Economics: Rituals of rigour: "The two branches of economics most relevant to the recent crisis are macroeconomics and financial economics…. [Macroeconomics's] dominant paradigm is known as “dynamic stochastic general equilibrium” (thankfully abbreviated to DSGE) – a complex model structure that seeks to incorporate, in a single framework, time, risk and the need to take account of the behaviour of many different companies and households. The study of financial markets revolves meanwhile around the “efficient market hypothesis”… and the “capital asset pricing model”…. A close relationship exists between these three theories. But the account of recent events given by proponents of these models was comprehensively false. They proclaimed stability where there was impending crisis, and market efficiency where there was gross asset mispricing….
[M]istaken claims found substantial professional support. In his presidential lecture to the American Economic Association in 2003, Robert Lucas of the University of Chicago, the Nobel prizewinning doyen of modern macroeconomics, claimed that “macroeconomics has succeeded: its central problem of depression prevention has been solved”. Prof Lucas based his assertion on the institutional innovations noted by Mr Greenspan and the IMF authors, and the deeper theoretical insights that he and his colleagues claimed to have derived from models based on DSGE and the capital asset pricing model. The serious criticism of modern macroeconomics is not that its practitioners did not anticipate that Lehman would fall apart on September 15 2008, but that they failed to understand the mechanisms that had put the global economy at grave risk….
The academic debate on austerity versus stimulus centres around a property observed in models based on the DSGE programme. If government engages in fiscal stimulus by spending more or by reducing taxes, people will recognise that such a policy means higher taxes or lower spending in the future. Even if they seem to be better off today, they will later be poorer, and by a similar amount. Anticipating this, they will cut back and government spending will crowd out private spending. This property – sometimes called Ricardian equivalence – implies that fiscal policy is ineffective as a means of responding to economic dislocation.
John Cochrane, Prof Lucas’s Chicago colleague, put forward this “policy ineffectiveness” thesis in a response to an attack by Paul Krugman, Nobel laureate economist, on the influence of the DSGE school…. Cochrane at once acknowledged that the assumptions that give rise to policy ineffectiveness “are, as usual, obviously not true”. For most, that might seem to be the end of the matter…. But Prof Cochrane will not give up so easily. “Economists”, he goes on, “have spent a generation tossing and turning the Ricardian equivalence theory, and assessing the likely effects of fiscal stimulus in its light, generalising the ‘ifs’ and figuring out the likely ‘therefores’. This is exactly the right way to do things.” The programme he describes modifies the core model in ways that make it more complex, but not necessarily more realistic, by introducing parameters to represent failures of the model assumptions that are frequently described as frictions, or “transactions costs”.
Why is this procedure “exactly the right way to do things”? There are at least two alternatives…. Joseph Stiglitz – another Nobel laureate – and his followers favour a model that retains many of the Lucas assumptions but attaches great importance to imperfections of information…. Another possibility is to assume that households respond mechanically to events according to specific behavioural rules, rather like rats in a maze – an approach often called agent-based modelling…. Another line of attack would discard altogether the idea that the economic world can be described by any universal model…. [M]odels, when employed, must be context specific. In that eclectic world Ricardian equivalence is no more than a suggestive hypothesis…. The generation of economists who followed John Maynard Keynes engaged in this ad hoc estimation when they tried to quantify one of the central concepts….
Consistency and rigour are features of a deductive approach, which draws conclusions from a group of axioms – and whose empirical relevance depends entirely on the universal validity of the axioms. The only descriptions that fully meet the requirements of consistency and rigour are completely artificial worlds, such as the “plug-and-play” environments of DSGE – or the Grand Theft Auto computer game.
For many people, deductive reasoning is the mark of science…. But this is an artificial, exaggerated distinction. Scientific progress – not just in applied subjects such as engineering and medicine but also in more theoretical subjects including physics – is frequently the result of observation that something does work, which runs far ahead of any understanding of why it works. Not within the economics profession. There, deductive reasoning based on logical inference from a specific set of a priori deductions is “exactly the right way to do things”…. Economics is not a technique in search of problems but a set of problems in need of solution. Such problems are varied and the solutions will inevitably be eclectic. Such pragmatic thinking requires not just deductive logic but an understanding of the processes of belief formation, of anthropology, psychology and organisational behaviour, and meticulous observation of what people, businesses and governments do.
The belief that models are not just useful tools but are capable of yielding comprehensive and universal descriptions of the world blinded proponents to realities that had been staring them in the face. That blindness made a big contribution to our present crisis, and conditions our confused responses to it. Economists – in government agencies as well as universities – were obsessively playing Grand Theft Auto while the world around them was falling apart.