That’s the claim in a brief, new and quite well-written paper called “The financial crisis and the systemic failure of academic economics”. The paper is written by a bunch of authors from US, Germany, France and Denmark, and claims that the profession was blind to the build-up of the financial crisis and underestimated its dimensions when it started to unfold. It argues that this failure can be traced “to the profession’s insistence on constructing models that, by desing, disregard the key elements driving outcomes in real-world markets.”
The authors take as a starting point that economists have a social function, an important part of which is to explain social phenomena such “unemployment, boom and bust cycles, and financial crisis”. Because of this, economists have an ethical responsibility to communicate when and where their models are applicable, and even to speak out if there is widespread abuse of them by others. This, the authors claim, is a responsibility economists have failed in.
They argue that financial models used for pricing derivatives and other instruments had to be based on short data series and shaky theoretical assujmptions, were used so widely or by market players so dominant that the individualistic “this is how you as a small and isolated market agent should value these assets” perspective was invalid, and provided a control illusion to users through their seemingly precise and quantitative relationships.
As for modern macro models, the authors argue that these are deeply flawed for a number of reasons:
- Expectations are rational, which is taken to mean model consistent. Agents in the model are taken to understand how the model they exist in works. This means that expectation mechanisms are only validated internally (by comparing the assumptions to the other assumptions in the model) rather than externally (by comparing the assumptions with data or what is known about expectations and judgments under uncertainty from psychology or other disciplines). “A behavioral interpretation of rational expectations would imply that individuals and the economist have a complete understanding of the economic mechanisms governing the world.”
- Representative agents. Each function (worker, consumer, invester etc.) in the economy is represented by one individual. This disregards the aggregation problem (how individual actions to achieve X may produce different outcomes in the aggregate from X. Like if everyone seated in an auditorium stands up to see better – each one assuming that the others will remain seated if they get up), and it reduces macro phenomena to micro phenomena. There are no differences in expectations or preferences between individuals, and there are no interaction mechanisms that allow emergent properties, where unintended and unforeseen consequences follow from the different individuals and the way they interact.
- Empirically, the models are calibrated – and parameter estimates of discount functions etc. are taken from micro studies and placed in the utility function of the representative agent – again skipping the entire aggregation and interaction problem.
The authors argue that we should develop flexible, data-driven models for the macroeconomic phenomena we are interested in – and use these as benchmarks against which to test proposed theoretical models.
Finally, they also argue that theoretical results without established empirical applicability are used to support questionable policy claims. Walrasian general equilibrium theory and the finding of Arrow-Debreu that all uncertainty can be eliminated given sufficient contingent claims in the market are seen as underlying
the belief shared by many economists that the introduction of new classes of derivatives can only be welfare increasing […]. It is worth emphasizing that this view is not an empirically grounded belief but an opinion derived from a benchmark model that is much too abstract to be confronted with data.
Again, as in so much criticism against economics, the “as-if” argument is not tackled directly. This will make it easy to avoid the criticism without dealing with it by saying that the theories in question are not meant to explain anything they can be shown not to explain (even if that should be claimed or implied in the theoretical works in question), that they were abused by stupid and greedy people, that the cutting edge of research (as opposed to what everyone learns and takes away from the subject) has already done some even more sophisticated and complicated shit that is really good and solves all our problems, that interaction is fully handled now because somebody put two consumers rather than one into a recent theory, etc. etc.
And so it goes.