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As I have repeatedly noted, mainstream economists and financial advisors have been using faulty and unrealistic models for years. See this, this, this, this, this and this.
And I have pointed out numerous times that economists and advisors have a financial incentive to use faulty models. For example, I pointed out last month:
The decision to use faulty models was an economic and political choice, because it benefited the economists and those who hired them.
For example, the elites get wealthy during booms and they get wealthy during busts. Therefore, the boom-and-bust cycle benefits them enormously, as they can trade both ways.
Specifically, as Simon Johnson, William K. Black and others point out, the big boys make bucketloads of money during the booms using fraudulent schemes and knowing that many borrowers will default. Then, during the bust, they know the government will bail them out, and they will be able to buy up competitors for cheap and consolidate power. They may also bet against the same products they are selling during the boom (more here), knowing that they'll make a killing when it busts.
But economists have pretended there is no such thing as a bubble. Indeed, BIS slammed the Fed and other central banks for blowing bubbles and then using "gimmicks and palliatives" afterwards.
It is not like economists weren't warning about booms and busts. Nobel prize winner Hayek and others were, but were ignored because it was "inconvenient" to discuss this "impolite" issue.
Likewise, the entire Federal Reserve model is faulty, benefiting the banks themselves but not the public.
However, as Huffington Post notes:
The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.
This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed's thrall, the economists missed it, too.
"The Fed has a lock on the economics world," says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. "There is no room for other views, which I guess is why economists got it so wrong."
The problems of a massive debt overhang were also thoroughly documented by Minsky, but mainstream economists pretended that debt doesn't matter.
And – even now – mainstream economists are STILL willfully ignoring things like massive leverage, hoping that the economy can be pumped back up to super-leveraged house-of-cards levels.
As the Wall Street Journal article notes:
As they did in the two revolutions in economic thought of the past century, economists are rediscovering relevant work.
It is only "rediscovered" because it was out of favor, and it was only out of favor because it was seen as unnecessarily crimping profits by, for example, arguing for more moderation during boom times.
The powers-that-be do not like economists who say "Boys, if you don't slow down, that bubble is going to get too big and pop right in your face". They don't want to hear that they can't make endless money using crazy levels of leverage and 30-to-1 levels of fractional reserve banking, and credit derivatives. And of course, they don't want to hear that the Federal Reserve is a big part of the problem.
Indeed, the Journal and the economists it quotes seem to be in no hurry whatsoever to change things:
The quest is bringing financial economists - long viewed by some as a curiosity mostly relevant to Wall Street - together with macroeconomists. Some believe a viable solution will emerge within a couple of years; others say it could take decades.
Saturday, PhD economist Michael Hudson made the same point:
I think that the question that needs to be asked is how the discipline was untracked and trivialized from its classical flowering? How did it become marginalized and trivialized, taking for granted the social structures and dynamics that should be the substance and focal point of its analysis?…To answer this question, my book describes the "intellectual engineering" that has turned the economics discipline into a public relations exercise for the rentier classes criticized by the classical economists: landlords, bankers and monopolists. It was largely to counter criticisms of their unearned income and wealth, after all, that the post-classical reaction aimed to limit the conceptual "toolbox" of economists to become so unrealistic, narrow-minded and self-serving to the status quo. It has ended up as an intellectual ploy to distract attention away from the financial and property dynamics that are polarizing our world between debtors and creditors, property owners and renters, while steering politics from democracy to oligarchy…
[As one Nobel prize winning economist stated,] "In pointing out the consequences of a set of abstract assumptions, one need not be committed unduly as to the relation between reality and these assumptions."
This attitude did not deter him from drawing policy conclusions affecting the material world in which real people live. These conclusions are diametrically opposed to the empirically successful protectionism by which Britain, the United States and Germany rose to industrial supremacy.Typical of this now widespread attitude is the textbook Microeconomics by William Vickery, winner of the 1997 Nobel Economics Prize:
Such disdain for empirical verification is not found in the physical sciences. Its popularity in the social sciences is sponsored by vested interests. There is always self-interest behind methodological madness. That is because success requires heavy subsidies from special interests, who benefit from an erroneous, misleading or deceptive economic logic. Why promote unrealistic abstractions, after all, if not to distract attention from reforms aimed at creating rules that oblige people actually to earn their income rather than simply extracting it from the rest of the economy?"Economic theory proper, indeed, is nothing more than a system of logical relations between certain sets of assumptions and the conclusions derived from them… The validity of a theory proper does not depend on the correspondence or lack of it between the assumptions of the theory or its conclusions and observations in the real world. A theory as an internally consistent system is valid if the conclusions follow logically from its premises, and the fact that neither the premises nor the conclusions correspond to reality may show that the theory is not very useful, but does not invalidate it. In any pure theory, all propositions are essentially tautological, in the sense that the results are implicit in the assumptions made."
As I have previously written, mainstream economists and financial advisors who promote flawed models are not necessarily bad people:
Selected CommentsI am not necessarily saying that mainstream economists were intentionally wrong, or that they lied because it led to promotions or pleased their Wall Street, Fed or academic bosses.
But it is harder to fight the current and swim upstream then to go with the flow, and with so many rewards for doing so, there is a strong unconscious bias towards believing the prevailing myths. Just like regulators who are too close to their wards often come to adopt their views, many economists suffered "intellectual capture" by being too closely allied with Wall Street and the Fed.
As Upton Sinclair said:
It is difficult to get a man to understand something, when his salary depends upon his not understanding it.
gordon, December 21, 2009 at 8:16 pmBut economists are amongst the new priests, who give legitimacy to the the oligarchs of our era. I have written about it.. maybe more in the future.
http://dissention.wordpress.com/2009/12/12/the_new_priests_01/
I was glad to see Hudson's smackdown of the supercilious Krugman, who could barely contain his disdain for the uncouth radical daring to criticize the majestic Samuelson.
Krugman couldn't even bring himself to write Hudson's name, but just linked to the anonymous post. (Of course K is always very respectful of anyone properly ensconsed in the Establishment, even where he disagrees with them.)
Quite the contrast with his protests over how he and others who were correct on Iraq remain marginalized on that subject.
Anonymous Jones, December 21, 2009 at 10:46 pmIf you liked Hudson's "smackdown", you'd love L.Randall Wray's comprehensive demolition of Krugman's position here:
http://neweconomicperspectives.blogspot.com/2009/12/krugman-gets-it-wrong.html
Andrew Foland, December 21, 2009 at 5:29 pmWell, you know, I appreciate a healthy debate, but if you think this is a "demolition," you were predisposed to a certain way of thinking long before reading this piece.
First of all, referencing Keynes's "publication date" is especially spurious, as anyone who has published knows what a long time can occur before deciding on a theory and then having it published. The idea that Keynes had no impact at all prior to a publication date is an assumption likely not grounded in reality.
Second of all, solely because certain of Samuelson's ideas were later discredited does not necessarily impugn his advancement of the discipline. I think if we read Aristotle and Plato closely, we could probably find one, or maybe two, inaccuracies as well. I doubt many find those two men dispensable, however.
I personally am skeptical of Samuelson and Krugman and their ideas, but this is not a "demolition" and referencing it as such shows you are an ideologue no better than they. Of course, that just makes you no different than at least 99.99999% of humanity (me included).
With all due respect, I do not think anyone's ideas are beyond reproach, but the belief that you can demolish people (not to mention their "comprehension") who are as smart and complex as Keynes, Samuelson and Krugman in nine paragraphs or less is … really … I lack non-curse words for it.
john c. halasz says:The powers-that-be do not like economists who say "Boys, if you don't slow down, that bubble is going to get too big and pop right in your face".
This warning would properly go unheeded, because that bubble didn't blow up in their face. It blew up in our face.
But Vickery was one of the last of the old radical full employment Keynesians. He won his Bank of Sweden prize just weeks before he died for some contributions to auction theory that he himself regarded as relatively trivial. So the citation of him is actually making the same point about the relative triviality of much economic theory.
framed, December 21, 2009 at 5:37 pm"Economics" and the Great Liquidation. " American Gothic, December 21, 2009 at 6:00 pmUmmm, let me see if I can follow the logic here. You're using arguments presented by academically trained economists (Simon Johnson, William Black, Michael Hudson) made against other academically trained economists to suggest that all academically trained economists have incentives to use faulty models. So which ones are bought and sold by the Fed and why didn't the Fed buy off the other ones?
MyLessThanPrimeBeef says:[...] http://www.nakedcapitalism.com/2009/12/guest-post-economists-are-trained-to-ignore-the-real-world.ht... [...]
cheese_eating_social_democrat_surrender_monkey, December 21, 2009 at 6:31 pmIf economists can ignore the everyday world, they should be Zen monks.
craazyman, December 21, 2009 at 7:11 pmframed, individual data points (e.g. economists) do not disprove a hypothesis. try harder.
Alexandra Spirer , December 21, 2009 at 7:11 pmIt amazes me how economists can look at the real world and stay in their bubble. The reality is that we are in tough times with people losing their jobs everyday. It's disheartening to think that they don't see what is really going on in America.
Q: If you threw 10 economists off the roof of a tall building, would they hit the ground?
A: No, they'd fall gently until they reached equilibrium.
... ...
Q: How many economists does it take to spot a bubble?
A: I don't know, we're still counting.
... ....
Q: What happened when they replaced God with an economist?
A: All hell broke loose.
... ...
Q: Why did the out-of-work economist starve to death when the Church down the street was handing out sandwiches to the homeless?
A: Because he didn't believe in a free lunch.
Not funny.
Q: How can a fool with demonstrably only half a brain win a Nobel Prize for Economics?
A: Because empiricism is irrelevant.
Uggh. That's a real Geek joke.
... .... ....
fresno dan, December 21, 2009 at 7:13 pmFrancois T, December 21, 2009 at 7:19 pmWell, Andrew Foland beat me to it, "The powers-that-be do not like economists who say "Boys, if you don't slow down, that bubble is going to get too big and pop right in your face" I will allow government officials some slack, because who gets elected saying we really need to slow the economy down? But on the other hand, it is their job – they're suppose to be leaders, not pop stars.
I remember, not so long ago, the miracle hormone estrogen, and how it just seemed common sensible and proved by research that this stuff prevented all manner of problems in post menopausal women. But medicine, though far short of real science, has enough familiarity with skepticism, evidence, and reality to discover that this treatment rested on a foundation of supposition, hope, and desire.
It seems to me there is a great deal of similarities between medicine and economics – an awful lot of theory demonstrably false. But economics seems to have a religious belief in its premises.
gordon, December 21, 2009 at 8:03 pmNo wonder that an economist like Steve Keen is practically unknown in the US.
He can't swallow the Kool Aid, since his allergy to BS is rather high.
HD, December 21, 2009 at 10:55 pmYou know you're getting old when a post like this reminds you of the book Theodore Roszak edited in 1967 – "The Dissenting Academy" – and particularly the essay on economics and economists, "Keynes Without Gadflies", by S. Rosen. It's not that we've been here before, it's that we've been here continuously for 40 years.
Is this an example?
http://www.time.com/time/specials/packages/article/0,28804,1946375_1948023_1947253,00.html
No, on your house. Do you have a mortgage? Bernanke: Oh, yes, we refinanced.
Oh, perfect. When?
Bernanke: About 5%. A couple of months ago.
Good time.
Bernanke: Yes. We had to do it because we had an adjustable rate mortgage and it exploded, so we had to.
Just the sort of sweetheart I want controlling our economic destiny ;-)
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An institutional Economics Prize: Congratulations to Elinor Ostrom and Oliver Williamson. What a day for them!
The way to think about this prize is that it's an award for institutional economics, or maybe more specifically New Institutional Economics. Neoclassical economics basically assumes that the units of economic decision-making are a given, and focuses on how they interact in markets. It's not much good at explaining the creation of these units - at explaining, in particular, why some activities are carried out by large corporations, while others aren't. That's obviously an interesting question, and in many cases an important one. For example, in my own home field of international trade, the basic models don't assign any particular role to multinational corporations; how do we get them into the story, and what difference do they make?
There was an old tradition of economics that focused on the origins and nature of economic institutions. This tradition was very influential before World War II. But it proved not at all helpful during the Great Depression. My caricature version is that when the Depression hit, institutional economics, asked for advice about what to do, replied that well, it's all very complicated, and has deep historical roots, and … Meanwhile, Keynesian economists, using very simple mathematical models, basically said "Push this button - we need more G". And this had a somewhat perverse effect. The rise of Keynesian economics also meant the rise of the equations guys (Samuelson in particular), and in the end the equations crowded out institutional economics even as Keynes fell into disfavor. But the questions didn't go away. And institutional economics has been making a quiet comeback for the past several decades.
Oliver Williamson's work underlies a tremendous amount of modern economic thinking; I know it because of the attempts to model multinational corporations, almost all of which rely to some degree on his ideas. I wasn't familiar with Ostrom's work, but even a quick scan shows why she shared the prize: if the goal is to understand the creation of economic institutions, it's crucial to be aware that there is more variety in institutions, a wider range of strategies that work, than simply the binary divide between individuals and firms.
The prize is also, of course, a happy reminder that most of the profession is not caught up in the macro wars!
Add: Don't tell Senator Coburn, but the NSF Political Science program has supported a lot of Elinor Ostrom's research.
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Economist's View
lark:
Our society has become a scam where the rhetoric of individualism and "anyone can make it" is like a smarmy sales pitch for its opposite, a tale of degradation and despair.
But let's be real. This is not by accident, but by design. Yes our job market is collapsing. All the supports have been pulled away, one by one, year after year. Not only do we have burst bubbles, we have decades of outsourcing accompanied by predatory Asian mercantilism (with American enablers). Wall Street salivates over job destruction here followed by factory building over there: it's a trade they make money on. WalMart pockets the profits. We've lost millions and millions of factory jobs, and Wall Street cheers. Venture capital wants overseas programmers in software startups.
And it's so hilarious that we are supposed to finance our own retraining, by taking out loans from predatory lenders who have been cut a sweet heart deal by the govt. What a crock.
No one has cared for decades about American workers. The free market ideology has its corollary in our vaunted "labor market flexibility". Way to go, fire at will. Yeah, we're so flexible we've beat our own labor market to death, without a fix in sight. Have you seen what has happened to state tax collections? No green shoots there!
It's a real shocker, what a bunch of toxic theories and ideologies have done to this economy.
Lafayette -> lark...LOTUS EATERS
{Our society has become a scam where the rhetoric of individualism and "anyone can make it" is like a smarmy sales pitch for its opposite, a tale of degradation and despair.}
What a lark! But, spot on.
I would only add that the above we have swallowed hook, line and sinker. Parents tell their children that is by dint of "True Grit" that one succeeds in America and off we trundle on our career believing such nonsense.
Of course, we are pulled by nose with media publicity that teaches us that owning this and showing off with that is the "pursuit of happiness". We accumulate "things", so we are "happy"?
Then why the plethora of factual evidence that all is not well in LaLaLand? Because that would question basic instincts and we cannot do that. Questioning the raison d'être of an existence is dangerous stuff, especially when that existence is like a house of cards.
All too easily brought down around our ears. A sickness here, a job loss there and over there a divorce that breaks apart a family.
We become flotsam on the sea of life.
Dear me, dear me ... enough of this, Cassandra. Mustn't disturb the Lotus Eaters ...
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FT.com
We need a new science of macroeconomics. A science that starts from the assumption that individuals have severe cognitive limitations; that they do not understand much about the complexities of the world in which they live. This lack of understanding creates biased beliefs and collective movements of euphoria when agents underestimate risk, followed by collective depression in which perceptions of risk are dramatically increased. These collective movements turn uncorrelated risks into highly correlated ones. What Keynes called "animal spirits" are fundamental forces driving macroeconomic fluctuations.
The basic error of modern macro-economics is the belief that the economy is simply the sum of microeconomic decisions of rational agents. But the economy is more than that. The interactions of these decisions create collective movements that are not visible at the micro level.
It will remain difficult to model these collective movements. There is much resistance. Too many macro-economists are attached to their models because they want to live in the comfort of what they understand – the behaviour of rational and superbly informed individuals.
To paraphrase Isaac Newton, macroeconomists can calculate the motions of a lonely rational agent but not the madness of the crowds. Yet if macroeconomics wants to become relevant again, its practitioners will have to start calculating this madness. It is going to be difficult, but that is no excuse not to try.
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The Economist gives us economists too much credit. It writes:
In... the idea that economics as a whole is discredited... backlash has gone far too far.... Economics is less a slavish creed than a prism through which to understand the world...
I would like to draw a distinction between economics as a way of thinking--the way good economists think, at least--and academic economics as a profession. Economics as a way of thinking is, I believe, still very valuable. But academic economics as a profession has proven itself to be not valuable at all in this financial crisis. As the Economist writes later on:
the financial crisis has blown apart the fragile consensus... [about] monetary policy... [because] in a banking crisis monetary policy works less well. With their compromise tool useless, both sides have retreated to their roots, ignoring the other camp's ideas. Keynesians, such as Mr Krugman, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, the cacophony underlines the profession's uselessness...
In my view, when you have Nobel Memorial Prize-caliber economists like Arizona State's Edward Prescott, Chicago's Robert Lucas and Eugene Fama, and Harvard's Robert Barro claiming that there are valid theoretical arguments proving that fiscal stimulus simply cannot work, not even in a deep depression--even though they cannot enunciate such theoretical arguments coherently--it is entirely fair for outsiders to conclude that academic economics as a profession is useless.
And I for the life of me cannot see what the arguments of the "purists" are. The basic quantity theory of money:
(M/P) * V(i) = Y
tells us that output depends on (a) the real money stock M/P, and (b) the velocity of money V, which (c) is an increasing function of the short-term nominal interest rate on government securities i. Fiscal policy--government deficits--change the quantity supplied of government bonds, and by supply-and-demand things that change the quantity of something change its price, and the price of government bonds is this interest rate i. It is true that Robert Barro has an argument that deficits caused by tax-law changes create offsetting changes in desired savings that neutralize the effect of increasing the supply of government bonds, but I know of no argument that claims the same for deficits caused by government-spending changes unless the goods the government buys and distributes with its spending are perfect substitutes for private consumption expenditures.
Some more context:
Economics: What went wrong with economics: OF ALL the economic bubbles that have been pricked, few have burst more spectacularly than the reputation of economics itself. A few years ago, the dismal science was being acclaimed as a way of explaining ever more forms of human behaviour, from drug-dealing to sumo-wrestling. Wall Street ransacked the best universities for game theorists and options modellers. And on the public stage, economists were seen as far more trustworthy than politicians. John McCain joked that Alan Greenspan, then chairman of the Federal Reserve, was so indispensable that if he died, the president should "prop him up and put a pair of dark glasses on him."
In the wake of the biggest economic calamity in 80 years that reputation has taken a beating.... [T]heir pronouncements are viewed with more scepticism than before. The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was "spectacularly useless at best, and positively harmful at worst." Barry Eichengreen, a prominent American economic historian, says the crisis has "cast into doubt much of what we thought we knew about economics."...
[T]wo central parts of the discipline-macroeconomics and financial economics-are now, rightly, being severely re-examined.... There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it. The first charge is half right. Macroeconomists, especially within central banks, were too fixated on taming inflation and too cavalier about asset bubbles. Financial economists, meanwhile, formalised theories of the efficiency of markets, fuelling the notion that markets would regulate themselves and financial innovation was always beneficial. Wall Street's most esoteric instruments were built on these ideas.
But economists were hardly naive believers in market efficiency. Financial academics have spent much of the past 30 years poking holes in the "efficient market hypothesis". A recent ranking of academic economists was topped by Joseph Stiglitz and Andrei Shleifer, two prominent hole-pokers. A newly prominent field, behavioural economics, concentrates on the consequences of irrational actions.... But as insights from academia arrived in the rough and tumble of Wall Street, such delicacies were put aside. And absurd assumptions were added.... The charge that most economists failed to see the crisis coming also has merit. To be sure, some warned of trouble. The likes of Robert Shiller of Yale, Nouriel Roubini of New York University and the team at the Bank for International Settlements are now famous for their prescience. But most were blindsided. And even worrywarts who felt something was amiss had no idea of how bad the consequences would be....
Macroeconomists also had a blindspot.... Their framework reflected an uneasy truce between the intellectual heirs of Keynes, who accept that economies can fall short of their potential, and purists who hold that supply must always equal demand. The models that epitomise this synthesis--the sort used in many central banks--incorporate imperfections in labour markets ("sticky" wages, for instance, which allow unemployment to rise), but make no room for such blemishes in finance. By assuming that capital markets worked perfectly, macroeconomists were largely able to ignore the economy's financial plumbing. But models that ignored finance had little chance of spotting a calamity that stemmed from it.
What about trying to fix it? Here the financial crisis has blown apart the fragile consensus between purists and Keynesians that monetary policy was the best way to smooth the business cycle. In many countries short-term interest rates are near zero and in a banking crisis monetary policy works less well. With their compromise tool useless, both sides have retreated to their roots, ignoring the other camp's ideas. Keynesians, such as Mr Krugman, have become uncritical supporters of fiscal stimulus. Purists are vocal opponents. To outsiders, the cacophony underlines the profession's uselessness....
[T]here is a clear case for reinvention, especially in macroeconomics.... [A] broader change in mindset is still needed. Economists need to reach out from their specialised silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work. And everybody needs to work harder on understanding asset bubbles and what happens when they burst. For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world.
The other-worldly philosophers: [M]acroeconomists were not wholly complacent. Many of them thought the housing bubble would pop or the dollar would fall. But they did not expect the financial system to break. Even after the seizure in interbank markets in August 2007, macroeconomists misread the danger. Most were quite sanguine about the prospect of Lehman Brothers going bust in September 2008.
Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.... For Mr Krugman, we are living through a "Dark Age of macroeconomics", in which the wisdom of the ancients has been lost.
What was this wisdom, and how was it forgotten? The history of macroeconomics begins in intellectual struggle. Keynes wrote the "General Theory of Employment, Interest and Money."... [The] classical mode of thought held that full employment would prevail, because supply created its own demand... whatever people earn is either spent or saved; and whatever is saved is invested in capital projects. Nothing is hoarded, nothing lies idle. Keynes... [thought] investment was governed by the animal spirits of entrepreneurs, facing an imponderable future. The same uncertainty gave savers a reason to hoard their wealth in liquid assets, like money, rather than committing it to new capital projects. This liquidity-preference, as Keynes called it, governed the price of financial securities and hence the rate of interest. If animal spirits flagged or liquidity-preference surged, the pace of investment would falter, with no obvious market force to restore it. Demand would fall short of supply.... The Keynesian task of "demand management" outlived the Depression, becoming a routine duty of governments... aided by economic advisers.... [T]heir credibility did not survive the oil-price shocks of the 1970s. These condemned Western economies to "stagflation", a baffling combination of unemployment and inflation, which the Keynesian consensus grasped poorly and failed to prevent.
The Federal Reserve, led by Paul Volcker, eventually defeated American inflation in the early 1980s, albeit at a grievous cost to employment. But victory did not restore the intellectual peace. Macroeconomists split into two camps.... The purists... blamed stagflation on restless central bankers trying to do too much. They started from the classical assumption that markets cleared, leaving no unsold goods or unemployed workers. Efforts by policymakers to smooth the economy's natural ups and downs did more harm than good.... [P]ragmatists... [saw] the double-digit unemployment that accompanied Mr Volcker's assault on inflation was proof enough that markets could malfunction. Wages might fail to adjust, and prices might stick. This grit in the economic machine justified some meddling by policymakers. Mr Volcker's recession bottomed out in 1982. Nothing like it was seen again until last year. In the intervening quarter-century of tranquillity, macroeconomics also recovered its composure. The opposing schools of thought converged.... For about a decade before the crisis, macroeconomists once again appeared to know what they were doing....
[Willem] Buiter... believes the latest academic theories had a profound influence.... He now thinks this influence was baleful... a training in modern macroeconomics was a "severe handicap" at the onset of the financial crisis, when the central bank had to "switch gears" from preserving price stability to safeguarding financial stability. Modern macroeconomists worried about the prices of goods and services, but neglected the prices of assets. This was partly because they had too much faith in financial markets....
Before the crisis, many banks and shadow banks... believed they could always roll over their short-term debts or sell their mortgage-backed securities, if the need arose. The financial crisis made a mockery of both assumptions. Funds dried up, and markets thinned out. In his anatomy of the crisis Mr Brunnermeier shows how both of these constraints fed on each other, producing a "liquidity spiral". What followed was a furious dash for cash, as investment banks sold whatever they could, commercial banks hoarded reserves and firms drew on lines of credit. Keynes would have interpreted this as an extreme outbreak of liquidity-preference.... But contemporary economics had all but forgotten the term....
In the first months of the crisis, macroeconomists reposed great faith in the powers of the Fed and other central banks.... Frederic Mishkin... presented the results of simulations from the Fed's FRB/US model. Even if house prices fell by a fifth in the next two years, the slump would knock only 0.25% off GDP, according to his benchmark model... [because] the Fed would respond "aggressively", by which he meant a cut in the federal funds rate of just one percentage point. He concluded that the central bank had the tools to contain the damage at a "manageable level". Since his presentation, the Fed has cut its key rate by five percentage points to a mere 0-0.25%. Its conventional weapons have proved insufficient to the task. This has shaken economists' faith in monetary policy. Unfortunately, they are also horribly divided about what comes next.
Mr Krugman and others advocate a bold fiscal expansion... stimulating resources that might otherwise have lain idle.... Mr Barro thinks the estimates of Barack Obama's Council of Economic Advisors are absurdly large. Mr Lucas calls them "schlock economics", contrived to justify Mr Obama's projections for the budget deficit....
Economists were deprived of earthquakes for a quarter of a century. The Great Moderation, as this period was called, was not conducive to great macroeconomics. Thanks to the seismic events of the past two years, the prestige of macroeconomists is low, but the potential of their subject is much greater. The furious rows that divide them are a blow to their credibility, but may prove to be a spur to creativity.
Financial economics: Efficiency and beyond: IN 1978 Michael Jensen, an American economist, boldly declared that "there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis" (EMH). That was quite a claim. The theory's origins went back to the beginning of the century, but it had come to prominence only a decade or so before. Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.
From that idea powerful conclusions were drawn, not least on Wall Street. If the EMH held, then markets would price financial assets broadly correctly. Deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well-informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form-or, at any rate, could not last: some wise investor would spot them and pop them. And trying to beat the market was a fool's errand for almost everyone. If the information was out there, it was already in the price.
On such ideas, and on the complex mathematics that described them, was founded the Wall Street profession of financial engineering. The engineers designed derivatives and securitisations, from simple interest-rate options to ever more intricate credit-default swaps and collateralised debt obligations. All the while, confident in the theoretical underpinnings of their inventions, they reassured any doubters that all this activity was not just making bankers rich. It was making the financial system safer and the economy healthier.
That is why many people view the financial crisis that began in 2007 as a devastating blow to the credibility not only of banks but also of the entire academic discipline of financial economics. That verdict is too simple. Granted, financial economists helped to start the bankers' party, and some joined in with gusto. But even when the EMH still seemed fresh, economists were picking holes in it.... Academia thus moved on, even if Wall Street did not.... The EMH, to be sure, has loyal defenders. "There are models, and there are those who use the models," says Myron Scholes, who in 1997 won the Nobel prize in economics for his part in creating the most widely used model in the finance industry-the Black-Scholes formula for pricing options. Mr Scholes thinks much of the blame for the recent woe should be pinned not on economists' theories and models but on those on Wall Street and in the City who pushed them too far in practice.
Financial firms plugged in data that reflected a "view of the world that was far more benign than it was reasonable to take, emphasising recent inputs over more historic numbers," says Mr Scholes. "Apparently, a lot of the models used for structured products were pretty good, but the inputs were awful." Indeed, the vast majority of derivative contracts and securitisations have performed exactly as their models said they would. It was the exceptions that proved disastrous.... Even as financial engineers were designing all sorts of clever products on the assumption that markets were efficient, academic economists were focusing more on how markets fall short....
Behavioural economists were among the first to sound the alarm about trouble in the markets. Notably, Robert Shiller of Yale gave an early warning that America's housing market was dangerously overvalued. This was his second prescient call. In the 1990s his concerns about the bubbliness of the stockmarket had prompted Alan Greenspan, then chairman of the Federal Reserve, to wonder if the heady share prices of the day were the result of investors' "irrational exuberance". The title of Mr Shiller's latest book, "Animal Spirits" (written with George Akerlof, of the University of California, Berkeley), is taken from John Maynard Keynes's description of the quirky psychological forces shaping markets. It argues that macroeconomics, too, should draw lessons from psychology. "In some ways, we behavioural economists have won by default, because we have been less arrogant," says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, "look foolish". Mr Scholes, however, insists that the efficient-market paradigm is not dead: "To say something has failed you have to have something to replace it, and so far we don't have a new paradigm to replace efficient markets." The trouble with behavioural economics, he adds, is that "it really hasn't shown in aggregate how it affects prices."...
One task, also of interest to macroeconomists, is to work out what central bankers should do about bubbles-now that it is plain that they do occur and can cause great damage when they burst. Not even behaviouralists such as Mr Thaler would want to see, say, the Fed trying to set prices in financial markets. He does see an opportunity, however, for governments to "lean into the wind a little more" to reduce the volatility of bubbles and crashes. For instance, when guaranteeing home loans, Freddie Mac and Fannie Mae, America's giant mortgage companies, could be required to demand higher down-payments as a proportion of the purchase price, the higher house prices are relative to rents. Another priority is to get a better understanding of systemic risk, which Messrs Scholes and Thaler agree has been seriously underestimated. A lot of risk-managers in financial firms believed their risk was perfectly controlled, says Mr Scholes, "but they needed to know what everyone else was doing, to see the aggregate picture." It turned out that everyone was doing very similar things. So when their VAR models started telling them to sell, they all did-driving prices down further and triggering further model-driven selling...
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July 06, 2009 | PrudentBear
Lessons from the global financial crisis
The global financial crisis (GFC) is financial, economic, social and increasingly ideological. French President Nikolas Sarkozy has pronounced the death of laissez-faire capitalism: "c'est fini." Leaders have penned fevered attacks on "neo-liberalism." Even religious leaders have taken to the pulpit to denounce capitalism.
Undoubtedly market failures, management excesses and errors caused the GFC. But the key lessons of the crisis may be subtler than first evident.
Global growth has been driven by cheap and abundant debt, and improperly costed carbon emissions and other forms of pollution. The reality is that this period of growth may be coming to an end.
All brands of politics and economics have been informed by assumptions about the sustainability of high levels of economic growth and the belief that governments and central bankers can exert a substantial degree of control over the economy. Harry Johnson, the famed Chicago economist, writing about England in the 1970s with his wife Elizabeth in "The Shadow of Keynes" (1978), provides a vivid description of this pre-occupation: "faster economic growth is the panacea for all" economic and political problems and "faster growth can be easily achieved by a combination of inflationary demand-management policies and politically appealing fiscal gimmickry."
The current debate misses the point, that it may not be feasible to reattain the growth levels in the global economy of the last 20 or so years.
Goldilocks economy
P.J. O'Rourke, writing in "Eat The Rich" (1998), observed that: "Economics is an entire scientific discipline of not knowing what you're talking about." The only quibble may be with the "scientific" part.
Recent global prosperity was founded on a series of elegant Ponzi schemes. Consumption rather than investment drove growth, particularly in the developed world. A deregulated financial system supplied the borrowing that financed the consumption. In the new economy, to borrow from Earl Wilson, there were three kinds of people – "the haves," "the have-nots," and "the have-not-paid-for-what-they-haves."
Growth in global trade was also debt-fueled. Since the 1990s, there has been a substantial buildup of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade financing arrangement. To maintain export competitiveness, many global currencies, including the Chinese Renminbi, were pegged to the dollar at an artificially low rate. This helped create the U.S. trade deficit driven by excess U.S. demand for imports based on an overvalued dollar. Foreign central bankers invested the dollars received from exports in U.S. debt to minimize the appreciation of their domestic currency that would make their exports less competitive. The recycled dollars flowed back to the U.S. to finance the spending on imports, helping keep U.S. interest rates low, which facilitated more borrowing to finance further consumption and imports.
Foreign central banks were lending their reserves to finance exports from the country. In essence, the exporting nations were not paid at least until the loan to the buyer was paid off.
Moderate debt levels are sustainable, provided the value of the asset supporting the borrowing is stable and significantly higher than the amount of the loan. The borrower or the collateral for the loan must generate sufficient income to service and repay the borrowing. In the frenzied market environment of low interest rates and ever-rising asset prices, the level of collateral cover and ability to service the loans deteriorated sharply. In 2005, rising interest rates and a cooling in the U.S. housing market set the stage for the GFC.
Taking the cure
There is currently confusion between the "disease" – the high levels of debt – and the "cure" – the reduction of the level of debt now underway (known as "de-leveraging").
Debt within the financial system is falling as some borrowers default, triggering problems for financial institutions, destroying both existing debt and also limiting the capacity for further credit creation by financial institutions. Total losses from the GFC are estimated by the International Monetary Fund at around $4.1 trillion of which $2.7 trillion will be borne by financial institutions.
Government ownership or de facto nationalization has become the primary option to recapitalize the banking system in many countries. Even after recapitalization, there is likely to be a capital shortfall in the global banking system (of around $ 1+ trillion), forcing a contraction in global credit of around 20% to 30% from existing levels, which affects the real economy.
The increased cost and reduced availability of debt to borrowers forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.
Recent excitement about the "stress tests" of U.S. banks misses an essential point. At best if you accept the premises of the test, the risk of failure of these institutions is much reduced. But the banks' ability to support lending levels that prevailed in say 2007 has not been restored. In short, the "credit crunch" or shortage of borrowing will continue for a prolonged period.
This combination of factors may lock the global economy into a cycle of low growth, bringing an end to the age of Ponzi prosperity. Sigmund Freud once remarked that: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces." The GFC was the "reality" on which the artificial pleasures of the Great Moderation and Goldilocks economy were smashed.
Socialist WIT
National and international "committees to save the world" have rushed to announce and occasionally even implement a bewildering and constantly changing array of measures – dubbed WIT ("What it takes") by British Prime Minister Gordon Brown – to counteract the financial and economic effects of the GFC. Governments and central banks have sought to remove toxic securities from bank balance sheets and supply share capital to cover losses from bad debts. In some countries, such as Australia, the government has guaranteed the bank's own borrowings to allow them to continue to raise funding. Bank of England Governor Mervyn King summed up the nature of the UK's support for the banking system with a Freudian slip: "The package of measures announced yesterday by the Chancellor are not designed to protect the banks as such. They are designed to protect the economy from the banks."
Governments have gone into massive deficit providing fiscal stimulus and support for the housing market (in the U.S.). Central banks have cut interest rates to levels not seen for decades. It seems "we are all Keynesians again."
Fiscal pretensions
The success of these actions is not assured. John Kenneth Galbraith once observed: "In economics, hope and faith coexist with great scientific pretension."
Credit conditions have not eased significantly. Money supplied to banks is not flowing into the real economy. Governments and central bankers, frustrated at the failure of policy actions to help the resumption of normal financial activity, have started to lend directly to business or drifted towards "directed lending" policies in an effort to get the economy going.
The policies miss the point that debtors still have too much debt that they are not able to service. Until the debt is written down and restructured, credit growth may not resume.
In the Trouble Asset Relief Program (TARP) Oversight Panel Report of April 8, Professor Elizabeth Warren observed:
"Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury's … approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury's approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth."
Well-intentioned government spending programs, such as infrastructure spending, will take time to have any meaningful effect. The return on poorly costed and targeted infrastructure investment is also not necessarily high. If this were otherwise, then Japan, which has concreted the country over several times, would have much higher rates of growth than it does.
Governments, some with significant budget deficits and also substantial levels of outstanding public debt, must also borrow to finance their spending. In 2009, governments around the world will have to issue $3 trillion to $4 trillion in debt.
The U.S. alone will need to issue around $2 trillion in bonds. China, Japan, Europe and other emerging countries have been major buyer of this U.S. debt. Wen Jiabao, China's prime minister, provided a reminder of this in February 2009: "Whether China will continue to buy, and how much to buy, should be in accordance with China's needs, and depend on the safety and protection of value of foreign exchange." Yu Yongding, a former adviser to the Chinese central bank, recently sought guarantees that the value of China's large holdings of U.S. government debt won't be eroded by "reckless policies." The U.S., he stated, "should make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way." In 2009, some German bund (government bond) auctions failed with insufficient bids to cover the amount of issues. One U.K. gilt auction and more recently, a U.S. 30-year bond auction encountered significant difficulty and lack of investor support.
At best, the government debt may crowd out other borrowers exacerbating existing financing problems. At worst, there is a risk of a collapse of the growing "bubble" in government debt markets as investors refuse to purchase debt at current rates triggering additional losses.
Since January 2009, long-term interest rates throughout the world have moved up sharply as markets start to absorb the import of government initiatives. As James Carville, Bill Clinton's campaign manager, once noted: "I want to come back as the bond market. You can intimidate everybody."
Hair-of-the-dog cures
The current strategy is a variant of the "hair of the dog that bit you" cure. Current problems can be traced to high levels of debt accumulated by banks, consumers and companies that is now being replaced by government debt. Debt-fueled consumption of consumers and companies is being replaced by debt-funded government expenditure.
The ineffectiveness of repeated fiscal shock therapy to rouse the Japanese economy from it somnolent state provides a worrying precedent for current policy.
Government actions seem primarily to be based on the recognition that Ponzi or pyramid games are only bad if they end. All efforts are now seemingly directed at keeping the game going for as long as possible!
Governments and central banks can smooth the transition but they cannot prevent the necessary adjustments taking place. In 1976, British Prime Minister James Callaghan delivered the following grim assessment of Britain's economic situation that is still relevant today: "We have been living on borrowed time. We used to think you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candor that that option no longer exists." That warning is as relevant today as it was some 30 years ago.
Built to fail
The key lesson of the GFC may be that the current economic order is "built to fail." The ability to sustain high rates of economic growth, required by governments and central bankers, is questionable.
Aggressive use of debt globally resulted in a sharp increase in sustainable growth rates. Four dollars to $5 of debt was required to create $1 of growth. Approximately half the recorded growth in the U.S. over recent years was driven by borrowing against the rising value of houses (mortgage equity withdrawals). A similar pattern is evident in Great Britain and Australia. As the level of debt in the global economy decreases, attainable growth levels also decline.
Debt allowed consumption to be accelerated. Spending that would have taken place normally over a period of many years was squeezed into a relatively short period because of the availability of cheap borrowings. Misreading demand and assuming that the exaggerated growth would continue indefinitely, businesses over-invested, creating significant over-capacity in many sectors. For example, the global car industry has production capacity of over 90 million units compared to peak demand of around 60 million that has now fallen to 40 million.
The nouveau Jeffersonian trinity – "whoever dies with the most toys wins;" "shop till you drop;" and "if it feels good, do it" – has proved to be unsustainable.
Global trade, on which Australia is heavily dependent, was also "built to fail." A model where sellers of goods and services indirectly financed the purchase is not sustainable.
The GFC has already reduced global trade and cross-border capital flows. Global trade is forecast to fall for the first time in 2009. The Institute for International Finance forecasts net private sector capital flows to emerging markets in 2009 will be less than $165 billion – 36% of the $466 billion inflow in 2008 and only one-fifth the record amount in 2007. Many emerging market nations, such as India, face severe funding difficulties in the near future.
In an essay titled "The Great Slump of 1930," published in December of that year, Keynes observed: "We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand."
Policy helplessness
Governments have limited available tools to address the deep-rooted problems in the current economic models. Given that interest rates are now at or approaching zero in many developed countries, there is little or no scope for further monetary action although central banks have creatively embarked on a program of "quantitative easing" – code for printing money (also know as the Weimar or Zimbabwe solution).
Government spending, if it can be financed, may not be able to adequately compensate for the contraction of consumption and lack of investment made worse by over capacity in many industries. Government spending has little multiplier effect or velocity. The badly damaged financial system means that the circulation of money in the economy is at a standstill. Government spending provides a short-term demand boost. Capital injections may partially rehabilitate banks. But it is far from clear what will happen when all these measures are reversed.
David Rosenberg, an economist from Merrill Lynch, described the process of adjustment that world is embarking on in the following terms: "This is an epic event; we're talking about the end of a 20-year secular credit expansion that went absolutely parabolic from 2001-2007. Before the U.S. economy can truly begin to expand again, the savings rate must rise to pre-bubble levels of 8%, the U.S. housing stock must fall to below eight-months' supply, and the household interest coverage ratio must fall from 14% to 10.5%. It's important to note what sort of surgery that is going to require. We will probably have to eliminate $2 trillion of household debt to get there, this will happen either through debt being written off, as major financial institutions continue to do, or for consumers themselves to shrink their own balance sheets."
The economic model itself is now seen as the problem. Zhou Xiaochuan, governor of the Chinese central bank, commented: "Over-consumption and a high reliance on credit is the cause of the U.S. financial crisis. As the largest and most important economy in the world, the U.S. should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits."
More ominously, Chinese President Hu Jintao recently noted: "From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies."
The GFC also marks the end of unquestioned advocacy of free markets. Wang Qishan, China's vice premier, tartly observed: "The teachers now have some problems.''
Limits to growth
The GFC coincides with another crisis: the GEC or Global Environmental Crisis. "Toxic debt" and "toxic emissions" increasingly clamor simultaneously for politician's attention.
Irreversible climate change, scarcity of vital resources (food and water) and falling biodiversity are not unconnected with the existing economic system. Economists and politicians implicitly assume that high levels of growth drive increased living standards, rescuing people from poverty and social development. No limit to economic growth is recognized.
The GFC brings into question much of established orthodoxy of economic models and approaches. It calls into question social and political models based on high levels of economic growth and financial rather than real economy driven growth. It also questions the ability of mandarins to control the economic engines. The world needs to adjust to a new economic order and a world of reduced expectations.
As Keynes wrote in 1933: "We have reached a critical point. We can ... see clearly the gulf to which our present path is leading….[If governments did not take action], we must expect the progressive breakdown of the existing structure of contract and instruments of indebtedness, accompanied by the utter discredit of orthodox leadership in finance and government, with what ultimate outcome we cannot predict."
Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall).
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The Economist
ROBERT LUCAS, one of the greatest macroeconomists of his generation, and his followers are "making ancient and basic analytical errors all over the place". Harvard's Robert Barro, another towering figure in the discipline, is "making truly boneheaded arguments". The past 30 years of macroeconomics training at American and British universities were a "costly waste of time".
To the uninitiated, economics has always been a dismal science. But all these attacks come from within the guild: from Brad DeLong of the University of California, Berkeley; Paul Krugman of Princeton and the New York Times; and Willem Buiter of the London School of Economics (LSE), respectively. The macroeconomic crisis of the past two years is also provoking a crisis of confidence in macroeconomics. In the last of his Lionel Robbins lectures at the LSE on June 10th, Mr Krugman feared that most macroeconomics of the past 30 years was "spectacularly useless at best, and positively harmful at worst".
These internal critics argue that economists missed the origins of the crisis; failed to appreciate its worst symptoms; and cannot now agree about the cure. In other words, economists misread the economy on the way up, misread it on the way down and now mistake the right way out.
On the way up, macroeconomists were not wholly complacent. Many of them thought the housing bubble would pop or the dollar would fall. But they did not expect the financial system to break. Even after the seizure in interbank markets in August 2007, macroeconomists misread the danger. Most were quite sanguine about the prospect of Lehman Brothers going bust in September 2008.
Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.
Among the passionate are Mr DeLong and Mr Krugman. They turn for inspiration to Depression-era texts, especially the writings of John Maynard Keynes, and forgotten mavericks, such as Hyman Minsky. In the humanities this would count as routine scholarship. But to many high-tech economists it is a bit undignified. Real scientists, after all, do not leaf through Newton's "Principia Mathematica" to solve contemporary problems in physics.
They accuse economists like Mr DeLong and Mr Krugman of falling back on antiquated Keynesian doctrines-as if nothing had been learned in the past 70 years. Messrs DeLong and Krugman, in turn, accuse economists like Mr Lucas of not falling back on Keynesian economics-as if everything had been forgotten over the past 70 years. For Mr Krugman, we are living through a "Dark Age of macroeconomics", in which the wisdom of the ancients has been lost.
What was this wisdom, and how was it forgotten? The history of macroeconomics begins in intellectual struggle. Keynes wrote the "General Theory of Employment, Interest and Money", which was published in 1936, in an "unnecessarily controversial tone", according to some readers. But it was a controversy the author had waged in his own mind. He saw the book as a "struggle of escape from habitual modes of thought" he had inherited from his classical predecessors.
That classical mode of thought held that full employment would prevail, because supply created its own demand. In a classical economy, whatever people earn is either spent or saved; and whatever is saved is invested in capital projects. Nothing is hoarded, nothing lies idle.
Keynes appreciated the classical model's elegance and consistency, virtues economists still crave. But that did not stop him demolishing it. In his scheme, investment was governed by the animal spirits of entrepreneurs, facing an imponderable future. The same uncertainty gave savers a reason to hoard their wealth in liquid assets, like money, rather than committing it to new capital projects. This liquidity-preference, as Keynes called it, governed the price of financial securities and hence the rate of interest. If animal spirits flagged or liquidity-preference surged, the pace of investment would falter, with no obvious market force to restore it. Demand would fall short of supply, leaving willing workers on the shelf. It fell to governments to revive demand, by cutting interest rates if possible or by public works if necessary.
The Keynesian task of "demand management" outlived the Depression, becoming a routine duty of governments. They were aided by economic advisers, who built working models of the economy, quantifying the key relationships. For almost three decades after the second world war these advisers seemed to know what they were doing, guided by an apparent trade-off between inflation and unemployment. But their credibility did not survive the oil-price shocks of the 1970s. These condemned Western economies to "stagflation", a baffling combination of unemployment and inflation, which the Keynesian consensus grasped poorly and failed to prevent.
The Federal Reserve, led by Paul Volcker, eventually defeated American inflation in the early 1980s, albeit at a grievous cost to employment. But victory did not restore the intellectual peace. Macroeconomists split into two camps, drawing opposite lessons from the episode.
The purists, known as "freshwater" economists because of the lakeside universities where they happened to congregate, blamed stagflation on restless central bankers trying to do too much. They started from the classical assumption that markets cleared, leaving no unsold goods or unemployed workers. Efforts by policymakers to smooth the economy's natural ups and downs did more harm than good.
Illustration by Brett RyderAmerica's coastal universities housed most of the other lot, "saltwater" pragmatists. To them, the double-digit unemployment that accompanied Mr Volcker's assault on inflation was proof enough that markets could malfunction. Wages might fail to adjust, and prices might stick. This grit in the economic machine justified some meddling by policymakers.
Mr Volcker's recession bottomed out in 1982. Nothing like it was seen again until last year. In the intervening quarter-century of tranquillity, macroeconomics also recovered its composure. The opposing schools of thought converged. The freshwater economists accepted a saltier view of policymaking. Their opponents adopted a more freshwater style of modelmaking. You might call the new synthesis brackish macroeconomics.
Pinches of salt
Brackish macroeconomics flowed from universities into central banks. It underlay the doctrine of inflation-targeting embraced in New Zealand, Canada, Britain, Sweden and several emerging markets, such as Turkey. Ben Bernanke, chairman of the Fed since 2006, is a renowned contributor to brackish economics.
For about a decade before the crisis, macroeconomists once again appeared to know what they were doing. Their thinking was embodied in a new genre of working models of the economy, called "dynamic stochastic general equilibrium" (DSGE) models. These helped guide deliberations at several central banks.
Mr Buiter, who helped set interest rates at the Bank of England from 1997 to 2000, believes the latest academic theories had a profound influence there. He now thinks this influence was baleful. On his blog, Mr Buiter argues that a training in modern macroeconomics was a "severe handicap" at the onset of the financial crisis, when the central bank had to "switch gears" from preserving price stability to safeguarding financial stability.
Modern macroeconomists worried about the prices of goods and services, but neglected the prices of assets. This was partly because they had too much faith in financial markets. If asset prices reflect economic fundamentals, why not just model the fundamentals, ignoring the shadow they cast on Wall Street?
It was also because they had too little interest in the inner workings of the financial system. "Philosophically speaking," writes Perry Mehrling of Barnard College, Columbia University, economists are "materialists" for whom "bags of wheat are more important than stacks of bonds." Finance is a veil, obscuring what really matters. As a poet once said, "promises of payment/Are neither food nor raiment".
In many macroeconomic models, therefore, insolvencies cannot occur. Financial intermediaries, like banks, often don't exist. And whether firms finance themselves with equity or debt is a matter of indifference. The Bank of England's DSGE model, for example, does not even try to incorporate financial middlemen, such as banks. "The model is not, therefore, directly useful for issues where financial intermediation is of first-order importance," its designers admit. The present crisis is, unfortunately, one of those issues.
The bank's modellers go on to say that they prefer to study finance with specialised models designed for that purpose. One of the most prominent was, in fact, pioneered by Mr Bernanke, with Mark Gertler of New York University. Unfortunately, models that include such financial-market complications "can be very difficult to handle," according to Markus Brunnermeier of Princeton, who has handled more of these difficulties than most. Convenience, not conviction, often dictates the choices economists make.
Convenience, however, is addictive. Economists can become seduced by their models, fooling themselves that what the model leaves out does not matter. It is, for example, often convenient to assume that markets are "complete"-that a price exists today, for every good, at every date, in every contingency. In this world, you can always borrow as much as you want at the going rate, and you can always sell as much as you want at the going rate.
Before the crisis, many banks and shadow banks made similar assumptions. They believed they could always roll over their short-term debts or sell their mortgage-backed securities, if the need arose. The financial crisis made a mockery of both assumptions. Funds dried up, and markets thinned out. In his anatomy of the crisis Mr Brunnermeier shows how both of these constraints fed on each other, producing a "liquidity spiral".
What followed was a furious dash for cash, as investment banks sold whatever they could, commercial banks hoarded reserves and firms drew on lines of credit. Keynes would have interpreted this as an extreme outbreak of liquidity-preference, says Paul Davidson, whose biography of the master has just been republished with a new afterword. But contemporary economics had all but forgotten the term.
Fiscal fisticuffs
The mainstream macroeconomics embodied in DSGE models was a poor guide to the origins of the financial crisis, and left its followers unprepared for the symptoms. Does it offer any insight into the best means of recovery?
In the first months of the crisis, macroeconomists reposed great faith in the powers of the Fed and other central banks. In the summer of 2007, a few weeks after the August liquidity crisis began, Frederic Mishkin, a distinguished academic economist and then a governor of the Fed, gave a reassuring talk at the Federal Reserve Bank of Kansas City's annual symposium in Jackson Hole, Wyoming. He presented the results of simulations from the Fed's FRB/US model. Even if house prices fell by a fifth in the next two years, the slump would knock only 0.25% off GDP, according to his benchmark model, and add only a tenth of a percentage point to the unemployment rate. The reason was that the Fed would respond "aggressively", by which he meant a cut in the federal funds rate of just one percentage point. He concluded that the central bank had the tools to contain the damage at a "manageable level".
Since his presentation, the Fed has cut its key rate by five percentage points to a mere 0-0.25%. Its conventional weapons have proved insufficient to the task. This has shaken economists' faith in monetary policy. Unfortunately, they are also horribly divided about what comes next.
Mr Krugman and others advocate a bold fiscal expansion, borrowing their logic from Keynes and his contemporary, Richard Kahn. Kahn pointed out that a dollar spent on public works might generate more than a dollar of output if the spending circulated repeatedly through the economy, stimulating resources that might otherwise have lain idle.
Today's economists disagree over the size of this multiplier. Mr Barro thinks the estimates of Barack Obama's Council of Economic Advisors are absurdly large. Mr Lucas calls them "schlock economics", contrived to justify Mr Obama's projections for the budget deficit. But economists are not exactly drowning in research on this question. Mr Krugman calculates that of the 7,000 or so papers published by the National Bureau of Economic Research between 1985 and 2000, only five mentioned fiscal policy in their title or abstract.
Do these public spats damage macroeconomics? Greg Mankiw, of Harvard, recalls the angry exchanges in the 1980s between Robert Solow and Mr Lucas-both eminent economists who could not take each other seriously. This vitriol, he writes, attracted attention, much like a bar-room fist-fight. But he thinks it also dismayed younger scholars, who gave these macroeconomic disputes a wide berth.
By this account, the period of intellectual peace that followed in the 1990s should have been a golden age for macroeconomics. But the brackish consensus also seems to leave students cold. According to David Colander, who has twice surveyed the opinions of economists in the best American PhD programmes, macroeconomics is often the least popular class. "What did you learn in macro?" Mr Colander asked a group of Chicago students. "Did you do the dynamic stochastic general equilibrium model?" "We learned a lot of junk like that," one replied.
It takes a model to beat a model
The benchmark macroeconomic model, though not junk, suffers from some obvious flaws, such as the assumption of complete markets or frictionless finance. Indeed, because these flaws are obvious, economists are well aware of them. Critics like Mr Buiter are not telling them anything new. Economists can and do depart from the benchmark. That, indeed, is how they get published. Thus a growing number of cutting-edge models incorporate one or two financial frictions. And economists like Mr Brunnermeier are trying to fit their small, "blackboard" models of the crisis into a larger macroeconomic frame.
But the benchmark still matters. It formalises economists' gut instincts about where the best analytical cuts lie. It is the starting point to which the theorist returns after every ingenious excursion. Few economists really believe all its assumptions, but few would rather start anywhere else.
Unfortunately, it is these primitive models, rather than their sophisticated descendants, that often exert the most influence over the world of policy and practice. This is partly because these first principles endure long enough to find their way from academia into policymaking circles. As Keynes pointed out, the economists who most influence practical men of action are the defunct ones whose scribblings have had time to percolate from the seminar room to wider conversations.
These basic models are also influential because of their simplicity. Faced with the "blooming, buzzing confusion" of the real world, policymakers often fall back on the highest-order principles and the broadest presumptions. More specific, nuanced theories are often less versatile. They shed light on whatever they were designed to explain, but little beyond.
Would economists be better off starting from somewhere else? Some think so. They draw inspiration from neglected prophets, like Minsky, who recognised that the "real" economy was inseparable from the financial. Such prophets were neglected not for what they said, but for the way they said it. Today's economists tend to be open-minded about content, but doctrinaire about form. They are more wedded to their techniques than to their theories. They will believe something when they can model it.
Mr Colander, therefore, thinks economics requires a revolution in technique. Instead of solving models "by hand", using economists' powers of deduction, he proposes simulating economies on the computer. In this line of research, the economist specifies simple rules of thumb by which agents interact with each other, and then lets the computer go to work, grinding out repeated simulations to reveal what kind of unforeseen patterns might emerge. If he is right, then macroeconomists, like zombie banks, must write off many of their past intellectual investments before they can make progress again.
Mr Krugman, by contrast, thinks reform is more likely to come from within. Keynes, he observes, was a "consummate insider", who understood the theory he was demolishing precisely because he was once convinced by it. In the meantime, he says, macroeconomists should turn to patient empirical spadework, documenting crises past and present, in the hope that a fresh theory might later make sense of it all.
Macroeconomics began with Keynes, but the word did not appear in the journals until 1945, in an article by Jacob Marschak. He reviewed the profession's growing understanding of the business cycle, making an analogy with other sciences. Seismology, for example, makes progress through better instruments, improved theories or more frequent earthquakes. In the case of economics, Marschak concluded, "the earthquakes did most of the job."
Economists were deprived of earthquakes for a quarter of a century. The Great Moderation, as this period was called, was not conducive to great macroeconomics. Thanks to the seismic events of the past two years, the prestige of macroeconomists is low, but the potential of their subject is much greater. The furious rows that divide them are a blow to their credibility, but may prove to be a spur to creativity.
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July 15, 2009 | Crooked Timber
on Discussion on the first post in this series went really well, so I'm carrying on. Here's the proposed introduction.1 Again, comments, both favorable and critical are very welcome and the best will be rewarded with a copy of Dead Ideas from New Economists (I'm back with the original title at present).
Updated As Chris Bertram points out, my second (or higher-order) hand attribution of the "Thesis, antithesis, synthesis" triad to Hegel was incorrect. As with Mundell's impossible trinity, these terms weren't used by Hegel (apparently they were borrowed from Fichte by Hegel's popularisers). I've changed the text a bit and added a bit more about Marx and idealism/materialism, still trying to keep it at a level that will be good for a broad audience and avoid the risk of bringing in yet more errors. There's lots more in the thread I will take into account in later parts of the book, coming soon. Thanks everyone, and keep the comments coming,
Introduction
The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. JM KeynesMost economics textbooks present the subject as a monumental scientific edifice, constructed by adding building bricks of empirical research to a solid and unassailable logical foundation. In reality no subject works this way, not even natural sciences like physics and chemistry. As philosopher Thomas Kuhn showed in his The Structure of Scientific Revolutions, periods of 'normal science', where a discipline is characterised by agreement on the methods of inquiry and the questions that need to be resolved, are interrupted by occasional 'revolutions' where one paradigm, such as that of Newtonian physics is displaced by a new and superior alternative, such as Einstein's relativity theory.
In the terminology commonly associated with the great German philosopher Georg Hegel, economic thought is a dialectical process in which an idea (the 'thesis') meets its contradiction (the 'antithesis') producing a synthesis which transcends its origins. This synthesis in turn encounters new contradictions and the process continues. There are plenty of examples of mechanical and simplistic application of the dialectical framework, but used carefully it can provide some powerful insights.
In Hegel, as in Keynes' statement quoted above, it is ideas that drive economic developments. Karl Marx famously 'turned Hegel on his head' arguing that the economic interests of contending classes drive ideas and not the other way around.
The reality of the interaction between ideas, economic systems and economic power is far too complex to be reduced to a simple aphorism. At all times and places, ideas that start from the assumption that existing institutions are natural and providential and proceed to derive conclusions that are favorable to the interests of the powerful will receive a ready hearing, and such ideas are likely to be dismissed as absurd when the wheel of power turns. But economic realities are stubborn. Ideas that are inconsistent with reality will sooner or later be falsified, and economic systems based on those ideas will run into trouble.
It might be thought, more than 200 years after Adam Smith's Wealth of Nations set out the classical framework that still guides much economic thought, that economics might have progressed beyond the stage conflict over basic ideas. But economic ideas do not develop in a historical vacuum. Big changes in economic thinking depend on major events such as economic crises, and such events occur only rarely.
The Great Depression of the 1930s was such a crises and it produced a revolution in economic thinking still associated with the name of its originator, John Maynard Keynes. Responding to what he perceived as the absurdity of a classical economic theory proclaiming that a market economy would inevitably return to full employment 'in the long run', Keynes observed tartly that 'in the long run we are all dead'. In his General Theory of Employment, Interest and Money, Keynes developed a model of the economy in which high levels of unemployment could represent a persistent equilibrium. The classical full employment model was reduced to a special case of Keynes 'General Theory'.
In the hands of Keynes' successors, such as John Hicks, the Keynesian model of the aggregate economy became the new subject of 'macroeconomics', contrasted with the classical model of individual markets, now christened 'microeconomics'. Hicks produced a graphical synthesis of Keynesian and classical macroeconomic ideas, taught to generations of students as the IS-LM model after the two curves on which it relied. In the process, Hicks relied heavily on some of Keynes' ideas, but ignored or discarded others, much to the dismay of more purist Keynesians such as Joan Robinson.
Whether or not it was entirely true to Keynes, the Hicks synthesis produced a theoretical framework to justify policies Keynes had long advocated, of using public works programs and other fiscal policy (that is, changes in tax rates and public expenditure) measures to stimulate demand for goods and services during periods of recession. Conversely, as Keynes argued in How to Pay for the War, the government should use budget surpluses in periods of strong economic growth to restrain demand and reduce the risk of inflation.
The combination of Keynesian macroeconomics and neoclassical microeconomics provided both an ideological justification for the 'mixed economy' that emerged after World War II and a set of practical policy tools for its economic managers. The mixed economy was, arguably, the first and most successful example of a 'Third Way' between the traditional antagonists of socialism and unrestrained capitalism. The increased macroeconomic role for government went hand in hand with the postwar expansion of the welfare state, already anticipated by such developments as the New Deal in the United States, and the anti-depression policies of social-democratic governments in such far-flung countries as Sweden and New Zealand.
The contrast between the privations of the Depression and war years and the prosperity of the 1950s and 1960s was striking, and transformed the political landscape in the developed world. The laissez-faire doctrines of economic liberalism were discredited, seemingly forever. While conservative parties continued to employ the rhetoric of the free market, the social-democratic reforms adopted in response to the Depression formed the basis of political consensus.
For the next thirty years, the combination of Keynesian macroeconomics and the liberal and social democratic versions of the welfare state were associated, at least in the developed world with strong economic growth, full employment, enhanced equality and improvements in public services of all kinds. It was these developments, and not the posturing of the Reagan era, that guaranteed the defeat of Communism.
During these decades, the victory of the Keynesian revolution was universally recognised and generally perceived as final, despite the grumbling of a relative handful of neoclassical critics, centred on the University of Chicago, and, on the left, an even smaller handful of post-Keynesians and Marxists who derided the new synthesis and its tools as 'hydraulic Keynesianism' and 'a permanent war economy'.
But by the late 1960s, a counter-revolution was brewing. Inflation rates were rising, and the most compelling analysis of the problem was provided by Chicago economists such as Milton Friedman, who argued that expansion of the money supply would inevitably cause inflation, whatever fiscal policy responses Keynesians might propose.
The economic chaos of the early 1970s, including the breakdown of the 'Bretton Woods' postwar system of fixed exchange rates, the OPEC oil shock was seen as vindicating Friedman. The biggest blow to Keynesianism was 'stagflation', the simultaneous occurrence of high unemployment and high inflation. In the standard Keynesian model of the day, which postulated a trade-off between unemployment and inflation (the famous 'Phillips curve'), this could not occur. Friedman's model, which took into account expectations of inflation that were incorporated into wage bargains, appeared to explain stagflation.
In the space of a few years, Friedman's 'monetarist' macroeconomic policies had largely displaced Keynesian demand management. But the counter-revolution did not stop there. In macroeconomic theory, Friedman's relatively modest (and empirically well-founded) changes to the Keynesian IS-LM model were succeeded by a full-scale return to the orthodoxy of the 19th century, under the banners of 'rational expectations' and 'new classical' macroeconomics.
Friedman's macroeconomic success prompted widespread acceptance of the free-market views on microeconomic issues he had long advocated both in academic research and in popular works such as Free to Choose and Capitalism and Freedom. Other advocates of the free market such as FA von Hayek enjoyed a similar vogue. The new version of free market ideology that emerged from the 1970s has been given various (mostly pejorative) names such as neoliberalism, Thatcherism and economic rationalism. I prefer the more neutral term 'economic liberalism'.
Speculative activity in financial markets had been seen by Keynesians as a crucial source of economic instability. During the Bretton Woods stringent controls were imposed on national financial markets and international capital flows. During and after the monetarist counter-revolution, these controls broke down, ushering in an era of financial deregulation. Over the ensuing decades, the financial sector, a minor and tightly controlled industry during the postwar years, experienced an explosion in the volume and complexity of trade, the profitability of the industry and the lavish rewards to industry participants.
This development called for, and received theoretical support from the economics profession in the form of the efficient markets hypothesis. Building on the relatively innocuous observation that the efforts of stockmarket 'chartists' to predict the future movements of stock prices from their past behavior were futile, the efficient markets hypothesis was developed to the point where it was seriously suggested, in the wake of the September 2001 attacks, that the best way to predict terrorist attacks would be to open a futures market.
The general acceptance of the anti-Keynesian counter-revolution was predicated first on the necessity for a way out of the economic chaos of the 1970s and early 1980s and then on the widespread prosperity it delivered from the 1990s onwards. Although problems became steadily more evident, they were ignored as long as profits kept rising and economic growth kept on keeping on.
The economic crisis that began in the US housing market in 2007 and had engulfed global financial markets by late 2008 showed clearly enough that there was something wrong with the dominant economic paradigm. While old-fashioned Keynesians on the left, and advocates of the Austrian School on the right, had pointed to growing economic imbalances as a source of impending disaster, economic liberals continued until well into 2008 to argue that any problems were minor and easily contained.
While it may be satisfying to observe that so many experts got the crisis wrong, it is not really useful. The big question is "What economic doctrines have been refuted by the crisis and what new doctrines (or improved versions of older doctrines) should replace them?". This book aims to answer the first of these questions, and to provide at least some suggestions on the second.
1 I've been out of order so far, but, after correcting with this post, I plan to offer excepts in the order I want them to appear.
{ 86 comments… read them below or add one }
- 1 dpinkert 07.15.09 at 1:18 pm
- I agree this is very interesting. But was "monetarism" (insofar as it is a doctrine about monetary policy) really so dominant for such a long period of time? I thought it was largely abandoned during Volcker's stewardship at the Fed.
- 3 F. Blair 07.15.09 at 1:34 pm
- "Building on the relatively innocuous observation that the efforts of stockmarket 'chartists' to predict the future movements of stock prices from their past behavior were futile"
Is this really true? I though that the EMH -as opposed to some comment about the randomness of prices-really began from a much more germane observation, which is that only a very small percentage of money managers outperform the market over time. If you're trying to figure out whether the market is the best available guide to prices (as opposed to a perfect guide), figuring out whether there are better guides-that is, individuals who can do a better job of allocating capital-seems like the relevant question.
- 6 Bunbury 07.15.09 at 2:48 pm
- Hidari,
It is actually quite difficult to state the EMH precisely but this site rounds up a few attempts and so gives a flavour of what's involved. They let some words , "economic profit" for example, do a lot of work.
A Chartist is someone who attempts to make market or investment decisions by looking at charts of economic indicators-in other words and after a jargon transplant, an Econometrician. The reasoning behind the second sentence is that if Chartists were able to make predictions then there would be prices that do not reflect information available just by looking at the history of the price. Thus an efficient market would have to be unpredictable. On the other hand if it were unpredictable it would be efficient in the sense that you couldn't predict it. Here predict is means predict under or over performance.
There are several strengths of definition of the EMH and presenting it as above neatly focusses on the weak form without getting bogged down in quibbles. It does miss out on a more natural motivation for the EMH: there are a lot of smart and well motivated people looking for ways to make money out of the market and they have very similar information so why should you know any better?
- 7 Chris 07.15.09 at 2:55 pm
- The general acceptance of the anti-Keynesian counter-revolution was predicated first on the necessity for a way out of the economic chaos of the 1970s and early 1980s and then on the widespread prosperity it delivered from the 1990s onwards.
I think you may want a different word here instead of "widespread". In the US at least, IIRC substantially all the economic growth of that period was captured by the top quintile, and real wages for the majority stagnated, with rising consumption allowed only by looser credit and greater consumer indebtedness, eventually culminating in the current crisis. Since the working and middle classes ended up worse off than in the postwar period (except for the fruits of technological advancement), "widespread prosperity" seems seriously misleading.
If you mean that the prosperity was geographically widespread (rather than demographically, which unless you have different statistics than I've seen, it wasn't, although to be fair I don't know if the US was typical during this time period), then maybe "worldwide" would convey that more clearly.
P.S. To me the overall sense of the passage is pointing in the direction of a synthesis of the most-confirmed-by-experience parts of Keynesianism and Friedmanism (given the invocation of Hegelian dialectic as the only way economics progresses). If that's not what you intend to present, then the reader's expectations may be disappointed (unless of course my interpretation is idiosyncratic).
- 8 Hidari 07.15.09 at 3:14 pm
- 'The reasoning behind the second sentence is that if Chartists were able to make predictions then there would be prices that do not reflect information available just by looking at the history of the price.'
Sorry to be stupid here, but after looking at that sentence with an increasing headache for ten minutes I still don't understand it.
Is there a missing assumption here? Is the 'hidden' assumption that new information is always being 'introduced' to the market? Therefore if one could infer the current/future price of X from its past price then by definition it's not keeping 'up to date' so to speak, with the new information?
If that's the case then at least I understand why efficiency precludes deterministic inferences from past performance.
But I still don't understand why it's inherently unpredictable? Surely any new information, in a 'perfect' market would also be instantly known by the Chartists as well? Isn't that what almost all the definitions linked to presuppose?
- 10 matthew kuzma 07.15.09 at 3:22 pm
- "Conversely, as Keynes argued in How to Pay for the War, the government should use budget surpluses in periods of strong economic growth to restrain demand and reduce the risk of inflation."
There's an idea that has been ignored for too long. I can't imagine how hard this would be to sell, politically, but I think it's the only adequate response to deficit spending. If governments ought to respond to economic hard times by spending on a scale large enough to steer the economy, at precisely the same time as their own sources of income are depressed, the only way to expect them to operate sustainably is if they also sock money away during the economic booms.
- 11 Hidari 07.15.09 at 3:33 pm
- Stop Press! OK i just looked up the Wikipedia.
- 'In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information. Therefore it is impossible to consistently outperform the market by using any information that the market already knows, except through luck.'
OK! You can't buck the markets because anything you might know, 'everyone' immediately knows, and so it will immediately be reflected in the prices, and 'Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.'
OK now I get it.
- 12 geo 07.15.09 at 5:01 pm
- The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.
Is Keynes right about this? I've always found Marx's classic formulation of historical materialism more plausible: "In every epoch, the ideas of the rulers are the ruling ideas."
I understand him to mean by this that, however ideas come into the world, they need to be propagated in order to have any effect. This takes money (or whatever is the currency of social power at the time).
In contemporary industrial societies, the manufacture of consent is a sophisticated and expensive affair, aiming at influence over education, media, and scientific research as well as government.
Only one social group, business, has the resources and organization to undertake it, hence the overwhelming dominance of pro-business ideology, at least in the United States.
Of course, there are intrinsic limits: even the Business Roundtable can't prevent widespread popular belief that 2+2=4. But they can-and so far have managed quite nicely to-prevent the idea that, say, cooperation may be sometimes more desirable than competition, or that truly drastic economic inequality is inimical to political freedom, from gaining any traction.
- 13 Katherine 07.15.09 at 5:09 pm
- I'm sure I'm jumping ahead here (and/or misunderstanding and/or oversimplifying), but didn't Stieglitz (and someone else) win a Nobel Prize for proving that you couldn't have a state of perfect information? Or something?
- 14 Akshay 07.15.09 at 5:22 pm
- Nice intro!
I would suggest that you can't simply neglect Marx in either the intro or the book; the GFC has a strong political-economic dimension. The sight of accumulation, verelendung, political control by corporations, capitalism-succumbing-to-crisis, ideological subservience and manipulation, etc. certainly reminds this reader of him. I therefore think one of the answers to your second question should be to return economics to its broader roots as political economy.
Similarly, where does your own tradition of Social Democracy come from? Since you are presumably going to push it in the conclusion of the book, you might want to use the introduction to plant the 'gun' you will use in Act III. At the moment your rhetoric suggests a return to 'true' Keynesianism will be necessary. But doesn't democratic socialism have other roots than Keynes? The US might have been Keynesian once, it was never Social Democratic.
A minor pedantic point, but about the very first paragraph: There is a vast secondary literature pro and contra Kuhn. See, for instance, the Stanford Encyclopedia of Philosophy entry on Scientific Revolutions. I would ask a philosopher to check, and if necessary amend, your two-line summary about what has been "shown" in this debate. IMHO, Special Relativity is a bad example of a 'Kuhnian' revolution. It would more easily provide fodder for the contra Kuhn camp. (To make a long story short, Classical Mechanics has not been 'displaced')
- 15 engels 07.15.09 at 6:28 pm
- Is Keynes right about this?
Without venturing anything substantive on this very interesting issue, I'm not sure your Keynes quote and your Marx quote contradict each other. I take Keynes to be pointing to the tremendous influence that the ideas of philosophers and economists have, even over people who claim to be guided by common sense and uninterested in theory-such people invariably turn out to be unacknowledged followers of an old, well-entrenched theory. I don't think Marx would really go along with this in general but in this particular quote all I think he is saying is that the theories and ideas that become dominant in any given society are those of (that serve the interests of) the ruling class. One could happily endorse both these points, I think: practical men of business in America today are usually the slaves of a defunct economist, but the fact that the defunct economist in question happens to be Milton Friedman may be explained by the Marxian/Chomskyan processes you talk about… But I haven't actually looked at the context for either quote so I could be I am being dumb.
- 16 engels 07.15.09 at 6:44 pm
- Keynes does say 'The ideas of economists and political philosophers, both when they are right and when they are wrong,' so it is not as if he is claiming that ideas rise to prominence on their intellectual merits or something, in a way that would have to exclude the possibility of ruling class interests playing a role, even a determining role. But I should probably read Keynes before spouting off any more.
- 17 JoB 07.15.09 at 6:44 pm
- John,
I guess mainly what geo said @ 11 (possible the best remark here in days).
But also this:
This is the second excerpt and the second time you start of with a quote of Keynes; not only is that one-sided but it also plays into the perception that the title can be whatever as the content will be neo-Keynesian (which is rather fashionable these days anyway).
I'd venture to suggest you'd better start your introduction with the dead ideas of post-Keynesianism. You could work in geo's thought, maybe setting the scene in Davos (I'm sure there just has to be a transcript out there of a panel discussion that is so ridiculous now with the benefit of hindsight that it's hilarious in a 'how-was-she-called' does Palin type of way). Work with the promises of eternal bliss of deregulation – the promises of American dreams – the automatism of automatic market-propelled equality (in fact, it has to be possible to start with a Blair quote) and then go back to deviled old notions & let the reader conclude herself how ridiculous it was to write off all of that.
Come to think of it, Kuhn is part of your problem. The paradigm shift thing is exactly a notion that supports the kind of theoretic revolution that neo-liberals propagated; just ignore the progression of thoughts & start with a clean slate. It also happens to be what allows the ruling few (those present in Davos minus the court jesters now Nobel prizer) to insitigate a ruling idea that's beneficial to those that rule & gives them the semblance of 'good' moral agency.
PS: Chris, yes but no: the worldwide benefits do not derive from the ideas John is going to try to refute. Not everything surrounding free market theory is one pot of baddies & globalization of trade certainly produced many goodies like this. But I'd be surprised if somebody would demonstrate that financial deregulation benefited developing world – if that would be so, why would China have a distinct advantage in Africa.
- 18 bert 07.15.09 at 6:55 pm
- re #11 I went to a book event by Gillian Tett ("Fools Gold") last night. Discussing the financial elite, and in particular the princes of the capital markets, she namechecked Pierre Bourdieu. Interesting.
20 SamChevre 07.15.09 at 7:25 pm- Over the ensuing decades, the financial sector, a minor and tightly controlled industry during the postwar years, experienced an explosion in the volume and complexity of trade.
That "tightly controlled" portion needs to be explained, or something-because it doesn't fit my knowledge of the world.
Banks were more controlled in some respects, less controlled in others. (Regulated interest rates, regulated service areas, but not much attention to risk concentration.)
Insurance was far less regulated.
Both those regulatory regimes disintegrated/failed spectacularly when interest rates became unstable (roughly, 1975-1985) but at least in the US, both banking and insurance are much more regulated than was the case in 1975.
It's my impression that stockbrokers/underwriters/public companies were also less regulated (short-selling, insider sales, research/sales/underwriting entanglements), but that isn't my area of expertise.
It seems that two key factors were more economic climate issues than regulatory issues. First, trading and information costs and time lags were much greater, producing a fair amount of friction (which tends toward stability). Second, interest rates and commodity prices were relatively stable.
- 21 John Quiggin 07.15.09 at 8:54 pm
- Chris B, I guess I'd prefer to keep the language and drop the attribution to Hegel. Does someone else deserve the credit, or is it one of these cases where the basic idea is in Hegel, but the most compelling encapsulation is not. In economics there is the Impossible trinity, not to mention the Keynes-attributed quote that the market can stay irrational longer than you can stay solvent.
- 22 bert 07.15.09 at 9:38 pm
- If the question of the title is still open, can I say that I prefer the suggestion made in the previous thread: "Zombie Economics". (You may or may not like the echo of "voodoo economics", a dismissive country-club-Republican criticism of the Laffer curve.) I'm not sure a general readership will queue up for a book full of dead ideas, whoever they're from. And as others have suggested, the spoonerism may be a little arcane. But that's just my subjective take.
By the way, my comment at 6.55pm was a response to Scialabba. Whenever soc1al1sm is discussed, comment numbers tend to be a work in progress, I've found.
- 23 Chris Bertram 07.15.09 at 9:45 pm
- I think it was devised by a Hegel populariser (I can't remember who exactly) and then taken up by Marx.
- 25 gcwall 07.15.09 at 10:59 pm
- The most dramatic change that I have observed taking place over the past several decades is the abandonment of pure research for research that serves a particular end.
- If this is the case than arrogance has created an aristocracy that attempts to manipulate reality to serve its purposes rather than a scientific approach that informs from discoveries deduced from activities that produce empirical data out of real interactions within an economic system. The abandonment of what is real for what a particular class wants the masses to believe is real creates an environment in which only the most powerful and influential can survive.
- It might be better to refer to modern economics as survival economics for a particular class of individuals that creates arbitrary paradigms designed to enhance its control of the economy over the welfare of society regardless of the harm or expense to the majority or a second tier lower class.
- 26 Jock Bowden 07.16.09 at 12:23 am
- Hidari/JQ
Hidari's quote from Wikipedia is the clearest and most succinct statement of EMH so far.
John, I wonder if it is necessary to muddy the waters by introducing references to Chartism, which, let's face it, is a bit like astrology. The idea of EMH is to demonstrate in a very abstract sense that an individual cannot consistently outperform the market, as an individual can never have access to all the information that has gone into setting the price of a security at any point in time.
The corollary being, if that investor has inside information that the market does not, then that investor has more information than the market and thus could then outperform the market.
- 27 Jock Bowden 07.16.09 at 12:27 am
- JQ
Promising start. But I wonder about the wisdom of incorporating notions of Kuhnian paradigm change and Hegelian dialectics.
As you say, Kuhn's paradigm concept was built for the physical sciences, not the social sciences. Remember, the central concept in Kuhnian paradigm change is the incommensurability between the old paradigm and the one that has replaced it. Correct me if I am wrong, but are you saying in the twentieth century the paradigm changes went from pre-war 'the absurd classical economic theory' (whose only practitioner you mention – Adam Smith – thrived in the 18th not 20th century, then to Keynes, then to Friedman's monetarism synthesised with 19th-century-based 'new classical' macro, which you choose to call "economic liberalism"?
If so, you might want to rethink mixing Hegelian/Marxian dialectics with Kuhnian paradigm change. If you are going to use dialectics and its marxian cognates of thesis > antithesis > synthesis, the reader will want to know why you are not using the economic theory that goes with it – marxian crisis theory. This is especially confusing as you claim the "the traditional antagonists of socialism and unrestrained capitalism." These terms are just dumped in, unexplained, and unhistoricized". It leaves the reader bewildered as to the differences – if any – between "antagonists/thesis-antithesis/paradigm change"
You could clean this sentence up, as at present it is hard to get what you mean:
In the language of Hegel, it is a dialectical process in which an idea (the 'thesis') meets its contradiction (the 'antithesis') producing a synthesis which transcends its origins.
Are you saying it is the 'synthesis' which transcends its origins? If so, I am not really sure how that happens. Are you saying the thesis was Keynesian macro aggregate demand management, the antithesis was neoclassical micro, and the synthesis was Hicks' IS-LM model? The new antithesis was Friedman monetarism, and the new synthesis was "economic liberalism"?
I have a few more suggestions, but I'll wait for your response just to make sure I am not missing something completely.
- 28 P O'Neill 07.16.09 at 1:37 am
- Is there going to be a refuted doctrine for exchange rates? You mention the demise of Bretton-Woods. And floating exchange rates certainly opened up the lucrative trading revenue from exchange rate speculation. But monetarists always seemed schizophrenic about exchange rates, some viewing it as "just another price" while others argued for fixed exchange rates against a real anchor-the goldbugs that Krugman talks about. Yet actual policymakers seem to prefer something in between: currency unions or highly managed floats if they do leave the exchange rate somewhat flexible. Yet the Wall Street Journal did years of exulting about currency boards although it's been quiet recently now that the painful adjustment costs that they impose are more obvious (see Latvia). So what does seem refuted is either independently fixing the exchange rate or completely ignoring it. I suspect that there are juicy classical/monetarist quotes out there advocating both of these positions.
- 29 Walt 07.16.09 at 4:05 am
- The "thesis, antithesis, synthesis" terminology is usually attributed to Fichte.
- 30 Robert 07.16.09 at 6:55 am
- I probably am weak on how to write for the target audience. But I have lots of problems with what I've seen so far. It seems focused on surface ideas. For instance, if I were to offer an idea in contrast to the EMH, I would talk about Joan Robinson's contrast between theories set in historical and logical time. Paul Davidson, by writing about non-ergodicity, offers a formal characterization of historical time.
In general, I don't expect John to be fair to Post Keynesians. For example, I don't see how Monetarism ever was more "compelling" than Post Keynesianism in the analysis of stagflation, however much the profession disagreed.
I have trouble with talk of paradigms in economics. Sometimes people are talking about different ways of understanding actually existing capitalist economies. And sometimes people are talking about different ways of organizing economies. I can see why one might argue the distinction is not hard and fast. But if one wants to be using the idea for both, as seems to be the case in John's extract, I think one should be making a conscious decision.
As far as refuted ideas of the sort John seems to be interested in, I have another. Some have been suggesting – I wish I could recall better who – that the way to align the incentives of corporate managers with stockholders is to give them stock options. One might here go back to Enron and such corporate scandals, before the global financial crisis, for refutation.
- 31 Robert 07.16.09 at 7:08 am
- What I am recalling as a model for John is John Cassidy, "The Greed Cycle", The New Yorker, September 23, 2002. (My name links.) The refuted idea is put forth in a 1990 Harvard Business Review article by Michael Jensen and Kevin Murphy.
- 32 John Quiggin 07.16.09 at 8:01 am
Yes to the first and no to the second. The synthesis of new classical and Hicksian IS-LM was micro-based macro (RBC and New Keynesian) to which I'll be coming soon.
I'd say (also responding to Robert above) that economic liberalism was the (ideal of) the policy system for which new classical macro and free-market micro were the theoretical basis.
Now both the theoretical and the policy paradigms have failed, and we need a new synthesis (with the role of antithesis being played by Minsky-type post-Keynesianism, behavioral econ and some elements of Austrianism).
All of this is obviously mechanistic/schematic, and I don't intend to present the arguments in this way, but I find it a useful way of thinking about things, whether it's due to Fichte, Hegel or (pre-inversion) Marx.
- 33 Jock Bowden 07.16.09 at 8:11 am
- JQ
You would be well advised not to include both Kuhnian and Marxist ideas together, as Kuhn was largely motivated by anti-Marxism. And if you include any Marxism, your thesis will get hammered from a Marxist perspective, as the ideologies you set up as antithetical, a Marxist does not.
- 34 Chris Bertram 07.16.09 at 9:13 am
- #33 Whatever Kuhn's motivations, very similar ideas are present in the Marxian tradition: for example Althusser uses the concepts of "problematic" and "epistemological break" as derived from Bachelard and Canguilhem.
- 36 Tracy W 07.16.09 at 9:18 am
- Quiggin: It might be thought … that economics might have progressed beyond the stage conflict over basic ideas.
Who might think this, and whether they have good reasons for thinking this, are interesting questions. After all physicists have been sitting around with two conflicting theories about reality (relativity and quantum physics) for several decades now, astronomers briefly had ages for oldest stars older than their age of the universe and recently and famously recently changed their consensus even about the number of planets in the solar system.
On the other side, in economics the labour theory of value does appear to be dead in the water, and it's generally agreed that it's not obvious that centrally-planned economies are inherently more efficient than market economies.
In terms of macroeconomic policy, we've only had the system of national accounts since after WWII, which makes analysing whole economies pre-WWII rather difficult, and of course we can't put a whole economy in a lab and perform experiments on it, so it's hardly surprising that macroeconomists are still having conflicts over basic ideas.
In the process, Hicks relied heavily on some of Keynes' ideas, but ignored or discarded others, much to the dismay of more purist Keynesians such as Joan Robinson.
It's interesting that a guy like Keynes, who made a couple of vivid statements about the okayness of being wrong, for example "There is no harm in being sometimes wrong - especially if one is promptly found out. " would wind up with 'purist' followers.
This development called for, and received theoretical support from the economics profession in the form of the efficient markets hypothesis. Building on the relatively innocuous observation that the efforts of stockmarket 'chartists' to predict the future movements of stock prices from their past behavior were futile,
Again, the Efficient Markets Hypothesis first came in three forms, the weak form of course was that chartism doesn't work, but the semi-strong and the strong forms of the hypothesis are not innocuous. That's why the EMH attracted so much empirical attention.
the efficient markets hypothesis was developed to the point where it was seriously suggested, in the wake of the September 2001 attacks, that the best way to predict terrorist attacks would be to open a futures market.
This statement is wrong. In the first post you made on this topic, I pointed out that the reasoning behind predictions markets is not dependent on the efficient markets hypothesis, at least not the EMH as defined by Fama, which is what I think most readers will think of when you start talking about EMH. To quote from the Statement on Prediction Markets (which I admit I forgot to provide a link to previously, see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=984584, page 4 of the pdf):
These markets work for several reasons: First, almost anyone can participate. Second, people think hard when they have to back up their predictions with money; buy the right presidential contract and you win, buy the wrong one and you lose. Third, the profit motive encourages people to look for better information.Nothing in there about the EMH. I can't see any inherent contradiction between believing that markets provide a useful way of aggregating dispersed information and also disbelieving even the weak-form of the EMH. And as I've said, I've never come across anyone who says that they believe the strong-form of the EMH (which is not to say that they don't exist). Given the relative economic performance of West Germany vs East Germany and North Korea vs South Korea, anyone who thinks that markets aren't a useful way of aggregating dispersed information is either ignorant, insane, or has a remarkable alternative explanation in their back pocket that I would be very interested in hearing.- 37 Jock Bowden 07.16.09 at 9:27 am
- Chris Bertram
What you say is absolutely true and fascinatingly so. But I'm sure you'd agree that to throw them all around together in the same paragraphs requires very supple treatment, and things could go pear shaped extremely quickly.
- 38 Jock Bowden 07.16.09 at 9:32 am
- OTOH, it would really neat to see someone use Bachelard to argue whether or not the Phillips Curve or even monetarism were "inside" the "Keynesian paradigm".
- 40 John Quiggin 07.16.09 at 11:06 am
- "In the first post you made on this topic, I pointed out that the reasoning behind predictions markets is not dependent on the efficient markets hypothesis, at least not the EMH as defined by Fama,"
Tracy, there are loads of statements from both supporters and critics to back up my claim here (try Google). More importantly, the points you cite are exactly the premises from which the strong-form EMH is derived – thick markets in which large numbers of rational individuals trade based on the information available to them. More generally, as several commentators have pointed out, you are drawing an untenable distinction between the exact form of words used by Fama on the EMH and the logically equivalent formulations I'm discussing.
- 41 John Quiggin 07.16.09 at 11:11 am
- Here for example is the CIA, which ought to know
The theories underlying PAM and other prediction markets are the Efficient Capital Markets Hypothesis (ECMH) and the Hayek hypotheses.[8]These hypotheses explain how information is aggregated such that market prices provide accurate estimates on the likelihood of future outcomes.[9]
According to ECMH, capital markets are "extremely efficient in reflecting information about individual stocks and about the stock market as a whole," such that no amount of analysis in an attempt to forecast future stock prices can beat the market
- 42 ron 07.16.09 at 1:12 pm
- You will lose credibility with physicists if you maintain that: "….such as that of Newtonian physics is displaced by a new and superior alternative, such as Einstein's relativity theory." First, Newtonian physics hasn't been displaced. It still works very well for everyday applications. Quantum physics added to knowledge in the area of small particles (thus "quanta"). Second, relativity is also not a departure. It is a special case, not a contradiction. NASA (and virtually all scientists) would use Newtonian physics much more than the others.
- 43 Rob 07.16.09 at 1:18 pm
- Given its an introduction its hard to say, but I think you need focus more on popular opinion versus what academia actually thought and what the Fed actually did. It was already mentioned that Monetarism was pretty much abandoned by Volker to stop the volatility of interest rates and inflation that money targeting brought. And while Greenspan was a Randite he followed a Neo-Keynesian monetary policy. Neo-classical RBC was dying by the mid 90s when it hit a dead end.
- 44 gcwall 07.16.09 at 1:36 pm
- Economic theory is similar to cancer treatments, sophisticated in knowledge and research, but barbaric in methodology.
- 45 Salient 07.16.09 at 1:37 pm
- In the terminology commonly associated with the great German philosopher Georg Hegel, economic thought is a dialectical process in which an idea (the 'thesis') meets its contradiction (the 'antithesis') producing a synthesis which transcends its origins.
If you were to split this into two sentences, the second of which concisely defines "synthesis," I think many more readers would understand where you're going: "transcends its origins," while retaining fidelity to the way this stuff's normally talked about, sounds unnecessarily mystical. --
Also, more generally, perhaps the introduction should begin with a couple paragraphs that lay out the need to explore this history, i.e., in order to track back and see where these New Economists went wrong. The first couple paragraphs could summarize some obvious problems with current economic paradigm, then point out that we have historical examples of similarly problematic thinking. The transition could be an assertion such as: we need to investigate what was wrong then, and how the paradigm then shifted, so that we may better understand what's wrong now, and in what ways the paradigm could/should shift again.
[I'm not sure if you're looking for these kind of stylistic suggestions, and I feel nervous that I might be being unintentionally offensive by providing them, and I am hoping no such offense is taken.]
- 46 Jock Bowden 07.16.09 at 1:51 pm
- Salient
In the context of this particular discussion and its focus on Kuhnian paradigm change, I am not really sure we can say that past economists were "wrong".
- 47 Salient 07.16.09 at 1:59 pm
- In the context of this particular discussion and its focus on Kuhnian paradigm change, I am not really sure we can say that past economists were "wrong".
Well, true, much for the same reason that we can't say Newton was "wrong." To be "wrong" implies there is some model which is "right" which is a misunderstanding of what a model is. I guess here "wrong" in my earlier statement would mean, roughly, "problematic" or "unsatisfactorily inaccurate."
But, if I replaced "wrong" with a more accurate phrase, my sentence might have been too convoluted to be comprehensible. I'd rather say something imperfect but comprehensible, than something perfectly incomprehensible. :)
- 48 Justin 07.16.09 at 2:11 pm
- I found the comment about the futures market in response to the difficulty of predicting a terrorist attack, not really making the point you were trying to about the hubris involved in the efficient markets hypothesis.
I'm sure there could be a better example somewhere to better demonstrate market triumphalism. My initial reaction to your example, was why not use a futures markets to predict something?
I'm not sure it is the best example, nor is it clearly linked to your point.
- 49 Salient 07.16.09 at 2:27 pm
- "Friedman's model, which took into account expectations of inflation that were incorporated into wage bargains, appeared to explain stagflation."
I would say "better accommodated" instead of "appeared to explain," at least if the former is true.
More generally, I think there's an ambiguity that needs to be explicitly resolved, between how a model fits to data in order to predict phenomena, and how a model attributes causal mechanisms to those phenomena.
- 50 Chris 07.16.09 at 3:10 pm
- #46: To be "wrong" implies there is some model which is "right" which is a misunderstanding of what a model is.
True, but isn't neoclassical economics itself based on a misunderstanding of what a model is? Confusing the map (rational actor models) with the territory (actual economies)? I think that's wrong in a sense deeper than that in which all models are wrong. Or maybe it would be even better described as "not even wrong".
#47:I think there's an ambiguity that needs to be explicitly resolved, between how a model fits to data in order to predict phenomena, and how a model attributes causal mechanisms to those phenomena.
A good point, especially regarding models developed after the phenomenon they "appear to explain".
Of course people are going to try to fit their theories to the data, but unless the theory also holds up with data other than that used to create it, it's not very useful and I don't think its explanatory mechanisms should necessarily be taken seriously. It may be incorrectly taking for granted idiosyncrasies of the original situation that do not actually generalize, for example. Was Friedmanism overfitted to stagflation, or does it have explanatory power outside that context?
- 51 Tom Hurka 07.16.09 at 4:07 pm
- More Hegel pedantry, I'm afraid.
The Ideas that Hegel thought drove history weren't ordinary ideas in people's heads: they were concepts that were embodied in social structures but not necessarily thought or understood at the time by people living in those structures. Remember his famous Owl of Minerva remark about philosophy: it comes on the scene when a historical period is coming to its end and only then understands it, i.e. conscious thought about an Idea typically appears only after the Idea has done its historical work.
Hegel certainly didn't think material interests or anything economic drove history; in that way he differed from Marx. But he also didn't think ideas, in the sense of thoughts in people's, e.g. philosophers', heads drove history. Capital-I Ideas drove history, and they were something completely different.
(I seem to remember Charles Taylor making this point. And anyway, why do you need to talk about Hegel?)
- 53 geo 07.16.09 at 4:31 pm
- The reality of the interaction between ideas, economic systems and economic power is far too complex to be reduced to a simple aphorism.
Darn. I keep hoping, though …
- 54 Hidari 07.16.09 at 4:43 pm
- 'The new version of free market ideology that emerged from the 1970s has been given various (mostly pejorative) names such as neoliberalism, Thatcherism and economic rationalism. I prefer the more neutral term 'economic liberalism'.'
Given the proviso that I don't know much about economics, isn't it generally agreed upon that the accepted term for what you are talking about is 'neo-classicism'? I mean, as an 'academic' theory? The problem with 'economic liberalism' as a phrase, apart from the fact that it seems to be very vague, is that it doesn't differentiate, so to speak, between the liberalism that follows from (e.g.) EHM, i.e. the very mathematical approaches you really want to be talking about (I think) and the liberalism that derives from the Austrian school. Policy wise, neo-classicists and Austrians have a lot in common, but not in terms of their basic assumptions and presuppositions.
Of course you may be planning to point out failures in Austrian economics as well, in which case my point is moot.
- 55 Rabbi 07.16.09 at 6:08 pm
- I'd like to add my vote to the "delete Kuhn" faction. If your reader is not familiar with Kuhnian ideas and the controversies around them the comment is incomprehensible, and if they are it's at best dubious.
- 56 engels 07.16.09 at 6:49 pm
- Following on from others, I do think your argument would be clearer if you could pare down the number and range of references to historical figures-just within the first few paragraphcs you have Keynes, Kuhn, Hegel, Marx, as well as Newton and Einstein in passing-especially when, like Kuhn and Hegel, they are from outside of economics and don't really seem needed to make your point. It also seemed to me that in the first couple of paragraphs you were trying to make two different points-about the power of ideas and the non-additive nature of progress in economics-at the same time with your reference to Hegel and this was a bit confusing.
But it is an interesting piece.
- 57 John Quiggin 07.16.09 at 7:58 pm
- To Salient and others, stylistic criticisms are welcome as are substantive objections and of course compliments. I'm getting a lot out of this, including the message summed up by Engels which I will accept, I think.
Hidari, although there is no settled terminology, "neoclassical" is most commonly used to refer to the entire body of economics emerging from the "marginal revolution" in C 19, including (a little uncomfortably) the Austrian school, but not institutionalists and Marxists or Sraffa-style post-Keynesians). In this sense, the famous Cambridge capital controversy (in which all the main protagonists were Keynesians of one kind or another) was about the logical validity of neoclassical economics. I don't plan to write at all about this controversy or to criticise neoclassical economics in the broad sense I've described – of course, I'll welcome comments arguing that I should. I'm aiming at a much smaller (but still wildly ambitious) target; the version of neoclassical economics that became dominant in late C20 and was associated with the political movement I'm calling economic liberalism.
- 58 Tom Hurka 07.16.09 at 8:03 pm
- Kid at #50:
But it's fun to talk e.g. about Hegel's explanation why women don't have orgasms. (It's because they're not civil servants.)
- 59 kid bitzer 07.16.09 at 8:12 pm
- oh, i just said it should always be asked, not that it could never be answered.
and in the case you cite, the answer "because it's fun to ridicule him" provides complete satisfaction.
(provided that one is a civil servant).
- 60 nickhayw 07.17.09 at 12:38 am
- To throw my hat into the ring, and in answer to your call in #55 for broader criticisms of neoclassical economics, please do! :) – you leap straight into Keynes and 'in the long run, we're all dead' without setting the scene, and I'd venture that your average lay reader (without a background in 20th century [economic] history) might not be able to make sense of why Keynes was such a huge break from the neoclassicals/marginalists/Say's law-devotees.
I for one would love to see an extra paragraph or two establishing the historical setting of the Great Depression, and a little more on the 'bad ideas' that caused that mess, or were bandied about at the time. Would provide a nice side-by-side for the current crisis, too, given the amount of talk in the media about the Great Depression (and how this one is 'the worst since then', etc.)
- 61 nickhayw 07.17.09 at 12:48 am
- Oh, and what exactly do you take to be 'the classical framework', exemplified by (or starting with) Smith? An homogenous, one-sector model framework? Capital = corn = perfectly substitutable/perfectly elastic? An emphasis on perfect competition? A lay-reader certainly isn't going to know anything about classical political economy, and I think it would help your case if you expanded a little on the continuities between the classicals and their marginalist successors (and, perhaps, the absurdity of maintaining classical conceits in a much-changed economic world?)
- 62 Not Really 07.17.09 at 2:22 am
- > These[prediction] markets work for several reasons:
I have seen exactly zero convincing arguments that the self-styled "prediction" "markets" work at all, for any meaning of the word work (utterly weak, weak, semi-weak, semi-strong, strong, oooblah, whatever). And there was a clear example of said gambling sites being manipulated during the last US election cycle. So let's not get too far ahead of ourselves there.
- 63 Robert 07.17.09 at 6:14 am
- My name links to 11 principles of neo-liberalism, as expounded by Philip Mirowski, in the book I'm currently reading.
- 64 Hidari 07.17.09 at 8:39 am
- 'To throw my hat into the ring, and in answer to your call in #55 for broader criticisms of neoclassical economics, please do! :)'
If you are interested in that, you might want to check out Paul Ormerod's Death of Economics.
But generally speaking, John, I think it's best to keep things tight and focus on the ideas that led up to our current situation. This also has the benefit of being able (implicitly? explicitly?) to attack Hayek, and the Austrians as well. To repeat, if you go back to their 'roots' these guys are really very different from the neoclassicals, but in terms of policy prescriptions it's much the same kinda stuff.
What I'm basically trying to say is that it seems to me that you want to attack the policies that led to our current mess and not so much the abstract, academic, ideas that may have led to these policies. This seems wise, although of course you are going to have to touch on the first to deal with the second.
It might also be a good idea to simply list all the ideas that you are going to call 'economic liberalism' with quotes to prove that people actually said that they believed them ('oh but goodness no one believes that!' is a classic way of wiggling out of these kind of accusations). I think it's important to to this because one of the depressing things about the current political stage is how many things are simply unargued and taken for granted.
For example, in the recent bank crisis/manufacturing crisis, it has simply been assumed by almost all sides of the political spectrum that 'private is good, public bad' and that even though (e.g.) GM has essentially been nationalised that this must be a short term move and that 'we' must 'all' try to move all these companies/banks etc. back into the private sector as quickly as possible.
Now this may be true or half true or false or whatever but it's still an assumption that needs to be argued: by which I mean, empirical evidence must be provided that in some meaningful semi-objective sense, public firms perform 'worse' than private firms.
So bringing them into the open, numbering them and then simply going through them pointing out
1: yes people really did say they believed them 2: Providing the reasons as to why people said they believed them and then 3; Looking at the rational (logical) and then empirical evidence as to whether or not they are true or not, in other words, do the reasons provided in '2' stand up?
So 1 could be the EMH, 2 could be the idea that private companies are 'better' than public ones, 3 could be the idea that financial deregulation is always a good idea, and so on and etc.
- 65 Tracy W 07.17.09 at 8:46 am
- John:
I haven't found said quotes. I did a search on Google – http://www.google.co.uk/search?hl=en&rlz=1T4GZEZ_en-GBGB237GB237&q=%22efficient+markets+hypothesis%22+%22prediction+markets%22&meta= on "efficient markets hypothesis" and "prediction markets".
The first result that came up with was yours, which of course is what I am disagreeing with. The second was a collection of papers which had my phrases in my random. The third was finally relevant, but merely says "Much of the enthusiasm for prediction markets derives from the efficient market hypothesis", firstly no support is provided for such claims, and secondly, much is not the same as all. The third paper is a general one about prediction markets merits and dismerits published by the CIA. If you check the CIA's reference, it is to an article by Robert Shiller: "From Efficient Markets Theory to Behavioural Finance". http://www.unc.edu/~salemi/Econ423/Shiller%20From%20EM%20to%20BF.pdf, which doesn't actually mention prediction markets as far as I can tell. Perhaps the CIA ought to know, but I advise some more skepticism in the future about whether people actually do what they ought to do. The fourth link was apparently recently moved. The fifth one states that:
Economic support for the efficacy of prediction markets ultimately derives from Adam Smith's "invisible hand", Hayek's "The Use of Knowledge in Society", and Eugene Fama's Efficient Market Hypothesis. Taken as a whole, they support the position that market prices fully reflect all available information about the product or asset under consideration.Again this bases prediction markets on more than the EMH. (And, perhaps, I've found your believer in the strong-form of EMH for you, though if I was you I'd check with the blogger a bit more thoroughly.)
- More generally, as several commentators have pointed out, you are drawing an untenable distinction between the exact form of words used by Fama on the EMH and the logically equivalent formulations I'm discussing.
Strong words, but you don't back them up. Your statement is, to quote again: "The EMH says that financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production."
I'm going to imagine two hypothetical people here. My imaginary person one believes in the strong form of EMH. She however also thinks that all good decision making processes must be democratic as a matter of definition, and thus therefore the "best possible guide" to the value of economic assets has to be a democratic one as a result of her definition. Such an imaginary person could favour prediction markets as a guide to how people should vote in their democratic decisions, without believing that EMH is wrong.
My other hypothetical person rejects all forms of EMH, weak to strong, but is currently convinced by Andrew Lo's "adaptive markets hypothesis". They believe that financial markets are the best possible guide to the value of economic assets and therefore to decisions about investment and production, because they believe that no other method can aggregate information that well and efficiency of information aggregation is how they define best. Therefore they reject Fama's EMH and accept your EMH.
Please note, I don't agree with either of these hypothetical people, I don't believe in the strong form of the EMH, and I don't know any mathematical proof that financial markets are the best possible …, for any definition of the word best except the trivial one where "best" is defined as "using financial markets", and on the whole I try to keep some awareness that I might be wrong in the absence of such proofs, although I also know that I struggle with self-consistency.
These sort of examples is why I keep saying that your EMH is logically quite different from Fama's EMH. In part because your EMH uses the word "best", which is terribly subjective. Simply telling me that I'm wrong is not going to convince me otherwise.
More importantly, the points you cite are exactly the premises from which the strong-form EMH is derived – thick markets in which large numbers of rational individuals trade based on the information available to them.
Nope. Going back to Fama's 1970 paper, Efficient Capital Markets: A Review of Theory and Empirical Work", available at http://www.ekonometria.wne.uw.edu.pl/uploads/Main/1970.Fama.EMH.pdf, he says that the weak form of EMH came from empirical observations:
"Rather, the impetus for the development of a theory came from the accumulation of evidence in the middle 1950s and early 1960s that the behaviour of common stock and other speculative prices could be well approximated by a random walk. Faced with the evidence, economists felt compelled to offer some rationalization.", page 8 of the pdf, page 389 of the original journal article in The Journal of Finance, Vol 25, No 2.
I can see nothing in here where the strong-form of EMH is derived from a thick market with large numbers of rational individuals trade based on information available from them, the progression that Fama outlines is from empirical work to theories trying to make sense of such empirical work.
And I have never come across anywhere where the strong form of the EMH is derived from thick markets etc. Perhaps it is derived somewhere, but you'll have to show me to convince me. (I would be interested in such a derivation from the mathematical point of view if nothing else).
Meanwhile, your post inspired me, last night in the library, to pick up a book on Keynes, specifically "Keynes" by Robert Skidelsky, Oxford University Press, 1996. He has a rather different account of the influence of Keynesian economics on the world of the 1950s and 1960s to yours. From page 112:
Keynesian policy may then be said to be in operation when budget deficits are deliberately incurred to raise the level of output. On this test there was no Keynesian policy during the height of the 'golden age' because, as R.C.O. Matthews pointed out in 1968, 'the [British] government, so far from injecting demand into the system, has persistently had a large current account surplus'. The same was true for the United States until 1964. Similarly there is no active demand management policy in the most successful 'golden age' economies: Germany and Japan.Skidelsky then goes on to speculate that the belief that Keynesian policy would work if required could explain the 'golden age'. He then goes on to write:In the 1960s Keynesianism was universalized … in a double sense: the use of fiscal policy to balance economies was extended to France, Italy, Germany and to a lesser extent Japan, and fiscal policy became more active and ambitious as fears of recession revived.(page 114)The record is clear: by the decade's end the OECD inflation rate had doubled from 3 per cent to 6 per cent, without any improvement in real variables. The rising inflation which was the real legacy of the growth Keynesianism of the 1960s set Keynesian macroeconomic policy an impossible task in the 1960s."(page 117)Is Skidelsky wrong in his history?
- 66 JoB 07.17.09 at 9:34 am
- John, do you really want to keep the "non-additive nature of progress in economics"? – besides being besides the point, it is an idea that imho can easily itself be refuted. You risk to make just that mistake that was made in the 70s: disregard a couple of decades and start afresh. There's a lot of value in the "Von-s" and denying that is hogwash. You also don't mention the fact that it's in the context of communist state failure and oil crises deficits that Keynes was abandoned (and then only somewhat, to be honest, outside of certain quarters in Chicago at least) and that there was good reason to steer clear of anything remotely similar to a Soviet state (& that Keynes for one would, most probably, have agreed with that – I have not read him but I have only seen him quoted not so much against market workings but only against the automatic bliss that would be coming from only free market workings).
- 67 Jock Bowden 07.17.09 at 1:00 pm
- JQ
Thinking about this a bit more, how are you going to justify this tautological phrase "economic liberalism" as the paradigm that replaced Keynesianism? Nobody in academia, policy circles, or governments used this phrase, so why are you?
You would be better off sticking to "monetarism".
- 68 financial economist 07.17.09 at 1:45 pm
- Tracy, you might surprised to discover that the literature on the efficient market hypothesis did not begin and end in 1970. I think it's odd how that one paper has such a totemic significance for you. John is completely right in how EMH is interpreted within the field. We teach MBAs that because of the efficient market hypothesis you should use the market's implied discount rate in capital budgeting, which fits John's point exactly.
Theoretically, the efficient market hypothesis is derived from rational utility-maximizing agents in general equilibrium, and everything John says follows directly from that. The market microstructure literature talks about the importance of thick markets to get anything like an efficient market.
- 69 Jock Bowden 07.17.09 at 1:58 pm
- FE
I am not sure where you teach, but I do not know of any business school or economics undergrad program that does not move on from the EMH very early on.
- 70 James C 07.17.09 at 10:17 pm
- I think "economic liberalism" is a pretty widely used and understood phrase.
But I'd like to see someone address Tracey W/Skidelsky's point about the scarcity of budget defecits in the postwar Keynesian golden age, mainly because I was going to pose it myself.
- 72 JoB 07.18.09 at 8:05 am
- Mises, Hayek.
I hope that doesn't offend you.
- 73 Robert 07.18.09 at 11:04 am
- John Quiggin wrote, "Hicks relied heavily on some of Keynes' ideas, but ignored or discarded others, much to the dismay of more purist Keynesians such as Joan Robinson."
In 36, Tracy W. writes, "It's interesting that a guy like Keynes, who made a couple of vivid statements about the okayness of being wrong, for example 'There is no harm in being sometimes wrong - especially if one is promptly found out.' would wind up with 'purist' followers."
If Tracy is suggesting that Robinson never said she was mistaken, she is just ignorant.
- 74 John Quiggin 07.18.09 at 11:57 am
- I wasn't offended, I just forgot that both these guys vonS
- 75 Jock Bowden 07.18.09 at 3:42 pm
- James
No it isn't. There are no journals called "The Journal of Economic Liberalism" which most economics read and cite, which are devoted to solving economic problems using models from the "economic liberalism" as opposed to Keynesian, monetraist, or Marxist schools. There are no scholars who are Professors of "Economic Liberalism". It is a tautological phrase, which JQ has only recently substituted for "neoliberalism" which he has used for the past five years. Why the sudden change?
There are already too many things wrong with this book – particularly historiography and epistemology – without adding this weird nomenclature.
- 76 engels 07.18.09 at 3:51 pm
- Economic liberalism
- 79 Robert 07.18.09 at 4:35 pm
- I prefer the term "neoliberalism". But Jock is just ignorant.
- "And if economics as a broad discipline deserves a robust defense, so does the free market paradigm. Too many people, especially in Europe, equate mistakes made by economists with a failure of economic liberalism." The Economist, July 18-24, 2009, p. 11, emphasis added.
Meanwhile various "hapless Wiki-workers" (Mirowski 2009) on the "neoliberalism" entry cannot get it through their heads that the label was used by various neoliberals (e.g., Milton Friedman 1951) to describe themselves. Instead they pretend it is a pejorative invented by leftists and social democrats.
- 80 Tim Wilkinson 07.18.09 at 6:21 pm
- Andy McNab @81 etc – move on from the EMH very early on yeah, to deliver a couple of those caveats to go into the bottom drawer for production on challenge (those whorish academics need some sor of figleaf). Then straight back to the main bullshit.
What "economic liberalism" is, is a projection of an 'Other' or alternatively a description of a main strand in political theorising – you see, "Liberalism' in the personal sphere is (in old fashioned terms) left wing – in the economic sphere, right (thanks largely to legal personality combined with limited liability). Monetarism properly so-called is a very specific doctrine, which doesn't go anywhere near covering the Tory-sans-concern-for-the-unwashed ideas that Econ. Liberalism aptly enough describes, and certainly names.
Starting? Aravya.
- 86 Tracy W 07.20.09 at 12:36 pm
- Financial economist: Tracy, you might surprised to discover that the literature on the efficient market hypothesis did not begin and end in 1970. I think it's odd how that one paper has such a totemic significance for you.
Hmm, two speculations about my psychology. This resort to ad hominem slightly increases my Bayesian estimate of the probability that I'm right. (For the record, I don't see how the answers to the questions of where Fama's EMH was derived from, and whether it is or isn't logically-equivalent to Quiggin's EMH, are affected by my potential levels of surprise, or whatever I place or don't place totemic significance on, I just don't think my inner states are that important to reality.)
John is completely right in how EMH is interpreted within the field. We teach MBAs that because of the efficient market hypothesis you should use the market's implied discount rate in capital budgeting, which fits John's point exactly.
John Quiggin's claim was that the EMH had been "developed to the point where it was suggested … that the best way to predict terrorist attacks would be to open a futures market".
I don't see how the truth or falsity of any version of the EMH implies a particular view on discount rates – surely, even if the weak-form of the EMH is false, if you are going to be funding a project by borrowing on the capital markets, it makes sense to consider the capital markets' implied discount rate in doing your budget? After all, that's the one that potential lenders are going to be deciding whether or not to invest against. Calculating it might be a bit more difficult of course depending on the alternative theory you adopt. Or alternatively, you could believe in even the strong-form of the EMH and also argue on philosophical grounds that the discount rate should be something else entirely (eg environmentalist arguments for using a discount rate of zero for certain situations where a massive loss is possible at some point in the distant future).
Theoretically, the efficient market hypothesis is derived from rational utility-maximizing agents in general equilibrium
Two points:
1. As I quoted before, Fama said in his 1970s paper that the EMH came as an explanation of empirical results. According to him, the theory followed the empirical work, not the other way around.
2. I would like to see this derivation, assuming that it exists. My financial economics professor never mentioned it at all, and I notice that neither you nor John have provided a citation for this supposed derivation.
The market microstructure literature talks about the importance of thick markets to get anything like an efficient market.
Remarkably, the behavioral economics literature shows that a rather efficient market outcome can be achieved with very few participants. See for example Markets, Institutions and Experiments, by Vernon L.Smith, http://www.ices-gmu.net/pdf/materials/393.pdf, page 15 of the pdf, where six buyers and six sellers are enough to reach the "optimal equilibrium outcome", or "Experimental Methods in Economics", http://www.ices-gmu.net/pdf/materials/370.pdf, from page 5 of that pdf:
Since 1956, several hundred experiments using different supply and demand conditions, experienced as well as inexperienced subjects, buyers and sellers with multiple unit trading capacity, a great variation in the numbers of buyers and sellers, and different trading institutions, have established the replicability and robustness of these results. … These experiments establish that the 1956 results are robust with respect to substantial reductions in the number of buyers and sellers. Most such experiments use only four buyers and four sellers, each capable of trading several units. Some have used only two sellers, yet the competitive equilibrium model performs very well under double auction rules.Robert: I was not suggesting that Robinson never said she was mistaken, I was merely saying that it was surprising that anyone would be a purist Keynesian, given Keynes' own apparent openness to the possibility that he might make mistakes, which implies that being a purist Keyneisan would require ignoring some of Keynes' own writings, a bit contradictory. But what do I know? Perhaps Robinson wasn't a purist Keynesian anyway.
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nakedcapitalism.com
The Economist has its lead editorial and two articles (here and here) on the state of play in the economics discipline, given its failure to see the financial train wreck coming and its dismissal of those who raised early warning flags. I must confess I only got a few paragraphs into it before getting thoroughly annoyed. It's one of those damage control affairs that does a clever job of asserting the failing of the discipline are really not all that serious. In fact, the refusal of the discipline to cop to much in the way of error is remarkable. By contrast, a period of failing enrollments in the 1990s produced vastly more soul-searching (doubters can read Mark Blaug, "Disturbing Currents in Modern Economics" Challenge, 1998, and contrast it with the state of play now).
Linda Beale. professor of law and creator of the blog, ATaxingMatter, will have none of it. She agreed to run her take on it as a guest post her.
From Beale:
The July 18th issue of The Economist is focused on the economic crisis and the economic theory that failed to prevent or, for most, even foresee the crisis. The cover is telling--a book labelled "Modern Economic Theory" that is melting away, with the words "Where it went wrong-and how the crisis is changing it" beneath. That sounds like the magazine intends to investigate the sources of the crisis in modern economic theory. But does it? Only in a sort of halfway approach. There's a lead-in on "what went wrong with economics" (page 11). It claims that economics as a discipline "deserves a robust defence" and that "so does the free-market paradigm."There is, to be quite clear, very little real justification for those statements. Both, in my view, have failed us, in that the free-market paradigm does not work--without substantial state processes and institutions that impose restrictions on free markets--such as regulatory agencies looking out for consumers, anti-trust enforcement preventing singular companies from growing so large that they can have a systemic effect on the system--we will have skullduggery llike the Madoff ponzi scheme and market control such as that exerted by the several large banks who have essentially set anti-consumer/pro-rent policies in lockstep over the last few years, while engaging in speculative behavior and abetting tax avoidance in many cases like UBS's that are bad for the system and bad for ordinary Americans but good for greedy bankers.
What does the lead-in admit to, then (if it still thinks economic and free market theory are worth defending)? It acknowledgs that the discipline is subject to three critiques:
1) it helped cause the current economic crisisIn my book, that doesn't leave much out. A theory that actively causes harm, can't prevent it, and can't cure it is not much of a theory.2) It failed to see it coming
3) It doesn't know how to fix it.
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This must be the period of soul searching, with the Economist engaging upon multi-article exegeses on where mainstream macro went wrong [1], [2], [3]. Alternatively, I think this is a happy time for some economists outside the (perceived) mainstream, who can now chortle "I told you so". One recent example is by Mario Rizzo.
The objective facts are far easier to handle in the models than the shifting, subjective expectations of people trying to deal with radically uncertain futures. This is what may get reflected in financial markets. Attempting to understand all of this requires conceding that some knowledge will be imprecise and will lie outside of the box (model). The model is simply a toy that can be thrown out when it no longer suits. This means that it is indeed possible to have valuable knowledge outside of hyper-models (although, of course, all thinking proceeds in terms of assumptions and simplifications).
But this will give the "scientists" among us headaches. As John Maynard Keynes famously said about the econometrician Jan Tinbergen, "[H]e is much more interested in getting on with the job than in spending time in deciding whether the job is worth getting on with."
As long as this is the dominant attitude, macroeconomics will remain "other-wordly." Instead, the way to greater realism is through more attention to the methodology of science and to whether "the job is worth getting on with." Paradoxically, greater philosophical sophistication would put economists is closer touch with the real world. (Or so I hope.)
Lean, mean DSGE machines?
Reading the recent characterizations of Ph.D. education in our top departments, one would conclude that all one ever learned in a program is how to write out and calibrate dynamic stochastic general equilibrium (DSGE) models, or for the older among us, calibrate a real business cycle model. I have to say that this all seems a little like an all too convenient caricature (and, as I have said repeatedly in the past, these types of models have led to important insights for issues besides crises [4]).
I won't deny that in the past 20 years, I haven't seen more than a few models that struck me as pretty irrelevant for analysis of real world issues. But I think that some mathematical training, and the use of models, is essential to economic analysis. After all, one can think of completely irrelevant frameworks for looking at the world even without a model, just as one can with a model.
Furthermore, perhaps my experience in a Ph.D. program is atypical but I don't remember being forced into a particular mode of analysis in writing my dissertation (University of California, Berkeley, 1985-1991). In macro/international/econometrics, my teachers included Roger Craine, George Akerlof, Jeffrey Frankel, Andy Rose, and Richard Meese. We studied Euler equations as well as the market for lemons. We knew what Arrow-Debreu markets were, but we also learned about the Great Depression (from Bernanke's paper as well as Friedman and Schwartz). The time series econometrics taught did not presuppose optimizing behavior. We even studied models with sticky prices (gasp!). Doesn't sound too doctrinaire to me.
So what was a common theme in the curriculum? For me, the defining feature in thinking about what model to use was whether the analysis answered the question posed, and whether the question posed was of interest. Now, whenever I read a dissertation prospectus, the key question I ask the student is: "What is the question being asked?", not "What is the methodology?" (Admittedly, the subdisciplines have different "characters", as alluded to by Paul Krugman; my focus was open economy macroeconomics, rather than macroeconomics/monetary economics.).
How monolithic?
I wonder if indeed the macroeconomic mainstream is as monolithic as conveyed by various observers. For instance, one certainly perceives a certain homogeneity amongst Ph.D.'s trained at certain universities. And there's a certain similarity in the mode of analysis preferred by economists in financial firms. Since the financial press tends to focus on Wall Street economists, one gets a misleading impression regarding the degree of uniformity of views.
To make this more concrete, let's consider whether academic economists differ in their views regarding the economy, as compared to those in the financial sector. I have some indirect evidence, pulled from Dilbert's survey of economists in the American Economics Association (see also [5]). Scott Adams, with the assistance of Joshua Libresco of the OSR Group, was kind enough to have the stats pulled. Last summer, academic economists believed that a President Obama administration would promise more progress on the economy than a McCain administration, by a 2 to 1 margin (n=314); in contrast financial sector economists were equally split. The sample in the latter case is quite small (n=29) (I dropped the undecided/no difference responses). Nonetheless, a difference in means test (recalling the variance of a binomial is (1/4)/n) rejects the null hypothesis of equality at 6%, using a two tailed test.
(As an aside, this finding further suggests that when the WSJ says most economist oppose a second stimulus, that probably characterizes Wall Street economists better than all AEA economists. Even for Wall Street economists, it's interesting to note that a majority of economists feel the stimulus package has already improved economics prospects, and will have a bigger impact in subsequent months. Hence, opposition to a second stimulus among WSJ-surveyed economists is not necessarily rooted in skepticism about the aggregate demand enhancing effect of the ARRA. (One would need a cross-tabulation of responses to verify that assertion.))
Concluding thoughts
If my conjecture is correct, then the supposed failure of macroeconomics is more the failure of macroeconomics as described in the popular press, rather than of the discipline itself (after all, Joseph Stiglitz is as much of the economics discipline, if not more, than Eugene Fama.) My conclusion: Not quite time to jettison the apparatus of modern macroeconomics.
For a less personal perspective, see Brad Delong and Paul Krugman, as well as my April post on "macroeconomic schisms".
Update 9am 7/21: See also Mark Thoma's observations.
Posted by Menzie Chinn at July 20, 2009 03:43 PM
digg this | redditWhy is no one interested in how India had a conservative Macro and Bank policy and avoided all of the problems. Perhaps Mr. Reddy is the macro economist with the results to show for his good ideas...
Posted by: Keating Willcox at July 20, 2009 04:17 PM
I had a good laugh when I heard that AER has offered authors with papers scheduled for publication the chance to withdraw them if they predict a strong economy -- and no one accepted. Getting published is more important than getting it right.The macro profession failed to see the crisis coming, and I think it's because modern macro is indeed an apparatus, a body of techniques that's first of all for tackling academic puzzles and publishing, rather than a body of theory that deals with the behavior of real humans in any important way. Summers' "The Scientific Illusion in Modern Macro" deserves a re-reading.
Posted by: Charles N. Steele at July 20, 2009 04:29 PM
Menzie,I trust that you don't have the time one your hands to do this, but a truly rigorous analysis of the effectiveness of your peers would be as follows:
-Identify the number of papers that would have been useful in predicting the bubble bursting.
-Divide those by the total number of papers produced.
-Compare that fraction to the number of papers that would have MISLED someone to not predict the bubble bursting, divided by the number of total papers.
That comparison will give you a more accurate picture of how the economics profession handles itself.
Posted by: David Pearson at July 20, 2009 05:26 PM
That's a thoughtful piece.I think macroeconomics is fine. The problem, I think, is more with macroeconomists. These concerns run along two lines.
The first is the 'peacetime military' syndrome. We hadn't had a really bad recession in such a long time, the skills went rusty, both on an individual and institutional level; indeed, I think we really didn't know how to think about the issue. I, for example, was running strategy for a small investment bank at the time, and I didn't think to sit down and calculate the oil price which would dump the economy into recession. It's not really a big deal, and having lived through both oil crises, I was certainly aware that oil could be a problem. But I didn't think to do the actual calculation. (I have since.) The failure was not analytical, it was one of mindset. And I don't think I was alone in this.
The second issue is one of character, and in particular, risk assumption. For example, the Econobrower recession index is at 99.5% when an economist on Bloomberg today called the trough for Q2. I also think the trough was Q2. Jim has defended the index as based on historical data. Fair enough. The index, on that basis, is accurate. But is it right, and it is useful? Probably not, if your orientation is forward-looking. But it comes down to an appetite for risk. Do you want to be defensible or do you want to be actionable? Is an economist a historian or a sentinel?
If there was a failure of the profession, it was that too few economists thought of themselves as sentinels at a time of impending crisis.
So, to my way of thinking, the issue is not one of analytics, it is one of mission. The objective function itself, and not just its optimization, is worthy of consideration.
Posted by: Steve Kopits at July 20, 2009 07:35 PM
Relax...economists are professional scapegoats.The profession exists to provide behavioral excuses on the way up, and cover on the way down. If any one of you could predict economic movement EVEN ONE DAY ahead, you could place bets, make a fortune, and retire.
So relax...it's time to earn your pay...that's all.
Baaah.
Posted by: KnotRP at July 20, 2009 07:38 PM
Sorry to be less than polite: I think most economists are epistemologically / methodologically very naive and unprepared. How many PhD courses have Kuhn as required reading?My take on things is that what you are looking for is ***explanations***. Models are a tool for checking that the mechanics that underpin the explanation function properly.
But all the incentives in the profession are skewed towards modelling. (When was the last time you saw a paper with ideas and no equations? the last one I recall is "Exogeneity" by Hendry, circa 1982...)
Posted by: JJ Saenz at July 20, 2009 08:01 PM
David Pearson: I think your exercise is ill conceived; shouldn't I be interested in growth, or productivity, or trade balances, even when crises occur occasionally? An analogy would be -- should I divide the number of papers that deal with diabetes by all the papers in the medical literature to assess whether doctors are studying the right things?
Steve Kopits: I think economics, as a social science, has multiple missions, only one of which is to be a "sentinel", as you put it. A related point is that most of economics is not focused on prediction/forecasting, even though a reader of the financial press might think that is the case.
KnotRP: You are mis-apprehending the goal of economics; it's not to make money (we leave that to business schools). The main objective of economics to understand how scarce resources are allocated.
JJ Saenz: You set up a false dichotomy. To me, if you have a framework that's internally consistent, even without equations, that's modeling. Equating models with equations is, dare I say it, naive. By the way, one doesn't have to read the entire Kuhn book to understand the author's thesis (unless one is dense).
Posted by: Menzie Chinn at July 20, 2009 08:24 PM
Your analogy is telling: diabetes is a major killer, and the bursting bubble has resulted in the biggest recession since the Great Depression. Surely it is relevant to find out whether doctors/economists focused on predicting or preventing both conditions.Also, major economists, including those resident at the Fed, analyzed the appropriateness of housing prices based on elevated terminal growth rates in an NPV calculation. This was an elementary error -- assume house prices rise forever more, and high house price valuations are justified. Then there were spurious analyzes showing that rising subprime delinquencies were not a risk because regressions showed that they were driven by unemployment, which of course was low. Then there were the number of economists that insisted that the banking system was better able to withstand credit cycles as they were so well-capitalized and geographically diversified.
You see, I could go and on. I know because I was actively betting on a housing collapse and wider, global, credit contagion from the summer of 2005 on. In my research I explored what economists -- academic, think tank, wall street -- had to say, to help me reach conclusions on the situation. I have to say that almost every piece of research I came across made me want to abandon my investment posture. In other words, I succeeded by ignoring economists. That, at least, I know to be a fact.
Posted by: David Pearson at July 20, 2009 08:55 PM
I recommend this article.It is titled "No-one saw this coming?" Balderdash!
http://www.debtdeflation.com/blogs/2009/07/15/no-one-saw-this-coming-balderdash/
Posted by: Get Rid of the Fed at July 20, 2009 09:01 PM
My problem with modern macroeconomics as I understand it is that there is no involuntary unemployment in the models. What can these models say to explain 4.4 million individuals unemployed for 27+ weeks.Posted by: malcolm at July 20, 2009 09:49 PM
The fact many economic time series display turbulent characteristics gives a good answer to the problems of scientists trying to predict the economic future.Turbulence is characterized by fat tail (non-gausian, broader than gausian) distributions (of e.g log returns on stock prices) in small time scales (relative to some driving information/energy input) process time scale) that include large deviations from average as a MUST.
To me the problem of predictive force of economic science seems to be that turbulence is by definition interaction of rational and irrational (observational, fad like) driving forces , and none of these is possible to eliminate without eliminating the markets themselves.
The current fast upswing in stock prices will most likely illustrate the force of observation over the force of econometrics- as it already happened after Lehmans collapse, just in opposite direction.
What economists are afraid of, is to recognize clearly that their short term predictive abilities are as bad as those of physicists trying to predict exact values of turbulent motion in small time scales because of the nature of the subject. Its impossible to separate it from the irrational subjects, Lagrangian particles having their own destiny but observing others and reacting.
But they should not be afraid since it is exactly such processes that will always require soothsayers.
Posted by: Ivars at July 20, 2009 11:16 PM
KnotRP: You are mis-apprehending the goal of economics; it's not to make money (we leave that to business schools). The main objective of economics to understand how scarce resources are allocated.To the first response -- yes, you leave the money making to business schools...and the business execs use economists in the way I described.
To the second response....misallocation cannot be identified before it's happened and misallocation is not typically reversible, so what's left to understand, and why is it useful when there is no means to apply the understanding?
This sounds more like self-entertainment than a profession, and I expect it'd pay at that rate if business execs didn't need a scapegoat handy.
Posted by: KnotRP at July 21, 2009 12:52 AM
Accept that any form of economics, with or without numbers, is a junior branch of history and this little difficulty disappears. As historians, the fact that economists en masse have near zero forecasting ability doesn't matter.No one expects historians to predict what will happen next year. But historical insights are of great value in understanding future possibilities. And some individual historian may hit the jackpot with a specific forecast. Picking which historian will be right ex ante is a little tricky, of course.
Posted by: c thomson at July 21, 2009 04:34 AM
Why are Economists beating themslves up over a banking crisis? After all, the bankers fired those economists that pointed out the risks, and promoted geeks with no common sense to tell them how clever they were, or better still, geeks whose maths they didnt understand but which made their strategies sound very clever indeed.Only for the geeks to find out that when one billion rush for the exit door it isnt big enough.
KnotRP - I wish it were true; in my experience a winning run merely scares ones bosses and leads to professional isolation.
Posted by: william simpson at July 21, 2009 05:42 AM
Real sciences are about humility and probity one may fake his results but his assumptions.As regards economics, what best representation of an organised social amnesia (unable or unwilling to draw lessons from the past) than this document?
http://www.nber.org/chapters/c2313.pdf
The economists temptations to bypass reality is reflected in the affirmed social definition of the NBER a non profit membership corporation for impartial studies.....
National Bureau of Economic Research BULLETIN 50 APRIL 18, 1934 A NON.PROFIT MEMBERSHiP CORPORATION FOR IMPARTIAL STUDiES IN ECONOMIC AND SOCIAL sciences
Do not despair it will happen again and again!
Posted by: PPCM at July 21, 2009 05:56 AM
David Pearson, I like the medical analogy... People die every day from diabetes, but we do not call it failure of modern medicine.Menzie, in answering your question, you focus too much on your peers... PhD economists. While it is people with no more than an undergraduate degree that make most of the decisions... to buy or sell some AAA CDO for their firm's pension fund...
Perhaps it is a failure of economics and financial education... I think Shiller feels this way.
Posted by: MikeR at July 21, 2009 07:43 AM
David Pearson,To take your "rigorous analysis" a little further it would be instructive to take papers submitted per discipline compared to those submitted by discipline that actually predicted the crash. Then discard those who have a low score and study those who have a high score.
How did Austrian economists rate against Keynesian economists, or how did monetarist economists rate against communist economists?
Posted by: DickF at July 21, 2009 08:14 AM
DickF: In conducting your proposed experiment, one would want to also tabulate "false positives", as well as true positives. Put in plain English (since I know you dislike the language of statistics), "even a broken clock is right twice a day..."
malcolm: I suspect your reading of modern macroeconomics is a little too circumscribed if you think all models assume zero involuntary unemployment.
Ivars: Most macroeconomists I know are aware of the limited ability to forecast. So I think we acknowledge the fact that you assert we're afraid of. Those who work on asset prices are typically even more humble about the ability to predict than others. On the other hand, there is a group of economists that are paid to forecast; they of course do not have an incentive to publicize the fact that some variables are hard to predict, but I suspect they are cognizant of the difficulties.
MikeR: I accept that your point may explain in part why the system behaved the way it did. But I wanted to focus on the argument that Ph.D. economists were so narrow in their training that they all failed to predict a crisis.
Posted by: Menzie Chinn at July 21, 2009 08:39 AM
As I understand it, the goal of (many) modern macroeconomic studies is to write down an internally consistent framework that is simultaneously compatible with balanced growth facts over the long run (stable ratios of C/Y and K/Y and trendless hours worked per-capita) and yet also compatible with the business cycle facts (C, I, hours pro-cyclical, with C less volatile than Y, I more volatile than Y, and hours as volatile as Y).It took a while for the profession to figure this out, but now most macroeconomics has this as a goal. Including macroeconomics at Princeton (Pat Kehoe)! Read the debate -- can't remember where published, but around 1985 -- between Ed Prescott and Larry Summers. It's very enlightening.
What makes this study difficult is that whatever mechanisms cause occasionally big fluctuations to macro variables in the short run have to basically wash out over the long run. This puts many restrictions on preferences, i.e. how people trade off utility from consumption or leisure today with utility from consumption and leisure in the future.
I'm sympathetic to the idea that our models are missing some key ingredient that would have been helpful in thinking through this current episode. It could be that all major recessions etc start out with a banking panic (Finn Kydland's Nobel speech I believe made mention of the fact that he thought some "technology shocks" were reduced form for banking panics). Fine. Then let's figure out an internally consistent way of including banking panics in our growth models. But then we need to test these models: They must deliver balanced growth in the long run, cycles in the short run.
I gets calls from journalists all the time that have no formal training in economics or finance. I have no sympathy, then, for journalists telling me that what I call macroeconomics is a waste of time. I suspect this sort of thing is why most newspapers are going broke: The market is speaking loudly.
Morris A. Davis
Wisconsin School of Business
Department of Real Estate and Urban Land Economics
Posted by: Morris Davis at July 21, 2009 08:50 AM
Humility is always a good lesson to learn, in or out of academia. At least some of those who needed to learn it, did.But the Economist's summary of two main debates, on efficient markets vs animal spirits, and Keynesians vs "purists", left me disappointed. On the former, is it so hard to see how bubbles are made by rationally selfish behavior? On the latter, isn't it clear that now, as in the late 70s, the US is faced with the ugly necessity of needing to adjust real wages downward, and is going through a phase in which it tries to politically engineer some escape from that necessity, which only drags out the process and delays recovery?
Posted by: Tom at July 21, 2009 09:12 AM
Professor, this train wreck was very easy to foresee, and required nothing more than simple tablulation of household debt to GDP over '22-'29-'33-'39 and comparing it to '81-today.Some economists did that simple tabulation, but not many.
As an outsider looking in and a reader of a range of economists' views daily, my sense is that economists have little appreciation for pre WWII history and statistics and have little appreciation for anything but Keynesian and Monetarist-Keynesian mechanics and models.
I came to appreciate the utility of complex mathematical tools in my U. of C. coursework, but have come to the conclusion that big simple concepts -- e.g., household debt to GDP -- appear to be the real driver of things.
So, like David P., I have an all-in bet that this mess lasts years, until household debt to GDP comes back in line with historical norms.
So far, I've been proven right, and relish that I have bested Ben 'This is contained to subprime' Bernanke, posterchild for the Monetarist-Keynesians.
Professor, I'll be forward, and recommend that you expand your horizons; I recommend Rothbard's 'America's Great Depression.' Fascinating, and frighteningly prescient. It will be a quick, easy read for you.
Posted by: jg at July 21, 2009 10:05 AM
Who cares what journalists think. Consider a majority community of investors, business owners, consumers, and financial professionals wondering what kind of bizarre metaphysical language macroeconomists are using to describe phenomena that has been predefined by convention and free revelation for decades, if not centuries.Nobody is against measuring things. The trouble is with the macroeconomists' voluntary selection of variables and constructs that are, as it turns out, wildly deconfigured from the conventions ("facts") they propose to measure.
The notion that an entire generation of firy-nostriled pit traders and clueless MBAs have spent the last couple decades urinating in the profession's general direction tends to say more about macro than it does the subject they claim to study. The market is speaking loudly indeed. And macroeconomists continue to ignore it, ruminating on "internally consistent frameworks" as though anyone in the business community hasn't already provided the framework thousands of thousands of times over, publicly and privately.
Macroeconomics is a sunk cost dilemma of wondrous proportions. The investment we cannot bear to cut loose is a grotesque cesspool of taxonomy that insures against its own improvement by innovation. Seasoned businessmen are forced to keep their economists locked out of any conspicuous decision making for sake of shame, while the nation's most promising young talent has its finances held hostage and its noses pressed incessantly into canonized literature, for years upon years of esoteric indoctrination. At some point the only thing macroeconomics will have to do with business and human behavior is its effective identity with the infested upper ranks of too-big-too-fail corporations. Constantly identifying problems and answering them by restating the questions. This farce of a self-critique has been going on for decades. When will it stop. Too many brilliant minds have been lured into this ridiculous sham of a "science," with its analogies to medicine and technology. The pride is appalling. The defiance is incredible. It is like watching heroine addicts rationalize their behavior. WOW!
Posted by: Hephaestus at July 21, 2009 10:17 AM
Menzie,So let me make sure I understand you plain language. You are saying that those who have a bad track record concerning the current crisis are worse than stopped clocks? Doesn't that mean that their analysis is actually destructive, I mean a stopped clock is right twice a day yet they are not even right once?
Enough of the cuteness. If you understand classical economics you know exactly why we had a crisis. Following Paul Krugman's advice too much money was pumped into the system. Following Barnie Frank's advice this excess liquidity was diverted to create the real estate and credit crisis.
Classical economists saw it coming. Demand siders are still stealing savings so the government can substitute for "consummers."
Posted by: DickF at July 21, 2009 12:10 PM
"I won't deny that in the past 20 years, I haven't seen more than a few models that struck me as pretty irrelevant for analysis of real world issues. But I think that some mathematical training, and the use of models, is essential to economic analysis. After all, one can think of completely irrelevant frameworks for looking at the world even without a model, just as one can with a model."Can you be more specific about this? By that I mean just what insight about the real world can mathematical modeling really create . Saying that nonsense unrelated to that can be found is nowhere near being good enough. Just because interpretations of literary works have been misleading without mathematical modeling of literary works, sure doesn't prove that mathematical modeling really would be helpful in analyzing literary works. You have to provide positive examples.
Posted by: Stefan Karlsson at July 21, 2009 02:28 PM
The Chairman of the Federal Reserve Board is much more influential in directing and creating conventional wisdom about the trajectory of the U.S. economy than all the other micoreconomist combined. The question is not why did microeconomists not see this coming; the question is why Alan Greenspan and Ben Bernanke did not see this coming? They are the people supposed to guide the economy - or at least, explain to us what is happening and why they are not intervening.Ben Bernanke's major contribution to conventional wisdom which misread the warning signs was his 2005 speech on "Global Savings Glut". In it he cleverly deflected attention from the growth in global liquidity by labelling it something else and he transferred responsibility for the U.S. trade deficit to our trading partners. Very clever. Just what Bush wanted to believe. I think that speech helped elevate him to head of the FRB.
Misleading suggestions from Bernanke was only a part of the problem. Long before either Barnanke or Bush came on the scene, Bill Clinton signed into law one of the worse bills ever passed by the Congress, the Commodities Futures Modernization Act of 2000. It assured participants in the shadow banking system that the U.S. courts would enforce the contracts they signed such as credit default swaps, combined with a prohibition of the Federal Government being able to require participants in the shadow banking system to provide information about what they were doing.
We did not know the extent and complexity of the contracts in the shadow banking system, therefore, economists and the rest of us were preventing, by lack of information, from connecting the dots that led to the collapse of the U.S. private financial system.
Don't blame economists for not knowing what they were prevented from knowing. Blame the people who pushed the 2000 Act through the Congress. And blame Alan Greenspan and Ben Bernanke for providing a false picture of what is going on in the U.S. economy.
Posted by: ReformerRay at July 21, 2009 02:30 PM
Keynesians are classical economists where it counts. Amazing how obsessed with monetary politics the anti-monetarists are. Stare too long into the eyes of a monster...If it is not clear by now that money was and is endogenous to the system, then economics as we once knew and loathed it is truly finished. There are no prizes for second place rallies by the heterodox schools whose claims to safety outside the herd is belied by their history. It is like watching a dysfunctional family of heroin addicts deny relation to one another, in some kind of bizarre reputational prisoner's dilemma. Austrian notions of some deistic interest rate providing the essential morality tale for mortal men of enterprise make about as much sense as anything the Keynesians have put forth to accommodate perceived crises. Pitting supply against demand in some kind of battle for moral priority makes about as much sense as politics and little more.
Keep obsessing about bank debt and the Fed as though there were some kind of prestige in it, as though it is not clear by now that the free market doesn't have hundreds if not thousands of other types of money and credit and leverage at its disposal to extend, exchange, and eventually withhold, to and from humanity. Each has its own limit in terms of enforceability, fraud, and title. What further ancient, banal concepts can we avoid admitting are still the foundation of our discourse by constructing even more byzantine networks of mathematical scaffolding and pop-logical festoonery? What obsolescence for the "Economists" will be assured as soundly as the Ephors or the Scholastics now find for themselves, as Paul Krugman, Ben Bernanke, and a hundred other angels of metaphysics dance on the head of a pin.
This is nothing more than pride and laziness masqueraded as mystery, to continue these attitudes of detached superiority, a la "we don't care about profit, we seek to explain allocation of resources" and such, in a system that is so obviously designed to carried out the same -- every day right in front of everyone's face -- via the profit motive, income, and marginal returns on credit. We cannot quit because we have to satisfy our advisors and pay our loans...Unbelieveable crypto-nihilist soap opera! lol
Posted by: Hephaestus at July 21, 2009 02:46 PM
Menzie: with regard to "methodology", I still believe the profession is underdeveloped. When I was starting my postgraduate studies in Economics I was research assistant in a neurobiology lab and the level of "methodological" reflection present there made me feel a bit embarrased by the innocent use of the word "rational" and all the other points where Economics seems to have a blind spot the size of an elephant. Anyway, things have been improving a lot lately on that front so maybe I shouldn't complain too much...MikeR: good point... possibly a lot of problems arise from some people making decisions based on an "Introductory Microeconomics" worldview...
Posted by: JJ Saenz at July 21, 2009 02:46 PM
Menzie,Your message to DickF above is disingenuous. Very, very few economists even fit the "stopped clock" criteria. That is, not many were right even "twice a day". Presumably you are thinking of the Austrians, or just some Austrians, but again, they are a tiny proportion of economists.
The reality is that doctors shouldn't be judged on whether they all spend all their time reseraching diabetes (MikeR), but whether they, collectively, spent SOME time researching it, and whether in that time they make sloppy conclusions from inadequate models with too-small data sets.
My direct criticism of economists is that they did not catch the simplest errors in their analysis.
Too-small data sets (delinquencies since 1994)? Everywhere you look.
Making huge going-in assumptions about key variables that define the model output (such as "house prices never fall")? Again, guilty.
Ignoring feedback loops ("subprime is only $150b -- a drop in the bucket!")? You know it.
There are many more examples. I think the problem was over-reliance on econometric models, and blinders for everything that didn't fit in those models.
Posted by: David Pearson at July 21, 2009 03:40 PM
In Wonderland the less connection between marvelous theories and drab reality the better.Posted by: politbureau at July 21, 2009 04:53 PM
I think the whole Keynes-ian macro 'invisible hand' ideas bespeak a great deal more about the difficulty of trying to pidgeon-hole anything 'macro' distilled down to 'macro-variables'.Maybe if the models went deeper, even macro models, we might see more semblance of a match to reality.
Adele
Posted by: Adele at July 21, 2009 06:30 PM
The Economists magazine has no interest in the role that excess liquidity or cheap money played in encouraging risk taking. Could that be because the excess of imports to exports in the U.S. created an overly large supply of dollars owned by U.S. trading partners?Posted by: ReformerRay at July 21, 2009 06:58 PM
Of course macroeconomics has failed. Any form of economics that attempts to largely ignore the real world while claiming to be dealing with it will fail. I read the entire three part Economist article. Look at it and ask how often it mentioned the need of people to make a living. The economists parallel Wall Street in how very little effort they put forth in understanding Main Street. How much attention is really paid to the destruction wreaked on real human beings by this disaster? Not much. Consider this possibility. GDP should no longer be considered the measure that determines where in a recession, depression or recovery we are. The purpose of an economy is to provide the ability to make a living to the people of a society/nation. This is in reality its only purpose. Everything else is gravy. Do any of the economic theorists who have screwed up so badly for so long really keep their eye on this ball? No, they do not. This is why they deserve to be beaten about the head for their failure.Posted by: Jim S at July 21, 2009 07:28 PM
Macroeconomics is not on trial so much in the Economist blog as is its prevailing paradigm, the rational expectations hypothesis (REH), which has been enthusiastically embraced by salt water as well as fresh water economists, not just by RBC theorists. The REH may or may not be per se inconsistent with the existence of a bubble. But, it is completely inconsistent with the notion that the bubble's bursting was unexpected--the widespread idea that "no one saw it coming".North American macroeconomics more generally, not just the REH paradigm, is now on trial for having swept under the rug with the rubric of "The Great Moderation" some very inconvenient, presaging events, such as the panic and near financial collapse from the demise of the single hedge fund LTCM and the Lost Decade in Japan after its famously exhuberant real estate market fell flat. These were studied but their broader implications seem not to been incorporated into the conventional wisdom. No doubt the same will prove true of the 2008-2009 financial crisis and its economic aftermath. It too will become, like the Great Depression, a single, isolated exceptional macroeconomic event with no implications for the present.
Posted by: d4winds at July 22, 2009 03:21 AM
I vote for a combination of the viewpoints of The Economist (there needs to be a fusion between financial and macro economics), and ReformerRay (eliminate secret proprietary transactions from financial markets).From my perspective, most Americans are scandelously ignorant of how finance, contracts, and banking works. This makes them easy prey for the loan-sharks of the mortgage, credit-card, and installment-purchase industries. It starts by not requiring basic finance & business eduction in the core curriculum of high schools in America; and ends in doctorate degrees conferred on researchers with little practical knowledge of how large-scale capital markets and finance work.
We're all marks for the banksters if we don't wise-up, get educated, and take control of our lives.
Posted by: MarkS at July 22, 2009 08:28 AM
Count me among those who side with the Economist, rather than the economists.Macroeconomics journals are full of very elaborate and sophisticated mathematical models that simply are not justified by the quality of their underlying data. They are like physicists trying to do precision quantum physics with 19th century lab equipment. There's nothing wrong with the math, but its irrelevant. More generally, macroeconomists are fundamentally operating like physicists or physical chemists, trying to develop mathematical models of the economy, when they should be acting more like biologists or geologists or palentologists, developing and expanding descriptive data sets that help show what is actually going on.
When economists aren't making models, as often as not, it seems, they are doing sterile game theory type experiments with college students involving poker night class stakes, when they should be doing ethnographies, to see what the players at the fulcrum of the economy are really doing.
There are exceptions, but the basic research plan of the discipline is wrong. I personally considered pursuing an economics PhD at three different times over the past decade and a half, once going so far as to send GREs that would have been good enough to get in to multiple programs. But, ultimately, I decided that the core curriculum that I would have to endure before doing my own research in the discipline was too far out of touch with the real world to be worth considering.
The microeconomic program of the discipline has been very successful in a wide variety of areas and has also had great impact on my profession, business and property law. But, the staff journalists at publications like the Wall Street Journal and the Economist, who don't have PhDs (and often don't even have graduate degrees), are publishing much better work on macroeconomic questions than the PhDs; not just more accessible work, but work that is on the merits more accurate, more insightful and more evidence based.
Widespread acceptance of mainstream, widely accepted academic macroeconomic theories in areas like the efficient market hypothesis and option pricing theory, by regulators, outsourced consultants for credit reporting agencies (and the credit reporting agency managers who accepted their reports) and Wall Street derivatives professionals (the nerds of New York) is indeed a big part of what led the markets to get things so horribly wrong on such a widespread basis prior to the financial crisis.
Yes, academic economists look at the Great Depression. This is an 80 year time horizon. But, how many seriously examine the panics that took place around the globe in the century or two before then. Everybody knows about the tulip bubble, but academics often don't know much more. The people who have a more balanced and proportionate view on the macroeconomy's potential fluxuations and characteristic failings of the market are not the macroeconomists, but the economic historians who a reading dusty newspaper articles, memoirs, household ledgers and archived business records.
Notably, both Adam Smith and Karl Marx built their own powerfully influential theories not on mathematical detail, but on the synthesis of vast amounts of raw descriptive data and historical examples of the phenomena they sought to describe.
Posted by: ohwilleke at July 22, 2009 09:20 AM
I am in general sympathy with much of what appeared in the articles in The Economist, although not everything. However, the points that current DSGE models do not adequately account for behavioral effects, heterogeneity of agents, along with an ability to model endogenous bubbles of the Minsky type, strike me as very pertinent (and, Menzie, you were rather lucky to have that early behavioral macroeconomist, George Akerlof, among your profs at Berkeley). I think the assumptions of rational expectations and homogeneous agents are going to be very hard to fit with these issues, whereas the supposedly non-orthodox sticky wages and prices can be easily put into the DSGE context by allowing for information costs. Will assuming these, along with learning, save the day for the supposedly new DSGE models?I saw this argument fought out last week at the 15th SCE conference on Computing in Economics and Finance in Sydney, Australia. There were representatives of some of the heterodox views, wtih Australia's "Dr. Doom," Steve Keen, pushing Minskyian positions (which he has been providing mathematical models of for some time), and plenary speaker, Cars Hommes of the University of Amsterdam, advocating a combination of behavioral and agent-based modeling. America's "Dr. Bounceback," Jim Morley was there also, talking a lot about Jim Hamilton's work, but being a bit more cautious as he averaged in an AR(2) model in wiht his "bouncier" model.
However, what struck me was the large number of people at this conference who came from central banks all over the world. To a person, they were fans of DSGE models. I had it reconfirmed that this is the only approach being used in the basement of the Board of Governors of the Fed. Albert Marcet was a plenary speaker also, and these folks were eating his stuff up. So, I got told that all the DSGE models need is to "include some learning" and all will be well. I beg to differ.
Posted by: Barkley Rosser at July 22, 2009 09:32 AM
Oh, let me add regarding Mario Rizzo, that he is indeed a leading Austrian economist. He makes some good points in the quoted piece, but he also ultimately rejects the use of mathematical modeling. I think he is barking up the wrong tree on that one, although a greater degree of "philosophical sophistication" would not hurt one bit right now.Posted by: Barkley Rosser at July 22, 2009 09:34 AM
"academic economists believed that a President Obama administration would promise more progress on the economy than a McCain administration"'promise more progress'? You can promise the moon on a stick but it's meaningless. And what is "progress"? Higher growth? A more uniform income distribution? Etc.
Posted by: J at July 22, 2009 09:42 AM
According to Blanchard, even the New Keynesian Calvo pricing based models have no involuntary unemployment. They may have employment fluctuations but they are not involuntary.Posted by: malcolm at July 22, 2009 10:22 AM
j: If you'd bother'd following the links provided, you'd find the question here.
malcolm: Yes, Blanchard is (of course) absolutely right -- in all the DSGE's I'm aware of, there's no involuntary unemployment ex ante. But it doesn't mean that all models (of which DSGEs are a subset) have price-clearing. Shapiro-Stiglitz's shirking model is one with unemployment that can't be cleared by price adjustment.
Barkley Rosser: Yes, I count myself lucky to have Akerlof as a teacher. But other Berkeley faculty did not adhere slavishly to rational expectations. Jeff Frankel had an early paper of chartists and fundamentalists interacting to explain long swings in exchange rates.
On a separate note, you must be talking to a different set of people than I am. I don't believe the only model they're running in the "basement of the Fed" is a DSGE (and there are many different variants of DSGEs). For better or for worse, they're still running the older style macroeconometric models. The same is true, to my knowledge, at the other international policy institutions and the central banks; that is they appeal to a multiplicity of models. If you want to say that most of the resources devoted to model development are focused on DSGEs, there I'd agree.
ohwilleke: Sure, I'll grant you Marx had some important insights. But do you really believe in the labor theory of value (which does involve some math)? Oh, and better tell Peter Garber he doesn't know anything else besides tulips...
Posted by: Menzie Chinn at July 22, 2009 11:34 AM
Menzie,I am sure you are right that some of the older style macroeconometric models are still being run, but they are certainly not the focus of the research efforts, as I guess you basically agree. Furthermore, I am not aware of most of those models dealing particularly well with the issues raised by the articles in The Economist, although perhaps some of them can be interpreted as doing so to some extent, at least implicitly.
Posted by: Barkley Rosser at July 22, 2009 12:12 PM
Agreeing with many points above, a personal summary:I LOVE maths and modelling, but the next true breakthrough will not come from improved DSGEs, from using cellular automata or any other modelling efforts. It will come from understanding the world better.
(Namely: i. devising a new set of distinctions ii. using them to create a new narrative iii. THEN making good models and all the rest)
Posted by: JJ Saenz at July 22, 2009 12:17 PM
That heterogeneity and homogeneity of agents are effectively identical is not just a DSGE problem. The inability to model endogenous bubbles is not just a DSGE problem. Rational expectations was not invented by modern macroeconomists, nor does its persistence as a market phenomena start or stop with DSGE.Charles Schwab is not going to be sued in 2009 because economists forgot to account for sticky prices. Home prices and balance sheets didn't plummet overnight because of someone's miscalculation of information costs.
Unemployment shocks don't happen because someone forgot to distinguish between voluntary and involuntary. Corporate bond prices haven't been deflated for nearly two years because of reserve balances kept behind the public money window.
It is quite likely that inputs and nodes of transformation through which modern business cycles flow have nothing at all to do with DSGE or anything even remotely commensurate in modern orthodoxy.
The news delivered from the SCE conference bodes ill for the American academy. It is clear that the models are so rife with universal qualifying assumptions, economists can't even trace which ones have been falsified. It is simply too painful to consider that the entire enterprise is a flexible Texas Sharpshooter Fallacy from the ground up. It will be simply bad manners to point out that the vast majority of agents in the real world may be utterly unaware of these strange assumptions and relationships assigned to them by these alien beings, "economists." It can be nothing but a dirty and filthy act of ill will to point out that, in fact, when agents occasionally become aware of these models, their sole utility is as levering instruments for highly gainful prevarication. Incredible.
Disclosure: I once had a summer job shuffling deck chairs on the Titanic. I also kept Samuel Untermeyer's water glass half full during the Pujo Committee investigations. I am a 136-year-old investment professional with $23 Trillion in puts on the modern macro industry.
Posted by: Hephaestus at July 22, 2009 12:43 PM
Menzie,I posted on a previous thread about potential output gap measuring methodology about a week ago.
Lo, and behold, the latest St. Louis Fed Review arrived at my mailbox the next day with a whole issue dedicated to potential output gap measurements.
I thought you might be interested (It's available free from the STL Fed's website): http://research.stlouisfed.org/publications/review/current/
Posted by: Lance at July 22, 2009 01:21 PM
Menzie,Of course you are right that Frankel was ahead of the curve on advocating use of chartist-fundamentalist type heterogeneous agent modeling for forex markets. This is now very much the workhorse for many of the agent-based modeling of financial markets, such as by Cars Hommes more generally and by Frank Westerhoff of forex markets more particularly, along with a bunch of other folks, some of whom were in Sydney.
I suspect the main recent use of those older macro models was to get dragged out to estimate impacts with multipliers of recent fiscal policies, given that most of the DSGE models (maybe there are some exceptions among the wide variety, which you would know better) simply assume away such multiplier effects, or have them very low.
And I would agree with Hephaestus that Calvo-style price-wage rigidity is not the source of what has been going on lately. Indeed, older Post Keynesian critics have argued that this aspect of the DSGE models is a joke, and only marginally Keynesian. Keynes did allow that such effects might occur and might cause problems, but emphasized that his more serious arguments held in a flexible price world, and quite a few PK economists have shown models backed up by empirical evidence that flexprice systems may actually be more macroeconomically unstable than fixprice ones, against the textbook and DSGE stories.
Posted by: Barkley Rosser at July 22, 2009 01:54 PM
lance: Yes, thanks, writing up a post on that right now... (actually, and on more).
Posted by: Menzie Chinn at July 22, 2009 02:59 PM
Menzie, it's a good thing that you limit your application of your statistics tools to the relatively inoccous areas of economics and politics, rather than say, medicine!
Your attempt to use the Dilbert survey to consider "whether academic economists differ in their views regarding the economy, as compared to those in the financial sector" fails miserably on the basis of design and interpretation: you are attributing a difference in choice of the two candidates solely to the economists' views regarding the economy, while there are many other factors it could be attributable to (e.g.: views regarding the candidates, or their policies, or even views on the candidates parties, etc.). And indeed, these alternate explanations are strongly suggested by the study report.
I have to comment that I also adore the subtle shift in connotation as well, from the Scott Adam's initial concept ("which candidate has the best plans for the economy"), to the survey's objectives ("understand which Presidential candidate...is believed...to be best for the economy overall, over the long term" and "which candidate is expected to make the most progress dealing with the issues that economists see as most important"), to your post's summary ("believed that a President Obama administration would promise more progress on the economy than a McCain administration"): a subtle but significant slide towards generalization which is unsupported by the study.
Of course, this to me illustrates a key problem germane to this exact discussion, the failure of macroeconomics (or is that macropolitics?)....
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Are the boards of major corporations, and the elite and powerful more generally, too interconnected to fail?:
Power elites after fifty years, by Daniel Little: When C. Wright Mills wrote The Power Elite in 1956, we lived in a simpler time. And yet, with a few important exceptions, the concentration of power that he described continues to seem familiar by today's standards. The central idea is that the United States democracy -- in spite of the reality of political parties, separation of powers, contested elections, and elected representation -- actually embodied a hidden system of power and influence that negated many of these democratic ideals. The first words of the book are evocative:
The powers of ordinary men are circumscribed by the everyday worlds in which they live, yet even in these rounds of job, family, and neighborhood they often seem driven by forces they can neither understand nor govern. 'Great changes' are beyond their control, but affect their conduct and outlook none the less. The very framework of modern society confines them to projects not their own, but from every side, such changes now press upon the men and women of the mass society, who accordingly feel that they are without purpose in an epoch in which they are without power.
And a page or two later, here is how he describes the "power elite":
The power elite is composed of men whose positions enable them to transcend the ordinary environments of ordinary men and women; they are in positions to make decisions having major consequences. Whether they do or do not make such decisions is less important than the fact that they do occupy such pivotal positions: their failure to act, their failure to make decisions, is itself an act that is often of greater consequence than the decisions they do make. For they are in command of the major hierarchies and organizations of modern society. They rule the big corporations. They run the machinery of the state and claim its prerogatives. They direct the military establishment. They occupy the strategic command posts of the social structure, in which are now centered the effective means of the power and the wealth and the celebrity which they enjoy.
Mills offers a sort of middle-level sociology of power in America. He believes that power in the America of the 1950s centers in the economic, political, and military domains -- corporations, the state, and the military are all organized around networks of influence at the top of which stands a relatively small number of extremely powerful people. (It seems that Mills's description of the military is less apt today; perhaps not surprising, given that Mills was writing in the middle of the Cold War.) Power is defined as the ability to achieve what one wants over the opposition of others; and the levers of power are the great institutions in society -- corporations, political institutions, and the military. And the thesis is that a relatively compact group of people exercise hegemony in each of these areas. Moreover, power leads often to wealth, in that power permits firms and individuals to gain access to society's wealth. So a power elite is often also an economic elite.
The central thrust of the book stands in sharp opposition to the fundamental assumption of then-current democratic theory: the idea that American democracy is a pluralist system of interest groups in which no single group is able to dominate all the others (Robert Dahl (1959), A Preface to Democratic Theory
). Against this pluralistic view, Mills postulates that members of mass society are dominated, more or less visibly, by a small group of powerful people in the elite. (See an earlier posting on power as influence for discussion of how power works.)
So what is Mills's theory, exactly? It is that there is a small subset of the American population that (1) possess a number of social characteristics in common (for example, elite university educations, membership in certain civic organizations); (2) are socially interconnected with each other through marriage, friendship, and business relationship; (3) occupy social positions that give them a durable ability to make a large number of the most momentous decisions for American society; (4) are largely insulated from effective oversight from democratic institutions (press, regulatory system, political constraint). They are an elite; they are a socially interconnected group; they possess durable power; and they are little constrained by open and democratic processes.
And, of course, there needs to be a theory about recruitment and the social mechanisms of steering given individuals into the elite group. Is it family background? Is it the accident of attendance at Yale? Is it a meritocracy through which talented young people eventually grasp the sinews of power through their own achievement in the organizations of power? We need to have an account of the social means of reproduction through which a set of power relations is preserved and reproduced throughout generational change.
What is interesting in rereading Mills's classic book today, is how scarce the empirical evidence is within the analysis. It is not really an empirical study at all, but rather a reflective essay on how this sociologist has been led to conceptualize American society, based on his long experience and study. The most empirical chapter is the section on chief executives of corporations; Mills provides an historical and quantitative narrative of the rise and consolidation of the corporation over the prior 75 years. But overall, there is quite a bit of descriptive assertion in the book; relatively little analysis of the social mechanisms that reproduce this social order; and very little by way of empirical validation of the analysis as a whole.
So how does it look today? To what extent is there a compact set of powerful people in contemporary America who have a disproportionate ability to bend the future to their interests and desires? One thing is strikingly clear: the concentration of wealth in America has increased significantly since 1956. Edward Wolff provides a summary graph for the percentage of wealth owned by the top 1% of wealth holders since 1920 in Top Heavy: The Increasing Inequality of Wealth in America and What Can Be Done About It
. In 1955 the top 1% held 30% of the nation's wealth; from 1970 to 1980 this percent declined to about 22%; and from the Reagan administration forward the percentage climbed past its previous highs to about 38% in 2000. So plainly there is an economic super-elite in the United States. This is a group that benefits from durable privileges and inequalities of access to wealth and income.
But this isn't exactly what Mills had in mind; he was interested in a power elite -- a fairly compact group of people who had the ability to make fundamental decisions in the three large areas of modern life that he highlights. And though he doesn't say very much about this point, he implies that it is an interconnected group -- through interlocking directorships in corporations, for example. So how can we assess the degree to which contemporary society in the United States is run through such a system? Is there a power elite today?
In one sense it is obvious what the answer is. Corporations continue to have enormous influence on our society -- banks, energy companies, pharmaceutical companies, food corporations. In fact, the collective power of corporations in modern societies is surely much greater than it was fifty years ago, through direct economic action and through their ability to influence laws and regulations. Their directors and CEOs do in fact constitute a small and interlocked portion of the population. And these leaders continue to have great ability to determine social outcomes through their "private" decisions about the conduct of the corporation. Moreover, as we have learned only too well in the past year, there is very little regulative oversight over their decisions and choices. So the existence of a "power elite" is almost a visible fact in today's world.
But to get more specific -- and to make more precise comparisons over time -- it seems that we need some way of identifying and quantifying the idea of a sociologically real "power elite." One way of trying to do that is by making use of the tools of social network analysis. For example, here is a network graph of corporate America compiled by kiwitobes. What the graph demonstrates is that the boards of America's largest corporations are populated with directors who overlap substantially across companies; there is a high degree of interconnectedness across the boards of directors of major corporations. So this bears out part of Mills's thesis in today's corporate social reality.
But even more compelling would be a study that doesn't exist yet -- a social network map that represents something like the whole population of a community, linking individuals to the institutions in which they occupy a position of power. The vast majority of the population would exist in single points at the bottom of the map; most people don't have a position of power at all. But, if Mills is right, there will be a small subset of people who are interconnected through many relationships to institutional sources of power: memberships in boards, offices in corporations, directorships of banks, trustees of universities. And we might give our thought experiment one additional feature: we might look at snapshots of the same data for each generation identified by families. Now we have Mills's hypothesis in a nutshell: at a given time there is a small subset of the population who occupy most of the positions of power; and the probability is great that the sons and daughters of this group will occupy similar positions of power in the next generation. And in fact, it is perfectly visible in our society that the likelihood of occupying a position of power in one generation is highly influenced by the power status of the antecedent generation.
Regrettably, we don't have a direct ability to carry out this experiment. But we might consider a test case invoking an important decision and a large number of "stakeholders", large and small: the current effort to reform the health care system in the United States. Will this issue be resolved in a fully democratic way, with the interests of all elements of society being represented fairly in the outcome? Or will a relatively small group of corporations, political interests, and professions be in a position to invisibly block reforms that would be democratically selected? And if this is in fact the case, then doesn't that speak loudly in support of the power elite hypothesis?
With the advantage of fifty years of perspective, I think two observations can be made about Mills's book. First, he seems to have diagnosed a very important thread in the sociological reality of power in America -- albeit in a way that is more intuitive and less empirical than contemporary sociologists would prefer. And second, he illustrates a profoundly important ability to exercise his sociological imagination: to arrive at a way of looking at contemporary society that allows us to make sense of many of the observations that press upon us.
(Another important voice on this subject is G. William Domhoff, Who Rules America? Power, Politics, and Social Change
(1967). Domhoff has a very nice web version of his theory on his web page.)
Recommended Links
bakho says...Kevin Phillips in Wealth and Democracy writes historically. Once families cross a threshhold of wealth, the wealth is self perpetuating. Some of the US wealthy go back to 18th century millionaires.
sewells says...Perhaps I'm being naive but it would appear to me that as long as we cling to the contingent fact of our having evolved as social primates in a dominance hierarchy that power elites are unavoidable.
I would suggest that if we want to change that, we should consider how best we can opt out of participation in dominance hierarchies to the greatest degree possible.
I think the best way to do that would be to reduce the incidence of coercion in our dealings with each other. Under such a scheme, the state monopoly on coercion would be directed toward ensuring that no one is coerced unless such coercion is absolutely necessary. This would give the government a role in say, ensuring that loan documents are clearly written and understandable in order to prevent coercion by fraud, etc.
Don't get me wrong. Criminals will have to be coerced by virtue of being imprisoned, etc. Holdouts will have to be coerced using eminent domain, etc. But, lessening the incidence of coercion to the greatest degree possible would seem the surest blow that could be struck against elitism in my opinion.
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EconoSpeak
The most recent issue of The Economist has three articles about The Crisis of Modern Economics, with a book on the cover whose title is "Modern Economic Theory" appearing to melt down, with the most interesting one being the one on macroeconomics, http://www.economist.com/displaystory.cfm?story_id=14040288
All three articles are linked to in a post by Menzie Chinn at on econbrowser at http://www.econbrowser.com/archives/2009/07/the_failure_of.html , where he also links to Austrian, Mario Rizzo, criticizing mathematical modeling. While recognizing some of the arguments in The Economist to be valid, Chinn definitely defends mathematical modeling, and seems to be not too critical of the dominant DSGE models. Mark Thoma at economists view also linked to all three articles at http://economistsview.typepad.com/economistsview/2009/07/the_state_of_macroeconomics.html#comments , along with a link to Mark Gertler's mini-course that attempts to try to show how the DSGE models might be fixed to do better (an effort that I think fails).
The main arguments in the article on macroeconomics (the main other one is on financial economics) involve failures to include behavioral economics, failures to do heterogeneous agent modeling, and a general failure to model bubbles well, with Minsky being mentioned, although also dismissed as not mathematical (despite work by Steve Keen and me and others). While these arguments are correct, there is all too much defense of the DSGE models for "benchmark" purposes, although my observation is that the people working on these models, which totally dominate central bank modeling, take them all too seriously and think that models assuming rational expectations by homogeneous agents in general equilibrium can be solved with minor tweaking (and think their inclusion of sticky prices and wages is some great breakthrough to ingenuity, a point Thoma pokes at, and that many Post Keynesians have argued is neither Keynesian nor even useful, with flexprice models often less stable than fixprice ones). There is also the general ignoring of deeper problems in microeconomics in these articles, such as those pointed out in Steve Keen's _Debunking Economics_, even if I disagree with some of what he has to say in that book
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