This may sound like common sense to investors and traders, but most people -- including policy makers -- do not readily accept the flawed nature of economic models.
Thank goodness we have professor David Colander testifying to Congress in order to enlighten an otherwise dim room. Colander's work at Middlebury College focuses on the incentives and work-product of economists. His work has become increasingly more important as economists have heavily influenced policy making in recent years.
In addition to exposing a few absurd underlying economic presuppositions such as "individuals behave with rational self-interest," Colander is helping shift incentives for professional economists away from publishing toward engaging in more useful studies. Based on these noble efforts to save us all from flawed economic models screwing up our daily lives, we are proud to award David Colander our third Medal of Honor for Excellent Service in addition to Josh Rosner and Chris Whalen ...
Damien Hoffman: David, what type of economics do you research and teach?
David: I'm called the "Court Jester of economics." I'm the person who says what everybody knows, but appropriate people know better than to say.
I'm an economist watcher. I look at the incentives economists face, then understand and interpret economics through those incentives. So, I look at the economics of economics of economists [laughs].
Most people assume economists are searching for truth. In reality, economists are searching to achieve certain institutional goals like getting tenure, publishing articles, or doing a whole variety of things which may be related to truth. Therefore, there's all kinds of incentive compatibility problems. What's happened in pure macro theory I have considered a travesty for a long time and have written about it for the last 20 years.
Damien: How did this travesty arise?
David: The models are useful and were useful at some point, but they quickly lost their usefulness. In order to make them manageable they had to use so many assumptions that they deviated so far from reality and ultimately stopped shedding light on reality.
Over time, we should have considered much more complicated non-linear dynamic models and a whole variety of new models -- but economists didn't do that. They kept dotting I's and crossing T's on a very restrictive equilibrium model which assumed away many of the most important elements that cause fluctuations and lead to the interesting effects that we see in the real macro economy.
Damien: How did this all lead to you testifying to Congress?
David: The Congressional Committee heard of that work and invited me for that reason.
Damien: When you testified and said the models are too rigid in the face of unpredictable human behavior constantly changing in real time, was that too scary for legislators whose role in society is to increase order and reduce chaos?
David: I hope not because that's reality. If reality is too scary, maybe some people think we have to hide it. I don't consider that especially scary at all. It's just a statement of common sense and the reality of what we know.
As opposed to moving on after discovering problems with the models, economists continued looking at the same model. Perhaps they did so to avoid the scary dimensions that would have all kinds of results happening.
Joseph Schumpeter once said when talking about these models that, "Most of the non-linear dynamic models that I favor have multiple equilibrium." And, he said, "You have to assume away all these multiple equilibria if economics is going to have any chance of being a science." I consider that absolutely wrong. You have to deal with the fact that there are multiple equilibria if economics is going to have any chance of being a science.
Damien: Over the past 20 years, economists have slowly altered their image as more of a hard science when in fact it's a social science. How do we return to understanding an economist's role in providing information instead of elevating them to a high priest of finance?
David: There are many different roles for economists. There's some roles for highly mathematical economists who analyze and study systems. There's some roles for people who understand the institutions. The problem is that economics has forgotten those advantages and gives people incentives to work only on fairly esoteric problems rather than practical problems. That has to do with the nature of incentives in academia.
Damien: How did you suggest Congress deal with these incentive issues?
David: The only way to change anything within the system is to change the incentive structure of the people who are operating there. That's a basic economic insight. The way to achieve progress isn't through regulation and telling people what to do. The way to do it is to change the incentives they face so their incentives match what you want them to do. Currently, the incentives in academia are for publishing articles written for other economists. And all economists compete in the same dimension.
My emphasis has been there should be multiple dimensions of competition -- multiple types of outlets for economic research. And, they should be equally rewarded. Economists need more cross-disciplinary input from outside. I suggest having a variety of people on the reviewing committee such as physicists, mathematicians, politicians, and business people.
My second suggestion was we need a lot more people with expertise in interpreting models -- people who can understand the reasons for the modeling, why it was done, and the mathematics behind it. Then, those interpreters will spend time in asking, "Is this particular model going to be useful for a particular problem?" Currently, there's no incentive for economists to ask these critical questions.
Damien: If economists are not focused on the efficacy of their models, what role should economists be playing as policy makers?
David: It depends on the particular economist. The training that economists get in graduate school does not prepare them to be policy makers. Instead, it prepares them to be article writers. Policy makers require a much broader sense and understanding. They need to know institutions. They need to know politics. They need to know a whole variety of issues. Some economists have that ability. Other economists don't.
A lot of economists don't have those skills because they're not trained in them. They have to learn them on their own. So, whether they should be policy makers or not depends upon the particular characteristics of the individual economist.
Damien: How has the Federal Reserve dealt with this problem?
David: I don't think the Fed can be condemned for causing the problem or praised for avoiding it. They're part of the whole overall system. However, they've told me in order to recruit the top economists, they've had to change their incentive structure. The only thing the young people want to do is continue publishing.
I get scared when the Fed gets more worried about publications rather than policy. In the past, the people at the Fed were promoted because they wrote good policy memos and provided good advice. Currently, Fed employees are being promoted in the research division by how much they publish.
Damien: David, thank you very much for all your hard work. We wish you the best in your efforts.
David: Thank you very much, Damien. I am honored you considered me for this award.