The Danger of Being Partly Right

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It is always a pleasant surprise to read an article by a leading economist who doesn’t claim to know all the answers. More often it’s one economist arguing that all the rest of his profession has missed some critical item. Paul Krugman, writing in the New York Times Magazine, is somewhere between these cases. He asks and answers the question, “Why economists from all parts of the theoretical spectrum missed seeing the arrival of the financial collapse and the recession?” Nobody, except for a handful of academics, foretold of the coming disaster, the parts of the article that argue for or against either of the two primary schools within economics. Krugman calls them the ‘saltwater’ and ‘freshwater’ schools because the leading thinkers of the two schools tend to be situated along the two coasts and the middle of the country, respectively. He does take sides, arguing for the saltwater version of Keynes theories, albeit modified to reflect learning since the Great Depression.

The more interesting and important part of the story for me is his discussion of the imperfections in the theory and the failure of the field to recognize these in making policy recommendations that were then enacted by the public and private financial systems.

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Over 80 years ago, the British philosopher, Alfred North Whitehead, saw this danger as a problem with theory in general. Calling the failure to distinguish reality from the elegant mathematical forms that theories take, “the fallacy of misplaced concreteness,” he saw this error as creating “great confusion in philosophy.” He was referring to the era when science fell under the rubric of philosophy. Now in our rationalizing and technocratic culture, this error can tunnel its way into the institutional framework that sets the rules and norms that drive society. This exactly what appears to have happened in the domain of macro-economic policy and practice over the past several decades or more. When beauty or elegance replaces truth, the outcome is uncertain as the models do not capture the essence of the real world. When the real world system is complex as it always is when human beings are integral to it, the missing understanding can and does lead to, not only missed targets, but serious upsets, collapses, and regime changes. Krugman does understand this, but shrugs it off in a short blog piece following his article in the Times.

Actually, let me put it this way: the economy is a complex system of interacting individuals — and these individuals themselves are complex systems. Neoclassical economics radically oversimplifies both the individuals and the system — and gets a lot of mileage by doing that; I, for one, am not going to banish maximization-and-equilibrium from my toolbox. But the temptation is always to keep on applying these extreme simplifications, even where the evidence clearly shows that they’re wrong. What economists have to do is learn to resist that temptation. But doing so will, inevitably, lead to a much messier, less pretty view. So be it.

Easy enough for Krugman to dismiss the problem with a shrug. He already has his Nobel prize. But try telling this to a rising young star silently thinking about the Nobel in Economics. One doesn’t win the prize by offering up a mess. In science being wrong doesn’t carry the same potential for human distress than do errors in the social (or, better, human) sciences. Ever since Popper introduces the idea of falsification into the scientific methods, most scientists accept that their models are contingent and conditional. Further their theories generally apply to some unchanging object although subject to changing internal dynamics. Economists’ worlds are always changing such that the a priori assumptions for the theory at time A are never quite those at time B. Proof of the validity, as in natural science, is not possible and, thus, the correct economic theory to apply in setting policy is alway arguable. As Krugman noted, disagreement is a notable feature of the economics discipline. The lesson for the rest of us is to insist that our economic leaders and advisors offer policies that can be adapted when the results turn out to be different from those they expected, and before the bubbles burst.

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