The devil is in the detail …

7th May, 2011

To my surprise, the book that inspired this column, The Undercover Economist, has shown enough staying power to merit a second edition, which was published on Friday.

Naturally I spent much of the editing process wincing at the prose and the cheerful overconfidence of my youthful self. But revising the book was also an opportunity to reflect on how the economics of half a decade ago looks from the vantage point of today.

I cannot make up my mind whether this is reassuring or alarming, but there was little that I needed to change in the light of the financial crisis. I removed a chapter on the dot-com bubble – old news – and of course I added a chapter on the banking crash. But what I had written before mostly needed tweaking and updating rather than removing, and the reason was that I simply didn’t say much about the details of high finance.

The strengths and weaknesses of my little book, coincidentally or not, seem to have reflected the strengths and weaknesses of academic economics itself. Economics did not cover itself with glory during the crisis, and its failures were chiefly those of omission, not commission. The crisis did not falsify cherished principles of economic thought, but it did catch most of us napping. For the banking system, the devil was in the details – legal niceties about how credit default swaps worked, or collateral requirements, or CDOs of CDOs – and most economists had no interest in those details.

There is a parallel here with other fields – for instance, structural engineering. Ambitious structures have a habit of falling down, or at least misbehaving, and the culprit is inevitably not some misinterpretation of the laws of physics, but something more mundane such as a failure to appreciate the detailed geology of the rocks under a dam, or the effect of snowdrifts on a roof accumulating unevenly under a cross-wind. Attention to detail matters. So does hard experience.

One of the old tales in the book which has gained new resonance is the economist Paul Klemperer’s warning about the uses and abuses of auction theory. Klemperer was one of the designers of the famously lucrative mobile phone spectrum auction in the UK in the spring of 2000. He pointed out that auction designers shouldn’t be distracted by fancy theoretical results, but should pay far more attention to institutional details. Will the bidders show up? If they win, will they pay? Will they collude with each other? Formal models have a tendency to assume away what really matters.

Three weeks ago, a former student of Klemperer’s, Jonathan Levin of Stanford University, won the John Bates Clark medal, one of the economics profession’s highest honours and one that has often heralded a Nobel prize later in life. Levin’s victory is striking because he combines some high-powered economic theory with a strong empirical slant: among other things he has studied college admissions, seller strategies on Ebay, auctions for timber and subprime loans for cars. Levin began as a theorist, but the sheer volume of data available now, he says, is transforming economics.

Other recent John Bates Clark medallists also mix theory and evidence. Emmanuel Saez, winner in 2009, is one. Susan Athey, winner in 2007, has a formidable line in deep theoretical results (and like Levin and Klemperer is an auction expert), but she’s conducted detailed research on real-world industries and is now chief economist for Microsoft.

This mixture of formal theory and attention to messy reality is fairly recent, and it is encouraging. It’s what distinguishes economics from pure mathematics on one side and history or anthropology on the other. It is also what I have always loved about my field. The logic of economic reasoning is powerful – but the world around us is far too fascinating to ignore.

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