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© 2012 Sanjeev Sabhlok's revolutionary blog
Economists make confident assertions in op-ed columns and on cable news—so why are their explanations often at odds with equally confident assertions from other economists? And why are all economic predictions so rarely borne out?[Source]
Extracts from an article in The Economist:
BACK in October 2008, just after the investment bank Lehman Brothers collapsed, the International Monetary Fund unveiled its forecasts for growth in 2009. The IMF is the global lender to national governments; its economic pronouncements are highly respected. So what did it predict? The US would grow 0.1% in 2009, countries in the euro zone 0.2% and the world as a whole 2.6%. The actual outturns were declines of 3.5%, 4.2% and 2.6% respectively.
Economists have regularly failed to predict recessions and were completely caught out by the recent financial crisis, as the Queen famously noticed.
The shortfalls of the profession are old news. All the way back in 1994, Paul Ormerod wrote a book called The Death of Economics, lamenting the failure to forecast the Japanese recession or the collapse of the Exchange Rate Mechanism, from which Britain was turfed out in 1992. “The ability of orthodox economics to understand the workings of the economy at the overall level is manifestly weak (some would say it was entirely non-existent)” Ormerod wrote.
To be fair to economists, there are two reasons why their forecasts are often likely to be wrong. The first is that humans are not inanimate objects; we change our behaviour and we watch the news. If every economist forecast a recession for 2013 and the predictions were widely publicised, businesses would cancel their investment programmes and consumers would start saving, not spending, for fear of losing their jobs. The recession would occur now, not next year. [Sanjeev: This is hubris of an extreme order! No sane businessman EVER listens to economists!]
Second, the economy is a complex mechanism with many working parts. Economists cannot run real-time experiments in the same way as scientists; operating one version of the economy with high interest rates and another with low rates, as a pharmacologist can offer one patient a new drug and another a placebo. There is no way of isolating the various factors that affect growth.
But there are more fundamental questions about the nature of the subject beyond the failure of economists to make accurate forecasts. Do economists have an accurate model of human motivation? Or do they assume that our motives are entirely mercenary?
In his excellent book, “The Assumptions Economists Make” Jonathan Schlefer tries to go back to first principles. Economists, he writes, “make simplified assumptions about our world, build imaginary economies based on those assumptions – otherwise known as models – and use them to draw practical lessons.” This is, as he admits, inevitable; the economy is too complex for any other approach to work. Simplified models can be manipulated mathematically to produce answers to economic problems. But it is easy to get carried away by the elegance of the model, and to forget the short cuts that were taken when the simplified assumptions were made.
The Chicago/neoclassical school tends to build up from the micro level, looking at the way that rational individuals will respond to incentives. The Keynesian school sees that the aggregated response of rational individuals might have perverse outcomes, as in the paradox of thrift, so calls on the government to take action in response. The Keynesians [are] reluctant to acknowledge that there may be a limit to the effectiveness of government intervention.
[Sanjeev: In my view BOTH schools of macroeconomics are deeply flawed. There is SIMPLY NO WAY to model entire economies without understanding (a) the entrepreneur and (b) incentives of the bureaucrat and politician. We need the insight of Schumpeter and Buchanan, along with detailed knowledge of the actual situation that is often known only to specialists in individual industries (e.g. housing finance industry). Since no human can have all this information, there can only be some broad medium and longer term generalisations made about the economy.]
On 25 January 2012 there was a panel discussion entitled, "The Future of Economics”, moderated by Martin Wolf. Key outcomes are summarised here.
I am amused at the classifications made by Martin Wolf (saltwater/freshwater economists), but let me not go there.
Key points with which I agree:
"economics suffers from physics envy. It seeks to be an exact science, which is impossible."
"the world is not computable"
"being a study of complex human behaviour, in which the world is created by human understand and motivations, economics is hard."
"even though economists get much wrong, they still have much to offer to non-economists who tend to assume that economic problems are far more simple than they actually are"
"there is a great danger that in rejecting the most simplistic pro-market mantras, economists and policymakers will embrace even more dangerous and naïve statism"
Partially agree
"orthodox economics had, in the years leading up to the crisis, become more a cult than a science, particularly with the assumption that what exists in competitive markets has to be the best possible outcome, since, if it were not, it could not exist. So, if crises are not predicted, it is because they cannot be: they are the result of unexpected shocks, by assumption". This is a criticism of the rational expectations school – a criticism with which I fully agree. But this must also be seen as a criticism of the neo-Keynesian school which manipulates these "perfections" (as if manipulating a recipe) in order to churn out its preferred imperfections. The economy is complex, not amenable to simplistic mathematical analysis, whether of the rational expectations or neo-Keynesian type. Without understanding institutions and political and historical context, we can't understand an economy.
"human beings are not rational calculating machines. Their mood and approaches to decision making varies with the circumstances." This is only partially correct. While humans don't use rational calculation, their behaviour is best predicted through the assumption that they DO think rationally.
So where should economics go from here?
Well, it should go back to the basics and reset the button. The value-add by economists was astoundingly huge in the first 100 years since Adam Smith's Wealth of Nations. It increased all the way till Menger came on the scene. Micro-economics, which is largely a deductive discipline, based ENTIRELY on the work of Menger, is still doing fine. But with the advent of Keynes, the "macro-economics" part of economics dropped off like a rock falling off a precipice. The figure below shows what's happened:
Associated posts:
When symbols become the truth: the religion of macroeconomics
In religion, the founder's words are taken at face value. No one challenges or questions, or demands proof. They are too scared to rot in hell if they challenge the authority of the person to whom a said truth has been "revealed".
Therefore we have all kinds of religions and sects, each based on the untested and unproven imagination and assertions of the founder. I won't take cite examples, since that would annoy 80 per cent of the readers of this blog.
The other crucial characteristic of religion is the use of symbols. Whether these be idols or icons or even religious texts, these objects take on greater meaning than the sum of their atoms.
It is possible to make anything into a religious symbol, ranging from an imagined "inner eye" to a perfectly natural stone. Then, of course, are the textual symbols. (Once again, I won't give examples.)
I've touched upon the fact that macroeconomics (particularly neo-Keynesian) is ENTIRELY divorced of any reference to reality, being a rational argument, pure and unblemished.
It struck me today that such imaginative rationalism is VERY similar to spiritualism. And that is why, perhaps, it is possible to be both a macro-economist and a religious believer. Both muddle up symbols with reality. Both imagine that symbols add up to something greater than the sum of the symbol's atoms. [Of course, I'm not denying the existence of meaning such as the meaning of words, but note that in words found in a dictionary all letters are essentially the same. The letters have no intrinsic value, nor the words any more value than the value of their meaning. These are just tools, like a screwdriver or hammer. Something we use for our purpose. We don't worship screwdrivers.]
In macro-economics, an equation is first written down. The equation presumably extracts the "spiritual" component of all relevant knowledge under investigation. A mere "i" can now represent the interest rate, divorced entirely from underlying dynamic interactions of demand and supply of money that confound real life. A mere "c" now represents consumption, unrelated to the dynamic nature of entrepreneurship, competition, fashions, and lifecycle changes that effect consumption. And so on.
Now, note that in the case of physics, these symbols are REAL. They MEAN something that is always the same. Lambda is actually the wavelength. Constants are actually constant (unless other factors come into play, which are then independently and precisely identified). Symbols in chemistry, physics, and other sciences are thus worthy of their claimed representation of reality.
The symbols in micro-economics are also REAL, to the extent that a proposed investigation is limited to a simple case. A micro-economic investigation can start fraying at the edges quickly enough, but is fairly reliable in its predictions, nevertheless. It can certainly be tested against reality.
But in macro-economics, these symbols come into their own, being presumably GREATER than what they can possibly represent. Symbols can now begin to represent the entire universe of humans and their interactions, totally divorced from all institutional frameworks and reality.
These now become very similar to RELIGIOUS SYMBOLS in their properties. You no longer can see reality through them. You must now imagine the reality they allegedly represent.
The macro-economist now behaves like a theologician. Once a bunch of assorted letters (symbols) are "processed", generally being pushed through hoops of elementary calculus, an "output" is now generated, which is treated with the same veneration accorded by theologicians to spiritual revelation.
The macro-economist now publishes, with great diligence and seriousness, a "paper" (the "paper" becomes like the original scripture). The paper is then presented in earnestness to colleagues in "conferences" (like religious gurus who go about preaching their message once they have become "enlightened").
Those who support the paper then come to one side. Those who oppose the paper (possibly having started with a different set of symbols and hence arriving at a different view of the "macroeconomy") now move to the other side. Macroeconomic sects are formed, and re-formed.
The ACTUAL BEHAVIOUR of macro-economists thus bears an uncanny resemblance to theologicians; very little to scientists.
At this stage macro-economists can be said to have become members of their specific macro-economic religion.
We know well enough that that proponents of religion REFUSE to consider the inconvenience of reality. Reality is inconsequential. It doesn't bother them. The peace they feel is "within". Fools (like me) who don't understand their "religion" have merely not reached "the level of understanding" necessary to become a practising member of their religious cult. They paternalistically try to "take me on the journey".
The same applies to macro-economic religions. Macro-economists entirely REFUSE to consider reality. If you bring up that question to them, they flare up and get quite worked up about it. No matter what reality is, they find an excuse to prove their religion to be "true", overcoming through such belief the unfortunate truth that their "model" did not even REMOTELY reflect reality.
(Btw, the same applies to "climate science". And many other such "disciplines".)
Let's demand a SOLIDLY PROVEN case each time someone comes to us with "policies" derived from untested and unproven models.
In REAL science, there are no differences in the views held by different scientists. In religion, everyone thinks differently. That should give away the nature of the underlying framework. "Policy" that is driven by non-science must be avoided like the plague.
Addendum
Closely related discussion here:http://www.quantumdiaries.org/2012/01/27/the-role-of-the-individual-in-science-and-religion/
On FB:
Sudeep Shetty Pretty Interesting … If older source (science) are true we can pickup the basic from old source and always make it better and stronger …Sanjeev Sabhlok Sudeep, in every science, the basics are automatically adopted into basic education. Aryabhata's work (zero) is taught in class 1, Newton's work in class 12 or first year BSc, Einstein's work in third year BSc (or earlier), and so on. By the time a person has finished graduation, he is now just about 30 years away from the frontier of knowledge. By the time post graduation is completed, he is 10 years from the fronter, and by the time PhD is completed, he is AT or beyond the frontier.Therefore, except for the student who wants to learn the history of science, there is no value in going back to Aryabhata or Newton.Only religion goes back to what was said thousands of years ago. That is because it ASSUMES that what was said is true. There is NO verification at any stage of the content of religious scriptures.
Descartes, the rationalist, made an important point: that we must use our reason. He can therefore be considered to be a key member of the group of philosophers whose work forms part of the Enlightenment.
However, as I've discussed earlier, pure reason unhindered by reality can take us seriously astray. This is the great risk of deduction – that its success depends entirely on the quality of the first assumption.
The scientific method therefore has a major component of empiricism, making it more robust than rationalism. It is this point that John Locke, the empiricist founder of the philosophy of the practice of liberty (classical liberalism), made when he wrote:
"When mathematical men will build systems upon fancy and not upon demonstration, they are liable to mistakes as others."
Locke was himself a keen scientist and worked closely with Robert Boyle, the founder of the Royal Society (the world's oldest academy for the advancement of science). Indeed, Locke kept a register of the weather at Oxford for Boyle's use, and conducted a variety of scientific experiments. Locke was also a close friend of Isaac Newton (ten years his junior), and had trained himself in medicine (even though his formal training was in philosophy), thus being able to successfully conduct small medical operations (and even save a life). It appears that Locke was so highly regarded as a scientist in his own right that he was elected Fellow of the Royal Society.
Therefore the "discipline" of "macro-economics", which emerged after the fanciful imaginations of Keynes, would have seemed most absurd and irrelevant to Locke. There is no way to make any meaningful proposition about the "macro-economy" in the scientific sense.
We can talk meaningfully about economic growth, institutions, and individual behaviour, but not about the "macro-economy". There is no society, hence no "macro-economy".
Mises seems to have been opposed to the idea of empiricism in economics, preferring an intuitive analysis of human choice. But such "intuition" is a form of empiricism, based on personal experience. We can also readily test these intuitions through appropriate experimental design. Mises's ideas are therefore not incompatible with the scientific method.
The key is to promote not just rationalism, but empiricism. True, there some mathematical models can lead to testable implications and therefore advance knowledge. But pure mathematical macroeconomics, as often practised today, being totally devoid of empirical validity, is (to put it mildly, as Locke did) "liable to mistakes". It is the Descartian method run amuck, a method that has become fanciful.
I chanced upon Ricardo J. Caballero's article in The Journal of Economic Perspectives (Fall 2010), entitled, "Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome". This paper is available at the SSRN website (here) and I'd strongly encourage you to read it.
I have had a bitter-sweet relationship with economics, with macro-economics being the bitter part. What puts me off macroeconomics is its delusional approach to society. Plug in some equations, imagine a few assumptions, and then cook up a monstrous 20 page series of mathematics to come out with something that pretends to tell us something about society. What put me off truly from this discipline was to hear praise about a pathetic Indian anti-poverty program based on imaginary set of mathematical calculations.
The subject of macro-economics is so divorced from reality that it tests one's patience. One doesn't know what is sensible and what is nonsense masquerading as sense.
The discipline of macroeconomics perhaps has its roots in the IS-LM models that came about after Keynes, based on simplistic and grandiose assumptions about the entire economy. Even later, rational expectations models, turned out to be quite a damp squib because of the dramatic imagination involved.
Before Keynes, economists perhaps never aspired to predict the macro-economy as a whole (except for the study of business cycles). They tried to measure it, understand its dynamics, but never to predict its future course.
Since Keynes a lot changed. Every macro-economist worth his salt spends an inordinate amount of effort in trying to predict the economy based on a few key variables and equations. And it is these people who parade about, offering predictions about the future on TV that the world sees. People therefore think of economists as predictors of the economy, than analysts of human freedom.
I would prefer that they restrict themselves to the study of freedom. More insights about "macroeconomic policy" are found in Hayek than in any standard advanced textbook on macro-economics. Surely Mises's warning against mathematical economics (discussed in my blog post here) has been vindicated.
Anyway, here are few extracts from the Caballero paper:
The recent financial crisis has damaged the reputation of macroeconomics, largely for its inability to predict the impending financial and economic crisis. Of course, it is well-known that certain elements can increase the fragility of a financial system, such as high levels of leverage or mismatches between short-term liabilities and long-term assets, and that these issues may justify policy intervention. But knowing these mechanisms is quite different from arguing that a severe crisis can be predicted.
What does concern me of my discipline, however, is that its current core—by which I mainly mean the so-called dynamic stochastic general equilibrium approach—has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in “fine-tuning” mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in “broad-exploration” mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected.
The dynamic stochastic general equilibrium strategy is so attractive, and even plain addictive, because it allows one to generate impulse responses that can be fully described in terms of seemingly scientific statements. The model is an irresistible snake-charmer. In contrast, the periphery is not nearly as ambitious, and it provides mostly qualitative insights.
Moreover, this tension is not new to macroeconomics or even to economics more broadly. In his Nobel-prize acceptance lecture, Hayek writes:
“Of course, compared with the precise predictions we have learnt to expect in the physical sciences, this sort of mere pattern predictions is a second best with which one does not like to have to be content. Yet the danger of which I want to warn is precisely the belief that in order to have a claim to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the process of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm” (von Hayek, 1974).
One reading of Hayek's comment is as a reminder of the dangers of presuming a precision and degree of knowledge we do not have.
There is no doubt that the formalization of macroeconomics over recent decades has increased its potential. We just need to be careful to not let this formalization gain its own life and distract us from the ultimate goal, which is to understand the mechanisms that drive the real economy. The idea is to place at the center of the analysis the fact that the complexity of macroeconomic interactions limits the knowledge we can ever attain.
I am almost certain that if the goal of macroeconomics is to provide formal frameworks to address real economic problems rather than purely literature-driven ones, we better start trying something new rather soon. The alternative of segmenting, with academic macroeconomics playing its internal games and leaving the real world problems mostly to informal commentators and “policy” discussions, is not very attractive either, for the latter often suffer from an even deeper pretense-of-knowledge syndrome than do academic macroeconomists.
Core and Periphery
The ultimate goal of macroeconomics is to explain and model the (simultaneous) aggregate outcomes that arise from the decisions made by multiple and heterogeneous economic agents interacting through complex relationships and markets. Neither the core nor the periphery is able to address this incredibly ambitious goal very satisfactorily. The periphery has focused on the details of the subproblems and mechanisms but has downplayed distant and complex general equilibrium interactions. The core has focused on (extremely stylized) versions of the general equilibrium interactions and has downplayed the subproblems.
The natural next step for the core, many would argue, is to add gradually the insights of the periphery into its dynamic stochastic general equilibrium structure. I am much less optimistic about this strategy, as I think it is plagued by internal inconsistencies and pretense-of-knowledge problems.
The Periphery
I believe that up to now the insight-building mode (both past and present) of the periphery of macroeconomics has proven to be more useful than the macro-machine-building mode of the core to help our understanding of significant macroeconomic events. I believe it would be good for macroeconomics to (re)orient a larger share of its human capital in this direction, not just for the study of crises but also for its broader concerns. It is only natural for macroeconomists to want more, but it is the rushed process to fulfill this ambition that I believe has led the core right into Hayek’s pretense-of-knowledge syndrome.
The Core
If we were to simply use these stylized structures as just one more tool to understand a piece of the complex problem, and to explore some potentially perverse general equilibrium effect which could affect the insights isolated in the periphery, then I would be fine with it. My problems start when these structures are given life on their own, and researchers choose to "take the model seriously" (a statement that signals the time to leave a seminar, for it is always followed by a sequence of naive and surreal claims).
My point is that by some strange herding process the core of macroeconomics seems to transform things that may have been useful modeling short-cuts into a part of a new and artificial “reality,” and now suddenly everyone uses the same language, which in the next iteration gets confused with, and eventually replaces, reality. Along the way, this process of make-believe substitution raises our presumption of knowledge about the workings of a complex economy, and increases the risks of a “pretense of knowledge” about which Hayek warned us.
After much trial and error, these core models have managed to generate reasonable numbers for quantities during plain-vanilla, second-order business cycle fluctuations. However, the structural interpretation attributed to these results is often naïve at best, and more often is worse than that.
A theory is no longer testable when rejection is used not to discard the theory, but to select the data moments under which the core model is to be judged. This practice means that well-known major failures just become “puzzles,” which are soon presumed to be orthogonal to the output from the quantitative model that is to be taken “seriously.”
By now, there are a whole set of conventions and magic parameter values resulting in an artificial world that can be analyzed with the rigor of micro-theory but that speaks of no particular real-world issue with any reliability.
Integration?
However, I think this incremental strategy may well have overshot its peak and may lead us to a minimum rather than a maximum in terms of capturing realistic macroeconomic phenomena. We are digging ourselves, one step at a time, deeper and deeper into a Fantasyland, with economic agents who can solve richer and richer stochastic general equilibrium problems containing all sorts of frictions.
Given the enormous complexity of the task at hand, we can spend an unacceptably long time wandering in surrealistic worlds before gaining any traction into reality.
We ultimately need to revisit the ambitious goal of the core, of having a framework for understanding the whole, from shocks to transmission channels, all of them interacting with each other. The issue is how to do this without over-trivializing the workings of the economy (in the fundamental sense of overestimating the power of our approximations) to a degree that makes the framework useless as a tool for understanding significant events and dangerous for policy guidance.
Facing and Embracing Economic Complexity
One of the weaknesses of the core stems from going too directly from statements about individuals to statements about the aggregate. The nodes of economic models are special, for they contain agents with frontal lobes who can both strategize and panic, and it is these features that introduce much of the unpredictability in the linkages I mentioned earlier.
Haldane (2009) compares the recent financial crisis to the Severe Acute Respiratory System (SARS) outbreak earlier in the decade. Morbidity and mortality rates from SARS were, “by epidemiological standards, modest.” Yet SARS triggered a worldwide panic, reducing growth rates across Asia by 1–4 percentage points. Parents kept their children home from school in Toronto, and Chinese restaurants in the United States were the targets of boycotts. Faced with Knightian uncertainty, people conflated the possibility of catastrophe with catastrophe itself.
Some Policy Implications of a Confusing Environment
[Sanjeev's note: In this section, Caballero deteriorates into a confused Keynesian, and starts prescribing statist interventions of all sort. Let me warn you in advance about this section!!]
Robustness
We need to rework the mechanism the core currently. The problem is that we do not know the mechanism, not just that we don’t know its strength.
For now, we shouldn't pretend that we know more than this, although this is no reason to give up hope. We have made enormous progress over the last few decades in the formalization of macroeconomics. We just got a little carried away with the beautiful structures that emerged from this process.
[These guys don't give up even after the theory has failed. Sanjeev]
The Pretense of Knowledge
The root cause of the poor state of affairs in the field of macroeconomics lies in a fundamental tension in academic macroeconomics between the enormous complexity of its subject and the micro-theory-like precision to which we aspire. The modern core of macroeconomics swung the pendulum to the other extreme, and has specialized in quantitative mathematical formalizations of a precise but largely irrelevant world.
From a policy perspective, the specifics of a crisis are only known once the crisis starts. For this reason, my sense is that, contrary to the hope of policymakers and regulators, there is limited scope for policy that can in advance eliminate the risk or costs of financial crisis, beyond some common-sense measures (like capital requirements for financial institutions) and very general public–private insurance arrangements (like deposit insurance).
The challenges are big, but macroeconomists can no longer continue playing internal games. The alternative of leaving all the important stuff to the “policy”-types and informal commentators cannot be the right approach.
Addendum
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