And you think I’m ornery? The Dahlem Report

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My rail­ing against the eco­nom­ics pro­fes­sion on this blog might give you the impres­sion that I’m a lone wolf, tak­ing on the eco­nom­ics pro­fes­sion sin­gle-hand­edly. I’m pleased to say that’s not the case; though the rebels are out­num­bered by the True Believ­ers in neo­clas­si­cal eco­nom­ics, there are many aca­d­e­mic econ­o­mists who are crit­i­cal of the eco­nomic ortho­doxy.

Recently some highly regarded econ­o­mists have made this emphat­i­cally clear with an elo­quent and well argued doc­u­ment enti­tled “The Finan­cial Cri­sis and the Sys­temic Fail­ure of Aca­d­e­mic Eco­nom­ics”.

The authors include the well-known eco­nom­ics text­book writer David Colan­der, and the lead­ing evo­lu­tion­ary game the­ory researcher Alan Kir­man, as well Thomas Lux, a leader in non­lin­ear dynamic analy­sis in eco­nom­ics.

Their doc­u­ment is an elo­quent insider’s call for seri­ous ref­or­ma­tion of eco­nom­ics, and should be read in its entirety by any­one want­ing to know how the finan­cial cri­sis took most aca­d­e­mic and indus­try econ­o­mists com­pletely by sur­prise.

Now that the cri­sis is well and truly upon us, the need to reform eco­nom­ics is no longer an aca­d­e­mic issue. But that reform will not come about if left to aca­d­e­mic eco­nom­ics depart­ments them­selves. The neo­clas­si­cal way of think­ing, whose flaws are bril­liantly out­lined in this doc­u­ment, is so ingrained that the same cur­ricu­lum could well con­tinue right up until the moment that the econ­omy col­lapsed, if left to the econ­o­mists them­selves.

The Dahlem Report should be read and widely distributed–and aca­d­e­mic eco­nom­ics depart­ments the world over should be chal­lenged about their response to it. It’s well past high time for the reform of eco­nom­ics.

Excerpts from the Dahlem Report

The global finan­cial cri­sis has revealed the need to rethink fun­da­men­tally how finan­cial sys­tems are reg­u­lated. It has also made clear a sys­temic fail­ure of the eco­nom­ics pro­fes­sion. Over the past three decades, econ­o­mists have largely devel­oped and come to rely on mod­els that dis­re­gard key factors—including het­ero­gene­ity of deci­sion rules, revi­sions of fore­cast­ing strate­gies, and changes in the social context—that drive out­comes in asset and other mar­kets. It is obvi­ous, even to the casual observer that these mod­els fail to account for the actual evo­lu­tion of the real-world econ­omy. More­over, the cur­rent aca­d­e­mic agenda has largely crowded out research on the inher­ent causes of finan­cial crises. There has also been lit­tle explo­ration of early indi­ca­tors of sys­tem cri­sis and poten­tial ways to pre­vent this mal­ady from devel­op­ing. In fact, if one browses through the aca­d­e­mic macro­eco­nom­ics and finance lit­er­a­ture, “sys­temic cri­sis” appears like an oth­er­worldly event that is absent from eco­nomic mod­els. Most mod­els, by design, offer no imme­di­ate han­dle on how to think about or deal with this recur­ring phenomenon.2 In our hour of great­est need, soci­eties around the world are left to grope in the dark with­out a the­ory. That, to us, is a sys­temic fail­ure of the eco­nom­ics pro­fes­sion…”

The implicit view behind stan­dard mod­els is that mar­kets and economies are inher­ently sta­ble and that they only tem­porar­ily get off track. The major­ity of econ­o­mists thus failed to warn pol­icy mak­ers about the threat­en­ing sys­tem cri­sis and ignored the work of those who did…”

This fail­ure has deep method­olog­i­cal roots. The often heard def­i­n­i­tion of economics—that it is con­cerned with the ‘allo­ca­tion of scarce resources’—is short-sighted and mis­lead­ing. It reduces eco­nom­ics to the study of opti­mal deci­sions in well-spec­i­fied choice prob­lems. Such research gen­er­ally loses track of the inher­ent dynam­ics of eco­nomic sys­tems and the insta­bil­ity that accom­pa­nies its com­plex dynam­ics…”

In our view, econ­o­mists, as with all sci­en­tists, have an eth­i­cal respon­si­bil­ity to com­mu­ni­cate the lim­i­ta­tions of their mod­els and the poten­tial mis­uses of their research. Cur­rently, there is no eth­i­cal code for pro­fes­sional eco­nomic sci­en­tists. There should be one…”

The most recent lit­er­a­ture pro­vides us with exam­ples of blind­ness against the upcom­ing storm that seem odd in ret­ro­spect. For exam­ple, in their analy­sis of the risk man­age­ment impli­ca­tions of CDOs, Krah­nen (2005) and Krah­nen and Wilde (2006) men­tion the pos­si­bil­ity of an increase of ‘sys­temic risk.’ But, they con­clude that this aspect should not be the con­cern of the banks engaged in the CDO mar­ket, because it is the gov­ern­ments’ respon­si­bil­ity to pro­vide cost­less insur­ance against a sys­tem-wide crash…”

Given the estab­lished cur­ricu­lum of eco­nomic pro­grams, an econ­o­mist would find it much more tractable to study adul­tery as a dynamic opti­miza­tion prob­lem of a rep­re­sen­ta­tive hus­band, and derive the opti­mal time path of mar­i­tal infi­delity (and pub­lish his exer­cise) rather than inves­ti­gat­ing finan­cial flows in the bank­ing sec­tor within a net­work the­ory frame­work…”

Cur­rently pop­u­lar mod­els (in par­tic­u­lar: dynamic gen­eral equi­lib­rium mod­els) do not only have weak micro foun­da­tions, their empir­i­cal per­for­mance is far from sat­is­fac­tory (Juselius and Franchi, 2007). Indeed, the rel­e­vant strand of empir­i­cal eco­nom­ics has more and more avoided test­ing their mod­els and has instead turned to cal­i­bra­tion with­out explicit con­sid­er­a­tion of good­ness-of-fit… It is pretty obvi­ous how the cur­rently pop­u­lar class of dynamic gen­eral equi­li­brum mod­els would have to ‘cope’ with the cur­rent finan­cial cri­sis. It will be cov­ered either by a dummy or it will have to be inter­preted as a very large neg­a­tive sto­chas­tic shock to the econ­omy, i.e. as an event equiv­a­lent to a large aster­oid strike…”

We believe that eco­nom­ics has been trapped in a sub-opti­mal equi­lib­rium in which much of its research efforts are not directed towards the most preva­lent needs of soci­ety. Para­dox­i­cally self-rein­forc­ing feed­back effects within the pro­fes­sion may have led to the dom­i­nance of a par­a­digm that has no solid method­olog­i­cal basis and whose empir­i­cal per­for­mance is, to say the least, mod­est. Defin­ing away the most preva­lent eco­nomic prob­lems of mod­ern economies and fail­ing to com­mu­ni­cate the lim­i­ta­tions and assump­tions of its pop­u­lar mod­els, the eco­nom­ics pro­fes­sion bears some respon­si­bil­ity for the cur­rent cri­sis. It has failed in its duty to soci­ety to pro­vide as much insight as pos­si­ble into the work­ings of the econ­omy and in pro­vid­ing warn­ings about the tools it cre­ated. It has also been reluc­tant to empha­size the lim­i­ta­tions of its analy­sis. We believe that the fail­ure to even envis­age the cur­rent prob­lems of the world­wide finan­cial sys­tem and the inabil­ity of stan­dard macro and finance mod­els to pro­vide any insight into ongo­ing events make a strong case for a major reori­en­ta­tion in these areas and a recon­sid­er­a­tion of their basic premises.”

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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