Economists failed to predict many aspects of the financial crisis but it was not because we didn’t have the right tools. It was due to where we chose to focus our teaching.
Some interesting views are being shared about how the mainstream economics curriculum needs to be revamped. Mark Thoma and Wren-Lewis are weighing in.
While I am sympathetic to some of the arguments made in these posts and the need for some serious rethinking of the way economics is taught, I would put the emphasis on slightly different arguments. First, I am not sure the recent global crisis should be the main reason to change the economics curriculum. Yes, economists failed to predict many aspects of the crisis but my view is that it was not because of the lack of tools or understanding. We have enough models in economics that explain most of the phenomena that caused and propagated the global financial crisis. There are plenty of models where individuals are not rational, where financial markets are driven by bubbles, with multiple equilibria that one can use to understand the last decade. We do have all these tools but as economics teachers (and researchers) we need to choose which ones to focus on. And here is where we failed. And we did it before and during the crisis but we also did it earlier. Why aren't we focusing on the right models or methodology? Here is my list of mistakes we make in our teaching, which might also reflect on our research:
1. Too much theory, not enough emphasis on explaining empirical phenomena. Models are easy to teach. Answering questions like "what caused the 2008 crisis?" or "what are the effects of an increase in the minimum wage?" is so much harder. So not only do we tend to avoid them but also criticise those who provide answers by saying that there is too much uncertainty and no one really knows the answer. This is just a bad excuse because policy makers need to make decisions regardless of uncertainty. Economics students should be aware of the uncertainty surrounding these questions but they should also be taught how to answer them.
2. Too many counterintuitive results. Economists like to teach things that are surprising. Teaching that consumption increases when taxes go down is not too exciting. But teaching that under some very implausible assumptions, consumers will save all the tax rebates to pay for future taxes makes you feel that you added some value in your class. Yes, clearly teaching something that our students have not thought about before can potentially be of more value, but this is only true if what we teach is relevant. If it just introduces confusion and makes our students be cynical about every economic policy proposal then we failed.
3. The need for a unified theory. The idea that economics is a rigorous science pushes economists to look for consistency via a unified framework when we teach the subject. We want to have one model to explain everything. The use of small and sometimes inconsistent partial equilibrium models to explain real-world phenomena is seen as a sign of weakness. A unified theory that is consistent (even if it does not explain much of what we seen in the real world) is always the way to go. Yes, a unified theory would be great, but we need to be realistic. Small ad-hoc models can be a lot more effective to learn about economic issues than the insistence on using the same unrealistic model to explain everything. And in most economics courses we spend all our time building this model and once we are done there is very little time to answer relevant questions. And when asked, we simply argue that "this model cannot capture that" (so back to mistake number 1, too much theory, not enough emphasis on understanding empirics).
4. We teach what our audience wants to hear. We conform too often to social beliefs about how the economy works and we simply support those beliefs with our teaching. Here is one example: when we teach about governments, cracking a few jokes about government inefficiency, bureaucrats and politics is very easy. Using models where government spending plays no productive role feels natural. But when we look at the private sector, we start with the opposite view, one of efficiency and absence of rents given the competitive environment in which firms operate (the famous analogy of no US$100 notes sitting on the sidewalk). If you want to argue that it is the other way around, be ready to fight a difficult battle. And it is not that we have plenty of empirical evidence to back up these statements. There is very limited research and in some cases with very uncertain results on the role of rents, inequality, market power in modern economies (although this might be changing). But rather than teaching about this uncertainty, we start with models that take a very strong stance on these very fundamental questions. So we are being inconsistent. While in some cases we use uncertainty to criticise certain economic policies, in other cases we use the same argument to support a certain view of the world because it matches either the status quo or the beliefs that most in the audience have.