Wednesday, November 24, 2010

The 'Next Big Thing in Economics'? Three Views

What is the “next big thing” in economics? What is it that non-economists know nothing about today but that everyone will be talking about in five or ten years?

I posed this question to three young economists following a panel discussion at George Mason University featuring three Nobel laureates: Amartya Sen, Elinor Ostrom, and James Buchanan.

The September 9 event honored Buchanan, one of the founders of “Virginia School” or public-choice economics, who taught at Virginia Tech in Blacksburg and the University of Virginia in Charlottesville before settling at George Mason (located in Fairfax, Virginia) in the 1980s.

The tribute attracted numerous professional economists, academics, and students interested in hearing about Buchanan’s contributions to social philosophy and political economy.

In addition to Buchanan's fellow Nobel prize winners, the program included encomia from GMU’s former law school dean, Henry Manne, and the current chairman of the university’s economics department, Daniel Houser, among others, as well as an opportunity for university President Alan Merten to show off a new conference facility.

Garett Jones
Garett Jones is assistant professor of economics at George Mason University as well as BB&T Professor for the Study of Capitalism at the Mercatus Center, which is headquartered at GMU's Arlington Campus near Virginia Square. His current research, he said, is about “why IQ matters more for nations than for individuals.”

He noted that “a person’s individual IQ has a very weak relationship and very small effect on their adult wages, but it seems as though a nation’s average IQ -- how people do on conventional IQ tests, on average -- is a really great predictor of how rich or poor that country is.” He described this as “quite a robust finding” and he is trying to discover “why that’s true.”

Jones’ prediction of what the “next big thing” comes from a different part of the field, however.

“This idea of balance sheets and net worth is being a big part of business cycles, is a really big deal,” he said.

Jones pointed to a review by Paul Krugman and Robin Wells of Richard C. Koo’s book, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, in the September 30 issue of the New York Review of Books, describing it as “this book that’s been kicking around for a little bit” as giving “some attention” to the topic.

Discussions like these, Jones said, are “trying to bring [Federal Reserve chairman] Ben Bernanke’s research into the broader public light,” such as ideas about “what makes it possible for us to trust each other, what makes it possible for firms to lend to individuals, [and] for investors to lend to banks.” What is necessary to make these things possible, he explained, “is that you want to lend to people who have a high net worth, people who have sound balance sheets.”

What’s “floating around,” he said, is “the idea that we’re in a so-called ‘balance sheet recession,’” yet, he added, “the absolute centrality of healthy balance sheets of individuals, of firms, [and] of governments, is something that has not made it [into] the mainstream.”

“Five years from now,” Jones said, “we’ll take it for granted in a way that don’t at all today.”

Margaret Polski
For her part, Margaret Polski of the Mercatus Center pointed to new forecasting tools that are becoming available to economists.

“The real problem that we have in economics,” Polski said, “is that we can’t forecast the things that are really interesting and really important: changes in the business cycle, when we’re going up, when we’re going down. We can’t forecast when we have shocks, big price changes, and catastrophic events.”

Polski offered the example of “the Congressional Budget Office’s record in forecasting and the error in their forecasts,” for which there’s a record dating back to 1976.

In six of the last 13 years, she said, the CBO’s forecasts have been “significantly off.”

It doesn’t end there, however, she added.

“It’s not just the CBO, it’s not just the Office of Management and Budget, it’s also the private sector economic forecasters. The practical matter is that our current tools for forecasting don’t serve us well.

“What you’re going to be hearing over the coming years,” Polski continued, “is the use of complex systems tools, agent-based models to help us develop a better understanding of what’s really happening at a micro level and how that translates into macro impacts.”

That she said, is “where I think it’s going. That’s what I think is interesting and cool.”

Polski noted that,” thanks to the most recent financial regulatory reform, we have an office of financial research,” which means that, “for the first time, we’ll actually be able to collect data. Researchers will be able to get their hands on this data and start putting these tools to work.”

These tools, she said, “will help us really imagine futures that we otherwise would have a hard time imagining, [and] imagine scenarios that are otherwise difficult for us to imagine,” so that we then “can think about what is the impact of our policy decisions in a different way that we’re able to do right now.”

The new tools, Polski emphasized, are “agent-based tools” and therefore more individualized and focused than traditional forecasting models.

“The reason the macro models don’t predict” as well, she explained, “is they’re based on historical data and they’re based on big patterns and big trends and the fact of the matter is that individuals matter, small groups matter.”

This is a point often lost on those engaged in traditional macroeconomic analysis, “because agents and small collectives of agents really do matter.”

Using the new tools, she said, these agents will not “lose that power; it’s that we don’t understand their power. That’s why our forecasts are wrong and they’re wrong in ways that cause us to make bad policy.”

The real challenge, Polski explained, “has always been to integrate micro and macro.”

In the economics profession, she pointed out, “there have always been microeconomists and macroeconomists, and never the twain shall meet,” with one exception.

“Theoretically, they meet in industrial organization theory, but that’s just not enough, because that’s very focused on business and on the structure of industrial markets. That’s not really what we’re talking about.”

What we are really talking about, Polski said, is “trying to bring those analytical tools together to understand how individual actions and small collectivities can produce macro patterns, and how there can be disruptive, unpredictable, non-linear events that occur.”

Once these tools are widely available, predictions will become more accurate and that, according to Margaret Polski, is the next big thing in economics.

Peter Boettke
Recently profiled in the Wall Street Journal as “the intellectual standard-bearer for the Austrian school of economics,” Peter Boettke teaches at George Mason University in Fairfax, Virginia, and conducts research there and at the Mercatus Center in Arlington, across the river from Washington, D.C.

Boettke singled out the work of Ostrom and Buchanan, particularly their ideas “about the nature of democracy and citizenry,” that democracy is more than just voting but more active participation, and exploring the preconditions for that.

Elinor Ostrom’s husband, Vincent Ostrom, Boettke said, “wrote a wonderful book called The Meaning of Democracy and the Vulnerability of Democracies. It’s a very densely written book, so it doesn’t have the sort of popular sway that it should,” but it establishes the way to think about “those conditions about what it means to be a citizen, or what they call an artisan-citizen.”

Following on the work of the Ostroms and Buchanan, he continued, “We’re now examining those things: how it is that you create or cultivate (educationally) individuals [so they] can become self-governing citizens or their own participants within the democratic process.”

That idea, Boettke said, “is going to get more and more explored,” and Ostrom’s Nobel Prize and other events mean that it is “going to capture the imagination of a lot of scholars [in] what Amartya Sen [calls] the ‘public reason project.'”

Looking at another discipline, Boettke noted, “if you read in philosophy, a lot of people in philosophy now are calling for an idea of ‘public reason.’ I think that idea is something that no one knows about now, but ten years from now, people will all know about it and think back, ‘When the hell did they get started thinking about that?’”

One of the developments that excites Boettke is the increasingly interdisciplinary nature of economic research and theory.

“There’s a rising trend of programs in philosophy, politics, and economics,” he said, and that is a return to “what actually took place back at the end of the nineteenth century.”

Boettke explained:

“You can think about modern economics as an hourglass shape. You start with really broad questions and then, as we believed that the role of the economist was to be a technical expert, the questions narrowed, but then we found out we knew more and more about less and less.”

Consequently, he said, “we had to open the questions up again. We opened them up to sociology, to psychology, to philosophy, to politics, so as a result the hourglass goes narrow and then widens up, and we’re at that point of the widening up.”

Boettke pointed out that “the financial crisis is a perfect example of this, because you can’t just answer it as a technician in economics. It’s a question about the legal and political rules, the culture of Wall Street.”

Citing Karen Ho’s book, Liquidated: An Ethnography of Wall Street, which he called “fascinating,” Boettke explained that “economists normally don’t look at those things, but now we have to. What are the implicit rules that are going on? What do these people believe that they are doing?”

Animated and smiling, Boettke returned to his hourglass analogy and concluded: “We started out, we got very narrow, we didn’t go anywhere -- or it didn’t really help – [and] now we’re opening up again.”

(This article originally appeared in three parts on on September 20September 21, and September 23, 2010.)

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