On Economics: New Paradigm or History of Flaws

Barry Ritholz, author of economics blog, The Big Picture, provides an interesting look into the flaws of economics as a profession.  His post is named, “Hubris of Economics.”

Economics has had a justifiable inferiority complex versus real sciences the past century. It has attempted to overcome this by throwing lots of smart mathematicians at its practice, in an attempt to make the social art seem more “sciency,” and thus  more credible. This had led to lots and lots of formulas and models. The problems is, Economics places way too much weight on these. It creates an illusion of precision where none exists. The belief in their models led to all manner of mischief, from subprime to derivatives to risk management.

And he continues on with an excerpt from the Wall Street Journal piece by Mark Whitehouse:  Crisis Compels Economists to Reach for New Paradigm.

“The past century saw two revolutions in the way economists view the world. Both required painful crises to set them in motion, but both arguably improved government’s ability to manage the economy.

The first came after the Depression, when economists built some of the first mathematical models that policy makers could use to try to manage the economy. The second came after the inflationary 1970s, when economists created new models that took into account how people’s expectations, such as about prices or income, can influence the economy over time.

During the second revolution, the U.S. economy entered a period of stability and low inflation that lasted from the 1980s through most of the 2000s, leading many economists to believe they had triumphed over business cycles. As Robert Lucas of the University of Chicago, one of the intellectual fathers of the models, put it in 2003: The “central problem of depression-prevention has been solved…for many decades.”

The result was a new orthodoxy, known as “rational expectations,” that still dominates, underpinning everything from the way pension funds invest to how financial analysts put values on securities. Among its main branches is the idea that markets are “efficient,” meaning that even an uninformed investor can get a fair shake, because the price of any security tends to reflect all available information relevant to its value.