So high expectations, so few riders.

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Here's What Economics Gets Right

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Criticizing economics for not being scientific enough is a crime of which many of us -- I’ve done it -- are guilty.  But there’s a right way to do it and a wrong way to do it.  Alex Rosenberg and Tyler Curtain, writing in the New York Times, have done it the wrong way.

Here are Rosenberg and Curtain:

Over time, the question of why economics has not (yet) qualified as a science has become an obsession among theorists, including philosophers of science like us...The trouble with economics is that it lacks the most important of science’s characteristics — a record of improvement in predictive range and accuracy...In fact, when it comes to economic theory’s track record, there isn’t much predictive success to speak of at all.

Economics doesn’t have predictive success, eh? This is something a lot of people claim, but once you look beyond the well-publicized fact that economists can’t predict recessions, you can see that the claim just isn’t true. Economics can predict plenty of things.

My favorite example is the story of Daniel McFadden and the BART. In 1972, San Francisco introduced a new train: the Bay Area Rapid Transit (BART). The authorities predicted that 15 percent of area commuters would use the system. But, using money from a grant provided by the National Science Foundation, University of California, Berkeley, economist McFadden and his team of researchers predicted that usage would be only 6.3 percent.

The actual number? 6.2 percent.

Now call me crazy, but I call that a predictive success. The models McFadden et al. used to make the prediction were clever extensions of simple utility theory -- the oldest trick in the economic playbook. Those models, called “random-utility discrete choice models,” have been applied in a huge number of areas, including product development, pricing decisions, marketing, energy usage and environmental-impact studies. In 2000, McFadden won a Nobel Prize for his efforts.

Want another example? Look at auction theory. Google may have an excellent search algorithm, but its real money-maker is the system by which it auctions its advertisement space. Those auctions are conducted with a setup known as a generalized second-price auction, developed relatively recently by economists such as Hal Varian (now employed by Google). That auction setup, like all others, is based on game theory -- another basic element of the economics toolbox. Auction theory is focused on predicting which types of auctions most reliably lead to profitable trades. It is more and more crucial to the profits of online-services companies, which is why many tech startups are now hiring economists.

Want yet another example? So-called “gravity models” of international trade, do a very good job of predicting how much trade will occur between any two countries, given the size of their economies and the distance between them.

In other words, Rosenberg and Curtain are just plain wrong. Economics theory has plenty of predictive successes.

Why do Rosenberg and Curtain get it wrong? Part of the fault is their own -- they just didn’t bother to do their homework. But part is the fault of economists, who don’t do a very good job of trumpeting their predictive successes to the world. Some economists still defend the idea that economic theory doesn’t need to make predictions in order to be useful, and instead merely has to give people a framework for thinking about the world.

That argument hasn't carried much water with the general public, and rightly so. Without empirical support, you can’t really be confident that a theory is a good framework for thinking about the world. It’s likely that economists using bad theories will make bad policy recommendations, no matter how organized or internally consistent those economists’ mental frameworks.

But detractors of economics tend to ignore the waning of the boom in economic-theory-for-theory’s-sake. Theory papers peaked as a percentage of the econ literature sometime in the 1980s, and are now down to less than a fifth of all papers published in top journals. As University of Chicago economist John Cochrane puts it:

Empirical economics has become very fact-oriented in the last 20 years…The stars in their 30s are scraping data off the internet.

So Rosenberg and Curtain’s characterization of economics looks like a caricature. Connection of theory to reality is becoming more and more important in economics, and predictive success exists in many areas.

The one notable exception, of course, is in the area of macroeconomics. In terms of predicting booms and busts, economics is still looking for its first big success. But if you think that predicting recessions is economists’ only mission in life, think again.                               

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net