I am just returning from the 12th Conference of the Society for the Advancement of Economic Theory at the University of Queensland, which was very successful in that a great many economic theorists from all over the world got together and presented their work. I presented my recent work on falsifiability, complexity, and revealed preference in a session devoted to revealed preference theory.
One of the sessions was a panel discussion on the question “What Can Theory Tell Us About the Financial Crisis?” (My comments below may reflect my (mis)interpretations.) The moderator, Rohan Pitchford (Australian National University) foreshadowed some of the comments to come by stating at the outset that the panelists should feel free to turn that question around, asking what the financial crisis can tell us about economic theory. Some of the comments made were expected—for example, that theory has, of course had everything about the crisis figured out, just take a look at (Name, Year), and (Name, Year), and (Name, Year)… you get the picture. Even granting that (Name, Year) were all brilliant, this is hardly answering the question in a satisfactory way. Another point, often said, but not without reason, is that one should not expect economic theorists to be able to predict when a crisis would take place, and predicting that there would be one (some time) is hardly news. In fact, if the crisis could be predicted correctly, it is often repeated, it wouldn’t take place! And if it did, (some) economic theorists would be very rich.
But some of the panelists made some interesting points. Stephen Morris (Princeton), for example, realized when the crisis hit that some of the research he was working on at the time was actually explaining the crisis. Then, he said, he realized that a bunch of other theorists came to the same realization! I suppose one way to put that would be: if you’ve got a hammer, you see every problem as a nail. But Morris’s point was that all these people actually did have a unique perspective on explaining some aspect of the crisis, and therefore the crisis has given economic theorists a great opportunity to think about how the multitude of perspectives that economic theory brings to explaining the crisis can be reconciled, how they complement each other. This synthesis has not really taken place, however, and if it doesn’t, that would be a crisis wasted, for economic theory, at least.
Andrew McLennan (University of Queensland), in the audience, actually did ask the panel specifically what they thought about the seeming lack of synthesis in theory at the moment. I thought that was a very good question, and one we should talk more about. However, only John Quiggin (University of Queensland) took it seriously, and he responded by saying that theory was well on its way to a synthesis before the crisis, but recent events called that synthesis into question. This followed from his earlier comments, in which he was very critical of the state of economic theory right now. He was, by far, the most critical on the panel, and perhaps the only one who was critical to any appreciable degree. He made it clear how appalled he was that the crisis has had so little of an effect on economic theory, and he said that recent events cast doubt on much of existing theory. He also pointed out that there were some in the profession who tried to call attention to the coming doom (and he himself called for a partial reversal of financial deregulation), but the profession did not pay attention to those voices. So, in his view, economic theorists are, to some degree, guilty of not recognizing the disaster that was looming.
Tim Kehoe (Minnesota) actually came closest to directly answering the question posed to the panel. He believes that in understanding the current European crisis, a lot can be learned from the crisis in Mexico in 1994-1995, which he has studied extensively. (Take a look at his webpage for a number of his papers on financial crises and depressions around the world, including this paper on the current crisis.) He actually has models that explain why Greece is acting rationally at the moment, marching towards default. In typical Kehoe fashion, he added a light touch by explaining how he carefully calibrated the parameter in his model that corresponds to the expected time to economic recovery. He spent several months in Spain recently, and traveled by taxi quite a bit. He says that taxi drivers are conversant in all matters economic by now, and have their fingers on the pulse of the economy. So, when they find out that he is an economist, all they want to talk about is economics. The first time he was asked “So when will the economy turn around?” he said it would be perhaps in a year, trying to give a positive, optimistic answer. He reports that his driver retorted, “In a year? You must be joking! What kind of an economist are you, anyways?” He decided to experiment by giving different answers on each taxi ride, and he claims that the smallest number he could get away with was about five years. The key to what has been happening with Greece, he says, is that it has made sense to borrow more, because there was a reasonable chance that the economy would turn around, and the crisis would solve itself. In the event, one bad draw followed another, and Greece went from bad to worse, last year reaching the stage where it became clear that it would default. That was the last time they could issue bonds. Kehoe actually gave a whole talk on his analysis of the crisis, at the end of which he said “Wow, it’s hot in here,” and took of his tie and white shirt, revealing a Spanish soccer jersey. He’s a long-time fan, so you can imagine that he was in high spirits, this being the day after the EuroCup final.
Herakles Polemarchakis (Warwick) took a longer view of what’s been happening in the theory world. He described how microeconomics made strides in building solid foundations starting in the 1950’s and 60’s, and macroeconomics started incorporating those into macroeconomics in the 70’s and 80’s. But by that time, microeconomics had moved on to thinking about the problems with that very elegant body of new theory, and how those problems should be addressed. What needs to happen now is for macroeconomics to catch up again, and to start incorporating that new microeconomics into macroeconomics. (Now that I am writing this down, I am suddenly wondering if it was Quiggin who said this, being one of the people who created the new micro theory to deal with the “anomalies” as we call them.)
This covers only what I found most interesting (and can recall) from the session. I apologize if I failed to do justice to anyone’s statements; feel free to correct, comment, or add.