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 a professional economist 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 debts accumulated in Australia, and our very low rate of inflation.
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