It has been very clear to me for three decades what needs to be done in economic theory. Start with Paul Krugman’s observations this morning:
…of perfectly rational behavior and perfectly functioning markets. Any economist with a grain of sense–which is to say, maybe half the profession?–knows that this is very much an abstraction, to be modified whenever the evidence suggests that it’s going wrong. But nobody has come up with general rules for making such modifications….
There are lots of ways to be slightly stupid…. It’s very hard to come up with a general theory about which of these ways they will choose in any given situation. Behavioral economics is a fine… collection of interesting and sometimes useful observations… [not] a general, well, paradigm…. Meanwhile, markets also fail… but while we know a fair bit… we don’t seem close to a general paradigm here either.
So how do you do useful economics?… Combine maximization-and-equilibrium as a first cut with a variety of ad hoc modifications reflecting… empirical regularities about how… individual behavior and markets depart from this idealized case…. This kind of rough-and-ready approach [has] done really well since 2008, on everything from inflation to interest rates to the effects of austerity….
Now maybe, someday, someone will find a way to… integrate neuroscience… for real… or turn agent-based models into a useful tool. I’m for it!
But so far we have failed. I thought a generation ago that by now we would have a three-dimensional mapping among (a) plausible and common ways that individuals could be slightly stupid, (b) market structures and adjustment processes, and (c) emergent classes of macroeconomic outcomes. We don’t. The field of industrial organization had, after all built up a one dimensional to one-dimensional mapping, perfect competition, monopolistic competition, oligopoly, price leadership, duopoly, Cournot, Stackelberg, monopoly. And as far as market failures were concerned, we had a twelve-fold classification of ways that a market-economy could fail to deliver maximum social welfare:
- increasing returns
- adverse selection
- moral hazard
- monopoly power by sellers
- monopsony power by buyers
- expectational disequilibrium
- rationing disequilibrium
with good ideas about how each of them set to work in producing interesting economic outcomes.
But a general framework, a paradigm? No. Instead, we are still building each application by hand–as if we are each a member of a handicraft guild, Master Clockmakers rather than proprietors of are workers in a clock factory. And for Paul Krugman it is fine to be a master clockmaker. And for Paul Krugman it is a useful intellectual discipline for him that increases the quality of his work to force him to start from a well-functioning Arrow-Debreu setup in which the market economy maximizes social welfare, and explain why in this particular application the market-optimality theorem’s assumptions are violated how.
But it is no way to run a railroad, or, rather, a clock factory–not if you want to make a lot of reliable clocks…
And I do not know why we have failed–if you are tied to the real-business cycle fake-microfoundations framework, of course it is too difficult; but what reason is there for anybody to tie themselves to that framework?
And, of course, there is the disconnect between the good economics we do and political action to produce public policy, which Paul covers in his second contribution linked below:
Here I have no special insight…
…who tries hard to be sympathetic to the latest hard science/engineering guy bustling in to show those dumb economists how to do it. But… the reason we don’t have a new economic paradigm isn’t that economists are dumb, or even that all of them are rigid…. The reason, instead, is that it’s hard. Specifically: we have a body of economic theory built around the assumptions of perfectly rational behavior and perfectly functioning markets. Any economist with a grain of sense–which is to say, maybe half the profession?–knows that this is very much an abstraction, to be modified whenever the evidence suggests that it’s going wrong. But nobody has come up with general rules for making such modifications…. Clearly people aren’t perfectly rational–but there are lots of ways to be slightly stupid, and it’s very hard to come up with a general theory about which of these ways they will choose in any given situation. Behavioral economics… a fine thing… is more a collection of interesting and sometimes useful observations than a general, well, paradigm…. Markets… fail… but while we know a fair bit about what happens to particular markets in practice, we don’t seem close to a general paradigm here either.
So how do you do useful economics?… Maximization-and-equilibrium as a first cut… ad hoc modifications reflecting… how both individual behavior and markets depart from this idealized case…. People using this kind of rough-and-ready approach have done really well…. But here’s the thing: economists have done their work this way for generations. So it’s really not a new paradigm. If anything, the true new paradigm was the attempt to justify everything with maximization and equilibrium–but that’s the paradigm that failed….
Maybe, someday, someone will… integrate neuroscience… or turn agent-based models into a useful tool. I’m for it! But merely noting the foolishness of some economists and calling for a new paradigm in the abstract won’t get us there.
That’s the argument of British money manager George Cooper’s very interesting if less-than-felicitously titled new book, Money, Blood and Revolution: How Darwin and the Doctor of King Charles I Could Turn Economics Into a Science. It is also, to be fair, something economists have been talking about for decades. Yet it keeps not happening. Why is that?…
In a manner remarkably similar to that described by Thomas Kuhn in his book, The Structure of Scientific Revolutions, we seem to be entering a stage where widely scattered and as yet incohesive evidence is arising which seems to be inconsistent with the theory. That evidence has just kept on piling up in finance. In macroeconomics, too…. But… a paradigm won’t give way until there’s a new one to replace it…. His ideas for a new economics paradigm:
- Replace utility-maximizing economic man with a Darwinian fellow who simply wants to do better than the next guy.
- Let this selfish creature fight it out in a macroeconomic model based on the circulatory system. “Capitalism would act to push wealth up the social pyramid,” Cooper writes, “while democracy, and its progressive taxation system, would act in the opposite direction to push it back down, causing a vigorous circulatory flow of wealth throughout the economy.”…
Cooper does his best to prep the reader… but I still found his suggestions to be almost laughably crude. Maybe that’s just me. Or maybe it’s the natural initial reaction to a potential new paradigm.
George Cooper: Money, Blood and Revolution: How Darwin and the Doctor of King Charles I Could Turn Economics Into a Science: “Economics is a broken science…
…living in a kind of Alice in Wonderland state believing in multiple, inconsistent, things at the same time. Prior to the financial crisis, mainstream economics argued simultaneously for small government on taxation, regulation and spending, but big government on monetary policy. After the financial crisis, economics is now arguing for more government spending and for less government spending. The premise of this book is that the internal inconsistencies between economic theories–the apparently unresolvable debates between leading economists and the incoherent policies of our governments–are symptomatic of economics being in a crisis. Specifically, in a scientific crisis.
The good news is that, thanks to the work of scientist and philosopher Thomas Kuhn, we know what needs to be done to fix a scientific crisis. Moreover, there are two scientists in particular whose ideas could show how to do this for economics: Charles Darwin, the man who discovered evolution, and William Harvey, doctor to King Charles I and the first man to understand blood flow and the workings of the human heart. In Money, Blood and Revolution, bestselling financial writer George Cooper explains how the ideas of Darwin and Harvey could revolutionise economics, making it more scientific and understandable, and might even reveal the true origin of economic growth and inequality. Taking readers on a gripping tour of scientific revolution, social upheaval and the secrets of money and debt, this is an unmissable read for anyone curious to understand how the world really works – and the amazing future of economics. #autoshambles
**Paul Krugman II: Why Economics Failed: “I don’t mean that economics was useless… the discipline has had a lot to offer. While… few… saw the crisis coming… because few realized how fragile our deregulated financial system had become, and how vulnerable debt-burdened families were to a plunge in housing prices… since the fall of Lehman Brothers, basic textbook macroeconomics has performed very well. But policy makers and politicians have ignored both the textbooks and the lessons of history. And the result has been a vast economic and human catastrophe, with trillions of dollars of productive potential squandered and millions of families placed in dire straits for no good reason….
Economists who took their own textbooks seriously quickly diagnosed the nature of our economic malaise: We were suffering from inadequate demand… an environment in which everyone was trying to spend less, but my spending is your income and your spending is my income, so when everyone tries to cut spending at the same time the result is an overall decline in incomes and a depressed economy. And we know (or should know) that depressed economies behave quite differently from economies that are at or near full employment…. And the diagnosis of our troubles as stemming from inadequate demand had clear policy implications: as long as lack of demand was the problem, we would be living in a world in which the usual rules didn’t apply. In particular, this was no time to worry about budget deficits and cut spending, which would only deepen the depression.
When John Boehner, then the House minority leader, declared in early 2009 that since American families were having to tighten their belts, the government should tighten its belt, too, people like me cringed…. But a few months later President Obama started saying exactly the same thing. In fact, it became a standard line in his speeches. Nor was it just rhetoric. Since 2010, we’ve seen a sharp decline in discretionary spending and an unprecedented decline in budget deficits, and the result has been anemic growth and long-term unemployment on a scale not seen since the 1930s.
So why didn’t we use the economic knowledge we had?… One answer is that most people find the logic of policy in a depressed economy counterintuitive…. Powerful political factions find that bad economic analysis serves their objectives. Most obviously, people whose real goal is dismantling the social safety net have found promoting deficit panic an effective way to push their agenda. And such people have been aided and abetted by what I’ve come to think of as the trahison des nerds–the willingness of some economists to come up with analyses that tell powerful people what they want to hear….
Whatever the reasons basic economics got tossed aside, the result has been tragic. Most of the waste and suffering that have afflicted Western economies these past five years was unnecessary. We have, all along, had the knowledge and the tools to restore full employment. But policy makers just keep finding reasons not to do the right thing.