The 'Inside Job' Effect

April 19, 2011

Many American economists have been stung by their failure to anticipate the financial meltdown of 2008, dogged by persistent suggestions of conflicts of interest -- that they were working for financial industries that they said were healthier than turned out to be true. In a notable break from the past, the pre-eminent professional society for the discipline is moving ahead with plans to examine ethical practices in the field.

Following its annual meeting in January, the American Economic Association has assembled an Ad Hoc Committee on Ethical Standards for Economists. It is being chaired by Robert M. Solow, a professor emeritus of economics at the Massachusetts Institute of Technology and winner of the Nobel Memorial Prize in Economic Science for his work on the theory of capital and economic growth. Also on the committee is Derek Bok, the former president of Harvard University, who is trained as a lawyer; David Card, the Class of 1950 Professor of Economics at the University of California at Berkeley, who specializes in immigration, wages, education and health insurance; William Nordhaus, the Sterling Professor of Economics at Yale University, whose work has focused on the economics of climate change and resource constraints on economic growth; and Nancy L. Stokey, the Frederick Henry Prince Professor of Economics at the University of Chicago, whose specialty is economic growth and development.

It is unclear how the members were selected or whether the committee will be expanded. AEA leaders declined to comment on the panel until it submits its report, which it is likely to do at the association's next annual meeting, taking place in Chicago in January 2012.

The establishment of the committee is significant because most economists have long dismissed the suggestion that they require a code of ethics. To some, any code would be meaningless if it couldn't be enforced through sanctions. Since the AEA does not license economists, the thinking goes, the AEA has no power or jurisdiction to carry out such a task (in fact, this was the argument recently articulated in a blog posting in the New York Times by Edward L. Glaeser, Fred and Eleanor Glimp Professor of Economics at Harvard University).

Periodic efforts to install a code date to the 1930s and continued into the early 1990s, but a code has been seen as simply unnecessary in a field that prides itself on empirical, objective inquiry. “The AEA needed no special code of ethics because the canons of correct professional practice were too obvious to require specification,” the economic historian Alfred W. Coats wrote in 1985 in “The American Economic Association and the Economics Profession,” which appeared in the Journal of Economic Literature.

But the assumption that ethical standards are unnecessary to the discipline has begun to crumble in the wake of the financial meltdown of 2008 -- a turn of events that, many say, economists failed to anticipate. Most pointedly, the Academy Award-winning documentary Inside Job has cast a harsh light on the chumminess of regulators, bond raters and bankers -- and on the academic economists who were supposed to have rendered disinterested advice and analysis. In recent days, an alumnus at Princeton University and students at Columbia University have raised questions probing the relationships of academic economists at their institutions to powerful financial firms. Columbia adopted a revised conflict of interest policy in 2009 (before the film's release) that requires its scholars to disclose their financial ties when commenting publicly on issues to which those ties might be relevant; administrators there are reviewing this policy once more, as part of a revisiting process put in place two years ago. Such increased scrutiny has been called “the ‘Inside Job’ effect.”

Close examination is coming from within the discipline as well. Gerald Epstein, professor of economics and co-director of the Political Economy Research Institute at the University of Massachusetts at Amherst, has focused on the need for a clear conflict of interest policy. He suggests a policy modeled on the one used by the American Sociological Association. It would require economists to disclose relevant sources of financial support and personal or professional relationships that “may have the appearance or potential for a conflict of interest in public speeches and writing, as well as in academic publications,” Epstein wrote, with Jessica Carrick-Hagenbarth, a doctoral student at UMass, in a Jan. 3 letter to Robert E. Hall, the Robert and Carole McNeil Joint Professor of Economics at Stanford University and Senior Fellow at the Hoover Institution, who was then president of the AEA. The letter has been signed by about 300 economists.

In their letter, Epstein and Carrick-Hagenbarth argue that economists play a key role in making economic policy, and that the public must have confidence in their trustworthiness. If an ethics code and conflict of interest policy were to be adopted, they continue, economists would state relevant sources of financial support, or ownership stakes in firms that might benefit as a result of policies they advocate when writing op-eds or testifying in front of Congress. Doing so, they said, is a “necessary step toward enhancing the credibility and integrity of the profession.”

Their letter followed a working paper that they produced last fall on the subject. Epstein and Carrick-Hagenbarth analyzed the public appearances and commentary and scholarly writings that were produced between 2005 and 2009 by 19 prominent economists -- 18 from academe and one from a research institute. As suggested by the small sample size, the survey was not meant to be statistically representative. None of the economists was named because the researchers wanted to focus on the systemic issues at play, not on questions about individual entanglements, Epstein said.

They found that, of the 19 scholars studied, 13 did some work for private financial institutions. Two were co-founders and held key positions in such firms. Another economist worked for two banks -- as president of one and as director of another. Eight served on the boards of directors of private financial firms, while two were identified as consultants or affiliated experts for firms. Epstein and Carrick-Hagenbarth determined these affiliations mostly through the economists’ curriculums vitae.

In their public statements and scholarly writings, very few of the economists acknowledged their private affiliations -- even though they might opine on policies that could have an impact on the firms that paid them, Epstein and Carrick-Hagenbarth found. Typically, the economists identified themselves by their academic position or their membership in the National Bureau for Economic Research; sometimes it was by their appointment to prestigious public or international institutions, such as the International Monetary Fund.

Seven of the economists -- including a president, several trustees and those who served on the boards of directors of private financial firms -- failed to mention their relationship to these firms during nearly 80 media appearances. While one economist divulged his or her dealings in all 25 appearances, three others did so only occasionally -- in one-third of 63 op-eds and interviews.

Epstein acknowledges that divulging such conflicts in public statements and scholarly writing would not have headed off the financial crash, and he stressed that he is not in favor of conducting witch hunts. The value of such a practice, he says, is in changing the way economists think about their entanglements. “It would make economists acknowledge these conflicts themselves,” he told Inside Higher Ed. “I think it would put it on their cognitive map.”

If it were to become expected practice for economists to name their private interests, it also would encourage members of the public and journalists to inquire about them when asking economists to weigh in on such matters, he continued. “If you’re saying the free market is best and should not be regulated, you can ask, ‘Are you paid by an organization that benefits from an unfettered free market?’ ” said Epstein. (Epstein, who describes himself as a heterodox economist who is influenced by a broad range of thinkers from Adam Smith to Karl Marx, says he has not taken any money from private financial institutions; but he adds that his work has been supported by various United Nations agencies, the Ford, Rockefeller and Cummings foundations, and the Institute for New Economic Thinking, which was launched by George Soros.)

Without such an awareness, he says, close ties between academe and the financial sector result in what he called “a dangerous self-reinforcing mixture” in which economists at top programs, such as Harvard, Princeton and Stanford, share a somewhat common perspective and ideology about financial markets and regulation -- and that professors from these departments also tend to get consulting work at private firms or at government agencies, thus circulating a fairly consistent ideology throughout the most influential agencies and universities.

Gene M. Grossman, chair of Princeton's economics department, said that, while it is true that more economists tend to be in favor of unfettered markets, this critique is both overstated and unfair (the chairs of the departments at Harvard and Stanford did not immediately respond to requests for comment).

Significantly, the proposed language about conflicts of interest would not bar the conflict itself -- it would merely encourage the disclosure of such a relationship. Some have argued that such arrangements between economists and outside firms can be useful for scholarship because economists would be unable to gather data otherwise.

To other economists, however, conflicts of interest represent a small piece of the larger question of why most economists failed to predict the crash. Paul Krugman, the New York Times columnist, Nobel-winning economist and professor at Princeton University, has written that group-think and financial incentives played a role. But the bigger problem, he has argued, is that economists grew too enamored of abstract mathematical models that they believed could accurately quantify and calculate the risks arising from inherently unpredictable human behavior. “The central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess,” he wrote in 2009. A similar argument was recently made from a very different perspective at a conference on the future of the humanities.

Solow, who is chairing the ad hoc committee, has expressed what sounds like a related sentiment. “The problem as I have thought about it is that currently fashionable macroeconomics likes to formulate things in a way that inevitably endows the economy with more coherence and purpose than we have any right to assume,” he told a publication of MIT.

But Grossman, of Princeton, said that math offers economists the best means of conducting empirical analysis and ensuring that their arguments maintain internal consistency. "Economists tend to agree on a certain style of rigorous, analytical thinking -- conclusions ought to follow rigorously from stated assumptions," he wrote in an e-mail. "Many outside of economics find this standard of deductive reasoning to be annoying, because they would like to make arguments that are not always internally consistent. This frustration often leads them to blame the 'mathematical modeling' but math is only a language which makes it easier to check that conclusions follow from assumptions."

Still others say that a code or a policy on conflicts of interest, in itself, isn't enough. Instead, what’s needed is a change in how economists think about ethics, said George DeMartino, professor of economics at the University of Denver and author of The Economist's Oath.

Such a change, he said, would encourage what he called a tradition of inquiry, which would shift economists’ narrow emphasis on objective, quantifiable truth and prod those in the profession to consider the implications of their work on other people, particularly those in developing countries. “We learn all these techniques but we don’t have five minutes of training in what it means to have power over the lives of others,” said DeMartino. “Economists impose far too much risk on the communities they’re trying to serve.”

While he agreed with Epstein’s argument that the top tiers of academe ought to have a wider range of perspectives, DeMartino saw the problem as having less to do with free-market ideology than with attitude. In his view, economists are trained to believe too much in the certainty of their conclusions.

“The single biggest problem in economics from a professional standpoint is we cultivate arrogance and hubris,” he said. The goal, he said, “is to be honest about what one does and doesn’t know and what one cannot ever know.”

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