THE GREAT Credit Crisis has cast into doubt much of what we thought we knew about economics. We thought that monetary policy had tamed the business cycle. We thought that because changes in central-bank policies had delivered low and stable inflation, the volatility of the pre-1985 years had been consigned to the dustbin of history; they had given way to the quaintly dubbed “Great Moderation.” We thought that financial institutions and markets had come to be self-regulating–that investors could be left largely if not wholly to their own devices. Above all we thought that we had learned how to prevent the kind of financial calamity that struck the world in 1929.
The late twentieth century was the heyday of deductive economics. Talented and facile theorists set the intellectual agenda. Their very facility enabled them to build models with virtually any implication, which meant that policy makers could pick and choose at their convenience. Theory turned out to be too malleable, in other words, to provide reliable guidance for policy.
In contrast, the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.
The author is an economist, so if this is a caricature, it’s from the inside….