Is Economics Ready for a New Model?

Economic theories based on rational behavior have been called into doubt by recent events. A few maverick scholars “are stepping up the hunt for new models that could more accurately describe the real world.” Some look to psychology for answers; others are interested in importing approaches from the physical sciences.

Sound like something you might have read in Tuesday’s Wall Street Journal? It does in fact accurately describe Mark Whitehouse’s article, headlined, “Economists’ Grail: A Post-Crash Model.” But it also describes (and the quote is taken from) a 1988 article in Fortune by Gary Hector.

If you want to learn about the subject, in fact, Hector’s article is probably better — it’s clearer in its descriptions of the relevant theories. But it’s 22 years old. Have we learned nothing in the intervening two decades?

In the sense that financial markets and the economy in general are far more fragile than most mainstream economists contemplated before 2008, there was a bit of unlearning done in the 1990s and early 2000s. The 1987 stock market crash (NYSE:SPY) was a scare. So were the currency and debt crises of 1997 and 1998, and the stock market collapse of 2000-2002. None of them brought economic devastation in the U.S. and Europe, though (and Japan’s long struggles were seen as the product of peculiarly Japanese economic traits). The conviction spread that, thanks in part to financial innovation, the world’s developed economies had become more resilient even as financial markets became more volatile. Alan Greenspan was the most prominent cheerleader for this idea, but he sure wasn’t alone. I know I believed it.

I don’t really buy that anymore, and I don’t think all that many economists do, either. But does that mean their theories and their way of going about their work are about to undergo wholesale change?

To get an idea, it’s helpful to go back to that 1988 Fortune article. It focused on three young economists who were arguing that emotion and error played a big role in financial market fluctuations than was countenanced in then-standard theories of the market. Their names: Robert Shiller, Lawrence Summers, and Richard Thaler. Thaler and Shiller are now among the most prominent economists on earth, best-selling authors, and regular betting favorites for (albeit not yet actual winners of) the economics Nobel. Summers, meanwhile, is the second most powerful economic official in the U.S. — at least for another couple of weeks.

Did these three men turn economics upside down? No. But they — mainly Shiller and Thaler, as Summers didn’t spend a whole lot of time on the practice of academic economics over the past two decades — have definitely helped open the discipline to new ideas about market volatility and the strange quirks of human behavior. You can find lots of scholars at top economics departments who study why bubbles and crashes happen, and how psychology and genetics shape individual decisionmaking. What you won’t find is many who think the entire infrastructure of rationality-based economics needs to be tossed out.

The other big idea in the 1988 article was chaos theory. The hope, expressed in the piece mainly by William “Buz” Brock of the University of Wisconsin, was that economists would soon be able to use tools developed by physicists, biologists and other hard scientists to predict market behavior. Chaos — and the broader catch-all, complexity — became an enormously fashionable economic topic for a few years.The physicist-founded Santa Fe Institute in New Mexico was the center of this work. Most of the economists involved, though, eventually concluded that chaos and complexity theory held few answers for them and physicists were on the whole too ignorant of and arrogant about economics to be much help. So they moved on (Brock’s Santa Fe affiliation ended in 2002).

In recent years J. Doyne Farmer, a Los-Alamos-National-Laboratory-scientist-turned-hedge-fund-manager-turned-Santa-Fe-Institute-professor, has bent over backwards not to be ignorant and arrogant about economics. He’s co-authored papers with economists from Yale, MIT, and other perfectly respectable places, and learned a remarkable amount about the nitty-gritty of financial market functioning.

Have economists begun to move in his direction? Farmer, as quoted in the Wall Street Journal article — and in a panel discussion I did with him over the summer — is a bit frustrated with how economists remain stuck on old, static ways of modeling reality. And economists are dubious of his proposals for massive agent-based computer models of the economy.

So if you’re looking for a revolution in economics, you’ll probably have to wait a long, long while. But evolution, sure, there’s some of that. And lots of cycling back and forth between the belief that, in a market-based economy, everything will always work out for the best, and the concern that markets — especially financial markets — might have a natural tendency to self-destruct from time to time.

Justin Fox is editorial director of the Harvard Business Review Group and author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.

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