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"Economists may not be any better at making decisions about their field than the general public is at choosing which detergent to buy."
During this first anniversary month of the financial crisis, we're running guest posts from economists about what they've learned in a miserable year. Today David Garman, who teaches econometrics at Tufts, explores the ways his own thinking has changed — and hasn't — and explores how hard it is to know whom to trust.
The financial crisis has had relatively little impact on my views about economists' models of macroeconomics or financial markets. Ironically, this is because my views have been little influenced by some of the most highly lauded economists of the last 30 years. Since I do not specialize in macroeconomics and have not taught it in many years, it has been easy for me to watch the evolution of the field with skepticism. The crisis has had a significant impact on my views about the ways that economists and policy makers decide which models and which analysts to believe.
Since the Great Depression, economists have produced many models of macroeconomies and financial markets. Some of these models produce contradictory conclusions.
For example, macroeconomic models that follow from J. M. Keynes tend to focus on the key role of aggregate demand, the impact of "animal spirits" on markets and imperfections in financial markets. On the other hand, macroeconomic models of the "real business cycle" (RBC) school begin with the premises that individuals are rational and that markets adjust to eliminate shortages or surpluses. Recessions (involuntary unemployment) are possible in Keynesian models and government can play a role in stabilizing the economy. Involuntary unemployment (recessions) are not possible in RBC models and government can not play a useful role in stabilizing the economy.
A similar distinction exists in models of financial markets. Some schools of thought use imperfections in the markets or failure of individual rationality to explain how asset prices can deviate from fundamental values. "Efficient market" models of financial markets begin with individual rationality and show that the current price of an asset is the best predictor of its value. Socially inefficient outcomes and speculative bubbles are serious concerns for the first group, but not for the second group.
I believe that involuntary unemployment exists and that the prices set by markets (financial and otherwise) can deviate from fundamental values for long periods. As a result, I have always been skeptical of economic models that claimed to show otherwise. It has been difficult for me to understand how so many clever and talented economists could believe so completely in rational business cycle and efficient market models. The situation reminds me of Hans Christian Andersen's classic fairy tale "The Emperor's New Clothes."
If economists disagree on such basic ideas, who are the policymakers and public to believe? Some economists presciently warned about "irrational exuberance," the underestimation of risk, and excesses in borrowing. Other economists dismissed these concerns as relics of outdated and unsophisticated models. Non-economists have a right to be confused (and bored) by these professional disagreements. When they hear Nobel Prize-winning economists advocating opposite policies, how do they choose sides? What do they choose when presented with the options of "shutting down the punchbowl" as the party peaks or "Don't worry, be happy"? It is no surprise that people tend to side with the positions that are most comfortable and convenient.
It is the lack of convergence and coherence in the beliefs of economists that surprises me. Don't economists aspire to be scientists? Aren't scientific theories confirmed or disconfirmed by evidence? Aren't economist bred to follow the evidence and take unpopular positions? I have tended to think (or hope) so, but my doubts have increased.
Perhaps it is time for economists to apply their analytical tools to themselves and their discipline. The new field of behavioral economics incorporates ideas on human decision making from psychology and cognitive science. Cognitive biases such as the bandwagon effect, confirmation bias, availability bias and authority bias may help us understand why failed or improbable theories live on. Economists may not be any better at assessing evidence and making decisions about their field than the general public is at choosing which detergent to buy.
This past year has been an exciting time to teach macroeconomics or financial markets and I wish that I was teaching a class where discussing the crisis was directly relevant. This is a natural time to reduce the focus on RBC models, reemphasize the Keynesian models, and introduce some historical perspective. Students should learn that business cycles, asset price bubbles and panics have always been a part of market economies. These are as surprising as philandering politicians, overpaid athletes or drunken college students. They should also understand that economic theory contains informative models about these phenomena and that a number of economists offered pre-crisis warnings. Students should be debating the importance of moral hazard, the degree of instability inherent in financial systems, the proper role of government in stabilization, and the scourge of "too large to fail (or jail)."