New Economic Thinking and Models

Brad DeLong calls attention to Howard Davies: "Economics in Denial", to which Stephanie Kelton alerted me. Davies writes:

In an exasperated outburst, just before he left the presidency of the European Central Bank, Jean-Claude Trichet complained that, “as a policymaker during the crisis, I found the available [economic and financial] models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.”

Trichet went on to appeal for inspiration from other disciplines – physics, engineering, psychology, and biology – to help explain the phenomena he had experienced. It was a remarkable cry for help, and a serious indictment of the economics profession, not to mention all those extravagantly rewarded finance professors in business schools from Harvard to Hyderabad.

So far, relatively little help has been forthcoming from the engineers and physicists in whom Trichet placed his faith, though there has been some response. Robert May, an eminent climate change expert, has argued that techniques from his discipline may help explain financial-market developments.

Epidemiologists have suggested that the study of how infectious diseases are propagated may illuminate the unusual patterns of financial contagion that we have seen in the last five years.
These are fertile fields for future study, but what of the core disciplines of economics and finance themselves? Can nothing be done to make them more useful in explaining the world as it is, rather than as it is assumed to be in their stylized models?

Professor Davies then proceeds to mention the Institute for New Economic Thinking (INET) and its recent conference where some new ideas were put forward, as well as recent developments at the Bank of England.

But it is not clear that a majority of the profession yet accepts even these modest proposals. The so-called “Chicago School” has mounted a robust defense of its rational expectations-based approach, rejecting the notion that a rethink is required. The Nobel laureate economist Robert Lucas has argued that the crisis was not predicted because economic theory predicts that such events cannot be predicted. So all is well.

The EMH fared no better than REH, But Eugene Fama is also unphased.

On the contrary, the University of Chicago’s Eugene Fama has described the notion that finance theory was at fault as “a fantasy,” and argues that “financial markets and financial institutions were casualties rather than causes of the recession.” And the efficient-market hypothesis that he championed cannot be blamed, because “most investing is done by active managers who don’t believe that markets are efficient.”

Davies concludes by noting that a reworking of the profession's economic models is in order.

Paul Krugman then jumped into object to the charge Davies makes that economics lacks suitable models.

Brad DeLong points us to Howard Davies, who accuses economists of being in denial, and of having had nothing useful to say in the crisis. The first part is definitely true for much of the profession; the second charge is just false. The truth is that basic macroeconomics, the stuff that is still taught in textbooks, has been very, very useful in this crisis. The problem is that half the profession and most policy makers turned their back on this kind of economics.

But Professor Krugman doesn't tell us what those models are. His own favorite model is the Hicksian ISLM, which Hicks later distanced himself from the way it was being used — as Lars Syll reminds us.

So Professor Krugman tells us that new thinking is unnecessary.

What that says, however, is that while we obviously need new thinking — we always do! — the biggest problem these days has been the rejection of knowledge we used to have.

In an article in Thought and Action Fall 2009, James K. Galbraith notes that Professor Krugman does not mention one person that got it right. Professor Galbraith rephrased the question in his article, which was entitled Who Are These Economists Anyway? Dirk Bezemer wrote a similar article in 2009, entitled "No One Saw This Coming": Understanding Financial Crisis Through Accounting Models (June 2009). Professor Bezemer summarizes it in a VOX post.

However, neoclassical economists and neoclassical synthesis Keynesians not only don't cite any of these economists, but also avoid considering them even when they are brought up. I was a bit nonplussed by this, since I had brought this up on several occasions in blog comments, only to be ignored or to get some perfunctory excuse.

Then I ran into a Twitter exchange yesterday that alerted me to what seems to be going on. Noah Smith rejected any "commonsense approach," which I realized is code for "no model." It's also a criticism Paul Krugman often makes. I could not understand that since Wynne Godley predicted the crisis using his stock-flow consistent macro model based on sectoral balances.

Matias Vernengo then brought in Godley and Professor Smith apparently took a look. (I had mentioned Godley to him on several occasions previously in the comments at Noahpinion.) Here's the Twitter feed:

Noah Smith ‏@Noahpinion: If macroeconomics had real forecasting power, people using "common sense" would be laughed off the stage.

Naked Keynes [Vernengo]: @Noahpinion Bezemer shows in this paper that some models (e.g. Godley's) did pretty well http://www.voxeu.org/article/no-one-saw-coming-or-did-they …

Noah Smith ‏@Noahpinion: @NakedKeynes Hmm...didn't predict timing, size, or features of crash...but not bad.

Naked Keynes ‏@NakedKeynes: @Noahpinion agreed, but stock-flow models emphasize the interaction of spending flows & debt accumulation essential for macro analysis

Noah Smith ‏@Noahpinion: @NakedKeynes Maybe. Or maybe it'll turn out not to be very useful to include that as a variable... ;-)

So the upshot is that anything advanced with "no (neoclassical) model" doesn't count as "scientific"in the sense of predictive, as a hypothesis must be. Therefore, no one actually saw the crisis coming since they didn't have a credible model — and even a broken clock is correct twice a day.

Too bad for Professor Godley, and so much for new economic thinking.