Thoughts on “Teaching Economics After the Crash”

This is a long post on the state of economics and how it is taught to undergraduates. The world is not crying out for another such discussion, so blame Tony Yates, via whom I ended up listening to Aditya Chakrabortty’s documentary “Teaching Economics After the Crash” for BBC Radio 4.

Like Tony, I viewed the programme as a hopelessly one-sided critique of the economics profession. Still, it was useful in the sense that it packed all the regular criticisms about economics into one short piece. I agree with most of what Tony wrote but I want to take a different approach because I think it’s worth engaging a bit more positively with the criticisms raised.

My sense is that a large number of undergraduate economics students are unhappy with the way that subject is taught and many would echo the criticisms in this programme. For this reason alone, these concerns are worth addressing constructively. Even if some of the criticisms reflect misconceptions that students have about economics, this raises questions about whether we should allow space in the curriculum for these misconceptions to be discussed and addressed.

The First-Year Student Problem: Economics and the Real World

A key part of the programme features economics students expressing their profound disappointment at what is (and is not) going on in the class room during their first year.

For example, this student from Oxford says:

It wasn’t very clear to me, a first-week economist student, how the economics profession has gotten itself into this strange cul-de-sac

Chakrabortty then editorialises that students were being “instructed by their professors to ignore the meltdown” based on the following story from the same student

“It felt like doing economics was being asked to go into a bubble. Sometimes our tutors actually said out loud “Don’t try to think about this in relation to current events or don’t try to think about this in relation to the news headlines right now … Go into the library and do your problem sets.”

Then there’s this, from one of the founders of the Post-Crash Economics Society at the University of Manchester.

Economics was in a state of uncertainty and flux and in a place where it didn’t have all the answers and then to come to uni and find people saying “this is how it works, learn it, recite it and we’ll do a multiple choice test for you at the end of the year” and one of the things I will never forget is when an economics student came up to me and said “I feel so embarrassed when my friends and family say `What’s going on with the financial crisis?’ and I just don’t know what to tell them. I don’t feel anything I have learned can explain to them satisfactorily what’s going on.”

Chakrabortty’s own attempt to demonstrate the weakness of the undergraduate syllabus is unintentionally hilarious and significantly less compelling than the explanations offered by the students. He explains that students don’t know “basic stuff about the economy” because they don’t do well on some “basic yet fun questions” that he asks, such as “What is world GDP?” and “When was the Bank of England nationalised?” Of course, these questions are not basic or fun or things that anyone needs to know off the top of their head.

It is easy enough for economists to dismiss much of the above as generic student whining or the ramblings of a confused journalist with an agenda. In what version of the world would staff not be telling students to do their problem sets and study material for tests? And ask yourself, if rote learning of dates and numbers did feature heavily in the economics syllabus, do you reckon Chakrabortty would have applauded such an approach?

More seriously, of course students would like to get straight to the parts of the subject that they figured would be interesting when they signed up. But economics is hardly unusual in asking students to learn basic skills first before building up to more complex topics. For example, I teach a third-year module that focuses at length on banking crisis but even within that quite advanced course, it takes a number of weeks of essential nuts-and-bolts material before we cover how crises occur and their effects.

I suspect you could probably find first-year computer science students at most universities complaining how they were hoping to hear about robots and artificial intelligence and are now bored by a steady diet of maths and C++ programming or first-year biology students moaning about not hearing anything about nanotechnology. But it’s unlikely the BBC would make a documentary about them.

All that said, we as economists have to accept that the frequency of these complaints isn’t just bad luck. Economics really is different from other subjects. You don’t hear stories about AI or nanotechnology on the news every day and when there’s a recession, biology students aren’t asked by their friends and family to explain what’s going on. Economic events are part of the fabric of people’s daily lives and those who to study economics in university hope it will help them understand the important events going on in the world.

In this sense, I think the students have legitimate complaints about first-year economics programmes. Yes it is crucial to give students a grounding in the analytical methods necessary to be a good economist but we also need to devote more time to connecting to the real world events that are going on around us.

Introductory economics should be linking directly every week with something that is going on in the real world, whether it be some event illustrating basic economic principles or perhaps a release of macroeconomic data. This may be difficult for hard-pressed individual staff members to put together but with major textbooks now backed by interactive websites, there is no reason why we shouldn’t expect these websites to be providing lots of this kind of material.

Similarly, rather than boring students with “introductory quants” classes that teach statistics in a dry fashion, students should be learning how to get their hands dirty with real-world data from day one, working with spreadsheets and preparing graphical presentations of data describing current events.

Another fair criticism aired in this documentary is that economics programmes don’t focus enough on past economic events. Economic history provides a crucial context for understanding how we ended up with the economy we have today and I think some amount of economic history should be part of every year of the economics syllabus.

So I can see both sides here. But, overall, I think the onus is on the economics profession to work harder to get the real world into the classroom.

Boring Abstract Theory?

The students are almost certainly right about the lack of real-world material in first-year classrooms. But what really jars with them is what they view as the abstract nature of much of the material they are asked to study. Another Manchester student from the documentary says

I was amazed at what the economics was that I was learning. I didn’t recognise it to be what I understood as economics at all. And I assumed there would be discussion and I assumed we would be talking about the real world but it was just incredibly abstract theory and only one theory which didn’t help explain anything at all.

The most common complaint — given a thorough outing in the BBC programme — is that real people are complex social creatures and not the cold analytical calculating machines described in the classroom models. Hence, the logic goes, these models are clearly useless.

Listening to this, it struck me that economists over-do the “rational choice maximisation as the core of economics” shtick with their first-year students. Most of the key insights of economics do not actually rely on people being optimising computers.

Take introductory micro, for example. We can derive models of supply and demand from first principles based on rational choice theory. But the basic insights of the model don’t rely on these assumptions. Do we need to assume hyper-rationality to argue that people probably purchase less of a good if its price goes up? Are we assuming people are maximising computer-like drones if we argue that the price of something going up makes it more attractive to supply it?

Similarly, undergraduate Keynesian macro is largely based on relationships that require minimal appeal to optimising behaviour, with examples being simple consumption functions, capital investment depending negatively on interest rates and prices being sticky. (This relatively weak link to optimisation is why many academic economists don’t like this stuff but it is undeniable that it still forms the core of undergrad macro at most universities).

But when we do use optimisation, how should we respond to “People don’t act that way so this model is false and therefore useless”? I think this is a critique that economists don’t do nearly enough to address when we discuss our theories with students and non-economists.

Why don’t models in economics describe how “real people” act? The answer is that human beings are the most complex thing in the world — collections of flesh and blood directed by an operating system more complicated than the most advanced computers could ever be — so economic models could never be literal descriptions of how people behave.

The purpose of theory in economics is to use a model that is literally false but could help us get a better (if still incomplete) understanding of the world than we would have if we weren’t using the model to organise our thoughts. Rather than spend days modelling precisely what’s going on in the brain of the person buying a loaf of bread, the supply and demand models helps the student to think through what might happen to the price of bread if the government raises VAT, or demand for food goes up in China or there is a drought in grain-producing countries. And that stuff is actually pretty useful.

These points argue for allocating a bit less time to teaching theory in first year and spending a bit more time articulating how we view the role of theory and why it is useful. Some time spent on the history of economic thought, so students can see how we ended up using these particular models, would also be beneficial.

Economists as Neoliberals

Moving beyond the “abstract and out of touch” material, Chakrabortty’s programme also focused on the idea that economics departments are devoted to promoting right-wing ideas, with academics consistently preaching the idea that free markets always work best.

The odd thing about this is that an enormous amount of undergrad economics education focuses on the many ways that free markets fail to produce the best outcome. After the standard treatment of supply and demand, most of the rest of undergrad microeconomics focuses on the many reasons why free and unregulated markets produce bad outcomes. Industrial organisation focuses on problems due to imperfect competition, public economics focuses on externalities and inequality, advanced micro focuses on problems caused by asymmetric information, game theory focuses on co-ordination problems and so on.

In addition, mainstream macro at the vast majority of universities is distinctly Keynesian in focus, emphasising the sub-optimality of a laissez faire approach and the need for systematic use of fiscal and monetary policy to promote macroeconomic stability.

It turns out that economists tend to vote in line with these widely-taught reservations about free markets. As the recent, widely publicised, paper by Marion Fourcade, Etienne Ollion and Yann Algan points out “Politically, economists vote more to the left than American citizens”.

In fact, the economics textbooks are so full of arguments for intervention, it might be surprising that economists are not a bunch of radical interventionists. So why aren’t we? I think the answer lies partly with many economists acknowledging the limitations of our own theories.

It’s one thing to know that a market with a small number of firms may produce sub-optimal outcomes. However, it is much harder in practice for a government regulator to know precisely what the socially-optimal price for various products should be at all points in time. In theory, governments may be able stabilise the economy using fiscal policy but in practice, an economy can often already be in recession by the time government notices it and then takes action.

More generally, government policies are not simply the actions of the perfectly informed benign social planner of the economics textbooks. Rather, they are the outcome of a complex and politicised process in which the government only ever has incomplete information and in which those involved in policy formulation (whether they be lobbyists or public sector unions) may seek to manipulate the process for their own narrow interests.

In other words, designing interventionist policies to offset the problems due to free markets comes with its own set of problems. Some economists focus on the problems due to government intervention more than others depending on their ideological slant. But, ultimately, when at its best, the profession takes an evidence-based approach to assessing the impact of policy interventions and I believe that improvements in econometric methods are promoting an evidence-based approach to policy assessment.

So that’s the nature of debates within economics about free markets and the role of government, at least as I see it. But Chakrabortty’s programme misses this subtle debate in its entirety. Its star witness for the prosecution of economists as free market capitalism promoters was Victoria Bateman of Cambridge Economics department.

Victoria contributed the following:

At the fundamental root cause of the crisis is the belief of economists in the free market capitalist system and the result of this growing faith, that really began in the 1980s with the rise of Margaret Thatcher and with Reagan in the US, the result of that belief was a liberalisation of markets, privatisation, the rolling back of the state, deregulation of the financial sector. And so we began to experience full-blown capitalism. That it would be set forth free reign and the result would be low unemployment, inflation that was under control, respectable even high economic growth rates. The result was that, on the eve of the global financial crisis, economists were looking ahead and imagining a rosy future.

I genuinely do not recognise the economics profession in this description, nor indeed the description of the actual economy. In light of what we know from economic history, could the UK economy of the Tony Blair years — with its national health care and social welfare system — credibly be called “full-blown capitalism”?

Truth is, Thatcher and Reagan were not people that influenced the thinking of mainstream economists. Rather, they were politicians that were heavily influenced by the views of people like Milton Friedman and other economists from the so-called Chicago school. However, the Chicago school’s viewpoints were never representative of the “median economist” and said median economist’s viewpoints on market liberalisations and regulation are generally boringly subtle.

Ultimately, mainstream economics can be used by either right or left-wing groups to make their points. Even if it appears that right-wing groups are very vocal in citing economic theories to support their viewpoints, equating the whole profession of economics with a right-wing political movement is misleading and unfair.

Methodological Narrowness?

While the criticism that economics is dominated by right-wing agenda is unfair, a related charge that is closer to the truth is that the profession is too narrow in its methodology.

Here the criticism comes in two brands. First, the profession is too focused on a specific narrow quantitative methodology. Second, the curriculum doesn’t focus enough on various “heterodox schools of thought.”

I have a lot of sympathy with the first point and less with the second. I do think economists are perhaps overly in love with their preferred set of methodologies and perhaps fail to see that mixing them up with the kind of broader knowledge I’ve discussed above could produce more rounded students. Even more critically, I think macroeconomists in particular are reluctant to admit to undergraduates (and sometimes to themselves) the full extent of the problems with their preferred modelling approach, based on rational expectations and optimisation.

Still, the fact that there are weaknesses in many of the theories taught at undergraduate level, does not mean there is a ready-made alternative set of models that work better.

For example, it is clear (to me anyway) that the standard rational-expectations-based model of asset pricing does not work for a wide range of important heavily-traded financial assets and that financial allocation decisions by households are some way different from what a textbook optimising model would say. This opinion is held by many economists so behavioural financial economics is a thriving field. There are plenty of insights from this research that can be distilled down and taught at an undergraduate level.

However, what behavioural economics has not yet achieved is an agreed core of principles and methods that are easily distilled and taught and which are proven to have general application. A “horses for courses” approach to figuring out which kind of behaviour appears to explain which kind of “anomaly” (economics for “stuff our models can’t explain”) can be insightful but it doesn’t provide an alternative foundation upon which to rebuild a discipline.

In relation to “heterodox” economics, I think many of the concerns raised by the Manchester students and other groups would be addressed by more focus on history of economic thought, both as a stand-alone module and also as something addressed within modules on specific subjects. Many of the historical economists that the protestors view as systematically excluded from the curriculum can be given an airing and their ideas put in context.

But beyond that, I think it’s reasonable to decide that the curriculum doesn’t have to devote time to every “school of thought” that was once fashionable. Most of the various schools that get mentioned in these debates turn out to be various forms of old-fashioned macroeconomics. But there really are more useful things for students of macroeconomics to learn about than Karl Marx’s labour theory of value or the Cambridge capital controversies. Sometimes, the profession moves on for the right reasons.

Prediction as the Litmus Test

Most of the complaints about economics from the Post-Crash society would have been accurate about any economics curriculum over the past few decades. They are so virulent now, however, because the global financial crisis changed many people’s view of economics. To many, the failure of mainstream economics to predict or prevent this crisis indicates that the subject has failed and needs to be fundamentally re-thought.

By definition, this specific critique is a post-crisis phenomenon but it can also be seen as a variant on a longer-running viewpoint that evaluates the success of economics on the basis of its ability to predict macroeconomic events, often likening it to a highly ineffectual version of weather forecasting.

This is an area where the public image of economists as masters of the universe with a superiority complex (as discussed by Fourcade et al) turns out to be misleading. The public focus on prediction in economics boils down to macroeconomics: Can we forecast business cycles, particularly the more extreme booms and busts? And here, the expectation levels of the general public (and first-year undergrads) about what is possible are way out of line with those of practicing macroeconomists.

People joke about weather forecasting but those guys have it easy. They pretty much know the underlying laws of physics that drive weather patterns, which is a great place to start. But solving millions of nonlinear differential equations and feeding them the correct initial conditions turns out to be tricky so they have to work on getting manageable approximations to the underlying true model.

Forecasting the macro-economy, however, is a completely different kettle of fish. We don’t know the underlying equations that determine one person’s economic behaviour and couldn’t even begin to imagine how we would ever write down the “right model” for data generated by aggregating over the behaviour of the 7 billion people on the planet.

Looked at this way, expectations for macroeconomic forecasting should be set very low. And indeed, it turns out that those macroeconomists that devote their career to providing forecasts are pretty lousy at it. In fact, there’s some evidence that those who appear to do better than others might just be lucky.

The reality is that most practicing macroeconomists don’t participate in forecasting at all nor is their research focused on improving forecasts. So posing what many regular people view as the crucial question by which you judge macroeconomists — “Did you forecast the global recession?” — is regarded my most macro people as a sign that you just don’t understand what they do.

So what use are macroeconomists then? One answer is they can explain important facts (such as how spending equals income in a closed economy) or important patterns in historical data (such as key trade-offs between various macro variables). Theoretical models and empirical analysis can also be useful for “What if?” analysis i.e. if X happened, then what usually happens to Y? That kind of analysis isn’t always useful for forecasting (it may not be easy to forecast whether X is going to happen) but it can be useful for understanding major events (when X happens, we can recognise why it is having a particular impact) and for policy formulation (if X tends to lead to bad outcomes, then perhaps the government can try to prevent X from happening).

This might all sound a bit limited but it has its uses. For example, U.S. macroeconomic policy making in 2008/09 was certainly much better than it was during the Great Depression and, bad as things turned out, it would almost certainly have been far worse for the American public if the Federal Reserve and President had the macroeconomic beliefs of their equivalents from the 1930s (which is not to say that many influential people in Washington don’t still have these beliefs).

The Financial Crisis as a Defining Failure of Modern Economics

Which brings us to the financial crisis. Funnily enough, this is perhaps an area where the documentary’s critiques are furthest off base. The documentary carries commentary from economists such as Steve Keen arguing that mainstream macroeconomics pretty much ignored the role of money and banks.

I don’t think this is a fair assessment of pre-crisis economics. None other than Ben Bernanke became a leading figure in the profession via his analysis of the role of banking problems in the Great Depression and did plenty of work on the various the ways that banks and credit affect the economy. The mechanics of how banking crisis occur were well articulated in models such as the Diamond and Dybvig model from 1983. The much-lauded work of Robert Shiller had also placed the idea that financial markets were much too volatile to be considered fully rational centre-stage in debates in the macro and finance communities. While published in 2009, most of the research underlying Reinhart and Rogoff’s This Time Is Different, detailing eight centuries of financial crisis, reflected research undertaken and published prior to the crisis.

In this sense, the economics profession was not lacking the theoretical tools or historical examples to understand how financial crises occur and why they have such negative effects. What it was lacking was a widespread misunderstanding of the specific mechanics of how this crisis operated.

While similar in many ways, each financial crisis turns out to be subtly different from its predecessors. Often this is because economists have learned from previous crisis and governments have introduced policies to prevent these specific types of crises re-occuring. For example, thanks to deposit insurance, this modern financial crisis did not see spates of retail bank runs with queues of depositors around the corner (Northern Rock being the dishonourable exception — take a bow Mervyn King).

However, the global regulatory system in 2008 was in no way ready to deal with a crisis caused by complex financial products that many regulators did not understand and a level of global financial inter-connectedness that had never previously prevailed. And despite the lessons now learned about how this crisis occurred, it would be foolish to argue that some other kind of financial crisis — with some new defining features — won’t emerge again in the future. Perhaps again, the crisis will be declared a defining failure of economics by those too young to remember it was always like this.

Greenspan’s “Model”

Chakrabortty’s documentary gives airtime to the idea the financial crisis showed that “economists’ models” were wrong. On this topic, there seem to be two different types of “model failure”.

The first is the type of model failure that the programme opens with: Alan Greenspan in 2008 saying he had

Found a flaw in the model that I perceive is the critical functioning structure that defines how the world works, so to speak.

(Chakrabortty — a fan of facts — gets his facts wrong in saying that Greenspan was head of the Fed when he made this statement. He had stepped down almost two years earlier.)

Greenspan went on to say

I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms

Greenspan held an incredibly powerful position and Chakrabortty notes he was called “the Maestro” by some. Hence, he is held up as an example of how economists thought. But this isn’t how the world works. Alan Greenspan was not an academic. He was a consultant who leveraged his substantial Washington connections into an appointment as Fed chairman. And his positions on economics were very far from the mainstream.

I worked for Alan Greenspan from 1996 to 2002 and met him quite a few times. He is a man of many talents but it’s an understatement to say that his approach to economics was idiosyncratic. It was an interesting combination of obsessive analysis of high frequency economic data and extreme right-wing views picked up from his time as part of Ayn Rand’s “inner circle.” Hard to believe as it may be, the most powerful economist in the world held views that were very far from those taught in mainstream economics degrees.

There seems little doubt that Greenspan’s views on financial regulation had some influence and contributed to a highly complacent attitude towards the dangers posed by the financial sector. Even if they didn’t necessarily reflect mainstream academic thinking on the financial sector, it is good news that this complacent “model” that sees financial institutions as self-regulating has hopefully been dealt a lethal blow.

Quantitative Macro Models of the Financial Sector

Then there’s a completely different type of model: A quantitative model with equations. Something that can be put on a computer and used to do scenario analysis or provide bad forecasts. Like Tony, I think Bank of England chief economist, Andy Haldane, is referring to this kind of model when, in the documentary, he talks about “it turns out that the model we had was false.”

Andy is certainly right that the official macroeconomic models used by central banks prior to the crisis had very limited details on the role of the financial sector. And even those academic models that did feature such a role (such as the Bernanke-Gertler-Gilchrist financial accelerator model ) did so in ways that were so stylised they could never have been used to forecast a financial crisis.

The positive spin doctor in me would point out that there is lots of work being done now on quantitative models featuring interactions between the financial sector and the wider economy. One can point to a large body of research on integrating banking sectors into “DSGE”-style quantitative macro models as well as smaller models by super-smart people like Markus Brunnermeier and Hyun Song Shin.

At the same time, the realist in me suggests we are still a long way away from having models that can be used to tease out the full range of mechanisms that could produce the next financial crisis. As with macro forecasting generally, anyone working in this area ends up becoming very humble in their ideas about what is feasible. I think the best we can hope for is that this kind of modelling can help us understand the mechanisms through which modern financial systems influence the wider economy. This could help us design better regulation and stave off the next crisis for longer than it would be if these issues were being ignored by economists. And that’s not a bad aspiration for a research programme.

Another aspect of the documentary that didn’t ring true to me was the idea — promoted by Steve Keen — that there are lots of alternative quantitative models of the role of credit in the economy that are very useful but just ignored by the mainstream for ideological reasons. I don’t see it this way.

So-called “heterodox” quantitative models such as stock-flow models or Keen’s own brand of post-Keynesian macro are really just standard quantitative macro models with some tweaks. They are also subject to the exact same critiques about abstract theorising and unbelievable assumptions as standard models and are just as technically difficult. There are reasons why I think these models are not particularly popular: The stock-flow models have very useful detail on the structure of the economy but tend to be very unstable and hard to work with; Keen’s own models are highly stylised and seem to me to feature odd definitions and assumptions. In other words, I don’t think the reasons these models are unpopular with other economists revolve around ideology.

What of the idea that what students really need to know is deep in Marx or Minsky? Well you won’t learn much about Collateralised Debt Obligations in Marx. And if Minsky’s argument was that financial crisis are an innate part of capitalism, will economics be a branded a success when the next crisis occurs if we have been teaching our students about Minsky and that such a crisis was inevitable? I reckon students would be better off reading Haldane’s speeches or having a go at reading Brunnermeier and Shin than ploughing through Marx.

Conclusion

I reckon nobody’s reading at this point, so I’ll just say what I think to keep myself happy.

The world economy is more complicated than any of us can understand and getting more so by the day. There are no magic formulae for understanding it and it takes many years of learning about it to even understand which kinds of approaches to thinking about the economy are useful versus which kinds are not. Undergraduate students are really not the best people to be designing a syllabus for a subject that is so bloody complicated.

But the truth is that many students are dissatisfied and a significant amount of their complaints are well-founded. With all the attractions of the information age available to them, students are more demanding than ever and can be turned off a subject more quickly than in the past. We need to work harder to show students how economics connects with the real world and we need to explain to them how we think and why we think that way.