Should economists be “imagineers” of our future?

By Mark Thoma
November 14, 2011

By Mark Thoma
The opinions expressed are his own.

This essay is a response to Roger Martin’s “The limits of the scientific method in economics and the world” (part one and part two), recently published on Retuers.com.

Roger Martin is unhappy with the state of economics. One charge is that:

[an economist] predicts a future that is based on the past.  And when it is anything but, he returns to the same tools to do it again, believing that in doing so he is being meritoriously scientific. … Extrapolating the future to be a straight-line projection of the past is neither accurate, nor is it helpful in creating better understanding and newer ideas.

As I will discuss further below, I agree that macroeconomists need to fix their models. But I don’t think that predicting the future based upon “a straight-line projection of the past” is the problem. Let me explain why, first in a relatively narrow sense, and then more broadly.

This year’s Nobel prize award to Thomas Sargent and the previous award to Robert Lucas were partly in recognition of their development of the tools and techniques that economists need to go beyond simply trying to extrapolate the future from the past, a procedure that can lead forecasters astray.

Prior to Robert Lucas, economists analyzing policy interventions by monetary or fiscal authorities did exactly as charged above, they extrapolated based upon the past and an assumed unchanging future. But the (often false) assumption that the future would be like the past is at the heart of what is known as the Lucas critique.

To understand the critique, suppose that the government is considering imposing a new tax on a particular industry. Based upon the government’s estimate of profits in the industry, it expects to collect a large amount of taxes and solve its revenue problems.

But when the tax is actually imposed, profits do not turn out to be as large as expected and tax revenues come in far short of projections. What happened? The firms took steps to reduce their tax exposure, e.g. they used the usual accounting tricks to inflate costs and lower reported revenues to reduce taxable profit. To the extent they were successful, tax collections were lower than expected.

The lesson from this example is that people change their behavior in response to changes in the conditions they face. And this is one of the things that separate what researchers in the hard sciences do from the work of economists. If I tell my TV set that I am going to smash the screen with a baseball bat, it will just sit there. It won’t take evasive action. But a human in the same situation will do their best to get out of the way and avoid harm. When harm is expected, whether it’s physical harm, higher taxes, more work for less pay — whatever — people try to avoid it.

This means that backward looking extrapolative estimates — the straight line projections objected to above — can give wrong answers about changes in economic policy. If, for example, the Federal Reserve uses estimates based upon past data to alter its policy rule and does not account for the fact that people will change their behavior in response to the change in the rule, then it will get policy very wrong.

Along with Robert Lucas, Thomas Sargent was in the forefront of developing tools and techniques to incorporate the response of people — the change in their expectations — to changes in policy. Sargent borrowed heavily from the engineering literature, for example the engineering literature on optimal control is useful to macroeconomists trying to develop monetary and fiscal policy rules to optimally control the economy. However, if that was all he had done — borrowed from another discipline — he would not have received a Nobel prize. As noted above, what makes economics different from engineering is that people can respond to changes in their environment. They will use all the information available to them to anticipate the future as best they can – they will form rational expectations in this sense — and then take action to avoid anything that will make them worse off.

Incorporating rational expectations into macroeconomic models increases the level of complexity by an order of magnitude over what was already a difficult problem in the engineering literature, and much of what Lucas, Sargent, and others did was to find a way to forge forward despite the technical difficulties. That was an important contribution, but for our purposes it is the conceptual contribution — the loud, clear message that simple extrapolation from the past can lead to problems — that was important.

But the objection about extrapolating from the past raised by Roger Martin is broader than this. He is referring to using the same models again and again even after they fail, i.e. returning to “the same tools” again and again rather than learning from failure and abandoning models that do not work.

I am in agreement with the argument that our models need to be improved. But the problem is not mindless extrapolation from the past. As the discussion of the recent Nobel prize awards above shows, we are well aware of the limitations of that approach. Nor is the problem the failure to abandon models and move on to new ones when they cannot adequately explain the data. In my career, the attempt to find models that can explain past data and predict future data with more accuracy has caused Old Keynesian models and New Classical Models to be replaced by Real Business Cycle and New Keynesian models.

And it’s time for that to happen again. One of the big problems with the existing class of macroeconomic models is the failure to adequately incorporate the possibility and consequences of a meltdown in financial intermediation. There are technical reasons for this, and also the fact that many macroeconomists did not think a Great Depression style financial meltdown was possible and hence it wasn’t important to invest time asking questions related to such an event. That was a mistake, when financial intermediation began to malfunction we did not have the models we needed, and this was far from the only mistake we have made.

Presently, there is no shortage of work trying to fix the problems with our models. I don’t know if we will succeed — the next model will work until it doesn’t — but we are certainly trying. And there is also no shortage within economics of “imagining things other than as they are,” a phrase the author uses repeatedly. From recommendations on how to fix markets, address pollution problems, stabilize the economy, put people back to work, to models of comparative economic systems that imagine societies with different institutional structures and societal relationships, economists are constantly imagining how to improve social conditions. In fact, for the most part we are charged with trying to do too much social engineering, not too little. In any case, we don’t think of the economy as an unchangeable “hunks of granite,” we understand that social relationships are at the heart of what we study and that those relationships are not etched in stone.

The end of the second essay calls for “attempts to create a future that does not now exist, rather than mindlessly crunching the numbers that do exist.” There are plenty of number crunchers in the profession, and as an applied econometrician I’ll certainly defend their value in grounding theorists in real world data. But there are also plenty of “imagineers” — people who play with toy models and toy ideas to envision worlds that do not now exist, but could — and perhaps one of them will discover the “blueprint for a better way” that Roger Martin hopes will emerge from the broader conception of science he writes about in his essay.

8 comments

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We will always be prey – now and for the foreseeable future – to Irrational Expectations and to External Shocks. The former lull us into a false sense of security – thinking we know it all. The latter are the cold water baths reminding us 20/20 vision is only Hindsight. Not sure this will ever change ?

Posted by PabloB | Report as abusive

One further point :

Maybe we all suffer from Optimism Bias ? Since when have most models predicted a darker future ?

Moreover, it may be alright to show a short-term downturn. But in the medium to longer term, things will always turn around.

Maybe Macawberism is alive and well in Science and in Economics ? But only with caveats in Climate Science !

Posted by PabloB | Report as abusive

“As noted above, what makes economics different from engineering is that people can respond to changes in their environment.”

Um, no. What makes engineering different from economics is that engineers test their models against reality and try to improve them if they fail. When systems do fail (and they will–economists always seem surprised by that) they’re examined for weaknesses and corrected. Admittedly, engineering as a practice can be subject to the same failings as others–buildings and bridges fail because someone cheated, cut corners, got lazy. People get hurt, cheaters get punished.

I mean, if you saw a bridge with a sign, “this bridge tested according to the best practices of economics!” would you drive across? I know I wouldn’t.

Posted by Moopheus | Report as abusive

Let’s zoom back some more. Engineers design things that work. Robots, automatic controls, and computers for example. Automatic control systems that run entire factories and advanced autopilots that can take off and land the airplane. There is a whole branch of engineering called systems engineering that the military and NASA uses to basically invent a new “thing that works” from just a set of functional requirements of what the thing is wanted to do. I see no conflict at all with that kind of engineering thinking and economics that would also design something that works.

Posted by wrylyfox | Report as abusive

I think this economist “gets it”.

Human beings are incredibly inventive and hard to predict in terms of what they will do when threatened. In fact nothing will ever predict every possibility, but trends will emerge over time as hindsight studies what happens even as we proceed forward with every tick of the clock into the unknown.

No one can be faulted for not “seeing” the results of every-rising wage expectations and the globalization of commerce, where countless millions of third-world workers suddenly became available as an alternative to American and European manufacturers. The economics of automation is an increasing factor affecting what unskilled, repetitive labor will be “worth” in the long term.

Just as in the “Industrial Revolution” lives and entire societies are being changed, like it or not. There is always good and bad in change, and when the “good” benefits the affluent and is adverse to those on the bottom of the economic pile there is societal challenge.

But what is “bad” for the American “middle class” has been good for ordinary citizens of Europe, Japan, and the advancing societies of Asia. Everything is relative, depending on who’s ox is being gored ;

Posted by OneOfTheSheep | Report as abusive

Prediction models are as good as their underlying assumptions and initial parameters. Now, the economies are non-localized and interdependent. In other words, separation between the consumer and consumption is no more static but dynamic one. Business transformation are occurring more rapidly than before. The digital economy has taken the front seat while the economist are still looking for answer in the hard data with help of classical models. Economist are more doing an analyst job with short term objectives otherwise long term trend must have predicted the financial crisis.

Engineers adopt and evolve. No offence to the economist but they tend to believe largely on the linear models with static variable for the long term trends. Also, economics, also a science, has yet to address the global amorphism.

Posted by metahuman | Report as abusive

Too many economist coming from our school systems which are brain washing machines for the far left! Europe is a great example of what happens to folks that embrace essential socialist doctrine-sounds good, but it doesn’t work in the long run! What we do with our time and money says everything about us as a Nation!

Posted by DrJJJJ | Report as abusive

I usually don’t listen to economists for financial information. I go with my outsourced cfo services for information on my industry. Every industry is effected differently in a downturn.

Posted by bjornbutton | Report as abusive