July 22, 2009

Economists don't know what they're talking about.

Classical macroeconomic models are in trouble. They have difficulty predicting even the most basic things. As is apparent to anyone who bothers to go back and check the predictions and forecasts that are made by economists they are mostly just random numbers. Not because of bad faith, but because of bad models.

In the current economic crisis one major school of economists, the Keynesians, propose massive government spending to stimulate the economy while another major school of economics, the Austrian School, warns that this will inevitably trigger high inflation and should be avoided at all costs. Both schools of thought have an impressive amount of Nobel laureates backing up their respective views, and are well respected for their views and models of the world. So should the government spend massively to regain its footing? Nobody knows.

In an economic stagmire such as the one we are experiencing now economists look back at similar scenarios of the past to get an idea of how to move forward . What triggered the great depression that started in 1929 and didn't end until the second world war? The keynesians believe that underconsumption and overinvestment caused it. The Austrian school of economics believe it was caused by the fall of money supply. Or as the Wikipedia article on the causes of the great depression states: "historians lack consensus in describing the causal relationship between various events and the role of government economic policy in causing the Depression." In other words: Nobody knows.

What about housing prices? Since they are at the heart of the crisis there's a keen interest in knowing whether they have reached the bottom or are still sliding. New numbers have just come out telling us that U.S. house prices rose 0.9% from April to May on a seasonally adjusted basis. Most experts had expected them to fall by 0,2%. Is this a green shot that will soon turn brown, or is it the start of a recovery? Nobody knows.

These examples are in no way unique. The June edition of the 1993 OECD Economic Outlook may have the best example of just how useless our macroeconomic models really are. The official GDP growth and inflation forecasts of the G7 countries from 1987 -92 were compared with a model that simply predicted that next year will be the exact same as this year. And they were equally good. The inflation forecast was even a little bit better. In other words, guessing that next years inflation will be the same as this years is a good a guess as the one government econmists spend vast resources deriving from complicated models. And these forecasts are the ones we base our econnomic policy on. And they're random. Nobody knows.

Why are we still using these models? Probably a combination of several reasons. Tradition is one. These models and their assumptions are the ones we have always used. Career economics is another. It is not unknown in science that the practitioners tend to stick to their models, since they have been using them for all of their careers. Old habits die hard, and it's hard to teach an old dog new tricks. Thirdly it's a question of mathematics. Most models assume that all human beings act in a rational way which anyone can tell you is not true. As a matter of fact a famous study has shown that the only two groups of people that act as economically rational beings are economists and psychopaths. Most models also assume that people don't interact. And that they all have perfect information about the market. Which is obviously not true. But these things are hard to model mathematically, so most economists just stick to their guns. The famous physicist Max Planck once remarked that in early life he had thought of studying economics, but had found it too difficult.

Where do we go? The problems of classical economics run deep. Macroeconomists can't agree on the most fundamental of things, give random predictions and advice, and base their models on assumptions that bear no resemblance to real life scenarios. It's not just the little things that don't work, it's the whole thing. What is needed is a fundamentally new way of thinking. People aren't rational. They don't have perfect information about the market. Supply doesn't always follow demand. We need a whole new framework. Behavioral economics, which Vernon L. Smith and Daniel Kahneman won the nobel prize for studying might be one way. Complexity and Chaos theory might be another.

Will we ever fully understand macro economy?

I don't know, but I do know one thing.

Right now the emperor has no clothes on.

If you made it all the way to the end you must have found it interesting.

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Anonymous Wanderley Caloni said...

Perhaps what we need is to formule new and interesting questions, like Freakonomics do.


2:24 AM  
Blogger Max Tobiasen said...


Yes, I think there's a revolution brewing in the high halls of economics. Frankly I'm rather flabbergasted that nobody has called out more of the bad shots.

If you liked freakonomics you should check Paul Ormerod's Why Most Things Fail: Evolution, Extinction and Economics

2:31 AM  
Blogger Grayson: Atlanta, GA said...

I don't know a damn thing about economics, but I know enough about life and the current economic circumstances (they're, like, bad) to appreciate this blog post.

4:36 PM  
Anonymous Steve Dekorte said...

Instead of considering disagreement among "respected" economists to imply neither has good models, why not look at which models have acurate predictions?

For example, the Keynesians didn't predict the current crisis but the Austrians did.

Another one: if the Keynesian model was correct, Zimbabwe would be the richest country on Earth.

9:00 PM  
Anonymous David, The Machine said...

You conflate disagreement with nobody knowing anything at all, and yet you quote that wikipedia article on the Great Depression, and conflate that with economists not knowing anything at all.

I have a Master's Degree in economics, and I can tell who the bad seeds, and they're people like Krugman and Mankiw--people who have written the textbooks that I used in my classes! Of the "schools" out there that have been predominantly right about the causes of this current manufactured crisis, the two that are close are the "freshwater" neo-classics, and the Austrians, but those aren't the guys who have newspaper columns and get quoted in the news.

9:22 PM  
Blogger Julien-Charles said...

You guys probably have heard about Game Theory which is one of the basis of economics.

This theory is nice in practice but almost always fails to predict the real behavior of humans when tested thoroughly. I met a teacher who has been working on an improvement of game theory by using evolutionary computation.

Basically using this method you can implement some sort of social behavior by relating individuals to others and adding influence of other people to the equation.

The results are very interesting and fit reality much closer. Perhaps we will see this kind of algorithms for economics in the future :)

9:16 PM  

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