Misleading Indicators: How U.S. economists missed the Great Recession

Economists, for the most part, failed to foresee the current financial and economic crisis—the worst since the 1930s. Now they cannot reach a consensus on how to resolve it. A few—such as Nouriel Roubini and Robert Schiller—saw what was coming but were ignored. James Galbraith, an economist at the University of Texas, said: “It’s an enormous blot on the reputation of the profession. There are thousands of economists. Most of them teach. And most of them teach a theoretical framework that has been shown to be fundamentally useless.” When Judge Richard Posner, a leading theorist of law and economics, was asked why the warnings about a looming crisis were ignored rather than investigated, he responded, “Many economists and political leaders are heavily invested in a free market ideology which teaches that markets are robust and self-regulating.“ A reasonable question might be: Why listen to economists?

How Economics Works

Economics is a lot like theology, despite the former’s claim to be a science. Theology uses self-evident first principles from revelation or natural law and then, through the use of intermediate principles and judgments, evaluates real world issues. Economics uses an abstract model constructed from similarly axiomatic assumptions about how the world works, such as the principles that people are motivated by self-interest, that wants exceed resources or that resources are mobile and fungible. From these principles, economists then develop economic policies, with appropriate regard for real world exceptions to their models.

The problem for both theologians and economists lies in going from the general to the specific. I cannot speak for theologians, but economists are seldom trained in the specifics of how the real world works. Instead, a graduate student in economics spends all of his or her time learning mathematics, statistics and general theory. These tools are then used to develop policy by finding a data set somewhere and applying the given tools to yield an answer. Economic theory says, for example, that interpersonal wage differences are the result of different amounts of human capital embodied in workers. Yet how is human capital to be measured? Since no such actual thing exists, a proxy for human capital has to be used, a measurable datum, like years of schooling for a worker. Yet the result of this method is that the theory being tested is rendered self-fulfilling. If a statistical test appears to falsify the theory being tested, the test is rejected and the economist tries different proxies until the test comes out the way he or she expects. The data will be massaged and the test redone until the results “prove” the theory. Why? Because economists believe the tenets of microeconomic theory the way theologians believe the core tenets of their faith.

Becoming an Economist

How do people become economists? David Colander writes in his delightful book, The Making of an Economist, Redux:

Were an undergraduate student to ask an economist how to become an economist, he would tell her to go to graduate school. She might demur, asking, “Wouldn’t it make more sense to go to Wall Street and learn how markets work?” Getting firsthand experience may sound like a good idea to her, but most economists would briskly dismiss the suggestion. “Well, maybe I should get a job in a real business—say, turning out automobiles.” The answer will be “no” again: “That’s not how you learn economics.” She might try one more time. “Well, how about if I read all the top economists of the past—John Stuart Mill, David Ricardo, Adam Smith?” Most economists would say, “It wouldn’t hurt, but it probably won’t help.” Instead, he would most likely tell her, “To become an economist who is considered an economist by other economists, you have to go to graduate school in economics.” So the reality is that, to economists, an economist is someone who has a graduate degree (doctorates strongly preferred) in economics. This means that what defines an economist is what he or she learns in graduate school.

Over the past 30 years or so the graduate economics curriculum has become more and more like a program in applied mathematics with a corresponding de-emphasis of economic history, history of economic thought, industry studies and industrial relations. This narrowing of focus gets reinforced as the student finishes the Ph.D. and gets a job in the academy. The greatest rewards go to those who make advances in theory and publish in the half dozen top academic journals. Few articles will be accepted by these journals that do not start with the standard abstract model and then derive some new “interesting” result. Publishing in public policy journals, by contrast, is considered much less prestigious and can even count against an aspiring academic by showing that one is not a serious economist. And of course, after receiving tenure this is what one knows how to do.

Laissez-faire Meets Keynes

The microeconomic model that forms the core of economic theory is a beautiful mathematical construct. Based on the assumptions of self-interested economic actors, perfect mobility of resources, perfect competition, no externalities and so on, the model yields a Pareto optimal outcome— that is, one in which no one can be made better off without making someone else worse off. Since economists rule out interpersonal comparisons of utility, there is nothing more to be said. The result is that economists learn to believe that this is the way the world works, and students drawn to study economics are frequently those who already believe this. In addition, behavioral economics research indicates that as undergraduate students study economics, they themselves demonstrate ever more self-interested behavior.

Until the mid-1930s, most economists believed a “free-market” economy would solve whatever problems arose. If goods and services and inputs into production were bought and sold in markets, they believed, the economy would function optimally. The result was a hands-off policy of laissez-faire economics; government would not interfere with the market.

With the breakdown of the economy in the 1930s, however, laissez-faire economics seemed discredited. In its place came the activist policies of Keynesian economics, which dominated until the stagflation of the late 1970s. One of the cornerstones of Keynes’s thought was his theory of investment. He argued forcefully that investment decisions were closely linked with what he called “animal spirits,” the emotional affect that governs human behavior. The term suggested fragility and instability in markets, even when the term was, in large measure, narrowed to refer to profit expectations or business optimism.

Keynes had ample evidence for his theory in the Great Depression, for even though investment was sorely needed then and the interest rates had fallen below 1 percent, there was still minimal investment. No sane businessperson would invest, regardless of the interest rate, if he or she was convinced that the project would incur losses in the future. Thus the psychological basis of profit expectations makes economics more of an art than a science.

In addition, Keynes rejected the neoclassical notion that wage reductions would restore full employment by leading employers to hire more workers because of lower costs. Instead, he argued that wages were more than simply a cost of production, but formed a part of aggregate demand. If wages fall, he argued, aggregate demand for goods and services and sales will fall. If sales fall, profits will decline and firms will require fewer workers. The experience of the Great Depression seemed convincing to all who were not wedded to classical or neoclassical economics.

A small band of economists, however, never accepted the Keynesian notion that government could play an important role in stabilizing the economy or that markets were not self-regulating. Almost from the beginning there were efforts to reinterpret Keynes to make his macroeconomics compatible with neoclassical microeconomics. Eventually this work produced the idea of “microfoundations,” the method in which any macroeconomics was built on individual behavior that was rational and informed. In this theory of rational expectations, in which the economic actors have perfect knowledge, they act in such a way that any governmental policy will not work unless it is a complete surprise. Thus Keynesian policy is seen as ineffective at best and most probably harmful.

This revised version of laissez-faire economics reigned in the 1980s after the election of Ronald Reagan. At the heart of the theory is a belief that markets are self-correcting. Financial economists developed this into the “efficient market hypothesis,” which argued that markets quickly and correctly incorporate all publicly available information into prices. Under the strong version of this theory, the only reason prices of assets like stocks change is that new information becomes available; thus financial markets could not consistently mis-price assets and therefore needed little regulation.

Between their narrow technical training and their bias toward free markets, most economists failed to see the coming perfect storm of economic recession and financial crisis. In fact they paved the way for it by urging the deregulation of financial markets, which in turn allowed the creation of all kinds of dubious new debt instruments, wildly increasing the leverage of bank capital, and even allowing huge Ponzi schemes to go undetected. When the extremely low interest rates set by the Federal Reserve were added to this, the “bubble” created in the housing industry was a natural outcome, and the spread to the financial sector was catastrophic.

Admitting Failure?

The most astonishing admission of failure of the free market model was that of former Federal Reserve chairman Alan Greenspan in autumn 2008, when he admitted that the Fed’s monetary management regime had been based on a “flaw.” The “whole intellectual edifice,” he said, “collapsed in the summer of last year.”

Robert Schiller, an economist at Yale, thinks the failure to foresee the financial collapse is the result of fearing to deviate from the consensus of the profession. And he does not think that economists have learned the lesson: “The rational expectations models will be tweaked to account for the current crisis. The basic curriculum will not change.” Dani Rodrick, an economist at Harvard University said, referring to the free-market model, “We have fixated on one of the possible hundreds of models and elevated that above the others.” John Kay, a financial columnist for The Financial Times, wrote:

Max Planck, the physicist, said he had eschewed economics because it was too difficult. Planck, Keynes observed, could have mastered the corpus of mathematical economics in a few days—it might now have taken him a few weeks. Keynes went on to explain that economic understanding required an amalgam of logic and intuition and a wide knowledge of facts, most of which are not precise: “a requirement overwhelmingly difficult for those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of comparatively simple facts which are known with a high degree of precision.” On this, as on much else, Keynes was right.

Encouraging Signs

I must not end without saying some positive things about economics and economists. There is much new work, even though still seldom included in the core curriculum, that is exciting and holds out varying degrees of hope for a regeneration of economics. Behavioral economics, evolutionary economics, happiness economics, economics of social capital and social norms, and the economics of asymmetric information all hold out hope of breaking through the twin constraints of methodological formalism and competitive equilibrium. Also, behavioral finance theory should provide a sounder basis than does the efficient-market hypothesis for future analyses of financial markets.

Even more encouraging is a growing recognition that economies require ethical behavior in addition to self-interest. Modern economics has selectively adopted Adam Smith’s metaphor of the invisible hand, focusing on the economically wondrous effects of the butcher and baker trading out of their self-interest and ignoring Smith’s prior description of the same deistic hand’s propelling the creation of a virtuous society. Virtue serves as “the fine polish to the wheels of society,” while vice is “like the vile rust, which makes them jar and grate upon one another.” As Jerry Evensky, an economist at Syracuse University, argues, for Smith “ethics is the hero—not self-interest or greed—for it is ethics that defends the social intercourse from the Hobbesian chaos.” Indeed, Smith sought to distance his thesis from the notion that individual greed could be the basis for social good. His understanding that virtue is a prerequisite for a desirable market society remains an important lesson.