Special Report: Crisis forces "dismal science" to get real

LONDON Tue Jul 3, 2012 2:52am EDT

1 of 5. Italian language economics textbooks are seen on display in this picture illustration at a book store in Milan June 28, 2012.

Credit: Reuters/Alessandro Garofalo

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LONDON (Reuters) - As economics teachers struggle to make sense of a post-crisis world, they may have an unlikely army of helpers: ants.

In September 2008, the same month that Lehman Brothers collapsed, the Argentinian ants became the unwitting stars of a German television show that set out to illustrate collective efficiency. To the frustration of the show's producers, the insects ended up showing how easily rational expectations can go awry.

The ants - Linepithema humile - had a choice between a long route and a short one to get to a pile of food. In theory, their chemical communication and millions of years of evolution should have led them to work out the short route.

They chose the long one, and most kept using it even though some had found the shorter path. "The Germans were furious," said economics professor Alan Kirman, whose neuroscientist friend and colleague Guy Theraulaz ran the experiments in the south of France.

Kirman, professor emeritus at Aix Marseille University and France's Ecole des Hautes Etudes en Sciences Sociales, has started to use the footage in a talk he gives about modern economic thinking. The insects were far from efficient, he said, but reached their goal in the end.

"I think the economy is a lot like that."

There lies a hint of the revolution that is building at the heart of academic economics, particularly in Europe.

As the euro zone crisis deepens, economists in France, Germany and Italy have been forced to turn away from classroom theories and look at the real world - from insects to financial markets, from banks to brain scans - to better understand what's going on. An increasing number of teachers argue that the textbooks, some by experts who didn't see the crisis coming, are divorced from reality, inconsistent, dull, and, in a crisis that has gripped the globe for more than four years, even dangerous.

"A crisis is a wonderful opportunity in some sense," said Kirman. "If it weren't for the fact that millions of people are suffering as a result, what better time to be an economist, because now you can see what's going wrong with our theory."

ROBOT BREAKDOWN

To suggest economies were not generally efficient would, until very recently, have been heresy in many classes.

The modern theoretical framework began to emerge in the 1980s by Nobel Prize winner Robert Lucas, the John Dewey Distinguished Service Professor of Economics at the University of Chicago. Lucas said economic models should be something you could put on a computer and run - "a mechanical artificial world populated by interacting robots." If it wasn't in the model, it couldn't happen. The collapse of the financial system, for example.

Others helped build on this idea. New Keynesians took a slightly different tack, including assumptions about market failure but still resting on the idea people behave rationally.

After the turn of the century, Lucas even suggested economists had cracked one of the profession's biggest questions. "The central problem of depression-prevention has been solved," he wrote in 2003.

Four years later, Roger Farmer, a professor of economics at the University of California in Los Angeles, was at a dinner at the Bank of England to celebrate the "Great Moderation", a term coined to describe an era in which some politicians claimed monetary policy had ended boom and bust. "We had entered a new era of economic prosperity," he recalled in a paper this February.

That night, British building society Northern Rock went under, heralding the start of Europe's crisis and a global backlash against economists.

Why didn't they see it coming, the Queen of England asked on a 2008 visit to the London School of Economics. "The Economist" magazine wrote of a "dark age of macroeconomics".

Economists began to ask how the profession had been blind to the fact that its theories were leading people down the wrong path - rather like Kirman's ants.

That debate continues, charged with political thunder. Diane Coyle, a UK-based economic consultant who is compiling a book on how economics teaching needs to change after the crisis, says it can't be separated from a backlash in Europe against free market liberalism. But whatever their politics, a significant number of economics teachers in both Europe and the United States think it's time for a new, more pragmatic approach.

Around one in five respondents to a 2010 survey of economics instructors by the St Gallen university in Switzerland said their profession needed a "major reorientation or new paradigm." Even those who thought the curriculum was more or less fine said they had started paying more attention to financial markets, banks or speculative bubbles, and included real world context.

Last year Coyle organized a conference on teaching post-crisis economics. Topics ranged from high theory to whether economists could expect to find employment.

Most economists graduating today would not be equipped to read the Financial Times, according to British economist John Kay, who argued they have for too long conflated the abstract and the real.

"CHERISHED BELIEFS"

On a wall in the lobby of the Bocconi University in Milan, the script on an artwork plays on a Christian prayer:

"Et Dimitte Nobis Debita Nostra." (And forgive us our debts)

Established in 1902, Bocconi was the first university in Italy to grant a degree in economics. Prime Minister Mario Monti was rector there from 1989 to 1994 and dozens of top Italian officials and bankers have attended. It is, in most ways, a cathedral to orthodox economic thinking.

That's now changing.

"All the macroeconomic paradigms have been put in discussion since the 2007 crisis," said Stefano Gatti, its Director of Bachelor of Economics and Finance.

Bocconi students use a European edition of a leading textbook by Olivier Blanchard, the IMF's chief economist. Like the other main volume, by Harvard professor Gregory Mankiw, it has been updated to take in the crisis. But an update may not be enough.

Blanchard, who in August 2008 had declared that "the state of macroeconomics is good", wrote in a 2011 blog that "our most cherished beliefs" had been brought into question by the crisis.

"The paradigm that the market corrects itself, on which all the traditional economists such as Blanchard and Mankiw base their theories, is on the rocks," said Gatti. "What the traditional theories do not consider is that the financial market must be regulated. A too-liberalized market creates monsters."

Both Blanchard and Mankiw declined to comment for this article.

Francesco Saita, dean of Bocconi's Graduate School and professor of financial markets and institutions, said teachers are bringing newspapers and academic papers into class, and Bocconi has invited leading bankers and economists to address students.

"Students need fewer economic models and more methods to understand the uncertainty," said Giovanni Valotti, professor of public management.

Alessandro Cofano, a third-year economics student, said questions are constantly raised about why the formulae and graphics published in the manuals cannot be found in real life.

"TERRIBLY FLAWED"

The drive for change is also evident in Germany, where Professor Peter Bofinger is passionate about the shortcomings of the main texts. Bofinger is head of monetary policy and international economics at the University of Wuerzburg and one of five "wise men" who formally advise Chancellor Angela Merkel.

He also thinks most text books are dangerous.

The author of a textbook himself, he didn't bother to read the modern texts, he said. But last year, he did a systematic analysis, and what he found shocked him.

"To me the most astonishing thing was that all these textbooks do not find an analytical explanation of unemployment," he said. "I was really amazed."

Up to one in four people can't find work in parts of Europe, and the reality of people who are unemployed without choosing to be is one of the biggest holes in mainstream theory, for Bofinger and others. In orthodox teaching, supply and demand in the labor markets should fix unemployment leaving just those people who choose not to work in the dole queue.

Bofinger also finds it incredible that the standard model does not allow for people to behave in a way that reflects uncertainty about the future. According to the theory, a Spanish person losing their job today, for instance, would act as if they knew they would find another job within a year.

In reality, it may take far longer: one of several truths economists say is ignored by the main theory.

"It's so terribly flawed," said Bofinger. "If students of medicine would learn such rubbish, you would be afraid to go to your doctor, no?"

THRILL OF THE MIDDLE

Most economists reject such wholesale criticism. But they do question how far the conventional approach to modeling has blinded people, Coyle says. "The gap between the interesting questions or real-world problems and the workhorse economics being taught to students at all levels has become a chasm."

Simon Evenett, professor of international trade and economic development at St Gallen University, said macroeconomists had ignored the financial system in most of their models, and the finance guys missed economic linkages. "That intellectual separation has been the cause of a lot of misdiagnoses."

London School of Economics economics professor Charles Goodhart told a conference macroeconomists had been "totally and egregiously hopeless." Their assumption that everyone in an economy can borrow at the same risk-free rate "blows one's mind, the degree of intellectual error."

Kirman was a theoretician until the mid-1970s and now studies behavioural economics, a branch of the discipline that began questioning mainstream theories long before the crisis.

He and a group of like-minded scientists are working on a project that focuses on the flaws in big economic theories and in economists' understanding of financial markets. He has used insect behaviour as the basis of insights into different economic models.

Kirman and others think it might be beneficial to look at how individuals interact and work together in networks. Such thinking is still fringe, though influential figures such as Jean Claude Trichet, the former governor of the European Central Bank, and UK central banker Andrew Haldane, have taken an interest.

Haldane co-wrote a 2011 study of how the work of ecologists could be used to understand the risks in the financial system. He has argued that looking at the way people interact - for instance, by anticipating what others will do - could provide a more sound basis for prediction than economists' current models.

Such thinking sits right in between the two main areas of the discipline: macroeconomics and microeconomics.

"When you teach students nowadays you teach them microeconomics and macroeconomics - what happens to the individual and what happens on the aggregate level - and you don't worry about what happens in between the two because you assume that the aggregate behaves like one individual," Kirman said. "What I would argue is that all the interesting stuff happens in the middle - the interaction between people and the changes that occur."

Kirman is one of many who think such ideas will start to change the ‘dismal science'. Others, including UCLA's Farmer, believe the greater availability of data online can help reshape economics completely. Digital processing, he believes, will do for economics what the telescope did for astronomy. "The way we teach our students will be changed in a fundamental way by the lessons we learn from the current crisis," he said.

For Paul Seabright, Professor of Economics at the University of Toulouse, the crisis has highlighted the way economists have long been hungry for something more "grounded in the scientific method."

New tools from psychology and neuroscience can show what really motivates people, he said. For example, it's well established that people in financial markets are strongly influenced by their testosterone levels. "Textbook economic man is only influenced by the returns and the risk."

As trillions of euros are piled into failing banks, many economists think their profession needs to get a lot more humble. "We need people whose idea of the big picture isn't based on some dominating gestalt that forces the detailed evidence to fit a big frame," said Seabright.

The Argentinian ants certainly didn't fit the frame. Theraulaz, who specialises in swarm intelligence, believes they were probably deterred by strong lights shining onto the shorter path that the film crew wanted them to take. Then the presence of chemicals on the longer path created a precedent.

Would they otherwise have chosen the short route? "No," said Theraulaz. "The initial choice is made at random."

(Antonella Ciancio reported from Milan; Additional reporting by Robert-Jan Bartunek in Brussels, Alessandra Prentice, David Milliken and Alan Wheatley in London; Editing by Simon Robinson and Richard Woods)

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Comments (36)
reuterskostas wrote:
The fact that economy is based on behavioral aspects is known to us “common people” for a long time. Simply look at all these millions of people who everyday go and buy packets who write with large letters “SMOKING DAMAGES YOUR HEALTH”. Tobacco industry is a multi billion industry. Its a simple example illustrating the irrationality of our economic choices (at least).

I think that psychology, neuroscience, history and a “new breed of mathematics” which connect the other three, need to be employed in order to create “models” that can approach the reality (up to a point). The factor of “randomness” will of course be quite dominant. No matter what we people believe, God plays with dices.

In the meantime, lets pray that God wins and will reduce the suffering of the people populating the real economy.

Jul 03, 2012 2:26am EDT  --  Report as abuse
reuterskostas wrote:
The fact that economy is based on behavioral aspects is known to us “common people” for a long time. Simply look at all these millions of people who everyday go and buy packets who write with large letters “SMOKING DAMAGES YOUR HEALTH”. Tobacco industry is a multi billion industry. Its a simple example illustrating the irrationality of our economic choices (at least).

I think that psychology, neuroscience, history and a “new breed of mathematics” which connect the other three, need to be employed in order to create “models” that can approach the reality (up to a point). The factor of “randomness” will of course be quite dominant. No matter what we people believe, God plays with dices.

In the meantime, lets pray that God wins and will reduce the suffering of the people populating the real economy.

Jul 03, 2012 2:26am EDT  --  Report as abuse
Parker1227 wrote:
Keynesians and socialists are all big gov parasites whose delusional dreams have depended upon funding by hard working free-market capitalists.

Now that they are killing the host, now that these dreams have become living (unfunded) nightmares, these same leftist sophists (who own 98% of our universities) are determined to throw a fog over the failure of their leftist ideologies.

Jul 03, 2012 3:04am EDT  --  Report as abuse
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