Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
Coinbase vs Binance for Bitcoin, Ethereum Crypto Trading & Investing During Bear Market 2021 - 11th Jun 21
Gold Price $4000 – Insurance, A Hedge, An Investment - 11th Jun 21
What Drives Gold Prices? (Don't Say "the Fed!") - 11th Jun 21
Why You Need to Buy and Hold Gold Now - 11th Jun 21
Big Pharma Is Back! Biotech Skyrockets On Biogen’s New Alzheimer Drug Approval - 11th Jun 21
Top 5 AI Tech Stocks Trend Analysis, Buying Levels, Ratings and Valuations - 10th Jun 21
Gold’s Inflation Utility - 10th Jun 21
The Fuel Of The Future That’s 9 Times More Efficient Than Lithium - 10th Jun 21
Challenges facing the law industry in 2021 - 10th Jun 21
SELL USDT Tether Before Ponzi Scheme Implodes Triggering 90% Bitcoin CRASH in Cryptos Lehman Bros - 9th Jun 21
Stock Market Sentiment Speaks: Prepare For Volatility - 9th Jun 21
Gold Mining Stocks: Which Door Will Investors Choose? - 9th Jun 21
Fed ‘Taper’ Talk Is Back: Will a Tantrum Follow? - 9th Jun 21
Scientists Discover New Renewable Fuel 3 Times More Powerful Than Gasoline - 9th Jun 21
How do I Choose an Online Trading Broker? - 9th Jun 21
Fed’s Tools are Broken - 8th Jun 21
Stock Market Approaching an Intermediate peak! - 8th Jun 21
Could This Household Chemical Become The Superfuel Of The Future? - 8th Jun 21
The Return of Inflation. Can Gold Withstand the Dark Side? - 7th Jun 21
Why "Trouble is Brewing" for the U.S. Housing Market - 7th Jun 21
Stock Market Volatility Crash Course (VIX vs VVIX) – Learn How to Profit From Volatility - 7th Jun 21
Computer Vision Is Like Investing in the Internet in the ‘90s - 7th Jun 21
MAPLINS - Sheffield Down Memory Lane, Before the Shop Closed its Doors for the Last Time - 7th Jun 21
Wire Brush vs Block Paving Driveway Weeds - How Much Work, Nest Way to Kill Weeds? - 7th Jun 21
When Markets Get Scared and Reverse - 7th Jun 21
Is A New Superfuel About To Take Over Energy Markets? - 7th Jun 21
Why Tether USDT, Stable Scam Coins Could COLLAPSE the Crypto Markets - Black Swan 2021 - 6th Jun 21
Stock Market: 4 Tips for Investing in Gold - 6th Jun 21
Apple (AAPL) Summer Correction Stock Trend Analysis - 5th Jun 21
Stock Market Sentiment Speaks: I 'Believe' We Rally Into A June Swoon - 5th Jun 21
Stock Market Russell 2000 After Reaching A Trend Channel High Flags Out - 5th Jun 21
Money Is Cheap, Own Gold - 5th Jun 21
Bitcoin and Ravencoin Cryptos CRASH Bear Market Buying Levels Price Targets - 4th Jun 21
Scan Computers - How to Test New Systems CPU, GPU and Hard Drive Stability With Free Software - 4th Jun 21
Hedge Funds Getting Bullish on Gold - 4th Jun 21
THERE ARE NO SOLUTIONS When the Media is the VIRUS - 4th Jun 21
Investors Who Blindly Trust the ‘Experts’ Will Get Left Behind - 4th Jun 21
US Stock Market Indexes Consolidate Into Flagging Pattern – Watch For Aggressive Trending Soon - 4th Jun 21
Microsoft (MSFT) Stock Trend Analysis - 3rd Jun 21
No More Market Bloodbath – Beyond Cryptos - 3rd Jun 21
Bank run, or run from the banks? - 3rd Jun 21
This Chart Shows When Gold Stocks Will Explode - 3rd Jun 21
The Meaning Behind Gold’s Triple Top - 2nd Jun 21
Stock Market Breakout Or Breakdown – What Does The Next Big Trend Look Like? - 2nd Jun 21
Biden’s Alternate Inflation Universe - 2nd Jun 21
What You Should Know Before Buying Car Insurance - 2nd Jun 21
Amazon (AMZN) Stock Summer Prime Day Discount Sale - 1st Jun 21
Gold Investor's Survival Guide - 1st Jun 21
Silver and Copper to Benefit from Global Electrification Push - 1st Jun 21
Will Gold Shine Under Bidenomics? - 1st Jun 21
Stock Market Buy the Dip, Again?! - 1st Jun 21
Stock Market Consolidation Ahead - 1st Jun 21
Stock Market Summer Correction Review, Crypto CRASH, Bitcoin Bear Market Initial Targets - 31st May 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

What Is the Current State of Economic Science?

Economics / Economic Theory Dec 22, 2010 - 01:55 PM GMT



Best Financial Markets Analysis ArticleErwin Rosen writes: What is the current state of economic science? In two words, "not good."

This is evident in the poor performance of the economics profession during the current financial crisis. Few economists saw it coming; once it started, its severity caught them by surprise; and now it is apparent that there is no agreement among them on how to end it.

To make this case, I will present some leading mainstream economists' views on the crisis. This will be followed by my personal remarks.

How Bad Is the Situation?
Just before the beginning of the crisis, work produced by a variety of leading economists was very positive on the state of macroeconomics; it concluded that the field had made big advances in the last decades. A sample of their comments is offered below:

Olivier Blanchard (2008) claimed that enormous progress had been made in the field of macroeconomics, and that economists were in significant agreement on the direction of the field; in essence, he concluded that the state of this field was good. He attributed this to more powerful computers, which have allowed higher model complexity. He referred mainly to advances made in the area of dynamic stochastic general-equilibrium models, or DSGEs.[1]

Robert Lucas (2003) went so far as to assert that macroeconomics had succeeded and that the problem with depression prevention had been solved.

Ben Bernanke (2004), the current chairman of the Federal Reserve Bank, commented that the reduction in macroeconomic volatility was in part due to improvements in economic policy.

However, the good feelings ended once the crisis began. Alan Greenspan, the former chairman of the Fed — celebrated by many as the "Maestro" for his ostensibly astute vision — admitted in a 2008 Congressional hearing to being in shock about the unfolding situation. He regretted having trusted so much the corrective power of the free market, and he confessed that he plainly failed to anticipate the crisis. These comments are most revealing, because in his position Greenspan was the key regulator of the American economy and, by default, the world economy (see Andrews, 2008).

John Taylor, a leading expert in monetary policy, gets deeper into the reasons. He blames the crisis on, not only the Fed's decisions under Greenspan, but also the current team responsible for economic decisions in government.

According to Taylor, it was mainly government intervention that created, prolonged, and has dramatically worsened the crisis. Firstly, the Fed's monetary strategy kept its target interest rate too low for too long, especially in the 2003–2005 period, creating monetary excesses, a main cause for the economic boom. Then, once the crisis started in mid-2007, the policy makers prescribed the wrong treatment, providing more liquidity via the Term Action Facility in December 2007, followed by the Economic Stimulus Act of 2008 (see Taylor, 2009).

More recently, because of the anemic recovery and ongoing very high unemployment, the Fed has proposed more economic stimulus. While the Fed, following Keynes, is proposing to pour hundreds of billions of dollars that it does not have into the economy, the Europeans are taking the opposite approach for the same illness by reducing budgets. Is this not further indication of the severity of the current problems with macroeconomics? It seems obvious that there is no consensus among economists on the basic course of action (see Geoff Colvin, 2010).

What Seems to Be Wrong with Macroeconomics?
Many economists blame the current problem with macroeconomics on the theories and mathematical models being used to make government economic decisions.

A group of American and European economists analyzing the current crisis have concluded that the economics profession adopts as gospel that the economy is inherently stable (see Colander et al., 2009). Mainstream economics, they claim, have missed the fact that speculative bubbles lead to inevitable crashes, and that such crises can bring down the whole economy. As significant, given this reality, they ask: Why did mainstream economists stick to such faulty models and ignore basic truths about how the economy really works?

The answer, according to David Colander, is simply that mainstream economists, both Keynesians and monetarists, are more concerned with models for the sake of models than with demonstrating their applicability to real-world situations. Their models ignore the fact that if the bubble is big enough, the resulting crash may take out the economy.

And both sides provided the illusion that surface problems can be easily fixed without addressing the real, core problems: Keynesian economics implies that you can manage crises as long as the government is willing to stimulate the economy when things crash. Likewise, Milton Friedman teaches that if you just increase the money supply enough, the system will remain stable. Unfortunately, Keynes and Friedman have become mainstream in the years after the Great Depression, and those economists asking hard questions, like the Austrian economists, have been ignored and sidelined.

Peter Boettke made the same points more than ten years ago (Boettke, 1997). He criticizes mainstream economists for basing their work on models that have no connection to reality. He quotes Hayek to the effect that the real market cannot possibly be always perfect, since it is the result of the spontaneous interaction of people, each possessing only fallible, partial knowledge. But neoclassical theory falsely assumes that the market always reaches equilibrium because all participants know everything. Notwithstanding this issue, Boettke claims that economics in academia has become merely a mathematical game where the generation of models is the end in itself. And the important task of testing theories against reality has turned into a very secondary goal.

Marius Gustavson (2010) explains that the mainstream economists plainly have the wrong models for analyzing crises. Their premise is that as long as prices are stable and unemployment is within target, there is nothing to worry about. In this way, they miss the signs to call for action before crises set in. Austrians, as an example of another view, saw the crisis coming. They saw the monetary disequilibrium in the boom phase, as the Fed manipulated interest rates and forced them lower than the natural rate of interest that would exist in a free financial system without the Fed tinkering with money.

In a statement to a US congressional committee, Robert Solow criticizes the macroeconomic models being developed today (2010). These models, DSGEs, are the very same that Blanchard uses to claim that macroeconomics is in good shape. Solow makes the point that DSGEs do not have anything constructive to add to antirecession policies, simply because they are constructed with the assumption that there is nothing for macroeconomics to do. They assume an idealized world of rational people that, when the unexpected and very occasional shocks occur, adapt to them in a rational fashion; this, according to Solow, is plainly inaccurate.

Following the same line of thought, John Kay states in a recent article in the Financial Times that macroeconomics is based on complicated mathematical models, which have proven useless in anticipating the current crisis. The model makers are plainly talking to themselves. They postulate models based on assumptions that are not real: perfectly rational market players, each holding all the information available.

In a New York Times article, Paul Krugman takes the reader through a comprehensive description of the elements that caused economists to fail to see the coming crisis (Krugman, 2009). In essence, current economic thought has been kidnapped by neoclassical ideas, which assume perfect market equilibrium and perfect rationality of all market participants.

Krugman's criticism centers on Eugene Fama's efficient-markets hypothesis, which hypothesizes that markets price assets precisely at their intrinsic worth, because investors have all publicly available information. This may be true most of the time, but one should ask whether they make sense during crises. The answer, according to Krugman is a solid "no." It is this short-sighted model that prevented the economists from conceiving the possibility of a crisis.

The paper ends with Krugman, a Keynesian, making a plea for reembracing Keynes. Krugman uses the field of behavioral finance to make his case: during times of confusion, i.e., crises, investors are subjected to irrationality and panic, and do not fit Fama's model. And even those investors that want to make rational decisions find themselves overwhelmed by the irrational majority and end up running with the herd.

Krugman accepts the Keynesian approach of Obama's economic team, but criticizes the stimulus as being too timid.

Taking a very different approach, James Buchanan asks why economists have "had so little meaningful to say" about the 2008 crisis (Buchanan, 2009). Where and when did the science get off track? And can anything be done to restore economics as a useful area of inquiry? He argues that the theories and models being used in modern mainstream economics are unable to explain current affairs. He argues for what he calls a "constitutional perspective."[2]

According to Buchanan, economics is not a physical science, rather it is a philosophical science; thus, economics cannot be studied properly outside of politics. He challenges the conventional thought that economics is about allocating scarce resources among competing ends. Instead, Buchanan stresses that economics is about studying the interaction and exchange of individuals within the limitations of the various institutions that they must operate in. His remedy for the failures of the economists is to strive for constitutional solutions that specifically define the duties and prerogatives of public-policy makers. In essence, he proposes structures to limit government power. With rules well established, economists can then proceed to develop realistic models.

For mainstream economists, the certain outcome of the current crisis will be the realization that macroeconomics needs a face-lift. As shown in this paper, the monetarist and Keynesian policies so influential in the United States are already being severely challenged.

The sad reality is that the Austrian economists have been warning us for a long time of these weaknesses. Over 40 years ago, Mises (1966) taught us that economics is about human action, unforecastable and untranslatable into mathematical models; economics, he said, can only provide qualitative predictions about particular polices. Further, the Austrian Mark Thornton (2004), in an extensive paper dedicated to assessing the predicting abilities of economists, concluded that most failed to see the dot-com bubble and to anticipate its bursting in 2000. From the few that succeeded, Austrian economists were in the majority. They were able, not only to anticipate it, but also able to explain it.

The Austrian economists have lectured us since Mises that the market should be allowed to freely operate, in essence allowing Adam Smith's invisible hand to do its thing. The Keynesian thinking that savings is a waste of capital was already discredited by Henry Hazlitt (1959) half a century ago, when he showed that governments cannot spend their way to prosperity.

John Taylor, a world-renowned expert in monetary theory, now comments in the Wall Street Journal that government intervention in fact created the current financial crisis. It is without doubt that if the United States were a business, it would have been bankrupt long ago.

I conclude my comments by hoping that this crisis forces the economics profession to take a fresh look at what Austrian economics can offer.

[1] According to Wikipedia, "DSGE models are dynamic, studying how the economy evolves over time. They are also stochastic, taking into account the fact that the economy is affected by random shocks such as technological change, fluctuations in the price of oil, or errors in macroeconomic policy-making. This contrasts with the static models studied in Walrasian general equilibrium theory, applied general equilibrium models and some computable general equilibrium models."

[2] Buchanan is one of the current leading economists promoting the concept of constitutional economics (CE). This is a "field of economics which describes and analyses the specific inter-relationships between constitutional issues and the structure and functioning of the economy. It takes into account the significant impacts of political economic decisions as opposed to limiting analysis to economic relationships as functions of the dynamics of distribution of 'marketable' goods and services. CE can often explain why policy outcomes are not what were intended from the standpoint of pure economic analysis."

Erwin Rosen advises mutual-fund companies and runs a high-tech startup firm. He is also a doctoral student in political economy at the SMC University in Switzerland. Send him mail. See Erwin Rosen's article archives.

© 2010 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in