Sorry, Economists: The Crisis is a Huge Problem for Your Discipline

I recently stumbled upon a reddit post called ‘A collection of links every critic of economics should read.‘ One of the weaker links is a defence of economists post-crisis by Gilles Saint-Paul. It doesn’t argue that economists actually did a good job foreseeing the crisis; nor does it argue they have made substantial changes since the crisis. It argues that the crisis is irrelevant. It is, frankly, an exercise in confirmation bias and special pleading, and must be fisked in the name of all that is good and holy.

Saint-Paul starts by exploring the purpose of economists:

If they are academics, they are supposed to move the frontier of research by providing new theories, methodologies, and empirical findings.

Yes, all in the name of explaining what is happening in the real world! If economists claim their discipline is anything more than collective mathematical navel gazing, then their models must have real world corroboration. If this is not yet the case, then progress should be in that direction. Saint-Paul is apparently happy with a situation where economists devise new theories and all nod and stroke their beards, in complete isolation from the real world.

He continues:

If [economists] work for a public administration, they will quite often evaluate policies.

Hopefully ones that prevent or cushion financial crises, surely? Wait – apparently this is not a major consideration:

One might think that since economists did not forecast the crisis, they are useless. It would be equally ridiculous to say that doctors were useless since they did not forecast AIDS or mad cow disease.

Yet again, an economist insists on analogies to hard sciences that make no sense.

AIDs and mad cow disease were random mutations of existing diseases and so could not have been foreseen. Financial crises are repeated and have occurred throughout history. They demonstrate clear, repeated patterns: debt build ups; asset inflation; slow recoveries. Yet despite this, doctors have made more progress on AIDs and MCD in a few decades than economists have on financial crises in a few centuries. It was worrying enough that DSGE models were unable to model the Great Depression, but given that ‘it’ has now happened again, under very similar circumstances, you’d think that alarm bells might be going off inside the discipline.

Saint-Paul now starts to defend economics at its most absurd:

One example of a consistent theory is the Black-Scholes option pricing model. Upon its introduction, the theory was adopted by market participants to price options, and thus became a correct model of pricing precisely because people knew it.

This is the same model whose use has consistently been associated with financial collapse, right? Anyway…

Similarly, any macroeconomic theory that, in the midst of the housing bubble, would have predicted a financial crisis two years ahead with certainty would have triggered, by virtue of speculation, an immediate stock market crash and a spiral of de-leveraging and de-intermediation which would have depressed investment and consumption. In other words, the crisis would have happened immediately, not in two years, thus invalidating the theory.

‘A crisis will happen if these steps are not taken to prevent it’ is not the same as ‘Lehman Brothers will collapse for certain on September 15th, 2008.’  Saint-Paul confuses different levels, and types of, prediction. Nobody is suggesting economists should give us a precise date. What people are suggesting is that, by now, economists should know the key causal factors of financial crises and give advice on how to prevent them.

Saint-Paul charges critics with:

…[ignoring] that economics is a science that interacts with the object it is studying.

How he thinks this is beyond me, seeing as the whole criticism is that policies designed by economists had a hand in causing the crash. Predictably, he goes on to state a ‘hard’ version of the Lucas Critique, the go-to argument for economists defending their microfoundations:

Economic knowledge is diffused throughout society and eventually affects the behaviour of economic agents. This in turn alters the working of the economy. Therefore, a model can only be correct if it is consistent with its own feedback effect on how the economy works. An economic theory that does not pass this test may work for a while, but it will turn out to be incorrect as soon as it is widely believed and implemented in the actual plans of firms and consumers. Paradoxically, the only chance for such a theory to be correct is for most people to ignore it.

It is reasonable to suggest policy will have some impact on the behaviour of economic agents. It is absurd to suggest this will always have the effect of rendering the policy (model) useless (irrelevant). It is even more absurd to suggest that we can ever design a model that sidesteps this problem completely. What we have is a continually changing relationship between policy and economic behaviour, and this must be taken into account when designing policy. This doesn’t imply we should fall back on economist’s preferred methods, despite a clear empirical failure.

Saint-Paul moves on – now, apparently, the problem is not that economist’s theories don’t behave like reality, but that reality doesn’t behave like economist’s theories:

In other words, if market participants had been more literate in, or more trustful of economics, the asset bubbles and the crisis might have been avoided.

If only everyone believed, then everything would be fine! Obviously, the simple counterpart to this is that many investors and banks did believe in the EMH or some variant of it, yet, as always, reality had the final say, as happened with the aforementioned Black-Scholes equation.

Saint-Paul now attempts to play the ‘get out of reality completely’ card:

While it is valuable to understand how the economy actually works, it is also valuable to understand how it would behave in an equilibrium situation where the agents’ knowledge of the right model of the economy is consistent with that model, which is what we call a “rational expectations equilibrium”. Just because such equilibria do not describe past data well does not mean they are useless abstraction. Their descriptive failure tells us something about the economy being in an unstable regime, and their predictions tell is something about what a stable regime looks like.

Basically, Saint-Paul is arguing that economic models should be unfalsifiable. Since we can hazard a guess that he isn’t too bothered about unrealistic assumptions, given the models he is defending, and since he clearly doesn’t care about predictions either, he has successfully jumped the shark. Economists want to be left alone to build their models which posit conditions which are never fulfilled in the real world, and that’s final!

As if this wasn’t enough, he proceeds to castigate the idea that economists should even attempt to expand their horizons:

The problem with the “broad picture” approach, regardless of the intellectual quality of those contributions, is that it mostly rests on unproven claims and mechanisms. And in many cases, one is merely speculating that this or that could happen, without even offering a detailed causal chain of events that would rigorously convince the reader that this is an actual possibility.

Note what Saint-Paul means by “detailed causal chain of events.” He means microfoundations. But he is not concerned about whether these microfoundations actually resemble real world mechanics, only that whether they are a “possibility.” To him, the mere validity of an economic argument means that it has been ‘proven,’ regardless of its soundness. In other words: economists shouldn’t be approximately right, but precisely wrong.

Saint-Paul concludes by rejecting the idea that financial crises can be modeled and foreseen:

This presumption may be proven wrong, but to my knowledge proponents of alternative approaches have not yet succeeded in offering us an operational framework with a stronger predictive power.

It has indeed been proven wrong, as alternative models do exist.

I hope – and actually believe – that most economists don’t believe that the crisis is irrelevant for their discipline. I’m sure few would endorse the caricature of a view presented here by Saint-Paul. Nevertheless, it is common for economists to suggest that the crisis was unforeseeable: a rare event that cannot be modeled because the economy is too ‘complex.’ This must be combated. Financial crises are actually (unfortunately)  relatively frequent occurrences with clear, discernible patterns drawing them together. To paraphrase Hyman Minsky: a macroeconomic model must necessarily be able to find itself in financial crisis, otherwise it is not a model of the real world.

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  1. #1 by W on February 13, 2013 - 8:28 pm

    …”What led to rational expectations was a fear of the uncertainty and, worse, the LACK OF UNDERSTANDING of how modern economies work. The rational expectationists wanted to bottle all that up and replace it with deterministic models of prices, wages, even share prices, so that the math looked like the math in rocket science.”… Ed Phelps in:

    http://www.bloomberg.com/news/2013-02-11/expecting-the-unexpected-an-interview-with-edmund-phelps.html

    • #2 by Unlearningecon on February 14, 2013 - 6:32 pm

      That’s great, thanks for the HT.

  2. #3 by Tering Nering (@TeringNering) on February 13, 2013 - 9:58 pm

    Austrian School Economists did predict the crises. (without pseudo-scientific math). Start here http://en.wikipedia.org/wiki/Austrian_business_cycle_theory

    • #4 by Roman P. on February 14, 2013 - 6:02 am

      ABCT has its own share of problems (see the blog http://socialdemocracy21stcentury.blogspot.ru/ for a LOT of them). And do you really think that the crisis was caused by the ‘unsustainable production structure’? That there occurs just a liquidation of the naturally unprofitable industries?
      That said, Hayek and other austrians were onto something: there could be, and usually are, malinvestments in any economy. But the real problems with booms and busts arise not in the production, but in the financial markets. The world weathered the Dotnet bust rather well, but the accelerating levels of the private debt used to gamble on the financial markets sent the world into the terrible depression. In that sense, Minsky’s Financial Instability Hypothesis could be seen as an advanced, more sensible form of the early 20th century ABCT.

      • #5 by Unlearningecon on February 14, 2013 - 6:32 pm

        Yeah, I’ve offered some limited critiques of the Austrian school, which I find unconvincing. Their claims that they predicted the housing bubble and crisis accurately are overblown, though there is some truth to them.

        I think people such as yourself are attracted to the Austrian school because it offers a coherent theory of the macroeconomy that incorporates bubbles and the financial sector, something neoclassicism struggles with. However Austrian theory is old and was abandoned for good reasons, good critiques (Sraffa, Keynes, Kaldor). Insofar as the essential elements remain useful it is probably, as Roman said, within a Minsky-ite framework. I tend to think those who still adhere to it 100% do so for ideological reasons, though this is of course not true for all Austrians.

  3. #6 by noteconomist on February 16, 2013 - 5:50 pm

    Once again you make me feel like I wasted 6 years of my life.

    But thank you anyway :)

  4. #8 by randommarxist on February 16, 2013 - 10:05 pm

    Many economists acknowledge the business cycle but attribute it to outside shocks. They claim that indeterminate exogenous variables can create the appearance of cycles. So although Saint-Paul’s argument is especially moronic and I doubt many would defend it, a significant segment of the discipline does dismiss business cycles. I find endogenous models of crisis like Minsky’s much more convincing, but I think we do need to critique the more nuanced defense of exogenous models.

    • #9 by Unlearningecon on February 19, 2013 - 9:21 am

      but I think we do need to critique the more nuanced defense of exogenous models.

      Which ones did you have in mind?

      • #10 by randommarxist on February 20, 2013 - 9:43 pm

        I was thinking along the lines of Adelman’s analysis of the Klein-Goldberger model.* It lacks oscillations, but under random exogenous shocks the model shows business cycles.

        *http://www.jstor.org/stable/1909353

  5. #11 by sandjarsandjar on February 19, 2013 - 4:56 am

    There is no crisis in economics. It’s just the nature of it. There has never been a time where economics was flat and everyone agreed with everybody. I am not sure why economists are charged with predicting how the world works. And in almost every crisis there have been economists who predicted them using some alternative model. Even if economists were able to explain how “the real world works”, all you need to do is look at how policy is made in this country, or in most countries for that matter. Conflict of interest, politics, corruption – there is no such thing as good policy any more. Everything is biased based on the incentives of the decision makers. Something is in crisis for sure, but it’s a lot bigger than economics.

    • #12 by Unlearningecon on February 19, 2013 - 9:23 am

      I am not sure why economists are charged with predicting how the world works.

      Because that is what their science, by definition, is supposed to do.

      And in almost every crisis there have been economists who predicted them using some alternative model.

      Yup, which is why the mainstream models should be abandoned.

      Even if economists were able to explain how “the real world works”, all you need to do is look at how policy is made in this country, or in most countries for that matter. Conflict of interest, politics, corruption – there is no such thing as good policy any more. Everything is biased based on the incentives of the decision makers.

      Well, maybe, but let’s reserve our judgment for when economists are able to explain the real world.

      Something is in crisis for sure, but it’s a lot bigger than economics.

      Capitalism?

      • #13 by Oilfield Trash on February 19, 2013 - 11:29 pm

        Capitalism?

        Sort of ironic that the neoclassical vision portrays capitalism as a perfect system, in which the market ensures that everything is ‘just right.’ It is a world in which meritocracy rules, rather than power and privilege as under previous social systems.

        This vision of a society operating perfectly without a central despotic authority is seductive – so seductive that neoclassical economists want it to be true. So when Capitalism behaves contrary to neoclassical models, we blame bankers, and capitalist; when we should be blaming neoclassical economist.

        In one sense, their ignorance is utterly justified, because they are behaving in the same way that professionals do in genuine sciences like physics. Most physicists don’t check what Einstein actually wrote on the Theory of Relativity, because they are confident that Einstein got it right, and that their textbooks accurately communicate Einstein’s core ideas. Similarly, most economists don’t check to see whether core concepts like ‘supply and demand microeconomics’ or ‘representative agent macroeconomics’ are properly derived from well-grounded foundations, because they simply assume that if they’re taught by the textbooks, then there must be original research that confirms their validity.

        The irony of all this is to save what is good in capitalism we all have to unlearn orthodox economics theory. I hope you are considering teaching as a career, there is much unlearning to be done.

      • #14 by Unlearningecon on February 20, 2013 - 9:51 pm

        This vision of a society operating perfectly without a central despotic authority is seductive – so seductive that neoclassical economists want it to be true. So when Capitalism behaves contrary to neoclassical models, we blame bankers, and capitalist; when we should be blaming neoclassical economist.

        You are broadly right, although I wouldn’t be so sure about the “despotic authority” part – it is not uncommon for neoclassical economists to assume a social planner. See here:

        The closest we can come to treating consumption, leisure and the public good in this model as ordinary goods is if we imagine a social planner…in other words, the social planner I am talking about is not a fallible human, but the Invisible Hand.

        Similarly, most economists don’t check to see whether core concepts like ‘supply and demand microeconomics’ or ‘representative agent macroeconomics’ are properly derived from well-grounded foundations, because they simply assume that if they’re taught by the textbooks, then there must be original research that confirms their validity.

        If you check my latest post, you’ll see exactly this, and why it leads to problems!

  6. #15 by Frances Coppola on February 19, 2013 - 7:41 pm

    Saint-Paul seems to argue that it is economists’ job to model the New Jerusalem so that we all know what we should be aiming for. But that has already been done, hasn’t it?

    • #16 by Unlearningecon on February 20, 2013 - 9:48 pm

      Economist’s ‘in the long run’ actually reminds me of the wait for New Jerusalem.

  7. #17 by Arthur carlson on February 20, 2013 - 4:14 pm

    There is an embedded presupposition in the Lucas critique and rational expectations arguments, the essence of which is that the parties are all equipped with efficacious economic models to predict the consequences of pending actions. Unless they have such a tool, their behavior will not follow the logic of these thesis, thereby introducing, at a minimum, noise into the real-world consequences of a real event. Further, if there is no model upon which the mass of players base their courses of action, a rational action may need to anticipate how the model-driven actions of various cohorts will alter the predictions inferred by their own model and make appropriate adjustments.

    The multiplicity of economic models and the degree of uncertainty between prediction and actual economic outcomes, not only of one’s own choice, but of the array of economic models deployed in anticipatory strategies somehow weighted for their level of involvement in real-world actions that muddles the hypothetical sequence of information and events and market dynamics to the point that a sampling of any of the essential components of they theory is going to be virtually identical to that of the same community without the predictive tools currently given us by economists.

    Fundamentally, the Lucas critique insists that iterative feedback loops neutralize the predictive power of the models that give the critique, itself, its own foundations. If this were not enough, economists themselves serve to randomize the behavior of economic actors by serving up idiosyncratic models as potential predictors. The philosophy of science followed by Saint-Paul; to wit, that the test of a model is the rigor of its mathematics, not its resistance to falsifyability that provide its bonafides deprives actors of the very tools demanded by Lucas, et al.

    What the empirical evidence of the last decade has shown is not that prior theory failed, but that prior theory is applicable only within some ill-defined context, leaving both the limits of appropriate context and the essential modifications as the elephant in the room. It is here that the intellectual dishonesty of Saint-Paul and so many in the profession is so glaring. Moreover, the ‘rational expectation’ is that expanding the field of economics to a broader contexts requires integrating ideas distasteful if not abhorrent to all but a minority of the profession.

    • #18 by Unlearningecon on February 20, 2013 - 9:44 pm

      Further, if there is no model upon which the mass of players base their courses of action, a rational action may need to anticipate how the model-driven actions of various cohorts will alter the predictions inferred by their own model and make appropriate adjustments.

      Yes. Richard Thaler noted that this potentially leads to an infinite regress.

      The philosophy of science followed by Saint-Paul; to wit, that the test of a model is the rigor of its mathematics, not its resistance to falsifyability that provide its bonafides deprives actors of the very tools demanded by Lucas, et al.

      That’s a great point, and one I hadn’t thought of before. If actors are to be equipped with a real model of how the world works in order to avoid the Lucas Critique, these predictions must at least converge to the truth. But every time their views change, they will, according to someone like Saint-Paul, render the model irrelevant. Basically it makes no sense.

      Moreover, the ‘rational expectation’ is that expanding the field of economics to a broader contexts requires integrating ideas distasteful if not abhorrent to all but a minority of the profession.

      Unfortunately, this appears to be the case. I sometimes think that just one history class would pound the context-free, ethnocentric, simplistic narratives out of economist’s heads.

  8. #19 by yourdreamboy on February 25, 2013 - 3:32 am

    I was not able to comment on your Steve Keen posts, so I would comment here:
    I discovered unlearningecon site when I was searching for what people say about Steve Keen’s critique of neoclassical firm theory.

    While he is generally accurate that neoclassicals make some absurd assumptions (debunking economics), the papers he claims that proved theoretical inconsistency of neoclassical firm theory have several serious errors – not just that assumptions are wrong – he omits several possible options that can rise from analysis, and most importantly, he makes some calculus errors. (Chris Auld – I guess – somehow gave why he was wrong, but stopped from further elaborating.) He uses chain rule not correctly (it is true that chain rule of calculus must hold. But it has to be used with cautions.)

    It’s not matter of whether setting industry-level profit or sole profit is a better option (and in fact, I suspect that with correction, there will be some more to think about this. Conclusions cannot be reached in simple manner) – it has mathematical errors.

    I am not sure if Steve Keen is really responding to critiques (about this matter) – and everyone else, I believe, has not elaborated much on why he is wrong.

    • #20 by Unlearningecon on February 25, 2013 - 9:40 am

      I agree. Both sides seem to take it as self evident truths that they are right and there doesn’t seem to be much communication between the two.

      Even Auld admits that price will always have a small impact on demand, though – he just says it will be tiny. But this is still enough to mean that the supply curve doesn’t exist. However, I think Keen’s idea that monopoly = perfect competition relies on summing effect on price each firm has up and assuming they will set their price equal to the sum of those prices. Surely, however, a profit maximising firm would only set their own price equal to the slight price difference they themselves create.

  9. #21 by freedomthistime on March 1, 2013 - 10:06 pm

    The ‘get out reality completely’ card quote is too perfect! (and from a Saint-Paul no less – valiantly defending the old orthodoxy against all these heretical doubting Thomases!)

    “While it is valuable to understand how the economy actually works, it is also valuable to understand how it would behave in an equilibrium situation where the agents’ knowledge of the right model of the economy is consistent with that model, which is what we call a “rational expectations equilibrium”. ”

    Um, why? Imagine I had just written “While it is valuable to understand how the economy actually works, it is also valuable to understand how it would behave if instead we were thirteen foot tall insectoid beings living on the moon”. Would you not at least expect an argument following such a statement to justify it? Instead we get:

    “Just because such equilibria do not describe past data well does not mean they are useless abstraction.”

    Actually, as far as physicists are concerned, that is pretty much a textbook definition of “useless abstraction”! For example, Richard Feynman:

    “If it disagrees with experiment – it’s wrong. In that simple statement is the key to science. It doesn’t make any difference how beautiful your guess is, it doesn’t make any difference how smart you are who made the guess, or what his name is (!) If it disagrees with experiment – it’s wrong. That’s all there is to it.”

    He (Saint-Paul) then rounds off by adding that:

    “Their descriptive failure tells us something about the economy being in an unstable regime, and their predictions tell is something about what a stable regime looks like.”

    So their failure tells us that we are not in fact thirteen foot tall insectoid beings living on the moon (at least, not all of the time…) – and they tell us something about how an economy of thirteen foot tall insectoid beings living on the moon would behave, were it to exist? How useful! (and *circular*, I might add, as a “justification” for his opening statement).

    • #22 by Unlearningecon on March 2, 2013 - 8:37 pm

      The circularity in his argument is something that I unfortunately didn’t note, but now that you mention it, pointing that out would have been enough to expose his entire argument!

      Thanks for your comments. It’s ironic that that a ‘science’ which defers to predictive power when questioned about its assumptions is so unwilling to embrace falsification.

  10. #23 by J Sterling on March 9, 2013 - 2:37 pm

    Doctors *do* predict AIDS and CJD: google “zoonosis” for their warnings. “Handle African apes and monkeys with care,” “don’t do each other up the ass without a condom.” “don’t feed the minced brains of cows to other cows,” and “don’t eat cows that have been fed the minced brains of other cows”.

    Where are the equivalent warnings from economists to e.g. not mess with Collateralized Debt Obligations? Economists up to 2008 were like doctors saying “Hey, go ahead and french kiss a pig, nothing can go wrong with that!”

    So much for their preventive skills, then there’s their suggested courses of treatment, such as curing a private sector recession by the (not so) homeopathic application of massive public recession. They’re in the Dark Ages, they can only dream of comparing themselves with doctors, unless it’s witch doctors.

    • #24 by Unlearningecon on March 9, 2013 - 2:41 pm

      Thanks for that. I almost invariably find economist’s analogies to real sciences fail.

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