If you want, you can just as easily build instability into the model’s defining equations.”
Schlefer is a political scientist by training and technically an outsider in the world of economics, but his work reflects a level of knowledge about the subject that even insiders would be envious of. The rational expectations revolution in macroeconomics followed the collapse of the Keynesian consensus in the wake of the stagflation of the 1970s.
But this was also the time when micro-economists led by Gerard Debreu had discovered serious problems in the stability of general equilibrium models. General equilibrium theory is a branch of micro-economics founded by Debreu and Arrow who showed in 1954 how it is possible for markets for all possible goods and services to be in equilibrium at the same time. But Debreu’s later work in the early 1970s showed that such equilibrium is unlikely to be stable.
The rational expectations theorists simply chose to ignore the instability problem. Although they claimed their model is built on ‘micro-foundations’, what they actually did was to circumvent the problem by tweaking assumptions.
Is it any wonder then that the model—which has severe theoretical limitations—has failed in practice, asks Schlefer, who calls such assumptions ‘Alice in Wonderland’ assumptions, borrowing the term from another economist.
Schlefer’s insightful book provides several such examples where economists (including for that matter, micro-economists) have chosen to just ignore quandaries, or have ruled them out through assumptions.
The problem with economists is not that they make assumptions. After all, any theory or model will have to rely on simplifying assumptions, as Schlefer too acknowledges. But when critical assumptions are made just to circumvent well-identified complexities in the quest to build elegant theories, such theories will simply end up being elegant fantasies.
Sin 2: Abuse of modelling
What compounds the sin of wild assumptions is the sin of careless modelling, and then selling that model as if it were a true depiction of an economy or society.
As the financial economist Paul Pfleiderer of Stanford University pointed out in a 2014 research paper , the models of economists are often used as ‘chameleons’, which change colour as it suits the user or the developer of the model.
“A ‘chameleon model’ asserts that it has implications for policy, but when challenged about the reasonableness of its assumptions and its connection with the real world, retreats to being a simply a theoretical (bookshelf) model that has diplomatic immunity when it comes to questioning assumptions,” wrote Pfleiderer.
Pfleiderer argues that if a theoretical model is to be used in real, it must pass through filters that determine its applicability in the real world, in the particular context for which it is being used.
The Harvard University economist Dani Rodrik makes a similar point in his 2015 book Economics Rules: The Rights and Wrongs of The Dismal Science, pointing out that the problem is often worse in empirical modelling since many of the assumptions are not explicitly spelled out and remain hidden.
Sin 3: Intellectual capture
Several post-crisis assessments of the economy and of economics have pointed to intellectual capture as a key reason the profession, as a whole failed, to sound alarm bells about problems in the global economy, and failed to highlight flaws in the modern economic architecture.
For instance, the United Nations committee on the crisis led by Nobel laureate Joseph Stiglitz pointed out that regulatory capture occurred through the realm of ideas, rather than mere lobbying for a specific cause. It highlighted the risks posed by the revolving doors between the world of academia, government, and investment banks. The 2010 documentary The Inside Job provided a detailed account of how such capture took place, and the complicity of economists in it.
In one of the few research papers on the issue, economist Luigi Zingales of Chicago University pointed out that economists have powerful incentives to generate theories and research that suit the powers that be.
“While not all data economists use are proprietary, access to proprietary data provides a unique advantage in a highly competitive academic market,” wrote Zingales in the 2013 research paper.
“To obtain those data, academic economists have to develop a reputation to treat their sources nicely. Hence, their incentives to cater to industry or the political authority that controls the data, are similar to those of regulators. Second, the natural audience of their work outside of academia is either business people or government officials applying some of that knowledge. The popularity and support among business people or the government gives credibility to a piece of research and the person who did it. Even if no researcher purposefully caters to business or the government, this selection will ensure that the most popular and successful researchers will be those who cater to business or the government.”
The nature of academic publishing further hampers the march of truth. All it takes to propagate certain ideas in the profession is to capture a few top editors, suggests Zingales. Young contributors, especially if they are untenured faculty, can easily give in to the suggestions of a persuasive editor, slanting the discourse on a certain subject.
Sin 4: The science obsession
The excessive obsession in the discipline to identify itself as science has been costly. This has led to a dangerous quest for standardisation in the profession, leading many economists to mistake a model of the economy for ‘the model’ of the economy, in the words of Rodrik.
The art of selecting the right model depending on the context and the situation at hand has not been adequately emphasised.
The science obsession has diminished the diversity of the profession, and arguably allowed complacency to take root in the run-up to the global financial crisis.
Just before the collapse of Lehman in 2008, former International Monetary Fund (IMF) chief Olivier Blanchard wrote a paper extolling the virtues of the neoliberal consensus, claiming that the convergence of views and methodologies in the discipline showed that the ‘state of macro-economics is good’.
It is only several years after the crisis that a senior economist from the Fund dared to wonder out aloud if neoliberalism had been oversold.
Sin 5: Perpetuating the myth of ‘the textbook’ and Econ 101
The quest for standardisation has also led to an astonishing level of uniformity in the manner in which economists are trained, and in the manner in which economists train others. Central to this exercise are textbooks that help teach the lessons of ‘Econ 101’—lessons disconnected from reality as they are from the frontiers of economic research.
While students who grow up to be economists do encounter other facets of economics and alternative economic explanations of the world, most others (including managers and policymakers who often take short economics courses) often end up with a rather naive view of the economy.
But even economists (and famous ones at that), who are made aware of the limitations of the textbook model as part of their training, tend to revert to it while writing op-eds and making policy prescriptions. This perpetuates the dangerous idea that Econ 101 is an adequate and powerful tool to understand the real economy.
Sin 6: Ignoring society
What makes Econ 101 and a lot of mainstream economics particularly limiting is its neglect of the role of culture and social norms in determining economic outcomes even though classical economists such as Adam Smith and Karl Marx took care to emphasise how social norms and social interactions shape economic outcomes.
Some social scientists continue to emphasise such links. For instance, in a classic 1985 research paper, economic sociologist Mark Granovetter persuasively showed how trust in economic interaction is based not on abstract faith in market-determined prices but on specific knowledge about those whom we are dealing with. But such research does not often find its way into mainstream economic thinking or teaching.
Economists typically don’t engage with other social sciences, even though insights from those disciplines have a direct bearing on the subjects of economic enquiry. Data from a 2015 research paper by researchers Marion Fourcade, Etienne Ollion and Yann Algan shows that economists are the most insular of all social scientists, and least likely to cite studies conducted outside the discipline.
Sin 7: Ignoring history
One way in which economists could have compensated for the lack of engagement with other social sciences is by studying economic history. After all, studying economic history carefully can help us understand the social and institutional contexts in which particular economic models worked, or did not work.
As Nobel Prize-winning economist Robert Solow pointed out in a 1985 research paper, a reading of economic history can offer the economist a sense of the different kinds of social arrangements and their interactions with economic behaviour.
“If the proper choice of a model depends on the institutional context—and it should—then economic history performs the nice function of widening the range of observation available to the theorist,” wrote Solow.
But economic history has been relegated to the margins over the past several years, and many graduate students remain unacquainted with the subject still.
In recent months, some commentators have suggested that the field may be witnessing a nascent resurgence in the wake of the crisis.
This brings us to the silver linings in this story of decline and depravity in economics. The crisis has jolted the profession out of its usual complacency, and has allowed dissenters to make their voices heard. The economic debates on minimum wages, on inequality and redistribution, and on economic incentives is much more nuanced today than ever before.
For several years, behavioural economists have been challenging several hoary assumptions of mainstream economists, and the profession has turned more receptive to their ideas in recent years.
The sins of economists are getting noticed, and prodded by students who want a more wholesome offering, academic economists have been forced to revisit their priors, and the way they teach.
These are still early days though. It remains to be seen how far these changes are sustained, and if the crisis turns into an opportunity for economics reform.