The Rise and (Non)Demise of Economics as a Study in the Sociology of Knowledge

This week’s economist has a three part feature on What went wrong with economics?*. The first part discusses in general how financial economics and macroeconomics have both been blamed for helping to create the current economic crisis, failing to see the crisis coming, and failing to provide useful solutions once the crisis hit. The second part examines the history and sate of macroeconomics, focusing on recent debates involving eminent econobloggers Brad DeLong, Paul Krugman, Greg Mankiw and others. Part three traces the history of financial economics, including the efficient markets hypothesis and the various models used to evaluate risky assets. The overall angle of the piece is to ask the title question – what went wrong? – and to speculate about where economics will go from here. In this post I’m going to make a few comments on various parts of the series, and try to use economics as an example to show why the old school sociology of knowledge divisions about knowledge being a mere reflection of the world or a totally independent causal force don’t make a lot of sense, at least when it comes to economics**.

One of the central themes in these articles is that economics reacts to crises in the economy, and to the extent that it moves forward at all, it does so on the backs of the failure of current theory to understand a given crisis. For example,

Macroeconomics began with Keynes, but the word did not appear in the journals until 1945, in an article by Jacob Marschak. He reviewed the profession’s growing understanding of the business cycle, making an analogy with other sciences. Seismology, for example, makes progress through better instruments, improved theories or more frequent earthquakes. In the case of economics, Marschak concluded, “the earthquakes did most of the job.”

So, at least at the beginning, macroeconomics arises in response to a crisis ‘out there’ by coming up with new ways to make sense of the world – in this case, the invention of macroeconomics as its own subfield! But, in a more radical way perhaps than other fields of knowledge (though probably not so different in kind), macroeconomics did not stop at pursuing an isolated understanding of the world (“mere reflection”). Instead, macroeconomic models became the tools by which policymakers saw and acted on the world. The models proliferated and grew complex, but were largely rooted in a few simpler stories – Keynesian ones about the falloff in aggregate demand, monetarist ones about the money supply growing too fast, New Keynesians and the introduction of menu costs, etc. Even though the simple models ignore much of the world (for example, as discussed at length in parts 2 and 3, the models ignored the existence and workings of financial institutions***) these benchmarks frame the policy debates more than the nuanced models:

But the benchmark still matters. It formalises economists’ gut instincts about where the best analytical cuts lie. It is the starting point to which the theorist returns after every ingenious excursion. Few economists really believe all its assumptions, but few would rather start anywhere else.

Unfortunately, it is these primitive models, rather than their sophisticated descendants, that often exert the most influence over the world of policy and practice. This is partly because these first principles endure long enough to find their way from academia into policymaking circles. As Keynes pointed out, the economists who most influence practical men of action are the defunct ones whose scribblings have had time to percolate from the seminar room to wider conversations.

These basic models are also influential because of their simplicity. Faced with the “blooming, buzzing confusion” of the real world, policymakers often fall back on the highest-order principles and the broadest presumptions. More specific, nuanced theories are often less versatile. They shed light on whatever they were designed to explain, but little beyond.

So not only do theories get used, but they get used in important places and in frustrating ways for professional macroeconomists – the fundamentals matter more than the details. Central banks model economies and then determine what to do about interest rates and the money supply. Similarly, investment banks used financial tools to model options and derivatives (for a great discussion, see this Wired article on the Gaussian copula model for the correlation of risky assets. It’s fascinating!). Once learned, these behaviors are hard to unlearn. Even though financial modelers or macroeconomic forecasters may know their models are unrealistic, and that each individual piece has been criticized by a more complicated model, the models become difficult to abandon. What option do they have? To give up on the quest to predict (and price) the future? Worse yet, the models don’t just offer quantitative predictions, they tell us what to predict. Interest rates, money supply, inflation, value-at-risk, correlation, implied volatility, etc. exist only inasmuch as they are categories for understanding the world put into practice by massive bureaucratic data collection systems and interpreted through the light of (often competing) theories (think, for example, of debates over which measure of inflation makes the most sense – one including the often volatile prices of food and energy or one excluding two of the most important things we buy?).

A good example is the connection between market price and value. The problem of how to figure out how much something is worse is perhaps the oldest in economics, and is perhaps the central question of financial economics. The dominant theory in that literature has been the Efficient Markets Hypothesis [EMH], which argues that markets know what they are doing****. This thesis has suffered a bit in light of recent asset bubbles, but in other ways remains vibrant:

For instance, Mr Thaler concedes that in some ways the events of the past couple of years have strengthened the EMH. The hypothesis has two parts, he says: the “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented.

So, we all acknowledge know that market prices frequently fail to satisfy our desires – they do not accurately reflect the current state of the world in some meaningful way, nor do they adequately predict the future. This problem is quite old – Adam Smith rejected the idea that market prices reflect the true value of something (when he argued that market prices may stay away from the true value derived from labor theory of value for long periods of time), and so does Karl Marx. And yet, as Kuznets (another skeptic to the idea that market prices were optimal) argued when he elected to use market prices in the creation of National Income statistics for the US, what else do we have?

Returning to the main narrative, here we see theories not just as reflection of the world, but tools that slice the world up into bits that we can manage – and guides that show us how to manage our newly sliced up world. Even if we acknowledge that a tool is insufficient (because of some major crisis), it will likely not be abandoned until it can be replaced by something new, something that’s workable (tractable models, concrete predictions) and compelling (narrative, rhetoric, with fundamentals explainable to undergrads and policymakers). Perhaps those new theories will use the same categories or perhaps they will offer new ones that seem more useful (a systemic risk measure, say, for regulating finance). Behavioral economics is one possible new system for making sense of the world, but one that appears too young or too messy to win out at the moment:

“In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”. Mr Scholes, however, insists that the efficient-market paradigm is not dead: “To say something has failed you have to have something to replace it, and so far we don’t have a new paradigm to replace efficient markets.” The trouble with behavioural economics, he adds, is that “it really hasn’t shown in aggregate how it affects prices.”

It’s strange how much Kuhn affected popular discourse about progress in the sciences, but there it is. Scholes, a pioneer in financial economics, argues that the old system is still more useful than the young alternative, even though the old system failed. Of course, Scholes blames that failure not on the models themselves, but rather the modelers, which brings us back to an earlier point:

The [Efficient Markets Hypothesis], to be sure, has loyal defenders. “There are models, and there are those who use the models,” says Myron Scholes, who in 1997 won the Nobel prize in economics for his part in creating the most widely used model in the finance industry—the Black-Scholes formula for pricing options. Mr Scholes thinks much of the blame for the recent woe should be pinned not on economists’ theories and models but on those on Wall Street and in the City who pushed them too far in practice.

I’m sure there are macroeconomists who say the same thing – don’t blame us, blame those idiots running the numbers. We produce complicated theories with scope constraints and caveats, you’re the idiots who bet money on this stuff. But these models are built to be used, and always have been (for an interesting look at the historical connections between economics and public policy see Bernstein’s A Perilous Progress). It’s like building a gun and then blaming someone for shooting it. Ok, sure, you didn’t mean for it to be accidentally fired at a small child… but you still built the gun, and maybe you could have put a few more safeguards in there. That’s a pretty weak gloss of this dense problem, but hopefully work like Beunza and Stark’s (on “reflexive modeling”) will help us find the right way to identify and make sense of this constant blame-shifting refrain.

So where does this all get us? I guess, for lack of a better conclusion, I want to argue that the rise and probable future non-demise of economics is an example of knowledge that both reflects changes in the underlying system it tries to know and is instrumental in producing and reproducing that system. Because such knowledge is integral to the guts of the system, however, it is very unlikely that it will be discarded simply because it’s been shown incomplete or even harmful. This is not so different from the Kuhnian model of change in science, except that (as Ian Hacking likes to note) quarks don’t care whether or not we think they exist. Employers and employees, pensioners, governments, in short, everyone, has a stake in the functioning of the financial system and the macroeconomy (which, after all, is the aggregate of all production and distribution). Perhaps the theories explicating the workings of these systems are in some ways stickier, even while being less satisfactory, because they are simply too integral to reject.

* See also this post at Socializing Finance about gender and the narrative of the heroic economist in these articles.
** I am, of course, drawing a lot here from the performativity tradition, e.g. Callon (1998) and MacKenzie et al. (2007). I’m going to try and minimize some of the jargon I so dearly love (“framing” and “overflowing”) as talking about the depths of economic theory already has enough density (“Gaussian copula”, “value-at-risk”, “Keynesian aggregate demand management”, etc.)

In the early years of the EMH, researchers spent little time worrying about the workings of financial institutions—a weakness of macroeconomics too. In 2000, in his presidential address to the American Finance Association, Franklin Allen, of the University of Pennsylvania’s Wharton School, asked: “Do financial institutions matter?” Lay people, he said, “might be surprised to learn that institutions play little role in financial theory.” Indeed they might. Mr Allen’s explanation was partly that the dominant theories had been shaped at a time when America, especially, was spared financial crises.

**** As a side note, the Efficient Markets Hypothesis is kind of hilariously anti-individualist. It’s a theory about a structure or institution (“the market”) in which individuals and their foibles play basically no role, and over which they have no control. The market acts, the market knows, the market decides. I wonder, are economists really more into “social facts” and “functionalism” than sociologists at this point?

Previous Post


  1. Economics seems to be breaking down because economists adamantly refuse to give consideration to the most dominant and rapidly changing variable in the whole economic equation – population growth.

    The biggest obstacle we face in changing attitudes toward overpopulation is economists. Since the field of economics was branded “the dismal science” after Malthus’ theory, economists have been adamant that they would never again consider the subject of overpopulation and continue to insist that man is ingenious enough to overcome any obstacle to further growth. This is why world leaders continue to ignore population growth in the face of mounting challenges like peak oil, global warming and a whole host of other environmental and resource issues. They believe we’ll always find technological solutions that allow more growth.

    But because they are blind to population growth, there’s one obstacle they haven’t considered: the finiteness of space available on earth. The very act of using space more efficiently creates a problem for which there is no solution: it inevitably begins to drive down per capita consumption and, consequently, per capita employment, leading to rising unemployment and poverty.

    If you‘re interested in learning more about this important new economic theory, then I invite you to visit either of my web sites at or where you can read the preface, join in the blog discussion and, of course, buy the book if you like.

    Please forgive the somewhat spammish nature of the previous paragraph, but I don’t know how else to inject this new theory into the debate about overpopulation without drawing attention to the book that explains the theory.

    Pete Murphy
    Author, “Five Short Blasts”

  2. joshmccabe

     /  July 19, 2009

    Macroeconomics has really become worthless in its present form. I suggest FA Hayek on the use of knowledge in society for a good critique of mainstream economics.

    @Pete Murphy: Economists ignore Malthus (and Paul Ehrlich) because they have proven wrong time after time. Remember the wager with Julian Simon?

  3. One quick thought re: Malthus – Not all economists ignore him. Brad DeLong mentions him quite frequently, and Malthus is discussed in his intermediate macro text in the chapters on growth (mostly to discuss DeLong’s contention that Malthus had the unfortunate luck of being accurate about every period of human history up to his own).

  4. Any mention of Malthus anyplace does seem to bring out the best in people…

%d bloggers like this: