Paradigm Lost

Originally published in The Boston Globe

December 21, 2008
Drake Bennett (Reporter, The Boston Globe)

The deepening economic downturn has been hard on a lot of people, but it has been hard in a particular way for economists. For most of us, pain and apprehension have been mixed with a sense of grim amazement at the complexity of what has unfolded: the dense, invisible lattice connecting house prices to insurance companies to job losses to car sales, the inscrutability of the financial instruments that helped to spread the poison, the sense that the ratings agencies and regulatory bodies were overmatched by events, the wild gyrations of the stock market in the past few months. It's hard enough to understand what's happening, and it seems absurd to think we could have seen it coming beforehand. The vast majority of us, after all, are not experts.
But academic economists are. And with very few exceptions, they did not predict the crisis, either. Some warned of a housing bubble, but almost none foresaw the resulting cataclysm. An entire field of experts dedicated to studying the behavior of markets failed to anticipate what may prove to be the biggest economic collapse of our lifetime. And, now that we're in the middle of it, many frankly admit that they're not sure how to prevent things from getting worse.
As a result, there's a sense among some economists that, as they try to figure out how to fix the economy, they are also trying to fix their own profession. The discussion has played out in blog posts and opinion pieces, in congressional testimony and at conferences and in working papers. A field that has increasingly been defined, at least in the public eye, by quirky studies explaining the economics of our everyday lives - most famously in the best-selling book "Freakonomics" - has turned decisively, in the last couple months, to more traditional economic turf. And at economics powerhouses like Harvard, MIT, and the University of Chicago, faculty lunch discussions that once might have centered on theoretical questions and the finer points of Bayesian analysis are now given over to dissecting bailout plans. Long-held ideas - about the stability of the business cycle, the resilience of markets, and the power of monetary policy - are being challenged.
"Everyone that I know in economics, and particularly in the worlds of academic finance and academic macroeconomics, is going back to the drawing board," says David Laibson, a Harvard economist. "There are very, very, very few economists who can be proud."
A few are suggesting, as well, that there are deeper problems in the discipline. Economists are asking aloud whether the field has grown too specialized, too abstract - and too divorced, in some sense, from the way real-world economies actually function. They argue that many of the models used to explain and predict the dynamics of financial markets or national economies have been scrubbed clean, in the interest of theoretical elegance, of the inevitable erraticism of human behavior. As a result, the analytical tools of the trade offer little help in a crisis, and have little to say about the sort of collapses that led to this one.
"You can't just say, 'I have a model for tremors that works great, I just can't explain earthquakes,' " says Kenneth Rogoff, a Harvard economist who has studied financial crises.
Historically, periods of severe economic distress have shaken up economics, and helped drive its evolution. And in the midst of the current crash, there is an urgent search for approaches and models that might better illuminate how to speed the recovery and forecast future meltdowns, and that might help us better understand the unruly flow of money.
The question of how well economists can model crises takes on an even greater importance because of the central role economic experts will play in Barack Obama's administration - not only at the Federal Reserve, the Council of Economic Advisors, and the Treasury, but in the Economic Recovery Advisory Board, a newly formed body created by the president-elect and headed by former Federal Reserve chairman Paul Volcker. Obama has a reputation as someone who places a great deal of stock in expertise and the power of data. For better or worse, the evolving understanding of economic breakdowns will have ample opportunity to test itself against the real thing.
Along with everything else they have done, the financial meltdown and attendant economic slump have spurred unprecedented political attention and participation on the part of economists.
"In my lifetime as an economist I've never seen economists so engaged by what's going on," says Richard Thaler of the University of Chicago. "At the University of Chicago people always talk economics at lunch, but for the last three months they've all been talking about the crisis and the bailout, and writing op-eds."
This is something of a change. The topics economists study often have little to do with the average person's economic life - as in most any academic field, practical relevance can have little to do with what questions are deemed most interesting and rewarding. This divergence was exacerbated, many economists say, during the span of almost uninterrupted economic growth that began in the late 1980s, a period when many of the more practical questions in economic policy-making came to be seen as having been settled. For years, leading economic figures like Larry Summers and Alan Greenspan argued that the United States had more or less brought the business cycle to heel.
Partly as a result, many bright young economists turned to questions that were quirkier, or more purely mathematical. To the wider public, the most visible ramification of this was the boom in papers and books about the economics of everyday life - the best-known practitioner was Steven Levitt of the University of Chicago, but economists like Ray Fisman of Columbia, Edward Miguel of UC Berkeley, and Justin Wolfers of the University of Pennsylvania also worked at least partly in this vein. In often ingenious studies, they used economics as a forensic tool to examine family dynamics, speed-dating, parking scofflaws, basketball games, or the life choices of street criminals.
For those who stayed on more traditional economic turf, however, the trend was toward narrower questions, and more abstract ones. Financial economists set out to figure out why it is that stocks earn more than bonds, or to devise better ways of calculating "beta," the correlation between the price of a single asset and the price of the market it was part of. Others took on the surprisingly difficult question of defining what, exactly, money is.
Wolfers, being an economist, describes these intellectually challenging but less policy-relevant questions as a sort of scholarly "luxury good." "During good times we all consume more luxuries," he says, "but during a bad economy, it feels to macroeconomists that what we should be doing is stuff to help today."
Some economists have suggested that this focus may account for why so many failed to see the warning signs of the financial crisis, and to predict the size and scope of its fallout.
Others see a broader problem in that the sort of behavior we've seen in everyone from home buyers to investment bankers in recent months is hard to fit into economists' analytical tools. The models that macroeconomists - those who study national and regional economies in their entirety - rely on do a poor job of describing the messiness of an actual market in flux. Many, for example, only have one variable for an interest rate, even though in times of economic turmoil the gap between various rates often widens so far that it's difficult to say what "the" interest rate actually is. As a result, economists end up oversimplifying such situations when they model them - or simply avoid studying them at all.
"We have a very restrictive set of language and tools, and we tend to work on the problems that are easily addressed with those tools," says Jeremy Stein, a financial economist at Harvard. "Sometimes that means we focus on silly questions and ignore greater ones."
Today there is a move to hone and rethink the models that describe the huge interlocking wheels of the economy, and to find a way to include the human tendencies that can bring them grinding to a halt. Some economists are looking to the methods and findings of psychology, others are applying themselves to the tricky task of modeling bubbles, a relatively neglected topic. Whatever the approach, the study of financial crises is likely to be a predominant question for the newest generation of economists.
"I guarantee that over the next couple of years you are going to see lots of papers on banking crises and financial blowups," says Andrew Lo, a financial economist at MIT's Sloan School of Management.
In addition, others predict, there's likely to be a sharp migration among young economists into these fields. "Banking has been an incredibly important field that has not been hot for some time," says Edward Glaeser, a Harvard University economist. "What's happened is that banking is sexy again."
Already, the crisis is reshaping long-running debates. It has chastened believers in the self-correcting abilities of the free market - Alan Greenspan said as much before Congress in October - and emboldened those who see the need for more active government intervention.
In a sense, it's a debate that has been seesawing back and forth from crisis to crisis over the past century. Classical economics was devastated by the Great Depression, and in the years afterward gave way to the ideas of the British economist John Maynard Keynes: that individually rational economic decisions could add up to collectively disastrous consequences, that the "stickiness" of prices and wages could lead to long-term unemployment and stagnation, and that the government, as a result, has to step in to kick-start the economy.
The stagflation of the 1970s, while mild compared with the Depression, swung the pendulum back. It was Milton Friedman, a sharp critic of Keynesianism and a fervent advocate of unfettered free markets, who solved the seeming paradox of simultaneous inflation and high unemployment by realizing the deadening power of people's expectation of future inflation, and it was Friedman's proposed solution - sharply restricting the money supply - that eventually, albeit painfully, solved the problem.
Today's crisis has brought Keynes back to the center of the discussion, but some economists also see it driving the field into new territory. Up until very recently, the study of market bubbles was marginalized - there was no widely accepted definition of what a bubble was, and some economists, believers in the complete rationality of markets, argued that bubbles didn't even exist. Today, however, there is a growing sense that understanding bubbles is vital to understanding markets - among those making the case is Federal Reserve chairman Ben Bernanke, who, as head of the Princeton economics department, made a point of hiring young economists interested in the topic.
Over the same time period, the field of so-called behavioral economics has risen to prominence, led by, among others, Thaler, Laibson, and Robert Shiller, a Yale economist who warned of both the housing bubble and, in 2000, the dot-com bubble. By borrowing the insights and methods of psychology, behavioral economics focuses on all the ways in which humans fail to act as the rational, self-interested beings that economic models call for - we aren't good at thinking about the future, we're susceptible to peer pressure, we overestimate our abilities and underrate the odds of bad things happening. It's a set of traits that describes perfectly the behavior of many of the people who, in a cascade of self-defeating decisions, helped create the subprime crisis.
"People used to think that these behavioral effects were small anomalies that turned up in experiments but washed out in the real world," says Tyler Cowen, an economist at George Mason University not himself affiliated with behavioral economics. "But there's a sense in which they get multiplied in the real world."
For now, behavioral economics remains a critique without a real alternative. That may be starting to change: Lo has developed what he calls the "adaptive markets hypothesis," a model that he argues reflects both the rationality of the investor in good times and the blind panic of the bad.
Nonetheless, for some economists, the lessons of the crisis are likely to be smaller, though no less humbling. These scholars argue that they're facing not a new challenge but a familiar nemesis.
"What we're experiencing now is a good old-fashioned financial panic," says Jeffrey Kling, an economist at the Brookings Institution. "This is perhaps the biggest scale, but on some level it's not that different."
Robert Lucas, an economist and Nobel laureate at the University of Chicago and a champion of the rationality of markets, doesn't see much fundamental change coming out of the crisis, either. What it has reminded us of, he argues, is simply the impossibility of seeing these events in advance.
"I don't know anybody involved who thought he could predict these turning points. Do macroeconomists know as much as we thought we did?" he asks. "Of course not."
By this logic, the problem isn't how economists see the world so much as it is what we expect of economics.
Laurence Ball, an economist at Johns Hopkins, makes a similar point. "Nobody ever sees anything coming," he says. "Nobody saw stagflation coming, nobody saw the Great Depression coming, nobody saw Pearl Harbor or 9/11 coming. Really big, bad things tend to be surprises."