Discussion Paper

No. 2010-18 | July 12, 2010
On the Economic Crisis and the Crisis of Economics

Abstract

The outburst of the 2008 global economic crisis sparked a myriad of criticism on mainstream neoclassical economic theory, held responsible for not even have considered the possibility of the kind of collapse that the subprime mortgage meltdown unleashed. In this paper, it is argued that what happened was a case of malpractice by hundreds of economists in banks and rating agencies who created and certified as almost risk-free securities assets that were actually highly risky as the events after 2007 overwhelmingly showed. Such a massive case of malpractice denounces deep failures in the regulatory system. The deregulation movement that took place during the 1980s and 1990s was inspired by an almost religious belief in the power of market forces to solve any economic problem. Neoclassical economics can be blamed for creating the ideological climate which stimulated the deregulation movement in the U.S.A during those decades. After discussing some aspects of economics methodology, arguing the need to approach the economy as an interactive complex system, and discussing the use of mathematics in economics, it is argued that the main object of economists´ efforts should be economic illness rather than economic health. Finally, a list of 15 guidelines is sketched out for improving the methodological approach as well the contents of economic analysis.

Please find attached a new version which takes into account the referee reports, comments and recommendations received (same version as uploaded by the author in the comment/question section):

dp2010-18_revised_version

 

JEL Classification

A11 B41

Cite As

Victor A. Beker (2010). On the Economic Crisis and the Crisis of Economics. Economics Discussion Papers, No 2010-18, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2010-18

Assessment



Comments and Questions


Anonymous - Just a polemic
July 14, 2010 - 09:41

This is a polemic that adds not much. It collects many mostly valid points without elaborating on any of them or making connections. It ends with a number of recommendations such as "economists should be more open-minded." Further, it is not well written, in the sense that many paragraphs are ...[more]

... made up of a few sentences, and the subsequent paragraph adds another disconnected statement. There is no clear flow of the argument.

I would think that this is a useful discussion paper that could be improved by strengthening the structure of the argument, but I would be reluctant to view it as a productive contribution.


Victor Beker - Response to Anonymous
July 17, 2010 - 15:38

First of all, I want to thank Anonymous for reading and commenting my paper.
S(he) argues that it is a polemic that adds not much, although admits it collects many mostly valid points.
I am not quite sure if these two assertions are quite compatible between them...


Anonymous - Referee Report 1
July 26, 2010 - 11:52

See attached file


Anonymous - Response to Referee 1
July 29, 2010 - 15:50

See attached file


Thomas Mayer - On the Economic Crisis and Crisis in Economics
July 29, 2010 - 10:30

Here are my comments on the Beker paper

Thomas Mayer


Victor Beker - Response to Thomas Mayer
July 29, 2010 - 20:32

I want to thank Professor Mayer for reading my paper and commenting it.
His main remark is that the paper does not exhibit the characteristics of most journal papers and instead of concentrating on a narrow issue it covers a broad waterfront.
Professor Mayer is right but let ...[more]

... me quote in this respect David Colander: “Because there are few incentives within the profession to be reflective on the overall rationality of profession’s methods and ideas, few economists are reflective. Most are concerned with narrower issues…”*
I try to be reflective as Professor Mayer is, although it is true that researchers who think about broad issues are much less likely to advance in the field of economics.
I take notice of the observations on the formal aspects of the paper for a future version.
*David Colander (2009). Economists, Incentives, Judgment, and the European CVAR Approach to Macroeconometrics. Economics: The Open-Access, Open-Assessment E-Journal, Vol. 3, 2009-9.


Anonymous - Referee Report 2
August 24, 2010 - 08:29

see attached file


Victor Beker - Response to Referee 2
August 26, 2010 - 22:05

First of all, I would like to thank Referee 2 for his comment.
Referee 2 criticizes what he thinks is a contradiction between what is said on page 14 of the paper and what appears on the next page.
On page 14 it is argued that the departing point in ...[more]

... economics should not be the individual but economic aggregates. ¨These aggregates are the result of the behavior of many agents, all interacting with one another at once. So, collective behavior and not individual behavior should be the departing point of economic analysis.¨
On page 15 it is mentioned that at the Santa Fe Institute models of interacting particle systems in physics served as examples of how local interaction at the micro level may explain structure at the macro level. I think this may be one way of modeling the interacting behavior of agents, the result of which economic aggregates are.
My point is precisely that the departing point in physics is not a representative particle nor it is assumed how individual particles take decisions. The departing point is the collective behavior of particles. In the same way, the departing point in economics should be the aggregate behavior which results from the interaction of individual agents. The Santa Fe Institute models referred to in the paper may be a valid approach for this.


Anonymous - Reader Comment
August 24, 2010 - 08:38

see attached file


Victor Beker - response to Anonymous - Reader comment
August 24, 2010 - 17:07

Because of its seriousness I want to promptly answer one of the points made by Anonymous, who argues that the paper contains plagiarised text. He mentions the sentence "substantial lending to subprime borrowers was a recent phenomenon and historical data on defaults and delinquencies of this sector of the ...[more]

... mortgage market was scarce" and adds that he found this exact phrase in http://www.hbs.edu/research/pdf/09-060.pdf, p15, which is a working paper by Joshua D. Coval, Jakub Jurek and Erik Stafford.
The paragraph in which that sentence is included has a footnote reference (footnote number 13) which was meant to refer to the article published by the same authors in the Journal of Economic Perspectives, Vol. 23, Number 1, Winter, p. 15. Footnotes 10 and 13 refer to this article.
Unfortunately, I did not realize that on the final version of the paper I had inserted footnotes 11 and 12; so Ibid. seems to refer to another paper and this may have misguided the reader. So, it is not an issue of plagiarism, it is just a writing mistake.
In conclusion: footnote reference 13 should be read as Coval et al., p. 15 instead of Ibid, p. 15.


Victor Beker - New version
December 30, 2010 - 14:49

Please find attached a new version which takes into account the referee reports,comments and recommendations received


Anonymous - Better models for crises?
April 14, 2011 - 20:21

Victor Beker (VB) advocates more discussion across economic schools (1.6). I propose that this sensible suggestion be expanded to include other relevant expertises, as I have reason to think such dialogue will be fruitful. I hope to demonstrate some possibilities below, drawn from process modelling, process-control, and structured problem-solving.
For ...[more]

... my own purposes, I have evolved a simple flow-model of an economy. While this needs more work to put it on a firm basis, it serves as an example of what may be practical.
I also take two of VB's topics (economic models, and controls) for this partial discussion. Motivation and behaviour etc are outside my competencies, but are clearly rich topics for others.
My prototype model was devised using a consistent model-building methodology upon a minimum set of assumptions, and has only two independent parameters. There is almost no scope for ambiguous adjustments; it is either valid or not, and if not, prompts review of its underlying assumptions, thus asking some of VB's needed new questions (2.1). It makes specific, falsifiable assertions, such as:
> For stability, any economy has a required balance condition;
> Lacking this, it evolves to a limit (ie a crisis);
> One of the limits is characterised by some of:
Excessive spending by the financial sector
High-risk investment, leading to increased bad debt
Reduced productivity of the commercial sector
Capital inflow to the most-affected economies
Masking of the above while growth continues
which may be directly compared (say) with the record of the 2008-9 crisis. I believe that the testable, falsifiable models clearly desired by VB are possible, and that the views of Elster referred to (p4) are unduly pessimistic. Such models are neither "right" nor "wrong" (p9); simply invalid, valid, or (most likely) of bounded validity.
VB states that "The challenge is to arrive at a unified theory valid both for normal and abnormal times." (p20). This is, I believe, impractical. An economy may be an "interactive complex system", but most real-word processes are. For these, process-control distinguishes "in-control" and "out-of-control" states, each with its own operating procedure, set of controls, and model. The "in-control" model typically contains many simplifying assumptions (valid only within the bounds), and the "out-of-control" model may be purely qualitative. Which state, and thus which procedure and model is appropriate, is determined by a consistent statistical rule. I suspect current economics does not generally use this methodology, so this distinction (identified by VB) is worth emphasising, as is the associated construction of the independent models.
A notable exception to 1.3 is the "in-control" model type above. Judicious simplification of a complex exact model can give a fair approximation which has the merit of a mechanism open to review. Also, something known to be an approximation is less likely to be inappropriately applied.
Minimising model assumptions may be informative. Crashes may well be "an example of stampede phenomena" (p14), but from my simple model might also indicate a fundamental instability in the system. It is all too easy to return a verdict of "pilot error" and miss a hidden design defect in the aircraft.
Control theory includes the inference that lacking a capable metric, even a well-behaved process may not be controllable. None of my model's three parameters appears to be in general use, which suggests that either a commonplace assumption is false, or there are better metrics than the current ones.
Control theory also teaches that even with the most sophisticated control system, an ill-behaved (= barely stable) process may not be reliably controllable, whereas a well-behaved (= difficult to destabilise) process needs only a few rudimentary controls. Models such as mine are useable as testbeds for candidate additions to the functionality of an economy towards better intrinsic behaviour. VB (with many others) lists and debates many external economic controls, but makes no mention of the possibilities in internal structural changes which become visible through effective modelling.
Finally, a small quibble (1.1). In hard science, anything which explains well is a hypothesis; only if it successfully makes falsifiable predictions does it become theory (eg K Popper). By this stringent test, I suspect mainstream economics currently has more hypothesis than theory.
VB's "Crisis of Economics" may be no more than that economics' internal resources are no longer sufficient, and it should borrow judiciously from other expertises, as so many other successful sciences have.

My prototype model is computable, generalisable, and steady-state, but is far from what an economist understands by a CGE model. The dialogue I propose may require economists to adapt their vocabulary appropriately.