Why Economics Failed

Atlantic Correspondent Richard Posner has good piece out this morning about British economists trying to explain to the Queen why economics failed so miserably to predict the financial crisis. He suggests, as many others have, that economists must admit they don't know everything when it comes to business cycles, and should refocus their efforts so to learn from their mistakes here. I think he's right, but I worry it won't help much.

Back in college I took a rather wonderful approximately graduate-level seminar called "Economics Meets Science Studies." The main purpose of the course was to examine the question of whether economics was more of a hard science or social science. By the end of the semester, I found the argument that economics was more like physics than anthropology completely unconvincing. (Though the course, ironically, counted towards my physics major, not my economics major.)

This view would anger many economists. Most generally believe that their discipline is more than a mere social science. After all, it involves lots of fancy math -- just like physics and chemistry. It also doesn't appear to involve as much mere documentation and interpretation as something like history. They believe that economic theory can use real world assumptions to derive legitimate predictions. I think they're right about very simple questions, but the more complex the system, the more I believe economics just fails.

It might be sacrilegious for me to admit this, but I am wholly unconvinced most macroeconomic theory can ever hope to make consistently accurate predictions. There are entirely too many variables, and people just aren't as rational as economists like to assume they must be. Here's an excerpt from Posner's piece that begins to touch on this assertion:

This failure was I think due in significant part to a concept of rationality that exaggerates the amount of information that people have about the future, even experts, and to a disregard of economic factors that don't lend themselves to expression in mathematical models, or are intractable to formal analysis.

That's true, but I'd take it a step further: the concept of rationality even exaggerates rationality. Even with good information, people often make stupid decisions based on emotion. I would even argue that generally people are more emotional than rational -- and that's a huge problem for modern economics.

I don't know I can think of a better example of emotion taking over than bubbles. They exemplify irrational exuberance. Investors get excited that there's a fortune to be made and inflate prices. Eventually, they begin to realize prices are too high, and then they panic, sometimes even driving prices too low. Market value says little about the rational price of a good, just what people feel that good is worth.

The real estate bubble wasn't a problem of investors not being able to obtain adequate information. They could have demanded more information, but they didn't think they needed it. They let their emotion through excitement carry them away, rather than allow their cool, rational side to request more information. Unfortunately, no math is advanced enough to model emotion.

Don't get me wrong: I don't think economics is doomed to be classified as a waste of time. I think economists do some very important, often valid work. But so do meteorologists. In both disciplines, it's easy to make broad claims that turn out to be generally correct based on probabilities. But just how sometimes meteorologists predict clear skies only to look foolish when it rains, economists may incorrectly predict good economic times that turn out to be very bad.

There's no question that macroeconomists have learned a lot over the years. But there's also no question that they have more to learn and can never hope to know it all. As a result, you cannot possibly expect them to be perfect, but should merely hope that they do more good than harm. I think their work in helping to dampen the blow of the financial crisis shows that, even though they got it wrong to begin with, their research helped to prevent another Great Depression. Through their failure, some success for the discipline cannot be denied.