Will Economists Escape a Whipping? -- Part II

The criticisms of the economics of business cycles made in the letter to the Queen are, I discover, echoes of criticisms made earlier. On May 13, Knowledge@Wharton, the online journal of the Wharton business school at the University of Pennsylvania, published an article entitled "Why Economists Failed to Predict the Financial Crisis," and like the letter to the Queen the article criticizes economists for having committed themselves to a model of human behavior that exaggerates human rationality. This is surprising coming from a business school, since so many business-school professors advocate efficient-markets theory in a very strong form.

I agree with the criticism but would prefer to avoid "rationality" and its cognates. It is an extremely vague word. I would define it very broadly--rationality means responding logically and consistently to whatever relevant information can be obtained at a cost less than the value of the information--and treat that as a workable assumption of economic behavior. And then I would emphasize the limited availability (high cost) of information bearing on many economic decisions, whether by businessmen or consumers, and the frequent presence of uncertainty, in the sense of risks that cannot be calculated.

Macroeconomists deploying the rational-expectations hypothesis and finance theorists deploying efficient-markets theory have exaggerated the amount of information that people can obtain about future values. Lack of information forces people to fall back on poor proxies--such as assuming that other people know what they're doing, and imitating those people--which can lead to asset-price bubbles. This kind of "herding" behavior ("momentum" trading, as it is often called when one is talking about the behavior of stock prices) is sometimes thought irrational, but I disagree; it's often a rational second-best solution to a problem of unobtainability of good information.

The Wharton article cites an earlier article by eight European economists (known as the "Dahlem Report") on the failure of the economics profession to foresee the financial crisis: David Colander et al., "The Financial Crisis and the Systemic Failure of Academic Economics" (Kiel Working Paper No. 1489, Feb. 2009), . As the authors succinctly state, "The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deper roots of this failure to the profession's insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets."

The report makes the important point that "as the crisis has unfolded, economists have had no choice but to abandon their standard models and to produce hand-waving common-sense remedies." There is indeed a striking contrast between the formalism of modern economic models of the economy and the advice that economists have been giving since the crisis erupted. Essentially they have advised the use of remedies that have been known and applied since the nineteenth century--or in some cases have disparaged those remedies--but neither side of the debate within the profession has provided quantitative evidence to support its advice.

When evidence is lacking, in economics as in other fields, the tendency is for responses to be shaped by preconceptions, and when the problem being responded to involves high ideological stakes, as the current economic crisis does, the driving preconceptions tend to be ideological. Though there are exceptions, generally if you know whether an economist is liberal or conservative you know whether he favors or opposes the $787 stimulus plan that Congress enacted in February and is slowing being implemented, and whether he worries more about unemployment than about inflation. This is not the sign of a mature science.