Monday, March 2, 2009

The failure of modern economics? Choosing theory over data

When your theory fails to explain what you set out to explain there are two strategies often followed: One seems to be driven by an interest in the real world phenomena, which makes people open to altering even basic assumptions if these are important causal factors in the theory but lack empirical support. The other seems to be driven by an interest in theoretical “purity”, which makes people open to creating more and more absurd theories if that is what they need to retain and defend the core assumptions that define the "discipline” in their own eyes.

This is my take on the issue Krugman discusses in today’s column in the NY Times. He writes about how modern macroeconomics has fallen into an ivory tower decadence that makes our profession fail in its role as informed and thoughtful policy advisers. Writing on how business cycles are more persistent than Lucas and the Real Business Cycle people would expect, he claims that the profession divided:

One group went down the “new Keynesian” route, arguing that something such as small costs of changing prices must explain the rigidity we actually seem to see. This group isn’t averse to putting a lot of rationality into its models, but it’s willing to accept aspects of the world that seem clear in the data, even if it can’t (yet?) be fully explained in terms of deep foundations.

The other group decided that since they couldn’t come up with a rigorous microfoundation for price stickiness, there must not be any price stickiness: recessions are the result of adverse technological shocks, not demand shocks.

And the latter group, the equilibrium macro side, was so convinced of the logical correctness of its position that schools dominated by that view stopped teaching demand-side economics.

The really nice thing about Krugman’s column is that he brings up the important point that this matters because we are dealing with real world problems.

And the sad thing is that all of this matters. Our ability as a nation to respond to the current economic crisis is being seriously hampered by the gratuitous ignorance of many of our economists.

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