The players do not behave as the mythical Homo economicus prescribes, and neither do all the other players in all the levels below them

TO BE NOTED: From Adam Smith's Lost Legacy:

"Thought for the Day - 3

One benefit, at least, of not being able to work for a few days, which included not reading my email alerts on Adam Smith across the world’s media, is the time it created for reflection. Not that this produced much retained sense; more a dream-like flow of unrelated thoughts, among which were strings of thoughts about roosting chickens.

There is a debate underway among historians of economic thought on whether economists really need to study the history of ideas in what we may loosely term our discipline. Those economists who take the view that the history of economic ideas really has nothing to do with modern economics, point to it being unnecessary for ‘real scientists’ to read the works of Isaac Newton, and his lesser luminaries, so why bother with Adam Smith and the rest?

My views on this debate (I have not joined in, so far) are predictable. The physical world is fairly constant – each and every carbon atom is assumed to behave the same way, and has done so through the ages, and unless that changes in known circumstances, its properties and relationships with other atoms are not expected to change. Knowledge gains in hard sciences build upon earlier knowledge gains, and future knowledge gains continue the process.

Turning to economics – part of human sciences – it is quite different. We hardly know about past economic history; even recent history is controversial and is wll sshort of arriving at a settled view. There are political views of economic behaviours – as far as I know, we do not have ‘leftwing’ or ‘rightwing’ carbon atoms – and we do not have a settled view on what constitutes economic society or on what would constitute a society that could be said to be the basis for all further societies without (controversial) changes.

As economics was derived from political economy, shedding within a century, philosophy, sociology, anthropology, history, politics, psychology, and such-like, though, unfortunately not shedding mysticism, idealism, utopianism, and, eventually, all traces of real human beings, an imaginary world has replaced the real world.

Now, that there were great gains from this process is not disputed, of course, but questions arise as to the costs in what the great ‘gains’ do not explain. Apart from which there is genuine concern about the usefulness of the abstract when directed at policy-making in real human societies. Even among the most mathematically-oriented of economists there is no agreement as to whether policy A is ‘better’ than policy B (or policy C to Z).

It is not as if modern economists are better fitted in 2009 to understand (stepping down from ‘to advise’) than their predecessors, already starting down the road we’ve travelled, in 1909 (or for that matter 1809). The current ‘global crisis’ has not produced a consensus among the brightest in our profession (Nobel prize winners stand on opposite sides with different prescriptions) as what should be (could be) done, even if the players in the mix of, say, the G20 were minded to accept whatever advice the equations would give them.

And that’s the rub. The players do not behave as the mythical Homo economicus prescribes, and neither do all the other players in all the levels below them. The aggregates in an economy, however expressed neatly in well-behaved functions, do not capture what the models require of them. And their authors are impotent to make them do so.

It is not as if we are talking about wildly improbable outcomes from clearly defined categories (the effect of heat on molecules of a specific quality as taught in Physics 101). For a ‘hard science’, surely we can expect a straight answer to a simple operation like ‘quantitative easing’ and its likely affect on activity? My colleagues among the historians of economic ideas are debating, hotly, just now about what constitutes money. Unlike, the physicists, who agree on the role of gravity, modern economists are not so sure about the venerable role of money.

No wonder, that ideas of modern economics fall foul to the barely understood ideas of past economists, where they are not simply made up (as has been the fate of Adam Smith among many modern economists who assert his so-called ideas shamelessly without reading him). We may not need to read Newton’s Principia to add to the knowledge base (so far it has not let us down, though it has been improved upon safely because its foundations were so strong), but where did our ideas about money, for instance, come from, and where may our ideas about money be built on less secure foundations than the ‘certainties’ we were taught recently?

I leave these thoughts for the thoughtful readers of Lost Legacy.

posted by Gavin Kennedy "

the value of an economic theory should be judged according to its contribution to economic policy

TO BE NOTED: From the Economist's View:

"What Use is Economic Theory?"

Given the discussion below, it seems like a good time to rerun this, a post that was suggested in a comment from Hal Varian:

I've weighed in on this debate in this essay. My thesis is that economics should not be compared to physics but to engineering. Or, alternatively, not to biology but to medicine. That is, economics is inherently a "policy science" where the value of an economic theory should be judged according to its contribution to economic policy.

There are many who disagree with this view, but hey, let a thousand flowers bloom.

Here it is:

What Use is Economic Theory?, by Hal R. Varian, August, 1989: Why is economic theory a worthwhile thing to do? There can be many answers to this question. One obvious answer is that it is a challenging intellectual enterprise and interesting on its own merits. A well-constructed economic model has an aesthetic appeal well-captured by the following lines from Wordsworth:

Mighty is the charm
Of these abstractions to a mind beset
With images, and haunted by herself
And specially delightful unto me
Was that clear synthesis built up aloft
So gracefully.

No one complains about poetry, music, number theory, or astronomy as being ‘‘useless,’’ but one often hears complaints about economic theory as being overly esoteric. I think that one could argue a reasonable case for economic theory on purely aesthetic grounds. Indeed, when pressed, most economic theorists admit that they do economics because it is fun.

But I think purely aesthetic considerations would not provide a complete account of economic theory. For theory has a role in economics. It is not just an intellectual pursuit for its own sake, but it plays an essential part in economic research. The essential theme of this essay that economics is a policy science and, as such, the contribution of economic theory to economics should be measured on how well economic theory contributes to the understanding and conduct of economic policy.

1. Economics as a policy science

Part of the attraction and the promise of economics is that it claims to describe policies that will improve peoples’ lives. This is unlike most other physical and social sciences. Sociology and political science have a policy component, but for the most part they are concerned with understanding the functioning of their respective subject matters.

Physical science, of course, has the potential to improve peoples’ standards of living, but this is really a by-product of science as an intellectual activity.

In my view, many methodologists have missed this essential feature of economic science. It is a mistake to compare economics to physics; a better comparison would be to engineering. Similarly, it is a mistake to compare economics to biology; a better comparison is to medicine. I think that Keynes was only half joking when he said that economists should be more like dentists. Dentists claims that they can make make peoples’ lives better; so do economists. The methodological premise of dentistry and economics is similar: we value what is useful. None of the ‘‘policy subjects’’--- engineering, medicine, or dentistry---is much concerned about methodology, and economists, by and large, aren’t either.

When you think about it, it is quite surprising that there isn’t more work on the methodology of engineering or medicine. These subjects have exerted an enormous influence on twentieth century life, yet are almost totally ignored by philosophers of science. This neglect should be contrasted with with other social sciences where much time and energy is spent on methodological debate. Philosophy of science, as practiced in philosophy departments, seems to be basically concerned with physics, with a smattering of philosophers concerned with psychology, biology, and a few social sciences.

I think that many economists and philosopher who have written on economic methodology have not given sufficient emphasis to the policy orientation of most economic research. One reason for this is the lack of an adequate model to follow. There is no philosophy of engineering, philosophy of medicine or philosophy of dentistry---there is no model of methodology for a policy science on which we can build an analysis. The task of constructing such a theory falls to economists. This is, in my view, one of the most interesting problems for those concerned with methodological issues and the philosophy of the social sciences.

2. Role of theory in a policy science

Given my view that economics is a policy science, if I want to defend a practice in economics, then I must defend it from a policy perspective. So I need to argue about how economic theory is useful in policy. The remainder of the paper will consists of list of several such ways. The list is no doubt incomplete, and I would welcome additions. But perhaps it can help focus some discussion on why economists do what the do, and how theory helps them do it.

Theory as a substitute for data

In many cases we are forced to use theory because the data that we need are not available. Suppose, for example, we want to determine how a market price will respond to a tax. We could estimate this effect by running a regression of market price against tax rates, controlling for as many other variables as possible. This would give us an equation that we could use to predict how prices respond to changes in taxes.

We rarely have data like this; taxes just don’t change enough. But if people only care about the total price of a good, inclusive of tax---a theory---then we can use estimated price elasticities to forecast the response of price to the imposition of a tax.

This uses a theory about behavior---people will respond to the imposition of a tax in the same way that they respond to a price increase---in order to allow data on price responses to be useful. We can use the theory to forecast the outcome of an experiment that has never been done.

Here is another, slightly more esoteric example. Consider the assumption of transitivity of preferences mentioned briefly above. This theory asserts that if A chosen when {A,B} is available and B is chosen when {B,C} is available, then we can predict A will be chosen when {A,C} is available. This is certainly a theory about behavior; it may or may not be true.

If we had data on choices between all pairs of A, B, and C, then the theory wouldn’t be necessary. When we want to predict the choice out of the set {A,C} we would simply look at how the person chose previously---that is, we would just use brute induction. And we know why induction works---it has always worked in the past!

But we rarely observe all possible choices; typically we observe only a few of the possible choices. Theory allows us to interpolate from what we observe to what we don’t observe. In the case of the {A,B,C} example brute induction requires observing all choices the consumer could make from the various proper subsets available, which requires 3 choice experiments. But if the assumption of transitivity holds, then 2 choice experiments are all we need. The theory of consumer choice allows us to economize on the data.

Naive empiricism can only predict what has happened in the past. It is the theory---the underlying model---that allows us to extrapolate.

Theory tells what parameters are important and how we might measure them.

The Laffer curve depicts the relationship between tax rates and tax revenue. At some tax rates tax revenue decreases when the tax rate increases. It has been said that the popularity of the Laffer curve is due to the fact that you can explain it to a Congressman in six minutes and he can talk about it for six months.

The Laffer analysis demonstrates both good and bad economic theory. The bad theory is that inference that because the Laffer effect can occur it does occur. The good theory is that we can use simple supply and demand analysis to determine what magnitudes the elasticity parameters have to be for the Laffer effect to occur. We can then compare the magnitudes of estimated elasticities to estimated labor supply elasticities. In the simplest model a marginal tax rate of 50% requires a labor supply elasticity of 1 to get the Laffer effect. The theory tells us what the relevant parameters are; without the theory, one would have no idea of the relevant parameters are. Indeed, if one examines the rather sordid history of the use of the Laffer curve in public policy debates in the U.S. this becomes painfully clear.

For another example, consider the theory of investment in risky assets. I take it as given that risk is a ‘‘bad.’’ Therefore when wealth goes up, people may want to purchase less of it. On other hand, you can afford to bear more risk when you have more wealth. So an argument based on intuition alone shows that investment in a risky asset can go up or down when wealth increases. A systematic theoretical analysis shows what the comparative statics sign depends on: how risk aversion changes with wealth. So the risk aversion parameter is the one you want to estimate in order to predict how investment in risky assets changes with wealth. Conversely how investment changes with wealth tells you something about how risk aversion changes with wealth.

Theory helps keep track of benefits and costs

I indicated above that the sorts of optimizing models used by economists serve the purpose of providing guidance for policy choices. Indeed one of the important roles of economic theory is to keep track of benefits and costs. The idea of opportunity cost is a fundamental one in economics, and would be very difficult to use without a theoretical model of economic linkages.

This brings up the important point that the correct way to measure an economic benefit or cost can only be determined in light of a theoretical model of choice: a specification of what objectives and the constraints facing an economic agent.

Consider for example, the practice of computing present value or risk adjusted rates of return. These computations are only meaningful in light of a model of choice behavior. If the model of behavior does not apply, the policy prescription cannot apply either.

Benefit-cost analysis is only one small field of economics. But the idea behind benefit-cost analysis permeates all of economics. If economic agents are making choices to maximize something, then we can get an idea of what is being optimized by looking at agents’ choices. This objective function can then be used as an input to making policy decisions. In some cases, one may need a quantitative estimate of the objective function. In other cases, one may want to show that one kind of market structure, or tax structure, may do a better job of satisfying consumers’ objectives than another. But the basic framework of moving from individual objectives, to individual choice, to social objectives and social choice is common to many, many economic studies.

Theory helps relate seemingly disparate problems

If one describes a model in a purely mathematical way, it often happens that the underlying equations will describe a rich set of economic phenomena. The classic example of this phenomenon is the Arrow-Debreu general equilibrium model. The concept of ‘‘good’’ can be interpreted as a physical commodity available at different times, locations, or states of nature. One theoretical model can thereby provide a model of intertemporal trade, location, and uncertainty.

Another example from general equilibrium theory is the First Welfare Theorem. This result shows the intimate relationship between the apparently distinct problems of equilibrium and efficiency.

A third example is that a formal analysis of the problem of second-degree price discrimination shows that it is equivalent to the design of an auction or the determination of optimal provision of qualities. Quality discrimination, auction design, and nonlinear price discrimination are essentially the same sort of problem.

Each of these insights came from examining an abstract theory. Once the the ‘‘irrelevant’’ details are stripped away, its becomes apparent that the same essential choice problem is involved.

Theory can generate useful insights

Let me illustrate this role of economic theory with an example. In the U.S. most interest receipts are taxable income, but many kinds of interest payments are tax deductible. This policy has been criticized as ‘‘subsidizing borrowing.’’ Does it?

The answer depends on the tax brackets of the marginal borrowers and lenders. If the tax brackets are the same, for example, the policy has no effect at all on the equilibrium after-tax interest rate. The supply curve tilts up due to the tax on interest income, but the demand curve tilts up by the same amount due to the subsidy on interest payments. This is a simple insight, but it would be very difficult to understand without a model of the functioning of the market for loans.

A theory that is wrong can still yield insight

Pure competition is certainly a ‘‘wrong’’ theory many markets; pure monopoly is a wrong theory for other markets. But each of these theories can be very useful for yielding significant insights for how a particular market functions. No theory in economics is ever exactly true. The important question is not whether or not a theory is true but whether it offers a useful insight in explaining an economic phenomenon.

In my undergraduate textbook I examine a very simple model of conversion of apartments to condominiums. One result of the model is that converting an apartment to a condominium has no effect on the price of the remaining apartments---since demand and supply each contract by one apartment.

This result can hardly be thought of as literally ‘‘true.’’ There are a host of reasons why converting an apartment to a condominium might influence the rent of remaining apartments. Nevertheless, it focuses our attention on a crucial feature of such conversions: they affect both the supply and the demand for apartments. The simple supply-demand framework shows us how to start thinking about the impact of condominium conversion on apartment prices.

Theory provides a method for solving problems

I take the method of neoclassical microeconomics to be 1) examine an individual’s optimization problem; 2) look at the optimal equilibrium configuration of individual choices; 3) see how the equilibrium changes as policy variables change.

This methods doesn’t always work---the models of behavior or equilibrium may be wrong. Or it may be that the specific phenomenon under examination is not fruitfully viewed as an outcome of optimizing, and/or equilibrium behavior. But any method is better than none. In the words of Roger Bacon: ‘‘More truth arises through error than confusion.’’

Methodological individualism is a limited way of looking at the world, no question about it. It probably doesn’t do very well in describing phenomenon such as riots or class loyalty. Certainly this sort of individualistic methodology works better for describing some sorts of behavior than others. But it is likely to add insight to all problems.

Theory is an antidote to introspection

Most people get their economic beliefs from introspection and their personal experience- --the same place that they get their beliefs about most things. Economic theory---and indeed science in general, can serve as an antidote to this kind of introspection.

Consider, for example, the widely held belief that all demand curves are perfectly inelastic. If the price of gasoline increases by 25%, a layman will argue that no one will change their demand for gasoline. He bases this argument on the fact that he would not change his demand for gasoline.

Indeed, it is perfectly possible that most people wouldn’t change their demand for gasoline...but some would. There are always some people at the margin; these people would change their demand. At any one time, most people are infra-marginal in most of their economic decisions. The marginal decisions are the ones that you agonize over. If the price were a little higher or a little lower, the results of your agonizing might be different, and this is what causes the aggregate demand curve to slope downward.

Another nice example of this phenomenon is free trade. It’s hard to convince a layman of the advantages of free trade since it is easy to see where the dollars go, but difficult to see where they come from. People have personal experience with imports of foreign goods of foreign goods; but they rarely encounter their own country’s exports unless they travel abroad extensively. Only by abstracting from introspection can we see the total picture.

A third example is the bias in perceptions of inflation: price moves are perceived to be exogenous from the viewpoint of the individual, but wage movements are personalized. Even if prices and wages move up by the same amount, people may feel worse off since they think that they would have gotten the wage increases anyway.

Verifying that something is obvious may show that it isn’t

One of the criticisms that economists have to deal with is that they spend a lot of time belaboring the obvious. Isn’t it obvious that demand curves slope down and supply curves slope up? But many theories that seem to be obvious turn out not to be. It may be obvious that demand curves slope down---but as the theoretical analysis shows, it is possible to have demand curves that don’t.

Economic theory shows that a profit-maximizing firm will decrease its supply when the output price decreases. But farmers often claim that removing milk price supports will increase the supply of milk since farmers will have to increase output to maintain the same income. The second effect sounds like it might be possible---after all, farmers wouldn’t advance the claim unless it had some plausibility. However, theory shows us that this particular claim cannot be true if the farmers attempt to maximize profits.

Strategic interactions are a good source of counterintuitive results. A simple analysis of a two-person zero-sum game shows that improving your backhand in tennis may lead to your using it less often.

It would seem that a public offer to match any competitor’s price is a sign of a highly competitive market. But when you think about the problem facing a cartel it is not so obvious. The prime problem facing a cartel is how to detect cheating on the agreed-upon prices and quotas. Offering to match a competitor’s price is a cheap way to gain information about what your competitors are doing. What appears to be a highly competitive tactic can easily be viewed as a device to support collusion.

Theory allows for quantification and calculation

According to Lord Kelvin, ‘‘When you cannot measure it, when you cannot express it in numbers, your knowledge is of a meagre and unsatisfactory kind.’'[1]

Theoretical economics gives us a framework to calculate and quantify economic relations. Consider the Laffer curve mentioned above. Laffer gave the existence proof, but it took some theoretical calculations to see what magnitudes were important.

In fact, one of the major differences between economics and the other social sciences is that in economics you can compute. There is very little computation in sociology, political science, history or anthropology. But economics is filled with computation.

Economic theory is useful since you can use it to compute answers to problems. They aren’t always the right answers---that depends on whether the model you have is right. (Or, at least, whether it is good enough for the purposes at hand.) But a desideratum of a good model is that you can compute with it: the model can be solved to determine some variables as a function of other variables.

In my view, it is impossible to learn economic theory without solving lots of problems. Richard Hamming, a highly prolific electrical engineer, once gave me some excellent advice about how to write a textbook. He told me to assemble the exams and problem sets that you want the students to be able to solve by the time they had finished the course, and then write the book that would show them how to solve them. In general, I have tried to follow this advice, with, I think, some success.

Economics is amenable to experimental verification

Because neoclassical economic models enables one to compute answers to problems, it is possible to compare the answers you get with the outcomes of controlled experiments. In my view, experimental economics has been one of the great success stories of the last 20 years. We now have rigorous ways to test models of human behavior in the laboratory. Some standard models, such as supply and demand, have turned out to be much more robust than we would have thought 20 years ago. Other models, such as expected utility, have turned out to be less robust.

But this is to be expected---if there were no surprises from experiments, they wouldn’t be worth doing. The growth of experimental economics has led many theorists to construct theories that simple, concrete and testable, rather than theories that are complex, abstract, and general. And experience in observing human subjects in the laboratory has no doubt contributed to the current emphasis on investigating models of learning. Laboratory observations have also been instrumental in alerting us to theoretical dead ends, such as some of the more convoluted refinements of game-theoretic equilibrium concepts.

I expect that the interaction between theory and experimentation will continue to grow in the future. As economists become more comfortable with experimentation in the laboratory, they will also become better at identifying ‘‘natural experiments’’ in real-world data. Such developments can only lead to better models of economic behavior.

3. Summary

I have argued that in order to understand why economic theorists behave in the way they do one has to understand the role of economic theory’s contribution to policy analysis. The fact that economics is fundamentally a policy science allows one to explain many aspects of economic theory that are quite mysterious otherwise.
___________________
1 However, the same poet whose praise for abstraction and synthesis I quoted in the introduction also once said: ‘‘...High Heaven rejects the lore of nicely calculated less or more.’’

Posted by Mark Thoma on Sunday, March 29, 2009"

turned out to be extremely dubious of the claims of academic economics and finance

From The Curious Capitalist:

"Physicists don't love economists, and other revelations

Posted by Justin Fox | Comments (3) | Permalink | Trackbacks (0) | Email This

My speech Friday to the assembled geniuses at the Hertz Foundation Symposium in Santa Clara went okay, I think. It was my first-ever PowerPoint presentation, and there was a fraught moment beforehand where my laptop and the projector simply would not—despite the efforts of several first-rate physicists and mathematicians who sprang to my aid—communicate. But then another laptop was brought in and it all worked. I felt like my talk, a short-hand version of The Myth of the Rational Market, rambled and went on for too long—the $100 I spent at Cartoonbank notwithstanding. But as soon as I stopped, everybody wanted to ask questions, make comments, etc. We could have gone on for hours. (You can see a little bit of the Q&A here.)

The hard-science types who populated the conference (the Hertz Foundation gives fellowships to "exceptionally talented individuals studying in the applied physical, biological and engineering sciences") turned out to be extremely dubious of the claims of academic economics and finance. This wasn't really that big a surprise, but I was still a little taken aback at the heat with which some of the Hertzians dissed the economists. I eventually fell back on the standard defense: economics is harder than physics. According to one guy in the audience, Max Planck once said the same thing. So it must be true.

Another interesting subtext was that a big minority of the Hertz fellowship recipients have worked in quantitative finance (of the 20-odd people I spoke with, three were current or former employees of D.E. Shaw & Co.), while another big minority are furious at how many talented people have been sucked out of physics, mathematics, and the like into finance. But maybe that's about to change.

Full disclosure: I didn't get a speaking fee, but the Hertz Foundation did pay my way (or at least will if I ever get around to sending in an expense report)."

Me:

1. donthelibertariandemocrat Says:
   Monday, March 23, 2009 at 1:26 pm

   Just one thought: In math, physics, and logic, which I studied, you learn that a lot depends, in proofs, say, on the assumptions you make. Sometimes, when I read economists, the assumptions about human behavior seem asinine. No amount of formalization can overcome asininity. I'm not saying that all economics is like this, but, a fair amount seems to assume behaviorism, a theory I don't think very highly of. Perhaps this is why I find Behavioral Economics so interesting. It could also just be difficult to identify the assumptions behind certain economic theories.

That which as no practical implications; has no implications for economic theory.

From The Money Illusion:

"Richard Rorty and the efficient markets debate

I use the efficient markets hypothesis in my research and in my blog. Once I started looking at the world through the EMH lens, I found it much easier to understand the relationship between policy and the financial markets—particularly in my research on the Depression. Here I’d like to do three things; indicate why I believe markets are more efficient than they seem, acknowledge that there are events that look like market inefficiency, and then argue that those perceived inefficiencies, even if real, don’t have the policy implications that many people assume they have.

Last Sunday I discussed cognitive illusions, aspects of economic theory that are highly counter-intuitive. I regard the EMH as one such economic theory—strange, but (almost) true. Let’s start with all of the studies showing market inefficiency. Many of these studies show that there are market patterns, or anomalies, that seem inconsistent with the EMH. But how do we know these aren’t just coincidence? One answer is that we can use statistical tests, such as the example of the correlation between equity returns on Wall Street and rainy days, which I discussed a few days ago. But are those statistical tests reliable? They tell us that certain events would be extremely unlikely to occur by chance, but what does that mean?

If I go to Vegas and observe the numbers 17-34-23-1-23-5-31-7-15-25 show up on a roulette wheel, I could argue that the odds were more than one in a quadrillion against that exact combination showing up on that particular wheel at that time. In response, anti-EMH types would argue that anomaly studies don’t just find patterns, they find interesting patterns. But there are lots of interesting patterns, far more than you might think at first glance. I’m always noticing interesting patterns in random strings of digits. Indeed the “uninteresting” string of numbers that I just listed, are actually very interesting—can you see how?

I am not an expert on EMH research, so let me just say that as long as asset prices seem to follow a path even close to the random walk predicted by theory, I am not going to be very impressed by academic studies finding “statistically significant” anomalies.

But of course there is a much more powerful argument for the anti-EMH position; the large asset price movements we occasionally see that don’t seem to have any fundamental explanation. Some of the most famous are the 1929, 1987, and 2000 stock market bubbles, as well as the 2006 housing bubble. Of course there are many more, but I think you will agree that these are some of the primary examples that EMH opponents point to. I’d like to consider these events from several perspectives, beginning with the question of fundamentals.

1. The 1929 bubble is the easiest to explain with fundamentals. Studies have shown that stocks were not grossly overpriced in 1929, and the collapse has a very good “fundamental” explanation—the Great Depression.

2. I know of no explanation for the 1987 bubble. The collapse (comparable to 1929) occurred when the overall economy was doing fine. Some argue for “computer trading,” as if computers have free will. I am not saying they are wrong, but then the correct term would be “really stupid computer programmers.” If correct, this is a good argument against the EMH position. But even here, one must be careful not to push things too far. At the time EMH opponents probably assumed more than just a inexplicable price change—they probably assumed that the bubble’s peak represented irrational exuberance. Were stock prices too high before the 1987 crash? We had no way of knowing then, and we still don’t really know. There is enormous uncertainty about what the stock market should be trading at, based on “fundamentals.”

I find it interesting that anti-EMH hypotheses often seem to be in conflict with each other. Some talk about “irrational exuberance” at various market peaks. Others point to the extraordinarily high average rate of return on long term equity investments in the U.S., which greatly exceeds the return on bonds (even adjusting for the higher risk on stocks.) Of course this latter anomaly implies that stock prices in the U.S. were far too low throughout much of the 20th century. So which is it? Is the stock market often way too high? Or way too low? And why do we hear so little discussion of “negative bubbles?” Is there even a word for the concept?

The 2000 bubble seems about half way between 1929 and 1987, there were some fundamentals involved, and traders certainly were looking at firms where there was great uncertainty (unlike say GM or Ford in the 1950s and 1960s.) But even so, in retrospect the valuations look far to high at the peak. Once again, however, a cautionary note for the anti-EMH crowd. Didn’t Robert Schiller mention the famous “irrational exuberance” phrase to Greenspan in 1996, before the stock bubble occurred? If so, this shows how hard it is to offer useful investment advice, even if you sense the market is overvalued. Those that exited in 1996 would have missed both the peak and subsequent crash. I also recall reading that Galbraith predicted a crash in January 1987, far too early to help stock investors.

It is widely assumed that the 2006 housing bubble was irrational, and perhaps in part it was. But again, let’s not get too overconfident. In fact irrational overconfidence—the same psychological trait that may generate bubbles, also generates an excessive level of confidence that we can spot bubbles. We all tend to remember when we make a correct prediction, or even have a correct hunch. But how often do we remember our failures? And if we forget the failures, do we grossly overestimate our batting average?

How many remember frequent predictions of bubbles, that turned out not to be bubbles? I have already argued that even today we don’t know for sure that stocks were overvalued in 1929, 1987, or 1996. There are respectable models that show they were fairly priced. (The 2000 NASDAQ is different.) How many people recall all the predictions of coastal housing bubbles during the long divergence after 1980, when an enormous gap gradually developed between housing prices in Middle America, and housing prices in LA/SF/NYC/Boston? Guess what, those bubble predictions were wrong. The housing price gap never really closed. Of course in any rapidly rising markets there are some pullbacks, and when these pullbacks occurred, the EMH opponents crowed “I told you so” about the ridiculous prices in coastal markets. But each new cycle the gap got wider, and in the long run the pessimists were wrong, even this crash hasn’t significantly narrowed the gap.

The housing bubble in 2004-2006 was partly driven by rapid immigration from Latin America (as was the bubble in Spain itself!), and also by a perception (which turned out false) that coastal zoning constraints were spreading into interior markets. Many Hispanic immigrants were snapping up older ranch houses, allowing native born Americans to move on to bigger McMansions. The immigration crackdown in 2007 dramatically slowed this immigration (as did the worsening economy.) Population growth estimates going several years forward fell sharply, hurting housing speculators. Ground zero of the sub-prime bust is in working class areas of the Southwest and Florida. Any guess as to who bought homes in those areas? In addition, after 2006 nominal GDP growth slowed gradually, and then very sharply, to a rate far below the level any rational investor could have anticipated in 2006. Even today, few people seem to realize the impact that going from plus 6.5% to negative 6.5% nominal growth has on housing prices. This didn’t trigger the collapse, but it dramatically deepened it.

I am certainly not arguing that fundamentals can fully explain the sub-prime crisis. There may have been some irrationality, especially in interior southwestern markets where land was still fairly plentiful. I’m sure that lots of explanations that have been offered (such as the Black Swan problem) have some merit. Consider this, however, if investors are foolish to ignore the risk of Black Swan events, why should we trust prob. values in anomaly studies?

More importantly, even if the anti-EMH position seems correct in a few cases, I will argue that it does not have the policy implications that many assume. So let’s ask ourselves this question; what are the policy implications of the anti-EMH position? And is there any evidence in the famous anomalies to support these policy implications?

It seems to me that there are two basic policy implications of the anti-EMH position, investors can do better than indexed stock funds, and regulators should prevent market bubbles that are likely to be disruptive to the broader economy. And I see zero evidence to support either of these policies, even if one accepts the view that many recent market anomalies cannot be explained by fundamentals. Let’s start with the easy case—managed stock funds.

EMH opponents argue that asset price movements are somewhat predictable, due to various market anomalies. We have a highly competitive investment industry made up of some of the smartest people from the best universities who are working day and night to outsmart markets. And many of them do. The problem is that they are not successful enough to push me away from indexed funds. A few managed funds will do better than indexed funds, but (ex ante) we don’t know which ones. So I don’t think there are any investment opportunities (open to the general public, i.e. me), that can reliably beat indexed funds. And don’t tell me that mutual fund X or hedge fund Y did such and such. Ex post there are lots of investments that have done very well, but that information is of no value to investors unless excess returns are serially correlated, and I don’t believe they are.

The big public policy issue, of course, is not whether indexed funds are a good investment, but rather whether the sub-prime fiasco shows the need for tighter regulation. I am really surprised by how many people seem to simply assume that the recent crisis shows the need for better regulation. You already know some of my objections to this view—the pro-regulation position is usually based on the assumption that the housing crisis somehow caused the current recession. This is despite the fact that virtually every cutting edge macro text says that monetary policy determines NGDP growth. And yet the moment a crisis hits we get a sort of mass amnesia, and reputable economists are suddenly assuming that the rapidly falling NGDP is not a failure of central banks, but rather of commercial banks. As if it is suddenly the job of commercial bankers to manage monetary policy!

I know that nobody will buy this argument, so I should just give it up. But even if I am wrong, even if the commercial bankers are 100% to blame for the current recession, the sub-prime fiasco does not support the anti-EMH argument for tighter regulation. I don’t doubt that one can find some arguments for regulation (moral hazard, too big to fail, etc.), but what I do deny is that any of these arguments are related to market inefficiency, to the anti-EMH position.

One can look at the sub-prime fiasco from a theoretical perspective, or a empirical perspective, but what one cannot do is compare an ideal regulatory scheme to actual banking practices. No one doubts that we would be better off if we could go back in time and install a regulation banning sub-prime mortgages in 2004. But if we had that ability, the bankers would have also known what was coming, and would never had made the loans in the first place.

[I hope no one gives me the silly moralistic argument that the villains got off Scott-free, while innocent investors were left holding the bag. The villains are exactly the people who have lost $100s of billions of dollars, even after the bailouts. I know it is never that way in Hollywood movies, but real life is different. This never would have happened (even without regulation) if bankers could have seen into the future.]

So the anti-EMH argument for regulation must be based on the following; bankers are irrational and make lots of foolish loans. Regulators are rational and can see that these loans are too risky, and can protect bankers from hurting themselves. At a theoretical level this doesn’t even pass the laugh test. But what happened in practice? What position did the “regulators” take in this crisis? First we need to define “regulators,” who are much more than just the low-paid Federal bureaucrats that oversee the banking industry. Regulators are the watchmen, those who watch the watchmen, and those who watch those who watch the watchmen. In other words:

1. The President
2. Congress
3. The Fed
4. The media
5. Most academics
6. Nouriel Roubini

Guess how many of these institutions warned us about the sub-prime crisis. Now guess how many were encouraging banks to behave even more recklessly than they did. Unless we plan on making Roubini dictator of the world, there is zero evidence from the sub-prime crisis that simply giving regulators more power would have helped. And how do we know that even Roubini wasn’t just lucky, and might miss the next fiasco?

This is a good time to trot out my favorite philosopher, Richard Rorty. In a recent book he quoted an old pragmatist maxim; “that which has no practical implications, has no philosophical implications.” I would re-word that slightly for the current discussion:

That which as no practical implications; has no implications for economic theory.

Thus Rorty suggested that it was pointless to argue about whether something is an objective fact or a justified belief, as we have no access to an extra-human perspective, and thus can never resolve the debate. To take another example, imagine two people looking at Mt. Monadnock. One says “That’s a very small mountain.” The other says “No, that’s just a big hill.” Pointless debate, isn’t it? Now imagine two economists look at the tech bubble. One says “boy, those rational investors made a big mistake,” whereas the other says “no, the investors were irrational.” Another pointless debate.

The only aspect of the EMH/anti-EMH debate that is of any interest is the policy implications. Are there any practical implications to the anti-EMH position? I have no trouble looking at some of the bubbles we considered here and saying: “Boy, those investors sure seemed irrational.” But it doesn’t help, because unless the anti-EMH people can find some interesting policy implications (investment advice for me, or public policy advice that will sway my vote), I would just as soon toss the anti-EMH theory away. I have found the EMH to be very useful in all sorts of ways mentioned in previous posts. The anti-EMH position? Not so much.

(To forestall some objections based on a misunderstanding of my argument, let me reiterate that I am not saying the sub-prime crisis does not point to the need for tighter regulation, I am saying that any regulation that comes out of this crisis would have to be justified on grounds other than market inefficiency, unless you can convince me that future regulators will be able to predict markets better than future financiers.)"

Me:

1. Don the libertarian Democrat
   22. March 2009 at 08:43

   I want to throw some philosophy into the discussion, and, to do so, I’m going to rough the edges up a bit to keep from writing a treatise. Although I agree with Rorty about theories/positions being more or less useful/practical, I approach the world from a different position.

   If your read Rorty, you will notice that he spends a lot of time talking about Dewey, Quine, Sellars, Ryle, Davidson, and Dennett. In my mind, all these philosophers are behaviorists. As Rorty says:

   http://plato.stanford.edu/entries/rorty/

   Rorty provides this view with a label: “Explaining rationality and epistemic authority by reference to what society lets us say, rather than the latter by the former, is the essence of what I shall call ‘epistemological behaviorism,’ an attitude common to Dewey and Wittgenstein.” (PMN 174)

   To me, “Word And Object” was the best place to see this expounded. Now, in economics, there seems to be a problem differentiating causal explanation from correlative explanation. I think that’s because, to the behaviorist, there’s no difference. There are simply correlations of behavior. Consequently, when tax cuts were passed last year, and didn’t work out as expected, behaviorists are stuck. The results are the results. That doesn’t mean that they don’t offer other explanations, but they offer non-behaviorist ones and fudge the issue a lot. This explains their fascination with biology, especially Darwin, and avoidance of math and physics. The latter two are a barrage of anomalies for the behaviorist. I would argue that confirmation bias is also a major problem for behaviorists.

   Is this a fair assessment? Probably not. I’m trying to be succinct, and I have a different view. But as I told Nick Rowe, behaviorism does seem to be the philosophy underlying much of modern economics. Anyway, since I approach economics through philosophy, but one centered on intentionality, I would be interested in how economists view their theories philosophically, if they do.

are not models of decentralised market economies, but models of a centrally planned economy

From Willem Buiter:

"The unfortunate uselessness of most ’state of the art’ academic monetary economics

March 3, 2009 1:37pm

The Monetary Policy Committee of the Bank of England I was privileged to be a ‘founder’ external member of during the years 1997-2000 contained, like its successor vintages of external and executive members, quite a strong representation of academic economists and other professional economists with serious technical training and backgrounds. This turned out to be a severe handicap when the central bank had to switch gears and change from being an inflation-targeting central bank under conditions of orderly financial markets to a financial stability-oriented central bank under conditions of widespread market illiquidity and funding illiquidity. Indeed, it may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding . It was a privately and socially costly waste of time and other resources.

Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck.

Complete markets

The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity - both funding illiquidity and market illiquidity - are also impossible, unless the guilt-ridden economic theorist imposes some unnatural (given the structure of the models he is working with), arbitrary friction(s), that made something called ‘money’ more liquid than everything else, but for no good reason. The irony of modeling liquidity by imposing money as a constraint on trade was lost on the profession.

Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered. They did not allow such questions to be asked.

It is clear that, when searching for an appropriate simplification to address the intractable mess of modern market economies, the starting point of ‘no markets’, that is, autarky or no trade, is a much better one than that of ‘complete markets’. Goods and services that are potentially tradable are indexed by time, place and state of nature or state of the world. Time is a continuous variable, meaning that for complete markets along the time dimension alone, there would have to be rather more markets for future delivery (infinitely many in any time interval, no matter how small) than you can shake a stick at. Location likewise is a continuous variable in a 3-dimensional space. Again rather too many markets. Add uncertainty (states of nature or states of the world), never mind private or asymmetric information, and ‘too many potential markets’, if I may ruin the wonderful quote from Amadeus attributed to Emperor Joseph II, comes to mind. If any market takes a finite amount of resources (however small) to function, complete markets would exhaust the resources of the universe.

Beyond this simple ‘impossibility of complete markets’ proposition, there is the deeper point, that the assumption of complete markets in most of the New Classical and New Keynesian macroeconomics assumes away the problem of contract enforcement. This problem is especially acute in trade over time or intertemporal trade, where the net value to each party to a contract of fulfilling the terms of the contract varies over time and can change sign. In a world with selfish, rational, opportunistic agents, able and willing to lie and deceive, only a small set of voluntary transactions will ever be observed, relative to the universe of all potentially feasible transactions.

The first set of voluntary exchange-based transactions we are likely to see are self-enforcing contracts - those based on long-term relationships, repeated interactions and trust. There are some of those, but not too many. The second are those voluntarily-entered-into contracts that are not self-enforcing (say because interactions between the same sets of agents are infrequent and market participants have a degree of anonymity that prevents the use of reputation as a self-enforcement mechanism) but are instead enforced by some external agent or third party, often the state, sometimes the Mafia (sometimes it’s hard to tell who is who). Third party enforcement of contracts is again often complex and costly, which is why it covers relatively few contracts. It requires that the terms of the contract and the contingencies it contains be third-party observable and verifiable. Again, only a limited set of exchanges can be supported this way.

The conclusion, boys and girls, should be that trade - voluntary exchange - is the exception rather than the rule and that markets are inherently and hopelessly incomplete. Live with it and start from that fact. The benchmark is no trade - pre-Friday Robinson Crusoe autarky. For every good, service or financial instrument that plays a role in your ‘model of the world’, you should explain why a market for it exists - why it is traded at all. Perhaps we shall get somewhere this time.

The Auctioneer at the end of time

In both the New Classical and New Keynesian approaches to monetary theory (and to aggregative macroeconomics in general), the strongest version of the efficient markets hypothesis (EMH) was maintained. This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation. Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many key asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. eduction. But most of the profession continued to swallow the EMH hook, line and sinker, although there were influential advocates of reason throughout, including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, Joseph Stiglitz and behaviourist approaches to finance. The influence of the heterodox approaches from within macroeconomics and from other fields of economics on mainstream macroeconomics - the New Classical and New Keynesian approaches - was, however, strictly limited.

In financial markets, and in asset markets, real and financial, in general, today’s asset price depends on the view market participants take of the likely future behaviour of asset prices. If today’s asset price depends on today’s anticipation of tomorrow’s price, and tomorrow’s price likewise depends on tomorrow’s expectation of the price the day after tomorrow, etc. ad nauseam, it is clear that today’s asset price depends in part on today’s anticipation of asset prices arbitralily far into the future. Since there is no obvious finite terminal date for the universe (few macroeconomists study cosmology in their spare time), most economic models with rational asset pricing imply that today’s price depend in part on today’s anticipation of the asset price in the infinitely remote future.

What can we say about the terminal behaviour of asset price expectations? The tools and techniques of dynamic mathematical optimisation imply that, when a mathematical programmer computes an optimal programme for some constrained dynamic optimisation problem he is trying to solve, it is a requirement of optimality that the influence of the infinitely distant future on the programmer’s criterion function today be zero.

And then a small miracle happens. An optimality criterion from a mathematical dynamic optimisation approach is transplanted, lock, stock and barrel to the behaviour of long-term price expectations in a decentralised market economy. In the mathematical programming exercise it is clear where the terminal boundary condition in question comes from. The terminal boundary condition that the influence of the infinitely distant future on asset prices today vanishes, is a ‘transversality condition’ that is part of the necessary and sufficient conditions for an optimum. But in a decentralised market economy there is no mathematical programmer imposing the terminal boundary conditions to make sure everything will be all right.

The common practice of solving a dynamic general equilibrium model of a(n) (often competitive) market economy by solving an associated programming problem, that is, an optimisation problem, is evidence of the fatal confusion in the minds of much of the economics profession between shadow prices and market prices and between transversality conditions that are an integral part of the solution to an optimisation problem and the long-term expectations that characterise the behaviour of decentralised asset markets. The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time - a God-like father figure - who makes sure that nothing untoward happens with long-term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.

What this shows, not for the first time, is that models of the economy that incorporate the EMH - and this includes the complete markets core of the New Classical and New Keynesian macroeconomics - are not models of decentralised market economies, but models of a centrally planned economy.

The friendly auctioneer at the end of time, who ensures that the right terminal boundary conditions are imposed to preclude, for instance, rational speculative bubbles, is none other than the omniscient, omnipotent and benevolent central planner. No wonder modern macroeconomics is in such bad shape. The EMH is surely the most notable empirical fatality of the financial crisis. By implication, the complete markets macroeconomics of Lucas, Woodford et. al. is the most prominent theoretical fatality. The future surely belongs to behavioural approaches relying on empirical studies on how market participants learn, form views about the future and change these views in response to changes in their environment, peer group effects etc. Confusing the equilibrium of a decentralised market economy, competitive or otherwise, with the outcome of a mathematical programming exercise should no longer be acceptable.

So, no Oikomenia, there is no pot of gold at the end of the rainbow, and no Auctioneer at the end of time.

Linearize and trivialize

If one were to hold one’s nose and agree to play with the New Classical or New Keynesian complete markets toolkit, it would soon become clear that any potentially policy-relevant model would be highly non-linear, and that the interaction of these non-linearities and uncertainty makes for deep conceptual and technical problems. Macroeconomists are brave, but not that brave. So they took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved. This was achieved by completely stripping the model of its non-linearities and by achieving the transsubstantiation of complex convolutions of random variables and non-linear mappings into well-behaved additive stochastic disturbances.

Those of us who have marvelled at the non-linear feedback loops between asset prices in illiquid markets and the funding illiquidity of financial institutions exposed to these asset prices through mark-to-market accounting, margin requirements, calls for additional collateral etc. will appreciate what is lost by this castration of the macroeconomic models. Threshold effects, non-linear accelerators - they are all out of the window. Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads at the insistence of the mainline models that all uncertainty is exogenous and additive.

Technically, the non-linear stochastic dynamic models were linearised (often log-linearised) at a deterministic (non-stochastic) steady state. The analysis was further restricted by only considering forms of randomness that would become trivially small in the neigbourhood of the deterministic steady state. Linear models with additive random shocks we can handle - almost !

Even this was not quite enough to get going, however. As pointed out earlier, models with forward-looking (rational) expectations of asset prices will be driven not just by conventional, engineering-type dynamic processes where the past drives the present and the future, but also in part by past and present anticipations of the future. When you linearize a model, and shock it with additive random disturbances, an unfortunate by-product is that the resulting linearised model behaves either in a very strongly stabilising fashion or in a relentlessly explosive manner. There is no ‘bounded instability’ in such models. The dynamic stochastic general equilibrium (DSGE) crowd saw that the economy had not exploded without bound in the past, and concluded from this that it made sense to rule out, in the linearized model, the explosive solution trajectories. What they were left with was something that, following an exogenous random disturbance, would return to the deterministic steady state pretty smartly. No L-shaped recessions. No processes of cumulative causation and bounded but persistent decline or expansion. Just nice V-shaped recessions.

There actually are approaches to economics that treat non-linearities seriously. Much of this work is numerical - analytical results of a policy-relevant nature are few and far between - but at least it attempts to address the problems as they are, rather than as we would like them lest we be asked to venture outside the range of issued we can address with the existing toolkit.

The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models that were then let loose on actual numerical policy analysis, was a major step backwards. I trust it has been relegated to the dustbin of history by now in those central banks that matter.

Conclusion

Charles Goodhart, who was fortunate enough not to encounter complete markets macroeconomics and monetary economics during his impressionable, formative years, but only after he had acquired some intellectual immunity, once said of the Dynamic Stochastic General Equilibrium approach which for a while was the staple of central banks’ internal modelling: “It excludes everything I am interested in”. He was right. It excludes everything relevant to the pursuit of financial stability.

The Bank of England in 2007 faced the onset of the credit crunch with too much Robert Lucas, Michael Woodford and Robert Merton in its intellectual cupboard. A drastic but chaotic re-education took place and is continuing.

I believe that the Bank has by now shed the conventional wisdom of the typical macroeconomics training of the past few decades. In its place is an intellectual potpourri of factoids, partial theories, empirical regulaties without firm theoretical foundations, hunches, intuitions and half-developed insights. It is not much, but knowing that you know nothing is the beginning of wisdom."

Me:

"The future surely belongs to behavioural approaches relying on empirical studies on how market participants learn, form views about the future and change these views in response to changes in their environment, peer group effects etc. Confusing the equilibrium of a decentralised market economy, competitive or otherwise, with the outcome of a mathematical programming exercise should no longer be acceptable."

I agree, and I'm reminded of a quote from my favorite philosopher, J.L. Austin:

"...our common stock of words embodies all the distinctions men have found worth drawing, and the connections they have found worth marking, in the lifetime of many generations: these surely are likely to be more numerous, more sound, since they have stood up to the long test of survival of the fittest, and more subtle, at least in all ordinary and reasonable practical matters, than any that you or I are likely to think up in our armchair of an afternoon – the most favorite alternative method."

I think that a Wittgensteinian/Austinian anlysis of the presuppositions and assumptions of Economic Models would be a worthwhile endeavor. Many of the models seem to presuppose a crude Behaviorism, although it's hard to tell, since it's not clear that they're claiming to be anything more than modelers.

I can't help but wonder if the desire to be scientific and professional has led to a sterile pursuit of clearly limited problems, much as it has in philosophy. Posted by: Don the libertarian Democrat

I used to have no time for the idea that economists never agree, so economics must be a bogus science and a waste of time

From Clive Crook:

"Politics is damaging the credibility of economics

By Clive Crook

Published: February 8 2009 17:06 | Last updated: February 8 2009 17:06

I used to have no time for the idea that economists never agree, so economics must be a bogus science and a waste of time. Of course economists disagree, I would say. Economics is difficult, and by its nature cannot be as clear-cut as the physical sciences. But it strives to meet the most rigorous standards of evidence-gathering and scientific method. As long as it remains aware of its own limits, one should not mock the discipline for aiming high.

Economists are right to disagree. This does not stop them improving public policy or raising the standard of discussion inside and outside the profession. Judge them by those standards, I used to say.

As a lapsed member of the guild – I had a spell as an economist in the British civil service – I have a lingering sentimental attachment. But my earlier confidence that economists are not wasting their own and everybody else’s time is diminishing. Are the leaders of the profession measuring up to the standards I just mentioned? Are they helping to improve policy, or raise the standard of public understanding? You could easily argue the opposite.

Economists are failing to express anything resembling consensus on the most basic questions of economic policy. Is fiscal stimulus desirable, or even possible? Some say yes, some say no. In a recession, is it best to cut taxes or raise spending, or both, or neither? They disagree about that. How should governments mend their broken financial systems? They disagree about that too.

I had thought they would at least agree that raising trade barriers at a time like this must be a bad idea. Then I read Paul Krugman, Nobel laureate, Princeton professor, and New York Times columnist, explain that raising tariffs – though perhaps unwise for other reasons – “can make the world better off”. “There is a short-run case for protectionism,” he went on, “and that case will increase in force if we don’t have an effective economic recovery programme.” What are his readers to make of this? Are all the economists who say otherwise just wrong?

This impression of disarray – that economics has nothing clear to say on these questions – is not the fault of economics as such. It is a mostly false impression created by some of its leading public intellectuals, Mr Krugman among them.

Economics outside the academy has become the continuation of politics by other means. If you wish to know what Mr Krugman thinks on any policy question, do not read his scholarly writings; see which policies are advocated by the progressive wing of the Democratic party. Mr Krugman agrees with liberal Democrats about most things, and for the rest gives as much cover as the discipline of economics can provide – which, given its scientific limitations, is plenty. He does this even on matters where, if his scholarly work is any guide, the economics is firmly against his allies. Liberal Democrats are protectionists. Mr Krugman is not, but politics comes first.

The syndrome affects economists on the right as much as on the left. Just as there is a consensus among economists that protectionism should be opposed, most economists believe that a powerful fiscal stimulus is both possible and desirable in present circumstances, and that the best stimulus would include big increases in public spending. Yet recently, Robert Barro, a scholar with conservative sympathies, wrote in the Wall Street Journal that this view was an appeal to “magic”.

The problem is not that Mr Krugman questions the consensus on trade (if indeed he does), or that Mr Barro questions the consensus on fiscal policy (as he certainly does). It is that both set the consensus aside so carelessly. In doing so, these stars of the profession destroy the credibility of their own discipline. Mr Krugman gives liberals the economics they want. Mr Barro gives conservatives the same service. They narrow or deny the common ground. Why does this matter? Because the views of readers inclined to one side or the other are further polarised; and in the middle, those of no decided allegiance conclude that economics is bunk.

Politics and economics are always difficult to keep apart. But the problem is getting worse, perhaps because political splits are deepening, or perhaps because the lack of disinterested economic advice is more keenly felt with so much at stake.

The web, for all its blessings, is an aggravating factor. Many of the most successful economics blogs promote communication within political groupings, not across them. On the web you best build an audience by organising a claque and stroking its prejudices. Extend elaborate courtesy to people you agree with and boorish contempt to those who do not get it. Celebrate exasperation and incivility as marks of intellectual authenticity – an attitude easier to tolerate in teenagers under hormonal stress than in professors at world-class universities.

Consensus economics does exist. The Obama administration and the Federal Reserve are trying to apply it. The economics professoriate has an obligation to criticise and improve those policies. But if politics is allowed to split the discipline, and communication across that divide continues to break down, the science of economics will forfeit what little respect it still commands.

Send your comments to clive.crook@gmail.com

Post and read comments at Clive Crook’s Washington Blog"

Me:

16. I think that there is a difference between Political Economy and Economics. Consequently, I can honestly say that I like Barro and Krugman and can use them both. My criticism of both is that they are rather too enamored of their own points, applying them almost mechanically, and not willing to understand the valid points that the other is making. Of course, my plan is a compromise plan:

1) Social Safety Net spending is not part of a stimulus. This can include aid to states for such services. It will cost what is necessary to truly help people suffering through this crisis. I have no set figure in mind.
2) $100 Billion for Infrastructure.
4) $300 Billion in Tax Cuts.
A. Sales Tax decrease or Payroll Tax decrease.
B. Tax Cuts for Investment.

In other words, I tend to agree with Krugman's amount, but use Barro's approach more. Politically, I would compromise in order to show unity in a crisis, which I believe to be very important. Since I have a Political Economy like Shiller's, I agree that a massive stimulus might work. However, like Buiter, I don't believe that we can risk it. I do think that government spending is important to show that we have enough confidence to invest in the future. Since I view the crisis through a more behavioral interpretation of Fisher's Debt-Deflation model, I would be much looser in my monetary policy.

In other words, I have an eclectic approach. What's wrong with that? Either politically, or economically?

Posted by: Don the libertarian Democrat

The science contributes to feedback, which biases the science.

From Free Exchange:

"New economics

Posted by:

Economist.com | WASHINGTON

Categories:

Heterodoxies

IN RECENT decades, economists have relished their role as departmental imperialists, extending economic analysis to questions of sociology, psychology, criminology, and a range of other subjects. Economists love annoying people, and so the annoyance this caused among sociologists, psychologists, and so on made such imperial forays highly rewarding.

But increasingly, the shoe is on the other foot. Economics (parts of it, at least) is broken, and mathematicians, sociologists, psychologists, and a bevy of other armchair -ologists are trying to fix it. At the Times, Anatole Kaletsky describes just a few of the ongoing attempts to bring knowledge from other disciplines into the dismal science. He mentions work done by students of aerodynamics and behavioural scientists, among others. But the most intriguing idea in the piece is that while it's possible our ideas are failing to accurately describe the economy, it could also be the case that the economy is failing because it's built on our inaccurate ideas:

[R]ational investors can find it very profitable to act on false premises - for example that credit will always be available without limit - if these false ideas become so widely accepted that they change the way the economy actually functions, at least for a time...

[T]he challenge that existing economic orthodoxy may find most disconcerting is Imperfect Knowledge Economics (IKE), the name of a path-breaking recent book by Roman Frydman and Michael Goldberg, two American economists. Building on ideas of Edmund Phelps, one of the few Nobel Laureate economists who rejected the consensus view on rational expectations, IKE uses similar tools to conventional economics to generate radically different results. It insists that the future is inherently unknowable and therefore that there is always a multitude of plausible models of the way the economy works.

Which model is right may well depend upon which model is the current dominant paradigm. This is quite headache-inducing. It suggests that economics may be plagued by observer effects; by investigating one aspect of a system and solidifying knowledge about it into widely held principles, we reinforce those principles, which proceed to work until they don't.

This is the inherent risk in studying a complex system constructed on the aggregated decisions of billions of creatures who base their actions on the actions of everyone else. The science contributes to feedback, which biases the science. Ideally, some brilliant individual will discover a way around this hurdle. In any case, the first lesson economists may learn in the wake of the crisis is that they actually know much less than they think they do. Or rather, they know what they know, only so long as other people continue to know it."

Me:

Don the libertarian Democrat wrote:

I base my understanding of Human Agency Explanations in Economics on the work of Anthony Giddens, especially this book:

In New Rules of Sociological Method (1976) (the title of which alludes to Durkheim's Rules of the Sociological Method of 1895) Giddens attempted to explain 'how sociology should be done' and addressed a long-standing divide between those theorists who prioritise 'macro level' studies of social life - looking at the 'big picture' of society - and those who emphasise the 'micro level' - what everyday life means to individuals. In New Rules... he noted that the functionalist approach, invented by Durkheim, treated society as a reality unto itself, not reducible to individuals. He rejected Durkheim's sociological positivism paradigm, which attempted to identify laws which will predict how societies will operate, without looking at the meanings understood by individual actors in society. He contrasted Durkheim with Weber's approach - interpretative sociology - focused on understanding agency and motives of individuals. Giddens is closer to Weber than Durkheim, but in his analysis he rejects both of those approaches, stating that while society is not a collective reality, nor should the individual be treated as the central unit of analysis.[2] "Society only has form, and that form only has effects on people, insofar as structure is produced and reproduced in what people do".[3] Rather he uses the logic of hermeneutic tradition (from interpretative sociology) to argue for the importance of agency in sociological theory, claiming that human social actors are always to some degree knowledgeable about what they are doing. Social order is therefore a result of some pre-planned social actions, not automatic evolutionary response. Sociologists, unlike natural scientists, have to interpret a social world which is already interpreted by the actors that inhabit it. Thus, there is a "Duality of structure", according to Giddens. With that he means that social practice, which is the principal unit of investigation, has both a structural and an agency-component: The structural environment constrains individual behaviour, but also makes it possible. He also notes the existence of a specific form of a social cycle: once sociological concepts are formed, they filter back into everyday world and change the way people think. Because social actors are reflexive and monitor the ongoing flow of activities and structural conditions, they adapt their actions to their evolving understandings. As a result, social scientific knowledge of society will actually change human activities. Giddens calls this two-tiered, interpretive and dialectical relationship between social scientific knowledge and human practices the "double hermeneutic".

Giddens also stressed the importance of power, which is means to ends, and hence is directly involved in the actions of every person. Power, the transformative capacity of people to change the social and material world, is closely shaped by knowledge and space-time.[4]

In New Rules... Giddens specifically wrote[5] that:

* Sociology is not about a 'pre-given' universe of objects, the universe is being constituted -or produced by- the active doings of subjects.
* The production and reproduction of society thus has to be treated as a skilled performance on the part of its members.
* The realm of human agency is bounded. Individuals produce society, but they do so as historically located actors, and not under conditions of their own choosing.
* Structures must be conceptualized not only as constraints upon human agency, but also as enablers.
* Processes of structuration involve an interplay of meanings, norms and power.
* The sociological observer cannot make social life available as 'phenomenon' for observation independently of drawing upon his knowledge of it as a resource whereby he constitutes it as a 'topic for investigation'.
* Immersion in a form of life is the necessary and only means whereby an observer is able to generate such characterizations.
* Sociological concepts thus obey a double hermeneutic.
* In sum, the primary tasks of sociological analysis are the following: (1) The hermeneutic explication and mediation of divergent forms of life within descriptive metalanguages of social science; (2) Explication of the production and reproduction of society as the accomplished outcome of human agency.

2/9/2009 5:03 PM GST

Good comment on a Tyler Cowen post at Marginal Revolution wherein Cowen unearths an ancient Keynes letter providing some support for tax cuts.

From Paul Kedrosky:

"Negative Externalities and Dueling Economists

Good comment on a Tyler Cowen post at Marginal Revolution wherein Cowen unearths an ancient Keynes letter providing some support for tax cuts. More fuel for my take that skepticism-verging-on-nihilism is the right answer when faced by economists splitting along party lines.

….negative externalities accrue when we disparage poor expert consensus in a way that doesn't clearly lead to advocating for better expert consensus.

As for unearthing an old Keynes letter, I understand it may be fighting fire with fire, but really, I think the economics and legal profession should move away the pre-rational human tendency to want to derive policy wisdom from interpreting the texts of ancestors. Let's leave that to religious fundamentalism.

I'm more intrigued by the empirical work of folks like Romer and Barro and others, than the dueling sacred texts of Keynes and Mises."

Me:

It depends upon how you view Economics. To me, it produces some theories and models that are more or less useful in helping us to understand the economy. The really important action exists in Political Economy. Keynes and Mises are of continuing interest because they studied Political Economy. Although I did read a couple of books by Barro that qualify, they were not great, but good. I haven't read books by Romer.

However, it is a bizarre claim that Political Economy can't use the classics. That's like saying that sociologists can't use Durkheim. After all, we still use Newtonian Mechanics. If you think that Economics is more like physics than a human science, I can understand this position, sort of. If not, it's strange.

Since we're not sure what to do, and the economic theories are of limited use, we naturally look to the past for help. Isn't a lot of economics based on comparing different historical examples and trying to derive some useful ideas? Keynes is useful because his theories are widely thought to have been of help in ending the depression. As well, he was a very good writer. He provides us a set of ideas which we can use as a guide in considering current ideas, and, quite frankly, a hopeful narrative of how we might get out of this mess. I consider narrative thinking to be very important for politics and political economy. Others don't, I suppose.

Merely appealing to Keynes is an example of the fallacy called the appeal to authority. I don't think that Cowen is doing this, since he believes, as I do, that a payroll tax cut is a good thing. The Keynes letter also gives some reasons for his views, which you can agree with or not. But, since there are reasons given, it is not simply the argument from authority. It is valid, in my opinion, to want to know what Keynes thought about this issue, because he was a brilliant. That's all.

However, just calling on Barro and Romer is also the argument from authority. I've been reading Romer and Barro. In fact, yesterday, their ideas were both on blogs. Barro called for tax cuts as incentives, without offering anything specific. Romer, if I've got the right Romer, advocated giving the FDIC more power to collapse banks and concerns like Lehman I believe, which, from my perspective, is just nationalization under a different rubric. I'm fine with it, but it qualifies as a government takeover.

So, it's fine to quote whomever you want, assuming that you can explain what they said, and give reasons why you do or don't agree. I don't take that for granted, by the way. I know that it's hard to do for all of us.

I see many theories proven each day, and gain an even deeper understanding of them

From Free Exchange:

"In defense of economists

Posted by:

Economist.com | NEW YORK

Categories:

Cause and effect

The Perils of Prediction

The econoblogosphere

MY COLLEAGUES have expressed their frustration at the economics profession. Some economists share their despair at the way the field has failed throughout this crisis. It’s strange; I find it an exhilarating time to be an economist. Rather than seeing everything I learned turned on its head, I see many theories proven each day, and gain an even deeper understanding of them.

The disappointment many non-economists feel is probably the result of unrealistic expectations. Contrary to the prevailing view, no economist I know of has, or ever had, a perfect understanding of the economy. Some understand it better than others, but the nature of research is the eternal struggle to figure out what exactly is happening. That would be hard enough if markets were static, but they change all the time. Being a relevant economist requires constant relearning and rethinking of theories and techniques. Expecting economists to have all the answers now and the ability to prevent crises is like expecting doctors to have a ready a cure for a new, fast spreading virus. Financial innovation was quicker than the pace of academic research and most academic economists have few ties to industry. That probably explains why so many did not see the crisis coming. It also explains why economists make far better Monday morning quarterbacks than fortune tellers.

Even if that were not the case, I am not convinced there exists any scientific way to have foreseen what happened. Economists should have been more worried about the housing bubble and a lousy allocation of capital from the savings glut. But so much of what went wrong was panic. Even psychologists can not predict perfectly at what point panic sets in and correlations go to one. Modelling the factors that bring about such a state of the world and assigning them a probability is extremely difficult if not impossible.

But that does not mean economists are completely useless. We may not posses a perfect understanding of a constantly changing economy or predict the future. But my training has never felt more relevant. For instance, economists have theories on decision making when risk turns to uncertainty. Our models may not be great at predicting tail outcomes, but they were never meant to do this. They function as a road map rather than a perfect guide. Blaming economic models is like driving on a road, having a lorry slam into you, and blaming your road atlas for the accident. The atlas has value (without it we’d always be driving in circles), but it does not guarantee safe driving. That atlas remains, for all its faults, our best bet to fix the economy.

The tedious back and forth you hear on the effectiveness of fiscal policy (and whether it should be temporary or permanent, tax cuts or spending) results from economists’ keen awareness of what can go wrong. There are many roads we can take and all have their hazards. True, we have few instances of Hail Mary fiscal stimulus to study. Even when we do, it’s still hard to understand what happened. I predict in twenty years there will be a school of economists who claim the fiscal stimulus was a raging success and another who’ll maintain that what Ben Bernanke did more quietly, injecting capital into the economy and providing currency swaps to foreign central banks, saved the day.

My colleague is frustrated with the tiresome tone that economists take in their debates on the blogosphere and in opinion pieces. Unfortunately, that is not due to the financial crisis. Economists have always spoken to each other this way—just go to any academic seminar and you’ll hear the same thing. It’s how we communicate with one another. I suppose it must be like finding out how dysfunctional that perfect-seeming family actually can be.

As I mentioned, we are great Monday morning quarterbacks, which means that economists learn best from crises like this one. From the Great Depression we got Keynesian economics, which revolutionised the field. I can’t wait to see what emerges from the ashes of this mess."

Me:

Don the libertarian Democrat wrote:

"But so much of what went wrong was panic. Even psychologists can not predict perfectly at what point panic sets in and correlations go to one. Modelling the factors that bring about such a state of the world and assigning them a probability is extremely difficult if not impossible."

I agree completely. However, once panic was evident, it seems to me that it was clear that only a government guarantee could stop it, because only the government has the resources to be believed in issuing a guarantee. My own view, is that on the Sunday before Lehman declared bankruptcy, it was evident that Merrill and AIG would be in big trouble. If you've read Fisher's paper on Debt-Deflation and feel that it's reasonable, if not exact, you could have easily concluded that Lehman falling could lead to a Calling Run.

One reason that I was for a version of the Swedish Plan that week, was because, however it worked out in practice, it fulfilled the need of a government guarantee to stop the Calling Run, and it placed the interest's of the taxpayers first. The alternative, which we've been trying various versions of, was to issue the guarantee but attempt to balance the interest's of the taxpayers with those of the shareholders and leadership of these financial institutions. This Hybrid Plan has been a disaster.

Life is full of paradoxes. As I've argued since September, if you wanted to end the crisis in the cheapest way possible, and get the government out of the banking business, the quickest way was to take them over and then, as quickly as possible, spit them back out. Of course, I'm only talking about the ones needing a government lifeline to even exist.

In essence, I'm arguing that the ability to accept and deal with the paradoxes of human life and society is necessary for a more robust and effective political economy. After all, it must strike many as strange that, after arguing that low interest rates caused the crisis, we now have low interest rates. After arguing that we had an artificially high housing market, we're attempting to keep the price of houses artificially high. After saying that banks loaned money incompetently, we're claiming that the same people, more or less, have suddenly become competent and that government running the show even for a short time would be worse than leaving decisions in the hands of people who have brought on a worldwide economic crisis. We're blaming the free market, when it's obvious that bankers and investors believed that there were implicit government guarantees to help the financial sector in the case of a financial crisis. People are offering theories that say that, if the government invests money, it will hinder private investment, when private investors are buying bonds that pay essentially no interest rather than invest in other areas. The list goes on.

2/6/2009 5:46 AM GST