Saturday, August 1, 2009

Economists understand everything – after the fact

The standard defence of absurd theories is usually that they predict. Predictive success is  the only relevant criterion, assumptions be damned. But what should we say when we fail to predict – and fail spectacularly at that, as in the recent financial crisis. The answer: Flip our defence around. We may not predict, but at least we have the understanding and insight to explain what happened after the fact. As Chris Dillows discusses here.

He starts by pointing out that it is possible to find theoretical concepts, small groups or individual researchers that have worked on things in the past that now seem relevant to understanding the financial crisis. He then relates this to Jon Elster’s troubling view of mechanisms as  a form of completely non-predictive understanding.

To put it more crudely than this guy himself does: We have loads and loads of story elements in economic theory that can be combined to join any set of assumptions to any outcome. All we need is to know what outcome actually occured, and we’ll be able to serve up a convincing and sophisticated “explanation” in no time.

[…]we have […] lots of mechanisms, capable of explaining why things happen and the links between them. What we don’t have are laws which generate predictions. In his book, Nuts and Bolts for the Social Sciences, Jon Elster stressed this distinction. The social sciences, he said:

“Can isolate tendencies, propensities and mechanisms and show that they have implications for behaviour that are often surprising and counter-intuitive. What they are more able to do is to state necessary and sufficient conditions under which the various mechanisms are switched on.”

This is precisely the problem economists had in 2007. We knew that there were mechanisms capable of generating disaster. What we didn’t know is whether these were switched on. The upshot is that, although we didn’t predict the crisis, we can more or less explain it after the fact. As Elster wrote:

“Sometimes we can explain without being able to predict, and sometimes predict without being able to explain. True, in many cases one and the same theory will enable us to do both, but I believe that in the social sciences this is the exception rather than rule.”

The interesting question is: will it remain the exception? My hunch is that it will; economists will never be able to produce laws which yield systemically successful forecasts.

What’s more, I am utterly untroubled by this. The desire for such laws is as barmy as the medieval search for the philosopher’s stone. If you need to foresee the future, you are doing something badly wrong.

I especially dig the ending. Friedman in the more extreme statements of his “as-if” article on positive economics made absurd assumptions a virtue, and now this guy is making a lack of predictive success a virtue.

Turning our assumptions on ourselves as economists, we are (of course) always doing the optimal thing. A fact that gives me immense peace of mind: Whatever I’m doing, I can rest assured that I could have done no better.

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