By Allison Schrager
Dec 3 (Reuters) - Recently, at the House of Sweden, there was a feisty exchange among the newest Nobel laureates. First, one of the economics winners, Robert Shiller, questioned the validity of the efficient markets hypothesis, the prize-wining idea of co-laureate Gene Fama. This prompted chemistry winner, Martin Karplus, to say "What understanding of the stock market do you really have?" He reckoned economics can't explain the market and questioned if "the dismal science" is even a science.
That conversation demonstrates the understandable frustration people have with the economics profession. That frustration deepened with the financial crisis, which few predicted, and the anemic recovery that followed it, where economic policies failed to revive growth. It leads many to ask: "What use are economists and their theories?"
It's important to understand that economics isn't fortune-telling. If you judge a single economic model by its ability to predict the future, inevitably it will fail you. Economics merely aims to determine the best use of scarce resources. That requires some understanding of how different factors in the economy interact. For example, if you have limited means to boost the economy and increase government spending, what happens to income?
To answer that question, economists design models that describe how the economy functions. These models are abstractions of the real world, which is complicated and contains an uncountable number of factors. It's similar to drawing a map: to construct a tractable map, you must make choices about what to include. If you included every tree, hill, and country road the map would be too confusing to be useful. The purpose is to understand how different, relevant factors relate to each other. That serves an important role, but it makes no guarantees. You might take a highway featured in a road atlas and a truck could slam into you on that road. But that doesn't negate the validity of the map. Driving on a highway poses some risk and, as financial economics cautions, so do markets.
What is included or left out in an economic model is where things get contentious, but economic models are still valuable. Many maps exist of New York State that don't resemble each other, but all are useful. For a hike in the Hudson Valley you'd use a trail map that contains every path and hill. But if you were driving from New York City to Albany, a trail map wouldn't get you too far - you'd use a road map. Or if you wanted to understand the size and location of New York relative to Ohio, you'd look at a coarser map of the states. Each map is accurate in the right context, but often useless for other purposes.
The same could be said in economics models. In 2008 chief IMF economist Olivier Blanchard summarized the state of macroeconomics. Despite some sharp divisions around what assumptions matter, he reckoned different schools of economic thought had reached some consensus. Take Keynesian models used by policymakers or neo-Keynesian models used by some academics. They assume the government can jump-start growth by boosting demand, getting people to spend more. That might be true in the short run. But these models aren't great at explaining how the economy behaves in the long run; neo-classical models perform better at that task.
The problem is, in economics, it's not always clear what assumptions should be used or even the nature of the journey. Consider unemployment. Some economists reckon it would be lower if the Fed increased inflation. Other economists believe the problem is structural and requires rethinking regulation and education. Another potential problem is that the personal values of any given economist may influence the model. If you believe active government intervention improves outcomes, your model would look very different than if you believe the government creates waste and inefficiency.
Despite these disagreements, and reliance on human judgment, economic models are our best hope to figure out how to lower unemployment and inequality. Maps aren't perfectly accurate either, but they are better than fumbling in the dark with no guidance at all.
Nonetheless, the disagreement among economists is frustrating and so is the lack of easy answers. Because all these models are valid, depending on the context, some will work some of the time. Depending on the nature of the problem or the natural evolution of the economy, the relevant issues can change. The best way to figure out which model is best is to have open and frank discussions about what assumptions were used and what was left out.
The problem is that as economics debates become more public, commentators often lose sight of that subtlety. They get attached to one model (often a stylized version of what's taught to undergraduates), use it in all contexts, and then complain economics over-simplifies how the world really works. A lot of commentary I read seems to assume a closed economy (meaning a country doesn't trade); that people don't respond to incentives; and that risk and uncertainty don't exist. Those may be valid assumptions depending on the country you are describing or the state of the economy. But we'd all be better informed if there was more discussion on what's missing.
I am not sure why it matters whether or not economics is considered "science." People should judge economics by its ability to provide knowledge and insight into how the economy functions. In that sense it's what drives disagreements, like the one between Shiller and Fama, that teach us the most.