Posted by: Dirk | July 31, 2009

Paul DeGrauwe on economics fail

At the FT some people where asked to explain why economics failed (to predict the crisis). Here is Paul de Grauwe:

If we believe, as macroeconomists do, that consumers and producers are rational and fully informed agents, we do not worry that large debt build-ups will be harmful because this build-up must be the result of rational and fully informed decisions that will lead to a new equilibrium.

Thus an economic theory can work as a framing device conditioning us to interpret the facts in a way that is consistent with the theory. Psychologists call this a “confirmation bias”.

It should not be like that. After all, economics is a science (or should be one). And in science, theories should be formulated in such a way that they can be refuted. The main preoccupation of scientists should then be to try to refute these theories.

But that is not the way macroeconomics has evolved during the last two decades. Instead it has become a system of beliefs, some will say a religion, about rational and fully informed agents operating in efficient markets. This belief has become so strongly held that it has fallen victim to the confirmation bias. As a result, it has stopped being science.

I definitely can confirm this. From my experience as a PhD and then a research assistant dealing with international economics, it is just astonishing how some people think of economics. For some, it is no problem to accept breathtaking assumption about fundamental issues that many believe to be the core of the subject. Saving-investment imbalances? Nah, people are rational. Off-shoring will not stop to increase as long as China and the rest of the world piles up dollar reserves? Nah, that’s monetary stuff, that has nothing to do with it. It is impossible to make future generations poorer by adding to government debt because that depends on how the money gets spend? Oh come on, that is just liberal thinking.

My favorite meetings were those with mainstream macroeconomists of big institutions, like the Bundesbank or ECB. These people form a church, and without the right kind of passion (mathematics, loyalty, no sense for reality) you will never enter. It is these people and their networks that are responsible for the failure of economics. The economists outside the mainstream have been doing better: the Bank for International Settlements, Joseph Stiglitz, Paul Krugman, Axel Leijonhufvud and many more. Just as the bankers who failed should step down, I would like to see some mainstream economists to step down as well, or at least acknowledge their errors. But just as in the financial world it seems that some are too big to fail.


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