Tuesday, May 31, 2011

How has the crisis changed the teaching of economics?

The Economist has organized a discussion on how the teaching of economics may change in the wake of the recent crisis. Around 15 prominent economists have weighed in, with few suggesting anything radical. Harvard's Alberto Alesina suggests that indeed nothing so far has changed:
As for the methods of teaching and research nothing has changed. We kept all that is good about methods in economics: theoretical and empirical rigor. But one may say we kept also what is bad: a tendency to be too fond of technical elegance and empirical perfection at the expense of enlarging the scope of analysis and its realism. Those who found our methodology good should not worry about changes. Those who did not like it should not hold their breath for any sudden change due to the crisis.
But some of the others suggest that things are changing, and that the crisis has at least stimulated a renewed interest in economic history. Indeed, for all the consternation that economists didn't see this crisis coming, and didn't predict it, this isn't really the most surprising thing about the crisis. More surprising is how many economists seemed convinced that an event of this magnitude simply couldn't happen, and believed this despite centuries of history showing a never-ending string of episodic crises in countries around the world. Some economists did foresee trouble brewing, precisely because they took the past seriously as a guide to what could happen in the future, rather than mathematical theory. As Michael Pettis writes,

ONE of the stranger myths about the recent financial crisis is that no one saw it coming. In fact quite a lot of economists saw it coming, and for years had been writing with dread about the growing global imbalances and the necessary financial adjustments. In 2002 for example, Financial Policy published my article, “Will Globalization Go Bankrupt?” in which I compared the previous decade to earlier globalisation cycles during the past two hundred years and argued that we were about to see a major financial crisis that would result in a sharp economic contraction, bankruptcies of seemingly unassailable financial institutions, rising international trade tensions, and the reassertion of politics over finance. I even predicted that at least one financial superstar would go to jail.

How did I know? It didn’t require a very sophisticated understanding of economics, just some knowledge of history. Every previous globalisation cycle except one (the one cut short in 1914) ended that way, and nothing in the current cycle seemed fundamentally different from what had happened before. ... So how should the teaching of economics change? That’s easy. While mathematical fluency is very useful, it should not be at the heart of economics instruction. That place should be reserved for economic history.

That seems like an eminently sensible attitude. Moreover, modelling in economics ought to be much more strongly focused on understanding how past events and crises have emerged and why they appear to be inherent in the nature of economics systems -- just as natural as thunderstorms or hurricanes are in the Earth's atmosphere. This means, it would seem clear, moving outside the context of the profession's beloved general equilibrium models to study natural instabilities in a serious way.

In any event, I'm not convinced this discussion reflects adequately the deep dissatisfaction -- perhaps even embarrassment -- some economists feel over the state of their field. A good gauge of the stronger views held by a fraction of academic economists is the report written by those at the 2008 Dahlem Workshop in economics. The opening paragraph sets the tone:
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. 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.