The Economic Case for Admitting You Just Don't Know

Photograph by Petrovich9

Economic models make Roman Frydman think of his youth in communist Poland. When he arrived at Columbia University as a graduate student in the 1970s, he says, ”the idea of market perfection sounded very much like some central planner’s platonic ideal.” Frydman now teaches economics at New York University. He also founded Project Syndicate, an online collection of academic commentary, often critical of mainstream economics. In June of this year, in an address (pdf) to launch a Polish version of the site, Frydman pointed out that countries like Poland with less developed financial markets had avoided the worst of the financial crisis. “Lucky laggards,” he called them.

The laggards didn’t make use of the financial instruments—derivatives, for example—that failed so spectacularly in 2008. Sophisticated derivative pricing rests on a certain kind of model, which in turn makes an assumption: that volatility can be measured and that it is consistent. Before the crisis, markets hadn’t completely freaked out in so long that an entire school of thought had come to rest on a profoundly wrong belief, that markets would never freak out again. Frydman’s criticism of financial instruments wasn’t new. In his June speech, he was going for bigger prey. “I do not think that the financial crisis should be viewed as the failure of capitalism,” he said, “Instead, I would like to pin a significant share of the blame on economists.”

In an essay on Project Syndicate last year, Dani Rodrik, an economist who teaches at the Institute for Advanced Study in Princeton, argued that it’s too simple to think that politics is just about power. Ideas are important. The powerful adopt the ideas that most please them, but the ideas have to come from somewhere. From Rodrik’s essay:

Economists aren’t just observers. They’re actors. The film Inside Job got to this a bit, showing the connection between financial firms and the academics who take their money. In 2012, the American Economic Association adopted a disclosure standard designed to flush out any conflicts of interest. But this is not what Rodrik and Frydman are saying. Economists aren’t compromised by power. Economists are just wrong.

Frydman calls his approach “imperfect knowledge economics.” In the last decade, groups of behavioral economists challenged the idea that market actors are rational. He argues that this doesn’t go far enough. You can’t factor neurology into the models and update your assumptions to include irrational behavior. This, just like Poland’s central planning model of Frydman’s youth, still assumes that it’s possible to know what will happen. But we can’t.

As we approach the fifth anniversary of the collapse of Lehman, politicians and investors will get their chance to wonder publicly what went wrong and what they’ve learned. We should include economists in this parade, too. Within the profession, and particularly at the top graduate programs that produce PhD economists for the finance industry, economists have yet to face completely an uncomfortable possibility. Maybe the models weren’t wrong. Maybe modeling is wrong.

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