March 9, 2019
Why Economics Must Get Broader Before It Gets Better
Even as the public’s skepticism toward their profession has grown, economists have continued to ignore increasingly obvious flaws in their analytical frameworks. A discipline long dominated by “high priests” must now adopt a more open mindset, or risk becoming irrelevant.
L-R: Stigltz- Hayek- Sowell-Keynes- Sen-Schwartz-Sachs- Friedman
NEW YORK – The economics profession took a beating after most of its leading practitioners failed to predict the 2008 global financial crisis, and it has been struggling to recover ever since. Not only were the years following the crash marked by unusually low, unequal growth; now we are witnessing a growing list of economic and financial phenomena that economists cannot readily explain.
Like Queen Elizabeth II, who famously asked in November 2008 why nobody had seen the crisis coming, many citizens have grown increasingly skeptical of economists’ ability to explain and predict economic developments, let alone offer sound guidance to policymakers. Some surveys rank economists among the least trusted professionals (after politicians, of course, whose trust economists have also lost).
A solid economic training is no longer regarded as a must-have for candidates for top positions in finance ministries and central banks. This marginalization has further weakened economists’ ability to inform and influence decision-making on issues that relate directly to their expertise (or what they would call their comparative and absolute advantage).
The profession owes its deteriorating reputation largely to excessive reliance on its own self-imposed orthodoxies. With more openness to interdisciplinary approaches and the broader use of existing analytical tools, particularly those offered by behavioral science and game theory, mainstream economics could start to overcome its shortcomings.Three recent developments underscore the urgency of this challenge. In the 12 months between the World Economic Forum’s 2018 and 2019 annual gatherings in Davos, those in attendance went from celebrating a synchronized global growth pickup to worrying about a synchronized global slowdown. Notwithstanding the deterioration in European growth prospects, neither the extent nor the speed of the change in consensus seems warranted by economic and financial developments, which suggests that economists may have misdiagnosed the initial conditions.
A second area of concern is monetary policy. Professional economists still have not spoken up clearly enough about the challenges facing the US Federal Reserve’s communication strategy, despite the fact that even slight misfires, such as occurred in the fourth quarter of last year, can trigger severe bouts of financial instability that threaten growth. Instead, they have simply continued to embrace the contemporary view that greater Fed transparency is always a good thing.
We have come a long way since the era of former Fed Chair Alan Greenspan’s “Fedspeak” (or, as he put it, “mumbling with great incoherence”). But that raises a new problem: illusionary precision. The Fed now follows every policy meeting with a release of statements, minutes, transcripts, blue-dot plots, and a press conference, signaling to markets a level of sophistication that is scarcely realistic in a world of fluidity and heightened uncertainty.
Rather than simply going along with the view that more is better, economists should be urging the Fed to adopt an approach more like that of the Bank of England, which emphasizes scenario analyses and fan charts. Economists could also be doing more to inform – and perhaps even influence – the Fed’s ongoing review of its policy frameworks and communications strategy. After all, the economics literature on asymmetrical information suggests that greater input from economists outside of the Fed is both appropriate and necessary for ensuring an optimal policy outcome.
A third area of concern is the Sino-American trade conflict, which is more controversial, owing to its political nature. So far, the vast majority of economists have trotted out the conventional argument that tariffs (real or threatened) are always bad for everyone. In doing so, they have ignored work from their own profession showing how the promised benefits of trade, while substantial, can be undermined by market and institutional imperfections. Those who wanted to make a productive contribution to the debate should have taken a more nuanced approach, applying tools from game theory to distinguish between the “what” and the “how” of trade warfare.
These are just three recent examples of how economists have dropped the ball. In addition, economists are struggling to explain recent productivity developments, the implications of rising inequality, the impact of persistently negative interest rates in the euro-zone, the longer-term effects of other unconventional monetary policy measures (amplified by the European Central Bank’s latest policy pivot), and the sudden slowdown in European growth. They also failed to foresee the Brexit saga and the political explosion of anger and alienation across the West in general.
None of this is a huge surprise, given the profession’s embrace of simplistic theoretical assumptions and excessive reliance on mathematical techniques that prize elegance over real-world applicability. Mainstream economics has placed far too much analytical emphasis on the equilibrium condition, while largely ignoring the importance of transitions and tipping points, not to mention multiple-equilibria scenarios. And the profession has routinely failed to account adequately for financial links, behavioral-science insights, and rapidly evolving secular and structural forces such as technological innovation, climate change, and the rise of China.
All of this should tell economists that there is plenty of room for improvement, and that they need to expand the scope of their analysis to take into account human interactions, distributional effects, financial-economic feedback mechanisms, and technological change. But this cannot just be about devising new analytical models within the field; economists also must incorporate insights from other disciplines that the profession has overlooked.
A discipline long dominated by “high priests” must now adopt a more open mindset. That means acknowledging and addressing unconscious biases, not least by making a concerted effort to improve inclusion and diversity within the field. It also means focusing more on inter-disciplinary approaches and distributional effects, and less on the purity of mathematical models, average conditions, and just the belly of distributions. Such structural changes will require more and better intellectual and institutional “safe zones,” so that analytical disruptions can be managed and channeled in productive directions.
Without significant adjustments, mainstream economics will remain two steps behind changing realities on the ground, and economists will be risking a further loss of credibility and influence. In an era of concern about climate change, political upheavals, and technological disruption, the shortcomings of mainstream economics must be addressed posthaste.
Keynesian economics works very well in understanding the last recession. The shock was very large, so large that interest rates hit the zero lower bound. What Keynesian economics says needs to be done then is fiscal stimulus. A little bit of that was done, but never enough. Resistance to it from many economists, who should have known better, drowned out the warnings of economists like Paul Krugman, who warned all along that what was being done was far too little. And when that proved right, far too many economists pinned the blame for the failure on what stimulus there had been instead of on the lack of adequate stimulus, and began preaching austerity. With economists speaking with such a divided voice, it is hard to blame politicians much if they steered a course somewhere in the middle. But that course was a disaster. Long years of unnecessary suffering were the result.
The only country to really apply Keynesian economics was China. It quickly implemented a stimulus plan that was 15% of it GDP (vs. ~2% elsewhere). The result was that it nipped the recession in the bud and continued its rapid growth.
The biggest mathematical problem they have is declaring an equal sign in algebra to be causation rather than correlation. Ridiculous conclusions like trade deficits are “caused by” low savings is one example. It is like saying a car moves because smoke comes out of the exhaust pipe. They are correlated only. Once incentives (i.e. behavioral) are put on the lhs of the equation you get Trade Deficits cause by stealing profits to maintain political control financed by state banks or central banks.
As for the Fed, they don’t have the guts to tell the US govt to balance trade and announce that they will not be complicit it another bubble caused by low rates and excessive deficits. Accountability? Don’t count on it.
The only antidote to the correlation-causation problem is to perform what is called by the IT industry AB testing. Create a hypotheses and test how it works with a control group. I would like to see more of this scientific approach by governments and their economists at a macroeconomic level.
But there’s another critical aspect here, relative to 2008: “CRIME.”
In the years leading up to 2008, financial crime was rampant. Critical protective legislation such as the Glass-Steagall Act was dumped. Trading in “derivative securities” went wild, and when bets went bad they were shoved into the banks, so that governments would have to “bail them out” as “too big to fail.”
The result was an explosion in the number of currency-units in circulation, and the papering-over of the consequences of these willfully criminal acts without doing anything to punish the wrongdoers or to reform the things which they exploited. The crimes did not stop and still haven’t stopped. Instead, they’re presented as though they were “the new normal.”
I think that economists routinely overlook the “crime” factor – the simple fact that people will steal when given the opportunity, and that overseers and “enforcement” authorities can easily be in-cahoots. The events of 2008 were principally the consequence of criminal activity, and the so-called “quantitative easing” response was to let the criminals avoid punishment while cashing-in all their chips. “Crime DID pay.” For them. But it meant that everybody else … lost, and are still losing.