It's called "the ivory tower"

Here's a thoughtful antidote to "boo economists!" by Barry Eichengreen at The National Interest. Perhaps the most forceful point is this:

What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.

Eichengreen notes that business schools, for example, are part of the production line of financial labor and ideas and so have no inventive to rock the boat; however, he also directs a lot of fire at academic economists for being part of the stitch-up. I accept that the author surely knows better than me the "pecuniary and psychic" benefits to academics from the use of their work, but a counter-hypothesis would be ignorance rather than malice, a sin of omission, not commission. How many in economics departments know what's going on in industry - or even business schools? Is it enough to claim a quorum of the profession?

There's probably analog to the hard sciences here. Newspaper science (cf. Bad Science, for example) is to natural science research as financial industry models are to economics research, or something like that. Imagine a house full of economists (reality show idea?) - every so often one wanders out to hand some obscure technical document to someone from the outside world, and something inevitably gets lost in translation. 

More navel-gazing

Since there are now, I estimate, more articles on the economics profession's predictions/responses to the recession than there are atoms in the known universe, replying to them all would presumably take a very long time. One example will probably suffice. 

In the Financial Times yesterday, John Kay talks about "How economics lost sight of real world". 

The past two years have not enhanced the reputation of economists. Mostly they failed to point out fundamental weaknesses of financial markets and did not foresee the crisis, and now they disagree on appropriate policies and on the likely future course of events.

As I have (almost) argued before, this is - for better or for worse - not in the job description of the vast majority of academic economists. It is precisely like attacking a physics professor because there was a blackout last night. More importantly:

Economists, like physicists, have been searching for a theory of everything. If there were to be such an economic theory, there is really only one candidate, based on extreme rationality and market efficiency.... a few deranged practitioners of the project believe that their theory really does account for all human behaviour, and that concepts such as goodness, beauty and truth are sloppy sociological constructs.

I have addressed the "economists don't feel feelings" argument before. And, by the way, I guess you can color me deranged. Economics is a theory of everything! 

First: the assumption of "rationality" that is central to economic theory is a modeling assumption and makes no restriction on behavior whatsoever. The auxiliary assumptions of what people care about - the things that they "rationally" try to achieve with their limited resources - are restrictive. Second: "market efficiency" is neither a theory or a modeling assumption. It is either a metric (one of many) by which we can evaluate outcomes (i.e. is this "efficient"?) or a result of an economic theory, which, like all economic theories, will probably require many assumptions. 

I would agree with the proposition that it is wrong to assume that markets are "efficient" (and what does that even mean?). Economists do not make such an assumption. I would agree with the proposition that it is wrong to assume that people care only about their own material wellbeing. Economists do not make such an assumption.

Academic economists did not predict this recession because that is not what academic economists are "supposed" to do with their time. 

Learning from your mistakes

The big policy lesson from our current recession is: save money in good times to see you through the bad. Obvious? Apparently not, especially in Britain, where the government spent the unprecendentedly long expansion period from the late 90s to 2007 running deficits. But it's good to know that we can learn from our mistakes, right? 

But [Alistair Darling] made clear his plans depended on a rapid economic bounce-back - with a forecast of 1.25% growth next year rising to 3.5% in 2011. [link]

The IMF World Economic Outlook (WEO) report predicts the UK economy will shrink by 4.1pc in 2009, with the downturn expected to continue into next year when the economy will fall by 0.4pc. [link]

This is unacceptable. After years of squandering prosperity by running deficits in boom years, now the government proposes to dig even deeper. 

My university, Brown, is cutting staff right now. By anecdote, it is far from alone in the higher education world in doing so. Why is it that a bad year means the operating budget is slashed? Why was the financial plan based on an assumption of constant, unlimited growth in the endowment (i.e. a constant, unlimited rise in stock prices)? Why were national governments operating under the same assumptions?