Why did mainstream economics
miss the crisis?
The role of epistemological and
methodological blinkers
John Cameron
& Karin Astrid Siegmann
International Institute of Social Studies
of Erasmus University Rotterdam (ISS)
JOURNEY’S STARTING POINTS
• The financial crisis that hit high-income
economies in 2008 has had a depressive
economic impact around the globe. It is
damaging many people’s well-being in terms
of growing unemployment and increasing
insecurity for those fortunate enough to keep
their employment.
• The crisis was not foreseen by economists
following neo-classical economics principles,
despite prediction being heralded as the main
objective of the discipline since Friedman
(1953).
JOURNEY’S STARTING POINTS (cont.)
• Underpricing of financial risk that paved the way
for the global financial crisis can be seen as
crucially influenced by institutional factors:
Banks’ strategies to reduce assets held as buffer
against losses through securitisation
Rating agencies both determined the risk of
collateralised debt obligations & advised banks
on how to structure them
International regulatory framework for banks
‘outsourced’ the determination of regulatory
capital to firms’ internal forecasting models
OUR JOURNEY’S ‘DESTINATION’
• This paper aims to investigate how a methodology,
rooted in logical positivist epistemology, may have
prevented neo-classical economists from detecting
discrete changes in the performance of the economy.
• As an alternative to this epistemological/
methodological nexus, we offer our interpretation of
a critical realist stance as underpinning for a political
economy focused on the specific instabilities of
contemporary global capitalism.
THE EPISTEMOLOGICAL COMPASS
OF NEO-CLASSICAL ECONOMICS
• The epistemological stance of neo-classical
economics can be characterised as logical positivist,
emphasising (potential) empirical falsification as the
pathway to progress in knowledge.
• Friedman (1953: 181) defined the aim of ‘positive’
economics as ‘to provide a system of generalisations
that can be used to make correct predictions about
the consequences of any change in circumstances’
THE EPISTEMOLOGICAL COMPASS
OF NEO-CLASSICAL ECONOMICS (cont.)
• The aim of correct prediction even justifies
unrealistic assumptions, e.g. the homo
oeconomicus as model of human behaviour. It
is assumed to give economic models their
precision, parsimony and predictive power.
• Acceptance of individualist axiomatic
rationality, also justified with a Popperian
emphasis on parsimony, became a
requirement to board the economics ship.
METHODOLOGICAL ‘BY-CATCH’:
hypothesis testing
• Hypothesis testing has become the methodological
corollary of falsification in applied economics.
• While it does not require a quantitative approach, in
applied research commonly historical, numerical
data are used, combining analytical statistics with
mathematised theorisation.
Theoretical emphasis on equilibrium reinforces a
methodology that looks for solution (of equations)
rather than for tension, it acts as a blinker for
forecasting crises
METHODOLOGICAL ‘BY-CATCH’:
hypothesis testing (cont.)
• The significance of coefficients is used as an indicator
of whether models are supported or rejected by
empirical data. The quantitative information required
for this process…
… largely reduces information about structures &
institutions to categorical variables, smoothing away
the effects of differing contexts
… leads to predictions emphasising extrapolation
from stable ‘structural’ relationships, constraining
the capacity to foresee discrete changes.
METHODOLOGICAL ‘BY-CATCH’:
methodological individualism
• The epistemological status given to the ‘axiomatically rational
individual’ in mainstream neo-classical economics owes its
origins to a mix of liberal ideology & mathematical tractability.
• But a possible associated model of Nietzschean ‘heroic’
human agency is constrained to only allow individual choices
at the margin in response to gradual movements in the vector
of prices.
These constraints are vital to the neo-classical economics’
claim to be scientific & in a position to uncover laws of human
behaviour. But, they also inhibit the ability to foresee the
consequences of non-marginal changes, such as rapid,
apparently unconstrained changes in asset values.
METHODOLOGICAL ‘BY-CATCH’:
separation economics/politics
• The distinction between the realm of positive
economics as an objective science in contrast
to the normative process of economic policymaking parallels Popper’s distinction between
science and non-science.
 In neo-classical economics, structures &
institutions have often been excluded from
the analysis
Role of epistemological &
methodological blinkers
epistemological
compass
methodological
by-catch
the wreckage…
smooth
extrapolation
falsification
parsimony
instrumentalism
neglect of institutions/
structures
focus on
marginal change
focus on
equilibrium
inability to
foresee crisis
HAVE CAPTAINS OF THE NE0-CLASSICAL ECONOMICS
SHIP LEARNT LESSONS FROM THE WRECKAGE?
• The response to the global financial crisis has been
characterised by an unusual degree of self-criticism of the
economists profession, yet, we see little evidence that the
methodological flaws we have pointed out above have been
addressed:
• While Stanford economist John B. Taylor is planning to update
his macro-economics textbook, including information about
the financial crisis, explanations of fundamental principles will
not change (Cohen 2009)
RE-ORIENTING ECONOMIC METHODOLOGY TOWARDS BETTER
FORECAST OF HEAVY WEATHER FOR THE ECONOMY
1.
Less emphasis on falsification as a key criterion for assessing
quality of knowledge
2.
More space for non-quantified, dialectical reflections on
relationships
3.
Thicker model of human agency
4.
Well specified model of collective human behaviour
5.
Endogenise the possibility of dramatic change within the
economic domain
CRITICAL REALISM: ontological &
epistemological outlook
• Ontology: reality is open and layered
• Openness: the social world is characterised by relations and
dependencies between people and institutions (extrinsic
openness) and the possibility for internal change (intrinsic
openness).
• Reality is separated into overlapping levels:
• While the real refers to causal structures and generative
mechanisms, it generates events at the actual level, which are
apprehended as experiences in the domain of the empirical.
• Epistemology: Critical realism aims at explanation that takes
the causal powers of the real level as a starting point and aims
at an identification of how they work and under what
conditions.
Less emphasis on falsification as a key
criterion for assessing quality of knowledge
• Critical realism values structural explanation
(retroduction) in place of hypothesis testing at
the, often superficial, empirical level
• Starting from an ontological position that
reality is holistic, knowledge should be
assessed in terms of its claims to integrate all
human experience into a single, complex
framework, including the potential for multidimensional, integrated crisis
More space for non-quantified reflections
on relationships
• While the empirical level may focus on
quantified indicators, there is no requirement
that observations at the actual level be
quantified
• The real level’s central concern with power
relationships means quantification has little or
no relevance
• De-prioritising quantitative data reduces the
temptation to extrapolate and impose path
dependence
Thicker model of human agency
• The actual level of critical realism lends itself
to a more ethnographic, life-world approach
to human identity and decision-making
• The structural level maps the complex terrain
on which people travel their actual level
journeys, making decisions that are emergent
from the structural level.
• Insights from complexity theory can help
identify emerging peaks and valleys and the
cusps and tipping points people must
negotiate
Well specified model of collective human
behaviour
• While much data at the empirical level is collected
from individuals (people or firms), the actual and
structural levels of critical realism create room for
creating analytical collectivities
• For instance, classes and fractions of capital can be
seen as possessing agency at the actual level,
possibly using concepts such as Bourdieu’s habitus
• If a large collectivity moves determinedly in a single
direction at the actual level then it may tip the
structural level into crisis
Dialectical rather than comparative static
equilibrium analysis
• An ontological characteristic of critical realism
is the claim that reality is dialectical and in a
perpetual state of change caused by
unresolved structural tensions
• This awareness of tension increases the
possibility of foreseeing crises, indeed the
challenge then becomes explaining relative
stability – as theories of false consciousness
and misrecognition testify
Endogenise the possibility of dramatic
change within the economic domain
• In critical realism, changes in structural
processes in any field can spread throughout a
system changing all other fields
• Structural changes in the economic field can
induce emergent changes in the political field
at the actual level
• Therefore decisions in formal politics are likely
to be de facto shifting responsibility for crisis
from economic structural processes to the
political field at the actual level
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Why did mainstream economics miss the crisis? The role of