What We Can’t Know About the Economy

Economics and Wizardry

Economics may no longer be the “dismal science,” the English historian Thomas Carlyle once said it was. So many students are drawn to it today and go on to enjoy lively and lucrative careers. Some can even become celebrities and earn Nobel Prizes along with considerable stature and respect. But how much of a science is it?

Two economists writing for Project Syndicate have suggested that it was pseudo-scientific models of economic behavior and financial risk that contributed to the financial meltdown 5 years ago: “These models provided the supposedly scientific underpinning for policy decisions and financial innovations that made the worst crisis since the Great Depression much more likely, if not inevitable.”

Driven by pressure from banks and other financial institutions to leverage their assets as much as possible, economists devised models that claimed to forecast precisely the risk they faced. In retrospect, according to Roman Frydman and Michael Goldberg, they placed too much faith in their models.

There is plenty of blame to go around: the mortgage industry that made mortgages available to those who could not afford them, the regulators who looked the other way, the rating agencies who handed out AAA ratings without understanding the derivatives they evaluated, legislators who removed safeguards, etc, etc. Clearly the credit bubble that led to the crash and the Great Recession from which we are still struggling to emerge was a kind of mass mania that swept up the whole industry, a process where competition and greed trumped reality.

But one benefit might be a more realistic appreciation of what economists can and cannot do, and the relationship between their models and fiscal reality. Freydman and Goldberg add, “We must accept what economic analysis cannot deliver in order to benefit from what it can.” That means: “Rather than trying to hit precise numerical targets, whether for inflation or unemployment, policymaking [should] dampen excessive fluctuations. It thus responds to actual problems, not to theories and rules.” (See “Did Capitalism Fail?)

Interestingly, that would bring it back to the realm of real science, away from the wizardry it was seen as being. Real scientists know the difference between a model and reality. That’s why they constantly test and retest, experiment and observe. Old theories are replaced with new, as scientists more than anyone else appreciate the gap between what they think and what they know.

Economists could learn to think that way too – and many already do. Investors and speculators, of course, will seize on any advantage they can to get ahead of the markets. And they will probably rush to conclusions prematurely. So it might be a good idea to label economic models, like other consumer products: “MAY BE DANGEROUS TO YOUR HEALTH,” or “EXPIRES IN SIX MONTHS.”

Right now, many in the industry still remember the debacle of 2007 and their part in it. But new bankers coming along will not, while many old bankers will eventually come to be persuaded the problems of reliability have been solved. More important, the pressure of competition in the financial industry will not abate.

How can they remind themselves that managing risk is more complicated that they want to believe?