Mark Twain could have been talking about Economists’ priors (the assumptions they make) when he is credited with observing:

It Ain’t What You Don’t Know That Gets You Into Trouble. It’s What You Know for Sure That Just Ain’t So.

It is their priors that are the downfall of the Economics profession.  This is particularly true for macro Economists where a Venn Diagram of their priors versus how the real economy actually works would have no overlap (see Nobel Prize winning Economist Paul Romer’s critique of their post real models).

Why do their priors cause the downfall of the Economics profession?

If the assumptions underlying their models are ridiculous, there is no reason to think they or their models can provide any insight into what actually happens in the real world.

Regular readers recall an epic failure of macro economists’s models:  they were blindsided by the Great Financial Crisis as their models didn’t include a financial system. Then, even after adding in their version of a financial system, the models continued to predict a much stronger recovery than has occurred.

Naturally, macro economists have offered up a defense of this abysmal forecasting track record.

I have previously argued, as have countless others, that the usefulness of policymakers (or macroeconomists more generally) should not be measured by their ability to forecast recessions, in the same way that the usefulness of doctors is not measured by their ability to forecast heart attacks. Instead, the usefulness of policymakers lies in their response to a recession when it is happening, and their understanding of general risk factors beforehand, just as the usefulness of a doctor lies in her treatment of a heart attack once it is happening, and her prescriptions for a healthy lifestyle to reduce the risk of a heart attack beforehand.

 

There is one glaring problem with this defense when it comes to financial crises.  Doctors actually know something about the heart, how it works and therefore the best treatment for a heart attack.  Macro economists know nothing about the financial system (see exclusion from their models pre-2008), how it is designed or how it is suppose to be used to protect the real economy during a financial crisis.

It is a very strong statement to say macro economists know nothing about the financial system or how to warn about the risk factors that actually result in a financial crisis, but why should they?

They never had a course on the design of the financial system or how it is suppose to be used to protect the real economy during a financial crisis while at graduate school*.

Yet, it is during graduate school that their priors about how the economy and the financial system operates are effectively set in stone.  This is reinforced post graduation as the acceptance of these priors is necessary if the PhD Economist wants to publish in one of the top academic journals or have a senior position at a central bank.

Once in place, their priors prove incredibly hard-to-move.  One can only despair at the outrageous burden of proof that Economists demand to see the obvious and acknowledge their priors might be wrong.  And even then there are some Economists who remain impervious to ANY evidence their priors might be wrong (see Ben Bernanke defending his priors).

And heaven forbid something like the Information Matrix should come along into a macro economist’s life.  You can watch them shudder when they realize just how many of their beloved priors the Information Matrix shows are wrong.

But don’t worry, a PhD macro economist is fully capable of retreating back to his/her world of flawed priors.  Their powers of denial are very strong.

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* Hat tip to Matt Stoller for these paragraphs including a Janet Yellen quote confirming my observation:

Former Fed Chair Janet Yellen, just before the 2016 election, gave an important speech about how economists don’t really know much about how finance and the economy intersect. Here’s what she said.

Extreme economic events have often challenged existing views of how the economy works and exposed shortcomings in the collective knowledge of economists. To give two well-known examples, both the Great Depression and the stagflation of the 1970s motivated new ways of thinking about economic phenomena. More recently, the financial crisis and its aftermath might well prove to be a similar sort of turning point.

Her thesis is that the crisis revealed an intellectual gap at the heart of economic thinking. Yellen was correct in her observation.