Time to tear down academic economics and rebuild?

The St. Louis Fed has posted some excellent economics papers on the financial crisis. What I really like about the ones I’ve read so far is that they’re full of rich historical facts, institutional details and thoughtful analysis and completely devoid of the fancy mathematical derivations that all too often substitute for substantive thinking in academic economics.

Coincidentally, another article, titled The Financial Crisis and the Systemic Failure of Academic Economics, grabbed my attention (while I was skimming through Research Papers in Economics). It declares:

The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.

Many economists with wonderful U.S. academic jobs know shockingly little about real businesses, consumers, or markets, esp. anywhere outside of America. Academic economics is so model-driven that fancy theoretical models are admired, even when completely contradicted by real economic behavior. Conversely, wonderfully insightful, empirically grounded, practical analyses of real economies that take into account real-world complexities are devalued (unless presented alongside fancy equations or statistical analysis).

We shouldn’t be surprised so many economists wear blinders because psychology was — for decades — banished from economics. The core premise of modern economics (at least when I was a grad student) — that people are rational, foresightful utility-maximizers — is quite at odds with reality. People are perhaps better described as emotional, backward-looking, information-constrained, prospect theory irrationalists. By treating human beings like robots, economists have been trying to describe and predict economic behavior with their hands tied behind their backs.

Given their lack of understanding of real economies and their false premises, many economists gave up trying to explain the messy real world and instead engaged in a form of navel-gazing called “pure economic theory.” It begins with premises true in some hyper-rational alternate universe populated with greedy robots and then derives predictions about how that alternate reality operates. The math is very impressive, but its utility is close to nil. Or, as the article above puts it:

The often heard definition of economics — that it is concerned with the ‘allocation of scarce resources’ — is short-sighted and misleading. It reduces economics to the study of optimal decisions in well-specified choice problems. Such research generally loses track of the inherent dynamics of economic systems and the instability that accompanies its complex dynamics. Without an adequate understanding of these processes, one is likely to miss the major factors that influence the economic sphere of our societies. The inadequate definition of economics often leads researchers to disregard questions about the coordination of actors and the possibility of coordination failures. Indeed, analysis of these issues would require a different type of mathematics than that which is generally used now by many prominent economic models.

It’s time to refocus the field on explaining/predicting real-world economic behavior. And you can’t do that without understanding human and social behavior. The iron wall between economics and the other social sciences has been coming down over the past decade. I hope the trend continues.

Posted by James on Tuesday, April 21, 2009