Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 9 October 2017

Economists: too much ideology, too little craft

Paul Krugman argued yesterday that the belief in the need for new economic thinking after the financial crisis was incorrect, but led to some crazy but influential ideas that suited big money and the political right. While I agree with a lot of what Paul says, I would want to add something. These thoughts are strongly influenced by the fact that I’m in the middle of reading Dani Rodrik’s new book, called ‘Straight Talk on Trade’ (of which hopefully more in a later post).

In the preface to that book he tells the story of how 20 odd years ago he asked an economist to endorse a previous book of his called ‘Has Globalisation Gone Too Far?’. The economist said he couldn’t, not because he disagreed with anything in the book, but because he thought the book would “provide ammunition to the barbarians”. Dani Rodrik argues that this attitude is still commonplace. That attitude is, of course, both very political and very unscientific.

I suspect that something similar might have been going on before the financial crisis among economists working in finance. Paul Krugman is certainly correct that mainstream economics contained models that could explain much of why the GFC happened, so little new thinking was required in that sense. But one reason why so few mainstream economists used those models before the event owed at least something to an ideological aversion to regulation, and perhaps also not wanting to bite the hand that feeds you.

One of the features of mainstream economics today is the huge diversity of models that are around. Academic prestige tends to come to those who add to that number. But how do you decide which model to use when investigating a particular problem? The answer is by looking at evidence about applicability. That is not a trivial task because of the probabilistic and diverse nature of economic evidence, and Dani Rodrik describes that process as more of a craft than a science.

So, in the case of the GFC, good craft was in seeing that new methods of spreading risk were vulnerable to system wide events. Good craft was to see, if you had access to the data, that rapid increases in bank leverage should always be a concern. And more generally that arguments that ‘this time was different’ do not generally end well.

In my own discipline, I can think at least one area that should not have got off the ground if the craft of model selection had been applied well. RBC models were never going to describe business cycles because we know increases in unemployment in a downturn are involuntary. If you do not apply the craft well, then what can replace it is ideology, politics or simple groupthink. This is not just an issue for some individual economists, but can sometimes be a concern for the majority.


  1. If I read Krugman correctly, his caveat was that the role of shadow banking was under appreciated.
    I assume he meant both by academic economists and regulatory economists (no such assumption required for MSM).
    First point. Surely the shadow banking businesses relied on their relative invisibility for their competitive position? But many were quite high profile businesses.
    And yet, mainstream banking still seems to be absent from much of the discussion. Or has the term "banking" now evolved to include shadow banking?

    1. I think it would be closer to the mark to say "shadow banking" relied upon opaque markets and complexity of financial instruments and relationships to hide risk and even assume it away entirely. So in that sense any financial institution can be a shadow banker.

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    1. Quite impressed you published a quasi personal attack . Just read krugman . He seemed to say he missed the shadow banking elephant in the room . Is this really credible ? Surely leverage would have risen over a long period . And how much money was in shadow banking ? This narrative that a few elephants were missed , but , you know , no ones perfect , seems a bit like a punt . Maybe there is a second narrative on the way

  3. Dear Professor Wren-Lewis,

    I think you need to acknowledge that economics has repeatedly acted as a sort of highly mathematical excuse for the self-interested behavior of the rich and powerful. It is especially useful to such people by denying the agency of the same rich and powerful, and offering alternatives to the obvious explanation of why so much of society's bounty ends up in their pockets: because they designed things to work that way.

    I grant this is by no means a blanket condemnation of the role economics *could* play in the world, but I think the constant excuse-making regarding the pernicious role the profession in fact generally plays in the today's political world by left-of-center economists must get awfully tiring after a while. I think if you actually come out and admit this you'll feel better, and perhaps then be able to move forward towards some better tomorrow.

  4. I think a lot of people have forgotten (or never knew) what Kuhnian paradigms were about. As in "paradigm shift".

    For Kuhn a paradigms is an approach to a science - a worldview, a set of ideas about how proof works, how data is gathered, core theories, and (this is very important) about what problems matter. All paradigms have anomalies - things they fail to explain, or don't bother to explain, get wrong.

    You get a paradigm shift when people are no longer happy living with those anomalies, because they mount up.

    But what causes anomalies to mount up is usually them simply not being addressed. Because the paradigm tells you what problems are important to work on.

    You see this with Piketty. It's not that mainstream economics had nothing to say about Inequality - more that it was not considered worth talking about until recently. Which is pretty odd, really.

    You see this with financial regulation. The view in 2006 seemed to be "theoretically uninteresting, problems solved decades ago, move along".

    Deciding which problems are important, and worth talking about, is hard. Very hard.

  5. I don't agree that mainstream economic models could explain the GFC, and especially the resulting downturn. Diamond Dybvig was there, of course, but it stood outside mainstream macro. It's only since the GFC that financial frictions have been widely incorporated in mainstream macro models (in yet another example of economists fighting the last war).

  6. There’s no need for any “new economic thinking”: the way to prevent bank crises was set out in the 1930s by Irving Fisher and other members of the Chicago school, and later on by Milton Friedman and other Nobel laureate economists. That’s simply to fund bank loans just from equity rather than deposits. That way it’s plain impossible for a bank to collapse. Plus that system prevents private banks from creating / printing money: an activity which amounts essentially to counterfeiting.

    Unfortunately half the economic profession (Krugman included) has no grasp of the above idea, just as half the economics profession does not understand the basic message that Keynes spelled out in the 1930s, namely that given a recession, the state should not hold back from printing and spending whatever amount of money is needed to escape the recession. Certainly there are numerous senior economists, e.g. Kenneth Rogoff and Carmen Reinhart who do not understand Keynes.

    1. Very interesting article by Richard Werner: Three theories of banking and the conclusive evidence, International Review
      of Financial Analysis (2015), He says deposits never funded bank lending. Lending creates money out of nothing because the "client money" rules do not apply to banks.

  7. You are absolutely right about globalisation. This has been questioned in other social science departments for many decades. Students are given the arguments on both sides. I find Krugman's comments indulgent. Yes, economists might have known about financial crashes before, indeed from the time the profession was created. It was the work of Minskys, Harrods, and Kindlebergers, however, who gave us the valuable insights - I am not to sure the same can be said of the mathematical models. Sure they might 'explain' it - but is it the right explanation, and do they give us anything like the breath and depth of knowledge to anticipate and prevent future such crises? Krugman's textbook ISLM might give us a geometric picture of a liquidity trap. But it does not begin to give us the reasons for them or the depth of knowledge to get out of them. It does not even give us the correct monetary transmission mechanism. Yet as students of economics we were all presented these models as if they were supposed to explain how the world actually worked. Subjects like such as the developments that took place in the world economy until the time of the GFC and so-called secular stagnation that followed it (really issues of long term dynamics of capitalist economies) require a very different sort of analysis. As for RBC, this is again a case of people like Sargent liking 'a nice model'. But a nice model in the culture of the economics profession is not one that comes close to capturing the complexities, contradictions and subtleties of the real world. And so it goes on, and on, at great social cost.


  8. What increasingly strikes me is that much in economics is about the short term and assumes infinite resources whereas the real problem is that we have finite (and getting more finite each year) resources and the models decouple economics from this issue.

    Demography and energy are two major issues now - and have been for some time - and will be even more so going forward but economics concentrates on the short term (when will productivity recover?). Frankly, compared to the above and the potential depredations of AI/robotics within the next twenty years, I find this baffling.

  9. "RBC models were never going to describe business cycles because we know increases in unemployment in a downturn are involuntary"

    I particularly find the critique of the RBC models in the above quote interesting in that how could any economist assume that unemployment is voluntary? Yet that is what the RBC model assumes.

    And the funny thing for me is how nobody asks why so many people i.e. the unemployed will choose or want more leisure all of a sudden. More-so when this unemployment itself deepens recessions as resources both capital and human are not put to use.

    It is hard to get one's paper published if one does not use DSGE models based on RBC models with a good number of flawed assumptions and fantastic mathematics which does not reflect any reality i.e. that economics itself is a study of how people interact with each other.

    I personally look forward to the day when a lot of these flawed assumptions in economics will be replaced with ones based on behavioural science i.e. an understanding of how human beings behave.

    Perhaps when economics as a social science has rid itself of these flawed assumptions, then we i.e. economists might be able to predict financial crises and downturns.

    1. "I particularly find the critique of the RBC models in the above quote interesting in that how could any economist assume that unemployment is voluntary? Yet that is what the RBC model assumes."

      Yep. I think it's telling that none of the New Classicals personally witnessed the Great Depression. (Lucas is, IIRC, the oldest, and he was born in 1937.) The elders in the field, like Samuelson and Solow, regarded the market clearing -- i.e. no involuntary unemployment -- assumption as beneath contempt, and they ridiculed it mercilessly. Even Friedman, who seems to have wished mightily that things had been otherwise, agreed that the Great Depression didn't look like any kind of "market clearing" worthy of the name.

  10. It seems to me that most economists forget that economics must first of all be relevant to all of us, it really is not a game of chess where after each failure we just rearrange the pieces for the next game, it is about a system that provides the basis for people to survive in.

    Clearly Krugman doesn't understand that large populations throughout the world are not served well by this system that he feels just needs a little tinkering here and there.

    It doesn't take a rocket scientist to work out that even before the crash it wasn't working for most people, this graph highlights how Neo-Liberalism actually transferred wealth and power further away from ordinary people and into the hands of the few.

    People make up the real economy, not the Casino we call the City of London, Money creation doesn't need financial centres to fund wealth creation. They just feed off it.

    As an example of how governments could interact in expanding the economy, a good example is the Mondragon Cooperative, where 6 people in 1954 set up the organisation to which today has over 73,000 working in it, and had risen to 100,000 until the crash came along and destroyed their markets.

    I am not of course advocating that we should all become cooperatives, but merely wish to point out what people have achieved without the help of economists, and that real economics works when it serves the interests of people. Not withstanding the impediments of the EU economic policies and the rest of the world.

  11. It is just a failure to properly model aggregate asset prices and net worth via feedback from the pace of new debt:

    America's Bubble Economy - April 1998

    Fisher debt deflation is an old but good theory.

  12. Now just imagine to teach such issues as described in this post to your students.
    I can hear a laugh from those students and abandoning all hope in understanding such economics.

  13. "Paul Krugman is certainly correct that mainstream economics contained models that could explain much of why the GFC happened, so little new thinking was required in that sense."

    I think I definitely missed something in my last 15 years as an economist.

  14. suppose this is what is meant - the biggest economic blunder in recent times.


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