A report by respected economists has come out severely criticizing the current state of academic economics and by extension the theories and models underlying many of the moves by the Fed and Treasury.
From the Dahlem report
Abstract: 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 deeper 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 economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.
This is a 17 page report that cogently and persuasively lays out a case for the failure of neo-classical economic theory, the theory that undergirds the actions of individuals like Ben Bernanke and Timothy Geithner. Some of the authors include well-known economics textbook writer David Colander, leading evolutionary game theory researcher Alan Kirman, and an important non-linear dynamical theorist Thomas Lux.
I am going to selectively quote compelling passages and try to give a layman's interpretation to the arguments presented. I will not be able to delve into the report thoroughly in this diary, but instead will encourage everyone here on this site to read it and consider the arguments presented as a true indictment of current economic "science."
The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession. Over the past three decades, economists have largely developed and come to rely on models that disregard key factors—including heterogeneity of decision rules, revisions of forecasting strategies, and changes in the social context—that drive outcomes in asset and other markets. It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, "systemic crisis" appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon.2 In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession.
This is the first paragraph in the report and it lays out a remarkable thesis, namely that the current discipline practiced by the majority of economists, their models and theories, do not reflect reality. It must be understood that scientific models don't portray reality perfectly, but instead are the basis for predicting results that can be tested by empirical research, being further refined or leading to new, better models. With neo-classical, Chicago school economics, this type of research had not lead to improved models in predicting the economy. Most economists were stunned by the power and scope of this global economic crisis and do not have tools available to give any type of accurate analysis to guide the world out of this deepening depression.
The implicit view behind standard models is that markets and economies are inherently stable and that they only temporarily get off track.
There is no actual basis for this view. This is the primary view guiding our economic technocrats.
Ironically, as the crisis has unfolded, economists have had no choice but to abandon their standard models and to produce hand-waving common-sense remedies. Common-sense advice, although useful, is a poor substitute for an underlying model that can provide much-needed guidance for developing policy and regulation. It is not enough to put the existing model to one side, observing that one needs, "exceptional measures for exceptional times". What we need are models capable of envisaging such "exceptional times".
This quote needs to really sink in within the community. Much of what has been driving the debates in various threads is the common-sense notions of how the economy is supposed to work. These notions are informative but they are missing the point. We are in a crisis the likes of which have never been seen. Part of this is because our economy is so vast and interconnected that pockets of instability can and have destabilized the whole system. A few months ago, the EU thought they were going to be immune from the credit fiasco here in the US, but events have quickly undermined that notion. It really is like the butterfly effect when talking about the weather, except it is the economy which has a more pervasive impact upon our lives. And considering the development of exotic finance and how little that has even been looked into by the authorities, much more instability is quite possible. And modern economic gurus are incapable of beginning to analyze the effects of these problems in any useful manner. Basically the argument boils down to the fact that that the "science" of economics is rudimentary at best.
This failure has deep methodological roots. The often heard definition of economics—that it is concerned with the ‘allocation of scarce resources’—is short-sighted and misleading. It reduces economics to the study of optimal decisions in well-specified choice problems. Such research generally loses track of the inherent dynamics of economic systems and the instability that accompanies its complex dynamics.
We all know that the economy is dynamic and constantly evolving (or devolving). Many of the basic assumptions underlying neo-classical theorizing (which also underlies a lot of financial theorizing) are completely divorced from reality. What this paragraph is arguing is that other types of system science have shown that optimization problems, while useful, rarely reflect the richness of reality. Basically economics is in a mathematical and physical sciences backwater when it comes to actually analyzing the economic system. One of the common assumptions used by economists is that of ceteris paribus -- holding all things equal while considering a limited set of variables. It is a way of generalizing without having to deal with the messiness of reality.
Many of the financial economists who developed the theoretical models upon which the modern financial structure is built were well aware of the strong and highly unrealistic restrictions imposed on their models to assure stability. Yet, financial economists gave little warning to the public about the fragility of their models;4 even as they saw individuals and businesses build a financial system based on their work. There are a number of possible explanations for this failure to warn the public. One is a "lack of understanding" explanation--the researchers did not know the models were fragile. We find this explanation highly unlikely; financial engineers are extremely bright, and it is almost inconceivable that such bright individuals did not understand the limitations of the models. A second, more likely explanation, is that they did not consider it their job to warn the public. If that is the cause of their failure, we believe that it involves a misunderstanding of the role of the economist, and involves an ethical breakdown. In our view, economists, as with all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. Currently, there is no ethical code for professional economic scientists. There should be one.
This to me is the most explosive part of the report. Part of the blame for the current economic crisis goes squarely on the shoulders of people like Geithner. Economists in power engage and feed the fiction that they have the ability to control the economy. There are all kinds of reasons that we can speculate to as why this is so, but part of it is the fact that their models seemed to work most of the time. There have been several crises in the past that were stopped or lessened by the work of these economists, further reinforcing the validity of their models. But a large part of that self-validation came through the willful disregard of the full effect various solutions to crises had upon the economies in crisis and the broader global economy. One can look to Naomi Klein's Shock Doctrine for evidence of this.
Ultimately a group of economists is calling for ethical standards that force behavior that should be given in discussing economic science. But in most cases, the over-reliance on assumptions and theories divorced from economic reality are not even discussed within the corridors of power or within general discussions of economics. One example of this that I see sometimes in this community, when discussing Keynesian solutions to the Great Depression, people ignore or disregard the impact of WWII. I personally think that the government should stimulate demand through direct acquisition and legislation like EFCA (giving workers the ability to capture the profits of their production means more consumer demand over a time horizon), but at the same time, the principle engine of economic growth after WWII was rebuilding the productive capacity of Europe, something that the US profited from as having most of its productive capacity spared destruction, and this was a process, rebuilding Europe, that took thirty to forty years. Secondly, the Cold War seriously distorted trade relations and the 'free market'. Thirdly there was a growing movement towards decolonization by Europe that led to the emerging markets. And on and on . . . Economics is a science that is affected by politics and political action. We should learn lessons from history but must understand that are moment within history is significantly different than the past and is going to require innovative thinking and understanding of that difference. But my understanding, like most, is common sense, the same kind of sense that directs our behavior regarding weather.
For natural scientists, the distinction between micro-level phenomena and those originating on a macro, system-wide scale from the interaction of microscopic units is well-known. In a dispersed system, the current crisis would be seen as an involuntary emergent phenomenon of the microeconomic activity. The conceptual reductionist paradigm, however, blocks from the outset any understanding of the interplay between the micro and macro levels. The differences between the overall system and its parts remain simply incomprehensible from the viewpoint of this approach.
This quote comes after thorough discussion underlying the problems in economic modeling, specifically the unacknowledged reliance on two major assumptions, that of rational expectations and representative agents. Most economic theory expects that humans are rational agents (with perfect knowledge of prices and the ability to move to the best deal). It is a way of closing off models so they don't have to deal with the messiness of the real world. This is a criticism that has been repeatedly made explicit for years and for years has been disregarded by most economic departments (in terms of research and funding). The study of economics is divided into to two broad spheres, microeconomics which concerns itself with the firm or individual economic behavior, and macroeconomic theory, which concerns itself with the economic system as a whole. The point that the make with the comparison to natural science is that the micro realms don't necessarily and neatly add up to the macro realm. What immediately comes to my mind is the division in physics between the interactions of the very small (molecules on down) versus the
interaction of everyday objects to the cosmos. In physics the theory of the small inform the the theories of the large and vice versa, but there is not a neat relationship between the two. Part of this is due to the nature of the forces effecting the very small and the large. In economics, what is happening in your town does not add up neatly to what is happening to the national economy. It is hard to defend that actions of individuals will add up to the macro-action expected by cutting taxes for example. But if we as human were to behave as fully economic rational actors, then tax cuts would lead to an immediate bump in consumer demand. At the same time, this assumption of rationality is really predicated on a philosophy or ideology of what constitutes rational behavior. Rather than actually testing how humans would respond to various situations (by creating elaborate games for example or by maintaining detailed surveys on the economic prospects and purchasing patterns of individuals in a specific economy) and using that to determine the value and validity of theories, instead most economists use an ideological construct of humanity to base their predictions, and consistently refuse to do anything about it or admit otherwise.
Many financial innovations had the effect of creating links between formerly unconnected players. All in all, the degree of connectivity of the system has probably increased enormously over the last decades. As is well known from network theory in natural sciences, a more highly connected system might be more efficient in coping with certain tasks (maybe distributing risk components), but will often also be more vulnerable to shocks and – systemic failure! The systematic analysis of network vulnerability has been undertaken in the computer science and operations research literature (see e.g. Criado et al., 2005). Such aspects have, however, been largely absent from discussions in financial economics. The introduction of new derivatives was rather seen through the lens of general equilibrium models: more contingent claims help to achieve higher efficiency. Unfortunately, the claimed efficiency gains through derivatives are merely a theoretical implication of a highly stylized model and, therefore, have to count as a hypothesis. Since there is hardly any supporting empirical evidence (or even analysis of this question), the claimed real-world efficiency gains from derivatives are not justified by true science. While the economic argument in favor of ever new derivatives is more one of persuasion rather than evidence, important negative effects have been neglected.
So the instruments of financial mass-destruction have no known basis in reality. The scientific underpinnings for derivatives and derivative trades as something for hedging risk and therefore helping banks and other financial institutions expand their available capital to further leverage the economy where based on nothing more than a hypothesis, a hypothesis that someone like Alan Greenspan fully embraced. As this paragraph shows, it ultimately boils down to they way that economists see the economy and how they chose to ignore developments in other branches of science and mathematics to refine their theories. This paper sounds like a broken record in this respect, that much of the science underlying economic theory as it is practiced in the halls of power, is either inadequate or fallacious in its ability to predict the behavior of the economic system.
Why is this important? President Obama laid out a budget proposal based off of many of these models, models that predict a fairly speedy recovery from the actions he has taken. But this crisis is unlike other recent crises, especially factoring in the implications of exotic financial instruments. GDP growth was revised downward for the US to negative 6.2% which was outside the consensus forecast of -5.5%, which doesn't seem like a lot until you look at it statistically in relation to all other Q to Q growth and forecasts, and then it appears as significant indicator of the breakdown of current models. This being only one piece and fitting into the broader issues of resolving the large banks and their derivative contracts. The growth of interconnections has added layers of complexity that can't even begun to be appropriately dealt with to lessen the impact that they are having on the economy.
So please read this report, it is a very thorough indictment of the failure of academic economics by knowledgeable economists. It should add to your suspicion that those in charge don't know what they are doing, and any attempt otherwise is an attempt to manipulate or manage the situation. And this is an ethical issue, as the authors indicated, the policy creating economic technocrats have a duty to actually inform that their models and theories are inadequate to the current task they face. Instead of an honest accounting, we get the kabuki dance that we have to deal with in our daily lives.
Note: I have quoted liberally from a 17 page document so I feel that I am well within fair use here. I barely even touched the surface of the critique in this report and I again encourage people to read it, as it is pretty straightforward in and of itself.