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{{DES | des = [[Dani Rodrik]] laments that while economics has innumerable models, it has very few tools for deciding which model is appropriate.  He also points out that simple answers, such as support of free trade, rely on long lists of preconditions which are seldom met. | show=}}
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{{Quotations|Economics: Science, Craft, or Snake Oil?|quotes=true}}

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When economists skip over real-world complications, it’s as if physicists spoke of a world without gravity.

When the 2013 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (colloquially known as the “Economics Nobel”) was awarded to Eugene Fama and Robert Shiller, along with Lars Peter Hansen, many were puzzled by the selection. Fama and Shiller are both distinguished and highly regarded scholars, so it was not their qualifications that raised eyebrows. What seemed odd was that the committee had picked them together.

After all, the two economists seem to hold diametrically opposed views on how financial markets work. Fama, the University of Chicago economist, is the father of the “efficient market hypothesis,” the theory that asset prices reflect all publicly available information, with the implication that it is impossible to beat the market consistently. Shiller, the Yale economist, meanwhile, has spent much of his career demonstrating financial markets work poorly: they overshoot, are subject to “bubbles” (sustained rises in asset prices that cannot be explained by fundamentals), and are often driven by “behavioral” rather than rational forces. Could both these scholars be right? Was the Nobel committee simply hedging its bets?

While one cannot read the jury’s mind, its selection highlighted a central feature of economics—and a key difference between it and the natural sciences. Economics deals with human behavior, which depends on social and institutional context. That context in turn is the creation of human behavior, purposeful or not. This implies that propositions in economic science are typically context-specific, rather than universal. The best, and most useful, economic theories are those that draw clear causal links from a specific set of contextual assumptions to predicted outcomes.

So financial markets behave sometimes like Fama’s theory and sometimes like Shiller’s. The value of their respective theories is that they discipline our understanding of what type of financial market behavior to expect under specific conditions. Ideally, they also help us choose which model/theory we should apply in a particular conjuncture, although this happens too rarely as I will explain below. (Aptly, the third laureate, Lars Peter Hansen, was given his prize for devising statistical techniques to test whether markets behave in a fully rational fashion.)

What is true of finance is true also of other fields within economics. Labor economists focus not only on how trade unions can distort markets, but also how, under certain conditions, they can enhance productivity. Trade economists study how globalization can reduce or increase, as the case may be, inequality within and across countries. Open-economy macroeconomists examine conditions under which global finance stabilizes or destabilizes national economies. Development economists study conditions under which foreign aid does and does not reduce poverty. Training in economics requires learning not only about how markets work, but also about market failures and the myriad ways in which governments can help markets work better.

When Economists Misbehave

The flexible, contextual nature of economics is both its strength and its weakness. The down side was in ample display during the buildup to the global finance crisis and its aftermath. As the world economy tumbled off the edge of a precipice, critics of the economics profession rightly raised questions about its complicity in the crisis. It was economists who had legitimized and popularized the view that unfettered finance was a boon to society. They had spoken with near unanimity when it came to the “dangers of government over-regulation.” Their technical expertise—or what seemed like it at the time—had given them a privileged position as opinion makers, as well as access to the corridors of power. Very few among them had raised alarm bells about the crisis to come (Robert Shiller was one such Cassandra). Perhaps worse, the profession failed to provide helpful guidance in steering the world economy out of its mess. Economists’ opinion on Keynesian fiscal stimulus never converged, ranging from “absolutely essential” to “ineffective and harmful.”

Many outsiders concluded that economics was in need of a major shake-up. Burn the textbooks and rewrite them from scratch, they said.

The paradox is that macroeconomics and finance did not lack the tools needed to understand how the crisis arose and unfolded. In fact, without recourse to the economist’s toolkit, we cannot even begin to make sense of the crisis. What, for example, is the link between China’s decision to accumulate large amounts of foreign reserves and a mortgage lender in California taking excessive risks? It is impossible to decipher such interrelationships without relying on elements from behavioral economics, agency theory, information economics, and international economics. The academic literature is chock-full of models of financial bubbles, asymmetric information, incentive distortions, self-fulfilling crises, and systemic risk. Pretty much everything needed to explain the crisis and its aftermath was in fact in the research journals! But in the years leading up to the crisis, many economists downplayed these models’ lessons in favor of models of efficient and self-correcting markets, which resulted in inadequate government oversight over financial markets. There was too much Fama, not enough Shiller.

Economists (and those who listen to them) became over-confident in their preferred models of the moment: markets are efficient, financial innovation transfers risk to those best able to bear it, self-regulation works best, and government intervention is ineffective and harmful. They forgot that there were many other models that led in radically different directions. Hubris creates blind spots. The economics of the profession was fine; it was the sociology that needed fixing.



It is surprising that very little research is devoted in economics to what might be called economic diagnostics: figuring out which among multiple plausible models actually applies in a particular, real-world setting. Image courtesy of Newsart.

Economists and the Public

Non-economists tend to think of economics as a discipline that idolizes markets and a narrow concept of (allocative) efficiency at the expense of ethics or social concerns. If the only economics course you take is the typical introductory survey, or if you are a journalist asking an economist for a quick opinion on a policy issue, that is indeed what you will encounter. But take a few more economics courses, or spend some time in advanced seminar rooms, and you will get a different picture.

Economists get stuck with the charge of being narrowly ideological because they are their own worst enemy when it comes to applying their theories to the real world. Instead of communicating the full panoply of perspectives that their discipline offers, they display excessive confidence in particular remedies—often those that best accord with their own personal ideologies.

In my book The Globalization Paradox (W. W. Norton, 2011), I contemplate the following thought experiment. Let a journalist call an economics professor for his view on whether free trade with country X or Y is a good idea. We can be fairly certain that the economist, like the vast majority of the profession, will be enthusiastic in his support of free trade.

Now let the reporter go undercover as a student in the professor’s advanced graduate seminar on international trade theory. Let him pose the same question: Is free trade good? I doubt that the answer will come as quickly and be as succinct this time around. In fact, the professor is likely to be stymied by the question. “What do you mean by ‘good?’” he will ask. “And good for whom?”

The professor would then launch into a long and tortured exegesis that will ultimately culminate in a heavily hedged statement: “So if the long list of conditions I have just described are satisfied, and assuming we can tax the beneficiaries to compensate the losers, freer trade has the potential to increase everyone’s well-being.” If he were in an expansive mood, the professor might add that the effect of free trade on an economy’s growth rate is not clear, either, and depends on an altogether different set of requirements.

A direct, unqualified assertion about the benefits of free trade has now been transformed into a statement adorned by all kinds of ifs and buts. Oddly, the knowledge that the professor willingly imparts with great pride to his advanced students is deemed to be inappropriate (or dangerous) for the general public.

Consider some of the issues that we have to confront when we take on board just one of these complications—the redistributive consequences of globalization. To pass judgment on distributional outcomes, we need to know about the circumstances that cause them. We do not begrudge Bill Gates or Warren Buffett their billions, even if some of their rivals have suffered along the way, presumably because they and their competitors operate according to the same ground rules and face pretty much the same opportunities and obstacles. We would think differently if Gates and Buffett had enriched themselves not through perspiration and inspiration, but by cheating, breaking labor laws, ravaging the environment, or taking advantage of government subsidies abroad. If we do not condone redistribution that violates widely shared moral codes at home, why should we accept it just because it involves transactions across political borders?

Similarly, when we expect redistributive effects to even out in the long run, so that everyone eventually comes out ahead, we are more likely to overlook reshufflings of income. That is a key reason why we believe that technological progress should run its course, despite its short-run destructive effects on some. We might also want to consider the consequences for others around the world who may be made significantly poorer than those hurt at home. When, on the other hand, the forces of trade repeatedly hit the same people—less educated, blue-collar workers—and benefit the relatively wealthy abroad, we may feel less sanguine about globalization.

Too many economists are tone-deaf to such distinctions. They are prone to attribute concerns about globalization to crass protectionist motives or ignorance, even when there are genuine ethical issues at stake. By ignoring the fact that international trade sometimes—certainly not always—involves redistributive outcomes that we would consider problematic at home, they fail to engage the public debate properly. They also miss the opportunity to mount a more robust defense of trade when ethical concerns are less warranted.

Economics instruction suffers from the same problem. In their zeal to display the profession’s crown jewels in untarnished form—market efficiency, the invisible hand, comparative advantage—economists skip over the real-world complications and nuances. It is as if introductory physics courses assumed a world without gravity, because everything becomes so much simpler that way. Downplaying the diversity of intellectual frameworks within their own discipline does not make economists better analysts of the real world. Nor does it make them more popular.

Economics Hijacked

When the stakes are high, it is no surprise that battling political opponents use whatever support they can garner from economists and other researchers. That is what happened recently when conservative American politicians and European Union officials latched on to the work of two Harvard professors—Carmen Reinhart and Kenneth Rogoff—to justify their support of fiscal austerity.

Reinhart and Rogoff had published a paper that appeared to show that public-debt levels above 90 percent of GDP significantly impede economic growth. Three economists from the University of Massachusetts at Amherst then did what academics are routinely supposed to do—replicate their colleagues’ work and subject it to criticism.

Along with a relatively minor spreadsheet error, they identified some methodological choices in the original Reinhart–Rogoff work that threw the robustness of their results into question. Most important, even though debt levels and growth remained negatively correlated, the evidence for a 90 percent threshold was revealed to be quite weak. And, as many have argued, the correlation itself could be the result of low growth leading to high indebtedness, rather than the other way around.

Reinhart and Rogoff strongly contested accusations by many commentators that they were willing, if not willful, participants in a game of political deception. They defended their empirical methods and insisted that they are not the deficit hawks that their critics portrayed them to be.

The Reinhart-Rogoff affair was not just an academic quibble. Because the 90 percent threshold had become political fodder, its subsequent demolition also gained broader political meaning. Despite their protests, Reinhart and Rogoff were accused of providing scholarly cover for a set of policies for which there was, in fact, limited supporting evidence. Clearly, better rules of engagement are needed between economic researchers and policymakers.

One approach that does not work is for economists to second-guess how their ideas will be used or misused in public debate and to shade their public statements accordingly. For example, Reinhart and Rogoff might have downplayed their results—such as they were—in order to prevent them from being misused by deficit hawks. But few economists are sufficiently well attuned to have a clear idea of how the politics will play out. Moreover, when economists adjust their message to fit their audience, the result is the opposite of what is intended: they rapidly lose credibility. This is clearly what has happened in the globalization debate, where such shading of research is established practice. For fear of empowering the “protectionist barbarians,” trade economists have been prone to exaggerate the benefits of trade and downplay its distributional and other costs. In practice, this often leads to their arguments being captured by interest groups on the other side—for example, global corporations that seek to manipulate trade rules to their own advantage. As a result, economists are rarely viewed as honest brokers in the public debate about globalization.

So What Kind of Science is Economics?

The firestorm over the Reinhart–Rogoff analysis overshadowed what in fact was a salutary process of scrutiny and refinement of economic research. Reinhart and Rogoff quickly acknowledged the spreadsheet mistake they had made. The dueling analyses clarified the nature of the data, their limitations, and the difference that alternative methods of processing them made to the results. Ultimately, Reinhart and Rogoff were not that far apart from their critics on either what the evidence showed or what the policy implications were.

So the silver lining in this fracas is that it showed that economics can progress by the rules of science. No matter how far apart their political views may have been, the two sides shared a common language about what constitutes evidence and—for the most part—a common approach to resolving differences.

Economics, unlike the natural sciences, rarely yields cut-and-dried results. Economics is really a toolkit with multiple models—each a different, stylized representation of some aspect of reality. The contextual nature of its reasoning means that there are as many conclusions as potential real-world circumstances. All economic propositions are “if-then” statements. One’s skill as an economic analyst depends on the ability to pick and choose the right model for the situation. Accordingly, figuring out which remedy works best in a particular setting is a craft rather than a science.

One reaction I get when I say this is the following: “how can economics be useful if you have a model for every possible outcome?” Well, the world is complicated, and we understand it by simplifying it. A market behaves differently when there are many sellers than when there are a few. Even when there are a few sellers, the outcomes differ depending on the nature of strategic interactions among them. When we add imperfect information, we get even more possibilities. The best we can do is to understand the structure of behavior in each one of these cases, and then have an empirical method that helps us apply the right model to the particular context we are interested in. So we have “one economics, many recipes,” as the title of one of my books puts it (One Economics, Many Recipes: Globalization, Institutions, and Economic Growth, Princeton University Press, 2007). Unlike the natural sciences, economics advances not by newer models superseding old ones, but through a richer set of models that sheds ever-brighter light at the variety of social experience.

It is surprising, therefore, that very little research is devoted in economics to what might be called economic diagnostics: figuring out which among multiple plausible models actually applies in a particular, real-world setting. Economists understand well the theoretical and empirical predicates of, say, Fama’s or Shiller’s models; but they lack systematic tools to determine conclusively whether it is one or the other that best characterizes Wall Street today or mortgage markets in 2007, for example. When they engage the real world, this leads them to render universal judgments rather than conditional ones—picking one model over the other instead of navigating amongst them as the circumstances require. The profession places a large premium on developing new models that shed light on as yet unexplained phenomena; but there seems little incentive for research that informs how appropriate models and remedies can be selected in specific contexts. My colleagues and I have brought such ideas to bear on problems of growth policy in developing countries. But clearly this ought to be part of a much more general research agenda. Over time, of course, good economists develop a knack for performing the needed diagnostics. Even then, the work is done instinctively and rarely becomes codified or expounded at any length.

Unfortunately, empirical evidence in economics is rarely reliable enough to settle decisively a controversy characterized by deeply divided opinion—certainly not in real time. This is particularly true in macroeconomics, where the time-series data are open to diverse interpretations. Those with strong priors in favor of financial market efficiency, such as Eugene Fama, for example, can continue to absolve financial markets from culpability for the crisis, laying the blame elsewhere. Keynesians and “classical” economists can continue to disagree on their interpretation of high unemployment.

But even in microeconomics, where it is sometimes possible to generate precise empirical estimates using randomized controlled trials, those estimates apply only locally to a particular setting. The results must be extrapolated—using judgment and a lot of hand waving—in order to be applied more generally. New economic evidence serves at best to nudge the views—a little here, a little there—of those inclined to be open-minded.

“One thing that experts know, and that non-experts do not,” the development economist Kaushik Basu has said, “is that they know less than non-experts think they do.” The implications go beyond not over-selling any particular research result. Journalists, politicians, and the general public have a tendency to attribute greater authority and precision to what economists say than economists should really feel comfortable with. Unfortunately, economists are rarely humble, especially in public. And it does not help that what gets academic economists ahead in their career is cleverness, not wisdom. Professors at top universities distinguish themselves not by being right about the real world, but by devising imaginative theoretical twists or developing novel evidence. If these skills also render them perceptive observers of real societies and provide them with sound judgment, it is hardly by design.

So economics is both science and craft. Ironically, it is the neglect of the craft element—aiming to elevate economics’ status as science—that occasionally turns it into snake oil. 

Recommended Viewing: “Past, Present, and Future of Economic Convergence,” a lecture given by Dani Rodrik at the Institute in October, may be viewed at http://video.ias.edu/2013-10-25-rodrik. 
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