Feb26

And you think I’m ornery? The Dahlem Report

by Steve Keen on February 26th, 2009 at 2:19 pm
Posted In: Debtwatch

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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.”