This is part 6 in my series on how the financial crisis is relevant for economics (here are parts 1, 2, 3, 4 & 5). Each part explores an argument economists have made against the charge that the crisis exposed fundamental failings of their discipline. This post discusses the argument that the ‘crisis in economics’ is confined only to macroeconomics, which is actually minority, so attacking all of economics is wrongheaded.
Argument #6: “Sure, modern macroeconomics is pretty weak. But most economists don’t even work on macro, so they are unaffected.”
Quite a lot of economists consider the debate about the financial crisis irrelevant to what they do. After all, why should a crisis at the macro level invalidate econometrics, game theory or auction theory? Attacking these fields and others for the recession is like blaming mechanical engineers for a bridge collapse. In fact, many economists hold macro in the same (low) esteem as the public: Daniel Hamermesh goes so far as to claim that “most of what the macro guys do in academia is just worthless rubbish”, but adds that the kind of field he works in “has contributed tremendously and continues to contribute”. Even the discipline’s most vehement defenders are willing to concede macroeconomics is bunk.
There is a considerable amount of truth to this view. While there may be critiques of all areas in economics, the claim that the financial crisis is what’s thrown them into disrepute is a non sequitur. Critics should therefore be careful to distinguish macroeconomists from their colleagues when (rightly) dismissing the former’s failure to deal with the crisis. Nevertheless, there are two major ways in which the failings of macroeconomics are symptomatic of more general problems with economic theory, so the discipline as a whole cannot be let off the hook.
The first is a lack of holism. A large amount of economic theories are built in an abstract theoretical vacuum, with little reference to what is happening around the individual agent. But the importance of the macroeconomy for behaviour in specific sectors or by specific actors cannot be ignored. For example, if you drop the macroeconomic assumption of full employment, this affects theories in areas from public goods provision to labour markets to Walrasian equilibrium. Consumers’ and firms’ expectations are strongly informed by the macroeconomic and political environment around them. Considering the effects of political institutions such as unions on the labour market, but ignoring their broader political role, can create narrow and misguided conclusions about their efficacy. New Institutional economics often takes ‘institutions’ as exogenous, failing to consider to two-way interaction between institutions and agents. The in-vogue ‘Randomised Control Trial’ restricts the economic environment to such a degree that it’s questionable whether one can generalise the results at all. And so forth.
Don’t get me wrong: there is an obvious case for different areas of economics being separate from one another: taking certain parameters as exogenous to look at a certain area, and using different tools for different areas. But even the most specialised fields should never forget the broader scope and context of their ideas, and this should be reflected in the theoretical approach. Thomas Piketty’s Capital is a shining example of how to intertwine theory, history, statistics and politics to build a better understanding of capitalism. Another is the attempt by ecological economists to place the economy in its environmental context, rather than simply taking resource endowments as a given and assuming pollution just sort of…disappears, save for its monetary cost. Minsky’s Financial Instability Hypothesis shows one way to make an effective link between the behaviour of investors and broader economic performance, integrating finance and macroeconomics. Overspecialisation may cause economists to miss these key insights.
The second issue is that many of the problems with macroeconomics can be applied to, or are relevant for, other areas of the discipline. One of the key complaints about macroeconomics – that it relies on microfoundations – is a problem precisely because it imports unrealistic assumptions about economic behaviour from microeconomics. The problem of having an abundance of abstract models, each seeking to explain one or two ‘things’, but with no real way to tell which model is applicable and when, applies not just to macroeconomics but also to behavioural economics, microeconomics, oligopoly theory. Endogenous money, which is central to macroeconomists’ lack of understanding of the crisis, also has major implications for finance. To reuse my above analogy, you might well be concerned about mechanical engineers after a bridge collapse if they largely relied on the same methods used by the civil engineers.
Your average economist is probably right to point out that the public’s ire should be focused not on them, but on macroeconomics. However, this doesn’t mean that they are immune from the serious questions the crisis raised about the methodology, assumptions and ethics of the field. It’s a case-by-case matter which areas are impacted and by how much, but any attempt to box off macroeconomic theory entirely should be resisted. There’s plenty of room for fruitful debate about all areas of economic theory, much of which will benefit from being informed by the shortcomings of economic theory as exposed by the financial crisis.