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.
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.
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.
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.
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.