Home > economics profession, financial markets > the crisis and the culpability of macroeconomic theory

the crisis and the culpability of macroeconomic theory

It is the ideas at the heart of modern macroeconomics which provided the intellectual justification of the economic policies of the past 10 to 15 years.  They bear a direct responsibility for the serious nature of the crash.  

The dominant paradigm in macroeconomic theory over the past 30 years has been that of rational agents making optimal decisions under the assumption that they form their expectations about the future rationally –  the rational agent using rational expectations, or RARE for short.

The specific problem is  the way in which RARE economics deals with risk and uncertainty.  It is this which is at the root of the crises, both for the discipline of economics and, much more importantly, for the economy itself.

RARE macroeconomics  provided the intellectual underpinning for a world in which situations involving risk led to it being systematically underestimated, and in which situations of genuine uncertainty were not recognized for what they were.

It is only by ignoring completely any aspect of RARE macroeconomic theory that the authorities managed to avoid a crisis on the scale of the Great Depression.  Effectively, they threw the last 30 years of mainstream macro into the trash can.

It surely now is time to scrap once and for all this RARE view of the world.  Central banks should ditch their DSGE models.  Funding agencies should no longer support RARE proposals.

These arguments are developed in a paper written for the British Academy of Social Sciences and available on my website http://www.paulormerod.com

  1. John Troughton
    November 4, 2009 at 10:48 pm

    Action Management: The only way to go
    Systems manage all of human actions which are allocated to various parts of the human to perform.
    They involve 500 trillion synaptic connections, 100 billion neurons with 1 million connections per sec.
    The actions are “judged” by other humans as behaviour.
    Businesses have 1000’s of actions that have to be integrated and allocated to individuals to perform.
    They can only be managed (and optimised) as systems, some of which can be automated.
    Each and all actions have to be assessed at the planning, action and impact stages for their social responsibility (minimum Triple Bottom Line) (modern PDCA with integrity)
    The output of the human actions plus the business actions is the business reputation.
    How simple and logical is that?

  2. November 5, 2009 at 3:40 am

    abstractly i’m a fan of general equilibrium theory, of which rare can be viewed as a subset theory. but its like the ideal gas—-abstractly interesting (second law) though obviously with limited application.

    however, i’d slightly alter the definition of the problem with RARE—beyond risk and uncertainty, i’d add bias, including the tendency of people to ‘follow the leader’, ‘be obediant to authority’, conform to culture or tradition or rules, etc. Those can be ways of dealing with uncertainty (or bounded rationality—lack of perfect information), but they emphasize that alot of people think they are rationally responding to uncertainty when they actually are quite certain about their decisions because they have been programmed.

    I also think people like Arrow who originated GET in its most abstract form, was quite aware of this (even arguing if I recall in the 70’s that ‘the economics of information’ was the field of the future), so in some ways it is not the theory itself that is the problem but its ideological/social use. (My impression is people like Lucas pretty much follow the ideological approach, and sweep any apparent imperfections observed in real data as external schocks or noise).

  3. charlie
    November 5, 2009 at 5:01 am

    I was impressed by mathematician Rene Mandelbrot’s analysis prior to the crash

    The (Mis) behavior of Markets … any comments from bloggers??

  4. November 5, 2009 at 8:10 am

    I do not think that the so called ‘mainstream economics’ failed at least in its main objectives. This bunch of ‘ideas’ can be considered very unacceptable from any logical or empirical standard but they got a tremendous success because they provided, dressed with academic authority, the legitimacy to justify anti popular policies. And in this sense the mainstream or products like the ‘RARE’ got its main objective. They are a perfect product of the ‘ideological cold war’. I think that they are unacceptable and very bad scientific products, but very good ideological tools. In fact, it won a lot of money and power for their mentors. Everybody got what they wanted: some academics got Nobel prices and money, politicians could cover their conservatives and unpopular ideas with the respectable dress of the academic discourse and they got power and money, executives got huge amounts of money even when their enterprises experienced bad results, so who needs to be worried about the scientific or political quality if prices, votes and bonus were so easy to win?

    And, of course, everybody with a minimal open mind could find a lot of good and critical work, mainly by colleagues outside the USA. But this points to another problem. Mr Gorbachev said recently that USA needs its own perestroika. I think that this can be said of the USA academy too.

    Best regards

  5. giuseppe russo
    November 5, 2009 at 3:19 pm

    I agree totally with the limits of RARE macroeconomics but we cannot entrust our safety to a new responsible behaviour of the institutions, FED or others. The guarentee against the overflowing of the financial capitalism is the law, or better a system of laws, as in the case of antitrust rules, indipendent from the factual economic dynamics even in the medium-long run. Surely it was RARE logics with a seeming support of weak economic cycles to feed the general deregulation of the financial markets, as the investment rules of the pension funds, the total freedom of the investment banks, etc., the leverage, etc from the Reagan time to the first Wall Street bubble. Obviously it is not enough restore the past limits but even to create new ones to the new financial tools, as the derivates.

  6. Dave Taylor
    November 5, 2009 at 3:39 pm

    Paul’s argument and all four previous comments were to the point. My own slant is that rational agents should rationally expect themselves as well as others to make mistakes which generate systematic noise, and after sixty years of Shannon/Weiner information error control and forty of Chomsky/Algol68 open linguistic systems, it is (as Mart indicates) not rational to ignore the context rather than evolve ways of recognising and correcting the unconsidered causes of unintended effects: especially the crucial effect (Miguel’s point) of inverted aims: assuming economics is about information (money) rather than human ecology.

    Looking up what DSGE was all about, I mistakenly threw up DSRG (Dependable Software Research Group), which is very relevant to what I have just said, as well as to safety-critical consideration in my own field of work. Looking up DSGE (Dynamic Stochastic General Equilibrium), that seems to hinge on an idealist Humean interpretation of Bayesian statistics in which likely effects on real context are reduced to updating imperfect knowledge. More generally, the matrix methods used in economic modelling seem similarly flawed, assuming that vectors relate to Grassman (multiple one-dimensional) rather than Hamiltonian (quaternion) space: the latter being one real space with exactly three independent degrees of freedom. [Cf. D E Littlewood, “The Skeleton Key of Mathematics”, pp. 102-6; Arthur M Young, “The Geometry of Meaning”].

    Something for Paul (and Tony Lawson) to think about?

  7. November 5, 2009 at 4:27 pm

    Paul: I agree RARE has to be front and centre in the blame game. There is a direct and tight connection between RARE as it exists in the minds of academic theorists, and as it exists in the risk models on Wall Street. The theory became a technology in the hands of people who were taught we had cracked human behavior. I do not blame them. I blame their teachers. When theorists tolerate the development of real world policy and commercial activity on the basis of their theories then their ethical response to its apparent failure should be to apologize and change their theory. I have yet to witness such a display of ethics.

    On the broader point others here have raised: the economy is irretrievably complex. The reference above to the second law holds the key: why pursue something like GET that we know lies beyond the limits of our knowledge?

  8. September 29, 2011 at 9:32 pm

    Excellent. Kudos to one & all. Yet, to take it all to the next level and, once & for “all” repudiate and dethrone sociopathic exploitation (that happens to lethally harm billions of dupes AKA children, elders, animals, etc.) posing as RAREified academic absurdity posing as rational academic theory & economic policy, shouldn’t we start discussing the strategy for initiating prosecution, litigation & restitution or, at least, emergency triage & therapy? Come on, we’re talking about sociopaths getting away with the most massive fraud (& crimes against humanity & peace) in the history of the world, possibly ecocide. Are you going to go down with the Titanic while rearranging the deck chairs for a better view or rise to the occasion and save the lower class passengers from drowning in the lower decks? Actually, it seems to me that acting as expert RWE doctors & witch doctors & exorcists, you can save the whole world by turning the NeoLib N-CE Titanic into a giant starship. Cheers & Victory

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