Thursday, January 13, 2011

"The profession danced around the wrong models..."

More macro-criticism from last year - this time quotes from Joseph Stiglitz. And again, it's a case of "those guys used these models, which I think are stupid. Luckily, other people used these models which I think are smart - and these are the ones we should start using."

Again - I miss a focus on evidence and methodology: If these critics are right that our profession allowed madness to reign - how can we avoid this in the future? What should we demand from researchers who claim that they can guide policy, explain society, etc? Surely we need to do better than "they should employ the assumptions and modelling approaches that I find reasonable and that lead to the conclusions I am comfortable with"?

It is hard for non-economists to understand how peculiar the predominant
macroeconomic models were. Many assumed demand had to equal supply – and
that meant there could be no unemployment. (Right now a lot of people are
just enjoying an extra dose of leisure; why they are unhappy is a matter for
psychiatry, not economics.) Many used “representative agent models” – all
individuals were assumed to be identical, and this meant there could be no
meaningful financial markets (who would be lending money to whom?).
Information asymmetries, the cornerstone of modern economics, also had no
place: they could arise only if individuals suffered from acute
schizophrenia, an assumption incompatible with another of the favored
assumptions, full rationality.

Bad models lead to bad policy: central banks, for instance, focused on the
small economic inefficiencies arising from inflation, to the exclusion of
the far, far greater inefficiencies arising from dysfunctional financial
markets and asset price bubbles. After all, their models said that financial
markets were always efficient. Remarkably, standard macroeconomic models did
not even incorporate adequate analyses of banks...: even a cursory look at
the perverse incentives confronting banks and their managers would have
predicted short-sighted behavior with excessive risk-taking. ...

Fortunately, while much of the mainstream focused on these flawed models,
numerous researchers were engaged in developing alternative approaches. ...
With a few exceptions, most central banks paid little attention to systemic
risk and the risks posed by credit interlinkages. Years before the crisis, a
few researchers focused on these issues, including the possibility of the
bankruptcy cascades that were to play out in such an important way in the
crisis. This is an example of the importance of modeling carefully complex
interactions among economic agents (households, companies, banks) –
interactions that cannot be studied in models in which everyone is assumed
to be the same. Even the sacrosanct assumption of rationality has been
attacked: there are systemic deviations from rationality and consequences
for macroeconomic behavior that need to be explored.

Changing paradigms is not easy. Too many have invested too much in the wrong
models. Like the Ptolemaic attempts to preserve earth-centric views of the
universe, there will be heroic efforts to add complexities and refinements
to the standard paradigm. The resulting models will be an improvement and
policies based on them may do better, but they too are likely to fail.
Nothing less than a paradigm shift will do.

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