Wednesday, 8 October 2008

Fundamentalists versus realists (updated)

Greg Mankiw points us to this posting at the Growth Blog by Paul Romer entitled Fundamentalists versus Realists. In part Romer writes
The financial crisis provoked three open letters to policy makers. Fundamentalists opposed the plan (here.) Realists supported the plan (here) or supported more discretionary powers for dealing with the crisis without endorsing any specific plan (here.)

A quick look through the lists of economists who signed the various letters shows that the camps do not separate cleanly along the familiar lines of left-versus-right or active-versus-limited government. The key difference lies in the relative weight each side gives to formal models as opposed to judgment.

Fundamentalists have an unswerving faith in models. Policies should always be derived from the best available model. Data should be filtered through a model. If an observation does not fit within the context of a model, it should be excluded from consideration.

Realists are more conscious of the limits of models and more comfortable with a division of labor between the researcher who improves the models and the clinician who makes policy decisions. They recognize that the power of models comes precisely from a commitment to abstraction that filters out potentially important complexity. They believe that useful evidence can accumulate with direct experience as well as through the research process of testing and refining models. They believe that researchers should consider the possibility that the fault lies with the model when its predictions diverge from clinical judgment and that policies should draw on both sources of evidence.

Many times, the confidence fundamentalists have had in abstract models turned out to be well founded and the objections raised by realists who were more focused on details were misplaced. The fundamentalists were right that an airline industry could still function even if airlines could set their own fares; that people could still talk to each other even if they purchased phone service from different companies. The realists pointed to all the complicated details that arise in such markets, details that simple models could not capture. Fundamentalists, correctly, ignored the detail and pushed prescriptions based on the textbook model of competition.

Other times, the models are missing something that is too important. In the study of macroeconomic fluctuations, real business cycle theorists and their descendants, the dynamic stochastic general equilibrium modelers, are the quintessential fundamentalists. Their models are a useful way to make research progress, but in macroeconomic policy making, the great depression, which these models cannot explain, is a decisive data point warning us that the models are incomplete and have to be supplemented by clinical judgment.
At EconLog Arnold Kling disagrees with Romer. He asks Who is a Realist? Kling writes,
I did not care for Paul Romer's claim that realists support the Paulson plan, while model-addicted fundamentalists oppose it. In my view, there are realistic reasons to oppose the Paulson plan.

First, many "realists" say that we need to boost home prices. But Ed Glaeser argues persuasively that trying to boost home prices is unrealistic. And if home prices have much farther to fall, then the premise that mortgage securities are undervalued is unrealistic.

I do not think it is realistic to say, "Credit markets are seizing up. Therefore, we must support the Paulson plan." In fact, if credit markets are seizing up, then something like what the Fed is doing today, as discussed by Tyler Cowen and Alex Tabarrok, makes more sense.

The theory that you can fix credit markets by "removing the clog" of mortgage securities is just that--a theory. My guess is that it will not work. I am sure that other things will have to be tried sooner or later--probably sooner. I hope the other moves work. I do not think it is at all realistic to rely on the Paulson plan. Trying to revive the mortgage securities market is not a realistic solution--it is a very unfortunate distraction.
It may well be that "the models are incomplete and have to be supplemented by clinical judgment". But you then have to ask on what basis do we pick the "clinical judgment" we are to use? Do we need a theory of clinical judgment? It seems to me that Romer's model-addicted fundamentalist economist is, at best, a caricature. As Keynes said of Alfred Marshall
...the master-economist must possess a rare combination of gifts. He must be mathematician, historian, statesman, philosopher–in some degree. he must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.
So a good economist has both a good understanding of theory and a good dose of realism. Those economists opposing the Paulson plan have a large measure of both.

Update: The visible hand in economists comments on the Romer piece here.


Matt Nolan said...

That is my favourite Keynes quote :)

Paul Walker said...

It's a great quote. Unfortunately it does show why I'm a crap economist, at least compared to Alfred Marshall!!!

Matt Nolan said...

"It's a great quote. Unfortunately it does show why I'm a crap economist, at least compared to Alfred Marshall!!!"

I feel the same. It makes me feel a bit bad about calling myself an economist - as I could never live up to that sort of standard :(

At least it gives us something to aspire to :P