The Economist on the Failure of Economics

The venerable Economist magazine must be feeling at least a little bit tarnished after the heavy (and well-deserved) criticism that has been directed toward the profession that they have represented since 1843 though, admittedly, they cover much more than economics.

In this report, they offer up a heavy dose of introspection:

What went wrong with economics

OF ALL the economic bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself. A few years ago, the dismal science was being acclaimed as a way of explaining ever more forms of human behaviour, from drug-dealing to sumo-wrestling. Wall Street ransacked the best universities for game theorists and options modellers. And on the public stage, economists were seen as far more trustworthy than politicians. John McCain joked that Alan Greenspan, then chairman of the Federal Reserve, was so indispensable that if he died, the president should “prop him up and put a pair of dark glasses on him.”

Yes, the profession clearly peaked (along with the housing bubble) when Freakonomics was published in 2006, but, more importantly, it's been some time since I've thought about that quip from a very different John McCain in late-1999.

It's aging well...

From Wikiquote comes the complete text and a reference at CNN. McCain s

I would not only reappoint Mr. Greenspan -- if Mr. Greenspan should happen to die, God forbid -- I would do like was did in the movie, 'Weekend at Bernie's.' I'd prop him up and put a pair of dark glasses on him and keep him as long as we could.

That may have produced a better outcome that what actually occurred between 2000 and 2006 when the former Fed Chairman retired.

Hmmm... back to The Economist:

In the wake of the biggest economic calamity in 80 years that reputation has taken a beating. In the public mind an arrogant profession has been humbled. Though economists are still at the centre of the policy debate—think of Ben Bernanke or Larry Summers in America or Mervyn King in Britain—their pronouncements are viewed with more scepticism than before. The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.”

There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it.

The first charge is half right. Macroeconomists, especially within central banks, were too fixated on taming inflation and too cavalier about asset bubbles. Financial economists, meanwhile, formalised theories of the efficiency of markets, fuelling the notion that markets would regulate themselves and financial innovation was always beneficial. Wall Street’s most esoteric instruments were built on these ideas.
...
The charge that most economists failed to see the crisis coming also has merit. To be sure, some warned of trouble. The likes of Robert Shiller of Yale, Nouriel Roubini of New York University and the team at the Bank for International Settlements are now famous for their prescience. But most were blindsided. And even worrywarts who felt something was amiss had no idea of how bad the consequences would be.

They would have been well served to make the point that many Wall Street economists (and whatever the equivalent street is in London) are bound to serve their masters who much prefer rosy predictions than the alternative.

It is no coincidence that most bearish economists in recent years have few ties to the banking industry, financial media outlets like CNBC, or investment banking where optimism seems to be a prerequisite for the job.

Comments

[Pax Americana:]

The term of Economist, has become synonymous with that of "half-wit" or "incompetent", as a palpable lack of prescience or vague ability to predict even the next few qtrs,let alone total Financial meltdown as engendered in me, a feeling of Disdain for this lofty body!

Jul 19 06:36 AM

[morph366:]

The more that economics has attempted to become a mathematics based science the less credibility it has had.
Many practitioners of the financial economics in particular need to read a lot more widely in economic history and generally in cultural and anthopological matters. This would make a lot more sense than ploughing through voluminous texts on fudges that supposedly make the calculation of VAR more robust.

Jul 19 07:37 AM

[Steve in Gr...:]

Thanks, Mr. Iacono, for a great post.

Does anybody out there know what the following sentence from the Economist could possibly mean:

"...Macroeconomists, especially within central banks, were too fixated on taming inflation and too cavalier about asset bubbles..."

Jul 19 07:38 AM

[basehitz:]

Bill Fleckenstein's book "Greenspan's Bubbles" was an enlightening read. 10 years ago, I also bought the folklore that Easy As deserved praise. Then policy decisions and repurcussions caused doubts. Bill's book erased all doubts. There were a lot of villains in how we got here. Easy Al deserves consideration for the lead role in this tragedy.

And now that we see the outcome of the Federal Reserve's misguided policy decision, BHO advodates increasing power of this secretive organization. Are we not learning anything?

Jul 19 09:03 AM

[CautiousInv...:]

In many ways economists are simply hired guns and are used to justify policy rather than create policy.

In the case of government, Keynesians are always prepared to support additional fiscal spending........whether because there is an output gap or to rescue the economy through emergency spending measures. Government economist are always down for spending more and forecasting grand outcomes stemming from these initiatives.

And, as the author notes, in the private sector economists of various stripes are prepared to shape forecasts to best serve the economic interests of their employers. In the case of stocks, it's hardly a secret that all institutions tend to do better in a rising market than a falling market. With respect to risk, institutions are better served by minimizing risks than overstating risks.

The argued failure of economics will be twisted around into a failure of democratic capitalism and we will see various attempts "to reshape democratic capitalism to save it from itself". In reality these steps are thinly veiled steps designed to retool the current system to permit greater government control over both institutions and economic outcomes. Economic outcomes will be judged against new metrics including "economic jsutice".

Finally, it will be argued in various circles that because economists failed and got it wrong.........we will need to rely more upon politicians as they are likley to get it right. I think we all know better than that.

Jul 19 11:38 AM

[User 119307:]

Economics is called the "dismal science" for a reason; it's not a science. Human behavior is not scientific. Despite the sad and pathetic attempts of the univ. profs, Nobel cmt, etc to make it so. You can slap equations, PhDs, titles & "scientific method" on a pig all day long and it's still a pig.

Jul 19 02:21 PM

[ArbyH:]

"In the wake of the biggest economic calamity in 80 years that reputation has taken a beating. In the public mind an arrogant profession has been humbled."


Good Article.
Economics is a wonderful science that mixes all inputs into the equation to arrive at probable outcomes. Behavioral science, quantitative analysis, supply and demand, government action, (for some) history, and even the weather is used to help determine the probable outcomes.

I agree with CautiousInv...: : "In many ways economists are simply hired guns and are used to justify policy rather than create policy.

In the case of government, Keynesians are always prepared to support additional fiscal spending........ "

So many of the economists are not as deep original thinkers as they would like others to believe. They subscribe to one pattern of thought and wrap around the horn on that model, rather then create original models that will evolve and adapt to current environments. I feel that they set models in stone and do not adjust the weight of the inputs well enough to reflect changing realities. Example Greenspan raised interest rates in the face of rising energy costs. By not weighing the energy costs he had to reverse his steps backwards several times and far past the start point.
Politician's like to use economists to justify their knee jerk reactions. They are both on the same payroll and are selling the same soap on the same erroneous path to mediocrity. I would suggest Austrian Free Market Economics to open both of their minds more.


Historically, repeatedly in the rise and decline of all of the great economic powers there were 6 things that always occurred:
1. One country secured and economic advantage, rather product or trade route, and applied that advantage to become a major economic power.
2. A second country learned (diffusion of technology) what that advantage was and copied it, becoming even more competitive then the economic power.
3. The second country, now being the more competitive, imported their product into the major economic power's markets. The people bought the import because it was good quality and cost less. The citizen's purchases of imports over domestic products led directly to their own country's economic decline.
4. The governments of the economic power were rigid, hamstrung and unable to respond to protect their own markets.
5. Once on the decline the armies of the economic power were always fully deployed in the furthest reaches of the empire.
6. There was always a moral decline in the people's behavior in the economic power. Decadence...perversion whatever.

Buy American!!! GM is American. Ford is American.
The military industrial complex is a perversion of what we have become great at producing.
We have given away almost all of the domestic industries we were great in. It is time we reclaimed some of them and bought American even if we pay a little more. It is either that, or collectively become poorer until the importers move on to other markets and we are forced to produce for ourselves.

Jul 19 03:45 PM

[1RuleNoRules:]

Without creating panic and sell-offs. Allen Greenspan has been warning of the housing bubble and banking problems for at least 10 years. He has been complaining about Fannie Mae and Freddie Mac pointing to derivatives as the vehicle that enables the process and the bubble to come clearly to Congress. The Bubble gum media did not see the words of a statesman as the warning bell that it was and Congress was unable to act because of decades of rhetoric and political posturing. Economics be damned as long as the bubble does burst during their term.
Now, the bubble gum media points to Greenspan as the source instead as the only culpable villain is Congress.

Jul 19 04:35 PM