Wednesday, May 20, 2009

Financial crisis and the academic economics

Here is a critical assessment of the stuff we learn in econ in light of the financial crisis.

The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession. Over the past three decades, economists have largely developed and come to rely on models that disregard key factors—including heterogeneity of decision rules, revisions of forecasting strategies, and changes in the social context—that drive outcomes in asset and other markets. It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, “systemic crisis” appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession.

This failure has deep methodological roots. 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.3 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.

We believe that economics has been trapped in a sub-optimal equilibrium in which much of its research efforts are not directed towards the most prevalent needs of society. Paradoxically self-reinforcing feedback effects within the profession may have led to the dominance of a paradigm that has no solid methodological basis and whose empirical performance is, to say the least, modest.

They argue that economists have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. And, this time they failed to do just that. They argue that there was some sort of “academic moral hazard”. Also, Rodrik argues that the failure has to do more with ideology-wrapped economists than economics itself. See this one about economics crisis under heterogeneity as well.