How to keep economists from missing the next financial crisis.
By ROBERT JOHNSON | January 19, 2012
After the financial crisis of 2008, the Queen of England asked economists, “Why did no one see the credit crunch coming?” Three years later, a group of Harvard undergraduate students walked out of introductory economics and wrote, “Today, we are walking out of your class, Economics 101, in order to express our discontent with the bias inherent in this introductory economics course. We are deeply concerned about the way that this bias affects students, the University, and our greater society.”
What has happened? Rebellion from both above and below suggests that economists, who were recently at the core of power and social leadership in our society, are no longer trusted. Not long ago, the principal theories of economics appeared to be the secular religion of society. Today, economics is a discipline in disrepute. It’s as if our ship of state broke from its stable mooring and unexpectedly slammed into the rocks. How could things have gone so spectacularly wrong? And what can be done to repair economics so economists can play a productive role in helping society?
As the Oscar-winning documentary Inside Job illustrated, there is a very lucrative market for false visions of financial-market behavior that legitimate the desires of participants to be unshackled and make more money. But good policy prescriptions are public goods that represent the social good and not just the concentrated financial interests. Unfortunately, as economists beginning with the work of Adam Smith have repeatedly shown, public goods are underprovided in the marketplace. In addition, the reputation of the economics profession is itself a collective good, and those who have tarnished it are not adequately penalized for the damage they do to their fellow professionals when they accept large sums of money in return for marketing a perspective that benefits vested interests.
These are problems that some within economics have been aware of for a long time, but the discipline as a whole has been unable to address them. The onus is on the profession to face these challenges and help lead society off the rocks.
How to Save Economics
first, economists should resist overstating what they actually know. The quest for certainty, as philosopher John Dewey called it in 1929, is a dangerous temptress. In anxious times like the present, experts can gain great favor in society by offering a false resolution of uncertainty. Of course when the falseness is later unmasked as snake oil, the heroic reputation of the expert is shattered. But that tends to happen only after the damage is done.
Second, economists have to recognize the shortcomings of high-powered mathematical models, which are not substitutes for vigilant observation. Nobel laureate Kenneth Arrow saw this danger years ago when he exclaimed, “The math takes on a life of its own because the mathematics pushed toward a tendency to prove theories of mathematical, rather than scientific, interest.”
Financial-market models, for instance, tend to be constructed with building blocks that assume stable and anchored expectations. But the long history of financial crises over the past 200 years belies that notion. As far back as 1921, Frank Knight of the University of Chicago made the useful distinction between measurable risk and “unknown unknowns,” which he called radical uncertainty. Knight’s point was that in a period of radical uncertainty, expectations couldn’t be anchored because they have nothing to latch onto. Financial theories and regulatory designs that hinge on the assumption of stable and anchored expectations are not resilient enough to meet the challenges presented by real financial markets in radically uncertain times.
The third remedy for repairing economics is to reintroduce context. More research on economic history and evidence-based studies are needed to understand the economy and overcome the mechanistic bare-bones models the students at Harvard objected to being taught.
But the economic orthodoxy continues its romance with the Enlightenment tradition of Cartesian “universal laws.” This began after the Thirty Years’ War, when society demanded both a method of investigation that did not antagonize religious factions and universal abstract laws and principles that could be objectively proven. Lost to the traumas of religious and social turmoil were the humble and pragmatic humanistic approaches of Francis Bacon and Michel de Montaigne and the suppleness of William Shakespeare. Reorienting economics away from the Enlightenment glamour of high theory and returning it to focusing on real problems, in the same way a clinical physician does, would make economics more relevant.
The profession needs to realign the incentives for doing reputable research in order to protect its integrity as a whole, as is done in medicine. Recent policies announced by the American Economic Association on disclosing conflicts of interest are a step in a healthy direction. Faculty members should also be forced to step down from consulting at the time they receive tenure.
Fourth, we must acknowledge the intimate, inseparable relationship between politics and economics. Modern debates about who caused the financial crisis—government or the private financial sector—are almost nonsensical. We are living in an era of money politics and large powerful interests that influence the laws and regulations and their enforcement. In order to catalyze the evolution of economics, research teams would benefit from multidisciplinary interaction with politics, psychology, anthropology, sociology and history.
Such interdisciplinary communication would also benefit another neglected area of economics: the study of macroeconomic systems. Psychologists mock what economists call the microfoundations of consumer behavior—a set of assumptions based on the idea that isolated individuals behave with clear knowledge of the future. That this framework is suitable for aggregate systems in a globalized economy simply because the tribe called economics has agreed to adhere to these ad hoc assumptions makes no sense. Increased interactions with disciplines that economists have often mocked as unscientific would greatly improve economists’ understanding of the real world and would be more truly scientific.
Many of these suggestions have been argued within the profession as far back as the formation of the American Economic Association in the late 19th century. Its committee on graduate economics education, a panel created in the early 1990s to take stock of the field, as well as the work of economist David Colander and others, has repeatedly illuminated these concerns with economic method and education. It is only now, with the force of recent events so damaging to societies everywhere on earth, and with the rise of developing countries that see the shortcomings of the economic orthodoxy’s prescriptions, that the resistance to renewing the economics profession may be overcome. Until then, we are really at sea without an anchor.
Johnson is the executive director of the Institute for New Economic Thinking in New York City and a former managing director at Soros Fund Management. He also serves on the U.N. Commission of Experts on International Monetary Reform