Published online 29 October 2008 | Nature | doi:10.1038/news.2008.1183

Column: Muse

What you don't learn at school about the economy

Ignoring decades of sophisticated economic theory spells trouble for us all, argues Philip Ball.

The column inches devoted to the global financial crisis must surely now be running into miles, and a fair yardage has been devoted to attacking economics and its practitioners.

graphsAs the financial crisis worsens, critics have their sights trained on economists.Punchstock

Many commentators have pointed out that a largely unregulated market has clearly failed to deliver the optimal behaviour promised by conventional theories of economic competition. Some are seizing the chance to debunk the alleged superiority of the free market. A few have even trained their ire on Adam Smith, the eighteenth-century Scottish philosopher generally regarded as the father of modern economics.

His ideas laid the foundation for the traditional 'neoclassical' microeconomic models developed during the first half of the twentieth century. These models assume that everyone involved in an economy knows everything about what is being traded — that is, that they have 'perfect information'.

If agents have access to perfect information, it is much easier to model how they will try to maximize their 'utility', often synonymous with wealth or profit. Under conditions of perfect competition, the self-interested actions of market agents supposedly create an optimally efficient market in which asset prices attain their 'correct' value and supply matches demand.

“The problem is that nobody is teaching the shortcomings of outdated economic models to our policymakers.”

But as Joseph Stiglitz of Columbia University in New York recently pointed out1: "For over a quarter of a century, we have known that Smith's conclusions do not hold when there is imperfect information — and all markets, especially financial markets, are characterised by information imperfections." Analysing the effects of imperfect information on the markets won Stiglitz a share of the Nobel prize for economics in 2001.

So when people criticize economics for its reliance on traditional models that are generally wrong, it's hardly surprising that economists take umbrage. We know all about the shortcomings of the neoclassical models, they say — just look at the way people like Stiglitz have been rewarded for pointing them out.

The problem is that nobody is teaching those shortcomings to our policymakers.

Major failure

Traditional economic models are still taught as a meaningful first approximation to economics students who may never encounter the caveats before graduating and becoming financiers and policy advisers. It's a major failure of basic economic education.

"Only a few percent of all students studying introductory microeconomics [in the United States] will likely use a textbook that seriously challenges the neoclassical paradigm," says economist Steve Cohn at Knox College in Galesburg, Illinois.

"Many of the problems our economy faces are the result of the use of misguided models," agrees Stiglitz. "Unfortunately, too many [economic policy-makers] took the overly simplistic models from courses in the principles of economics, which typically assume perfect information, and use them as a basis for economic policy."

Indeed, free-market fundamentalism seems to have become an unqualified act of faith among many pundits and advisers, particularly in the United States, as this year's Nobel laureate Paul Krugman has explained2.

Robert Hunter Wade of the London School of Economics also agrees that the sophistication of academic economics tends to vanish in the real world, despite the claims of its defenders. "Go to the journals, they say, where some of the best work is done on issues of market failure. But one should also sample economics as it is applied by people such as World Bank country economists when they advise a government; and as it is hard-wired into World Bank formulas for evaluating countries' policies and institutions." In this kind of real-world economics, he says, the sophistication of the academic discipline is stripped away to leave only 'the fundamentals'.

Arguing that economics is backwards and unscientific will not help, because it's not true. A glance at the Nobels reveals the dramatic leaps in understanding and realism that the discipline has made since its origins.

But economists must take a stand against the use of vulgarized, introductory or plain incorrect models as instruments of policy. 

Read more about the trouble with economics in this week's Essay, 'Economics needs a scientific revolution'.

  • References

    1. Stiglitz, J. New Statesman 18 (20 October 2008).
    2. Krugman, P. Peddling Prosperity (W. W. Norton, 1995).
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