The Divide Among Multi Handed Economists

Something has always bugged me. It seems too irresponsible and naive to classify economists by the usual left versus right argument, or intervention versus non-intervention. Instead, Paul Romer gives us an alternate and better way of dividing economists (via Greg Mankiw):

Debate among economists about the $700 billion Paulson plan reveals a deep divide between realists and fundamentalists.

To be more specific:

The financial crisis provoked three open letters to policy makers. Fundamentalists opposed the plan. Realists supported the plan or supported more discretionary powers for dealing with the crisis without endorsing any specific plan.

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.

Well, so who is right!? The answer is not clear:

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.

In my humble opinion, a level of abstraction is important for economics. There are a plethora of variables that affect an economic outcome, and the relationship between each variable is also too complicated to trace. Economic models are important for policy makers who wish to make decisive and quick judgements on the issues at hand. A model that is too complicated shadows the one or two variables that are truly important for making the right decisions. In other words, abstract models allow economists to focus on the things that matter.

However, economic models are inherently different from the real economy. Though the models are quite right under certain given conditions, changes in the environment that is ignored by the models can lead to incorrect predictions. As a result, on the other hand, economists also have to be wary of the limitations of these models. For too long, financial economists have downplayed the role of default risks, and risk managers have thus focused too much on market risks, leading to an underestimate in the amount of risk their assets are exposed to. The primary reason for this is their belief in models.

As to the 700 billion bail out plan... I have no idea whether or not it is a good idea. But to rejuvenate the economy with a large dose of liquidity is a good thing, and probably the only way to reignite the confidence in investors again. The question though, is how should we use this 700 billion dollar wisely? Where does this money go and how?