Complex economic models often ignore reality

  • By James McCusker, Columnist
  • Friday, October 31, 2008 7:29pm
  • Business

By far the best piece of recent economic news did not come out of Wall Street, or even Main Street, but from a biomedical laboratory. Scientists working in Augusta, Ga., and Shanghai, China, were able to get mice to overproduce an enzyme, calcium calmodulin protein kinase II, the effect of which was to erase the rodents’ memory of specific frightening events, leaving other memories and mental abilities intact.

The word overproduction is itself scary for economists, but somehow we always knew that science would come up with just what we needed: a pill to make us forget that this colossal financial meltdown ever happened. Soon, if the research works out, we can just take the pale blue pill marked “Wall Street” and we are good to go.

And we really need some help to forget at this point. If left alone, we would probably be able to gain some perspective and deal with the painful memory ourselves, but that is not to be. Instead, we are reminded of it constantly by an endless parade of politicians, each seeking to blame someone else for the mess.

It would be a good thing for us if the medical researchers and neuroscientists actually come up with something useful for us. Economists, by contrast, have been no help at all in this financial crisis — not in predicting it, not in explaining it and certainly not with any useful ideas as to how we can dig ourselves out of it.

N. Gregory Mankiw, a Harvard economist with a formidable reputation and global influence, wrote recently about how in the late 1920s and early 1930s, the leading economists at the “competing forecasting services at Harvard and Yale” failed to predict the market crash and subsequent financial crisis. Their understanding of the economic depression that followed was an even more complete failure.

Economists certainly didn’t predict the extent of this mess. Whether you prefer blue chip economists or buffalo chip economists, none of their forecasts mentioned a financial meltdown or anything resembling one.

There may be a reason why economists aren’t much help when we really need them. In his recent testimony before Congress, former Federal Reserve Chairman Alan Greenspan admitted that the Wall Street meltdown caught him by surprise. He added, though, that the very smart economists and their sophisticated models used on Wall Street also grossly underestimated the risk that financial institutions had taken on.

Steve Forbes was recently singing the praises of Joseph Schumpeter, who was not only a brilliant economist but a man of broad experience, achievement and intellectual curiosity. In a review of a new biography of Schumpeter (“Prophet of Innovation”), Forbes wrote, that “He (Schumpeter) would look upon the bulk of today’s economists, with their obsession with numbers and regression analysis, as hideously narrow-minded and suffering from academic constipation.”

Perhaps that is the way we should look upon them, too. More importantly, maybe that is the way they should look at themselves.

In many respects the economics profession is simply a victim of both technological change and market externalities — precisely the kinds of things that no longer seem to interest them. The computer revolution made complex mathematical models possible just at the time when our universities were overproducing graduate students who needed “original work” to obtain their doctorates.

The result was a concentration of thought and effort on mathematical models that had to be increasingly complex and focused on narrower slices of reality in order to be considered original. Unfortunately, the more rigorous the math, the more that reality had to be left out. And the result, as we now know, is that some of most beautiful minds in the country had created a financial sector model that left out key elements of institutional and human behavior. The models weren’t wrecked by “bad data” as Greenspan believes, but a fundamentally flawed and ultimately useless idea of what economics is all about.

There are some good reasons to be optimistic about the future of the U.S. economy. We have seen repeated attempts of the housing sector to revive itself, and the Treasury Department’s efforts, while not always perfect enough to avoid criticism, show signs of being able to refloat our financial system. Current housing lenders are finding highly qualified home buyers and we see some mortgage lenders trying to stabilize their existing home loans and reduce foreclosures.

Whether the financial meltdown will have a sobering effect on the economics profession isn’t at all clear at this point. When people have spent so much of their professional lives developing mathematical models, it is tough to give them up, even if they turn out to be wrong. It’s human nature … oops.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.

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