“The Twenty-First Century Will be the Age of Inductive Economics”

So says Barry Eichengreen:

The Last Temptation of Risk, by Barry Eichengreen, National Interest: The Great Credit Crisis has cast into doubt much of what we thought we knew about economics. … The question is how we could have been so misguided. One interpretation, understandably popular given our current plight, is that the basic economic theory informing the actions of central bankers and regulators was fatally flawed. The only course left is to throw it out and start over. But another view, considerably closer to the truth, is that the problem lay not so much with the poverty of the underlying theory as with selective reading of it… That … encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions’ decisions. The consequence was that scholarship that warned of potential disaster was ignored. …

[I]t was not that economic theory had nothing to say about the kinds of structural weaknesses and conflicts of interest that paved the way to our current catastrophe. In fact, large swaths of modern economic theory focus squarely on the kind of generic problems that created our current mess. The problem was not an inability to imagine that conflicts of interest, self-dealing and herd behavior could arise, but a peculiar failure to apply those insights to the real world. …

What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. … It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster. …

[A]mid the pervading sense of gloom and doom, there is at least one reason for hope. The last ten years have seen a quiet revolution in the practice of economics. For years theorists held the intellectual high ground. … The methods of empirical economists seeking to analyze real data were rudimentary by comparison. …

But the IT revolution has altered the lay of the intellectual land. … The data sets used in empirical economics today are enormous, with observations running into the millions. Some of this work is admittedly self-indulgent… But now it is on the empirical side where the capacity to do high-quality research is expanding most dramatically… And, revealingly, it is now empirically oriented graduate students who are the hot property when top doctoral programs seek to hire new faculty.

Not surprisingly, the best students have responded. The top young economists are, increasingly, empirically oriented. … To the extent that their work is rooted concretely in observation of the real world, it is less likely to sway with the latest fad and fashion. Or so one hopes.

The … twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.

Should this reassure us that we can avoid another crisis? Alas, there is no such certainty. … [entire article]

Originally published at the Economist’s View and reproduced here with the author’s permission.

One Response to "“The Twenty-First Century Will be the Age of Inductive Economics”"

  1. Guest   May 13, 2009 at 12:04 pm

    wow great article,