The systemic failure of academic economics

A few barbs have been cast in the direction of Steve Keen from this little outpost in the financial blogosphere before (something having to do with an irreversible deflation death spiral or somesuch), but many thanks are in order today for bringing to our attention some amazing introspection by a few enlightened individuals who practice the dismal science.

In And you think I'm ornery?, Steve points us to The Dahlem Report(.pfd):

The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.

And that's just the executive summary.

The introspection becomes even more brutal another page or two in:

It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, “systemic crisis” appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession.

The entire paper is worth reading in its entirely - very nicely done.

It's possible that Floyd Norris at the New York Times may have had a look at this before penning yesterday's Failing Upward at the Fed in what is yet another scathing attack on central banks and their policies.

Books will be written on the failure of the Fed in the last cycle. It decided that it did not need to worry itself over rising asset prices. So it stood by, first in the technology stock bubble, then in the housing bubble. It saw credit getting excessively loose, and leverage piling up, but comforted us with assurances that if there was a bubble, the Fed knew how to clean up after it burst, principally by cutting interest rates.

It championed letting the shadow financial system grow without oversight, and shied away from doing anything about highly risky mortgages.

Perhaps most important, the Fed and other regulators had no idea how much risk they had allowed into the system. They knew that various financial innovations were designed to let banks make more money without being required to put up more capital, but they did not figure out that that meant the capital there might be inadequate. They threw up their hands at the complexity of it all, and said banks could use their own models to assess risk.

In sum, the Fed thought it had learned the lessons of the 1930s, but it had not learned the lesson of the 1920s, that allowing asset prices to soar to absurdly leveraged heights could lead to a financial collapse as the need to repay loans forced sales that drove prices lower, resulting in the need to repay more loans, and so on and so on.
...
Mr. Bernanke’s predecessor, Alan Greenspan, has been trying to restore his reputation without admitting any error beyond assuming that banks would act rationally in making loans, and therefore not requiring large enough capital buffers.

“The real lesson here appears to be that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic or whether a particular tranche of a collateralized debt obligation will default, or even if the financial system will seize up,” he said in a speech last week to the Economic Club of New York. It sounded to me a little like a failing student protesting, “Dad, nobody could have passed that test.”

Is the current Fed leadership so modest about its abilities? No doubt it cannot “fully or accurately” forecast what will happen, but does it think that it can do a much better job now than it did in the years leading up to the current crisis? If so, how?

These are all good questions. It's nice to see them being asked.

ooo