Why we all need to be clear on the limits of economic theories

When policymakers turn to economists for guidance, they expect the advice they receive to be grounded in science, not academic factionalism or political presuppositions. After all, the policies they will be putting in place will have real implications for real people. Unfortunately, however, sound science is not always the driving force behind economic analysis and policy recommendations.

In a recent critique of what he calls the “mathiness” of modern economics, Paul M. Romer of New York University argues that economists should take measures to exclude academic factionalism and politics from the dismal science. Romer grounds his case in an ongoing debate in his field about the role that ideas play in promoting economic growth.

Romer seems to be worried principally about some economists’ tendency to claim that what is true about certain types of theories is true of all theories and thus applicable to the real world. As an example of this tendency, Romer cites the work of the University of Chicago economist Robert Lucas, who, in his 2009 paper “Ideas and Growth,” dismisses the role that books or blueprints can play in driving growth. “Some knowledge can be ‘embodied’ in books, blueprints, machines, and other kinds of physical capital, and we know how to introduce capital into a growth model,” Lucas argued, “but we also know that doing so does not by itself provide an engine of sustained growth.”

The problem is that Lucas’s statement is true only for models of economic growth that are specified in such a way that the return on “embodied” capital drops to zero as capital accumulates. As Romer notes, there are many models for which this is simply not true. What Lucas makes out to be a general truth – that the path to economic growth cannot lie in creating and acquiring the kind of knowledge that is “embodied” in books, blueprints, and machines – rests on a barely examined decision to restrict attention to only a few kinds of models.

Lucas’s decision might be somewhat justifiable if the models he chose were the only ones that were correct. But of course that is not the case. In addition to criticizing those that draw general conclusions from specific cases, Romer takes aim at those who claim that economic models permit only one mode of interaction and only one mode of individual decision-making.

Romer’s principle objection is to the assumption that the only interaction allowable in economic growth models is what is known as “price taking,” the buying or selling of goods and services at the price currently offered by the market. I would add to that my objection to the assumption that individual decision-making is always characterized by rational expectations.

Assumptions like these might be adequate as foundations on which to build models to help us understand the world, but only if market processes were structured exactly right, smoothing out at the aggregate level all the deviations from price-taking and rational expectations that are clearly evident at the individual level. Asking whether, which, and when market processes meet such criteria is an empirical question. Claiming that all market processes must be so structured is theoretical malfeasance.

And it is widespread. In the field of growth theory, Romer sees the current generation of neoclassical economists grind out paper after paper imposing the theoretical restrictions necessary for a price-taking equilibrium. As he correctly notes, such papers are useless for any purpose other than advancing their authors’ positions in academic status games.

Meanwhile, in my field, macroeconomics, I see economists, bankers, industrialists, technocrats, and politicians make the claim that the policies governments could implement to speed an economic recovery must be, if not counterproductive, at least too risky. After all, that is what a model with a very restricted class of rational expectations would predict.

At the same time, we should recognize that the problem Romer pinpoints is not a new one. Just the other day, I came across critiques of expansionary fiscal and monetary policy made by the Canadian economist Jacob Viner and the French economist Étienne Mantoux. They both argued in the 1930s (in the middle of the Great Depression!) that government efforts to boost employment would always result in undesirable and unwarranted inflation, and would probably reduce output in the long run.

What is most depressing about Romer’s argument is how unlikely it is to be heeded. Romer may be able to convince academic economists to be more cautious about making claims concerning the generality of theories of economic growth. But it is less than clear that bankers, industrialists, technocrats, and politicians – who are responsible for the policies that impact people’s lives – will do the same.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Author: J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research.

Image: A man looks at a stock quotation board outside a brokerage in Tokyo May 11, 2012. REUTERS/Toru Hanai.