What to do to make economics a relevant and realist science

8 Jul, 2014 at 16:04 | Posted in Economics | 17 Comments

The other day yours truly wrote re Krugman‘s dangerous neglect of methodological reflection:

The financial crisis of 2007-08 and its aftermath definitely shows that something has gone terribly wrong with our macroeconomic models, since they obviously did not foresee the collapse or even make it conceivable … Modern mainstream macroeconomics obviously did not anticipate the enormity of the problems that unregulated ‘efficient’ financial markets created. Why? Because it builds on the myth of us knowing the ‘data-generating process’ … Mainstream macroeconomists … want to be able to use their hammer. They decide to pretend that the world looks like a nail and that uncertainty can be reduced to risk. So they construct their mathematical models on that assumption–and the ensuing results are financial crises and economic havoc.

Now Brad DeLong earlier today commented on my critique:

OK …

Suppose we decide that we are no longer going to:

Pretend that agents — or economists — know the data-generating process…

Recognize that people are not terribly committed to Bayesianism -– that they do not model probabilities as if they have well-defined priors and all there is is risk…

What do we then do –- what kind of economic arguments do we make–once we have made those decisions?

“What do we then do?” The despair heard in the question reminds me of the first time I met Phil Mirowski. It was twenty years ago, and he had been invited to give a speech on themes from his book More Heat than Light at my economics department in Lund, Sweden. All the neoclassical professors were there. Their theories were totally mangled and no one — absolutely no one — had anything to say even remotely reminiscent of a defense. Being at a nonplus, one of them, in total desperation, finally asked “But what shall we do then?”

Moments like that you never forget. It has stayed with me for all these years. The emperor turned out to be naked.

keynes-right-and-wrong

What shall neoclassical economists do when the modeling assumptions made are shown to be harmful and not even remotely matching reality?

What shall neoclassical economists do when university students all over Europe and US are increasingly beginning to question if the kind of economics they are taught — mainstream neoclassical economics — really is of any value — and some even question if economics really is a science at all?

How do we re-establish credence and trust in economics as a science?

I think five changes are absolutely decisive if we want to rethink economics and make it a truly pluralist, relevant and realist science:

(1) Stop pretending that we have exact and rigorous answers on everything. Because we don’t. We build models and theories and tell people that we can calculate and foresee the future. But we do this based on mathematical and statistical assumptions that often have little or nothing to do with reality. By pretending that there is no really important difference between model and reality we lull people into thinking that we have things under control. We haven’t! This false feeling of security was one of the factors that contributed to the financial crisis of 2008.

(2) Stop the childish and exaggerated belief in mathematics giving answers to all important economic questions. Mathematics gives exact answers to exact questions. But the relevant and interesting questions we face in the economic realm are rarely of that kind. Questions like “Is 2 + 2 = 4?” are never posed in real economies. Instead of a fundamentally misplaced reliance on abstract mathematical-deductive-axiomatic models having anything of substance to contribute to our knowledge of real economies, it would be far better if we pursued “thicker” models and relevant empirical studies and observations.

(3) Stop pretending that there are laws in economics. There are no universal laws in economics. Economies are not like planetary systems or physics labs. The most we can aspire to in real economies is establishing possible tendencies with varying degrees of generalizability.

(4) Stop treating other social sciences as poor relations. Economics has long suffered from hubris. A more broad-minded and multifarious science would enrich today’s altogether too autistic economics.

(5) Stop building models and making forecasts of the future based on totally unreal microfounded macromodels with intertemporally optimizing robot-like representative actors equipped with rational expectations. This is pure nonsense. We have to build our models on assumptions that are not so blatantly in contradiction to reality. Assuming that people are green and come from Mars is not a good – not even as a “successive approximation” – modeling strategy.

17 Comments

  2. […] P. Syll has a fun post on what’s wrong with neoclassical economics and what needs to change. According to Lars, the […]

    Pingback by That We’re Necessarily Becoming Less Rational Means Neoclassical Econ is Necessarily Becoming Less Useful | Econolosophy— 12 Jul, 2014 #

  3. I think this is not quite right. What about 21st Century physics? Complex and chaotic systems don’t reduce to simple rules like force = mass x acceleration but they do follow laws. Meteorologists were able to predict hurricane Sandy would take a left turn into New York City days before it happened. By embracing the complexity and tossing equilibrium in the dustbin, someday Agent Based Models will have similar success.

    Comment by Thornton Hall— 9 Jul, 2014 #

    • There is no model which can tell us at what point the psychological effects of uncertainty will tip us into recession, or forecast the behavior of a market without reducing individuals to the level of an automaton acting in perfect synchronicity with the model’s assumptions. We will never overcome these things and instead of aiming for precision should focus on determining trends and probabilities. Weather forecasters did not lredict the future of Katrina based on iron principles of complexity, they generated a series of probabilities based on observations and made an educated guess. Some were right and some were wrong because it is impossible to eliminate uncertainty in a complex adaptive system, where forecasting is as much intuition and art as hard data.

      Comment by Ben Johannson— 10 Jul, 2014 #

  4. The apologists/beneficiaries of current dogma seen to be emphasising the importance of it’s underlying philosophy, as opposed to admitting the “emperor’s new clothes” scenario that has occurred. JK Galbraith predicted a 2007/8 type crash & no doubt others. Of course the real “philosophers” would call this occurence a “correction” anyway and start quoting Schumpeter et al!

    Comment by John DV— 9 Jul, 2014 #

  5. Um, here’s an idea: stop trying to microfound your explanations of economic activity. Stick to macro-aggregates. It’s really very simple. The idea that working economists cannot practice their field without reference to crystal-ball gazing agents is stupid in the extreme. The “what do we do now” defence is the defence adopted by people who are not really economists at all. Rather they are second-rate mathematicians who didn’t make the cut. My answer to them is simple:”What do YOU do? Get another job. Bye.”

    Comment by pilkingtonphil— 8 Jul, 2014 #

  6. On the Robin Cursoe point, Don Ross’ new, despite a somewhat contorted argumentation, book on the Philosophy of Economics makes a good case that economist don’t really structure their models on the metaphor despite its enunciation. Overall, I slightly agree with the “caricature” point. Ross, Athreya and Leamer are not that far apart.

    Comment by dwayne woods— 8 Jul, 2014 #

  7. I think that is possible to formulate microeconomic models suitable to represent economic behavior, if initial assumptions are ontologically integrated with reality. One first error in microeconomie is to begin with a “robinson cruzoe” representation of economic agent, with only this error, models are failing and must not to have conclusions on suitability of models or mathematical models. Is necesary to argument in counter of this disocial arguments like “robinson cruzoe” economics?.
    A second error propagated by Adam Smith is negation of colonial profits by England and its aristocratic class, profits that explain commerce development and wars along history.
    With both assumptions resolved we can to formulate microeconomic models compatible with macroeconomy.

    Comment by robertoviera1— 8 Jul, 2014 #

  8. So in response to the question “What should we do?”, you provide another list of things we shouldn’t do, without a single constructive example of “relevant and realist science”. Why am I not surprised?

    And by the way, who are these mythical neoclassical economists who actually insist that “we have exact and rigorous answers on everything”, and “mathematics gives answers to all important economic questions”, or “economies are like planetary systems”? Can you provide quotes and references tto any real person making such claims? In fact, don’t bother, because there are of course no such quotes – just yet another straw-man carricature.

    Comment by ivansml— 8 Jul, 2014 #

    • “…the methods developed in this paper lay down a convenient framework for investigating the effects of changes in economic fundamentals or animal spirits on uncertainty and the feedback effects of such swings in uncertainty on the economic dynamics. (p37)”

      That would, to my mind, constitute an “exact and rigorous answer” to decision making under uncertainty. It would also constitute using “mathematics to give answers to all important economic questions”. But no matter ivansml. You and I both know you cannot answer the substance of Syll’s critique. Neither can Delong.

      People are beginning to get a sense that the emperor is naked. And you can’t prove that he has any clothes. Lol!

      Comment by pilkingtonphil— 8 Jul, 2014 #

      • We’ve been over this paper already Phil, so just quickly – since when is “convenient framework for investigating” equivalent to “answers to all important economic questions”? English is my second language, but I’m pretty sure those are not the same things. As usually, you think that a mathematical model can only be interpreted as a literal description of the world, and then project your naive (mis)understanding of mathematical modelling on others. But that’s your problem, not theirs.

        Comment by ivansml— 8 Jul, 2014 #

    • James K. Galbraith in answer to Krugman, Who were these economists, anyway?

      Click to access TA09EconomistGalbraith.pdf

      See also Dirk Bezemer, “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models

      Click to access No_one_saw_this_coming.pdf

      One of the economists that got it right was Wynne Godley. His stock flow consistent macro modeling approach is set forth in Godley and Lavoie, Monetary Economics: : An Integrated Approach to Credit, Money, Income, Production and Wealth.

      Steve Keen was another, using a Post Keynesian approach.

      Then there is Hyman Minsky, who the mainstream only remembered after the crisis, but whose work his student Randy Wray used, with Godley, to warn about impending financial crisis and the folly of adopting the euro as a common currency.

      Then take a look at Piketty et al’s empirical and historical data base and their methodology, which they have made transparent.

      Brad DeLong is one of the smartest guys on the block among economists and he also well aware of history and social sciences. He knows all this and therefore also the answer to his own question, if he would let himself think it. Psychologists call this being in denial.

      Comment by Tom Hickey— 9 Jul, 2014 #

  9. perhaps you should tell people like Brad DeLong he should read my 2002 book FINANCIAL MARKETS, MONEY AND THE REAL WORLD especially pager 117 where I warn that the
    “growth of [unregulated] mutual funds and other nonbank financial intermediaries …has permitted significant expansion of debt obligations on the part of debtor households and enterprises. This suggests that a sudden switch by many households [holding these debt obligations as a form of liquid savings] to a fast exit strategy at a future date could cause a horrific liquidity problem.” which is exactly what happened in 2007-2008!

    Tell him that in a nonergodic economic world, people know they do not know the future — and therefore liquidity as a protective blanket against being unable to meet monetary contractual obligations as they come due becomes central to understanding decision making.

    The Post Keynesian analysis — as I told Milton Friedman in the 1970s book MILTON FRIED,AM’S MONETARY FRAMEWORK: A DEBATE WITH HIS CRITICS
    – explains why liquid assets are so different from other assets that may have value.

    It is this theory which explains that in order fro an asset to be liquid it must be readily resalable in a well organized and ORDERLY market— and in order to maintain orderliness there is required an institution called a market maker- who can swim against a tide when many bulls suddenly become bears and wish to make a fast exit.

    what DeLong and his ilk do not understand is that it is the development of human institution such as money contracts, the civil law of contracts, orderly markets, etc that govern economic activity.

    Comment by paul davidson— 8 Jul, 2014 #

  10. I’m not really persuaded by the rejoinder. Krugman et al wouldn’t disagree with any of it, except to argue that some assumptions are needed for an kind of model. Bernstein puts things in a nice perspective – http://jaredbernsteinblog.com/evidence-is-it-really-overrated/

    To me the real critique is not the recycling of neo-classical economists (as McCloskey argues a too homogenizing label) unrealistic models but a formulation of “realistic” models.

    Comment by dwayne woods— 8 Jul, 2014 #

    • Or maybe economists should, as Keynes put it, become more like dentists: modest people who look at a small part of the body but remove a lot of pain. 🙂

      Comment by Lars Syll— 8 Jul, 2014 #

    • Seems to me you’re missing the point. This is a critique of the very idea that we should or even *can* create models of economics, seeing as how it’s practically impossible at this juncture of the climb toward the pinnacle of humanity to completely or even adequately account for all the necessary variables it would require to create an overarching or even moderately arching model or theory of economics in general.

      Comment by Patrick Elder— 14 Aug, 2014 #


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