Economic Theory For The Real World

I have been highly critical of the government for its economic policies.  Well, here is one initiative that I think does have potential.

The Subcommittee on Investigations and Oversight of the Committee on Science and Technology of the House of Representatives is holding hearings on “the promise and limits of modern macroeconomic theory in light of the current economic crisis.”

As the Subcommittee explains in its hearing call:

The Subcommittee has previously looked at how the global financial meltdown of 2008 may have been caused or abetted by financial risk models, many of which are rooted in the same assumptions upon which today’s mainstream macroeconomic models are based. But the insights of economics, a field that aspires to be a science and for which the National Science Foundation (NSF) is the major funding resource in the Federal government, shape far more than what takes place on Wall Street. Economic analysis is used to inform virtually every aspect of domestic policy. If the generally accepted economic models inclined the Nation’s policy makers to dismiss the notion that a crisis was possible, and then led them toward measures that may have been less than optimal in addressing it, it seems appropriate to ask why the economics profession cannot provide better policy guidance. Further, in an effort to improve the quality of economic science, should the Federal government consider supporting new avenues of research through the NSF?

The hearing call then describes the essence of the mainstream macro model:

The dominant macro model has for some time been the Dynamic Stochastic General Equilibrium model, or DSGE, whose name points to some of its outstanding characteristics. “General” indicates that the model includes all markets in the economy. “Equilibrium” points to the assumptions that supply and demand balance out rapidly and unfailingly, and that competition reigns in markets that are undisturbed by shortages, surpluses, or involuntary unemployment. “Dynamic” means that the model looks at the economy over time rather than at an isolated moment. “Stochastic” corresponds to a specific type of manageable randomness built into the model that allows for unexpected events, such as oil shocks or technological changes, but assumes that the model’s agents can assign a correct mathematical probability to such events, thereby making them insurable. Events to which one cannot assign a probability, and that are thus truly uncertain, are ruled out.

The agents populating DSGE models, functioning as individuals or firms, are endowed with a kind of clairvoyance. Immortal, they see to the end of time and are aware of anything that might possibly ever occur, as well as the likelihood of its occurring; their decisions are always instantaneous yet never in error, and no decision depends on a previous decision or influences a subsequent decision. Also assumed in the core DSGE model is that all agents of the same type – that is, individuals or firms – have identical needs and identical tastes, which, as “optimizers,” they pursue with unbounded self-interest and full knowledge of what their wants are. By employing what is called the “representative agent” and assigning it these standardized features, the DSGE model excludes from the model economy almost all consequential diversity and uncertainty – characteristics that in many ways make the actual economy what it is. The DSGE universe makes no distinction between system equilibrium, in which balancing agent-level disequilibrium forces maintains the macroeconomy in equilibrium, and full agent equilibrium, in which every individual in the economy is in equilibrium. In so doing, it assumes away phenomena that are commonplace in the economy: involuntary unemployment and the failure of prices or wages to adjust instantaneously to changes in the relation of supply and demand. These phenomena are seen as exceptional and call for special explanation.

The Subcommittee goes on to ask whether this model is really sufficient for our needs, given that it appears to rule out the kind of crisis we are now struggling to overcome.  It concludes by raising the following challenging questions in an effort to determine whether “the reigning macroeconomic model [is] trustworthy for policy-making purposes? If not, should the government consider funding different kinds of research that may provide more useful insights to real economic outcomes?”

  • Last month’s G20 summit in Toronto produced a broad policy consensus behind “austerity” plans designed to reduce public debt. Practically speaking, that means governments made commitments to slash their public spending. The recovery is still shaky, and the possibility of a double-dip recession looms on the horizon. What might be the consequences of cutting government spending now? How can we determine when austerity policies make economic sense?
  • The basic unemployment rate in the United States has been hovering at just below 10 percent. Adding in the long-term unemployed who have become too discouraged to continue looking for work, as well as those who are working part time but would like to work full time, pushes the percentage of unemployed above 16 percent.  Yet not so long ago the consensus figure among economists for the U.S. “natural rate of unemployment” was stable at between 4 and 5 percent. How do economists explain this high and lingering unemployment rate? What can and should be done about it?
  • It has been suggested that one reason so many are staying unemployed is that they are lazy and enjoy receiving unemployment benefits. What can economics tell us about whether unemployment benefits have a large perverse effect of increasing the unemployment rate? If that is so, why was the “natural rate” of unemployment thought to be closer to 4 percent just a few years ago?
  • Japan has been stuck in a deflationary spiral for almost 20 years. Relatively high unemployment, weak productivity gains and slack demand appear to have become permanent features of its economy. Some observers point to signs that a similar condition could await the United States. How do macroeconomists explain Japan’s lingering deflationary situation? Is the U.S. in danger of falling into a similar trap, and what might be done to avoid it?
  • The mortgage housing bubble that expanded throughout the first years of this century was anything but inconspicuous. Why weren’t more economists able to identify it and to recognize its potential for doing broad damage to the U.S. and world economies? If economics cannot currently identify emerging conditions that could threaten the Nation’s economic well-being, what kind of work do we need to fund to receive such insights.

This is a far more acceptable stance than that taken by Kartik Athreya, a senior economist in the Research Department of the Federal Reserve Bank of Richmond.  Athreya recently posted a four page statement (which no longer seems to be on the internet) arguing that too many people are unfairly challenging the work of mainstream economists.  In particular, “neither non-economist bloggers, nor economists who portray economics—especially macroeconomic policy—as a simple enterprise with clear conclusions, are likely to contribute any insight to discussion of economics and, as a result, should be ignored by an open-minded lay public.”

He goes on to say:

Many of those I am telling you not to listen to will more than successfully be able to match wits, in any generalized sense, with me. This is irrelevant. The question is: can they provide you, the reader, with an internally consistent analysis of a dynamic system subject to random shocks populated by thoughtful actors whose collective actions must be rendered feasible? For many questions, I and my colleagues can, and for those that the profession cannot, the blogging crowd probably can’t either.

To sum up his point: economics is a complex science, best left to well trained economists who are skilled in working the appropriate models.  Public debate over policy, or even the assumptions underlying the models, is inappropriate.  In short, our models are sound and we are making them better all the time; know your place people.

Finally, for a more critical and entertaining discussion of how mainstream economics has failed us, why leading economists continue to refuse to acknowledge its failure, and the lessons we should learn from this disastrous situation, read “The Great Mortification: Economists’ Responses to the Crisis of 2007–(and counting)” by Philip Mirowski.

A few highlights:

Mirowski notes that beginning in the 1980s leading economists took steps to marginalize methodologists and historians of economics from the discipline.  Their cover story was that students needed “more mathematics preparation, more statistics, and more tutelage in ‘theory,’ which meant in practice a boot camp regimen consisting of endless working of problem sets, problem sets, and more problem sets, until the poor tyros were so dizzy they didn’t have the spunk left to interrogate the masses of journal articles they had struggled to absorb.”

This, of course, did little to help either the students or their professors actually develop an understanding of real economic processes.  “Consequently, when the Great Mortification followed in the wake of the demise of the Great Moderation, those occupying the commanding heights of the profession were bereft of any sophisticated resources to understand their predicament.”

With economists unable to explain what was happening, the media turned to other sources for explanations.  What resulted were popular explanations of the crisis that had little to do with actual economic theory.

For example, most explanations of the crisis soon focused on the problem of toxic assets.  “People liked [this focus] because it embodied both a notion of the problem and the cure—if you ‘ingest/invest’ too many ‘toxic assets’ you die, but the way to get rid of poison is to flush it out of your system. Hence the entire crisis was not so different from an outbreak of E. coli in your spinach: dangerous, to be sure, but not a system pathology. All we had to do was detox, and everything would return to health. . . . The assets were toxic; we didn’t need to know how or why. We didn’t stop to think that the financial system intentionally produced them and therefore the entire metaphor was wonky at base. . . .
But more to the point, the metaphor had no basis whatsoever in the orthodox theory of finance.   In that theory, efficient markets are arbitrage-free, and any contingent claim can be reduced to any other contingent claim through some stochastic wizardry. Hence risk itself can always be commodified and traded away—that is the service the financial sector supposedly performs for the rest of the economy. The system as a whole simply cannot fail to price and allocate risks; hence there are no such things as virulently ‘toxic’ assets. Crappy assets, junk bonds, dogs with fleas, yes, but inherently ‘toxic,’ never.”

Economists have tended to ward off criticism by pointing to the scientific underpinnings of their work.  However, “although they trafficked in mathematical models, statistics, and even ‘experimentation,’ their practices and standards barely resembled those found in physics or biology or astronomy. Fundamental constants or structural invariants were notable by their absence. Indeed, one would be hard pressed to find an experimental refutation of any orthodox neoclassical proposition in the last four decades . . . . In the heat of battle, economists purported to be defending ‘science,’ when in fact, they were only defending themselves and their minions.”

Economists, who rely on models populated by agents acting on the basis of self-interest, rarely, if ever, examine their own work from the same lens.  “In any case, most conventional outlets for economic ideas have become willfully uninterested in the tangled conflicts of interest of the modern economics profession. Does anyone care that Martin Feldstein was on the board of AIG in the runup to its disastrous failure? Or that Paul Krugman once consulted for Enron (and got radicalized after the New York Times made him foreswear such perks)? Is anyone curious about the tangled history of the funding and organization of the Chicago School of economics? Does anyone care that Larry Summers worked for numerous hedge funds and investment firms before they had to be rescued by an administration that included…Larry Summers?”

Well, there is lots more interesting stuff there.


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