Why did mainstream economics miss the crisis? The role of epistemological and methodological blinkers

1. Why did mainstream economicsmiss the crisis?The role of epistemological and methodological blinkers John Cameron & Karin Astrid Siegmann International Institute of Social Studies of Erasmus University Rotterdam (ISS)

2. JOURNEY’S STARTING POINTS • The financial crisis that hit high-income economies in 2008 has had a depressive economic impact around the globe. It is damaging many people’s well-being in terms of growing unemployment and increasing insecurity for those fortunate enough to keep their employment. • The crisis was not foreseen by economists following neo-classical economics principles, despite prediction being heralded as the main objective of the discipline since Friedman (1953).

3. JOURNEY’S STARTING POINTS (cont.) • Underpricing of financial risk that paved the way for the global financial crisis can be seen as crucially influenced by institutional factors: • Banks’ strategies to reduce assets held as buffer against losses through securitisation • Rating agencies both determined the risk of collateralised debt obligations & advised banks on how to structure them • International regulatory framework for banks ‘outsourced’ the determination of regulatory capital to firms’ internal forecasting models

4. OUR JOURNEY’S ‘DESTINATION’ • This paper aims to investigate how a methodology, rooted in logical positivist epistemology, may have prevented neo-classical economists from detecting discrete changes in the performance of the economy. • As an alternative to this epistemological/ methodological nexus, we offer our interpretation of a critical realist stance as underpinning for a political economy focused on the specific instabilities of contemporary global capitalism.

5. THE EPISTEMOLOGICAL COMPASSOF NEO-CLASSICAL ECONOMICS • The epistemological stance of neo-classical economics can be characterised as logical positivist, emphasising (potential) empirical falsification as the pathway to progress in knowledge. • Friedman (1953: 181) defined the aim of ‘positive’ economics as ‘to provide a system of generalisations that can be used to make correct predictions about the consequences of any change in circumstances’

6. THE EPISTEMOLOGICAL COMPASSOF NEO-CLASSICAL ECONOMICS (cont.) • The aim of correct prediction even justifies unrealistic assumptions, e.g. the homo oeconomicus as model of human behaviour. It is assumed to give economic models their precision, parsimony and predictive power. • Acceptance of individualist axiomatic rationality, also justified with a Popperian emphasis on parsimony, became a requirement to board the economics ship.

7. METHODOLOGICAL ‘BY-CATCH’:hypothesis testing • Hypothesis testing has become the methodological corollary of falsification in applied economics. • While it does not require a quantitative approach, in applied research commonly historical, numerical data are used, combining analytical statistics with mathematised theorisation. Theoretical emphasis on equilibrium reinforces a methodology that looks for solution (of equations) rather than for tension, it acts as a blinker for forecasting crises

8. METHODOLOGICAL ‘BY-CATCH’:hypothesis testing (cont.) • The significance of coefficients is used as an indicator of whether models are supported or rejected by empirical data. The quantitative information required for this process… … largely reduces information about structures & institutions to categorical variables, smoothing away the effects of differing contexts … leads to predictions emphasising extrapolation from stable ‘structural’ relationships, constraining the capacity to foresee discrete changes.

9. METHODOLOGICAL ‘BY-CATCH’: methodological individualism • The epistemological status given to the ‘axiomatically rational individual’ in mainstream neo-classical economics owes its origins to a mix of liberal ideology & mathematical tractability. • But a possible associated model of Nietzschean ‘heroic’ human agency is constrained to only allow individual choices at the margin in response to gradual movements in the vector of prices. These constraints are vital to the neo-classical economics’ claim to be scientific & in a position to uncover laws of human behaviour. But, they also inhibit the ability to foresee the consequences of non-marginal changes, such as rapid, apparently unconstrained changes in asset values.

10. METHODOLOGICAL ‘BY-CATCH’: separationeconomics/politics • The distinction between the realm of positive economics as an objective science in contrast to the normative process of economic policy-making parallels Popper’s distinction between science and non-science. In neo-classical economics, structures & institutions have often been excluded from the analysis

11. Role of epistemological &methodological blinkers epistemological compass methodological by-catch the wreckage… smooth extrapolation falsification neglect of institutions/ structures inability to foresee crisis parsimony focus on marginal change instrumentalism focus on equilibrium

12. HAVE CAPTAINS OF THE NE0-CLASSICAL ECONOMICS SHIP LEARNT LESSONS FROM THE WRECKAGE? • The response to the global financial crisis has been characterised by an unusual degree of self-criticism of the economists profession, yet, we see little evidence that the methodological flaws we have pointed out above have been addressed: • While Stanford economist John B. Taylor is planning to update his macro-economics textbook, including information about the financial crisis, explanations of fundamental principles will not change (Cohen 2009)

13. RE-ORIENTING ECONOMIC METHODOLOGY TOWARDS BETTER FORECAST OF HEAVY WEATHER FOR THE ECONOMY Less emphasis on falsification as a key criterion for assessing quality of knowledge More space for non-quantified, dialectical reflections on relationships Thicker model of human agency Well specified model of collective human behaviour Endogenise the possibility of dramatic change within the economic domain

14. CRITICAL REALISM: ontological & epistemological outlook • Ontology: reality is open and layered • Openness: the social world is characterised by relations and dependencies between people and institutions (extrinsic openness) and the possibility for internal change (intrinsic openness). • Reality is separated into overlapping levels: • While the real refers to causal structures and generative mechanisms, it generates events at the actual level, which are apprehended as experiences in the domain of the empirical. • Epistemology: Critical realism aims at explanation that takes the causal powers of the real level as a starting point and aims at an identification of how they work and under what conditions.

15. Less emphasis on falsification as a key criterion for assessing quality of knowledge • Critical realism values structural explanation (retroduction) in place of hypothesis testing at the, often superficial, empirical level • Starting from an ontological position that reality is holistic, knowledge should be assessed in terms of its claims to integrate all human experience into a single, complex framework, including the potential for multi-dimensional, integrated crisis

16. More space for non-quantified reflections on relationships • While the empirical level may focus on quantified indicators, there is no requirement that observations at the actual level be quantified • The real level’s central concern with power relationships means quantification has little or no relevance • De-prioritising quantitative data reduces the temptation to extrapolate and impose path dependence

17. Thicker model of human agency • The actual level of critical realism lends itself to a more ethnographic, life-world approach to human identity and decision-making • The structural level maps the complex terrain on which people travel their actual level journeys, making decisions that are emergent from the structural level. • Insights from complexity theory can help identify emerging peaks and valleys and the cusps and tipping points people must negotiate

18. Well specified model of collective human behaviour • While much data at the empirical level is collected from individuals (people or firms), the actual and structural levels of critical realism create room for creating analytical collectivities • For instance, classes and fractions of capital can be seen as possessing agency at the actual level, possibly using concepts such as Bourdieu’s habitus • If a large collectivity moves determinedly in a single direction at the actual level then it may tip the structural level into crisis

19. Dialectical rather than comparative static equilibrium analysis • An ontological characteristic of critical realism is the claim that reality is dialectical and in a perpetual state of change caused by unresolved structural tensions • This awareness of tension increases the possibility of foreseeing crises, indeed the challenge then becomes explaining relative stability – as theories of false consciousness and misrecognition testify

20. Endogenise the possibility of dramatic change within the economic domain • In critical realism, changes in structural processes in any field can spread throughout a system changing all other fields • Structural changes in the economic field can induce emergent changes in the political field at the actual level • Therefore decisions in formal politics are likely to be de facto shifting responsibility for crisis from economic structural processes to the political field at the actual level