Raising High before Smiting Down

Last night at Tuck, yours truly was on a panel discussing climate change. It was fun, and we had Professors Richard Howarth and Walter Sinott-Armstrong from "up the street" here as well.

I detect a certain cockiness in some of the climate change scientist crowd, and it infects even the more casual observers of the science. A telltale remark is along the lines of, "Well, 1000 scientists believe it to be right, so how can we argue?" (Now what exactly "it" is that is right is of course very interesting. I said numerous times that I believe some climate change has occurred and that humans are likely responsible for some of it, but people still asked me after what it would take to make me believe...)

So if a 1000 scientists believe a paradigm or theory to be absolutely true, that is the end of the story right?

Just in my short academic career, I can think of three paradigms in economics that have been overturned quite dramatically. At least two of them were characterized before the fall of extreme confidence in the paradigm -- yes, cockiness.

Two examples come from finance. The Capital Asset Pricing Model in the 70s and early 80s was held to be the key to understanding asset pricing, in particular the cross section of stock market returns. It is now dead.

A second related one comes from finance as well -- versions of market efficiency, especially that rational investors determine prices and that any inefficiencies in prices would be quickly eliminated. Now I and others can still argue this one pretty well, but there is no doubt that two decades of empirical studies on stock market pricing anomalies, along with experimental work on behavioral economics and finance, has removed the aura of invincibility around strong forms of market efficiency.

A third one is outside of my area a bit, but a colleague suggested it this morning: the death of structural equation macroeconomic modeling upon the development of the rational expectations critique by Robert Lucas. The Lucas critique effectively brought a whole industry of macro modeling to a stop.

So let's be a little respectful of the scientific process. The beauty of these examples is that knowledge does evolve: that even in a discipline as self-sure as the finance profession, a steady stream of contrary theory and evidence, even when produced by a small set of contrarians (think Richard Thaler of behavior finance), can lead to upheavals in the fundamental structure of theory.