November 30 2010
New Directions in How We Understand the Economy
How can we understand a world that has proven far more complex than the most advanced economic models assumed? (WSJ)
Economists have long struggled to fit real world phenomena into the narrow assumptions of neo-classical equilibrium theory. The Chicago School of Economics is one of the premier institutions that adhere to this model, and the school has become well known for its perspective of "first assumption" and "good approximation."
Since real world phenomena never fit the perfectly competitive market model, with its assumptions of a large number of sellers, all of whom have perfect information, in a market that allows free entry and exit, and in which the relevant goods are homogenous, the Chicago school holds that although the assumptions are not fully met, real markets come sufficiently close to the model that the insights are still useful.
The insights gained are, thus, good approximations. When econometric results clash with the results expected from the equilibrium model, Chicago economists are more likely to question the data or declare the incident an anomaly which requires further examination, than to reconsider their assumptions. However, the recent economic recession is now leading many to challenge the predominance of this school of thought. From the Wall Street Journal:
In the wake of a financial crisis and punishing recession that the models failed to capture, a growing number of economists are beginning to question the intellectual foundations on which the models are built.
The question is far from academic. For decades, most economists, including the world's most powerful central bankers, have supposed that people are rational enough, and the working of markets smooth enough, that the whole economy can be reduced to a handful of equations. They assemble the equations into mathematical models that attempt to mimic the behavior of the economy. From Washington to Frankfurt to Tokyo, the models inform crucial decisions about everything from the right level of interest rates to how to regulate banks.
The main flaw in the dominant models, [Mr. Frydman] says, is the same feature that makes them so attractive to policy makers: Their ability to make precise predictions. To generate their predictions, the models assume that people, firms and other players always make decisions in the same way. The players must also share the same beliefs about the exact probabilities of various outcomes, such as a rise in car prices or tax rates.
"It's like socialist planning," says Mr. Frydman. "If we really knew that much, we could have Communism and God knows what." Capitalism works better than other systems, he says, because it lets people disagree about the future and profit from their insights-rational behavior that models don't accommodate.
Mr. Frydman doesn't offer a better way to make predictions. Rather, he believes economists and policy makers must come to terms with the limits of their knowledge.
Mr. Frydman's insights about the limits of our knowledge are crucial. Understanding those limits can reduce our eagerness to meddle with economic outcomes, thereby creating unintended consequences. This past recession has certainly demonstrated how the attempt by well-intentioned politicians to make the dream of owning a home a reality for more Americans can backfire with disastrous consequences, the brunt of which were born by the very same group the policies were intended to benefit.
Last week, CNBC featured an article explaining the recession from the perspective of the Austrian School of Economics, which emphasizes a dynamic approach to studying economics, while the WSJ article discusses the potential of agent-based modeling to simulate an economy that includes a variety of different actors who don't always behave in the way neoclassical theory would predict.
The new directions in economics look promising in helping us understand real world phenomena better. Nevertheless, we should not lose sight of Friedrich von Hayek's important insight in The Fatal Conceit:
The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.