Sunday :: Mar 1, 2009

Economics Research on Systemic Risks

by eriposte

Via Lambert at Correntewire and Yves at Naked Capitalism, here's an interesting opinion paper by a bunch of academics from the US and Europe:

The Financial Crisis and the Systemic Failure of Academic Economics

Here's the abstract:

The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.

This paper is definitely worth reading. One of the most interesting aspects touched upon by the paper is this, and I have to say I agree with this (emphasis mine):

Many of the financial economists who developed the theoretical models upon which the modern financial structure is built were well aware of the strong and highly unrealistic restrictions imposed on their models to assure stability. Yet, financial economists gave little warning to the public about the fragility of their models;4 even as they saw individuals and businesses build a financial system based on their work. There are a number of possible explanations for this failure to warn the public. One is a “lack of understanding” explanation--the researchers did not know the models were fragile. We find this explanation highly unlikely; financial engineers are extremely bright, and it is almost inconceivable that such bright individuals did not understand the limitations of the models. A second, more likely explanation, is that they did not consider it their job to warn the public. If that is the cause of their failure, we believe that it involves a misunderstanding of the role of the economist, and involves an ethical breakdown. In our view, economists, as with all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. Currently, there is no ethical code for professional economic scientists. There should be one.

I'm highlighting the last point in bold primarily because I routinely see economists - especially of the conservative variety - talk authoritatively about stuff without bothering to acknowledge real world situations that run counter to their assumptions.

One point that came to mind upon reading the paper is this - what are the principal sources of funding for economics research? How much of it is funded by universities themselves versus government agencies versus the private sector (especially the financial sector)? How much of the research is dependent on the cooperation of entities (whether government or industry) that have a stake in the implications of the findings? I don't have a good idea and am trying to find out - because the quality and depth of research is often dictated by who is funding it and what their expectations are. For example, if some research on derivatives, financial models and what not, is funded by companies in the private sector that have an interest in using the research or models, then it becomes more likely that the models might tend to gloss over realities.

eriposte :: 9:20 AM :: Comments (3) :: Digg It!