An Economist’s Mea Culpa
By Uwe E. Reinhardt
Uwe E. Reinhardt is an economist at Princeton.
Update | 3:19 p.m.
If, like every university, the American Economic Association had a coat of arms, its obligatory Latin banner might read: “Est, ergo optimum est, dummodo ne gubernatio civitatis implicatur.” (“It exists, therefore it must be optimal, provided that government has not been involved.”)
With only minor injustice, one may take this as the overarching mantra to which the core of the economics profession marches. Government is accorded a beneficial role in this vision only to provide purely public goods, such as national defense; to remove private-market imperfections, such as monopoly power on either side of the market; or to deal with so-called spillover effects from private decisions, which economists call “externalities.” These exceptions aside, unquestioned belief in the sagacity, efficiency and beneficence of private markets reigns supreme.
These thoughts occurred to me as I attended the American Economic Association’s annual conference in San Francisco over the weekend. It offered a humongous smorgasbord of eloquent theory, clever econometric tricks, illuminating empirical insights and a few standing-room-only panel discussions on the shocking surprises the real economy served up as the economics profession was otherwise preoccupied during the past two decades or so.
Fewer than a dozen prominent economists saw this economic train wreck coming — and the Federal Reserve chairman, Ben Bernanke, an economist famous for his academic research on the Great Depression, was notably not among them. Alas, for the real world, the few who did warn us about the train wreck got no more respect from the rest of their colleagues or from decision-makers in business and government than prophets usually do.
How could the economics profession have slept so soundly right into the middle of the economic mayhem all around us? Robert J. Shiller of Yale University, one of the sage prophets, addressed that question in an earlier commentary in this paper. Professor Shiller finds an explanation in groupthink, a term popularized by the social psychologist Irving L. Janis. In his book “Groupthink” (1972), the latter had theorized that most people, even professionals whose careers ostensibly thrive on originality, hesitate to deviate too much from the conventional wisdom, lest they be marginalized or even ostracized.
If groupthink is the cause, it most likely is anchored in what my former Yale economics professor Richard Nelson (now at Columbia University) has called a ”vested interest in an analytic structure,” the prism through which economists behold the world.
This analytic structure, formally called “neoclassical economics,” depends crucially on certain unquestioned axioms and basic assumptions about the behavior of markets and the human decisions that drive them. After years of arduous study to master the paradigm, these axioms and assumptions simply become part of a professional credo. Indeed, a good part of the scholarly work of modern economists reminds one of the medieval scholastics who followed St. Anselm’s dictum “credo ut intellegam”: “I believe, in order that I may understand.”
An inference drawn from the profession’s credo is that private markets invariably are self-correcting and are driven by rational human beings whose careful decisions serve to allocate scarce resources efficiently — that is, these decisions maximize a nebulous thing economists call “social welfare.”
“Social welfare” in this view is thought to increase when those who gain from a change in the economy — e.g., a corporate restructuring or deregulation of the financial sector or increased foreign trade — gain more from the change than those who lose from it, even if the gainers had already been wealthy before the change and the losers poor. Thus, few economists were troubled by the explosion of executive compensation on Wall Street or elsewhere in corporate America. It was just the efficient market at work, rewarding these executives for the “value” they were creating. With their model of how the economy works, economists seem to have great difficulty recognizing bubbles in asset values and often are the last to recognize such bubbles, which is why the Fed has never addressed them.
As far as diagnoses of economic trends and predictions about the future are concerned, the profession’s preferred analytic structure and the groupthink it begets might work superbly well on planet Vulcan, whence hails the utterly logical Mr. Spock of “Star Trek” fame.
On Planet Earth, however, that analytic prism can seriously blur one’s vision. It simply cannot accommodate the fact that our entire 21st-century banking sector, managed as it is by graduates of the nation’s top business schools, supported by highly trained financial engineers, and monitored around the clock by thousands of allegedly bright financial analysts, immolated itself with highly toxic assets, purchased with borrowed money, and in the process infected the entire world economy.
And thus the economics profession slept comfortably as Wall Street was imploding. One can only hope that the medical profession would do better, should America ever be struck by a serious epidemic.