Earlier this week, Noah Smith wrote a response to critics of modern economics. Smith argues that most critics do not have a proper understanding of the successes of modern economics. He points out that while their arguments may have held weight in the past, they fail to acknowledge new improvements in the field. Here are two quotes that I think summarize his position,
"The problem with Reed's critique, like so many of the others listed above, is that it leaves out much of the story. Auction theory, random-utility models, matching theory, gravity-trade models, and some other mathematical theories have enjoyed enormous quantitative predictive success, sometimes using the neoclassical assumptions of utility maximization and rational action that Reed derides."Smith goes on to say,
"The idea seems to be that economists mainly engage in a deductive enterprise, dispensing high theory from Olympian mounts of authority. This may have been an accurate stereotype at one point, but these days it bears little resemblance to reality: most economists are out combing through mountains of data, straining to glean facts about how the world really works. Economists study gender relations in the workplace, racial gaps, changes in labor contracts, early childhood education, minimum wage policy gaps, automation and the future of jobs and a vast array of other highly important, immediately relevant topics."I agree with Smith that mathematical equations can have predictive success in economics. There are real mechanical relationships in the social realm that accurately fit mathematical equations. Although I think such relationships exist, I'm more inclined to believe that the vast majority of social reality does not operate mechanistically. There are too many non-conforming variables in the social realm that can't be inserted into a mathematical equation. This does not diminish the fact that sometimes mathematical relationships hold.
Smith is also correct to say that economists recognize the need for empirically supported theories. Most academic economists know that when a theory doesn't fit reality, the theory is wrong. This may have been a problem in past decades, but economists are now more cognizant that theories written in mathematical form are not automatically true.
When it comes to testing economic theories, econometric studies are always going to be questionable. Applying the scientific method (i.e. controlled experiments) to social reality is a difficult task. Quasi-experimental methods are worth developing, but we should always be wary about unseen confounding variables. Despite these difficulties, I believe that there are real economic relationships that can be discovered using econometrics. Smith is correct to mention this as a positive trend in the discipline.
Although I agree with points Smith makes above, I still believe that academic economics does an inadequate job analyzing current events. In my opinion, this neglect of current events is the true failing of academic economics. I don't think Smith properly addresses this issue. I believe this is the fundamental reason why economists did not foresee the financial crisis.
Today academic economics is dominated by theories about general economic phenomena. This includes econometrics and mathematical models. Academic economics can be accurately described as looking for general truths in economics. This is in the spirit of hard sciences such as chemistry and physics.
That's not to say that academic economists completely ignore current events and history. For example, MIT economist David Autor has analyzed the impact of trade with China. There are also entire journals dedicated to economic history. But just by reading some of the abstracts of the most recent issue of The Quarterly Journal of Economics and other top journals, it's clear that analyzing current events is not the focus. Instead the focus is on establishing general theories.
This can be most clearly seen in economics education. My undergraduate education was heavily weighted toward theory instead of analysis of real world events. There were some classes devoted to real world analysis (Economics of the European Union, Economies of the Pacific Rim) but for the most part, my education depended on learning theories. In order to know what was going on in the real world, I had to read The Economist and other publications outside of class.
This trend explains why economists did not foresee the 2008 financial crisis. Instead of analyzing the real world and examining sub-prime lenders, academic economists were busy trying establish general theories. In a sense, academic economists were (and still are) blind to the world around them. The incentive structure (i.e. publication in the top five journals) is based around establishing general theories rather than analyzing the real world events.
Before the financial crisis, there should have been academic economists devoted to analyzing exotic financial products in the financial system. These economists would have published papers maybe as early as 2005 to ring the alarm about the widespread fraudulent subprime mortgage securities. Although this type of work would have been useful, it was largely absent.
There was one person who did this type of research but he worked at a hedge fund. Michael Burry, the main character in The Big Short by Michael Lewis said, "I was in a state of perpetual disbelief. I would have thought that someone would have recognized what was coming before June 2007. If it really took that June remit data to cause a sudden realization, well, it makes me wonder what a 'Wall Street analyst' really does all day." I think this quote also works if we replace the words 'Wall Street analyst' with 'academic economist'.