economists have no robust system of determining which statements about economics are true, and which are not

TO BE NOTED: From the Atlantic Business Channel:

"May 1 2009, 8:54 am by Charles Davi

The Sorry State Of The Dismal Science

John Authers' recent interview with University of Chicago professor Richard Thaler is a fine example of what I hope are broader trends in economic thought. To some, it might seem like just another interview. But Authers undoubtedly recognizes its significance. Thaler is a professor at the University of Chicago, which is the birth place of the Efficient Market Hypothesis, and Authers is a well-respected columnist for the Financial Times, which is arguably the voice of the free market in the press. And yet, there they are, casting doubt upon the very theories underpinning a generation of thought that have made the University of Chicago the epicenter of free market ideology. In the language of soda-pop-economics, this interview is a "black swan."

It seems Authers is leaning ever closer towards a world view informed by behavioral economics. While I haven't done any empirical research into Authers' work, I do read his column, The Short View, religiously (personally, I recommend you do the same). And as the recent downturn developed, I noticed several articles that suggest he's come to question at least some of the assumptions underlying the old free market dogmas, particularly the Efficient Market Hypothesis. In my opinion, this is a welcomed development. And I sincerely hope it is part of a broader trend away from grandiose theories about how humans make decisions and towards precise theories which are supported by real-world observations.

Those that have toiled through my writing in the past know that I am a big fan of free markets. Yet, I am not a big fan of the EMH. And in general, I find a lot of economic theory, particularly macroeconomic theory, to be little more than hand-waving. There's an almost priestly air about it that makes me deeply suspicious of its validity. In gentler terms, Economics lacks a rigorous epistemological theory. That is, economists have no robust system of determining which statements about economics are true, and which are not. This is in stark contrast to say, mathematics. A statement about an alleged mathematical truth is verifiable (putting Gödel and Turing aside for the moment). If you tell me that you have discovered a new mathematical truth, you can sit down and in a finite number of words, provide a logical path from assumptions we both agree are true to your new found conclusions that I must accept as true, else I reject either the assumptions or logic itself. Now, I understand that economics can never be a purely deductive sport, since it is complicated by the nuance and uncertainty of, well, reality. But that doesn't mean we can't do better than simply assuming away all of human ridiculousness.

The economics that assumes rational behavior on the part of humanity is, in my opinion, dead. It is simply at odds with everyday experience. It's arguable that the desire for wealth is itself an inherently irrational impulse for most of the developed world, given that our needs would likely be satisfied on public assistance. That said, those who are able to control their behavior and act rationally do a much better job at generating and accumulating wealth. But once they get the money, they go and do something absurd with it, like buy a fleet of planes. So while reason and deferred consumption might be the means by which we accumulate wealth, the end goal of accumulating wealth seems to be driven by a need to express dominance, or at least an antisocial impulse to be free of society's constraints. This view finds support in popular culture, which often equates wealth with conspicuous consumption, sexuality, and control. All of this suggests that somewhere buried under all of those pinstripes is a real brute.

If I am correct, and there is a sea change taking place in how economists view human behavior and the markets humans create, then there may be a lot of quackery in the short term. That is, during the intellectual power vacuum that will follow the demise of the old Chicago School, a few crackpots might temporarily seize power as we trace our way from the four humors to phlogiston. But when we finally get our Lavoisier, this time let's remember to keep his head on, despite our penchant for the irrational."

‘nudging’ the market

TO BE NOTED: From the FT:

Short View

Richard Thaler talks to John Authers about ‘nudging’ the market

Richard Thaler on market efficiency

TO BE NOTED: From FT:

Nudging the market
Video: Richard Thaler on market efficiency

"they believe they are doing good and so not constrained by what they themselves would consider proper principles of morality and honesty "

From David Friedman:

"Rationality, Nudges and Slippery Slopes

In order to explain and defend the economic approach to human behavior one must justify the assumption that individuals are rational, that they tend to take the actions that best achieve their objectives. One argument I have long made is that, while rational behavior is not a complete description of how humans act( TRUE ), it describes the predictable part of their action( CAN'T IRRATIONAL ACTION BE PREDICTABLE? ). In most situations there is one correct way of acting to achieve an objective and lots of incorrect ways someone could act. Unless one has a theory of what particular mistake someone is going to make, the best approach is to treat the mistakes as random error, to predict his behavior on the assumption he is rational while realizing that the prediction will sometimes be wrong.

So far as I know, neither Cass Sunstein nor Richard Thaler ever read either of the books in which I made that argument. But their recent book Nudges offers a rebuttal. Using evidence from behavioral economics, they argue that irrational action is not merely random error. There are patterns to it, predictable ways in which individuals act that are inconsistent with the economist's assumption of rationality( I AGREE ). Thaler and Sunstein propose that those setting up alternatives for someone else to choose among—"choice architects" in their terminology—can and should take advantage of those patterns to nudge the chooser into making the choice they think he ought to make, the choice he would make if he were fully rational. This is the approach that I described in an earlier post as "soft paternalism" and that has been described elsewhere as "libertarian paternalism." It is paternalism because it is getting people to act as someone else thinks they ought, libertarian because it leaves the individual free to act in a different way if he wants to—a nudge, not a compulsion( YES ).

The argument as stated is persuasive and interesting. As the authors point out, any time you are offering someone else choices—whether "you" are a government agency, an employer, or a firm selling something—you are necessarily deciding in what form to make the offer, hence engaging in choice architecture. If you are going to do it, you ought to know what you are doing and do it in a way designed to produce the result you want to produce—in their case, choices that result in the chooser better achieving his own goals.( A GOOD POINT )

The libertarian part of the proposal depends on leaving the individual free, at no significant cost, to make the choice you don't want him to make. But if you don't want him to make that choice, it will be tempting to make it more and more difficult—to require him to fill out forms, file them in the right place, perhaps even to neglect to tell him that forms exist to be filled out, that the alternatives you don't want him to choose are available. There is thus a serious slippery slope problem, making it possible for libertarian paternalism to be used as the justification for government actions that end up as paternalism, or compulsion for other purposes, that is far from libertarian. The point occurred to me when I read the book. It was reinforced by a real world experience at about the same time.

It was the beginning of my daughter's first year at college and the college sent us a bill, a list of charges and a total we were to pay. One of the items in the list, included without explanation, was ten dollars for the "Green Edge Fund." Being curious, I did an online search to find out what it was. It turned out that it was a fund to subsidize environmental projects by students. It had been voted in the previous year—as an optional ten dollar per pupil payment.

"Optional" means that you don't have to pay. We sent in our check minus the ten dollars and I sent an email to the president of the College, pointing out that he was billing parents for money they did not owe. I received back an apologetic email from an administrator, explaining that the program was a new one and they had not yet gotten everything set up properly.

A month or so later I received a bill from the College for ten dollars. I wrote back to the office that sent the bill, pointing out that they had billed me, and all other parents, for ten dollars we didn't owe, that rather than my owing them money they owed money to all of the parents who had paid the ten dollars. I also sent an email to the administrator. A few weeks later, I received second bill for ten dollars—shortly followed by an email from the administrator telling me that the matter had been taken care of and I could ignore the bill.

Recently we got our bill for the second semester. It included a form for our daughter to sign and hand in during the first two weeks of the semester requesting a waiver of the charge for the Green Edge fund. The form contained a description of the fund—put in terms of how the money would be used, not how they hoped it would be used—that I suspect most students and faculty at the college would regard as fraudulent advertising if it were the product of, say, the phone company.

The bill did not include any mention of the fact that the College had, in the previous semester, charged parents for some tens of thousands of dollars that they did not owe, nor any offer of a refund to any parent who wanted it.

As it happened, my wife went to the same college thirty-some years earlier—and had had a similar experience. In her day it was a one dollar per student charge to support one of Ralph Nader's PIRGs. A student could get out of it by going to the right office on the right day and telling them he didn't want to pay it. On further enquiry, we discovered that the one dollar per student "donation" was still there, although there did not seem to be any effort to inform parents or students that they had the option of not paying it.

An optional charge where the default choice is to pay it is the sort of thing Sunstein and Thaler propose, a nudge in the direction of doing what those responsible believe, possibly correctly, that most of those nudged would want to do if they took the time to think about it. But the people constructing the choice architecture know what result they want to get, they believe they are doing good and so not constrained( HOW DOES THIS FOLLOW? ) by what they themselves would consider proper principles of morality and honesty in a commercial context, so it is very easy to make the "wrong" choice more and more difficult and obscure until what is optional in theory becomes mandatory in practice."

There is a difference between a nudge and misleading or fooling someone. In order for slippery slope arguments to be valid, the two terms held to be equivalent need to be indistinguishable. A nudge and a ruse seem different and distinguishable to me.It is always tempting for people to exaggerate or fudge or blur their arguments, even when purporting to be based on reason or experiment. The answer is to hold people to standards of fairness and decency. We might want to begin with the financial industry.

""I don't know anybody involved who thought he could predict these turning points."

Via Marginal Revolution, Drake Bennett on the Boston Globe discusses the current state of Economics:

"THE DEEPENING ECONOMIC downturn has been hard on a lot of people, but it has been hard in a particular way for economists. For most of us, pain and apprehension have been mixed with a sense of grim amazement at the complexity( CONNECTEDNESS ) of what has unfolded: the dense, invisible lattice connecting house prices ( A BUBBLE ) to insurance companies( POOR DECISIONS ) to job losses( MANY PREEMPTIVE ) to car sales( LIKE HOUSES, FINANCED THROUGH CREDIT WHICH IS NOW HARD TO GET ), the inscrutability of the financial instruments( VASTLY OVERSTATES THE COMPLEXITY ) that helped to spread( HIDE ) the poison, the sense that the ratings agencies and regulatory bodies were overmatched( TRY CONFLICT OF INTEREST ) by events, the wild gyrations( AMIDST THE WILD GYRATION'S OF GOVERNMENT POLICIES ) of the stock market in the past few months( NO MENTION OF FRAUD AND GOVERNMENT GUARANTEES ). It's hard enough to understand what's happening, and it seems absurd to think we could have seen it( WE MIGHT HAVE TRIED PREPARING FOR IT ) coming beforehand. The vast majority of us, after all, are not experts ( THANK GOD ).

	Discuss
	COMMENTS (8)

(Getty Images, Globe Staff photo illustration)

But academic economists are. And with very few exceptions, they did not predict the crisis, either( WERE THEY SUPPOSED TO? ). Some warned of a housing bubble, but almost none foresaw the resulting cataclysm. An entire field of experts dedicated to studying the behavior of markets failed to anticipate what may prove to be the biggest economic collapse of our lifetime. And, now that we're in the middle of it, many frankly admit that they're not sure how to prevent things from getting worse( THAT'S SIMPLY THE TRUTH ).

As a result, there's a sense among some economists that, as they try to figure out how to fix the economy, they are also trying to fix their own profession. The discussion has played out in blog posts and opinion pieces, in congressional testimony and at conferences and in working papers. A field that has increasingly been defined, at least in the public eye, by quirky studies explaining the economics of our everyday lives - most famously in the best-selling book "Freakonomics" - has turned decisively, in the last couple months, to more traditional economic turf. And at economics powerhouses like Harvard, MIT, and the University of Chicago, faculty lunch discussions that once might have centered on theoretical questions and the finer points of Bayesian analysis are now given over to dissecting bailout plans. Long-held ideas - about the stability of the business cycle, the resilience of markets, and the power of monetary policy - are being challenged ( GOOD ).

"Everyone that I know in economics, and particularly in the worlds of academic finance and academic macroeconomics, is going back to the drawing board( AGAIN, TRY A NOTEBOOK )," says David Laibson, a Harvard economist. "There are very, very, very few economists who can be proud( THAT'S SILLY )."

A few are suggesting, as well, that there are deeper problems in the discipline. Economists are asking aloud whether the field has grown too specialized, too abstract - and too divorced, in some sense, from the way real-world economies actually function( TRUE, BUT THAT HAS MORE TO DO WITH NOT RECOGNIZING OR CARING ABOUT THE DIFFERENCE BETWEEN ECONOMICS AND POLITICAL ECONOMY ). They argue that many of the models used to explain and predict the dynamics of financial markets or national economies have been scrubbed clean, in the interest of theoretical elegance( THERE'S A POINT TO THIS AT THE KANTIAN LEVEL OF EXPLANATION ), of the inevitable erraticism of human behavior( THAT'S WHY WE NEED HUMAN AGENCY EXPLANATIONS, WHICH ARE EXISTENTIAL ). As a result, the analytical tools of the trade offer little help in a crisis, and have little to say about the sort of collapses that led to this one( IF THEY TURNED TO POLITICAL ECONOMY, THEIR HELP WOULD BE QUITE USEFUL ).

"You can't just say, 'I have a model for tremors that works great, I just can't explain earthquakes,'( YOU JUST DID ) " says Kenneth Rogoff, a Harvard economist who has studied financial crises.

Historically, periods of severe economic distress have shaken up economics, and helped drive its evolution. And in the midst of the current crash, there is an urgent search for approaches and models that might better illuminate how to speed the recovery and forecast future meltdowns, and that might help us better understand the unruly flow of money.( UNRULY, ERRATICISM, GYRATIONS,INSCRUTABIlITY,DENSE,LATTICED,TREMORS, SCRUBBED CLEAN, DISSECTING, CATACLYSM, DEEPER PROBLEMS,BUBBLE, COLLAPSE, PREVENT, EARTHQUAKES, ETC. AND THAT'S JUST SO FAR )

The question of how well economists can model crises takes on an even greater importance because of the central role economic experts will play in Barack Obama's administration - not only at the Federal Reserve, the Council of Economic Advisors, and the Treasury, but in the Economic Recovery Advisory Board, a newly formed body created by the president-elect and headed by former Federal Reserve chairman Paul Volcker. Obama has a reputation as someone who places a great deal of stock in expertise and the power of data ( THAT'S GOOD. JUST MAKE SURE TO DIVERSIFY YOUR PORTFOLIO. SAY, BY ADDING THIS BLOGGER AS COURT JESTER FOR FINANCES ). For better or worse, the evolving understanding of economic breakdowns will have ample opportunity to test itself against the real thing( ISN'T THAT WHAT IT'S SUPPOSED TO DO? EVEN WITH MATH YOU SHOULD TRY ).

Along with everything else they have done, the financial meltdown and attendant economic slump have spurred unprecedented political attention and participation on the part of economists ( THEY'RE BETTER THAN MANY OTHERS ).

"In my lifetime as an economist I've never seen economists so engaged by what's going on," says Richard Thaler of the University of Chicago. "At the University of Chicago people always talk economics at lunch, but for the last three months they've all been talking about the crisis and the bailout, and writing op-eds( HAVE YOU TRIED STUDYING AT ALL? )."

This is something of a change. The topics economists study often have little to do with the average person's economic life - as in most any academic field, practical relevance can have little to do with what questions are deemed most interesting and rewarding. This divergence was exacerbated, many economists say, during the span of almost uninterrupted economic growth that began in the late 1980s, a period when many of the more practical questions in economic policy-making came to be seen as having been settled( NOTHING IS WRITTEN ). For years, leading economic figures like Larry Summers and Alan Greenspan argued that the United States had more or less( THE QUALIFYING SOUNDS A NOTE OF SKEPTICISM FOR ALL WHO CARE TO HEAR. I'M RATHER LIKE ODYSSEUS IN THAT REGARD, AND ONLY THAT ) brought the business cycle to heel ( THEY'RE LIKE TRAINERS IN THIS MODEL ).

Partly as a result, many bright young economists turned to questions that were quirkier, or more purely mathematical. To the wider public, the most visible ramification of this was the boom in papers and books about the economics of everyday life - the best-known practitioner was Steven Levitt of the University of Chicago, but economists like Ray Fisman of Columbia, Edward Miguel of UC Berkeley, and Justin Wolfers of the University of Pennsylvania also worked at least partly in this vein. In often ingenious studies, they used economics as a forensic tool to examine family dynamics, speed-dating, parking scofflaws, basketball games, or the life choices of street criminals.

For those who stayed on more traditional economic turf, however, the trend was toward narrower questions, and more abstract ones. Financial economists set out to figure out why it is that stocks earn more than bonds, or to devise better ways of calculating "beta," the correlation between the price of a single asset and the price of the market it was part of. Others took on the surprisingly difficult question of defining what, exactly, money is.

Wolfers, being an economist, describes these intellectually challenging but less policy-relevant questions as a sort of scholarly "luxury good." "During good times we all consume more luxuries," he says, "but during a bad economy, it feels to macroeconomists that what we should be doing is stuff to help today."

Some economists have suggested that this focus may account for why so many failed to see the warning signs of the financial crisis, and to predict the size and scope of its fallout.

Others see a broader problem in that the sort of behavior we've seen in everyone from home buyers to investment bankers in recent months is hard to fit into economists' analytical tools. The models that macroeconomists - those who study national and regional economies in their entirety - rely on do a poor job of describing the messiness of an actual market in flux( THAT'S WHY WE NEED A HUMAN AGENCY EXPLANATION ). Many, for example, only have one variable for an interest rate, even though in times of economic turmoil the gap between various rates often widens so far that it's difficult to say what "the" interest rate actually is. As a result, economists end up oversimplifying such situations when they model them - or simply avoid studying them at all.( THAT'S POLITICAL ECONOMY )

"We have a very restrictive set of language and tools, and we tend to work on the problems that are easily addressed with those tools ( THIS IS TRUE OF ALL HUMAN ENDEAVOR )," says Jeremy Stein, a financial economist at Harvard. "Sometimes that means we focus on silly questions and ignore greater ones( SO DOES MODERN PHILOSOPHY )."

Today there is a move to hone and rethink the models that describe the huge interlocking wheels of the economy, and to find a way to include the human tendencies that can bring them grinding to a halt. Some economists are looking to the methods and findings of psychology, others are applying themselves to the tricky task of modeling bubbles, a relatively neglected topic. Whatever the approach, the study of financial crises is likely to be a predominant question for the newest generation of economists. ( POLITICAL ECONOMY AND HUMAN AGENCY EXPLANATIONS ARE ALL THAT IS NEEDED,AND ALL THAT WE CAN EXPECT )

"I guarantee that over the next couple of years you are going to see lots of papers on banking crises and financial blowups," says Andrew Lo, a financial economist at MIT's Sloan School of Management.

In addition, others predict, there's likely to be a sharp migration among young economists into these fields. "Banking has been an incredibly important field that has not been hot for some time," says Edward Glaeser, a Harvard University economist. "What's happened is that banking is sexy again ( BECAUSE OF A CRISIS. NOW THAT'S PARADOXICAL )."

Already, the crisis is reshaping long-running debates. It has chastened believers in the self-correcting abilities of the free market - Alan Greenspan said as much before Congress in October - and emboldened those who see the need for more active government intervention( TRUE ).

In a sense, it's a debate that has been seesawing back and forth from crisis to crisis over the past century. Classical economics was devastated by the Great Depression, and in the years afterward gave way to the ideas of the British economist John Maynard Keynes: that individually rational economic decisions could add up to collectively disastrous consequences, that the "stickiness" of prices and wages could lead to long-term unemployment and stagnation, and that the government, as a result, has to step in to kick-start the economy.

The stagflation of the 1970s, while mild compared with the Depression, swung the pendulum back. It was Milton Friedman, a sharp critic of Keynesianism and a fervent advocate of unfettered free markets, who solved the seeming paradox of simultaneous inflation and high unemployment by realizing the deadening power of people's expectation of future inflation, and it was Friedman's proposed solution - sharply restricting the money supply - that eventually, albeit painfully, solved the problem.

Today's crisis has brought Keynes back to the center of the discussion, but some economists also see it driving the field into new territory. Up until very recently, the study of market bubbles was marginalized - there was no widely accepted definition of what a bubble was, and some economists, believers in the complete rationality of markets, argued that bubbles didn't even exist( BRILLIANT ). Today, however, there is a growing sense that understanding bubbles is vital to understanding markets - among those making the case is Federal Reserve chairman Ben Bernanke, who, as head of the Princeton economics department, made a point of hiring young economists interested in the topic( GOOD FOR HIM ).

Over the same time period, the field of so-called behavioral economics has risen to prominence, led by, among others, Thaler, Laibson, and Robert Shiller, a Yale economist who warned of both the housing bubble and, in 2000, the dot-com bubble. By borrowing the insights and methods of psychology, behavioral economics focuses on all the ways in which humans fail to act as the rational, self-interested beings that economic models call for - we aren't good at thinking about the future, we're susceptible to peer pressure, we overestimate our abilities and underrate the odds of bad things happening. It's a set of traits that describes perfectly the behavior of many of the people who, in a cascade of self-defeating decisions, helped create the subprime crisis. ( A GOOD APPROACH )

"People used to think that these behavioral effects were small anomalies that turned up in experiments but washed out in the real world," says Tyler Cowen, an economist at George Mason University not himself affiliated with behavioral economics. "But there's a sense( TRYING LOOKING AND IT WILL BE MORE THAN THAT ) in which they get multiplied in the real world."

For now, behavioral economics remains a critique without a real alternative. That may be starting to change: Lo has developed what he calls the "adaptive markets hypothesis," a model that he argues reflects both the rationality of the investor in good times and the blind panic of the bad( MIGHT HELP ).

Nonetheless, for some economists, the lessons of the crisis are likely to be smaller, though no less humbling. These scholars argue that they're facing not a new challenge but a familiar nemesis.

"What we're experiencing now is a good old-fashioned financial panic," says Jeffrey Kling, an economist at the Brookings Institution. "This is perhaps the biggest scale, but on some level it's not that different( A SLIGHT SIMILARITY )."

Robert Lucas, an economist and Nobel laureate at the University of Chicago and a champion of the rationality of markets, doesn't see much fundamental change coming out of the crisis, either. What it has reminded us of, he argues, is simply the impossibility of seeing these events in advance ( TRUE ).

"I don't know anybody involved who thought he could predict these turning points. Do macroeconomists know as much as we thought we did?" he asks. "Of course not( NO ONE DOES )."

By this logic, the problem isn't how economists see the world so much as it is what we expect of economics ( NOT MUCH ).

Laurence Ball, an economist at Johns Hopkins, makes a similar point. "Nobody ever sees anything coming," he says. "Nobody saw stagflation coming, nobody saw the Great Depression coming, nobody saw Pearl Harbor or 9/11 coming. Really big, bad things tend to be surprises( OTHERWISE THEY WOULDN'T HAVE HAPPENED )."

A little chastening isn't bad, but, please, no hand wringing.

A Review Of "Nudge"

Will Wilkinson reviews the book "Nudge" on Reason. The conclusion:

"All Nudge really offers is the idea that we should use what we know about how people act in order to design policy that will help them. And we shouldn't take away their choices. Well, I'm for all of it. If some policy makers really are misled by unrealistic economic models of rationality, then they should cut it out and bone up on psychology. Behavioral economics provides valuable new information about what will and won't work, and why. Thaler's work on savings plans is a great example of what can be done by taking into account new findings in psychology.

But it's no source of ideological realignment, no basis for what Thaler and Sunstein call a "Real Third Way." This book offers some whiz-bang behavioral economics that can be used for any ideological end, and it gives us the agreeably banal doctrine of choice-preserving helpfulness. The whiff of paradox in "libertarian paternalism" may have set up hopes for a category-defying revolution, but Nudge is the book where those hopes, and that tiny monster of an idea, prove flightless."

I consider Sunstein and Thaler to be proponents, more or less, of my agenda, so I'm going to have to read the book myself. However, Wilkinson does make some good points.