Is economics in a state of denial?

It’s time for economists to come out of denial and embrace new ideas

Author: David Orrell
April 2, 2014

One of the greatest talents of the human race is our capacity for denial. Without the ability to deny reality, it could be hard to make progress. Yet by ditching out-dated values on efficient markets, new ideas could bring a fresh perspective and realism into solving economic disparity.

Without denial, we would have to face up to all sorts of scary and unwelcome facts, such as death, the ballooning national debt, climate change, the heat death of the universe, numerous personal failings, and so on. In a recent book, scientists Ajit Varki and Danny Brower went so far as to argue that denial was key to the development of human intelligence: without it, our brains would self-implode from too much negative information.

[M]any economists appear to have decided to do the academic equivalent of putting your fingers in your ears and humming loudly

While denial can be useful as a way to avoid anxiety or pain, it obviously has a shadow side, as when addicts deny that they have a problem, or when we refuse to accept new evidence because it clashes with our belief system. Consider for example the state of economics. The financial crisis that began in 2007 was a traumatic event for the profession – or it should have been. It certainly came as a complete surprise to nearly all economists, including institutions such as the IMF or OECD who pride themselves on their expertise at economic forecasting.

Following the crisis, there was also a widespread acknowledgement by policy makers and others that mainstream theory had been less than useful. Jean-Claude Trichet, then President of the ECB, said that “in the face of the crisis, we felt abandoned by conventional tools.” Willem Buiter – who was a member of BoEs Monetary Policy Committee from 1997 to 2000 – stated on his blog that a training in modern macroeconomics was a “severe handicap” when it came to handling the credit crunch. So how has economics reacted to the crisis?

Crisis, what crisis?
There have certainly been some positive developments, such as the George Soros-funded Institute for New Economic Thinking. But rather than engage with any kind of new thinking, many economists appear to have decided to do the academic equivalent of putting your fingers in your ears and humming loudly.

Consider for example the award of the 2013 Bank of Sweden Prize (the “economics Nobel”) to Eugene Fama for his efficient market hypothesis. This theory posits that the market is at a state of equilibrium, but is buffeted by random, independent events, to which the market instantaneously adjusts.

Markets are therefore unpredictable and impossible to beat: no investor can take advantage of a new piece of information, because as soon as it becomes available, the market has already re-priced itself accordingly. Different versions of the theory exist, ranging from strong to weak, but the basic idea remains that markets are approximately at equilibrium and price changes are effectively random.

Now, one would think that a market crash of the type experienced in 2007 and 2008 – which appears to show if nothing else a certain lack of equilibrium – would have shaken one’s belief in market efficiency. But when asked by the New Yorker in 2010 how the theory had performed, Fama replied: “I think it did quite well in this episode.” Indeed, the Economist Robert Lucas said that the reason the crisis was not predicted was because economic theory predicts that such events cannot be predicted. So everything makes sense.

[A]s some students have protested, there is little discussion in economics courses or textbooks of the actual financial crisis, which shows how the denial has continued

However, the fact that a system is unpredictable does not mean that it is efficient (snow storms are unpredictable, but no one calls them efficient). The theory is right for the wrong reasons. Markets are not at equilibrium – in the terms of complexity science, it makes more sense to see them as a process that is far from equilibrium. And price changes are not random and independent, as assumed by the theory, but highly coupled.

The efficient market hypothesis is the cornerstone of a range of financial techniques, such as the Black and Scholes model used to price options, or the Value at Risk technique for assessing risk, that failed spectacularly in the crisis for exactly these reasons. People on the whole do not think that these methods “did quite well in this episode”, to use Fama’s phrase. As one biologist remarked at a conference about economics after the crisis, “I’ll believe economists have reformed when the men behind Black and Scholes have been stripped of their Nobels.” But instead of revising efficient market theory, economists gave it another gong. Sound like denial?

General disequilibrium
Another example of how economics failed during the crisis was its reliance on Dynamic Stochastic General Equilibrium (DSGE) models. These similarly assume the existence of an underlying equilibrium around which the economy bounces, and assume that markets are self-correcting. Money is viewed as nothing more than a placeholder, so most models exclude things like banks, even though they turned out to play a rather important role during the crisis.

As Philip Mirowski points out in his book Never Let a Serious Crisis Go to Waste, DSGE modelling could “serve no useful function once the crisis hit, because it essentially denied that any such debacle could have materialised.” But these models continue to be taught and used by university economists. In contrast, as some students have protested, there is little discussion in economics courses or textbooks of the actual financial crisis, which shows how the denial has continued. Of course, many of the reasons for this denial and inertia are institutional.

Academic departments take their lead from tenured professors who built their careers around orthodox ideas, and are unlikely to drop them now. Those without tenure have their careers on the line, so are afraid of taking a risk. And most students are willing to play along, which is unsurprising given that the most common reason to sign up for economics is not to change the world, but to get a good-paying job.

As HG Wells is attributed as saying, though, “Every dogma must have its day.” It’s time for economists to come out of denial, ditch antiquated ideas about efficient markets and equilibrium, and open the field up to new ideas from areas such as complexity, network theory, and systems biology.