Why was economics so insular?

Noah Smith has a good piece on what seems like the never ending stream of popular articles in the UK slagging off economics (or economists). Here I outlined three potential reasons for this epidemic: people do not understand unconditional macro forecasts, politicians from the right do not like economists spoiling their pet schemes (e.g. Brexit), and many heterodox economists from the left wage endless war against the mainstream. All these complaints get airtime when the economy is bad.

The UK economy, right now, is perhaps in a worse state than at any time in the last eighty years. As John Lewis shows in this Bank blog, productivity growth has perhaps never been as bad as it is now: we have to go back to before 1800 to find anything comparable.

The natural reaction when the economy is bad is to criticise economists. That was what happened after the Global Financial Crisis, with some justification. But what is happening in the UK right now is mainly a result of first austerity and then Brexit. As I explained in detail in my earlier post, if we had followed the advice of mainstream economics austerity and Brexit would not have happened. [1] I have as yet not read a single critique of economics that has pointed that fact out, which if you think about it is extraordinary.

There is a little more to say about why economics is an easy target. Historically it has been very insular, and in this respect quite unlike other social sciences. I have already discussed the paper by Haldane and Turrell in the OXREP Rebuilding Macroeconomic Theory volume on Agent Based Models, but I did not have space to show an interesting chart from the introduction to that paper.

It tracks citations in papers to those in other disciplines. Until around 2000, there was no doubt which was the most insular discipline: economics. This is no surprise to me and I suspect most social scientists.

The paper does not explore the reasons why economics is so self-referential: their aim is simply to suggest that it needs to look to other disciplines to see what methods they use. Here I want to sketch why I think mainstream economics (and here the qualification mainstream is required) is so insular.

I once gave a lecture course on the methodology of economics, and in one lecture I used a large blackboard to describe how nearly all economics can be derived from the basic axioms of rational choice. For example the modern macroeconomics of consumption is just the choice between buying apples or pears transformed to the choice between consumption at different times. In that sense economic theory is like an immense tree, where every branch deductively builds on this core. Sometimes large branches grow by adding new elements, like asymmetric information, which then becomes part of the tree and can be used by other branches. This deductive tree of economic theory did not grow all by itself: its growth was and is influenced by the real world problems it wanted to address.

In using the idea of explaining decisions by optimising welfare under constraints economists have created a whole series of widely applicable tools. Economists naturally think about opportunity costs, adverse selection, moral hazard, incentives etc. There is something distinctive about thinking like an economist. To say, as Tom Clark does here, that sometimes this is just formalising common knowledge may be true (see also Cahal Moran here), but in many cases it is not. Try persuading someone who has invested in what is now a sub-optimal project about sunk costs.

This body of theory includes the neoclassical economics that heterodox economists and others love to hate, but it also includes game theory that has applications well beyond economics, and more. In my first year of studying economics I was told in some lectures that this whole endeavour was a huge ideologically driven misstep, but I began to see it differently after reading this famous 1963 paper by Arrow. It shows why (asymmetric) uncertainty in the health service means that the standard competitive model just cannot work for medical care. That may be obvious to us in the UK but it appears otherwise to many in the US. To be fair Clark also acknowledges that this economic theory has produced positive successes: he mentions auction theory but there are many more.

As to ideology, if you want an effective critique of neoliberalism you have to use economics (see, for example Colin Crouch’s book on neoliberalism or this by Dani Rodrik). So many critiques of economics use a kind of bastardised version that insists that workers are always paid their marginal products that the political right also employs. But monopoly and monopsony power are also part of the deductive tree. A paper I like to refer to in this context is by Piketty, Saez and Stantcheva (discussed here) which uses a simple bargaining model to show how cutting the top rate of tax can increase pre-tax CEO pay.

There is nothing like this deductive tree in other social sciences, and I think it at least partly explains why economics used to be so insular. As non-economists academics seemed to add little to building on this theory, there seemed little point in collaborating or even citing them. But, from the point of view of other disciplines, it was worse than that. Economics could also be imperialistic. Its methods, both theoretical and empirical, could be applied to other fields (with varying degrees of success): here is David Hendry applying his econometric methods to climate change, for example. So not only did economists not talk much to other social sciences, they trod on toes as well.

But although there may still be important branches to be added [2], the limitations of what you can do with a few axioms about rational choice have led in recent years to economics becoming much more empirical, and much less tied to this deductive theory. (See the article by Noah Smith which began this post. Unfortunately in my view an exception to this trend so far is macroeconomics.). We can see this in the citations data above, and the most obvious manifestation is behavioural economics. But a more immediate example of a data rather than theory based idea is the gravity model in international trade, which lies at the heart of why Brexit is such a bad idea. It is irony indeed that just at the point at which we have all these articles attacking economics, a large number of people who believe the UK is committing a large act of self harm are seeing the virtue of just one small part of what economists do.

Having said all this, I think there is an unfortunate hangover from this insularity. As a discipline economics shows little interest in communicating its core knowledge to others [3]. This can be true both within academia and with the outside world. Within academia publishing in top economics journals still has far higher status than top journals in other disciplines. When it comes to policy and the public, there is a belief among many that when either requires our wisdom, they will seek out the best of us for advice. In part this epidemic of articles about the failings of economics reflects this communication failure. More importantly, both Brexit and Trump should be a wake up call that economists as a collective has to get better at communicating the core insights of economics.

[1] There are of course more underlying problems behind the UK productivity crisis beyond the negative shocks of austerity and Brexit. But economists overwhelmingly argue for more R&D spending and more public investment. In short if you want someone to blame for why the UK economy is currently in such a dire state, blame those who have ignored the advice of economists.

[2] Most of the good criticisms that I see of economics amount to requests to add to the tree. But economics is so rich that most things are possible. In part (but only in part) what is done follows the money: you will find it relatively easy to get money for work on free trade compared to work on rent seeking. To blame economists for that is just bad economics. As economists found out after the financial crisis, they had many tools to understand what had happened, but had just not applied them before the crisis.   

[3] I say as a discipline because I mean economists as a collective, not as individuals. There is no equivalent institutional infrastructure in economics to that built by the hard sciences. Of course many individual economists do their best, but there are also others who ignore the consensus to plug their own personal ideas or to further some political or ideological cause.

Large models, small models and Brexit

Non-economists with no interest in modelling techniques can skip to paragraph starting 'How is this all related to Brexit'.

I promised to look at some of the other papers in the OxREP volume “Rebuilding macroeconomic theory” besides my own, but as usual other things - including Brexit - got in the way. In this post I want to talk about the paper by Haldane and Turrell, which is about Agent Based Models, or ABMs. Right at the end of this post, however, I will come back to Brexit.

As a result of the microfoundations hegemony, any paper talking about a different modelling strategy often feels it must start by describing some drawbacks of that hegemony, and this paper is no exception. I might talk about that some other time, but instead I want to recommend what I think is one of the most realistic discussions of what ABM can or cannot do I have read.

As you might guess from the name, ABMs model the economy as a collection of a large number of different agents, each of which behaves in a specified way. The authors generalise the idea of a choice between internal and external consistency that I talk about in my paper to also include a degree of heterogeneity.

As you can see, ABMs are all about allowing as much heterogeneity as you wish. This is not to say that other methods cannot do heterogeneity (they can), but ABMs major in this dimension, and in practice often keep the behaviour of agents relatively simple compared to a DSGE. (A slight quibble: I would argue that as DSGEs are internally consistent by definition, the orange square representing them should be a slimmer and perhaps taller rectangle.) ABMs (within the bounds of tractability) owe no allegiance to any school of thought: the paper has a nice table of the many different types of consumption function used in a range of ABM studies.

As the macroeconomy is indeed made up of many different types of agents who may be doing different things, and whose interaction may produce unexpected results, it seems like ABMs can only be a good thing. But this additional freedom brings a large cost. Because, and unlike some hard sciences, there is a large amount of uncertainty about how people actually behave, we cannot treat any model as a black box, the output from which has to be accepted without question. No civil servant or central bank economist can go to politicians or governors and simply say it is what the model said.

Exactly the same problem can arise with SEMs, simply because of their complexity or disaggregation. It could also arise from a complex DSGE. The first question any economist asks when seeing an output from any large and complex model is does the result make sense given the smaller theoretical models they carry around in their head. It is why I proposed for SEMs the process I called theoretical deconstruction, where model properties were either reduced to familiar results from simpler models, or show the limitations of those simpler models. Again, as the paper notes, a similar process needs to, and in some cases has, happened with results from ABMs.

How is this all related to Brexit? The results showing how different degrees of Brexit would do the economy damage to different extents that I talked about in my last post were produced by trade theory’s equivalent of ABMs, called computable general equilibrium (CGE) models. These allow for considerable heterogeneity (across sectors and countries) in modelling trade. As Chris Giles recounts in this excellent piece, the model is more complex than anything the Treasury had before Brexit, and was built specifically to help with Brexit.

As Chris writes

“It must have come as a bit of a shock to government economists that the moment some results of this new model were leaked this week, ministers rushed to deny the usefulness of the tools they commissioned. Such models are “always wrong”, declared Steve Baker, a junior Brexit minister, on Tuesday.”

As I note in a postscript to my last post, he went further on Thursday to suggest that civil servants had deliberately cooked the model to sabotage Brexit.

How do we know that this didn’t happen, apart from the implausibility that so many civil servants could concoct such a conspiracy. Precisely because in this case the results from a highly disaggregated model broadly agrees with most other studies, and also common sense: the more difficult you make trade, the less there will be and the more costly that will be for UK output. Chris ends with some words that should be sent to every journalist in the country.

“Ministers now have a choice. They can opt for an honest Brexit in which they argue in public that people should pay an economic price for their policies. Or they can opt for a dishonest Brexit, pretending they have a secret plan for economic nirvana and trashing their own internal economic evidence. Ministers’ initial reaction in disowning the analysis suggests deception is the government’s central Brexit strategy. People talk about a crisis in economics. After this episode, it is the crisis in politics that should really concern us.”