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Rational Fools vs. Efficient Crooks:
Efficient Markets Hypothesis

Skepticism -> Political Skeptic  -> Libertarian Philosophy

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"Rational, or sane? Those are very different standards..."

From slashot comment July 17, 2013

“The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all.

It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight.

‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”

Jeremy Grantham

Fama's last reasonable chance to retire (without making Sveriges Riksbank a laughingstock) may have been last year...

(comment from 1997 forum)


The efficient market hypothesis (EMH) is a flavor of economic Lysenkoism which became popular for the last 30 years in the USA. It is a pseudo scientific theory or, in more politically correct terms, unrealistic idealization of market behavior. Like classic Lysenkoism in the past was supported by Stalin's totalitarian state, it was supported by the power of neoliberal state, which is the state captured by financial oligarchy (see Casino Capitalism and Quiet coup for more details).

Among the factors ignored by EMH is the positive feedback loop inherent in any system based on factional reserve banking, the level of market players ignorance, unequal access to the real information about the markets, the level of brainwashing performed on "lemmings" by controlled by elite MSM and market manipulation by the largest players and the state (see ignorance).

Economics, it is said, is the study of scarcity. There is, however, one thing that certainly isn't scarce, but which deserves the attention of economists - ignorance.

...Conventional economics analyses how individuals choose - maybe rationally, maybe not - from a range of options. But this raises the question: how do they know what these options are? Many feasible - even optimum - options might not occur to them. This fact has some important implications. ...

Slightly simplifying, we can say that (financial) markets are mainly efficient in separation of fools and their money... And efficient market hypothesis mostly bypasses important question about how the inequity of resources which inevitably affects the outcomes of market participants. For example, the level of education of market players is one aspect of the inequity of resources. Herd behavior is another important, but overlooked in EMH factor.

There is a proven tendency of pseudo-scientific economic theories to act as smoke screen to financial gangsterism, as a tool for ideological capture. Instead of complex question about how to maintain a balance of market based economy and effective government regulation, it provides a "magic solution". Just abolish regulation, so that the unscrupulous can tear down the protections erected by previous generations, to lure the foolish and gullible with their siren songs of quickly and effortlessly acquired prosperity. Those crooks should be seen for what they really are: the direct descendants of financial gangsters of 20th of the XX century with the same unsaturable greed and the same old bag of dirty tricks. One of the most efficient ways to achieve their goals proved to be seducing or outright bribing of economists in leading universities (that is what $100K lectures by Summers and Co. are about). Capture on economic departments in major universities in turn allows to brainwash students and in a generation to achieve general acceptance of a bizarre, but very profitable nonsense as a sound theory. Maoist brainwashers can only dream about such an efficiency. That was done starting from 1980th when "market fundamentalism" school captured several major economics departments. See Noug Noland interesting analysis at

Another important factor working against EMH is the ignorance of history. It looks like mankind has a propensity to forget the lessons of previous generation in approximately 50-70 years. For "investors" this period is probably shorter then a decade ;-). As a result, there is a strong tendency to step on the same rake again and again. Baby-boomers proved to sufficiently brainwashed to go into this trap "en mass" two times: in 2000 and 2008. If market tanks in, say, 2015, that would be the third time the same trick worked with the same lemmings. I think 401K investors should remember Ian Fleming quote "Once is happenstance. Twice is coincidence. Three times is enemy action." Note the part about enemy action in view of position in a food chain Street and 401K investors (with their role of plankton for financial whales). Even twice (2000 and 2008) to lose a considerable part of savings due to selling at the bottom or close to it probably should be enough to learn the lesson. Unfortunately, as we see in 2013, it is not. As Bernard Show noted "If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience."

Remember Ian Fleming quote "Once is happenstance. Twice is coincidence. Three times is enemy action." Note the part about enemy action in view of relationship between Wall Street and 401K investors. Even twice (2000 and 2008) to lose a considerable part of savings due to selling at the bottom or close to it probably should be enough to learn the lesson. Unfortunately, as we see in 2013, it is not. As Bernard Show noted "If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience."

Due to financial industry support and huge amount of money injected into system to support EMH since probably 60th this unscientific garbage was floating as the official economic doctrine and is now included into all textbooks used in the best US (and not only US) universities despite little or no supporting empirical evidence. All this did not change even after the most recent financial crisis. That's why we can talk about EMH as a part of neoliberal ideology, not a part of scientific discourse.

At the same time events, which happened during dominance of neoliberal ideology (from 1970 till now) have conclusively demonstrated the inadequacy of the efficient market hypothesis. It neither predicted nor explained what happened. In other words is an ideological doctrine. Or even religious doctrine of sort, if we assume the neoliberalism is a secular religion, which become state religion of the USA instead of Christianity, much like previous Marxism in Russia since 1917. EMH is one of the sings of the partial fusion of religious conservatism and neoliberalism in the US. And it would be only fitting to merge economic department of say Chicago University with the department of theology and gave degrees as "master of divinity", instead of "master of arts" (or, better, "master of sacred economic doctrine").

Like in Marxism in the past the proclaimed ideas and reality drastically differ. The pseudo theories of market “efficiency” and “rationality” have led economics and, what is more important, economic policy in the direction favorable to financial oligarchy during the past decade, with recent disastrous results.

Fama and others, including Greenspan, Rubin, Summers, etc. have done huge damage with the EMH-based push for deregulation. I suspect that their suppressed by still primary motivation was greed. Nobody in the US has ever seriously proposed eliminating all of the laws prohibiting murder, assault etc. and eliminating the police because people are naturally “self-regulating” since it would be in their rational self-interests not to kill and maim people because people may do the same to you.

Just imagine the reaction of the proposal to remove red lights on intersection because it is in best interest of motorists to avoid a fatal crash. But we are daily forced fed with the equally childish notion that de-regulating the financial sector is a sound idea, because the market will efficiently price everything anyway due to availability of perfect information.

In reality, there is always a group of psychopaths who take advantage of any weakness of laws and regulations in financial markets, to further their own self-interests, regardless of the impact on society. We already saw these group of psychopaths in action twice, first in 2000 and then in 2008. That's why the real game in the market is between majority of rational fools (lemmings) vs. will organized and possessing huge financial resources group of efficient crooks (canning psychopaths who consider own enrichment above everything else, including the health of the society in which they live).

History of the concept

According to Wikipedia the "Lysenkoist in chief" was Eugene Fama (with Burton Malkiel, John Bogle and The Vanguard Group in supporting roles; actually Bogle has its own variant -- "lowest cost, same returns" or superiority of index funds hypothesis). Huge support of financial oligarchy led to the situation in which the they managed to push the hypothesis into mainstream, despite the fact that evidence was scant and contradictory:

The efficient-market hypothesis was developed by Professor Eugene Fama at the University of Chicago Booth School of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school. It was widely accepted up until the 1990s, when behavioral finance economists, who were a fringe element, became mainstream.[1]

Empirical analyses have consistently found problems with the efficient markets hypothesis, the most consistent being that stocks with low price to earnings (and similarly, low price to cash-flow or book value) outperform other stocks.[2][3] Alternative theories have proposed that cognitive biases cause these inefficiencies, leading investors to purchase overpriced growth stocks rather than value stocks.[1]

Although the efficient markets hypothesis has become controversial because substantial and lasting inefficiencies are observed, Beechey et. al. (2000) consider that it remains a worthwhile starting point.[4]

The efficient-market hypothesis was first expressed by Louis Bachelier, a French mathematician, in his 1900 dissertation, "The Theory of Speculation". His work was largely ignored until the 1950s; however beginning in the 30s scattered, independent work corroborated his thesis. A small number of studies indicated that US stock prices and related financial series followed a random walk model.[5] Research by Alfred Cowles in the ’30s and ’40s suggested that professional investors were in general unable to outperform the market.

The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul Samuelson had begun to circulate Bachelier's work among economists. In 1964 Bachelier's dissertation along with the empirical studies mentioned above were published in an anthology edited by Paul Cootner.[6] In 1965 Eugene Fama published his dissertation arguing for the random walk hypothesis,[7] and Samuelson published a proof for a version of the efficient-market hypothesis.[8] In 1970 Fama published a review of both the theory and the evidence for the hypothesis. The paper extended and refined the theory, included the definitions for three forms of financial market efficiency: weak, semi-strong and strong (see below).[9]

Further to this evidence that the UK stock market is weak-form efficient, other studies of capital markets have pointed toward their being semi-strong-form efficient. Studies by Firth (1976, 1979, and 1980) in the United Kingdom have compared the share prices existing after a takeover announcement with the bid offer. Firth found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi-strong-form efficient. However, the market's ability to efficiently respond to a short term, widely publicized event such as a takeover announcement does not necessarily prove market efficiency related to other more long term, amorphous factors.

David Dreman has criticized the evidence provided by this instant "efficient" response, pointing out that an immediate response is not necessarily efficient, and that the long-term performance of the stock in response to certain movements are better indications. A study on stocks response to dividend cuts or increases over three years found that after an announcement of a dividend cut, stocks underperformed the market by 15.3% for the three-year period, while stocks outperformed 24.8% for the three years afterward after a dividend increase announcement.[10]

Fama freshman-style mistake

Fama in his observation that most managed mutual funds underperform index funds made a freshman-style mistake: he assumed that managers of mutual funds are thinking and behaving rationally. But in reality this is not the case due to institutional contains on their behaviour. For example, most mutual fund managers are benchmarked against market indexes quarterly, and have cash-holding limits as a matter of fund policy. These constraints obviously have disadvantaged them and made it extremely hard to behave rationally. In addition fund managers are afraid more of not catching the speculative wave (underperforming in the bull market and missing bonuses) then going down with the crowd (when bonuses are history, anyway). That reinforces herd behaviour.

This is why most large managed fund managers are closet indexers and this tendency increases with the size of the fund (which coincides with its success among the investors). In those circumstances extra management costs and fees virtually guarantee that large actively managed mutual funds under-perform market indexes. This has nothing to do with market efficiency.

Most large managed fund managers are closet indexers and this tendency increases with the size of the fund (which coincides with its success among the investors). In those circumstances extra management costs and fees virtually guarantee that large actively managed mutual funds under-perform market indexes. This has nothing to do with market efficiency.

Moreover, regardless how one tries to improve the incentive structure for managers of mutual funds, nothing could overcome the incentive distortions inherent in the managing other people's money. Mutual funds, once hailed as a great tool for individual investors, has proven ripe with conflicts of interests that drastically diminish efficiency (agency problem and "short-termism" are probably two the most well studied).

Exact definition of EMH depends on your tolerance for sharp and vulgar words ;-). John K. Galbraith said it best about the economists like Eugene Fama :

Economics is the only profession in which it is possible to rise to eminence without ever once being right.

As one commenter aptly said in Delong blog (Time to Bang My Head Against the Wall Some More )

Cochrane is a decent empirical asset pricer with an excessive ideological commitment to efficient markets. He has also just proved beyond any doubt that he doesn't know shit about macro economics.

If you want to be less tolerant, then Fama is just another white-collar academic criminal, not that different from Madoff. EMH laid the foundation for tearing down the regulatory structure built from the lessons of the Great Depression, so he probably should be tried for the conspiracy to defraud American people. Actually RICO statute might be applicable to at least some of economic departments of major universities. See Harvard Mafia, Andrei Shleifer and the economic rape of Russia.

Negative serial correlation and profitability of arbitrage as counterarguments to hypothesis of efficiency of the markets

The efficient market hypothesis, which has had a dominant role the last three decades presuppose that all relevant information is reflected in the price. That means that prices move only in response to new information. The movement of the market in this case will correspond to the “random walk”.

The latter conclusion is empirically false: stock markets exhibit pretty strong “negative serial correlation”. More simply, there is an effect of reversal to means -- real returns from stock markets are likely to be lower, if they have recently been high, and vice versa. That means that theoretically cost averaging is a wrong strategy. In a sense, the right time to buy is not when markets have done well, but when they have done badly. We can assume that markets oscillate around fair value (and during panic oscillations can be substantial as drop of S&P500 from almost 1500 to 666 in 2009; I would like to see Fama explanation of this ;-). But what is important is that the period of oscillation and the level of overshooting/slump is unknown (which make arbitrage extremely difficult and very risky).

Another interesting fact that refutes efficient market hypothesis is that arbitrage is profitable "in a long run". It is used by a large number of financial players for a long time and this fact is incompatible with EMH. This is another proof that EMH is in its core an ideological construct supported by the state, not so much different from the idea of proletariat to be a God chosen progressive class that will lead societies from capitalism to socialism in Marxism.

When inertia (or herd mentality, if you wish) drives particular asset prices too high or too low arbitrager can exploit inefficiencies. Moreover, some large financial players like Goldman Sachs managed even simultaneously contribute to the creation of inefficiencies (dot com boom and then subprime mortgages bubble) and exploit them.

It still a very risky strategy, but it is a risky strategy for the reasons that has nothing to do with the efficient market hypothesis. In case of borrowed funds, "honest" arbitrage can be defeated by unpredictability of the period of oscillations (or "reversion to mean" in economic speak). The length of time over which markets can have significant deviation can measure in decades. In other words it is very risky to exploit such opportunities using borrowed funds. Similarly short sellers often go broke long before the value ship comes in and market proved them right. The difficulty of exploiting such opportunities is amplified for professional managers by the necessity to preserve a critical mass of customers. The danger is to lose most of the clients long before they can prove that they are right. This fact was aptly reflected in the famous John Maynard Keynes maxim: "The market can stay irrational longer than you can stay solvent".

Oversized financial sector as an argument against market efficiency

Another argument against EMH is profitability of HFT (high frequency trading). That suggests that oversized financial system can create "built-in" inefficiencies in the system which it successfully exploits. From the point of view of EMH high speed trading should not be profitable. But it is. Moreover it is now prevalent in financial markets with most trades performed by HFT machines working with their proprietary algorithms

So contrary to EMH, the "real" market does provide an opportunity for enrichment of useless individuals who happen to be close to "money river" to drink from it without any restrain. A Benjamin Friedman noted:

"Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three. These talented and energetic young citizens could surely be doing something more useful.”

Generally, if profits and compensation in the financial sector go up that’s an evidence of inefficiency, not efficiency of the markets. In this sense oversized profits of financial companies is a strong arguments against EMH and suggest that markets are rigged favoring the largest players. In other way they are able to imposing a tax on the "real" economy and extract the rent.

Market as voting machine

Also, as Soros stresses many times, markets are composed of thinking participants who have their own set of forecasts and as such are always biased. The famous trader maxim states that during the crash nothing rise other then correlations. In a sense, in short term, market is not so much about the ‘value’ (aka efficiency), but about psychology (voting machine, not a weighting machine to site Benjamin Graham). It is dynamic self-adapting system which actually constantly dynamically redefines the notion of "expected equilibrium" and thus the direction of change. That means that multiple equilibriums can exist as a huge external shock is not necessary to move the market from one equilibrium to another. So unlike EMH suggests, the market is "self-propelled" not only "information propelled" and thus defy the notion of static equilibrium. Minsky theory suggests that market self-generates bull markets which ends in crashes due to the nature of fractional reserve banking, which create a positive feedback loop in the economy. Fractional reserve banking periodically causes the credit collapse, when the leveraged credit expansion goes into reverse.

As Soros suggested, actually functioning of financial markets is more like a ruthless competition on who’s the best at screwing the “great unwashed masses”. Success of Goldman Sachs speaks volumes about the high viability of such strategy. It is called vampire squid not without the reason.

Corruption of regulators and Kaji-ba dora-bo
("thief at the scene of a fire")

Another interesting observation that refutes efficient market hypothesis is that regulators, who in theory should play the role of arbiters and firefighters, actually enjoy playing the role of arsonists with Greenspan as a classical example. Under neoliberal regime, they are simultaneously arbiters and (via revolving door mechanism) market players. In their role of market players they are easily corrupted by the most powerful players on the market, the financial oligarchy.

While Corruption of regulators is a problem under all social regimes, be it feudalism, socialism or industrial capitalism, it is a systemic problem under neoliberalism (aka casino capitalism), where greed is officially declared a virtue in an interesting above face with Christianity. So much "In God we trust" for the modern USA. Coexistence of neoliberalism and Christianity the USA is something approaching the level of famous British hypocrisy as Pope Francis recently observed in his exhortation. In this sense we can state that neoliberal regime is the most corrupt regime in history of humanity, because its ideology elevates the greed to the level of virtue ("Greed is good").

Moreover, the corruption of regulators (and especially their propensity to create bubbles and subsequent reaction to crisis directed on saving the biggest players at the cost for taxpayers) creates another type of shady players who can be called using the Japanese phrase Kaji-ba dora-bo "thief at the scene of a fire": someone who turns the misfortune of others into his or her own benefit. In no way this type of players is concerned about fair price or other nonsense that efficient market hypothesis operates with. They actually understand that a crisis can make them richer and that they can with impunity pursue the antisocial course of action which is creating "disequilibrium", not equilibrium. "Too big to fail" (TBTF) financial institutions represent exactly this type of players.

For example, by keeping the FED rate too low by Greenspan created a happy army of fraudulent mortgage originators, who were ready to sell mortgages to anybody with a warm breath without any consideration about fair price of the house, or the ability to repay the loan. And those players understood that in case of acute crisis they will be saved by government, so they consciously adopted destructive for society course of actions.

As one commenter to Firefighter Arson And Our Macroeconomic Policymakers « The Baseline Scenario noted:

My personal view is that they [regulators -- NNB] know that exponential debt and growth can from here (”here” being since the 80s at least) on be propped up only through bubbles, while disaster tactics can still reap profit from the inevitable crashes.

So this, named the “Great Moderation” in classic Orwell fashion, is the new economic model, for as long as globalization and financialization can be propped up:

  1. Blow bubbles, sucking in as much rent as possible along the way.
  2. Capitalize opportunistically during the crashes.

So they hardly have to commit arson when we’re already always either in the flames or about to topple back into them.

Their kind of warmth demands permanently playing with fire, which is why they certainly won’t willingly regulate for the next bubble.

If they can’t blow another bubble, that’ll be the end of corporatist growth right there. Game over for mass industrial “capitalism”.

Obviously, keeping this game going as long and as profitably as they can is their only priority.

In a sense FED is deeply politicized institution the pursue the policies directly related to creation of two last bubbles in vain attempt to stimulate growth. So much about naive postulate that multiple players on the market by their actions tend to create an equilibrium. What efficiency we can talk in this context is completely unclear. It is politics pure and simple.

Disaster Capitalism

The same trick of creating deep disequilibrium (crisis) in order to profit from it is used by multinationals on international arena as a way to loot the third world and xUSSR countries. See Naomi Klein’s The Shock Doctrine --The Rise Of Disaster Capitalism for detailed explanation of the mechanisms involved. The book exposes the sad fact that manufacturing of crisis in third word and xUSSR space countries is a well established method of facilitating financial reward for multinationals.

Such an anti-social behavior is actually an integral part of neoliberalism, as an ideology (a part of Randism, to be precise) and is stimulated by neoliberalism dominance. So, paradoxically, while efficient market hypothesis is a part of neoliberal ideology, it is incompatible with the actual practice of neoliberal players such TBTF financial institutions and multinational.

Neoliberalism and free market hypothesis: the fear of being seen as "market-unfriendly" paralyzing fiscal and regulatory policy

As a part of neoliberal doctrine the efficient market hypothesis played prominent role in shaping how the country thought and acted in the last 30-plus years. And the ability of free market hypotheses to paralyze fiscal and regulatory policies greatly contributed to the current financial crises, the crisis that seriously wounded, if not killed, neoliberalism as an ideology. Like all ideological constructs of neo-classical economy it has no basis in reality. But it was shrewdly used by unscrupulous players (aka financial oligarchy) as a very effective smoke screen which allows to pursue their actions in redistributing wealth in the society with impunity. For example it allowed to steal a lot of money from 401K investors by luring them into stock market, where they served the role of Financial Plankton for larger Wall Street fish.

In other words, the efficient market hypothesis was used as a crowbar by financial oligarchy to promote deregulation and that led to serious policy mistakes not only in 401K investments, but for the financial markets as a whole. One tremendously negative side effect was dismantling Great Deal safeguards.

Susan Strange called the resulting social organization Casino Capitalism, a variant of neoliberalism typical for G7 countries. As Sushil Wadhwani in the Insight column How efficient markets theory gave rise to policy mistakes (please remember that FT is a City publication and the bastion of conservative economic thinking) noted:

Clients frequently tell me they are puzzled that policymakers allowed such a significant crisis to develop. Their incomprehension is deepened by the recognition that, in recent years, many countries made their central banks independent, and these are typically run by people with formidable reputations as academics.

I wonder whether a common thread running through many of the policy mistakes is a belief in the efficient markets hypothesis (EMH).

Over the past decade, while the bubbles were emerging, it was frequently argued that central bankers had neither more information nor greater expertise in valuing an asset than private market participants. This was often one of the primary explanations for central banks not attempting to "lean against the wind" with respect to emerging bubbles.

As I argue in my recent National Institute article, it is likely that, had central banks raised interest rates by more than was justified by a fixed-horizon inflation target while house prices were rising above most conventional valuation measures, the size of the eventual bubble would have been smaller. At least as importantly, because of the fear of being seen as "market-unfriendly", fiscal and regulatory policy did not lean against the wind either. Our economies would plausibly have exhibited greater stability if tax policy had been used in an anti-bubble fashion (e.g. a counter-cyclical land tax) and if regulatory policy had been more activist (e.g. a ceiling on loan-value ratios) and contra-cyclical (e.g. time-varying bank capital requirements).

Once the recent bubbles burst in 2007, some central banks (including many of those in Europe) were surprisingly slow to cut interest rates, and this policy mistake may well lead the current recession to be longer and deeper than it might have been. One reason for their reluctance to cut interest rates was the significant rise in commodity prices. In relying on the EMH yet again, policymakers used longer-dated futures prices for these commodities in preparing their inflation projections. Their failure to allow for the then widely discussed possibility that a "bubble" had developed in the commodity markets thereby led them significantly to overestimate prospective inflationary pressures.

Recently the Nobel laureate George Akerlof has, with Robert Shiller, argued that Keynes's explanations for excessive financial market volatility and depressions relied importantly on the possibility that individuals can act irrationally and for non-economic reasons. However, modern-day "Keynesian" models of the economy typically ignore this essential insight and can therefore be a deficient tool for setting policy. Personally, I find this neglect of Keynes surprising as at least some fund management companies (including the hedge funds I help manage) assign an important role to this insight in their investment process.

This failure to incorporate the role of what Keynes described as "animal spirits" might well have permitted the naive belief that recapitalizing the banks would lead them to lend again. Once "confidence" has evaporated, banks will not lend however well-capitalized they may be. Unsurprisingly, governments are now having to explore other ways of making banks lend, and one has to wonder whether they might be driven to full-scale nationalization.

Of course, because of "animal spirits" one can find that monetary policy becomes surprisingly ineffective in slumps. Hence, although it is laudable the Bank of England has cut UK interest rates significantly in recent months, we should all have been much better off if it had reduced rates more pre-emptively. Now we will need so-called quantitative easing - with, perhaps, the Treasury guaranteeing assets acquired by the Bank.

This financial crisis should not have surprised anybody: financial history is littered with examples of bubbles, manias and crashes.

The main lesson is that our monetary, fiscal and regulatory policies must be designed to protect the many innocent people in the rest of the economy from the consequences of excessive financial market volatility.

(The writer is chief executive of Wadhwani Asset Management and a former member of the Bank of England's monetary policy committee FT Syndication Service)

Now we do need to revise economic textbooks on the efficiency of markets. As a responses to Seeking Alpha post Technical Rally Could Indicate Computerized Panic Buying suggested the following edit might be appropriate:

Change "Markets provide an efficient pricing mechanism" to "In the long term, markets may be efficient, but in the short term, it is far more important to have a double head and shoulders pattern with broken candlesticks under the full moon eating a muffin with an Italian Coffee, but watch your Taylor series conversion."

... ... ...

Like almost everybody, I was taught to believe in the efficiency of the markets. And therein lies the problem. One market paradigm that is always true is that the market likes to disprove as many people as possible. So, once the efficient markets model universally accepted and followed, the markets will adapt in such a way as to render the model incorrect.

Another problem with the model is that it assumes that all players in the markets are investors who are concerned entirely with future earnings prospects. Unfortunately, market participants are simply not a homogenous group. Some participants care about earnings, others care about momentum, statistics, and so forth. This latter group can and sometimes does set prices. In fact, when the momentum players really get a hold on things, many of the purported "earnings-oriented" crowd start to join in and become momentum obsessed themselves. Efficiency by that time gets tossed by the wayside, because as an investment model, it's not making as much money for you as other models (like momentum) are. There are different types of participants in the market, but they all do share one characteristic: they like to make money, and the ones who are good at that will adopt any approach that makes money, and discard any approach that does not.

You make an interesting second point, which is that in the long term, perhaps efficiency does matter. My question then is, how would we know that?

Okay, one consequence of market efficiency is that nobody can beat the market's average performance over the long term. Why? Because any information they have is already priced in, so there's no way to get an edge. In fact, what we see is that most investors out there end up performing at or below the market's average. There are the Buffetts and Soroses of the world, but those are the exceptions that prove the rule. The law of averages catches up to most folks in the end, so it looks like efficiency is at work. At least that's the obvious answer. But look behind the curtain a little bit, and you'll find that there are many, many, many traders who quietly beat the market for years and years. I've drafted quite a few estate plans for guys like this who you've never heard of and probably never will. Why? They're smart enough to quit while they're ahead (or, in some cases, way way way ahead). And guess what. Most of them aren't crunching income statements and reading analyst reports, either. These guys tend to be crackerjack mathematicians, who know how to spot a trend, leverage up, and profit from it.

Free market hypothesis and excessive 401K investing in stock market

For twenty years or so his hypothesis served as the theoretical justification of investing in stocks index funds. This "application" of efficient market hypothesis cost tremendous amount of money to 401K investors: as of July 2009 401K investor who invested using cost averaging into S&P500 lost approximately 45% in comparison with an investor who put all his/her money in a stable value fund (or 10 year bonds). That does not mean that this can't change this this situation is probably way too extreme. But there is no guarantee that it will and those who need to retire in 2009 and used this method are royally screwed. No question about it.

The second important problem with most publicly traded companies is that much of their business is a black box - without faith you have a hard time valuing the company since you can't see behind the curtains. That's true even if you work for the company and have access to some internal data. That means that situation is quite different from what is written about it in Money magazine and similar "feel good" publications. As Bill Fleckenstein The meddlers can't tame the market - MSN Money noted:

We have just come through a decade-plus in which the Fed intervened "successfully" enough so that folks came to look upon the stock market (and then the real-estate market) as pet kittens that spit out hundred-thousand-dollar bills. Markets are not like that at all. They are more like savage beasts looking to rip your head off.

The era of "pet markets" that effortlessly make people rich is definitely behind us.

When Vanguard PR people try to persuade you that "Whether you're an expert of not, it's human nature to imagine that have some unique insight into the market, something that's eluded everyone else" they forget to mention that this is perfectly applicable to the idea that S&P 500 outperforms bonds for a "long enough" period. Due to changes in S&P500 composition there is no scientific evidence for that, and popular "proofs" smell data mining. The last 15, 10 and 5 years periods provide evidence opposite to this hypothesis.

Ezra Klein once noted about quality of advice of two clowns: Jim Cramer, the famous financial advice clown and Larry Kudlow -- a prominent supply side clown ( December 2008):

CXO Advisory Group tracked Jim Cramer's picks for awhile and concluded "Based on subsequent stock market performance and our judgments about his forecasts for overall stock market direction, Jim Cramer is right about 46% of the time with his stock market predictions, a little below average." Stunning performance. Meanwhile, anyone who has ever read Larry Kudlow wonders how he's able to manage a folding chair without assistance, much less other people's money. He's the sort of guy who monocausally attributes market movement to Obama's standing in the polls. Indeed, if markets are half as efficient as he believes, than his show exists in stark contradiction to the implications of efficient markets.

But he has a finance show. Because like with political commentary, ratings come from entertainment, not insight and accuracy. And a broadcast that was all doom and destruction and frank admissions of ignorance wouldn't be very fun to watch.

I think that his line of thinking is perfectly applicable to Fama and friends. Fama existence in academy is a stark contradiction to the efficient markets hypothesis :-).


The concept of EMH evolved with time and gradually became an ideological construct belief in which is a required postulate of the neoliberalism, as a secular religion which serves as a state ideology in the USA. As such it is enforced by the power of state.

As any idealized system EMH might be useful not because it is an accurate descriptions of the market (it is not, although accidentally it may come close for certain short periods), but only as a benchmark to measure departures of the real market behaviour from an idealized model: deviation from an idealized model can sometimes serve as a useful indicator. For example, although we discussed Fama freshmen-style mistake, comparison of performance of mutual funds with the performance of S&P 500 become very common since early 90th and outside the periods of market crashes might have some value. But to the extent financial oligarchy encourages policy makers to use flawed models ("cognitive capture"), they are in the same moral position as physicists who encourage engineering of mechanisms while ignoring friction, or the engineers who did not understand the influence of low temperatures on the O-ring behaviour.

While the ideas of self-regulation and feedback loops are definitely applicable to economic systems, naive (or crooked) belief in "permanent equilibrium" typical for guys like Fama is really absurd.

While the ideas of self-regulation and feedback loops are definitely applicable to economic systems, naive (or crooked) belief in "permanent equilibrium" typical for guys like Fama is really absurd.

Like most of neoclassic economy this idea serves the interests of financial oligarchy to the detriment of other economic players. It was used to loot 401K investors by luring them into stock market and fleecing them during the crisis, when the panic allow bigger fish, who understood that they will be saved by regulators, to buy assets that are sold during the panic by 401K lemmings for pennies on the dollar.

Professor Eugene Fama is a really special gift to the economic profession: later he went as far as to deny that bubbles are possible and instead of being isolated from society managed to preserved his academic position at Chicago university ;-) As for classical dilemma of "intellectual dishonesty or fundamental ignorance" I am inclined to see him probably as 50:50 split (equally ignorant and intellectually dishonest :-).

The fact that Fama got The Sveriges Riksbank Prize in Economic Sciences (Aka Nobel Prize in Economics which was created in 1968) also tells us something about the group which award it. One comment to Philip Mirowski video Why Is There a Nobel Memorial Prize in Economics aptly noted

"...the corruption and incompetence of the tight, mafia-like group of fanatics that controlled (and still controls) economics in Sweden. The power of this group was (and still is) largely based in their control of the Nobel prize."

Here is the full post (by Jorge Buzaglo on Thu, 12/29/2011):

Grassman, Sven, 1940-1992
Det tysta riket : skildringar från falsifikatens och jubileumsfondernas tidevarv : [svensk ekonomi från föredöme till problembarn] / 1981

This is a very important book related to your research project. Sven Grassman was a Keynesian economist marginalized by his colleagues at the Institute of International Economics, University of Stockholm (the same group, leaded by Assar Lindbeck, which was deciding on the Nobel prize). I think that this cruel persecution by his colleagues led to his early death (at 52). In this book Sven Grassman describes the corruption and incompetence of the tight, mafia-like group of fanatics that controlled (and still controls) economics in Sweden. The power of this group was (and still is) largely based in their control of the Nobel prize.

The greatly increased political ascendancy of this fundamentalist group of economists was perhaps not unrelated to the sharp increase of inequality in Sweden — Sweden is by far the OCDE country where inequality increased the most since the mid-1980s (Gini increased by 31% in 1985-2010; see

Other highly relevant books by Grassman are:

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[Jun 19, 2019] Bias bias the inclination to accuse people of bias by James Thompson

Highly recommended!
Notable quotes:
"... Early in any psychology course, students are taught to be very cautious about accepting people's reports. A simple trick is to stage some sort of interruption to the lecture by confederates, and later ask the students to write down what they witnessed. Typically, they will misremember the events, sequences and even the number of people who staged the tableaux. Don't trust witnesses, is the message. ..."
"... The three assumptions -- lack of rationality, stubbornness, and costs -- imply that there is slim chance that people can ever learn or be educated out of their biases; ..."
"... So, are we as hopeless as some psychologists claim we are? In fact, probably not. Not all the initial claims have been substantiated. For example, it seems we are not as loss averse as previously claimed. Does our susceptibility to printed visual illusions show that we lack judgement in real life? ..."
"... Well the sad fact is that there's nobody in the position to protect "governments" from their own biases, and "scientists" from theirs ..."
"... Long ago a lawyer acquaintance, referring to a specific judge, told me that the judge seemed to "make shit up as he was going along". I have long held psychiatry fits that statement very well. ..."
"... Here we have a real scientist fighting the nonsense spreading from (neoclassical) economics into other realms of science/academia. ..."
"... Behavioral economics is a sideline by-product of neoclassical micro-economic theory. It tries to cope with experimental data that is inconsistent with that theory. ..."
"... Everything in neoclassical economics is a travesty. "Rational choice theory" and its application in "micro economics" is false from the ground up. It basically assumes that people are gobbling up resources without plan, meaning or relevant circumstances. Neoclassical micro economic theory is so false and illogical that I would not know where to start in a comment, so I should like to refer to a whole book about it: Keen, Steve: "Debunking economics". ..."
"... As the theory is totally wrong it is really not surprising that countless experiments show that people do not behave the way neoclassical theory predicts. How do economists react to this? Of course they assume that people are "irrational" because they do not behave according to their studied theory. (Why would you ever change your basic theory because of some tedious facts?) ..."
"... The title of the 1st ed. of Keen's book was "Debunking Economics: The Naked Emperor of the Social Sciences" which was simply a perfect title. ..."
Jun 19, 2019 |

Early in any psychology course, students are taught to be very cautious about accepting people's reports. A simple trick is to stage some sort of interruption to the lecture by confederates, and later ask the students to write down what they witnessed. Typically, they will misremember the events, sequences and even the number of people who staged the tableaux. Don't trust witnesses, is the message.

Another approach is to show visual illusions, such as getting estimates of line lengths in the Muller-Lyer illusion, or studying simple line lengths under social pressure, as in the Asch experiment, or trying to solve the Peter Wason logic problems, or the puzzles set by Kahneman and Tversky. All these appear to show severe limitations of human judgment. Psychology is full of cautionary tales about the foibles of common folk.

As a consequence of this softening up, psychology students come to regard themselves and most people as fallible, malleable, unreliable, biased and generally irrational. No wonder psychologists feel superior to the average citizen, since they understand human limitations and, with their superior training, hope to rise above such lowly superstitions.

However, society still functions, people overcome errors and many things work well most of the time. Have psychologists, for one reason or another, misunderstood people, and been too quick to assume that they are incapable of rational thought?

Gerd Gigerenzer thinks so.

He is particularly interested in the economic consequences of apparent irrationality, and whether our presumed biases really result in us making bad economic decisions. If so, some argue we need a benign force, say a government, to protect us from our lack of capacity. Perhaps we need a tattoo on our forehead: Diminished Responsibility.

The argument leading from cognitive biases to governmental paternalism -- in short, the irrationality argument -- consists of three assumptions and one conclusion:

1. Lack of rationality. Experiments have shown that people's intuitions are systematically biased.

2. Stubbornness. Like visual illusions, biases are persistent and hardly corrigible by education.

3. Substantial costs. Biases may incur substantial welfare-relevant costs such as lower wealth, health, or happiness.

4. Biases justify governmental paternalism. To protect people from theirbiases, governments should "nudge" the public toward better behavior.

The three assumptions -- lack of rationality, stubbornness, and costs -- imply that there is slim chance that people can ever learn or be educated out of their biases; instead governments need to step in with a policy called libertarian paternalism (Thaler and Sunstein, 2003).

So, are we as hopeless as some psychologists claim we are? In fact, probably not. Not all the initial claims have been substantiated. For example, it seems we are not as loss averse as previously claimed. Does our susceptibility to printed visual illusions show that we lack judgement in real life?

In Shepard's (1990) words, "to fool a visual system that has a full binocular and freely mobile view of a well-illuminated scene is next to impossible" (p. 122). Thus, in psychology, the visual system is seen more as a genius than a fool in making intelligent inferences, and inferences, after all, are necessary for making sense of the images on the retina.

Most crucially, can people make probability judgements? Let us see. Try solving this one:

A disease has a base rate of .1, and a test is performed that has a hit rate of .9 (the conditional probability of a positive test given disease) and a false positive rate of .1 (the conditional probability of a positive test given no disease). What is the probability that a random person with a positive test result actually has the disease?

Most people fail this test, including 79% of gynaecologists giving breast screening tests. Some researchers have drawn the conclusion that people are fundamentally unable to deal with conditional probabilities. On the contrary, there is a way of laying out the problem such that most people have no difficulty with it. Watch what it looks like when presented as natural frequencies:

Among every 100 people, 10 are expected to have a disease. Among those 10, nine are expected to correctly test positive. Among the 90 people without the disease, nine are expected to falsely test positive. What proportion of those who test positive actually have the disease?

In this format the positive test result gives us 9 people with the disease and 9 people without the disease, so the chance that a positive test result shows a real disease is 50/50. Only 13% of gynaecologists fail this presentation.

Summing up the virtues of natural frequencies, Gigerenzer says:

When college students were given a 2-hour course in natural frequencies, the number of correct Bayesian inferences increased from 10% to 90%; most important, this 90% rate was maintained 3 months after training (Sedlmeier and Gigerenzer, 2001). Meta-analyses have also documented the "de-biasing" effect, and natural frequencies are now a technical term in evidence-based medicine (Akiet al., 2011; McDowell and Jacobs, 2017). These results are consistent with a long literature on techniques for successfully teaching statistical reasoning (e.g., Fonget al., 1986). In sum, humans can learn Bayesian inference quickly if the information is presented in natural frequencies.

If the problem is set out in a simple format, almost all of us can all do conditional probabilities.

I taught my medical students about the base rate screening problem in the late 1970s, based on: Robyn Dawes (1962) "A note on base rates and psychometric efficiency". Decades later, alarmed by the positive scan detection of an unexplained mass, I confided my fears to a psychiatrist friend. He did a quick differential diagnosis on bowel cancer, showing I had no relevant symptoms, and reminded me I had lectured him as a student on base rates decades before, so I ought to relax. Indeed, it was false positive.

Here are the relevant figures, set out in terms of natural frequencies

Every test has a false positive rate (every step is being taken to reduce these), and when screening is used for entire populations many patients have to undergo further investigations, sometimes including surgery.

Setting out frequencies in a logical sequence can often prevent misunderstandings. Say a man on trial for having murdered his spouse has previously physically abused her. Should his previous history of abuse not be raised in Court because only 1 woman in 2500 cases of abuse is murdered by her abuser? Of course, whatever a defence lawyer may argue and a Court may accept, this is back to front. OJ Simpson was not on trial for spousal abuse, but for the murder of his former partner. The relevant question is: what is the probability that a man murdered his partner, given that she has been murdered and that he previously battered her.

Accepting the figures used by the defence lawyer, if 1 in 2500 women are murdered every year by their abusive male partners, how many women are murdered by men who did not previously abuse them? Using government figures that 5 women in 100,000 are murdered every year then putting everything onto the same 100,000 population, the frequencies look like this:

So, 40 to 5, it is 8 times more probable that abused women are murdered by their abuser. A relevant issue to raise in Court about the past history of an accused man.

Are people's presumed biases costly, in the sense of making them vulnerable to exploitation, such that they can be turned into a money pump, or is it a case of "once bitten, twice shy"? In fact, there is no evidence that these apparently persistent logical errors actually result in people continually making costly errors. That presumption turns out to be a bias bias.

Gigerenzer goes on to show that people are in fact correct in their understanding of the randomness of short sequences of coin tosses, and Kahneman and Tversky wrong. Elegantly, he also shows that the "hot hand" of successful players in basketball is a real phenomenon, and not a stubborn illusion as claimed.

With equal elegance he disposes of a result I had depended upon since Slovic (1982), which is that people over-estimate the frequency of rare risks and under-estimate the frequency of common risks. This finding has led to the belief that people are no good at estimating risk. Who could doubt that a TV series about Chernobyl will lead citizens to have an exaggerated fear of nuclear power stations?

The original Slovic study was based on 39 college students, not exactly a fair sample of humanity. The conceit of psychologists knows no bounds. Gigerenzer looks at the data and shows that it is yet another example of regression to the mean. This is an apparent effect which arises whenever the predictor is less than perfect (the most common case), an unsystematic error effect, which is already evident when you calculate the correlation coefficient. Parental height and their children's heights are positively but not perfectly correlated at about r = 0.5. Predictions made in either direction will under-predict in either direction, simply because they are not perfect, and do not capture all the variation. Try drawing out the correlation as an ellipse to see the effect of regression, compared to the perfect case of the straight line of r= 1.0

What diminishes in the presence of noise is the variability of the estimates, both the estimates of the height of the sons based on that of their fathers, and vice versa. Regression toward the mean is a result of unsystematic, not systematic error (Stigler,1999).

Gigerenzer also looks at the supposed finding that people are over-confidence in predictions, and finds that it is another regression to the mean problem.

Gigerenzer then goes on to consider that old favourite, that most people think they are better than average, which supposedly cannot be the case, because average people are average.

Consider the finding that most drivers think they drive better than average. If better driving is interpreted as meaning fewer accidents, then most drivers' beliefs are actually true. The number of accidents per person has a skewed distribution, and an analysis of U.S. accident statistics showed that some 80% of drivers have fewer accidents than the average number of accidents (Mousavi and Gigerenzer, 2011)

Then he looks at the classical demonstration of framing, that is to say, the way people appear to be easily swayed by how the same facts are "framed" or presented to the person who has to make a decision.

A patient suffering from a serious heart disease considers high-risk surgery and asks a doctor about its prospects.

The doctor can frame the answer in two ways:

Positive Frame: Five years after surgery, 90% of patients are alive.
Negative Frame: Five years after surgery, 10% of patients are dead.

Should the patient listen to how the doctor frames the answer? Behavioral economists say no because both frames are logically equivalent (Kahneman, 2011). Nevertheless, people do listen. More are willing to agree to a medical procedure if the doctor uses positive framing (90% alive) than if negative framing is used (10% dead) (Moxeyet al., 2003). Framing effects challenge the assumption of stable preferences, leading to preference reversals. Thaler and Sunstein (2008) who presented the above surgery problem, concluded that "framing works because people tend to be somewhat mindless, passive decisionmakers" (p. 40)

Gigerenzer points out that in this particular example, subjects are having to make their judgements without knowing a key fact: how many survive without surgery. If you know that you have a datum which is more influential. These are the sorts of questions patients will often ask about, and discuss with other patients, or with several doctors. Furthermore, you don't have to spin a statistic. You could simply say: "Five years after surgery, 90% of patients are alive and 10% are dead".

Gigerenzer gives an explanation which is very relevant to current discussions about the meaning of intelligence, and about the power of intelligence tests:

In sum, the principle of logical equivalence or "description invariance" is a poor guide to understanding how human intelligence deals with an uncertain world where not everything is stated explicitly. It misses the very nature of intelligence, the ability to go beyond the information given (Bruner, 1973)

The key is to take uncertainty seriously, take heuristics seriously, and beware of the bias bias.

One important conclusion I draw from this entire paper is that the logical puzzles enjoyed by Kahneman, Tversky, Stanovich and others are rightly rejected by psychometricians as usually being poor indicators of real ability. They fail because they are designed to lead people up the garden path, and depend on idiosyncratic interpretations.

For more detail:

Critics of examinations of either intellectual ability or scholastic attainment are fond of claiming that the items are "arbitrary". Not really. Scholastic tests have to be close to the curriculum in question, but still need to a have question forms which are simple to understand so that the stress lies in how students formulate the answer, not in how they decipher the structure of the question.

Intellectual tests have to avoid particular curricula and restrict themselves to the common ground of what most people in a community understand. Questions have to be super-simple, so that the correct answer follows easily from the question, with minimal ambiguity. Furthermore, in the case of national scholastic tests, and particularly in the case of intelligence tests, legal authorities will pore over the test, looking at each item for suspected biases of a sexual, racial or socio-economic nature. Designing an intelligence test is a difficult and expensive matter. Many putative new tests of intelligence never even get to the legal hurdle, because they flounder on matters of reliability and validity, and reveal themselves to be little better than the current range of assessments.

In conclusion, both in psychology and behavioural economics, some researchers have probably been too keen to allege bias in cases where there are unsystematic errors, or no errors at all. The corrective is to learn about base rates, and to use natural frequencies as a guide to good decision-making.

Don't bother boosting your IQ. Boost your understanding of natural frequencies.

res , says: June 17, 2019 at 3:29 pm GMT

Good concrete advice. Perhaps even more useful for those who need to explain things like this to others than for those seeking to understand for themselves.
ThreeCranes , says: June 17, 2019 at 3:34 pm GMT
"intelligence deals with an uncertain world where not everything is stated explicitly. It misses the very nature of intelligence, the ability to go beyond the information given (Bruner, 1973)"

"The key is to take uncertainty seriously, take heuristics seriously, and beware of the bias bias."

Why I come to Unz.

Tom Welsh , says: June 18, 2019 at 8:36 am GMT
@Cortes Sounds fishy to me.

Actually I think this is an example of an increasingly common genre of malapropism, where the writer gropes for the right word, finds one that is similar, and settles for that. The worst of it is that readers intuitively understand what was intended, and then adopt the marginally incorrect usage themselves. That's perhaps how the world and his dog came to say "literally" when they mean "figuratively". Maybe a topic for a future article?

Biff , says: June 18, 2019 at 10:16 am GMT
In 2009 Google finished engineering a reverse search engine to find out what kind of searches people did most often. Seth Davidowitz and Steven Pinker wrote a very fascinating/entertaining book using the tool called Everybody Lies

Everybody Lies offers fascinating, surprising, and sometimes laugh-out-loud insights into everything from economics to ethics to sports to race to sex, gender, and more, all drawn from the world of big data. What percentage of white voters didn't vote for Barack Obama because he's black? Does where you go to school effect how successful you are in life? Do parents secretly favor boy children over girls? Do violent films affect the crime rate? Can you beat the stock market? How regularly do we lie about our sex lives, and who's more self-conscious about sex, men or women?

Investigating these questions and a host of others, Seth Stephens-Davidowitz offers revelations that can help us understand ourselves and our lives better. Drawing on studies and experiments on how we really live and think, he demonstrates in fascinating and often funny ways the extent to which all the world is indeed a lab. With conclusions ranging from strange-but-true to thought-provoking to disturbing, he explores the power of this digital truth serum and its deeper potential – revealing biases deeply embedded within us, information we can use to change our culture, and the questions we're afraid to ask that might be essential to our health – both emotional and physical. All of us are touched by big data every day, and its influence is multiplying. Everybody Lies challenges us to think differently about how we see it and the world.

dearieme , says: June 18, 2019 at 11:25 am GMT
I shall treat this posting (for which many thanks, doc) as an invitation to sing a much-loved song: everybody should read Gigerenzer's Reckoning with Risk. With great clarity it teaches what everyone ought to know about probability.

(It could also serve as a model for writing in English about technical subjects. Americans and Britons should study the English of this German – he knows how, you know.)

Inspired by "The original Slovic study was based on 39 college students" I shall also sing another favorite song. Much of Psychology is based on what small numbers of American undergraduates report they think they think.

Anon [410] • Disclaimer , says: June 18, 2019 at 3:47 pm GMT
" Gigerenzer points out that in this particular example, subjects are having to make their judgements without knowing a key fact: how many survive without surgery. "

This one reminds of the false dichotomy. The patient has additional options! Like changing diet, and behaviours such as exercise, elimination of occupational stress , etc.

The statistical outcomes for a person change when the person changes their circumstances/conditions.

Cortes , says: June 18, 2019 at 4:14 pm GMT
@Tom Welsh A disposition (conveyance) of an awkwardly shaped chunk out of a vast estate contained reference to "the slither of ground bounded on or towards the north east and extending two hundred and twenty four meters or thereby along a chain link fence " Not poor clients (either side) nor cheap lawyers. And who never erred?

Better than deliberately inserting "errors" to guarantee a stream of tidy up work (not unknown in the "professional" world) in future.

Tom Fix , says: June 18, 2019 at 4:25 pm GMT
Good article. 79% of gynaecologists fail a simple conditional probability test?! Many if not most medical research papers use advanced statistics. Medical doctors must read these papers to fully understand their field. So, if medical doctors don't fully understand them, they are not properly doing their job. Those papers use mathematical expressions, not English. Converting them to another form of English, instead of using the mathematical expressions isn't a solution.
SafeNow , says: June 18, 2019 at 5:49 pm GMT
Regarding witnesses: When that jet crashed into Rockaway several years ago, a high percentage of witnesses said that they saw smoke before the crash. But there was actually no smoke. The witnesses were adjusting what they saw to conform to their past experience of seeing movie and newsreel footage of planes smoking in the air before a crash. Children actually make very good witnesses.

Regarding the chart. Missing, up there in the vicinity of cancer and heart disease. The third-leading cause of death. 250,000 per year, according to a 2016 Hopkins study. Medical negligence.

Anon [724] • Disclaimer , says: June 18, 2019 at 9:48 pm GMT

1. Lack of rationality. Experiments have shown that people's intuitions are systematically biased.

2. Stubbornness. Like visual illusions, biases are persistent and hardly corrigible by education.

3. Substantial costs. Biases may incur substantial welfare-relevant costs such as lower wealth, health, or happiness.

4. Biases justify governmental paternalism. To protect people from theirbiases, governments should "nudge" the public toward better behavior.

Well the sad fact is that there's nobody in the position to protect "governments" from their own biases, and "scientists" from theirs.

So, behind the smoke of all words and rationalisations, the law is unchanged: everyone strives to gain and exert as much power as possible over as many others as possible. Most do that without writing papers to say it is right, others write papers, others books. Anyway, the fundamental law would stay as it is even if all this writing labour was spared, wouldn't it? But then another fundamental law, the law of framing all one's drives as moral and beneffective comes into play the papers and the books are useful, after all.

Curmudgeon , says: June 19, 2019 at 1:42 am GMT
An interesting article. However, I think that the only thing we have to know about how illogical psychiatry is this:

In 1973, the American Psychiatric Association (APA) asked all members attending its convention to vote on whether they believed homosexuality to be a mental disorder. 5,854 psychiatrists voted to remove homosexuality from the DSM, and 3,810 to retain it.

The APA then compromised, removing homosexuality from the DSM but replacing it, in effect, with "sexual orientation disturbance" for people "in conflict with" their sexual orientation. Not until 1987 did homosexuality completely fall out of the DSM.

(source )

The article makes no mention of the fact that no "new science" was brought to support the resolution.

It appears that the psychiatrists were voting based on feelings rather than science. Since that time, the now 50+ genders have been accepted as "normal" by the APA. My family has had members in multiple generations suffering from mental illness. None were "cured". I know others with the same circumstances.

How does one conclude that being repulsed by the prime directive of every living organism – reproduce yourself – is "normal"? That is not to say these people are horrible or evil, just not normal. How can someone, who thinks (s)he is a cat be mentally ill, but a grown man thinking he is a female child is not?

Long ago a lawyer acquaintance, referring to a specific judge, told me that the judge seemed to "make shit up as he was going along". I have long held psychiatry fits that statement very well.

Paul2 , says: June 19, 2019 at 8:08 am GMT
Thank you for this article. I find the information about the interpretation of statistical data very interesting. My take on the background of the article is this:

Here we have a real scientist fighting the nonsense spreading from (neoclassical) economics into other realms of science/academia.

Behavioral economics is a sideline by-product of neoclassical micro-economic theory. It tries to cope with experimental data that is inconsistent with that theory.

Everything in neoclassical economics is a travesty. "Rational choice theory" and its application in "micro economics" is false from the ground up. It basically assumes that people are gobbling up resources without plan, meaning or relevant circumstances. Neoclassical micro economic theory is so false and illogical that I would not know where to start in a comment, so I should like to refer to a whole book about it:
Keen, Steve: "Debunking economics".

As the theory is totally wrong it is really not surprising that countless experiments show that people do not behave the way neoclassical theory predicts. How do economists react to this? Of course they assume that people are "irrational" because they do not behave according to their studied theory. (Why would you ever change your basic theory because of some tedious facts?)

We live in a strange world in which such people have control over university faculties, journals, famous prizes. But at least we have some scientists who defend their area of knowledge against the spreading nonsense produced by economists.

The title of the 1st ed. of Keen's book was "Debunking Economics: The Naked Emperor of the Social Sciences" which was simply a perfect title.

Dieter Kief , says: June 19, 2019 at 8:22 am GMT
@Curmudgeon Could it be that you expect psychiatrists in the past to be as rational as you are now?

Would the result have been any different, if members of a 1973 convention of physicists or surgeons would have been asked?

[Apr 08, 2017] Neoliberals do not care about applicability of neo-classical economics or the validity of generalized stochastic equilibrium. They used neo-classical theories as a ram to destroy New Deal Capitalism

Apr 08, 2017 |
RGC , April 08, 2017 at 06:35 AM
Re: The ideas of Kenneth Arrow - Steven Durlauf
"Yet the theorem trails a dense cloud of caveats, which Arrow himself recognized could be more important than the proof itself. For one, it worked only in a perfect world, far removed from the one humans actually inhabit. Equilibrium is merely one of many conceivable states of that world; there's no particular reason to believe that the economy would naturally tend toward it. Beautiful as the math may be, actual experience suggests that its magical efficiency is purely theoretical, and a poor guide to reality."

"Remarkably, academic macroeconomists have largely ignored these limitations, and continue to teach the general equilibrium model -- and more modern variants with same fatal weaknesses -- as a decent approximation of reality. Economists routinely use the framework to form their views on everything from taxation to global trade -- portraying it as a value-free, scientific approach, when in fact it carries a hidden ideology that casts completely free markets as the ideal."

"This perversion isn't Arrow's fault. He merely helped to prove a mathematical theorem, and was no blind advocate for markets. Indeed, he actually thought the theorem illustrated the limitations of capitalism, and he was prescient in understanding how economic inequality might come to impair the workings of democratic government. Perhaps it would be best to use his own words: "In a system where virtually all resources are available for a price, economic power can be translated into political power by channels too obvious for mention. In a capitalist society, economic power is very unequally distributed, and hence democratic government is inevitably something of a sham.""

RC AKA Darryl, Ron said in reply to RGC... , April 08, 2017 at 06:48 AM
libezkova -> RC AKA Darryl, Ron... , April 08, 2017 at 12:56 PM
"This perversion isn't Arrow's fault. He merely helped to prove a mathematical theorem, and was no blind advocate for markets. Indeed, he actually thought the theorem illustrated the limitations of capitalism"

This quote illustrates that there is some difference between neoliberalism and neo-classical economics. Neoliberals do not care about applicability of neo-classical economics or the validity of generalized stochastic equilibrium.

They used neo-classical theories as a ram to destroy New Deal Capitalism and paid "useful idiots" outsized amount of money to keep them in power in economics departments.

[Feb 27, 2017] Kenneth Arrow has died

Feb 27, 2017 |
The person who had promoted general equilibrium fallacy and mathiness in economics

Patrick S. O'Donnell 02.22.17 at 3:34 pm

I won't dispute the accolades (and not only because it's in bad taste), especially the long-standing consensus that he was "a very good guy."

All the same, I'm inclined to believe that Arrow's undoubtedly clever if not brilliant "impossibility theorem" (Amartya Sen describes it as a 'result of breathtaking brilliance and power') had, and speaking generally, a pernicious effect on the discipline of economics, captured in part by Deirdre (né Donald) McCloskey's comment that it, along with other qualitative general theorems in the discipline, "do not, strictly speaking, relate to anything an economist would actually want to know," in other words, "axiomatizing economics" (which Arrow alone cannot be held responsible for) was a turn for the worse, no doubt motivated by a desire to bring (natural) scientific respectability and putative "rigor" (of the sort believed to characterize physics) to a field not amenable to same (to put it bluntly if not mildly).

For a different sort of critique of his work in this regard in economics and the "social choice" literature, see Hausman and McPherson's Economic Analysis, Moral Philosophy, and Public Policy (Cambridge University Press, 2nd ed., 2006).

There is also a vigorous critique of the use of this theorem by professional economists and political scientists in S.M. Amadae's Rationalizing Capitalist Democracy: The Cold War Origins of Rational Choice Liberalism (University of Chicago Press, 2003).

Sen has a decidedly more favorable assessment of the "impossibility theorem" in his book, Neoliberal_rationality/ and Freedom (Belknap Press of Harvard University Press, 2002).

Alas, it was mischievous interpretations and application of his famous "impossibility theorem" that unequivocally did enormous harm to the discipline of political science, particularly with regard to democratic theory (and by implication, praxis as well): see Gerry Mackie's Democracy Defended (Cambridge University Press, 2003). Donald A. Coffin 02.22.17 at 4:16 pm ( 5 )

Links abound of course. For an excellent discussion of his contributions, this (the first of four posts that will appear this week) is a good place to start.
peterv 02.23.17 at 10:57 pm ( pnee:

For us members of the general public, the return of Jobs to Apple was a complete surprise. It was not rumored in any way in any public forum, to my knowledge. The futures for the company considered possible by external observers (ie, non-insiders) were many more than before. Exactly as I said and as you agree, the public announcement of Jobs' return was new information which increased public uncertainty.

Lee A. Arnold 02.24.17 at 11:45 am ( 19 )
"Information" has different definitions in different disciplines. One of Arrow's last lectures explains his use of the word, and also his view of the current state of many other things. Only 9 pages, no math:

likbez 02.26.17 at 11:20 pm (

Two questions to esteemed commenters here:

1. Is not the idea of permanent equilibrium a fallacy?

2. If not excessive use of mathematics in economics called mathiness?

[Feb 19, 2017] Neoclassical economics rests on the assumption that economies have a natural propensity to equilibrium

Notable quotes:
"... As we discussed long form in ECONNED, orthodox economics rests on the assumption that economies have a natural propensity to equilibrium, and that equilibrium is full employment. ..."
"... their mathematical exposition enables them to dismiss lay critics. ..."

I hate to come off like a nay-sayer, because I have no doubt that the underlying methodology is useful. But this sounds an awful lot like a new improved version of system dynamics, which the economics profession successfully beat back in the 1970s.

As we discussed long form in ECONNED, orthodox economics rests on the assumption that economies have a natural propensity to equilibrium, and that equilibrium is full employment.

As Paul Samuelson stressed, that assumption is necessary for economics to be science, as in mathed up, and the dominance that economists have achieved is due to their scientific appearances and the fact that their mathematical exposition enables them to dismiss lay critics.

[Feb 01, 2017] General equilibrium thinking is the enemy of understanding

Notable quotes:
"... General equilibrium thinking is the enemy of understanding - it requires as the interview shows (and he seems unaware of) a cascade of absurd assumptions. He also seems unaware that a series of unreal assumptions can't cancel out - their effects multiply. ..."
"... One of my finds in economic efficiency is to not read articles by George Farmer. Unlike Greg Mankiw, whom I never read, it is not a hard fast prohibitive rule. I sometimes allow myself to get sucked into reading George Farmer by an enticing title but such actions always come with a pang of guilt. ..."
Feb 01, 2017 |
reason : January 31, 2017 at 01:45 AM , 2017 at 01:45 AM
Roger Farmer showing that he is part of the problem, not part of the solution again:

He shouldn't humor such complete nonsense with so much respect.

General equilibrium thinking is the enemy of understanding - it requires as the interview shows (and he seems unaware of) a cascade of absurd assumptions. He also seems unaware that a series of unreal assumptions can't cancel out - their effects multiply.

RC AKA Darryl, Ron -> reason ... , January 31, 2017 at 03:39 AM
One of my finds in economic efficiency is to not read articles by George Farmer. Unlike Greg Mankiw, whom I never read, it is not a hard fast prohibitive rule. I sometimes allow myself to get sucked into reading George Farmer by an enticing title but such actions always come with a pang of guilt.

One can argue that reading Mankiw or Farmer is useful just to see what others are saying, what other people read, and preventing oneself from isolation in the bubble chamber, but I don't buy that argument. I get enough open mindedness just from Dani Rodrik, Dean Baker, Jared Bernstein, and Menzie Chinn. I used to read Krugman, but that is mostly in the past now with exceptions a little less rare than Farmer. I also skip reading most of the comments once the day gets going.

I am planting my last 25 daffodil bulbs today. It's a bit late. I already have over a dozen coming up from earlier planting. I get up every morning to fix my wife coffee and the just wait around doing this until the sun rises. Practicing good economics is worth more to me now that reading bad economics.

RC AKA Darryl, Ron -> RC AKA Darryl, Ron... , January 31, 2017 at 03:48 AM
Today, I just read Tim Duy. He had nothing stupid to say. I like that.
Jerry Brown -> RC AKA Darryl, Ron... , January 31, 2017 at 09:25 AM
Ron, what about these consecutive sentences from Duy- "That said, the central bank tends to react fairly nimbly to changing economic conditions. It has repeatedly delayed action in response to deteriorating economic or financial conditions."

Which one is it? Act nimble, or fail to act? I know what Duy means but I find the sentences contradictory in a humorous way.

Peter K. -> Jerry Brown... , January 31, 2017 at 10:07 AM
I don't think it's contradictory.

The Fed was signaling they were going to "normalize" and raise rates but held off because of unforeseen, changing economic conditions.

RC AKA Darryl, Ron -> Jerry Brown... , January 31, 2017 at 10:21 AM
What Peter K said, at least in the terms that Duy would consider realistic. One can also posit that the Fed failed to do enough or react soon enough in 2006-2007 or a host of other criticisms, but all those criticisms would be out of bounds for central bank behavioral expectations in general and Fed-watcher Tim Duy in specific. Market monetarists are less generous in that respect.
Jerry Brown -> RC AKA Darryl, Ron... , January 31, 2017 at 11:18 AM
Ron (and Peter), I know. I just found the sentences one after the other to be somewhat humorous. Apparently, I have an odd sense of humor :).
Jerry Brown -> Jerry Brown... , January 31, 2017 at 11:56 AM
Economists are not noted for their sense of humor and I have a theory that exposure to economists impairs the sense of humor in normal people. I am afraid mine has been badly damaged at this point. Anyone here a lawyer? Maybe we can do a class action suit?
Jerry Brown -> Jerry Brown... , January 31, 2017 at 12:04 PM
Anne can no doubt provide statistics favorable to our case on this. :)
Chris Lowery -> Jerry Brown... , January 31, 2017 at 03:11 PM
Jerry, you and Ron just made my day! My wife and are in lake Placid celebrating out 47th wedding anniversary, and during our pre-dinner cocktail hour were depressing one another with excerpts from today's news, and then I came across your Ron's comments. We nearly fell of our chairs laughing! Thanks guys, we really needed this!
Jerry Brown -> Chris Lowery ... , January 31, 2017 at 04:58 PM
Darn it, you wont be able to join as a plaintiff if you keep that up Chris. Falling out of your chair laughing does not demonstrate impaired humor- you will ruin my case! Perhaps you can maintain that you were being very sarcastic? Sarcasm is the last bit of humor to be affected by economism in my theory...

Congrats to you and the wife on your anniversary!

Chris Lowery -> Jerry Brown... , January 31, 2017 at 05:27 PM
Thanks Jerry! I can modify my story to fit whatever narrative thats helpful. It comes from decades in finance, for which Im still doing penance...

Chris Lowery

JF -> RC AKA Darryl, Ron... , January 31, 2017 at 11:18 AM
He neglected to bring illumination to his mention of cash replacing the maturing bond, and where this cash comes from and what happens with the cash in light if the remittance requirements (where excess cash is swept into the Treasury's accounts).

They cannot destroy the cash. The redeeming cash will come, in the case of a Treasury bond, from Treasury who must borrow this amount to pay the Fed. If they are permitted to hokd the cash on their books, and not remit, we still have borrowing by the public (and this sweeps excess off of the books of buyers of this new debt) fir it to be placed somewhere if not remitted.

As I have said for quite some time it makes basic common sense to have a mature bond redeemed via an accounting offset with Treasury as this avoids the need to borrow the money just to then have it remitted back to Treasury. And why would the Fed and Treasury not do this??? I would like someone to explain.

For example, why is the Fed doing this now when it could have been redeeming by offset during the Obama administration (lowering the amount of public borrowing but financing the same nominal spending).

This piece by Duy misses the absolutely most critical part of the redemption story.

Peter K. -> RC AKA Darryl, Ron... , January 31, 2017 at 05:34 AM
"One can argue that reading Mankiw or Farmer is useful just to see what others are saying"

You need to read more, Farmer is miles away from the establishment Mankiw. He's more "Post-Keynesian" than "New Keynesian." More Baker than Krugman.

RC AKA Darryl, Ron -> Peter K.... , January 31, 2017 at 06:09 AM
OK for you, but still not for me.
Peter K. -> RC AKA Darryl, Ron... , January 31, 2017 at 06:24 AM
Yes you have such high standards...
RC AKA Darryl, Ron -> Peter K.... , January 31, 2017 at 07:18 AM
Not what I meant. I have limited time and limited interest. Economics is secondary to politics as it stands. I don't have sufficient means to become more politically involved yet though. So, this is something rather than just nothing, but I cut my losses short. You are younger and apparently more involved in this aspect of thought about the political economy. I am older and more intent on positive action in my remaining time. There is not much new for me to think about that will matter at all to me.
Peter K. -> reason ... , January 31, 2017 at 05:31 AM
I don't understand the hostility towards Farmer. He seems like an interesting heterodox thinker to me who questions mainstream equilibrium thinking.
Jerry Brown -> Peter K.... , January 31, 2017 at 09:43 AM
Well the other day Farmer said he rejects the Keynesian concept of Aggregate Demand and the consumption function based on income. And provides no evidence except a recommendation to go and buy his book to find out. That about does it for me.
Peter K. -> Jerry Brown... , January 31, 2017 at 10:05 AM
Fair enough.

[Jan 18, 2017] The idea of equilibrium is a neoclassical fallacy as financial sector introduces the positive feedback loop leading to system instability

Jan 18, 2017 |
reason : , January 16, 2017 at 02:03 AM
I know I will completely offside with my view on this, but I think the behavioural/rational expectations debate is rather besides the point. The much bigger issues are uncertainty and disequilibrium.

pgl -> reason ... , January 16, 2017 at 02:06 AM
Not offside. Spot on.
reason -> reason ... , January 16, 2017 at 02:09 AM
The fundamental problem is in trying to model an evolutionary system as though it was a quasi stationary system (with exactly proportional growth).
New Deal democrat -> reason ... , January 16, 2017 at 05:31 AM
As I noted the other day, and Johnnny Bakho refers to below, the essence of this problem is that the thing being observed, observes back and adapts.

The only kind of model that might work in the long run, is a model that works even after everybody becomes aware of it and adapts their behavior to it.

As to the issue of uncertainty, if we assume that most people operate with formal or informal budgets, anything that causes them to think that their budget is about to increase or decrease is going to change their consumption. And since people *hate* to sustain and realise losses, the change is going to be disproportionately intense if the uncertainty include an possible increase to the downside.

reason -> New Deal democrat... , January 16, 2017 at 07:14 AM
No that isn't enough. Sure people might change their behavior as their understanding changes. But other things are changing as well as the behavior. In particular, technology and available resources change.

As I said the system is evolutionary (which means an adaptive system - which includes behavior changes), and evolution is never easy to anticipate, which implies uncertainty. And the existence of uncertainty leads to persistent disequilibrium (as people adopt defensive contingent strategies to cope with uncertainty). The big errors in macro are all associated with the general equilibrium paradigm and the assumptions that come with it.

New Deal democrat -> reason ... , January 16, 2017 at 07:38 AM
Point taken re technology and resources, although behavioral adaptation is a big part of why models fail.

I had a big long response worked out re the biggest endemic problem with "the assumptions that come with" macro's paradigm. Then my iPad decided to randomly pop up a keyboard screen and when I touched to get rid of it, deleted the entire comment!

The screaming at crapified Apple has passed now. I am zen again.

reason -> New Deal democrat... , January 16, 2017 at 08:40 AM
P.S. Rational expectations IS an attempt to build in behavioral adaptation. It is just that it turns out not very useful (it is empirically a complete flop).
JohnH -> New Deal democrat... , January 16, 2017 at 07:36 AM
I thought we were in a time of uncertainty right now due to Trump.

Anybody see any slowing of the economy? Markets are up.

New Deal democrat -> JohnH... , January 16, 2017 at 07:39 AM
Well-to-do GOPers foreseeing unfettered capitalist nirvana. It will pass.
JohnH -> New Deal democrat... , January 16, 2017 at 08:11 AM
So there is 'uncertainty' and 'uncertainty.' Which kind of uncertainty leads to a slower economy? Why wouldn't unknown after-shocks from repealing Obamacare have current economic repercussions?

Republicans used to claim that the roll-out of Obamacare was causing economic uncertainty and hurting the economy.

Seems to me that the whole foundation of 'economic uncertainty' is rather shaky, particularly if the promised, disruptive actions of Trump don't cause economic repercussions.

reason -> JohnH... , January 16, 2017 at 08:45 AM
Uncertainty (as for instance PK pointed out) can work in different ways in the short and long terms. In the short term it can result in hedging behavior which might actually promote some investment. In the longer term it will push up risk margins which will probably push growth rates down.
ilsm -> reason ... , January 16, 2017 at 04:39 AM
jonny bakho -> reason ... , January 16, 2017 at 04:49 AM
Humans evolved as social animals.
If rational expectations focuses on the individual and ignores that humans act as members of groups, not individuals, then it will not accurately predict human behavior or outcomes.
point -> reason ... , January 16, 2017 at 06:07 AM
Perhaps your comment is similar to supposing that perhaps "equilibrium" is a not always useful concept when the modeled surface may have multiple local maxima, minima and saddles.
reason -> point... , January 16, 2017 at 07:18 AM
Nope. I think we are trying to model a system converging to an equilibrium that is changing faster than the system can possibly adapt. We should forget all about equilibrium in macro-economics. It only misdirects.

I once tried to explain this with an analogy to flying a plane - the plane is always sinking and rising and net path the outcome of the sum of different (constantly varying) forces. This is quite distinct for instance, from the way that a boat floats on the ocean (which is much closer to how we are trying to model things today). The stochastic shocks in economic models are like waves on the sea - where the net effect in the end is that the average position remains the same. I don't think the economy is like that.

libezkova -> reason ... , -1
The idea of equilibrium is a neoclassical fallacy. financial sector introduced in the system systemic instability, the positive feedback loop.

Cassidy called it "Utopian economics".

As you wrote in 2015

reason :

The problem in thinking here is the equilibrium paradigm. Equilibrium NEVER exists. If there is a glut the price falls below the marginal cost/revenue point, if the seller is desperate enough it falls to zero!

Ignoring disequilibrium dynamics means this obvious (it should be obvious) point is simply ignored. The assumption of general equilibrium leads to the assumption of marginal productivity driving wages. You are not worth what you produce, you are worth precisely what somewhat else would accept to do your job.

See also

"The Virtues and Vices of Equilibrium, and the Future of Financial Economics"
J. Doyne Farmer and John Geanakoplos (2008)

[Dec 11, 2016] It is high time to put laissez faire and equilibrium doctrines firmly back in their place as Utopian constructions

Dec 11, 2016 |
Sandwichman : December 07, 2016 at 12:06 PM Terence Hutchison concluded his appendix on "Some postulates of economic liberalism" in Significance and Basic Postulates of Economic Theory with the admonition, "It is high time to put these theories [laissez faire and equilibrium doctrines] firmly back in their place as Utopian constructions." He cited S. Bauer's 1931 article, "Origine utopique et métaphorique de la théorie du "laissez faire" et de l'équilibre naturel."

Prominent in Bauer's discussion is the role of Baltasar Gracian's Oráculo Manual, which was translated into French by Amelot de la Houssaie in 1684, in popularizing both the notion and the term, laissez faire. Pierre le Pesant Boisguilbert is credited with introducing the term into political economic thought in a book published in 1707. It is conceivable that Keynes knew of the Gracian maxim because he used the image Gracian had used of tempestuous seas in his famous rejoinder about "the long run" being "a misleading guide to current affairs."

In his book Hutchinson noted that "several writers have argued that some such postulate as 'perfect expectations' is necessary for equilibrium theory." This observation lends a special note of irony to Gracian's coinage of laissez faire. In his discussion of Gracian's Oráculo, Jeremy Robbins highlighted the observation that:

"Gracián's prudence rests firmly on a belief that human nature is constant... In Gracián's case, human nature is viewed as a constant in so far as he believes it to act consistently contrary to reason."

In fact, Robbin's chapter on Gracian is titled "The Exploitation of Ignorance." Gracian's maxims establish "a sharp distinction between the elite and the necios [that is, fools]." Assuming that most people are fools who act contrary to reason is obviously something quite different from assuming perfect expectations. For that matter, the prudence of a courtier seeking to gain power over others is something quite distinct the foresight required of a policy professional acting ostensively on behalf of the public welfare.

That metaphorical and Utopian notions of laissez faire and natural equilibrium have managed to persist and even prevail in economics -- impervious to Hutchinson's warning (or Keynes's) -- is testimony to the perceptiveness of Gracian's estimate of human nature.

In the long run, we are all Baroque... anne -> Sandwichman ... , December 07, 2016 at 04:12 PM

Meticulously done, I am slowly learning how to approach your writing much to my satisfaction. I understand the argument and agree.
Sandwichman : , December 07, 2016 at 01:31 PM
"Let's stop pretending unemployment is voluntary" is the title for chapter four of Roger Farmer's book,"Prosperity for All: How to Prevent Financial Crises."

That is not good enough.

No. Let's stop pretending that the "pretending" is innocent. Let's stop pretending that it isn't a deliberate fraud that has been aided and abetted by most of the economics profession.

Sandwichman -> Sandwichman ... , December 07, 2016 at 01:36 PM
Why did they do it?

Because "equilibrium" is their shiny expert's meal ticket. Without it, they are nobody special with nothing valuable to sell to the Rich and Powerful.

fledermaus -> Sandwichman ... , December 07, 2016 at 03:31 PM
It is amusing to see a bunch of economists with physics envy totally disregard entropy w/r/t their vaunted "equilibrium" hypothesis.
Sandwichman -> fledermaus... , December 07, 2016 at 03:41 PM
It may be amusing the first time. After a while it just gets tedious.
Tom in MN : , December 07, 2016 at 03:43 PM
If you want to access the dynamical systems literature you should know the terminology that self-equilibrating systems have at least one stable equilibrium point with a non-empty domain of attraction (think downward pointing pendulum). Any state (set of variables describing the system configuration) that starts in this domain will end up at the stable equilibrium point. Non-linear systems can have several equilibria and some may be unstable as well, in that starting any small distance from those equilibria results in movement away from that equilibrium (e.g. an upside down pendulum). It is not enough to determine if a point is an equilibrium point, you must also check its stability.
reason -> Tom in MN... , December 09, 2016 at 07:27 AM
The trouble with this approach is that economics is describing a system that is not an equilibrium system in the first place. Economics is describing a system that is
1. Evolutionary
2. Dynamic. (In fact all the measurements are not measurements of a static state but of movements. Even apparently static things like asset values or the discounting sum of flow over time.)
reason -> reason... , December 09, 2016 at 07:30 AM
Just in case you don't see the relevance, just think about what happens if it is not the position that is moving but the equilibrium point (and worse the equilibrium point is not known, and perhaps unknowable).
reason : , December 08, 2016 at 12:32 AM
" If the expectations of agents are incompatible or inconsistent with the equilibrium of the model, then, since the actions taken or plans made by agents are based on those expectations, the model cannot have an equilibrium solution. ..."

There is clearly one very important word missing in this sentence.

Let me try again:

"" If the expectations of ANY agents are incompatible or inconsistent with the equilibrium of the model, then, since the actions taken or plans made by agents are based on those expectations, the model cannot have an equilibrium solution. ..."

Now what at first look seems merely far fetched, just became laughable.

reason -> reason ... , -1
I'm sorry, but this is very, very important. General equilibrium is the original sin of economics (especially Macro-economics). It is where it all went wrong. They should just drop it, and try to model the dynamic response of agents and the system to disequilibrium, which inevitably arises faster than equilibrating forces can possibly work. A more fundamental way of thinking about this is to realize that economics deals with transactions and all transactions are the result of a disequilibrium (at equilibrium all the trades are already made).

Where did the disequilibrium come from? When you understand the answer to that, you can understand what drives the economy. Not before.

[Nov 13, 2015] Rational Fools vs. Efficient Crooks: The efficient markets hypothesis

[Oct 18, 2015] Alan Kirman interview: everything You Need to Know about Laissez-Faire Economics

Notable quotes:
"... That's the idea that is underlying our whole social and philosophical position ever since. Economics is trying to run along side that. Initially the idea was to let everybody do what they want and this would somehow self-organize. But nobody said what the mechanism was that would do the self-organization. John Stewart Mill advanced the same position. He had the idea that people had to be given, as far as their role would permit, the possibility of doing their own thing, and this would be in the interests of everybody. And gradually we came up against this difficulty that we couldn't show economically, in a market for example, how we would ever get to such a position. I think what happened was on the one hand people became obsessed with proving there was some sort of socially satisfactory situation that corresponded to markets in equilibrium, and on the other hand, there was a lot of effort made, right up to the 1950's, to try to show that a market or an economy would converge on that. But we gave up on that in the 70's when there were results that showed that essentially we couldn't prove it. So the theoreticians gave up but the underlying economic content and all of the ideology behind it has just kept going. We are in a strange situation where on the one hand we say we should leave markets to themselves because if they operate correctly and we get to an equilibrium this will be a socially satisfactory state. On the other hand, since we can't show that it gets there, we talk about economies that are in equilibrium but that's a contradiction because the invisible hand suggests that there is a mechanism that gets us there. And that's what we're lacking–a mechanism. Is that clear more or less? ..."
"... Theory of Moral Sentiments ..."
"... Nowadays, if you take a very primitive version of the invisible hand, people say something like "greed is good". Somehow, if everyone is greedy and tries to serve their own interest, it will get to a good position socially. Adam Smith didn't have that view at all. He had the view that people have other things in mind. For example he said that one of the strongest motivations men have is to be seen to be a good citizen and therefore would do things that would appear to other people to be good. If you have motivations like that then you can be altruistic and you're not behaving like the strict Homo economicus ..."
"... Walras wasn't someone who pushed hard for laissez faire, but he started to build the weapons for trying to understand whether all markets could get into equilibrium. He wasn't so interested, himself, on whether the equilibrium was good for society; in other words, Adam Smith's original position. I would say that Walras was more a person who was worried about the very existence of equilibrium and he tried desperately at various points to show how we might get there. I don't think he was arguing in favor of laissez faire. I wouldn't regard Walras as being strictly in that tradition. ..."
"... Pareto was concerned about the idea of the invisible hand himself. He said: "Look, what I want to show you is that the competitive equilibrium is a social optimum. He was the person to define what we now call a Pareto optimum, a situation in which you cannot make one person better off without making somebody else worse off-which is a pretty weak criterion, but still is a criterion for some sort of social efficiency. He was interested in the relationship between the two, so he brought us back on track to what I interpret as the invisible hand. Then, we can make a huge jump it you want to the first theorem of welfare of economics. That, mistakenly, is often referred to as the invisible hand theorem. But it is nothing about the invisible hand. It just says that if you are in a competitive equilibrium, then that will be a Pareto optimum, in the sense that I have just mentioned. You couldn't make someone better off without making someone else worse off. That's all it says. It does not say that if you leave a society alone it will get there, but thousands of people have interpreted it in that way. ..."
"... He had a different position from Walras company and he wasn't very consistent in his views. According to Hayek, Walras said that nobody influences prices but take prices as given, and then somebody, not specified, adjusts them until they get to equilibrium. There is some mechanism out there. ..."
"... The Road to Serfdom ..."
"... He believed that people with little information of their own, like ants, would somehow collectively get it right. It was a very different view of the world than Walras. ..."
"... he was a pioneer in two respects. First of all, he grasped the idea of self-organizing and decentralized processes-that the intelligence is in the system, not in any individual, and secondly cultural group selection, that the reason economic systems were like this is because of some past history of better systems replacing worse systems. The wisdom of the system was the product of cultural group selection, as we would put it today, and that we shouldn't question its wisdom by tampering with it. Is that a fair thing to say? ..."
"... Yes, that's a fair thing to say and I think it is what Hayek believed. He didn't actually show how it would happen but you're absolutely right-I think that's what he believed and he thought tampering with this system would make it less perfect and work less well, so just leave it alone. I don't think he had in mind, strictly speaking, group-level selection, but that's clearly his idea. A system that works well will eventually come to outstrip other systems. That's why he was advising Thatcher. ..."
"... He was much less naïve than Friedman. Friedman has a primitive natural selection argument that if firms aren't doing better than other firms they'll go bust and just die. That's a summary of Friedman's evolutionary argument! But Hayek is much more sophisticated-you're absolutely right. ..."
"... Friedman and Hayek didn't see eye to eye at all, as I understand it. Hayek was actually very concerned that Friedman and other mathematical economists took over the Mont Pelerin Society, if I understand it correctly, but now let's put Friedman on center stage, and also the society as a whole and the creation of all the think tanks, which caused the society to become politically influential. ..."
"... "Greed is Good" sounds so simplistic, but what all of this seems to do is to provide some moral justification for individuals or corporations to pursue their own interests with a clear conscience. It's a moral justification for "Greed is Good", despite all of the complexities and all of the mathematics-that's what it seems to come down to. Am I wrong about that? ..."
"... Macroeconomic models are still all about equilibria, don't worry about how we got them, and their nice efficient properties, and so forth. They are nothing to do with distribution and nothing to do with disequilibrium. Two big strands of thought-Keynes and all the people who work on disequilibrium-they're just out of it. We're still working as if underlying all of this, greed-we don't want to call it greed, but something like greed-is good. ..."
"... Nowadays, you hear all the time about how neoliberal ideology and thought is invading European countries and is undoing forms of governance that are actually working quite well. I work a lot in Norway and Scandinavia and there you hear all the time that Nordic model works and at the same time it is being corrupted by the neoliberal ideology, which is being spread in some sort of cancerous fashion. Please comment on that-Current neoliberalism. ..."
"... We're always, always, worrying about efficiency. People like to say that this is efficient or not efficient. The argument is, we know that if you free up markets you get a more efficient allocation of resources. That obsession with efficiency has led us to say that we must remove some of these restraints and restrictions and this sort of social aid that is built into the Scandinavian model. I think that's without thinking carefully about the consequences. ..."
"... just to make my position clear, the idea of no regulations is absurd. For a system that is basically well adapted to its environment, then most of its regulations are there for a reason, as you say, but one of the things that everyone needs to know about evolution is that a lot of junk accumulates. There is junk DNA and there is junk regulations. Not every regulation has a purpose just because it's there, and when it comes to adapting to the future, that's a matter of new regulations and picking the right one out of many that are wrong. The question would be, how do you create smart regulations? Knowing that you need regulations, how do you create smart ones? That's our challenge and the challenge of someone who appreciates complexity, as you do. How would you respond to that? ..."

What you always wanted to know about the "let it be" philosophy

I'll bet money that Alan Kirman is the only economist with animated ants running around his email signature. Highly regarded by mainstream economists, he is also a critic of equilibrium theory and proponent of new economic thinking that takes complex systems theory into account. It was my privilege to work with Alan and Germany's Ernst Strungmann Forum to organize a conference titled "Complexity and Evolution: A New Synthesis for Economics" that was held in February 2015 and will result in a volume published by the MIT press in 2016.

After the conference was over, I sought Alan out to help me understand the complex history of laissez faire, the "let it be" philosophy that underlies mainstream economic theory and public policy.

DSW: I'm so happy to talk with you about the concept of laissez faire, all the way back to its origin, which as I understand it is during the Enlightenment. Then we can bring it up to date with some of its formalized versions in economic theory. Tell me what you know about the early history of laissez faire.

AK: I think the basic story that really interests us is that with the Enlightenment and with people like Adam Smith and David Hume, people had this idea that somehow intrinsically people should be left to their own devices and this would lead society to a state that was satisfactory in some sense for everybody, with some limits of course–law and order and so on. That's the idea that is underlying our whole social and philosophical position ever since. Economics is trying to run along side that. Initially the idea was to let everybody do what they want and this would somehow self-organize. But nobody said what the mechanism was that would do the self-organization. John Stewart Mill advanced the same position. He had the idea that people had to be given, as far as their role would permit, the possibility of doing their own thing, and this would be in the interests of everybody. And gradually we came up against this difficulty that we couldn't show economically, in a market for example, how we would ever get to such a position. I think what happened was on the one hand people became obsessed with proving there was some sort of socially satisfactory situation that corresponded to markets in equilibrium, and on the other hand, there was a lot of effort made, right up to the 1950's, to try to show that a market or an economy would converge on that. But we gave up on that in the 70's when there were results that showed that essentially we couldn't prove it. So the theoreticians gave up but the underlying economic content and all of the ideology behind it has just kept going. We are in a strange situation where on the one hand we say we should leave markets to themselves because if they operate correctly and we get to an equilibrium this will be a socially satisfactory state. On the other hand, since we can't show that it gets there, we talk about economies that are in equilibrium but that's a contradiction because the invisible hand suggests that there is a mechanism that gets us there. And that's what we're lacking–a mechanism. Is that clear more or less?

DSW: Yes, but it was very fast! I want to pull us back to the early times and make a couple of observations. First of all, that the first thinking about laissez faire came at a time when government was monarchy and absolutist rule. The whole struggle of the Enlightenment, to have a more egalitarian and inclusive society, was part of this. Am I right about that?

AK: Absolutely right. There was a social and philosophical revolution, precisely because of that. Men were trying to liberate themselves from a very hierarchical and monarchical organization. And economics tried to go along with that. There were good reasons and I think that even now there is no reason to say that there is anything wrong with the liberal position. On the other hand, what we can't show is that there is anything that would enable a liberal approach like that to get things under control. So you're right. It was a reaction to very autocratic systems that led the whole of the laissez faire and liberal position to develop.

DSW: Right. So laissez faire made a lot of sense against the background of monarchy and controlling church and so on. Now I know that Adam Smith invoked the invisible hand metaphor only three times in the entire corpus of his work and it is said that his first book on moral sentiments is much more nuanced than the popular notion of the invisible hand. Could you speak a little more on Adam Smith? On the one hand he's an advocate of laissez faire but on the other hand he is very nuanced in both of his books but especially in his Theory of Moral Sentiments. What do you have to say about that?

AK: Right. Adam Smith was fully cognizant of the fact that man is motivated by many things. Nowadays, if you take a very primitive version of the invisible hand, people say something like "greed is good". Somehow, if everyone is greedy and tries to serve their own interest, it will get to a good position socially. Adam Smith didn't have that view at all. He had the view that people have other things in mind. For example he said that one of the strongest motivations men have is to be seen to be a good citizen and therefore would do things that would appear to other people to be good. If you have motivations like that then you can be altruistic and you're not behaving like the strict Homo economicus. Adam Smith didn't take the strong position that people left entirely to their own selfish devices will make things OK. He had the view that man is much more complicated and governed by his emotions. He talks a lot about sympathy, which we would now call empathy.

DSW: That's great! Now let's talk about Walras and what his ambitions were to come up with the first mathematical justification for laissez faire, as I understand it.

AK: Actually, Walras himself didn't talk so much about laissez faire. He at that time had a very simple idea, that the amount of goods that people wanted to supply at a given price would be the amount that people would want to buy; i.e, demand at that price, so if those two were equal then that was the equilibrium price. Then he said that if we have many markets, how can we be sure that they will simultaneously be cleared, because after all if you raise the price in one market then that will effect the price in other markets. If you raise the price of bananas then the price of oranges will be effected, and so forth. He said "my problem is to solve the market clearing for all goods", but he was not so interested in the underlying philosophical context. Walras wasn't someone who pushed hard for laissez faire, but he started to build the weapons for trying to understand whether all markets could get into equilibrium. He wasn't so interested, himself, on whether the equilibrium was good for society; in other words, Adam Smith's original position. I would say that Walras was more a person who was worried about the very existence of equilibrium and he tried desperately at various points to show how we might get there. I don't think he was arguing in favor of laissez faire. I wouldn't regard Walras as being strictly in that tradition.

DSW: OK, that's new for me. So what about the rise of so-called neoclassical economics. At what point did it become toward demonstrating what I understand is the first fundamental theorem of economics-laissez faire leads to the common good and that being justified by some mathematical apparatus. Where does that come from, if not from Walras?

AK: We missed a very important step, which is [Vilfredo] Pareto. Pareto was concerned about the idea of the invisible hand himself. He said: "Look, what I want to show you is that the competitive equilibrium is a social optimum. He was the person to define what we now call a Pareto optimum, a situation in which you cannot make one person better off without making somebody else worse off-which is a pretty weak criterion, but still is a criterion for some sort of social efficiency. He was interested in the relationship between the two, so he brought us back on track to what I interpret as the invisible hand. Then, we can make a huge jump it you want to the first theorem of welfare of economics. That, mistakenly, is often referred to as the invisible hand theorem. But it is nothing about the invisible hand. It just says that if you are in a competitive equilibrium, then that will be a Pareto optimum, in the sense that I have just mentioned. You couldn't make someone better off without making someone else worse off. That's all it says. It does not say that if you leave a society alone it will get there, but thousands of people have interpreted it in that way.

DSW: OK. So where do we go from here? Tell me a little about agency theory, which is also something that seems to imply, if I understand it, that the only responsibility of corporations is to maximize their profits. The economy will work well if that's their only obligation.

AK: That's not exactly a sideline but a development where people are worrying about firms in addition to individuals. When you are just dealing with individuals in a simple economy, when they are exchanging goods there is no problem. When you get firms in there you need to ask "What's the objectives of these firms?" The objective, the argument is, is if they maximize profit then they are maximizing their shareholders' benefits and so therefore we get to the idea of increasing the welfare of society as a whole. But there is a huge leap there, because we haven't specified closely in our models who owns these firms and how ownership is transferred between these people. So I think there is a fuzzy area there, which is not completely included in the theory.

DSW: Please give me a thumbnail history of the Mont Pelerin Society and the role it played in advancing economic theory and policy. So this would be Hayek, Friedman and all that.

AK: The great hero of that society was Hayek. He had a different position from Walras & company and he wasn't very consistent in his views. According to Hayek, Walras said that nobody influences prices but take prices as given, and then somebody, not specified, adjusts them until they get to equilibrium. There is some mechanism out there. That was Walras. Hayek said "Not at all!" He said - actually he was a horrid man.

DSW: Wait a minute! Why was he a horrid man? You can't just glide over that!

AK: The reason I say that is-he had very clever ideas-but he was extremely bigoted, he was racist. There is a wonderful interview with him that you can find on You Tube, where he says (imitating Hayek's accent) "I am not a racist! People accuse me of being a racist. Now it's true that some of the Indian students at the London School of Economics behave in a very nasty way, typical of Indian people…" and he carries on like this. So that's one reason he is horrid. A second thing is that if you don't believe he is horrid, David, I will send you his book The Road to Serfdom, which said that if there is any planning going on in the economy, it will inevitably lead you to a fascist situation. When he produced that book it had a big success, particularly in the United States, and what is more, he authorized a comic book version of it, which is absolutely dreadful. One Nobel Prize winner, [Ronald] Coase, said "you are carrying on so much against central planning, you forget that a large part of our economy is actually governed by centrally planned institutions, i.e., big firms, and these big firms are doing exactly what you say they can't do. Hayek shrugged that off, but what he did in his book was say that if any planning goes on then eventually you are all going to wind up in a fascist state where you'll be shot if you don't do what you're told to do. At the end of the book there is some poor guy who's being shot because he wants to be a carpenter or a plumber, or something like that. It's terrible! And the irony of the whole situation is that comic book was issued and financed by General Motors, and GM of course is one of those corporations that Hayek didn't see were centrally planned institutions. That's way I say that Hayek was a dreadful person.

Hayek's idea was, there is no way that people could know what was going on and could know what the prices of goods are. Everyone has a little piece of information of their own, and in acting upon it, this news gets out into the market. So, for example I buy something such as a share, and you say "Oh, Kirman bought a share, so something must be going on there, based on information that he had that I didn't have", and so forth. Hayek's idea was that this mechanism-people watching each other and getting information from their acts, would lead you to the equilibrium that would be a socially optimal state. But again, he never specified closely what the mechanism was. He has little examples, such as one about shortage of tin and how people would adjust, but never really specified the mechanism. He believed that people with little information of their own, like ants, would somehow collectively get it right. It was a very different view of the world than Walras.

DSW: So he was a pioneer in two respects. First of all, he grasped the idea of self-organizing and decentralized processes-that the intelligence is in the system, not in any individual, and secondly cultural group selection, that the reason economic systems were like this is because of some past history of better systems replacing worse systems. The wisdom of the system was the product of cultural group selection, as we would put it today, and that we shouldn't question its wisdom by tampering with it. Is that a fair thing to say?

AK: Yes, that's a fair thing to say and I think it is what Hayek believed. He didn't actually show how it would happen but you're absolutely right-I think that's what he believed and he thought tampering with this system would make it less perfect and work less well, so just leave it alone. I don't think he had in mind, strictly speaking, group-level selection, but that's clearly his idea. A system that works well will eventually come to outstrip other systems. That's why he was advising Thatcher. Just trust the markets and let things go. Get rid of the unions, and so forth. So it's clearly he had in mind that interfering with that system would just lead you to a worse social situation. He was much less naïve than Friedman. Friedman has a primitive natural selection argument that if firms aren't doing better than other firms they'll go bust and just die. That's a summary of Friedman's evolutionary argument! But Hayek is much more sophisticated-you're absolutely right.

DSW: I think Hayek was explicit about cultural group selection, and Friedman-I've paid quite a bit of attention to his 1953 article on positive economics, in which he makes a very naïve evolutionary argument. Friedman and Hayek didn't see eye to eye at all, as I understand it. Hayek was actually very concerned that Friedman and other mathematical economists took over the Mont Pelerin Society, if I understand it correctly, but now let's put Friedman on center stage, and also the society as a whole and the creation of all the think tanks, which caused the society to become politically influential.

AK: Yes, I think that it coincided very nicely with conservative ideology and people who had really strongly liberal-not in the Mills sense (you have to make this distinction particularly in the United States where these words have different meanings), but really completely free market leave-everybody-to-their own-thing libertarian point of view. Those people found it a wonderful place to gather and reinforce themselves. And Hayek was a strong member of that. Another was Gary Becker, but I don't know how directly. Becker had the economics of everything-divorce, whatever. You'd have these simple arguments, but not necessarily selection arguments, often some sort of justification in terms of a superior arrangement. The marginal utility of the woman getting divorced just has to equal the marginal utility of not getting divorced and that would be the price of getting divorced, and that sort of stuff. Adam Smith would have rolled over in this grave because he believed emotions played a strong role in all of this and the emotions that you have during divorce don't tie into these strict calculations.

DSW: This is a tailor-made ideology for powerful interests, powerful people and corporations who simply do want to have their way. Is that a false statement to make?

AK: No, I think that's absolutely right. They can benefit from using that argument to advance their own ends. As someone once said, if you think of saying to firms, we're going to diminish their taxes, no firm in its right mind would argue with that. Even though they might think deep down that there are other things that could be done for society. There are some things which are part of this philosophy which is perfect for firms and powerful interest groups. You're absolutely right. And so they lobby for this all the time, pushing for these positions that are in fact in their own interest.

DSW: So, at the end of the day, "Greed is Good" sounds so simplistic, but what all of this seems to do is to provide some moral justification for individuals or corporations to pursue their own interests with a clear conscience. It's a moral justification for "Greed is Good", despite all of the complexities and all of the mathematics-that's what it seems to come down to. Am I wrong about that?

AK: I think you're absolutely right. What's interesting is that if you look at various economic situations, like today the first thing that people tell you about the Greeks is that they are horrid ideological people. But the people on the other side have an equally strong ideology, which is being justified by the sort of economic models that we are building. Remember that even though we had this discussion about how this became a real difficulty in theoretical economics, in macroeconomics they simply carried on as if these theoretical difficulties hadn't happened. Macroeconomic models are still all about equilibria, don't worry about how we got them, and their nice efficient properties, and so forth. They are nothing to do with distribution and nothing to do with disequilibrium. Two big strands of thought-Keynes and all the people who work on disequilibrium-they're just out of it. We're still working as if underlying all of this, greed-we don't want to call it greed, but something like greed-is good.

DSW: Could I ask about Ayn Rand and what role she played, if any? On the one hand she was not an economist, she was just a philosopher and novelist. On the other hand, she is right up there in the pantheon of free market deities alone with Smith, Hayek and Friedman. Do you ever think about Ayn Rand. Does any economist think about Ayn Rand?

AK: That's an example of my narrowness that I never read Ayn Rand, I just read about her. I think it would be unfair now to make any comments about that because I'd be as uninformed as some people who talk about Adam Smith. What I should do at some point is read some of her work, because she is constantly being cited on both sides as a dark bad figure or as a heroine in the pantheon as you said, with Hayek and everybody else. I just admit my ignorance and I don't know if Rand had a serious position on her own or whether she is being cited as a more popular and easily accessible figure.

DSW: Fine! I'd like to wrap this up with two questions. This has been a wonderful conversation, by the way. Nowadays, you hear all the time about how neoliberal ideology and thought is invading European countries and is undoing forms of governance that are actually working quite well. I work a lot in Norway and Scandinavia and there you hear all the time that Nordic model works and at the same time it is being corrupted by the neoliberal ideology, which is being spread in some sort of cancerous fashion. Please comment on that-Current neoliberalism. What justifies it? Is it spreading? Is that a good thing or a bad thing? Anything you would like to say on that topic.

AK: I think that one obsession that economists have is with efficiency. We're always, always, worrying about efficiency. People like to say that this is efficient or not efficient. The argument is, we know that if you free up markets you get a more efficient allocation of resources. That obsession with efficiency has led us to say that we must remove some of these restraints and restrictions and this sort of social aid that is built into the Scandinavian model. I think that's without thinking carefully about the consequences. Let me tell you my favorite and probably not very funny story about how economists are obsessed with efficiency. There were three people playing golf; a priest, a psychoanalyst, and an economist. The got very upset because the guy in front was playing extremely slowly and he had a caddy to help him. So these guys get very upset and they start to shout and say "Come on, can we play through please! You can't waste all of our afternoon!" They sent the priest up to find out what was going on and he came back absolutely crestfallen and said "You know why that poor guy is laying so slowly? It's because he's blind. I'm so upset because every Sunday I'm preaching to people to be nice to others." He turns to his psychoanalyst friend and say's "Joe, what do you think?" Joe says "I have these guys on my coach every week. I'm trying to help them live with this problem and here I am screaming at this guy. It's horrible!" Then they turn to the economist and say "Fred, what do you think?" Fred says "I think that this situation is totally inefficient. This guy should play at night!" As you can see, this is a very different attitude to how the world works.

I think what has happened is, because of this mythology about totally free markets being efficient, we push for that all the time and in so doing, we started to do things like-for example, we hear all the time that we have to reform labor markets in Europe. Why do we want to reform them? Because then they'll be more competitive. You can reduce unit labor costs, which usually means reducing wages. But that has all sorts of consequences, which are not perceived. In model that is more complex, that sort of arrangement wouldn't necessarily be one that in your terms would be selected for. When you do that, you make many people temporary workers. You have complete ease in hiring and firing so that people are shifting jobs all the time. When they do that, we know that employers then invest nothing in their human capital. When you have a guy who may disappear tomorrow-and we have a lot of these temporary agencies now in Europe–which send you people when you need them and take away people when you don't. Employers don't spend anything on human capital. We're reducing the overall human capital in society by having an arrangement like that. If you're working for Toyota, Toyota knows pretty much that you'll be working all your lifetime, so they probably invest quite a lot in you. They make you work hard for that, but nevertheless it is a much more stable arrangement. Again, the idea that people who are out of work have chosen to be out of work and by giving them a social cushion you induce them to be out of work-that simply doesn't fit with the facts. I think that all the ramification of these measures-the side effects and external effects-all of that gets left out and we have this very simple framework that says "to be competitive, you just have to free everything up." That's what undermining the European system. European and Scandinavian systems work pretty well. Unemployment is not that high in the Scandinavian system. It may be a little bit less efficient but it may also be a society where people are a little bit more at ease with themselves, than they are in a society where they are constantly worrying about what will happen to them next. The last remark I would make is that to say "you've got to get rid of all those rules and regulations you have"-in general, those rules and regulations are there for a reason. Again, to use an evolutionary argument, they didn't just appear, they got selected for. We put them in place because there was some problem, so just to remove them without thinking about why they are there doesn't make a lot of sense.

DSW: Right, but at the same time, a regulation is a like a mutation: for every one that's beneficial there are a hundred that are deleterious. So…

AK: You are an American, deep at heart! You believe that all these regulations are dreadful. Think of regulations about not allowing people to work too near a chain saw that's going full blast, or not being allowed to work with asbestos and so forth. Those rules, I think, have a reason to be there.

DSW: Well of course, but just to make my position clear, the idea of no regulations is absurd. For a system that is basically well adapted to its environment, then most of its regulations are there for a reason, as you say, but one of the things that everyone needs to know about evolution is that a lot of junk accumulates. There is junk DNA and there is junk regulations. Not every regulation has a purpose just because it's there, and when it comes to adapting to the future, that's a matter of new regulations and picking the right one out of many that are wrong. The question would be, how do you create smart regulations? Knowing that you need regulations, how do you create smart ones? That's our challenge and the challenge of someone who appreciates complexity, as you do. How would you respond to that?

AK: I think you're absolutely right. It's absolutely clear that as these regulations accumulate, they weren't developed in harmony with each other, so you often get even contradictory regulations. Every now and then, simplifying them is hugely beneficial. But that doesn't mean getting rid of regulations in general. It means somehow managing to choose between them, and that's not necessarily a natural process. For example, in France when I arrived here it used to take about a day and a half to make my tax return. Now it takes around about 20 minutes, because some sensible guy realized that you could simplify this whole thing and you could put a lot of stuff already into the form which they have received. They have a lot of information from your employer and so forth. They've simplified it to a point where it takes me about 20 minutes a year to do my tax return. It used to take a huge amount of time.

DSW: Nice!

AK: What's interesting is that you have some intelligent person saying "let's look at this and see if we can't make these rules much simpler, and they did. I have conflicting views, like you. These things are usually there for a reason, so you shouldn't just throw them away, but how do you select between them. I don't think that they necessarily select themselves out.

DSW: I would amend what you said. You said that some intelligent person figured out how to make the tax system work better in France. Probably not just a single intelligent person. Probably it was an intelligent process, which included intelligent people, but I think that gets us back to the idea that we need systemic processes to evaluate and select so that we become adaptable systems. But that will be systemic thing, not a smart individual.

AK: You're absolutely right. I shouldn't have said smart individual because what surely happened was that there was a lot of pressure on the people who handle all of these things, and gradually together they realized that this situation was becoming one where their work was becoming almost impossible to achieve in the time available. So there was some collective pressure that led them to form committees and things that thought about this and got it together. So it was a natural process of a system, but it wasn't the rules themselves that selected themselves out, as it were. It was the collectivity that evolved in that way to make it simpler.

DSW: There's no invisible hand to save the day.

AK: (laughs). Joe Stiglitz used to say that we also need a visible hand. The visible hand is sometimes pretty useful. For example in the financial sector I think you really need a visible hand and not an invisible hand.

DSW. That's great and a perfect way to end. I'm so happy to have had this conversation, Alan, and to be working with you at the conference we just staged and into the future.

AK: A pleasure. Always good to talk with you.

Alan Kirman is professor emeritus of Economics at the University of Aix-Marseille III and at the Ecole des Hautes Etudes en Sciences Sociales and is a member of the Institut Universitaire de France. His Ph.D. is from Princeton and he has been professor of economics at Johns Hopkins University, the Universite Libre de Bruxelles, Warwick University, and the European University Institute in Florence, Italy. He was elected a fellow of the Econometric Society and of the European Economic Association and was awarded the Humboldt Prize in Germany. He is member of the Institute for Advanced Study in Princeton. He has published 150 articles in international scientific journals. He also is the author and editor of twelve books, most recently Complex Economics: Individual and Collective Rationality, which was published by Routledge in July 2010.

[Jun 15, 2015] Bookblogging Dead Ideas Introduction by John Quiggin

"...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."
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,


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 Keynes

Most 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

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

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'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

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
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"?

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

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, 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

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

I haven't found said quotes. I did a search on Google – 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"., 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, 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

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

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

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,, page 15 of the pdf, where six buyers and six sellers are enough to reach the "optimal equilibrium outcome", or "Experimental Methods in Economics",, 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.

[May 12, 2015]Infinity And The Bond Market Wormhole

Zero Hedge
The infinite loop continues.

Central banks ease, cajole, fluff up their feathers and push markets to where they don't belong. Markets try to reprice themselves closer to normalcy (sanity). Central banks see their main equity index fall and panic. Central bank pushes more chips in and everyone has to cover. Central banks declare victory. Smart investor sells.

It is so utterly appropriate that in the definition of infinite loop on Wiki it is pointed out that a synonym is "unproductive loop."

Like any table stakes game, running out of wherewithal is a killer. What if the other player doesn't value the keys to your car? It certainly feels that way when debating how clever it would be to juice inflationary expectations by increasing the inflation target, which will ignite the animal spirits of the economy, even though (wink, wink) we will pull back before it becomes a problem.

Another conceit being floated -- by the same central bankers who get night sweats thinking about the day after they raise rates some nominal amount -- is that their communication strategy has been so straight-forward and consistent that surely markets and the banks are on the same page.

Yes, it will be a "regime change," but surely we are all seeing and evaluating the data the same way. That is code for, we don't have a clue either, but we desperately can't threaten the wealth effect of higher equity prices. This supposed wealth effect is used to celebrate (see a chart of Chinese equities) what in an alternative universe would be viewed as a bubble.

Bonds are down because they are overpriced. They use the elevator rather than the stairs because the conceit of getting out right before it gets ugly never works unless there is massive official support, but even that is not always enough, let alone appropriate.

The numbers out of Europe have been getting better. 1Q growth in Europe was better than in the U.S. or U.K. QE is working and the economy is building momentum. So explain to me again why 10-year rates should be negative? The EUR is up over a percent this morning. That may look nice, but that is precisely what they don't need and shouldn't want. Let the rally continue and we can dust off the negative yield talking points.

[May 12, 2015] An Open Letter to Bill McNabb, CEO of Vanguard Group

Economist's View
Stephen G. Cecchetti and Kermit L. Schoenholtz (sort of a follow up on the claim that financial reform is working -- perhaps -- but as noted in the post below this one there is more to do):
An Open Letter to Bill McNabb, CEO of Vanguard Group: Dear Mr. McNabb,
We find your WSJ op-ed (Wednesday, May 6) misleading, short-sighted, self-serving, and very disappointing.
Vanguard has been in the forefront of providing low-cost, reliable access to U.S. and global capital markets to millions of customers, including ourselves. Following the financial crisis of 2007-2009, the firm naturally should be a leader in promoting a more resilient financial system. Your op-ed sadly goes in the opposite direction.
Let's start with the most stunning example: your defense of money market mutual funds. MMMFs are simply banks masquerading as professionally managed investment products. Like banks, they engage in liquidity and maturity transformation. Like banks, they faced runs in 2008 that ended only when the federal government provided a guarantee that put taxpayers at risk. Even with that guarantee, the government still had to support many healthy U.S. corporations with household names that – having previously relied on MMMF purchases of their commercial paper – suddenly faced a severe credit crunch. And, to limit a fire sale amidst the crisis, the Federal Reserve had to provide special funding to buyers to help MMMFs unload their assets.
Unsurprisingly, fund sponsors and their clients – both creditors and borrowers – want to keep these opaque federal subsidies (especially the implicit guarantees that only become explicit and transparent in a crisis). Like them, you make the false, but popular claim that power-hungry regulators (who wish to limit the subsidies that make future crises more likely) are attacking (taxing!) Main Street instead of Wall Street.
In fact, the investment company industry captured its primary regulator long ago, and hasn't let go. The Securities and Exchange Commission's 2014 "reform" of MMMFs is exhibit A. It almost surely makes these funds more, not less, liable to runs (see here and here). And – what a surprise – Congress seems to find protecting U.S. taxpayers from contingent liabilities (like implicit financial guarantees to your industry) less attractive than the largesse of financial lobbyists. Even the voluminous Dodd-Frank Act didn't address MMMFs! :

After quite a bit more, they conclude with:

As the CEO of one of the largest mutual fund companies in the world that is dedicated to serving and protecting small investors, you should be in the vanguard of advocating reforms that enhance stability.
Instead of complaining about regulation under the guise of protecting Main Street, you should highlight the vulnerabilities in our financial system and make the case for efficient regulation that treats all activities equally. You should also promote investment vehicles that are likely to prove robust in a crisis, while warning about existing products that probably won't be.
Only greater resilience in the system can make investors confident that capital markets here and elsewhere will remain strong. That is in Vanguard's interest, too.
Stephen G. Cecchetti and Kermit L. Schoenholtz
anne -> anne:

Stephen Cecchetti and Kermit Schoenholtz are intent on undermining the most important stock and bond investment vehicle for moderately wealthy investors. Vanguard sets the finest of examples for the entire investment industry.

pgl -> anne:

Maybe you are being paid by Vanguard but you are wrong. You are not qualified to comment on financial economics. Stephen Cecchetti and Kermit Schoenholtz are.

And they are not trying to undermine anyone. They are simply telling the truth. Repeat your garbage all you want but it is garbage.

mulp -> anne:

Anne, unless you call the FDIC bailout of the money market funds, and the Fed providing liquidity to them in 2008-9 totally wrong and you should have suffered losses in your holding in MMMF as they marketed to market (breaking the buck) and froze withdrawals until they could liquidate their holdings, or alternatively, declared bankruptcy, then you are totally bought into the free lunch economics of Friedman, Reagan, and all the bank lobbyists dependent on government handling the losses while they reap the profits.

I remember the debate in the late 60s and early 70s on money market funds. We (the People) were assured that MMFs would never be seen as banks by any one investing in them because everyone would know the MMF would someday lose value and in the process freeze the assets for some length of time until the fund could be liquidated.

In other words, not one person putting money in a MMF would see it as a bank that pays higher interest. More importantly, no business or corporation would ever confuse a MMF with a bank.

In 2008, it is clear that the promises made four decades earlier to allow unsophisticated investors access money market funds without lengthy notice of intent to withdraw funds was all a lie, or a belief in tinker bell, pixie dust, and free lunches.

The money market funds should have been left to collapse in 2008 to destroy all faith in them as safe for individuals to use, and in the process, "destroy trillions in wealth" held by tens of millions of upper middle class workers.

I would have lost more than I did in 2008, but the demand for greater government control of the financial sector plus greater social safety nets would have followed.

This is the first time I've seen someone besides me state that mutual funds are banks as we knew them in the 60s, except they pay nothing for the protection of FDIC and Federal Reserve membership.


May 9, 2015

Fees on Mutual Funds Fall. Thank Yourself.

Wall Street is reaping mounting revenue from mutual funds and exchange-traded funds, yet investors are paying lower fees.

That sounds like a good deal for the millions of people who use the funds to invest their savings, and a great deal for the companies that run and sell the funds.

But that win-win situation is not quite as benign as it would seem. Many investors are still - often unwittingly - paying huge fees that cut into retirement savings.

A new Morningstar study offers an excellent explanation of what is happening. The report, "2015 Fee Study: Investors Are Driving Expense Ratios Down," found that, by one measure, mutual fund and E.T.F. fees paid by individual investors had dropped significantly - 27 percent - over the last 10 years. But it isn't mainly because Wall Street fund managers have been reducing fees. The study found that investors have been voting with their feet, moving money from expensive funds into cheaper ones, like index funds. That drives down the asset-weighted cost of mutual funds, skewing the statistics.

"It's not mainly thanks to the efforts of the fund companies," Michael Rawson, an author of the Morningstar study, said in an interview. "It's mainly because people have gravitated toward lower-cost funds."

There's a good reason for the migration to lower-cost funds: They tend to outperform higher-cost ones. As I've written recently, most actively managed mutual funds don't beat the market; those that do beat it rarely manage the feat consistently. Many consumers have gotten the message. Of the 100 lowest-cost funds on the market in March, 95 were index funds that merely try to match the market, not beat it, according to an unpublished study by the Bogle Financial Markets Research Center. Many investors have chosen index funds.

Yet because of the peculiar economics of the asset management industry, fund companies are still doing great. The companies that run the funds have been reaping outsize rewards because as fund assets have grown - thanks in part to the market's terrific performance over the last six years - the companies' own costs have declined.

That's because of economies of scale that the companies don't share fully with customers. "The cost of individual funds has dropped, but the assets have gotten so much bigger that the companies' revenue from fees has grown tremendously," Mr. Rawson said. "They could be sharing more of those revenues with consumers, but they're not."

Using publicly available documents, the Morningstar researchers estimated that in 2014, fee revenue from all stock and bond mutual funds and E.T.F.s reached a record high of $88 billion, up from $50 billion a decade earlier. Assets under management grew 143 percent, and industry fee revenue surged more than 75 percent. The asset-weighted expense ratio - the funds' publicly declared expenses divided by the actual money that investors put into them - declined, too, but only by 27 percent. "The industry - rather than fund shareholders - has benefited most," the report said. Mr. Rawson, a Morningstar analyst, wrote the report with Ben Johnson, director of global E.T.F. research at the company.

The details are fresh, but the economic machine that propels the asset management business has been whirring along for decades. In a telephone interview last week, John C. Bogle, the founder of Vanguard, the industry's low-cost leader, said that in some ways, running a fund company is like operating a factory. As you ramp up production, it becomes cheaper to produce additional items because important costs - fixed costs - don't rise.

For an asset management company, he said, a stock or bond portfolio is the core product and the intellectual exercise of selecting stocks and bonds for it is a fixed cost. "When you set up and run the portfolio, it's not much more expensive to do it when your fund has, say, $1 billion in assets, than when it had only $30 million," Mr. Bogle said.

"Unless you cut your fees drastically, you're going to generate a lot more money for your company as assets grow," Mr. Bogle said. "But do you think the industry wants you to understand that? Absolutely not. Most fund companies aren't passing those savings on to investors."

Vanguard, which is owned by shareholders of its funds, passes along most of the savings. Morningstar found that Vanguard's average asset-weighted expense ratio in 2014 was 0.14 percent, lower than any of the other top asset management companies and lower than 0.64, the current asset-weighted expense ratio for all funds.

Mr. Bogle says companies should charge a modest, flat fee for setting up a portfolio - not a percentage of assets, charged annually, which is the current practice - and give fund investors the rest of the money. That would not generate the splendid profits that asset management companies and their owners have enjoyed, however.

No wonder that in a rising market, shares of publicly traded asset management companies tend to outperform their own stock portfolios. For example, since the beginning of March 2009, the start of the current bull market, through April, the stock of BlackRock, the giant E.T.F. company, returned 27.1 percent, annualized, compared with 20.8 percent annualized in the iShares Core S&P 500 E.T.F., a BlackRock fund that tracks the Standard & Poor's 500-stock index, according to Bloomberg. You would have been better off investing in BlackRock, the company, than in its own S.&.P. 500 index fund.

Why should mutual fund and E.T.F. investors care about the economics of fund expenses? Because it's the dark side of compounding, a force that can be magical when it works in your favor:.


Vanguard 500 Stock Index Fund

Average annual returns as of 3/31/2015

3/31/2014 ( 12.56%)
3/30/2012 ( 15.93)
3/31/2010 ( 14.29)
3/31/2005 ( 7.89)

08/31/1976 ( 11.05)

Vanguard Long-Term Investment-Grade Bond Fund

Average annual returns as of 3/31/2015

3/31/2014 ( 14.54%)
3/30/2012 ( 8.42)
3/31/2010 ( 10.34)
3/31/2005 ( 7.49)

07/09/1973 ( 8.71)

anne -> anne:

This is what Vanguard has meant for modestly wealthy conservative long term investments since the 1970s. From Warren Buffett to David Swenson, the chief investment officer at Yale, Vanguard has been the recommended vehicle for ordinary stock and bond investors.

Harming Vanguard would be a tragedy.

anne -> anne:

"Harming Vanguard would be a tragedy."

The point is harming Vanguard would be harming the ordinary investors who in effect own Vanguard since Vanguard is indeed a "mutual" fund company, a company owned by fund investors.

Dan Kervick -> anne:

The well-being of modestly wealthy long-term investors is only one factor to consider in relation to the well-being of the entire US and global economy. Shouldn't we broaden the discussion?

anne -> Dan Kervick:

Vanguard forms a model for investment well-being in the United States.


Anne, having liquidity requirements is not a tax on investors. When McNabb represents it as such, he is lying. There are no new fees or taxes imposed. It just requires that stock funds hold a percentage of assets in safe bonds in order to handle redemptions in panic situation rather than rely on taxpayer bailouts.

Investors are still entitled to 100% of the returns from the fund. Yes, it is true that the total return may be somewhat less because bond returns are typically less than stock returns. However, that isn't a tax or fee on investors.

Almost no investors maintain a 100% stock portfolio. The typical investor my have anywhere from 20% to 80% bonds. So with the liquidity proposal, some portion of the bond assets they hold anyway will be in their stock fund. They can adjust their stock vs bond allocation accordingly, taking into account the bonds held in their stock fund. After this adjustment, they will receive exactly the same total portfolio return as previously.

The idea that this is a tax or fee is simply a lie. Investors still receive 100% of their investment return.

Dan Kervick -> anne:

Well, it seems prima facie plausible that the ability of some firms to deliver very high returns at low cost is due to the amount they have invested in high-risk, high-yield assets. An economy filled with many such firms is going to be an economy with a higher level of systemic risk. If we want a financially safer world, then some rich people are going to have to get richer much more slowly than they did in the past.

JohnH: I don't believe Vanguard needs any liquidity requirements because none of its investments use leverage. If money is needed, they would just sell the assets at the current market value and disburse the proceeds.

MMMFs are a little different, because there is the presumption that that value of each share will always be $1, which it will be if short term treasuries are kept to term. In case of a run, the Fed could also buy the treasuries and keep them a few weeks to maturity, as they do under QE.

For funds that use leverage, the risk of a run is entirely different:


My interpretation of Anne's issue is that she simply favors individualism's credo for the "moderately wealthy" over the rest of our society, and rationalizes her position by believing (in faith) that Vanguard is immune to failure and thus would not be a participant in any new liquidity meltdown, ergo the nation's taxpayers should shoulder the burden of for profit financial investors when such financial markets fail.

I'm not sure what Anne's position is/was related to the meltdown just past.. but she's caught on the horns of dilemma --- either taxpayer's bail out private investors or they suffer an even greater financial and economic calamity.

The whole point of Cecchetti & Schoenholtz open letter is that a) Vanguard is not immune, and b) taxpayers should NOT be placed on the horns of that dilemma again, and thus the Vanguard letter was indeed self-serving and misleading.

EMichael -> Longtooth:



Well, the critiques may be technically accurate enough as far as they go.

But I fail to see how attacking one of the last pockets of low-fee, consumer-facing investment helps anyone in the long run, except those who wish to herd all money into complex, opaque, high-fee vehicles.

Money Market "reform" may have found some reasonable-sounding talking points on which to promote itself, but stepping back, one cannot help but see it is simply one more wave in the voracious plunder and elimination of any and all alternatives to the relentless and jealous Wall Street flim flam machine.


A democratic investment company is a company that is investor owned, that offers the finest quality long term stock and bond funds with minimal transactions or turnover at low management cost for investors with $10,000. For those men and women who prefer to deal with a Goldman Sachs, a suggest giving that company a call and finding the difference.

The idea that a Warren Buffett is paid by Vanguard for recommending Vanguard only shows a failure to understand that Vanguard is owned by investors and there are no payments made to financial advisers for recommending the company.

DeDude -> anne:

If you think the leadership if Vanguard is controlled by and serving its investors - then you need to get out of the Ivory tower a little more.

Leadership in any Wall Street company are always serving themselves first, second and third. It is just that some of them are better at hiding that fact than others.


As much as Vanguard is trying to sell itself as the investors friend on Wall street, their leadership is just as much a part of the Wall street vampire tribe as the rest of them. Yes, they suck less less blood from each victim, but they are still blood-suckers. When I see Vanguard offering a fund that restrict its investments to companies that compensate CEOs less than average (for that industry and size), then I will know they have left the blood-sucker tribe. The one product that would truly serve the interest of investors is not available from any investment company, because as useful as it would be for us it is dangerous for them.


The descent to profane and violent language on this thread, the descent to intimidation and bullying, is intolerable, horrifying, and meant only to destroy this thread and this blog.

EMichael -> anne:

Personally, I think the constant repetition of a Edwardian rant about language is "intolerable, horrifying, and meant only to destroy this thread and this blog."

As Keynes said, "words ought to be a little wild".

Syaloch -> EMichael:

Amen to that.

Syaloch -> anne:

Am I missing something? Neither "vampire" nor "blood-sucker" is profanity -- unless you mean it in the sense of blasphemous, i.e. criticism of something sacred.

Do you think that this "class of people" who work on Wall Street are holy deities and therefore beyond reproach?

You attitudes toward Vanguard certainly seem to point in that direction:

anne -> Syaloch:

These very terms were used to characterize and dehumanize a class of people in the 1930s. These are terrible, fearful terms to use to describe and stereotype people.


The use of profanity and a metaphor from the 1930s in describing a class of people is intolerable. Paul Krugman made a serious mistake in using a 1930s metaphor in description, both for the dismissing of the decency of the humanness of an entire class of people and for setting an example as to use of the metaphor.

Millions of people were methodically murdered during the 1930s in the wake of a campaign to stereotypically deny their decency, to deny their humanness by using dehumanizing metaphors to describe them.

likbez -> anne:

While behavior that you mentioned are unacceptable, a part of the blame is on you: you demonstrated a perfect example of the psychology of rentier, Anna.

Rentier capitalism is a term used to describe the belief in economic practices of parasitic monopolization of access to any kind of property, and gaining significant amounts of profit without contribution to society.


No, I think people are just having a little fun with your stuttering failure to address the issues. However, I will stop now (before being called a Nazi again – but don't think your bullying has worked, its just that I am tired)

DrDick -> DeDude:

Nothing I love more than passive-aggressive bullies, but that is Anne's schtick.


The key question to Anne is whether Vanguard is really better for unmanaged funds then ETFs. You need to provides us with solid evidence or all your post with belong to the category that Prince Hamlet defined as:

The lady doth protest too much, methinks.

And for managed funds Vanguard experienced several high profile disasters such as with their flagship Primecap fund around 2008. In this sense there is not much to talk about here. Thir managed funds is just a typical example of "go with the crowd" approach.

Issue of fees was important in 90th. But now IMHO Vanguard belongs to "also run" category: for each Vanguard fund you probably can find other fund or ETF with comparable fees.

So why you so adamant in defending Vanguard Anne? It' just one of Wall Street sharks which was broght to the surface by establishing 401K in 1978

P.S. I also consider Vanguard to be among more decent category of Wall Street sharks. But it is still a shark.

[Apr 10, 2015] Keynes and the casino

July 13, 2009 | John Quiggin

A short extract from my proposed book, over the fold. Lots more like this to come! Comments and criticisms much appreciated, with free books for the top ten!

Dead Ideas from Live Economists: The Efficient Markets Hypothesis

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done, JM Keynes, General Theory of Employment, Interest and Money Ch 12, p142 in Google Book edition, Atlantic Publishers

If there is one economic doctrine that has been central to thinking about economic and social policy over the last three decades, it is the Efficient Markets Hypothesis, or more properly, the efficient financial markets hypothesis. 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.
Although economists since Adam Smith have pointed out the virtues of markets in general, the EMH with its focus on financial markets is specific to the era of finance-driven capitalism that emerged from the breakdown of the Keynesian Bretton Woods system in the 1970s. The EMH justified, and indeed demanded, financial deregulation, the removal of controls on international capital flows and the massive expansion of the financial sector that ultimately produced the greatest financial crisis in history.

Some more linking material to come here

Keynes and the casino

Few economists have been successful investors, and quite a few have been disastrous failures. But after a narrow escape from disaster early in his investing career John Maynard Keynes made a fortune for his Cambridge college by speculating in futures markets It is a striking paradox that Keynes was among the most scathing of all economists in his assessment of the role of financial markets.

"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done" (General Theory Ch 12, p142 in Google Book edition, Atlantic Publishers

During the decades of the long Keynesian boom, financial markets were tightly regulated, and, as a result, financial crises disappeared almost entirely from the experience and memory of the developed world. At the margin, substantial profits could be made by finding ways to work around the regulations, while relying on governments to maintain the stability of the system as a whole. Not surprisingly, there was a warm reception for theoretical arguments that presented a more favorable view of financial markets.

Keynes' views were reflected in the systems of financial regulation adopted as governments sought to rebuild national economies and the global economic system in the wake of World War II. The international negotiations undertaken at a meeting in Bretton Woods, New Hampshire, in 1944, where Keynes represented the British government, established an international framework in which exchange rates were fixed and movements of capital tightly controlled.

National governments similarly adopted policies of stringent financial regulation, and established a range of publicly-owned financial institutions in response to the failures of the private market. In the United States, a host of regulatory bodies were established to control financial institutions. The Glass-Steagall Act established the Federal Deposit Insurance Corporation (FDIC) and prohibited bank holding company from owning other financial companies. The Federal National Mortgage Association (later quasi-privatised as Fannie Mae, and then renationalised during the early stages of the 2008 meltdown) was established to support the mortgage market.

Although the details of intervention varied from country to country, the effect was the same everywhere. Banking in the 1950s and 1960s was a dull but secure business, resembling a public utility in many respects. Parents scarred by the Depression urged their children to look for 'a nice safe job in a bank'.

The Efficient Markets Hypothesis changed all that.

Sinclair Davidson July 13th, 2009 at 18:59 | #1 Reply |

Quote Zero price books – the cost comes out of the author's royalty.

The problem with your argument, as I understand it, is this

Efficient market theory is an ideology a few may share, but it is not a mechanism for direct action-taking. As such, and unlike the theories that truly caused the crisis, it cannot lead to activities by professionals that may cause trouble.

There is also the point that the efficient market hypothesis says markets cannot be beaten, and yet the current nightmare was created by those who very much wanted to outperform.

Had Wall Street and the City abided by the theory, they would have gorged on index funds rather than on subprime CDOs. They would have tried to make money by boringly replicating the index, not by selling optionality though credit default swaps.

Rather than being followed, the efficient market theory was scorned.

Andrew Reynolds July 13th, 2009 at 19:15 | #2 Reply PrQ,

You seem to point to the "Efficient Markets Hypothesis" as being the cause of the "collapse" of the tight regulation and the Bretton Woods System. My understanding is that at least Bretton Woods was brought down by comprehensive cheating by many, if not most, participating governments.

The massive overspending by Johnson and Nixon, combined with the steady debasing of the USD made the US's exit from Bretton Woods a fait accompli, only hastened by the speculation that it would happen, not caused by it.

If you are also going to argue that there was a reduction of stringent financial regulation it would probably also help to justify that position, rather than assuming it. In the US, for example, none of the regulatory bodies disappeared and I am not aware of many, if any, of their powers that were removed.

Peter Wood July 13th, 2009 at 19:23 | #3 Reply |

Quote John, I recall you had an earlier post describing both strong and weak forms of the efficient market hypothesis. While I have big problems with strong forms of the efficient markets hypothesis, I do have sympathy for weaker forms.

I think fleshing out the differences between strong and weak forms of the efficient hypothesis could be quite interesting.

jquiggin July 13th, 2009 at 19:41 | #4 Reply |

Quote AR, my final sentence is a bit ambiguous. It was intended to refer only to the last few sentences, about banking being safe and boring etc. I broadly agree with your account on the end of BW – this paved the way for deregulation.

Sinclair, I'll be coming to your point later in this chapter. Relevant quote:

There was something of a paradox here. The Black-Scholes pricing rule shows how an option price ought to be determined in an efficient market. But traders can only make a profit using Black-Scholes and similar rules to price derivatives if the market price deviates from the 'correct' price, that is, if the efficient markets hypothesis is not satisfied.

Economists have wrestled with this problem for a long time without working out a completely satisfactory solution. The most common view was one that seemed to preserve the efficient markets hypothesis while justifying the huge returns reaped by financial market professionals. This is the idea that the market is just close enough to perfect efficiency that the returns available from exploiting any inefficiency are equal to the cost of the skill and effort that goes into discovering it.

philip travers July 13th, 2009 at 20:11 | #5 Reply |

Quote The Reynolds number above doesn't know his pipelines. Recently a move by DeMint to audit the Federal Reserve, was met by a a non-supporting Democrat House that was so uninterested like the Republicans a qourum could not be..and the bill or amendment was rescinded. A Video of DeMint outlining his stuff is on YouTube. A whole history of trying to audit The Federal Reserve has met with a dulling hammer. Who knows, if this had occured, Wonderboy Al Gore maybe in jail today.

hrvoje July 13th, 2009 at 21:37 | #6 Reply |

I'm not an economist. So I hope your book will be easy to read (i.e not too much hard core economic theory. I very much like Krugman's style of writing of non academic texts simply because it appeals to more people and ordinary folk can read it. And it's important that ordinary folk reads Krugman and similar authors like yourself), which I am sure it will. I have a copy of General Theory, and I must say it's a slog to read. He obviously did not intend to still be popular among non economists 60 years on.

Thing that I don't understand about finance industry and which I hope you will address is this. In quite a few industries you can sue someone for professional negligence and malpractice i.e doctors, civil engineers, food factories, car companies etc. Hence they have a lot of incentive to besides winning consumers and making money also not to make catastrophic mistakes thus endangering their own financial survival and or jail time. What it boils down to is the question of incentives. If you (individually or as business) have all the incentive in the world to keep on pushing the envelope but have very little deterrent against the actions you might take, then you will keep on pushing the envelope. So what's the worst thing that can happen to you as a trader or a finance exec, if you're sitting on few million dollars a year. Well if you stuff up big time, you might get demoted, not get your bonus, or worse case scenario you might loose your job. Big deal, you already have made the money. Everything else after couple of million is a matter of peer prestige. So what do you do. You keep on pushing the envelope, because everyone else is doing it.. And for a certain period of time it works. Until it stops. In the meantime all of your friends (individual or similar type businesses) keep on pushing the envelope, until it stops. And then we all have a problem. I realise that we do not have current laws which could be successfully applied across the globe to prosecute those who have caused the financial crisis caused. A lot of it is a system error, beyond the control of one individual. But at the same time, this was a human made catastrophe which will push millions into poverty, cause civil unrest etc. Having said this, we also did not have laws for atrocities committed in second WWII or in the following wars. Yet perpetrators of atrocities committed did get successfully prosecuted and punished. It is a bit of a starch to compare finance guys to war criminals, but at the same time you do have a lot of pissed of people asking the obvious question? Should someone be punished? As they say, … just follow the money trail and where it went. If not jail time then maybe we could at least take their bounty away. And this could serve as a little bit of a deterrent to the next generation. To paraphrase and extend Keynes's "magneto trouble" analogy, "you don't mess around with the light switch, because if you do and you turn the darkness on to the rest of us. Well then, you should get your fingers chopped off".

So Prof Q, how would you address the issue of incentives in finance industry and all other industries which are essential in the modern day society. As good old Keynes said it "Soon or late, it is ideas, not vested interests, which are dangerous for good or evil."

haiku July 13th, 2009 at 21:49 | #7 Reply

There's a quote out there somewhere from Charlie Munger (Warren Buffett's business partner) along the lines of "if investment banking is too big to fail, it should be tightly regulated and boring …" Or something like that.

gerard July 13th, 2009 at 22:04 | #8 Reply |

is this hypothesis falsifiable?

This is the idea that the market is just close enough to perfect efficiency that the returns available from exploiting any inefficiency are equal to the cost of the skill and effort that goes into discovering it.

There doesn't seem to be much in the way of a burden of proof.

Or concrete terms under which the hypothsis could be rejected.


Show me an institution that is too big to fail and I will show you one that has used the regulations to become that way.

SeanG July 13th, 2009 at 22:59 | #10

I think with EMH you should split it up with the primary focus being on the strong-form efficient market hypothesis which has driven options pricing. There is another great quote from Markowitz I believe that you could use about EMH, something that the view of the world from the Charles river is considerably different than the view from Hudson river.

Jill Rush July 14th, 2009 at 00:08 | #11

Were the aims of the two systems somewhat different? I had thought that the aims from Bretton Woods were nation building and reconstruction ie for the social good.

The aims of Efficient Market Hypothesis seems to be the creation of wealth for individuals/corporations where the nation and social benefit are no longer in the picture except as an implied consequence.

Andrew Reynolds July 14th, 2009 at 00:21 | #12 Reply


There was no "system" that went with the EMH. It is simply an hypothesis – one that is susceptible to proof – i.e. at least in some way scientific. Bretton Woods was a system.

One allows the participants to cheat like bandits – which they did from the get go. The other was the EMH.

Jack Strocchi July 14th, 2009 at 00:38 | #13

The Efficient Markets Hypothesis changed all that.

Keynes was undoubtedly as good an economic theorist and financial operator as Pr Q would have it. But his philosophy of history exaggerates the role of ideological ideas over institutional interests. In the General Theory he concludes:

It is ideas, not vested interests, which are dangerous for good or evil…Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

In reality it is interests, not ideas, that tend to prevail. Power seeking organizations will of necessity engage in ideological manipulation of special interests in preference to institutional incarnation of general ideas.

And then there are "events, dear boy, events" that no government or philosopher can do much about. In particular, it was the advent of fiscal inflation which drove a liberalisation of financial policy.

The Bretton Woods agreement collapsed for institutional, not ideological, reasons. The US govt from the late sixties onwards could no longer square the politico-economic circle ie pay for gigantic increases in its Warfare (Vietnam/Arms Race) and Welfare (Civil Rights/Great Society) state, run a non-inflationary fiscal balance/trade deficit AND adhere to a USD exchange rate pegged to a fixed gold standard @ $35.00 per ounce.

The result was that foreign govts, worried about inflation-driven devaluation of their dollars were starting to exchange them for gold. Causing the price of gold to skyrocket and the US to suffer a massive outflow of gold in exchange for less worthy paper.

Nixon solved this by closing the gold window – the so-called Nixon shock. But this was pure policy opportunism by Nixon and not driven by an ideological preference for free exchange rates. Nixon was, if anything, more statist than most US Presidents.

Of course Nixon's ending a "corporal" regulatory regime is not the same as Reagan's innaugurating a liberal de-regulatory regime. The biggest de-regulation occurred with the relaxation of Regulation Q by a liberal Democratic congress in 1980. This was done to allow larger banks to compete with non-Bank financial instittutions for deposit funds by raising interest rates, thereby stemming the inflation-driven outflow of money.

That allowed financiers to get out into the market place and become "players", rather than just errand boys for industrialists. Thereby allowing executives to effectively privatise public companies through LBOs.

So really it was inflation that forced the financial genie out of the regulatory bottle. After that it was leverage and arbitrage that did the rest.

Jack Strocchi July 14th, 2009 at 01:03 | #14 Reply

Pr Q says:

There was something of a paradox here. The Black-Scholes pricing rule shows how an option price ought to be determined in an efficient market. But traders can only make a profit using Black-Scholes and similar rules to price derivatives if the market price deviates from the 'correct' price, that is, if the efficient markets hypothesis is not satisfied.

Oh God here we go again. Neo-classical economists who attempt to justify liberal capitalism often do so by theoretically abolishing those aspects of the system that allow the opportunity to make profits which make it all worthwhile, at least from the pov of the capitalist.

And then, to compound the irony, they practically establishing exactly those kinds of rackets that the competitive system is supposed to wipe out. Does the acronym LTCM strike a distant chord?

If the perfect market theory were true then there would really be little role for entrepreneurial risk taking since information is freely available and reliable. Competitive firms would quickly compete away all profits, driving down prices to equate with marginal costs.

The rate of profit would approximate the rate of interest. So there would be precious little incentive to take a risk on a new investment.

In short, if perfectly efficient markets prevailed the capitalist system would quickly evolve into a predictable routine and everyone would die of economic boredom.

In reality capitalist markets, whether industrial or financial, are anything but perfectly competitive, equitably informed or efficiently operated. They are characterised by large anomalies of information and disparities of incentive.

Its the hunger to exploit these niches that keeps the system humming along. Nothing inherently wrong in that so long as the niches represent real differences in the value of useful things.

The trouble with financial competition is that, left unchecked, its institutional churn of value creates artificial niches in virtual things. There is also an almighty tendency to market concentration as Big Banks swallow up Small Banks in order to better absorb risk.

But their attraction to reward always outruns their aversion to risk. So they get into strife.

And of course, in the late sub-prime crisis we had the added complication of the entry into the market of a vast, new and hitherto unknown risk quantity: marginal minority borrowers. Boy didn't that generate a few surprises!

Martin July 14th, 2009 at 02:32 | #15 Reply

Macao isn't doing that badly…

Chris Warren July 14th, 2009 at 10:27 | #16 Reply |

I cannot see much value in exploring the efficient "financial" market hypothesis, if you ignore the underlying efficient economic market hypothesis (Smith, Mill, Ricardo, Marx).

useful insights can be gleaned by starting from a prison camp analysis of cigarette currency similar to RA Radfords 1945 paper "Economic Organisation of a POW camp".

As Adam Smith used Robinson Crusoe to simplify matters, looking at a artificial system like Radford's has value.

So I would assume that whatever distribution or allocation results from cigarettes, then presumably there could exist a better distribution based on a non-market distribution.

Efficient Markets only exist if there is initially an equitable distribution of endowments. These two must coexist. We do not want a society that has to choose between and equitable distribution and a efficient distribution.

In any such case – society will always go for the equitable outcome and efficient markets become a laughing stock.

Gaz July 14th, 2009 at 11:01 | #17 Reply

On the EMH and the role of regulation, Treasury guy David Gruen made a refreshing speech referring to it last month.

Best quote: "It is as if, as the Titanic was sailing into iceberg-infested waters, those with the requisite skills and training to warn of the impending danger were instead hard at work, in a windowless cabin, perfecting the design of ship hulls … for a world without icebergs."

Socrates July 14th, 2009 at 12:28 | #18 Reply

I think the Efficient Markets Hypothesis would be better titled the Convenient Assumptions Hypothesis, because that is all it is. The easiest lie to tell people is always the one they want to hear.. EMH told a lot of right wingers and wealthy people what they wanted to here.

I have another theory I'd like to see shot down in the wake of this mess: Alignment and Inncentive theories. These hold that, if you structure the incentives right, you can align people's interests with your own. Jensen and Murphy made careers out of running this argument. But its rubbish! People's interests are what they are; you can't change them. You might be able to align their behaviour with the right incentives. The difference between aligning interests and only aligning behaviour is not trivial. If you assume you can align CEO's interests then you don't need a corporate watchdog to police CEOs. If you only assume you can aling behaviour then you still need a watchdog, in case the circumstances arise where the CEO has a greater incentive to rip off the shareholders than act on their behalf.

S. Haines July 14th, 2009 at 15:03 | #19 Reply


What exactly does "during the Keynesian long boom" mean? Does this mean a phase that Keynes himself described as a "long boom?" When did it take place and where?

jquiggin July 14th, 2009 at 15:18 | #20 Reply #19 The "Keynesian long boom" refers to the period from WWII to the early 1970s in the developed world, a period of full employment and strong growth attributed at the time (and still attributed by some) to the use of Keynesian policies.

Andrew Reynolds July 14th, 2009 at 17:18 | #21 Reply

…and which ended with the collapse of virtually the entire infrastructure built up after the war in the face of systematic cheating by governments.

S. Haines July 14th, 2009 at 18:12 | #22 Reply

The boom between the end of WW2 and the mid-late 60s (the trouble set in long before 1973) was a result of three things more important that Keynes' economic theories:

1. The massive profits the US made out of WW2 were able to be lent to Western Europe and Japan – the Marshall Plan – to rebuild them after WW2.

2. The unquestioned militarisation of a bipolar globe led by the US and the Soviets.

3. Incredible technological advances in production processes, which largely derived from war time Physics.

Andrew Reynolds July 14th, 2009 at 18:59 | #23 Reply

S. Haines,

I would put at the top of the list the fact that the world economy was starting from a situation where there had been a prolonged depression followed by the most destructive war in history. As with China today, growing quickly from a low base is not a real challenge – all you have to do is stuff it up as little as possible. Growing quickly from a high base is the real challenge.

Alanna July 14th, 2009 at 19:06 | #24 Reply


Andrew – you say
"and which ended with the collapse of virtually the entire infrastructure built up after the war in the face of systematic cheating by governments."

Sorry Andrew – if you must know why we never got back to the long boom post war (which did work and was more keynesian) – because of inflation in the 1970s due to Vietnam War Boom and poorly managed aggregate demand in the US post 1966 causing a wage explosition and prices up worldwide (yes – dont be naive enough to comment it was unions here "that done it" – it happened in lots of industrial countries at the same time…way too international for that – it was as it ever was …the US sneezed) and then oil (check yr government in the US at that time) – a bunfight over theory from a bunch of slightly misguided monetarists in the 1970s, then of course then (drumroll) you know who came to really stuff it up and make sure we NEVER revovered…the truly mad neo liberals.

jquiggin July 14th, 2009 at 19:37 | #25 Reply

AR @21, this point seemed a lot more convincing 18 months ago. The system based on the efficient markets hypothesis has collapsed just as spectacularly, and with much less to show for itself as far as OECD countries are concerned (China has done pretty well since the 1970s, but it's not exactly an advertisement for free capital markets).

Andrew Reynolds July 14th, 2009 at 19:39 | #26 Reply

So "were all Keynesians now" Nixon was a neo-liberal? Fascinating. I look forward to your book on the subject. It should be a doozy.

Governments everywhere cheated the system, Alanna – that is one of the reasons why it failed and fell into stagflation. It really was that simple.

I never mentioned the unions – why did you feel a need to bring them up?

Ernestine Gross July 14th, 2009 at 19:56 | #27 Reply

JQ, Given the post and some comments (eg #1, #3), it seems to me there are several ideas and problems superimposed or entangled.

My reading of your post is that you are using the term 'efficient market hypothesis' the way people in the financial sector (including accountants and corporate lawyers, management consultants …) and in policy areas and beyond have used this term. In this context, the term substitutes for phrases such as 'markets allocate resources efficiently', 'governments can't pick winners', 'the market outcome cannot be improved upon, therefore privatise, deregulate, etc, etc. I am not sure whether an appropriate label would be ideology or mythology or dogma.

The comment in #1 is but a variant of the foregoing in the sense that the said practical men and women take 'theory' to be prescriptive and there doesn't seem to be time taken to distinguish between a 'theory' and a 'hypothesis'.

The comment in #3 belongs to the professional Finance literature. In this literature, Fama is a big name. Fame wrote about three linked 'efficient capital market hypothesis', all of which linked the term 'efficiency' to information (weak form, semi-strong from, strong form). The Fama weak and semi-strong form hypotheses created a growth industry in publishing empirical tests. This literature was influential because it was empirical and it was said to be 'evidence based'. As I mentioned in an earlier post, in a 1986 Working Paper, titled "A Note on the Testability of Fama's Semi-Strong-Form Efficient Capital Market Hypothesis, Dept of Economics, University of Sydney (available in the Fisher Library), I showed that the hypothesis is not falsifiable. At most, the empirical 'tests' test a weaker proposition, namely that, relative to a benchmark 'market portfolio' and a hypothesis about the pricing of securities, one cannot make excess returns on average during a particular period of time from making investment (in securities) decisions that are conditioned on publicly available information. I learned from Frank Milne, formerly ANU, that he had reached a similar conclusion in an also unpublished paper (ie not published in an 'internationally recognised' journals because at the time they rejected such papers) paper. For all I know, there may be another 100 or 200 or more analytical economists in this world who had reached the same conclusion around the same time. In a later Working Paper "Shareholders' Valuation Response to Corporate Direct Foreign Investment Announcements', School of Banking and Finance, UNSW, 1989 (available at the UNSW Library), I found that the valuation responses (magnitude) varied with the regulatory framework within the sample period (ie one observation on the effect of a change in regulation of a particular type – no other big conclusions can be drawn).

There is another literature relevant to the topic (IMHO). It consists of theoretical models on 'Fully Revealing Rational Expectations Equilibria (FRRE). This literature belongs to mathematical economics, using a methodology compatible with general equilibrium models at the time). This literature belongs to the 1980s. It 'covers' a notion of strong form informational efficiency and allocative efficiency in the sense of a Pareto-type criterion. Big names in this area are Grossman, Hellwig, Laffont.

Then there is at least one study which aims to examine the likelihood of FRRE, using numerical methods (Boehm et al.)

The point I end up making is that the 'efficient market hypothesis' in the Fama sense has been discredited before the term 'efficient market hypothesis' as you seem to use it became popular. Do you have a chapter or an appendix to the chapter on quality versus quantity of research output ?

Does G Soros deserve a mention in relation to making money in the financial markets and being critical of some beliefs?

I look forward reading your book.

Ernestine Gross July 14th, 2009 at 20:18 | #28 Reply

JQ, further on the 'efficient market hypothesis' – ideology or mythology or dogma:

At least since 1987, some research took place in the area of financial stability or lack thereof. For example, H.W. Wilson et al, "A model of financial fragility", Journal of Economic Theory, Jul/Aug 2001.

I'd be most interested to hear from academics in Commerce Faculties about their luck or otherwise in getting a course accepted which introduces at least an outline of the methodology and results from this body of literature. It was possible at UNSW in the 1980s and early 1990s, at least for honours students.

The topic of derivative securities and their effect on equity prices has also been studied. In this area, a topic of interest to me has been the observation that the Black and Scholes model is a characterisation of an equilibrium of model of an economy with complete securities markets. Derivatives are redundant because their payoffs are priced by duplication portfolios of underlying securities. In practice the Black and Scholes model is 'applied'. Now, if the model is 'true' then introducing redundant securities and using past data of the underlying securities must have an effect on 'everything else', unless the number of derivatives is negligible in relation to the market of underlying securities. So I thought. Geoff Wells (honours student at the time) and I did a simulation study, modelling the application of Black and Scholes in a model where the conditions for the B&S model hold. Indeed, equity prices were affected and commodity prices (1 'good' only). The 1999 paper is available from the Library at UNSW.

I have no sympathy with the opinion authors and practical men and women in formerly highly paid jobs who now wish to blame 'economists' for the GFC. But I am absolutely delighted hearing you are to write the book in question. The 'truth' wants to come out.

S. Haines July 14th, 2009 at 20:24 | #29 Reply AR

Yes, your point about growth from a very low base point is well made.

I emphasise the Cold War polarisation as it more or less forced individual nationas to be hermetically sealed behind the military protection of whichever Cold War empire they belonged to. It had nothing to do with politicians from Canberra to London to Rome to Tokyo to Copenhagen reading Keynes

But in the mid-1960s, inflation broke out, which Keynesianism could not control, and then not even the US could stop private companies and banks engaging in cross-border investment independently of regulatory attempts to control them.

The so-called "Keynesian Long Boom" had less to do with Keynes than it was a result of the success of American militarism and imperialism. And it was not all that long. It stopped in the mid 60s, with the reemergence of inflation.

Alice July 14th, 2009 at 21:08 | #30 Reply @Andrew Reynolds

Look Andrew – it was you that brought up history…and Im so glad you did because you are way way off course as usual.

I can find you an economists quote back in 1950 that said the trouble with policy (then!!!!) was that "laisssez faire" beleifs had infiltrated US power structures. Now just to get this truly in perspective "laissez faire" economics was always the enemy and always will be the enemy. It is they who make a monumental mess in the name of enriching a few. They were around before Keynes, who put paid to them, but they will always be with us. The enemies of sound economic policy. They have a new name but they are the same breed. Neoliberals is laissez faire by any other name.
lets go back in time – Korean War boom also caused a run up in prices, again starting in the US and transmitted here like swine flu – but it didnt last long. The Budget of 1951-52 delivered shart tax rises and a credit squeeze. It lasted barely a year. A Keynesian budget delivering what it should have to restrain demand – and another "little budget" in 1956 when it threatened to rear its ugly head again. Problem solved – Keynesian policies. Fast forward to 1966 – again another run in the US – and another war – Vietnam. Only this time – no good policies – Nixon in in 1968 – the start of the rot and no decent constraints (Keynesian demand management). Instead he escalated the Vietnam war. He used wage and price controls instead of Keynesian remedies. He abolished the gold standard. He devalued the dollar 8%. His budget deficit of 1971 was the largest in US history (petrol) and he was a crook and it declined from there.

Andrew, in case you don't remember – Nixon was a republican. It was the abandonment of Keynesian economics that stuffed up economic policy and got us into the mess of the past 35 years being nowhere near as decent as the post war years. Neoliberalism = Laissez Faire by another name – thats all.

Tony G July 14th, 2009 at 21:09 | #31 Reply

" I'd be a bum on the street with a tin cup if the markets were always efficient "

Ernestine Gross July 14th, 2009 at 21:14 | #32 Reply

S. Haines, Are you suggesting that the military expenditure ("American militarism and imperialsim" in your words) had nothing to do with the "re-emergence of inflations"?

Ernestine Gross July 14th, 2009 at 21:18 | #33 Reply

Tony G, your comment reminds me of a former colleague in a School of Finance who was the only one with a 'fat merc'. On the topic of efficient capital markets he used to love putting on a little smile saying: you buy cheap and sell expensive. He was very popular among those who thought they were testing a Fama hypothesis.

S. Haines July 14th, 2009 at 21:20 | #34 Reply


No, I am not. I am merely questioning the significance of 'Keynesianism' that JQ seems to give it.

Alice July 14th, 2009 at 21:33 | #35 Reply

@S. Haines

This is the sort of comment I object to…"But in the mid-1960s, inflation broke out, which Keynesianism could not control"

A) Inflation did not break out in the mid 1960s. It broke out in the late 1960s. Wage rises started breaking out in the mid 1960s BUT NO Keynesian remedies were applied. It was this failure that led to the extreme inflation of early 1970s that was an international phenomenon transmitted to the rest of the world by an unrestrained boom in the US.

It was a failure to restrain aggregate demand in the US. It was the failure to apply Keynesian remedies, primarily due to the Nison government (republican). It wasnt until early in the 1970s sometime that Greenspan stepped in (in Fords company – another republican) after Fords solution to high inflation in the early 1970s was to get people to wear WIP badges ("Whip Inflation Now" – now that was useful wasnt it) to advise a stimulus because by then the ugly thing has imploded and thrown people on the streets) and what was Greenspans stimulus?

What else? Stimulus via tax cuts.

Tax cuts – then became so popular they were given for breathing. They were even given to the rich. Big ones. Fast forward to Reagan and supply side tax cuts given to all in business to cure everything from a headcold to impotence (except budget deficits and declining govt investment).

By this time the economy is becoming impotent. People are told they are losing their jobs because of "structural change" and "technology improvements seeking skilled workers" ha ha.

It was just lousy management all round.

Alice July 14th, 2009 at 21:35 | #36 Reply WIN badges – sorry (Whip Inflation Now). Oh my goodness. Sounds like the start of media and politics (the Howard Govts interest rate election…..ew). If they were doing something useful they wouldnt need to advertise it.

Alice July 14th, 2009 at 21:52 | #37 Reply "Obviously, we've got budget matters. You know, when I was running for President, in Chicago, somebody said, would you ever have deficit spending? I said, only if we were at war, or only if we had a recession, or only if we had a national emergency. Never did I dream we'd get the trifecta." (Laughter.)

George Bush

and Keynes said if you can build and economy for war for you can build it in a time of peace

But the neoliberals (in the Republicans) only liked war because they had mates in oil or military supply lines. But they knew what war spending could do and if REAL unemployment wasnt so high in the US (as opposed the offficial measured unemployment) they would have got another bad dose of inflation. Instead they got a global ponzi boost and some war looting thrown in for good measure (Gulf war 1 and 2 – thankyou to the Bush Family who know how to look after their own).

TerjeP (say tay-a) July 14th, 2009 at 23:26 | #38 Reply JQ – Can you fit in a few chapters discussing the Bancor and how it might have made for a different global monetary system?

Ernestine Gross July 15th, 2009 at 08:01 | #39 Reply Correction, comment #28, para 4, last sentence should read:

"The 1989 paper is available …" (not 1999).


S. Haines July 15th, 2009 at 13:56 | #40 Reply Alice

My economic history is a bit rusty, and I do not have the data at my fingerprints, but I am pretty sure the inflationary break out occurred in 1965 in the US, while average profit rates peaked the year after in 1966 and continued to decline until the early 1980s. This led to the credit-crunch of 1966-67. If you have contradicting data, I would be grateful for the correction.

Alice July 15th, 2009 at 16:27 | #41 Reply @S. Haines
Inflation was between 4 and 6% in the US between 1965 and 1970 S.Haines (having risen from 1960 from slightly under 2%). However, deespite a small dip after 1968 – Inflation then took off, reaching 10 to 11% around 1972 fell back to about 8% in 1977 and then rose to 12% around 1980. I havent got the actual inflation figures for the US in front of me but they are shown graphically hence Im reading these numbers from a chart (so not absolutely precise but probably close enough). On the scale of things the rise after 65 was both relatively small and dipped back relative to the peaks of early 1970s and early 1980s inflation (and the US the early 1980s peak which was even higher than the early 1970s). It was this inflation I was referring to. For a look at how inflation looked in a lot of countries at around the same time, this article illustrates well. It was def a worldwide event and as such most unlikely to be caused by any local union activity (US intyernational transmission more likely). These authors found not a lot of evidence to suggest oil price rises or food price rises triggered inflation starts (exacerbate maybe, trigger – no) in OECD countries. They suggest

"High real GDP
growth prior to many inflation starts is consistent with the idea that policy-makers focused on the short-term benefits of stimulating real growth while avoiding the costs of ending incipient inflation. Exchange rate stability concerns seem to have led other countries to follow U.S. inflation policy even after the demise of Bretton Woods. Thus policy mistakes in the U.S., coupled with the U.S. role as a leader in setting inflationp olicy, contributed to a large number of inflation starts in OECD countries in the 1960s and 1970s."

What Starts Inflation: Evidence from the OECD Countries
Author(s): John F. Boschen and Charles L. Weise
Source: Journal of Money, Credit and Banking, Vol. 35, No. 3 (Jun., 2003), pp. 323-349. You can find it in Jstor.

Alice July 15th, 2009 at 16:27 | #42 Reply excuse spelling mistakes above

rog July 15th, 2009 at 16:30 | #43 Reply I thought it was more a system that relied heavily on sophisticated models had collapsed.

And it was the collective view of the majority of academics and economists that everything was A-OK

"I do not know anyone who predicted this course of events. This should give us cause to reflect on how hard a job it is to make genuinely useful forecasts. What we have seen is truly a 'tail' outcome – the kind of outcome that the routine forecasting process never predicts. But it has occurred, it has implications, and so we must reflect on it" (RBA 2008).

jquiggin July 15th, 2009 at 16:33 | #44 Reply Rog, while the nature of the crisis was such as to make it impossible to predict in detail, there was a substantial group of economists (admittedly, as you say, a minority) who pointed to both the unsustainability of imbalances in the global economy and the dangers of a breakdown in the financial system.

Alice July 15th, 2009 at 16:37 | #45 Reply If history is any guide JQ, when the wealthy are making large stock market profits, minority group economists with substantially sound advice not only dont get listened to…they often get pilloried by the press.

S. Haines July 15th, 2009 at 19:16 | #46 Reply Alice

Your data confirms my own rusty memory. Between 1965 and 1970, US inflation experienced once of its biggest break outs in history increasing by nearly 300%. The official US and OECD figures confirm inflation going from 1.5% to 5.5%

S. Haines July 15th, 2009 at 19:19 | #47 Reply And in Australia the breakout started even earlier in 1963.

Alice July 15th, 2009 at 21:17 | #48 Reply @S. Haines
Im dont think you can add or just average two years of inflation rates to come up with 300% (it is indexed to a base year) growth. You should actually use the original index. The inflation I was referring declined from your peak of 5.5% before rising again to a peak of 12.3% in 1974 declined and rose again to peak at almost 15% in 1980. There are three distinct peaks – the latter two larger (1970s and 1980s). We are at odds in our views depending on whether you see the first peak as part of the two larger ones. It would be interesting to compare to other countries. Was it inflation really at 5.5%?? Then the question is where were the appropriate Keynesian restraints? The Vietnam war and labour constraints (manufacturing wage rises had started) may have indicated the need for some constraint and that is the point I was making.

Notwithstanding, I dont see the more severe inflation of the 70s decade and 1980 as a "failure of Keynesian Policy" which was your original point. I mentioned Nixons largest budget deficit in US history (to that time) in 1971 – now that is hardly a fiscal contraction is it?? Three years later inflation was between 10% and 12% depending on what month you want – either way that is more sinister than a 5% rate. What I see was actually see here is a "failure to administer Keynesian policy" not a "failure of Keynesian policy."

The details of individual inflation rates also depend on the month selected which can differ substantially but notwithstanding, there are three distinct peaks between 1966 and 1980 (and in between falls).

Tony G July 15th, 2009 at 22:09 | #49 Reply Ernestine

I was just making the observation that Warren Buffet thought EMH was crap and that he was glad business schools churned out lots of graduates willing to apply EMH to their investments so he could succesfully apply his theory to their investments as well.

Hence his quote;

" I'd be a bum on the street with a tin cup if the markets were always efficient ."


Ernestine Gross July 16th, 2009 at 08:20 | #50 Reply Tony G, # 49, and somebody may have also said that some business schools don't penalise students who don't reference their quotes.

Except for the possible interest of your #49 for #1, we are getting off topic.

Damien Morris July 16th, 2009 at 15:50 | #51 Reply The Efficient Markets Hypothesis is a bit like the notion of water finding its own level; it does, but that does not help you survive intermittent tsunamis.

S.Haines July 17th, 2009 at 18:31 | #52 Reply Alice

Your point about "failure to administer Keynesian policy" actually agrees with my position that Keynesian ceased to be the governing policy paradigm years before 1973. And my stats on inflation are indeed correctly used. So we had monetary policy taking over in the states in the 1960s, and an end to the so-called "Long Boom" nearly a decade earlier than is often claimed.

Alice July 17th, 2009 at 19:23 | #53 Reply S.Haines – I would agree entirely with that – the demise of Keynesian policy was probably in part to blame for the end of the long boom and the beginning of the downward slide…Monetarism sacrificed employment for the benefit of a low inflation environment which primarily rewards the wealthy. The dogma of the benefits of a low inflation environment have been pursued, and promoted, no matter what the cost to employment and indeed the employed have been sacrificed on this alter of false worship.

It is this one eyed view in policy I find abhorrent. Unemployment (and underemployment and increasingly marginal employment) has been used to keep inflation low (and increasingly it has needed higher and higher unemployment (real not published) to perpetuate the myth that low inflation is good.

The federal reserve banks have effectively taken over management of economic policy and its all about one single statistic.

Alice July 17th, 2009 at 19:27 | #54 Reply I simply dispute one comment S.Haines …and that is "nearly a decade before it is claimed". At most it is half a decade.

S.Haines July 17th, 2009 at 19:58 | #55 Reply As I said my economic history is rusty, but to what extent could Australia and the UK have described as "Keynesian" at any time during the Long Boom?

Alice July 17th, 2009 at 20:07 | #56 Reply I dont know why you would ask that S.haines. The pursuit of full employment (and the attainment) – the rapid response to crises like the wool spike were particularly Keynesian. The budget was used frequently as a method of control.

Alice July 17th, 2009 at 20:12 | #57 Reply @S.Haines
S.Haines – you only need look at the percentage of Govt investment in the economy (not welfare – it was very small and not needed) in this country in the 1940s and 1950s to see the impact of Keynesian policies at work. Im very surprised at your comment and seriously hope you arent intending to dispute the existence of keynesian policies during the long boom because I woul have to put you firmly in the denialist out tray if you are…

S.Haines July 17th, 2009 at 20:44 | #58 Reply I would be interested to see these figures. Given the mess you made with inflation, perhaps we both really need to have a look.

Alice July 17th, 2009 at 21:03 | #59 Reply Mess S.Haines ?? You are obviously in the business of spreading misinformation. If you were any genuine economist or reseaarcher (shame about your rusty memory – I suspect you never had any economic history to start with and barely economics either) you would know that inflation depends on the month, which can vary over the year and as for your figures you dont even understand that you cant add or divide annual inflation rates….end of discussion. Waste of space and arguments…just another right wing delusionist.

Alice July 17th, 2009 at 21:15 | #60 Reply What I really dont understand is why people like S.haines bother to lie and make false arguments about history. This generation has all the facts at their fingertips in the electronic world but they would rather subscribe to a two bit political machine's political rag of misinformation and garbage (and I dont care what party it is – its all still rubbish). All I can think is that they dont know how to research or how to look up the facts and the correct information (and they damn well have it so easy compared to when I was a student).
Its an insult to any thinking person to have to deal with them.

SeanG July 17th, 2009 at 23:22 | #61 Reply Alice,

I am a little shocked at your cavalier attitude towards inflation. This destroys the value of the least well to do – those who receive a fixed income like pensioners or the unemployed. Historically it has torn apart countries with great examples being Germany and Bolivia.

Alice July 18th, 2009 at 08:02 | #62 Reply Sean G – so does high unemployment

S.Haines July 18th, 2009 at 23:57 | #63 Reply


I am surprised that you still fall for these "Keynesian Long Boom" and "Golden Age" fairy tales. I also believe very strongly in evidence based analysis and discussions. So here's a few more for you.

1. During the 1950s and 1960s, Australian governments did not pursue the sort of active expansionary Keynesian fiscal policies you claim. There was the horror budget of 1951-52, for example.

2. On average, budgets were in SURPLUS, and when there were deficits, they were tiny. The big deficits did not come until the 1970s.

3. In fact, successive governments showed more sensitivity to monetarey policy, fuelled by bureacrats obssessed with inflation more than fiscal expansion, hence the legendary credit squeezes of the early 1950s and 1960s. The latter nearly lost Menzies the election.

4. In fact by the early 1960s, policy unequivocally shifted from any pretence to growth and full employment to price control and stability – inflation being the number one policy objectivity. I have already presented the data to explain why.

5. Your claims about government investment are like your others, without data, and are just wrong. For starters being 1950 and 1973, Australian GDP growth was below the OECD average the entire time, compared with being near the top of the OECD for the whole of 1880 to 1950. In fact, during the 1950s and 1960s, government outlays as a % of GDP average only 20%, compared to 30% during the 1970s and 1980s.

6. Given that Australia had one of the largest immigration programs in the world, when we look at GDP per cpaita, Australia becomes a basket case relatively. In the 1950s, our GDP per capita growth was a measley 1.7%, compared to the OECD average, which was nearly double at 3.3%. In the 1960s, we gained a bit to 3.2%, but still way behind the 3.9% average.

7. Any "boom" Australia did experience was ironically due to good old fashioned liberalism; the liberalisation of global trade in the post-war era accounts for a huge amount of Australian growth and prosperity.

Alice, I get the impression you are a teacher of some sort. What do you teach, and where do you get your materials? And where have you picked up all these myths about Keynes and Australian economic history?

Alice July 19th, 2009 at 00:14 | #64 Reply Oh for goodness sake S.haines. The horror budget you refer to corrected the inflationary Korean war wool boom within a year (alongisde the crash in the wool price). What part of keynesian contractionary budgets dont you understand …or did you think Keynesian policy only expanded indefinitely? I think you have confused Keynesian policy with Greenspan style policies. You havent lived long enough S.Haines and its obvious.
Look up Govt investment S.Haines as a percentage of GDP in the 1950s – tell me what do you see?
Ill look it up tomorrow for you S.Haines but Im too tired tonight to deal with this nonsense.

Alice July 19th, 2009 at 00:15 | #65
And S.Haines…its none of your business where I work and its none of my business where you work and I dont ask you (and I dont care) so dont overstep the mark.
Alice July 19th, 2009 at 00:24 | #66
Liberlaim also wasmnt even in the vocabulary in 1950s S.Haines (unfortunately for you). Liberalism is a sham dogma for young liberals to read instead of the bible (sign of the times) but they would be far better off with the latter in terms of social usefulness.

Alice July 19th, 2009 at 00:26 | #67
Correction to above – "liberalism wasnt even in the vocabulary in the 1950s S.Haines".


Haines July 19th, 2009 at 00:31 | #68
ROFL. That would have been news to Bob Menzies!! On your other points, I have provided arguments and data. Now, it is your turn.

SeanG July 19th, 2009 at 04:43 | #69
Liberalism a sham dogma? Freedom for individuals is a shame? Opening opportunties such as voting rights is considered a sham? How about the Old Age Pension which was introduced in the UK by a Liberal Government. This Government acted like a beta test for the Australian Liberals. Liberalism has been a guiding light for humanity compared to socialism which has delivered stagnant economies and societies and being the precursor to a more authoritarian state.

jquiggin July 19th, 2009 at 06:57 | #70
Can we cool things down a bit, please. S. Haines, I can't say I'm convinced by your claims here. Alice is exactly right about the horror budget for example, and more generally, you seem to be conflating Keynesian demand management with budget deficits. But if you have references to published work dating the end of the long boom to the early 60s, or official statements on a shift away from reliance on fiscal policy, I'd be keen to see them.

Alice July 19th, 2009 at 15:33 | #71
S.haines doesnt distinguish between Government investment and Government welfare outgoings either. In the 1950s Govt social capital investment was high and government unemployment benefits payments were extremely extremely low. The expenditure of public authorities was approximately equal to private investment in fixed capital throughout the 1950s, Funny about that. Public authorities (as opposed to the public committees that proliferate today) created jobs so that people didnt need their hand out for welfare but there is no distinction able to be made by S.Haines who cant see the link between high unemployment today and the expectation that private investment would see it trickle down. It didnt and it wont adequaltely in this country. In addition investment in stocks was a very small part of GDP 1950s, unlike today where the speculative component of investemnt has been mistaken for production in a real sense and allowed to run over to far too large a part of the economy (financial services sector). This is not sound economic management but I doubt certain so called economic liberals in this blog would see any of this. The simple view that "govt is bad and private = good" is all that they are capable of arguing by whatever blinkered means possible.

SeanG July 19th, 2009 at 17:31 | #72

You bring up an interesting point. During the era of full employment the government employed a lot of people which kept welfare payments low. However, what is the difference between welfare payments and employing people for the sake of employing them? If employing someone to do a non-existant job is social capital investment, is that nothing more than welfare under a different guise?

Alice July 19th, 2009 at 18:03 | #73
The difference is the idea of the Keynesian injection Sean (G). It has a multiplier effect and it expands GDP much like the budget deficits are doing now – but back then in the 1950s the idea of Government investment in the economy had not yet come to be derided by the extreme economic liberals amongst us (who I prefer to be classified under their real name of those who subscribe to laissez faire beliefs, who were always with us and always will be with us – if only for the betterement of a few powerful groups amongst us, if not all of us..and the foolishness of the laissez faire economics view is that in the long run, the market will sort it out without any government presence and the choice of the individual becomes all powerful. It just doesnt work (the choice of large merged oligopolistic and monopolistic enterprises becomes all powerful until they disturb and fracture the very foundations of democracy and erode the choice of the individual a say in how and by whom they are governed…thus it becomes self defeating to the liberal view) and those who subscribe to it unquestionly in the name of "liberalism" do us all harm…and their party of choice…. and themselves. Even the US Govt was still investing heavily in the US economy in social capital and infrastructure in the 1950s and this was considered the home of liberalism dont forget).

Any growth in GDP must carry the majority in an economy with it, Sean G , for maximum effect (economic welfare maximisation). A divided society (a growing tail left beind) will ultimately correct itself and sometimes unpleasantly. Despite how much economic liberals may want to see those people as lazy or bereft of the necessary skills for satisfying employment, you leave them behind at all of our peril. It is in all of our interests to keep these numbers of unemployed to a minimum by enuring there is sufficient investment for job creation (be it public or private).

SeanG July 19th, 2009 at 18:58 | #74

There is a debate as to the size of the multiplier effect. The problem with the idea of full employment is that it does not place resources – labour – to their most productive use. That is one reason why in the 1970s-1990s there was a wave of large scale privatisations to break down unproductive and inefficient public sector entities. Examples include the use of Six Sigma to minimise variations in production, 20-70-10 pioneered by General Electric's Jack Welch, the general "profit maximisation" goal and remuneration incentives.

The next problem is that welfare maximisation as a "right" creates a corresponding obligation on others. For everyone who is employed in an unproductive manner can only be employed by taking money away in the form of taxes by someone else. The concept of "idleness" has long bothered economists and politicians (including socialists).

Liberalism in the 1950s grew from the experiences of both WW2, the Great Depression and pre-Depression post-WW1 political economy. That is why Menzies promoted the middle class and free enterprise but wanted a strong social net. Liberalism is an organic belief that changes with society and it has swung back to free markets due to the brief 20-30 year experience of big government within a democracy.


Oats July 19th, 2009 at 19:35 | #75
Six Sigma Blackbelts, they karate-chopped big businesses into small businesses. Well, maybe not, I just felt like saying that. The difficulty with six sigma is that not every business has a production function that is easily measurable in a manner meaningful to the goals of the business. Take a software firm and six-sigma it at your peril. A six-sigma hatchet job risks throwing out some of the important informal practices – having an impromptu brainstorm upon a free whiteboard for example – and replacing them with overburdened formal practices. Pre-six-sigma, a question concerning how a piece of networking software handled certain conditions might have been answered by a couple of s/w techies wandering down to the local computer store, buying a couple of computers and other bits and pieces, and then jury-rigging it together and, well, just experimenting. A post-six-sigma corruption of this could simply freeze out initiative in the mistaken belief that skiving off to the IT store and building an informal testbed is an unproductive or uncontrolled task. To continue, so long as the results of the experiment are captured for posterity and are communicated effectively, it shouldn't be viewed in a negative light.
Anyway, while it isn't impossible for six-sigma to add something beneficial, for a S/W chop shop it isn't necessarily the best tool for the job.

As for Jack Welch, the 20-70-10 rule involved flushing of the 10% annually – pink slip time would have been a barrel of laughs at GE I'm sure. Wouldn't production have taken a hit as morale started reflecting the uncertainty of employment? Wouldn't people become secretive about expert knowledge that they possess, rather than sharing it with others to further the company interest?
And in any case it is a rough way to look at headcount – oops, I mean fellow journeymen and women.

Alice July 19th, 2009 at 19:59 | #76

Menzies also said "the people need protection from monopolies" Sean. Another idea sacrificed on the alter of liberalism (Goldman Sachs…gets big because they are brilliant, The grocery industry gets concentrated "because they are clever." Big oil and big pharma can teach us all a lesson about business intelligence…Im sure).

But economic liberalism has chased very few with monopoly power in the past few decades Sean, to the extent the ordinary man is becoming impatient with lack of regulatory action by governments concerning monopoly market power.

So Menzies wasnt liberal enough? Is that what you are telling me? Because now, no social net is positive to economic liberals (no social net at all…and correct me if I am wrong) and de-regulation ensures monopoly power grows and anti comptetitive practices grow unchecked, but its not our right to interfere?? Is that it?

So what is really important is total unfettered freedom in markets with no government intervention or presence because the right of the individual rides over it all?

Even Menzies views Sean

What you also ignore also is the fact that a person who is "flexibly employed" ( and in many cases this may mean tenuously employed) lacks the "animal spirits" to spend freely in the economy (theirn confidence is sapped), deprived as they are of security of employment or tenure or a reasonable expectation that their work will continue and the ordinary man adjusts savings accordingly…to save for the lean times which are unknown at the point they decide to be more careful with their expenditure …and we all know savings is a leakage…so the mere unquestioning acceptance of NAIRU (and an ever upwardly adjusting NAIRU) with its concommitant acceptance of a higher "human labour force discard rate" becomes an escalating drag on the economy which then requires an even higher NAIRU to justify.

SeanG July 19th, 2009 at 20:06 | #77

Six Sigma is implemented in service as well as manufacturing firms. It is about variations in performance and output. Six Sigma does improve productivity and it can be applicable to government as well as private sector.

With Welch's 20-70-10 all you have to do is look at the results of his time there to see the amazing growth in revenues and profitability. GE always prided itself on being candid which is something not replicated by other companies. After nearly 20 years of this type of practice, GE was the largest company in the world. So it looked like it worked.


Haines July 19th, 2009 at 20:35 | #78

Let me give you a hint why Keyesianism itself was responsible for the inflationary breakouts in the 1960s. Keynesianism relied on hermetically-sealed national economies. In Ausstralia, it relied on US foreign investment to build big industry. The state provide protection for the development of monopoly industries like the car industry. The resulting government-created monopolistic production and competition among largely foreign capital within Australia was one of the causes of the inflationary breakout.

SeanG July 19th, 2009 at 20:49 | #79

A coupled of things.

1) Monopolistic competition is a symptom of a lack of competition due to stringent regulation or the event where competition policy is not enforced. This is as much a problem during Keynesian economics than during the free market because if we look at the US economy as an example where you have a large number of very large companies you also see an amazing growth in smaller companies which compete and challenge the larger companies.

Goldman Sachs, you bete noir, is one of two remaining Wall Street investment banks. Goldman gets competition from numerous other banks but employs the best people, has a culture that is about excellence so when they are challenged by other banks, hedge funds and private equity firms they adapt and survive while others like Bear or Lehman Bros can barely make it in a competitive environment. Schumpeter's "creative destructionism" at its best.

2) Where did I say that Menzies was not liberal enough? Liberalism, as I have said, is organic which changes with the environment. It was the experience of the Liberal Party in the UK, the Depression and WW2 that lead to the liberals to adopt a very centrist position of free enterprise with a strong social safety net. You need to learn more about Liberal history.

3) When has anyone said that total unfettered markets is the best way to go? Do you even read comments on this thread or make things up as you go along?

S.Haines July 19th, 2009 at 21:00 | #80


How can you say "liberalism wasnt even in the vocabulary in the 1950s"? Follow this link and note the start date. Still waiting for your promised data.

S.Haines July 19th, 2009 at 21:07 | #81

Bob Hawke killed the Left in Australia, and Keating turned the ALP into the Australian Liberal Party.

Michael of Summer Hill July 19th, 2009 at 21:32 | #82
John, this is for dear Alice,

It seems you were taught to work and play,
Full of work and full of play,
Have your say and let it out,
Wright or wrong, let it out,
Get up their nose and rub it in,
They'll never forget dear Alice.

Kevin Cox July 20th, 2009 at 06:41 | #83

Markets are efficient. The so called Financial market as it is constructed is NOT a market. A market has the characteristic that as demand increases and supply cannot meet demand then prices rise so encouraging an increase in supply.

So called financial markets are "markets" where as demand increases, prices rise but supply decreases. Similarly when demand decreases, prices drop but supply increases. This is not a market but a casino because the size of the price peaks and troughs are random when you have these positive feedback mechanisms in the "market place".

Don't believe me? Our current situation is that the demand for money has increased, the price has dropped but the banks have difficulty lending money because the value of assets against which loans can be made has dropped and hence the supply of money has decreased.

Also a system where inflation is tolerated and even targetted is flawed. How can we have an efficient market when the unit of measurement changes. It is like trying to keep to the speed limit when the unit of measurement, kms per hour changes in meaning, and we do not know what the change is until a couple of months after we have broken the speed limit.

To stop the so called business cycle, to eliminate inflation, and to make financial true efficient markets then the "commodity" being traded – namely money – must follow the following rules.

When the demand for money increases and price rises then the amount of money needs to be increased. When the demand for money decreases and the price drops the amount of money needs to be decreased.

The solution. Stop using loans as the method to increase the money supply.

Alice July 20th, 2009 at 09:44 | #84
S.Haines – cause of inflationary breakout in the 1950s was due to not only excess demand in the Australian economy but excess demand in the US economy.

We were not as hermetically sealed as you like to imagine. Yes we had surging import demand but export demand came first and rose more sharply, but its also no accident that the wool export price crashed the same quarter in the same year that the US announced price controls to manage their own inflationary outbreak and we developed a large BOP deficit (51-52). The Uk (30%) and US (21%) accounted for for 51% of our entire wool production in 1950-51. and that boost at those prices added substantial export demand and income to the economy before the wool price fell.

If you look at growth in all the other price and wage indexes for the period, the growth in the export price index far outstrips their contribution and aligns directly with the period of high inflation in 1950-52.

Alice July 20th, 2009 at 09:47 | #85
How soon you forget Sean…the creative destruction of Goldman Sachs was prevented by a bailout of taxpayers funds.

Alice July 20th, 2009 at 09:57 | #86

I would also like to let S.haines know that according to the Economic Record Vol 1. which notes "practically all import restrictions lifted by this time…" next to 4th quarter, 1950.

So much for your comment that Australia was "hermetically sealed" and the inflation was driven by big government monopolisation.

S.Haines – it appears your memory of economic history is rusty after all.

S.Haines July 20th, 2009 at 15:34 | #87

Vol. 1 of which year of ER?

Alice July 20th, 2009 at 18:43 | #88
1950-1960 (the decade) S.Haines. Private subscription published by ERA House Pty Ltd. It should be in the reference section.
SeanG July 20th, 2009 at 21:59 | #89
Very true, Alice.

[Apr 07, 2015] Economists, financial markets and theory-induced blindness

Idea of theory-induced blindness
Institute for Financial Transparency

In Transparency Games, I get to talk about how economists, both academic and those working for the financial regulators, have theory-induced blindness when it comes to how financial markets actually work.

Theory-induced blindness is the application to economists of Upton Sinclair's line, "It is difficult to get a man to understand something, when his salary depends upon his not understanding it." For economists, it is reflected in their inability to see what is actually happening in the financial markets when it contradicts their beautifully derived theory.

In talking about his idea of theory-induced blindness, Daniel Kahneman said

The mystery is how a conception that is vulnerable to such obvious counterexamples survived for so long. I can explain it only by a weakness of the scholarly mind that I have often observed in myself. I call it theory-induced blindness: Once you have accepted a theory, it is extraordinarily difficult to notice its flaws. As the psychologist Daniel Gilbert has observed, disbelieving is hard work.

The efficient market hypothesis (EMH) is the classic example of a theory that was widely accepted and, as a result, it became extraordinarily difficult for economists, both academic and those working for the financial regulators, to notice its flaws. Flaws that were revealed by the financial crisis.

EMH looks at the issue of how financial market prices reflect the available information. EMH has 3 forms; the strongest of which asserts that even information that is hidden from most market participants is reflected in the price. EMH effectively says that even in the absence of transparency, prices reflect what would occur if transparency existed.

For their original tests of the theory, economists chose the most transparent financial market in the world. A financial market which also just happens to have restrictions on insider trading. That market was the US stock market. Prices in this market confirmed the theory.

Unfortunately, the US stock market is currently a special case. This was clearly shown by the financial crisis when the market for private label mortgage-backed securities effectively froze and the price for these securities dropped significantly (think from the 80s to the 20s). The price for these opaque securities on Day 1 didn't reflect their underlying fundamentals. Fundamentals which due to a lack of transparency the buyers did not have access to. Rather, the price buyers paid reflected the maximum price Wall Street could obtain based on the story it told about the underlying fundamentals. Wall Street had an incentive to maximize the price because it pocketed the difference between the price it sold the securities at and the price it paid for the mortgages it bundled into the securities.

The financial crisis also showed that within the US stock market EMH did not hold for all stocks. In particular, it did not hold for bank stocks. Why? Given how they are paid, there is no reason to think that bankers would not try to maximize their compensation by hiding the losses sitting on and off their balance sheet. They could do this because, as the Bank of England's Andrew Haldane said, banks are black boxes.

One of the benefits of the Transparency Label Initiative™ is it addresses theory-induced blindness when it comes to the EMH. Specifically, it ensures there is the transparency in the financial markets that the theory assumes is there.

[Nov 19, 2014] Even the Best Can Fall Victim To the 'Efficient Markets Hypothesis'

The preamble to this recent column by Ted Butler (subscription but worth it for his fine work in tracking the silver market) is a discussion of how 'gold loans' are not really proper loans, because the collateral gets reformatted and sold off.

What sparks the discussion is the recent talk and articles in Bloomberg about the Gold Forwards rates being negative, implying that it is difficult to obtain leased gold. Ted finds this kind of discussion frustrating apparently. They disclose rates, but not the amount of ongoing transactions.

I should add that to me there is little substantial difference between leases and swaps in what these fellows are doing. That seems to be largely a manner of terminology and choice of market venue when you boil the transaction down to the essentials.

Ted explains that when you loan a tool to your neighbor, you expect to get your tool back. In the case of gold leasing, as Bloomberg points out, the gold gets reformatted and sold off to Asia. So the gold leasing really does not make sense to Ted.

Now I would beg to differ at this point, because unlike your favorite power tool monetary objects are often considered to be 'fungible' and in a lease you may not expectto get the exact bars back necessarily. You merely ask for the same quality, form and amount as I understand it. If this is not the case, then Bloomberg has inadvertently disclosed a massive fraud.

You don't expect to get your bars back unless it is a custodial arrangement. But as the German people have recently discovered, good luck with that. You may get whatever the custodians at the Fed can find, because they have not merely stored the gold for you, but they have apparently utilized it.

Therefore, Ted's reasoning goes, because they do not make sense, gold leases do not exist in any appreciable size anymore. They were just a kind of fad perpetrated by JPM and some foolish miners some years ago. That forward selling in the form of hedges blew up badly and miners like Barrick were forced to take sizable losses in a rising market.

At this point I would say the leases do not make sense, but not for the same reason Ted cites. They do not make sense to me because they both misprice the counterparty risk AND the terms and other details of the leasing are not disclosed to all the interested parties. The lenders who are central banks do not inform. the public who actually own their nation's gold. Such leasing ought to be disclosed transparently and in real time.

But this is not the case. The lengths to which the public must go to discover the extent of the leasing of their gold has been well documented by GATA for example.

The reason I find Ted's conclusion weak, and potentially harmful, is that it is obviously based on the 'efficient markets hypothesis.' If something does not make economic sense, it ought not to exist in an efficient market, and therefore it does not exist except as some limited anomaly. Gold leases don't make sense to me, so therefore they do not exist, or if they do, are not significant enough to be considered.

Economists used to joke that if you told an efficient markets guy that there was a ten dollar bill lying on the sidewalk, he would reply that 'there couldn't be, because if there was someone would pick it up.'

I have asked the fellows at GATA if they have any firm numbers on current gold loans out, primarily from central banks. I know this is an ongoing quest because central banks are notoriously reticent to providing any such details of their activities.

We know leasing exists, we know the rates, we just do not know the details of the size of the market and the extent of the deals.

I found this column to be of concern because Ted is a very well respected analyst. I read his columns regularly and like him quite a bit. So I do not wish this to seem to be overly critical. And I realize that it might seem that I am trivializing his argument, but this is the heart of it.

Ted has been quite vocal in asserting that JP Morgan et al. have been manipulating the silver market based on what he has seen at the Comex.

But I did want to take the time to point out that a) gold leasing is not like lending out a specific object and b) just because something does not make economic sense to you, does not mean it is not happening. His argument is not based on any new data, but rather dismissive of something because there is no 'smoking gun' available, only circumstantial evidence.

These markets and this financial system is all too often the story of all control frauds and bubbles, and misappropriation of others people's money and goods. Lots of things don't make sense to the rational, honest mind anymore. Many of the financial deals that cities, counties and nations engaged in that cost their people hundred of millions of dollars made no economic sense. But there they are.

The efficient markets hypothesis has been used to justify an enormous amount of financial fraud and bad policy decisions over the past thirty years. It is the mother of frauds, from MF Global to Enron to Madoff to the Housing Bubble.

These are smart and important men. They are far too rational and god-like, your betters, to do things that you would not even think of doing. They are 'the System.'

Given the extent of the frauds and riggings, I am often tempted to think these days that if there is money to be made at it, if it is being conducted in secrecy, and if it involves other people's property, people who are relatively unheard and powerless, it probably does exist. But I prefer to stick to the facts, even if it is a plodding and sometimes frustrating path.

GATA was kind enough to provide this link to more recent news below. What do you think they mean by 'actively managing their gold reserves?' Moving the bars around and dusting them off?

If the world 'leasing' troubles you, think about OTC swaps.

Related: Central Banks More Actively Managing Their Gold Reserves

Ted Butler's column of Nov 19 - Popular Misconceptions

"Gold loans are fraudulent through and through, because the real owners don't get the proceeds when the sale is made and the collateral ends up with an unrelated third party who has no obligation to return the metal. But because they appeared to work for a while, otherwise intelligent people overlooked the obvious fraud and collected the benefits while they were available. Today, those tracking gold loans report the amounts of these loans outstanding are down 95% from levels at the peak around the year 2000. For me, I can't figure out how even 5% of these loans could still be in existence.

That's why I'm skeptical about all the talk of GOFO and gold lending as who in their right mind would ever loan or borrow metal under the circumstances I've described? There are few, if any, documented instances of specific loans and the parties involved or to the purpose of these loans. I suppose it might make sense to be a borrower if one intends to default on the loan, but that's hardly legitimate. Likewise, I suppose a central bank might lease metal if there was an illegitimate intent to depress prices, but that couldn't be discerned from GOFO rates.

Therefore, I think all the articles and commentary about GOFO are still goofy and unproductive. It seems akin to some deep debate by religious philosophers during medieval times about how many angels can dance on the head of a pin. I'm not trying to be insulting, because I believe there is a negative side to the current discussion about gold loans and lending rates that would be eliminated if the discussion ended once and for all. There is somewhat of a common denominator in the debate over gold lending in that most reporting on GOFO appear to be staunch believers in the ongoing gold and silver price manipulation. It is also well-known that those who insist that there is an ongoing manipulation in silver and gold (like me), are considered to be fringe conspiracy theorists. I think that is somewhat earned because so many who believe in manipulation tend to espouse other conspiracy theories (definitely not me). "

[Jan 20, 2014] 'Rational Agents: Irrational Markets'

Economist's View

Roger Farmer:

Rational Agents: Irrational Markets: Bob Shiller wrote an interesting piece in today's NY Times on the irrationality of human action. Shiller argues that the economist's conception of human beings as rational is hard to square with the behavior of asset markets.
Although I agree with Shiller, that human action is inadequately captured by the assumptions that most economists make about behavior, I am not convinced that we need to go much beyond the rationality assumption, to understand what causes financial crises or why they are so devastatingly painful for large numbers of people. The assumption that agents maximize utility can get us a very very long way. ...
In my own work, I have shown that the labor market can go very badly wrong even when everybody is rational. My coauthors and I showed in a recent paper, that the same idea holds in financial markets. Even when individuals are assumed to be rational; the financial markets may function very badly. ...
Miles Kimball and I have both been arguing that stock market fluctuations are inefficient and we both think that government should act to stabilize the asset markets. Miles' position is much closer to that of Bob Shiller; he thinks that agents are not always rational in the sense of Edgeworth. Miles and Bob may well be right. But in my view, the argument for stabilizing asset markets is much stronger. Even if we accept that agents are rational, it does not follow that swings in asset prices are Pareto efficient. But whether the motive arises from irrational people, or irrational markets; Miles and I agree: We can, and should, design an institution that takes advantage of the government's ability to trade on behalf of the unborn. More on that in a future post.

[Nov 16, 2013] 'Ignorance'

November 06, 2013 | Economist's View

Ignorance: Economics, it is said, is the study of scarcity. There is, however, one thing that certainly isn't scarce, but which deserves the attention of economists - ignorance. A recent paper by Richard Zeckhauser and Devjani Roy - which introduces a new method of economic research - shows that this is unjustly neglected in economics.

Conventional economics analyses how individuals choose - maybe rationally, maybe not - from a range of options. But this raises the question: how do they know what these options are? Many feasible - even optimum - options might not occur to them. This fact has some important implications. ...

... In a brilliant post, Will Davies gives a lovely example of this. Academics making funding applications, he says:

have to describe the entire project, its outcomes and 'impact' in advance. These pieces of science fiction serve little purpose of ensuring that money goes to the 'best' recipients, but a great purpose in reassuring the state that nothing unexpected will happen.

But the entire point of economics - and indeed of life - is that the unexpected does happen. An ideology which overlooks ignorance is therefore a fiction. And worse still, a potentially costly one.


Psychology pays a lot of attention to this. Dunning-Kruger effect, anyone? This is another instance where economics really needs to start paying attention o the research results of other social sciences. Alas, their meta ignorance of what they're missing keeps them ignorant even of where to look...

Wisdom Seeker
Yet more proof that "Economics" is not (yet) a science.

Also, the unexpected should not be unexpected. Most of the time the "unexpected" is really just proof that "this time isn't different". But policymakers and other econogandists* must feign ignorance of the "unexpected" in order to avoid receiving career-ending blame.

And yes, grant writing is a stylized exercise in science fiction.

* Econoganda - economic propaganda, see

reason :

People are missing the point of this. Chris Dillow's real target is "managerialism". (And to a lesser extent I suppose the presumptiveness of stock market driven investment - not to mention the strong rational expectations hypothesis).

[Oct 20, 2013] Fama Has Shiller to Thank for his Nobel Prize

October 20, 2013 | The Big Picture
My Sunday Washington Post Business Section column is out. This morning, I look at how Eugene Fama's early insights were nearly eclipsed by his latter bad theories.

Not to give away the ending, but if it weren't for Robert Shiller's criticism, Fama may very well not have won.

Here's an excerpt from the column:

"For this, Fama is thought of as the intellectual father of indexing. The entire concept of passive investing in indexes grew around his insights. His work became hugely influential, and remains so to this day. If you own a Standard & Poor's 500-stock index, you do so because of Fama the Younger's observations.

Had he stopped there, Fama the Younger probably would have flown to Sweden to pick up his Nobel Prize money decades ago.

But the years went by, and Fama kept coming back to his hypothesis. He pushed it to all manner of odd places. So the Nobel committee was confronted with the problem of Fama the Elder - the second Eugene Fama. That professor built on his own work. The influence of his insight imbued the Elder with prestige far beyond what his latter flawed work should have generated. It allowed him to expand his efficient-market thesis. That, dear readers, is where our boy ran into trouble."

I usually can gauge how resonant a column is by the comment response - but not this time. As of Sunday at 8am, not a single reader responded to it! I assume its due to the wonky nature of the subject matter.

Regardless, I am really pleased with the clever way the inherent conflict of the Nobel committee gets resolved. You can read the entire piece here.

[Oct 15, 2013] Are Rationality and the Efficient Markets Hypothesis Useful?

Economist's View

Just a quick note on the efficient markets hypothesis, rationality, and all that. I view these as important contributions not because they are accurate descriptions of the world (though they may come close in some cases), but rather because they give us an important benchmark to measure departures from an ideal world.

It's somewhat like studying the effects of gravity in an idealized system with no wind, etc. -- in a vacuum -- as a first step. If people say, yes, but it's always windy here, then we can account for those effects (though if we are dropping 100 pound weighs from 10 feet accounting for wind may not matter much, but if we are dropping something light from a much higher distance then we would need to incorporate these forces).

Same for the efficient markets hypothesis and rationality. If people say, if effect, but it's always windy here -- those models miss important behavioral effects, e.g., -- then the models need to be amended appropriately (though, like dropping heavy weights short distances in the wind, some markets may act close enough to idealized conditions to allow these models to be used). We have not done enough to amend models to account for departures from the ideal, but that doesn't mean the ideal models aren't useful benchmarks.

Anyway, just a quick thought...

[Oct 15, 2013] Philip Mirowski - Why Is There a Nobel Memorial Prize in Economics by Jorge Buzaglo

"In this book Sven Grassman describes the corruption and incompetence of the tight, mafia-like group of fanatics that controlled (and still controls) economics in Sweden. The power of this group was (and still is) largely based in their control of the Nobel prize."
12/29/2011 | The Institute for New Economic Thinking

Grassman, Sven, 1940-1992
Det tysta riket : skildringar från falsifikatens och jubileumsfondernas tidevarv : [svensk ekonomi från föredöme till problembarn] / 1981

This is a very important book related to your research project. Sven Grassman was a Keynesian economist marginalized by his colleagues at the Institute of International Economics, University of Stockholm (the same group, leaded by Assar Lindbeck, which was deciding on the Nobel prize). I think that this cruel persecution by his colleagues led to his early death (at 52). In this book Sven Grassman describes the corruption and incompetence of the tight, mafia-like group of fanatics that controlled (and still controls) economics in Sweden. The power of this group was (and still is) largely based in their control of the Nobel prize.

The greatly increased political ascendancy of this fundamentalist group of economists was perhaps not unrelated to the sharp increase of inequality in Sweden - Sweden is by far the OCDE country where inequality increased the most since the mid-1980s (Gini increased by 31% in 1985-2010; see

Other highly relevant books by Grassman are:

Why do we still have a Nobel Prize in economics by John Quiggin

"I think it primarily exists to give a sense of self-satisfaction to the people who go to considerable lengths to let all and sundry know that "It's not a real Nobel, don't you know." Because of course the fact that old Alfred did not include economics in his original list is a damning indictment into the state of "scientific" economic research, the bunch of political hacks they are, don't you know."
October 14, 2013 | Crooked Timber

Ingrid links to some fascinating discussion from Philip Mirowski of the role of Swedish domestic politics in the establishment of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, with emphasis on the way in which claims of "scientific" status for economics helped the claim of the Swedish central bank to independence from government.

In the broader context, it seems pretty clear that, if the idea had arisen even a few years later, it would have been rejected. In 1969, economics really did seem like a progressively developing science in which new discoveries built on old ones. There were some challenges to the dominant Keynesian-neoclassical synthesis but they were either marginalized (Marxists, institutionalists) or appeared to reflect disagreements about parameter values that could fit within the mainstream synthesis.

Only a few years later, all of this was in ruins. The rational expectations revolution sought, with considerable success, to discredit Keynesian macroeconomics, while promising to develop a New Classical model in which macroeconomic fluctuations were explained by Real Business Cycles. This project was a failure, but led to the award of a string of Nobels, before macroeconomists converged on the idea of Dynamic Stochastic General Equilibrium models, which failed miserably in the context of the global financial crisis. The big debate in macro can be phrased as "where did it all go wrong". Robert Gordon says 1978, I've gone for 1958, while the New Classical position implies that the big mistake was Keynes' General Theory in 1936

The failure in finance is even worse, as is illustrated by this year's awards where Eugene Fama gets a prize for formulating the Efficient Markets Hypothesis and Robert Shiller for his leading role in demolishing it. Microeconomics is in a somewhat better state: the rise of behavioral economics has the promise of improved realism in the description of economic decisions.

Overall, economics is still at a pre-scientific stage, at least, as the idea of science is exemplified by Physics and Chemistry. Economists have made some important discoveries, and a knowledge of economics helps us to understand crucial issues, but there is no agreement on fundamental issues. The result is that prizes are awarded both for "discoveries" and for the refutation of those discoveries.

[Oct 15, 2013] Economists Clash on Theory, but Will Still Share the Nobel By BINYAMIN APPELBAUM

Swiss banks really like Fama ;-)

The economist Robert J. Shiller in 2005 described the rapid rise of housing prices as a bubble and warned that prices could fall by 40 percent.

Five years later, with home prices well on the way to fulfilling Mr. Shiller's prediction, the economist Eugene F. Fama said he still did not believe there had been a bubble.

"I don't even know what a bubble means," said Mr. Fama, the author of the theory that asset prices perfectly reflect all available information. "These words have become popular. I don't think they have any meaning."

The two men, leading proponents of opposing views about the rationality of financial markets - a dispute with important implications for investment strategy, financial regulation and economic policy - were joined in unlikely union Monday as winners of the Nobel Memorial Prize in Economic Science.

Mr. Fama's seminal theory of rational, efficient markets inspired the rise of index funds and contributed to the decline of financial regulation. Mr. Shiller, perhaps his most influential critic, carefully assembled evidence of irrational, inefficient behavior and gained a measure of fame by predicting the fall of stock prices in 2000 as well as the housing crash that began in 2006.

They will share the award with a third American economist, Lars Peter Hansen, who developed a method of statistical analysis to evaluate theories about price movements that is now widely used by other social scientists.

The three economists, who worked independently, were described as collectively illuminating the workings of financial markets by showing that stock and bond prices move unpredictably in the short term but with greater predictability over longer periods. The prize committee said these findings showed that markets were moved by a mix of rational calculus and irrational behavior.

Mr. Fama and Mr. Hansen are professors at the University of Chicago, known as the principal home of free market economics; Mr. Shiller is a professor at Yale University. Their work "laid the foundation for the current understanding of asset prices," according to a statement from the Royal Swedish Academy of Sciences, which awards the annual prize.

Yet in jointly honoring the work of Mr. Fama and Mr. Shiller, the committee also highlighted how far the economics profession remains from agreeing on the answer to a basic and consequential question: How do markets work?

"It encapsulates the state of modern economics," said Justin Wolfers, an economist at the University of Michigan. "We have big important questions that remain largely open and we have giants bringing evidence to bear. And the answer turns out to be more complicated than markets are efficient - or markets are inefficient."

The dispute is not merely academic. The deregulation of financial markets beginning in the 1980s was justified by the view that markets are rational and efficient. Complacence about rising home prices in the 2000s similarly reflected the view that prices are inherently rational. In the aftermath of the crisis, conversely, the work of Mr. Shiller and other proponents of behavioral economics - the integration of psychology into economic models - has been influential in shaping an intensification of financial regulation. And Federal Reserve officials are now debating whether bubbles can be identified and when they should be popped.

Mr. Fama, 74, was honored for showing in the 1960s that asset prices are "extremely hard to predict over short horizons." He has said the seeds of his theory were planted as an undergraduate at Tufts University, while working for a professor who ran a stock market forecasting service. Mr. Fama was charged with devising and testing forecasting schemes, which invariably failed to work. He later coined the term "efficient markets" to describe his view that asset price movements could not be predicted because prices fully reflected all available information.

The theory basically asserted, in the words of the economist Burton Malkiel, that "a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts."

It has been repeatedly validated, sometimes in experiments involving actual monkeys. And while many market prognosticators on Wall Street still thrive in part by claiming that they can offer investments that will consistently beat the market averages, Mr. Fama's well-established theory has influenced the way millions of people now invest, contributing to the popularity of index funds that hold broad, diversified baskets of equities.

Mr. Shiller, 67, introduced in the early 1980s an important limitation on the idea that markets operate efficiently. He showed that the volatility of stock prices was greater than the volatility in corporate dividends. Moreover, he found that some of those irrational deviations fell into predictable patterns.

Mr. Fama is among the economists who have since documented other patterns of predictable price movements, although he explains these patterns as a form of compensation for the greater risk associated with some assets.

Mr. Shiller, by contrast, has argued that the predictability of prices reflects irrational but repeating patterns in human behavior, and he is among a group of prominent economists who are trying to integrate behavioral theories from psychology and other social sciences into rigorous models of economic activity.

An enthusiastic popularizer, Mr. Shiller wrote in "Market Volatility," a 1989 book published by MIT Press, that the assertion stock prices were rational was "one of the most remarkable errors in the history of economic thought." Instead, he wrote, "Mass psychology may well be the dominant cause of movements in the price of the aggregate stock market."

Bubbles are one of the most tangible manifestations of the disagreement between Mr. Shiller and Mr. Fama. The housing crash that began in 2006 is widely regarded as evidence that prices had climbed to irrational heights, and Mr. Shiller's accuracy in diagnosing the problem suggests that future bubbles could be identified, too.

Janet L. Yellen, nominated earlier this month to lead the Fed, has said the central bank needs to reconsider its traditional view that bubbles cannot be spotted and should not be popped - or restrained from growing too large.

But Mr. Fama, like other proponents of efficient markets theory, is dismissive of Mr. Shiller's record as a forecaster and more broadly, of claims that it is possible to consistently identify asset bubbles before a collapse.

Asked in 2010 about those who warned that housing prices would crash, he responded, "Right. For example, Shiller was saying that since 1996."

Mr. Hansen, 60, on Monday found himself temporarily labeled "the youngster." He was honored for developing the "generalized method of moments," a technique for evaluating relationships among explanatory factors that allows social scientists to work around the absence of some kinds of information.

He said that he learned he had won while walking his dog.

Mr. Shiller, in a news conference at Yale, said he rushed from the shower to answer the phone. After learning he had won, he called his brother in Detroit.

"Did you hear the news?" he asked. "Yeah," his brother said. "The Tigers lost."

Mr. Fama, asked whether he had anticipated this moment, said, "I didn't want to presume that I would win." He added, "I knew that I would be thrilled, of course."

[Jul 18, 2013] Is Economics a Science or a Religion by Mark Buchanan

Neo-classic economy is really just an ideology of neoliberalism with fig leaf of mathematic equations of top of free-market exited economists selling themselves to highest bidder.
Jul 17, 2013 | Bloomberg

Is economics a science or a religion? Its practitioners like to think of it as akin to the former. The blind faith with which many do so suggests it has become too much like the latter, with potentially dire consequences for the real people the discipline is intended to help.

The idea of economics as religion harks back to at least 2001, when economist Robert Nelson published a book on the subject. Nelson argued that the policy advice economists draw from their theories is never "value-neutral" but foists their values, dressed up to look like objective science, on the rest of us.

Take, for example, free trade. In judging its desirability, economists weigh projected costs and benefits, an approach that superficially seems objective. Yet economists decide what enters the analysis and what gets ignored. Such things as savings in wages or transport lend themselves easily to measurement in monetary terms, while others, such as the social disruption of a community, do not. The mathematical calculations give the analysis a scientific wrapping, even when the content is just an expression of values.

Similar biases influence policy considerations on everything from labor laws to climate change. As Nelson put it, "the priesthood of a modern secular religion of economic progress" has pushed a narrow vision of economic "efficiency," wholly undeterred by a history of disastrous outcomes.

Rational Responses

The economic zeal reached its peak several years back, when a number of economists openly celebrated what they called economic imperialism -- the notion that the inherent superiority of their way of thinking would lead it to displace all other social sciences. Academics sought to bring the advanced calculus of rationality -- with its assumption that everything can be explained by people's perfectly rational responses to incentives -- to the primitives in fields ranging from sociology to anthropology.

The imperial adventure lost much of its momentum in the wake of the 2008 financial crisis. More attention has turned to the psychological, or behavioral, revolution, which has established that the rational ideal of economic theory isn't even a good starting point as a crude caricature of the way real people act. We're often goal-oriented, of course, but we seek those goals through imperfect heuristic rules and trial and error, learning as we go. If anything, rationality is the anomaly in human life.

Of equal significance is a growing acceptance of Nelson's larger point: that economics is riddled with hidden value judgments that make its advice far from scientific. In one notable development, the Journal of Economic Perspectives published a paper by economists Daron Acemoglu and James Robinson that examines how value judgments -- in this case, the dismissal of political repercussions -- have undermined well-intentioned economic interventions.

Most economists, for instance, see the weakening of trade unions in the U.S. and other Western nations in the past few decades as a good thing, because unions' monopoly power over wages impairs companies' ability to adapt to the demands of the market. As Acemoglu and Robinson point out, however, unions do a lot more than influence the supply and cost of labor. In particular, they have historically played a prominent role in creating and supporting democracy, in limiting the political power of corporations, and in mitigating income inequality.

Narrow policy analyses have repeatedly led economists to push for policies that have had unexpected consequences for the balance of political power. Acemoglu and Robinson cite the push to privatize industries in Russia in the 1990s. The idea was that private ownership, no matter how it came about, would ultimately benefit the entire economy. In practice, a rigged process gave rise to an illegitimate oligarchy and an increase in inequality that set the stage for the ascendance of President Vladimir Putin's authoritarian regime.

Tragic Flaw

More recently, the gospel of economic efficiency helped lay the groundwork for the financial crisis, mostly by encouraging overconfidence in the wonders of financial engineering. Theory-induced dreams of market discipline provided justification for stripping away entirely sensible regulations, such as barriers between commercial and investment banking, and for avoiding oversight of the booming trade in derivatives. One result was an extremely wealthy financial lobby that is still working hard to block reform.

In all these cases, the tragic flaw lies in the heady confidence that comes with a one-size-fits-all theoretical framework. There's a real danger in seeing economics as an objective science from which all values have been stripped. Nelson preferred an older, more modest perspective on economics espoused by Frank Knight, a founder of the University of Chicago's free-market school of thought. Knight expressed the view that truly careful social and economic analysis emphasizes the limits to human knowledge and "the fatuousness of over-sanguine expectations" from economic-policy designs, including those favoring free enterprise.

In short, economists would do well to derive their prescriptions from observations of how the world really works, with a healthy respect for its complexity. Faith is no substitute for informed inquiry.

(Mark Buchanan, a theoretical physicist and the author of "Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics," is a Bloomberg View columnist.)

To contact the writer of this article: Mark Buchanan at [email protected]

Mark Buchanan, a theoretical physicist, is the author of the book "Forecast: What Physics, Meteorology and the ... MORE

[Jul 09, 2013] "James Tobin's Hirsch Lecture"

Rajiv Sethi discusses James Tobin's "four distinct conceptions of financial market efficiency," particularly his notion of functional efficiency"

James Tobin's Hirsch Lecture, by Rajiv Sethi: James Tobin's Fred Hirsch Memorial Lecture "On the Efficiency of the Financial System" was originally published in a 1984 issue of the Lloyds Bank Review, and republished three years later in a collection of his writings. Willem Buiter discussed the essay at some length about a year ago in a provocative post dealing with the regulation of derivatives. Both the original essay and Buiter's discussion of it remain well worth reading today as guides to the broad principles that ought to underlie financial market reform.

In his essay, Tobin considers four distinct conceptions of financial market efficiency:

Efficiency has several different meanings: first, a market is 'efficient' if it is on average impossible to gain from trading on the basis of generally available public information... Efficiency in this meaning I call information arbitrage efficiency.

A second and deeper meaning is the following: a market in a financial asset is efficient if if its valuations reflect accurately the future payments to which the asset gives title... I call this concept fundamental valuation efficiency.

Third, a system of financial markets is efficient if it enables economic agents to insure for themselves deliveries of goods and services in all future contingencies, either by surrendering some of their own resources now or by contracting to deliver them in specified future contingencies... I call efficiency in this Arrow-Debreu sense full insurance efficiency.

The fourth concept relates more concretely to the economic functions of the financial industries... These include: the pooling of risks and their allocation to those most able and willing to bear them... the facilitation of transactions by providing mechanisms and networks of payments; the mobilization of saving for investments in physical and human capital... and the allocation of saving to to their more socially productive uses. I call efficiency in these respects functional efficiency.

The first two criteria correspond, respectively, to weak and strong versions of the efficient markets hypothesis. Tobin argues that the weak form is generally satisfied on the grounds that "actively managed portfolios, allowance made for transactions costs, do not beat the market." He notes, however that efficiency in the second (strong form) sense is "by no means implied" by this, and that "market speculation multiplies several fold the underlying fundamental variability of dividends and earnings."

My own view of the matter (expressed in an earlier post) is that such a neat separation of these two concepts of efficiency is too limiting: endogenous variations in the composition of trading strategies result in alternating periods of high and low volatility. Nevertheless, as an approximate view of market efficiency over long horizons, I feel that Tobin's characterization is about right.

Full insurance efficiency requires complete markets in state contingent claims. This is a theoretical ideal that is impossible to attain in practice for a variety of reasons: the real resource costs of contracting, the thinness of potential markets for exotic contingent claims, and the difficulty of dispute resolution. Nevertheless, Tobin argues for the introduction of new assets that insure against major contingencies such as inflation, and securities of this kind have indeed been introduced since his essay was published.

Finally, Tobin turns to functional efficiency, and this is where he expresses greatest concern:

What is clear that very little of the work done by the securities industry, as gauged by the volume of market activity, has to do with the financing of real investment in any very direct way. Likewise, those markets have very little to do, in aggregate, with the translation of the saving of households into corporate business investment. That process occurs mainly outside the market, as retention of earnings gradually and irregularly augments the value of equity shares...

I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. I suspect that the immense power of the computer is being harnessed to this 'paper economy', not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges. For this reason perhaps, high technology has so far yielded disappointing results in economy-wide productivity. I fear that, as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost of facilitation nth-degree speculation which is short sighted and inefficient...

Arrow and Debreu did not have continuous sequential trading in mind; when that occurs, as Keynes noted, it attracts short-horizon speculators and middlemen, and distorts or dilutes the influence of fundamentals on prices. I suspect that Keynes was right to suggest that we should provide greater deterrents to transient holdings of financial instruments and larger rewards for long-term investors.

Recall that these passages were published in 1984; the financial sector has since been transformed beyond recognition. Buiter argues that Tobin's concerns about functional efficiency are more valid today than they have ever been, and is particularly concerned with derivatives contacts involving directional bets by both parties to the transaction:

[Since] derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution. Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game.

The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults. Defaults, insolvency and bankruptcy are key components of a market economy based on property rights. There involve more than a redistribution of property rights (both income and control rights). They also destroy real resources. The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved. There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners. But there is such a thing as insolvency for losers, if the losses are large enough.

The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple. The party purchasing the insurance should be able to demonstrate an insurable interest. [Credit Default Swaps] could only be bought and sold in combination with a matching amount of the underlying security.

The debate over naked credit default swaps is contentious and continues to rage. While market liquidity and stability have been central themes in this debate to date, it might be useful also to view the issue through the lens of functional efficiency. More generally, we ought to be asking whether Tobin was right to be concerned about the size of the financial sector in his day, and whether its dramatic growth over the couple of decades since then has been functional or dysfunctional on balance.


"I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity."

The key question here, is not whether this has happened, it seems beyond question that this fear has been realized, the real question is why it is profitable to do this.

ken melvin said in reply to reason...

Diverting these resources back to investment in productive capacity, utilities, ... would be the payoff of good regulation, no?

[Jun 07, 2013] 'The Great Persuasion Reinventing Free Markets Since the Depression'

No it's not the end, but this an end of the beginning. Neoliberalism entered Zombie stage after 2008.
Economist's View

The end of an era?:

Persuasion, Great and Intimate, by David Warsh: ...The Great Persuasion: Reinventing Free Markets Since the Depression by Angus Burgin, of Johns Hopkins University ... is the latest of a lengthening shelf of books by intellectual historians that seek to explain the election of Ronald Reagan in 1980 in terms of the influence of ideas or money or both. To most of those writing the narrative of American politics in the 1970s, the enthusiasm for markets and reduced government that accompanied "the Reagan revolution" (or, earlier, the deregulation of transportation, under Jimmy Carter, or finance, under Richard Nixon and Gerald Ford), seemed to come out of nowhere. They were expecting, per Keynes and Schumpeter, "the end of laissez-faire."
Burgin's argument is that a group of market advocates formed in the late 1930s, around a discussion of Walter Lippmann's The Good Society, then took flight after World War II as the Mont Pelerin Society, and subsequently influenced the evolution of postwar economic and political thought. That thought isn't new, but Burgin's is the by far the best account of the organization's history. The MPS was the brainchild of Austrian economist and social philosopher Friedrich von Hayek, then in the process of relocating from London to Chicago. He intended the organization to be "something halfway between a scholarly association and a political society." Thirty nine persons attended its first meeting, in April 1947, at a mountain hotel near Vevey, Switzerland, on the north shore of Lake Geneva, not far from Lausanne.
Among them were economists (Hayek, Lionel Robbins, Maurice Allais, Fritz Machlup, Ludwig von Mises, Frank Knight, Milton Friedman, George Stigler, Aaron Director); philosophers (Karl Popper, Michael Polanyi, Bertrand de Jouvenal); journalists (Henry Hazlitt, John Davenport); and activists (Leonard Read and representatives of the Volker Fund, the Kansas City, Mo., foundation that bankrolled the Americans' participation) – a regular Who's Who of young men (only one woman, British historian Veronica Wedgewood, was included). They would become influential theorists of the turn towards markets.
Burgin, a historian, shows that from the beginning the group comprised two factions, European traditionalists and American upstarts. The Europeans were concerned with the difficulty of reconciling capitalism with social traditions that had evolved over the centuries. The Americans were not. Eventually, Burgin writes, Milton Friedman got the upper hand and brought in "a more strident version" of market fundamentalism. His predecessors' work, Burgin writes, had been "ingrained with a sense of caution at the knife's edge of catastrophe. Friedman's was infused with Cold War dualisms…. Friedman's philosophical models brooked no concessions to communism, and the America of his time found a ready audience for a philosophy that did not allow itself to be measured in degrees."
For all his fascination with Friedman, Burgin does not pay much attention to developments in economics itself. Robert Solow, of the Massachusetts Institute of Technology, has written that Burgin tends to endow the MPS with more significance than it ever really has, whether within the economics profession or in the world at large." And surely Burgin stints the debates that gave rise to the Mont Pelerin Society. He doesn't mention the "calculation debate" about the technical possibility of planning that had preoccupied the Austrians economists since Germany's surprisingly successful administration of its national economy during World War I; nor the controversy over the New Deal's National Industrial Recovery Act of 1933, which was the background for the Lippmann book; nor the various crises of peacetime planning that were unfolding in Europe as the group first met.
Moreover, as a historian of ideas, Burgin ignores various more purely experiential means of persuasion by which faith in markets was renewed in the 1960s,'70s and '80s. There was the success of Toyota, for example, in improving standards of automotive quality. Then, too, the Cultural Revolution in China and the Prague Spring of 1968 had powerful effects on views of political economy, in both East and West; so did the US war in Vietnam. Populism, meaning the durable sectional rivalries within the US itself (Midwest vs. the Coasts, South vs. North) played a role as well. So did rivalries between the United States and Europe.
For my money, Burgin's real find (apparently for his, too, since his book ends with an account of it) is a 1988 essay by Milton and Rose Friedman (his economist wife and collaborator) tucked away in a Hoover Institution volume, Thinking About America: The United States in the 1990s. In "The Tide in the Affairs of Men," they discerned a tendency of powerful social movements to begin as works of opinion, spread eventually to the conduct of policy, then generate (often) their own reversal, only to be succeeded by another tide. The Friedmans discerned three such movements in the past 250 years – a laissez-faire or Adam Smith tide, beginning in 1776 and lasting until around 1883 in Britain and the United States (with policy lagging: 1820-1900 in Britain, 1840-1930 in the US); a Welfare State or Fabian tide, beginning around 1883 and lasting until 1950 in Britain and 1970 in the US (policy tide 1900-1978 in Britain, 1930-1980 in the US); and a resurgence of free markets or Hayek tide, beginning around 1950 in Britain and 1980 in the US, whose opinion phase was "approaching middle age" and whose policy phase twenty-five years ago was "still in its infancy."
This is standard cycle theory, familiar to readers of Ralph Waldo Emerson, Henry Adams, Arthur Schlesinger Sr. and Jr, Albert Hirschman and a host of others, unexceptional except insofar as it portends, even in the Friedmans' view, not exactly the end of laissez-faire, but the beginning of some new tide of emphasis on the social. Burgin doesn't make much of it except to note that, at the height of the financial crisis, in the autumn of 2008, "commentators on both sides of the political aisle declared that a long era in American political history was drawing to a close." ...

Barkley Rosser:

The most important of the "European traditionalist" at that first MPS meeting is not mentioned here, Walter Eucken, who would die in 1950. He invented "Ordo-Liberalism" in 1937, which would become the inspiration for the "social market economy" (sozialmarktwirtschaften) that would dominate the policies of the West German economy throughout its wirtschaftswunder, or postwar "Economic Miracle," with Ludwig Erhard particularly influenced by him and implementing policies with his influence in mind.

Second Best :

Milton Friedman once said there is a fundamental conflict between economic freedom and political freedom, that the freedom of the latter to suppress the former will always prevail and therefore must be restrained with eternal vigilance.

It did turn out that way, but in reverse order of what he meant. The economic freedom he had in mind in terms of maximum economic welfare for all was actually suppressed for maximum welfare for the few.

All those foxes guarding the henhouses just couldn't stand up to the onslaught of corporate lobbyists.


If the original question is the "Reagan revolution" the answer is much simpler. The United States Supreme Court decisions on one man one vote destroyed the typical political control of local corporations in the states. This forced a national political coalition of corporations that was enunciated by the Powell Memorandum to the U.S. Chamber of Commerce to coordinate this coalition. The Powell Memorandum emphasized the growing threat of democratic social movements such as the autosafety efforts of Ralph Nader and the environmental movement.

The Republican "Southern Strategy" reflected this national corporate effort to channel political funds to low population states where they could overwhelm local efforts. Ronald Reagan was dominantly a creation of the Powell Memorandum efforts, he became a national spokesman for this pro-corporate movement and then implemented the "Southern Strategy".

The creation of a national corporate economic coalition funding local political activity fell under the influence of the international rise of multinational corporations which sought to elude political restraints imposed by rising democratic movements such as environmental and consumer safety laws. That, in turn, created the need to reinterpret "Laissez Faire" to mean a pro-corporate deregulation. And, of course, the reinterpretation of Hayek et al in this vein.

Thus the simple answer is that the underlying effort is a thin political skin over the multinational corporate effort to eliminate legal restrictions on their ability to operate on the basis of profits unconstrained by concerns about workers and environmental issues.

Darryl FKA Ron:

In "The Tide in the Affairs of Men," they discerned a tendency of powerful social movements to begin as works of opinion, spread eventually to the conduct of policy, then generate (often) their own reversal, only to be succeeded by another tide.

[Please let's not conflate market economics as a powerful social movement such as civil rights. The conflicted views of Joe Schumpeter regarding capitalism as valiant entrepeneurs innovating juxtaposed against the efficiency of innovation by monopoly seeking uber corporations somehow interlocking into a creative destruction that in the end would evolve into a system of capitalism so evil that it would be overthrown is the dream, or nightmare, that we are living.

For Schumpeter it was both the dream and the nightmare. That's what conflicted means. The thoughts of the economic elite never changed. They needed no new idea. They were just trying to get the old one back in motion. The policy shift from this idea started as soon as FDR lay cold and dead and its first major victory was the tax reform of 1954, which was a clever act of tax the rich stealth by Republicans to rescind the dividends tax credit making the return to capital via capital gains incentive the transformational force in enterprise.

Democrats took over Congress after 1954, but who were they to go against raising taxes on the rich if that is what Republicans wanted? It looked great while growth potential was unbound by virtually limitless resources and rapid population growth. But it facilitated the consolidation of corporate enterprises large enough to rule every aspect of public life that they deemed useful. Then every kind of incremental deregulation and liberlization of finance and assurance for the value of currency for capital's muscle would follow. ]

Charles Peterson said in reply to Darryl FKA Ron...

Thanks for the bit about the tax reform of 1954.

But you could probably find rollbacks from the New Deal vision of Roosevelt as early as 1945. The one that stands out to me is the Taft Hartley act of 1947. I also wonder whether if FDR had lived longer, the Cold War could have been avoided and instead of the endless overt and covert wars we could have had the Four Freedoms. So another suspect is the National Security Act of 1947, which created the military industrial complex as we know it, and the endless pursuit of world control through military dominance.

These disgruntled aristocrats and petit bourgeois who started MPS were angry both at democracy and unions. Friedman blamed the business failures of his parents on unions.


The shift toward neoliberalism occurred in the 1970s because businesses and the super-rich began a process of political self-organization in the early 1970s that enabled them to pool their wealth and influence to achieve dominant political power and to capture administration.

Money pouring into lobbying firms, political campaigns, and ideological think tanks created the organizational muscle which mimics the Bolsheviks organizational muscle. And Repugs got a bunch of Trotskyite turncoats such as James Burnham, who knew the political technology of bolshevism from the first hands, were probably helpful in polishing this edifice. All that gave the Republicans a formidable institutional advantage since 1980s.

Carter and Clinton sold Democratic Party to the same forces.

This rise of special interests politics has been at the expense of the middle class. In this sense already in 1994 the USA became very unhealthy society although the crisis of 200 was still six years ahead. Collapse of the USSR and subsequent looting of the territory by Clinton administration slowed down this process, but now it's by-and-large over (with the USA failing to prevent reelection of Putin) and "latin-americanization" of the USA is again in full force.

There are no sizable countervailing forces on the horizon, although the level of public debt might be an implicit limiting factor for neoliberalism. It will be interesting to see how and by what political forces neoliberal regime in the USA ends. Some people suggest that the USA might eventually disintegrate along the lines of Civil War alliances. I think much depends how "peak oil" crisis unfolds. And will the wars with terrorism continue to give the USA elite the required level of the national unity and meaning. Rise of separatist movements in Texas, Alaska and other states is pretty indicative here.

[Jun 5, 2013] What to Do When the Invisible Hand Stops Working By Mark Buchanan

Jun 5, 2013 | Bloomberg

Economists rave about the power of the market to deploy productive resources better than any central planner possibly could. A mysterious process, which Adam Smith called the "invisible hand," guides countless individuals with conflicting aims to somehow coordinate into a remarkably effective economic organization. Usually.

But as the British economist John Maynard Keynes famously argued, markets can also fall into dysfunction. A crisis can set off a downward spiral: Spending declines, companies fail, people lose jobs, spending declines further. Much of the wonderful coordination disappears, as if the invisible hand were injured.

None of this is controversial. But if you ask how best to cure an afflicted economy, you get vicious and sometimes hysterical argument, typically polarized along political lines. Should markets be left alone, because the invisible hand is self-healing and intervention can only make matters worse? Or does an economy, like a real living thing, sometimes need direct medical (or governmental) intervention?

Resolving the debate is difficult, largely because we know surprisingly little about how the invisible hand actually achieves such precise economic coordination. Even more surprising, few economists over the past 30 years have been focusing on this area of ignorance.

Perfect Rationality

If that sounds hard to believe, consider the "state-of-the-art" mathematical models currently used by economists. They ditch all the complexity of the real economy in favor of a peculiar scheme in which one ideal household and one ideal firm meet and optimize their behavior with perfect rationality. Adam Smith would be mystified -- I think even horrified. Such "rational expectations" models can be tweaked to back up just about any story you like, so it is little wonder that the vicious arguments over policy persist.

Happily, there is hope. A few economists have been trying to go deeper by exploring the actual coordinating mechanisms of the invisible hand, how they emerge and also how they can break down.

One notable example is a line of research initiated about a decade ago by Robert Clower and Peter Howitt. They noted that useful economic coordination comes about over time as people interact, discovering where to find the goods they like as well as the companies they trust and find useful. Businesses get started after people learn about one another's needs and wants. In other words, there's a necessary and usually messy growth history behind the familiar structures -- firms, shops, and other intermediaries -- that provide the coordination for a functioning economy.

To get a sense of how the process works, Clower and Howitt set up a computer simulation. They let lots of virtual people interact with one another, following fairly simple rules to trade among themselves while seeking their desired goods. People finding many potential trading partners for certain goods could choose to set up a specialist firm trading that good, profiting while also making it easier for others to find that good. Over time, a vast web of useful firms covering all goods emerged, without any central planning, to solve the coordination problem of getting goods to the people who wanted them. Something else happened, too: One of the goods in the economy came to be valued universally by all as a convenient medium of exchange. The market discovered money all on its own.

Unlike traditional economic models, Clower and Howitt's way of looking at an economy respects Adam Smith's core heroic insight: that coordination emerges in a wholly natural way, from the interactions of ordinary people (For more on this fascinating research, see my blog). It can also offer insight into practical policy matters, including those that so interested Keynes.

Valuable Infrastructure

In recent work with Quamrul Ashraf and Boris Gershman, for example, Howitt finds an important effect of financial crises that rational-expectations models miss: the hard-to-reverse failure of firms. The disappearance of firms destroys valuable coordinating infrastructure, making economic life more challenging for others. As other firms lose key sources of income, supplies and customers, they might also go bankrupt, furthering the destruction.

Afterward, the recovery of an economy won't be only a matter of restoring confidence, letting prices and wages adjust, or keeping interest rates low. Recovery requires the time-consuming rebirth of entire networks of firms. Although the research doesn't model that process explicitly, it's pretty clear that government action could easily help, by providing individuals with unemployment benefits until they find a new job, or by intervening to keep crucial firms alive (remember the U.S. automaker bailouts of 2009).

The work of Howitt and colleagues is only a beginning, but a huge step in the right direction. The unfortunate reality is that most economic theory today still rests on analyses of extremely intelligent people acting in unrealistic situations. We need to explore the way people of ordinary intelligence manage in the face of an incredibly complex world. Until we can really understand the coordination mechanisms that help us do it, policy making will remain a dark art.

(Mark Buchanan, a theoretical physicist and the author of "The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You," is a Bloomberg View columnist. The opinions expressed are his own.)

To contact the writer of this article: Mark Buchanan at [email protected]

To contact the editor responsible for this article: Mark Whitehouse at

[Apr 29, 2012] Stiglitz - Politics Is At the Root of the Problem

Where Stiglitz refers to 'free markets' here, he means the 'efficient markets hypothesis.' That is, if markets are left entirely to their own devices they will manage themselves, honestly and efficiently.

Government and regulation are the problem, and they distort markets. Therefore if you 'free' markets from the influence of imperfect supervision, the natural efficiency of the market will prevail.

This model of the markets assumes that most market participants, people, are naturally good and almost perfectly rational, that information disperses equally among those participants, and that fraud becomes quickly known to all and is shunned, so that no participant will be encouraged to engage in it.

One of the things that will be reconsidered in the aftermath of this crisis, besides the perennial tendency of academic theories to act as handmaidens to thugs and gangsterism, is how to maintain a market based economy with effective regulation, so that when the unscrupulous come to tear down the protections erected by previous generations, to lure the foolish and gullible with their siren songs of progress and freedom, they might be seen for what they really are: the old familiar frauds come back to rob again.

I am a strong believer in a market based economy, where the rules encourage fairness and transparency, and decision making is broadly dispersed amongst a large number of well-informed participants. Monopolies, corruption and fraud are inimical to such a system.

An excess of planning and regulation, on the other hand, leads to a concentration of power in few hands, which is a form of monopoly or cartel which is the same abuse that occurs with too little transparency and regulation.

It takes hard work and an alert public to maintain the balance of justice, and it is hardly natural. For the affairs of all men do not naturally tend to virtue, alas, but from a minority of the lawless there is the tendency to selfish and short term thinking, and entropy from temptation, and the concentration of power in unworthy hands.

Such is the tendency of the world as it is, not naturally good, but imperfect and fallen. And this is not only the theme, but the force of history, the recorded actions of people, the continuing struggle between moderation and excess, between good and evil. Without it, history would be merely the progression of happiness and contentment, and that is not the condition of this world, but of the next.

Cross Posted from The European

"Politics Is at the Root of the Problem"

by Joseph Stiglitz 23.04.2012

Austerity policies are driving us towards a double-dip recession, warns US economist Joseph Stiglitz. He sat down with Martin Eiermann to discuss new economic thinking and the influence of money in politics.

The European: Four years after the beginning of the financial crisis, are you encouraged by the ways in which economists have tried to make sense of it, and by the ways in which those insights have been taken up by policy makers?

Stiglitz: Let me break this down in a slightly different way. Academic economists played a big role in causing the crisis. Their models were overly simplified, distorted, and left out the most important aspects. Those faulty models then encouraged policy-makers to believe that the markets would solve all the problems. Before the crisis, if I had been a narrow-minded economist, I would have been very pleased to see that academics had a big impact on policy. But unfortunately that was bad for the world. After the crisis, you would have hoped that the academic profession had changed and that policy-making had changed with it and would become more skeptical and cautious. You would have expected that after all the wrong predictions of the past, politics would have demanded from academics a rethinking of their theories. I am broadly disappointed on all accounts.

The European: Economists have seen the flaws of their models but have not worked to discard or improve them?

Stiglitz: Within academia, those who believed in free markets before the crisis still do so today. A few people have shifted, and I want to give credit to them for saying: "We were wrong. We underestimated this or that aspect of our models." But for the most part, the response was different. Believers in the free market have not revised their beliefs.

The European: So let's take a longer view. Do you think that the crisis will have an effect on future generations of economists and policy-makers, for example by changing the way that economic basics are taught?

Stiglitz: I think that change is really occurring with the young people. My young students overwhelmingly don't understand how people could have believed in the old models. That is good. But on the other hand, many of them say that if you want to be an economist, you still have to deal with all the old guys who believe in their wrong theories, who teach those theories, and expect you to believe in them as well. So they choose not to go into those branches of economics. But where I have been even more disappointed is American policy-making. Ben Bernanke gives a speech and says something like, there was nothing wrong with economic theory, the problems were a few details in implementation. In fact, there was a lot wrong with economic theory and with the basic policy framework that was derived from theory. If your mindset is that nothing was wrong, you will not demand new models. That's a big disappointment.

The European: There seemed to have been quite a bit of disagreement among Obama's economic advisers about the right course of action. And in Europe, fundamental economic principles like the absolute focus on GDP growth have finally come under attack.

Stiglitz: Some American policy-makers have recognized the danger of "too big to fail," but they are a minority. In Europe, things are a bit better on the rhetorical side. Influential economists like Derek Turner and Mervyn King have recognized that something is wrong. The Vickers Commission has thoughtfully re-examined economic policy. We have nothing like that in the United States. In Germany and France, the financial transactions tax and limits to executive compensation are on the table. Sarkozy says that capitalism hasn't worked, Merkel says that we were saved by the European social model – and they are both conservative politicians! The bankers still don't understand this, which explains why we still see the head of the European Central Bank, Mario Draghi, arguing that we have to give up the welfare system at a time when Merkel says the exact opposite: That the social model kept us going when the central banks failed to do their regulatory job and used politics to change the nature of our societies.

The European: How have your own convictions been affected by the crisis?

Stiglitz: I don't think that there has been a fundamental change in my thinking. The crisis has reinforced certain things I said before and shown me how important they are. In 2003, I wrote about the risk of interdependence, where the collapse of one bank can bring about the collapse of other banks and increase the fragility of the banking system. I thought it was important, but the idea wasn't picked up at the time. The same year we looked at agency problems in finance. Now we recognize just how important those issues are. I argued that the real issue in monetary economics is about credit, not money supply. Now everybody recognizes that the collapse of the credit system brought down the banks. (I don't agree, the collapse of the credit system was a symptom not a cause. It was the fraudulent paper, and the subsequent insolvency it promoted, that collapsed confidence which is the foundation of credit - Jesse) So the crisis really validated and reinforced several strands of theory that I had explored before. One topic that I now consider much more important than I did previously is the question of adjustment and the role of exchange rate systems like the Euro in preventing economic adjustment. A related issues is the linkage between structural adjustment and macroeconomic activity. The events of the crisis have really induced me to think more about them.

The European: The financial transaction tax seems to have died a political death in Europe. Now, economic policy in Europe seems largely dominated by the logic of austerity, and by forcing other European countries to become more like Germany.

Stiglitz: Austerity itself will almost surely be disastrous. It is leading to a double-dip recession that could be quite serious. It will probably make the Euro crisis worse. The short-term consequences are going to be very bad for Europe. But the broader issue is about the "German model." There are many aspects to it – among them the social model – that allow Germany to weather a very big dip in GDP by offering high levels of social protection. The German model of vocational training is also very successful. But there are other characteristics that are not so good. Germany is an export economy, but that cannot be true for all countries. If some countries have export surpluses, they are forcing other countries to have export deficits. Germany has taken a policy that other countries cannot imitate and tried to apply it to Europe in a way that contributes to Europe's problems. The fact that some aspects of the German model are good does not mean that all aspects can be applied across Europe.

The European: And it does not mean that economic growth satisfied the criteria of social fairness.

Stiglitz: Yes, so there is one other thing we have to take into account: What is happening to most citizens in a country? When you look at America, you have to concede that we have failed. Most Americans today are worse off than they were fifteen years ago. A full-time worker in the US is worse off today than he or she was 44 years ago. That is astounding – half a century of stagnation. The economic system is not delivering. It does not matter whether a few people at the top benefitted tremendously – when the majority of citizens are not better off, the economic system is not working. We also have to ask of the German system whether it has been delivering. I haven't studied all the data, but my impression is no.

The European: What do you say to someone who argues thus: Demographic change and the end of the industrial age have made the welfare state financially unsustainable. We cannot expect to cut down on our debt without fundamentally reducing welfare costs in the long run.

Stiglitz: That is absurd. The question of social protection does not have to do with the structure of production. It has to do with social cohesion or solidarity. That is why I am also very critical of Draghi's argument at the European Central Bank that social protection has to be undone. There are no grounds upon which to base that argument. The countries that are doing very well in Europe are the Scandinavian countries. Denmark is different from Sweden, Sweden is different from Norway – but they all have strong social protection and they are all growing. The argument that the response to the current crisis has to be a lessening of social protection is really an argument by the 1% to say: "We have to grab a bigger share of the pie." But if the majority of people don't benefit from the economic pie, the system is a failure. I don't want to talk about GDP anymore, I want to talk about what is happening to most citizens.

The European: Has the political Left been able to articulate that criticism?

Stiglitz: Paul Krugman has been very strong on articulating criticism of the austerity arguments. The broader attack has been made, but I am not sure whether it has been fully heard. The critical question right now is how we grade economic systems. It hasn't been fully articulated yet but I think we will win this one. Even the Right is beginning to agree that GDP is not a good measure of economic progress. The notion of the welfare of most citizens is almost a no-brainer. (Median is the message. - Jesse)

The European: It seems to me that much of the discussion is still about statistical measurements – if we're not measuring GDP, we're measuring something else, like happiness or income differences. But is there an element to these discussions that cannot be put in numerical terms – something about the values we implicitly bake into our economic system?

Stiglitz: In the long run, we ought to have those ethical discussions. But I am beginning from a much narrower base. We know that income doesn't reflect many things we care about. But even with an imperfect indicator such as income, we should care about what happens to most citizens. It's nice that Bill Gates is doing well. But if all the money went to Bill Gates, the system could not be graded as successful.

The European: If the political Left hasn't been able to fully articulate that idea, has civil society been able to fill the gap?

Stiglitz: Yes, the Occupy movement has been very successful in bringing those ideas to the forefront of political discussion. I wrote an article for Vanity Fair in 2011 – "Of the 1%, by the 1%, for the 1%" – that really resonated with a lot of people because it spoke to our worries. Protests like the ones at Occupy Wall Street are only successful when they pick up on these shared concerns. There was one newspaper article that described the rough police tactics in Oakland. They interviewed many people, including police officers, who said: "I agree with the protesters." If you ask about the message, the overwhelming response has been supportive, and the big concern has been that the Occupy movement hasn't been effective enough in getting that message across.

The European: How do we move from talking about economic inequality to tangible change? As you said earlier, the theoretical recognition of economic problems has often not been translated into policy.

Stiglitz: If my forecast about the consequences of austerity is correct, you will see a new round of protest movements. We had a crisis in 2008. We are now in the fifth year of crisis, and we haven't solved it. There's not even a light at the end of the tunnel. When we come to that conclusion, the discourse will change.

The European: The situation needs to be really bad before it will get better?

Stiglitz: Yes, I fear.

The European: You recently wrote about the "irreversible decay" of the American Midwest. Is this crisis a sign that the US has begun an irreversible economic decline, even while we still regard the country as a potent political player?

Stiglitz: We are facing a very difficult transition from manufacturing to a service economy. We have failed to manage that transition smoothly. If we don't correct that mistake, we will pay a very high price. Already, the average American is suffering from the failed transition. My concern is that we have set in motion an adverse economics and an adverse politics. A lot of American inequality is caused by rent-seeking: Monopolies, military spending, procurement, extractive industries, drugs. We have some economic sectors that are very good, but we also have a lot of parasites. The hopeful view is that the economy can grow if we rid ourselves of the parasites and focus on the productive sectors. But in any disease there is always the risk that the parasites will devour the healthy body parts. The jury is still out on that.

The European: Have we at least understood the disease well enough to prescribe the correct therapy? Especially with regard to policy-making and the Euro crisis, there seems to be a lot of shooting into the dark.

Stiglitz: I think the problem is not a lack of understanding by dispassionate social scientists. We know the basic dilemma, and we know the effect of campaign contributions on policy-makers. So we are facing a vicious circle: Because money matters in politics, that leads to outcomes in which money matters in society, which increases the role of money in politics. You have more gerrymandering and more disillusionment with parliamentary politics.

The European: Has politics become too focused on outcomes, and is it not sensitive enough to the processes that lead to those outcomes? The bedrock of democracy seems to hinge on the avenues for participation, not on the effectiveness of particular policies.

Stiglitz: Let me put it this way: Some people criticize by saying that we have become too focused on inequality and are not concerned enough about opportunity. But in the United States, we are also the country with the biggest inequality of opportunity. Most Americans understand that fraud political processes play in fraud outcomes. But we don't know how to break into that system. Our Supreme Court was appointed by moneyed interests and – not surprisingly – concluded that moneyed interests had unrestricted influence on politics. In the short run, we are exacerbating the influence of money, with negative consequences for the economy and for society.

The European: Where is change rooted? In parliament? In academia? In the streets?

Stiglitz: You look in the streets and a little bit in academia as well. When I say that the major thrust of the economics profession has disappointed me, I need to qualify that statement. There have been groups that push new economic thinking and challenge the old models.

The European: You have written that the challenge is to respond to bad ideas not with rejection but with better ideas. Where is the longest and strongest lever to bring new economic thinking into the realm of policy?

Stiglitz: The diagnosis is that politics is at the root of the problem: That is where the rules of the game are made, that is where we decide on policies that favor the rich and that have allowed the financial sector to amass vast economic and political power. The first step has to be political reform: Change campaign finance laws. Make it easier for people to vote – in Australia, they even have compulsory voting. Address the problem of gerrymandering. Gerrymandering makes it so that your vote doesn't count. If it does not count, you are leaving it to moneyed interests to push their own agenda. Change the filibuster, which turned from a barely used congressional tactic into a regular feature of politics. It disempowers Americans. Even if you have a majority vote, you cannot win.

The European: We're looking at six months of presidential campaigning. The role of money has been embraced by both parties. Campaign finance reform seems rather unlikely.

Stiglitz: Even the Republicans have become more aware of the power of money by seeing how it influenced and distorted the primaries. The outcomes are not what the Republican party establishment had hoped for. The disaster is becoming clear – but that will not lead to immediate remedies. Those who become elected depend on that money. It will require a strong third party or civil society to do something about this.

[Nov 17, 2011] The Anatomy of Influence - The Chronicle Review - By Evan R. Goldstein

But for Kahneman and Tversky, it was self-evident that people are neither fully rational nor completely selfish. Their "Prospect Theory: an Analysis of Decision Under Risk," published in Econometrica, exposed flaws in utility theory by pointing out how it fails to capture the way people actually behave: We are easily influenced by frames and anchors; we're overconfident; we fear losses more than we value gains. Prospect theory, they argued in 29 equation-packed pages, provides a more psychologically realistic model of economic behavior. (The name itself, "prospect theory," is meaningless. Kahneman and Tversky wanted something distinctive and easy to remember.)
November 8, 2011 | The Chronicle of Higher Education

In 1971, Daniel Kahneman and Amos Tversky, psychology professors at the Hebrew University of Jerusalem at the time, began a sabbatical year at the Oregon Research Institute. The two Israelis, both in their 30s, seemed like a study in contrasts; where Tversky, a decorated paratrooper with shrapnel lodged in his body, was optimistic and analytical, Kahneman was pessimistic and intuitive. But they shared a sense of humor, and an interest in the psychology of mistakes.

That year they ran dozens of experiments. In one, they built a wheel marked 0 to 100, but rigged it to stop on only 10 or 65. After each spin, the subject wrote down the number and was then asked to guess the percentage of countries in the United Nations that are African. On average, those who spun a 10 guessed 25 percent, while those who spun a 65 guessed 45 percent.

The number on the wheel, though arbitrary, unconsciously swayed people's predictions-hence the phenomenon is known as anchoring. It happens everywhere. For instance, a sale on cans of tuna that limits each customer to 12 causes the average shopper to buy twice as many cans (seven) than if there were no limit. People also anchor on ideas, sometimes with serious consequences. Recent studies indicate that physicians can fixate on an initial but ultimately misleading symptom, jump to conclusions, and fail to make an accurate diagnosis.

Kahneman and Tversky became connoisseurs of such cognitive biases, meticulously cataloging the ways in which human thinking is flawed.

Beneath the laboratory curiosities lurked an explosive idea. In the 1970s-and still today, though to a lesser extent-two beliefs held sway in the social sciences. First, that people are generally rational and have sound judgment. Second, that when they depart from rationality, it's a temporary aberration, resulting from emotions like fear, hatred, and love. Kahneman and Tversky's research suggested an entirely different view: that it is the very way we think-our use of what they called heuristics, or mental shortcuts-that leads us astray.

In 1974 they published their findings in Science. "In general," they wrote, "these heuristics are quite useful, but sometimes they lead to severe and systematic errors." That might not sound like the opening shot of a revolution, but as Mark Kelman, a professor of law at Stanford University, puts it: "This was reconceptualize-the-world-type stuff."

Five years later, Kahneman and Tversky did it again, this time upending conventional wisdom about economic behavior. Assumptions about rationality and selfish profit-seeking are built into utility theory, the dominant model in economics, which holds that people will always act in their own best interests. But for Kahneman and Tversky, it was self-evident that people are neither fully rational nor completely selfish. Their "Prospect Theory: an Analysis of Decision Under Risk," published in Econometrica, exposed flaws in utility theory by pointing out how it fails to capture the way people actually behave: We are easily influenced by frames and anchors; we're overconfident; we fear losses more than we value gains. Prospect theory, they argued in 29 equation-packed pages, provides a more psychologically realistic model of economic behavior. (The name itself, "prospect theory," is meaningless. Kahneman and Tversky wanted something distinctive and easy to remember.)

"Going back to Adam Smith, everyone knew that the idea that people operate optimally is a simplification," says Eric Wanner, president of the Russell Sage Foundation and an early enthusiast of Kahneman and Tversky's work. "But until prospect theory, nobody had pinned down the psychology well enough to do anything about it." Richard Thaler, a professor of economics at the University of Chicago, has an earthier explanation of prospect theory's impact: "Rationality was f***ed."

Perhaps, but it didn't feel that way to most people at the time. Kahneman and Tversky (who died in 1996) had early converts among some junior professors and insurgent types, but their thinking was at first far from the mainstream. Today, however, their ideas have rippled across the scholarly landscape, from economics to engineering, medicine to environmental studies. Their Science and Econometrica papers are among the two most cited in all of social science. According to the Thomson Reuters Web of Science, Kahneman has appeared or been cited in scholarly journals more than 28,312 times since 1979. In 2002 he won the Nobel in economic science for "having integrated insights from psychological research into economic science."

Kahneman's career tells the story of how an idea can germinate, find far-flung disciples, and eventually reshape entire disciplines. Among scholars who do citation analysis, he is an anomaly. "When you look at how many areas of social science he's put his fingers in, it's just ridiculous," says Jevin West, a postdoctoral researcher at the University of Washington, who has helped develop an algorithm for tracing the spread of ideas among disciplines. "Very rarely do you see someone with that amount of influence."

But intellectual influence is tricky to define. Is it a matter of citations? Awards? Prestigious professorships? Book sales? A seat at Charlie Rose's table? West suggests something else, something more compelling: "Kahneman's career shows that intellectual influence is the ability to dissolve disciplinary boundaries."

You don't glean much about how he did that from his new memoir, Thinking, Fast and Slow (Farrar, Straus and Giroux). The book's scope is wide-Kahneman, 77, revisits his entire body of scholarship, including the research on judgment and bias he did with Tversky, as well as his later work on happiness-but his focus is on the science, not himself. (Kahneman was unable to comment for this article, because of an arrangement with another publication.) For a clearer sense of his stature, turn to the blurbs. "Among the most influential psychologists in history," says Steven Pinker. "One of the greatest psychologists and deepest thinkers of our time," says Daniel Gilbert. Nassim Nicholas Taleb declares Thinking, Fast and Slow "a landmark book in social thought, in the same league as Adam Smith's The Wealth of Nations."

That's not book-flacking hyperbole. (OK, maybe a little.) Ask around and you hear pretty much the same thing. "Kahneman is the most influential psychologist since Sigmund Freud," says Christopher Chabris, a professor of psychology at Union College, in New York. "No one else has had such a broad impact on so many fields."

Born in Tel Aviv in 1934, the son of Lithuanian Jews, Kahneman spent his boyhood in Paris, where the family prospered until Germany invaded, in 1940. Precocious and math-minded, the 6-year-old decided to sketch a graph of the family's fortune: The curve dipped into negative territory.

Jews in France were placed under curfew and required to wear a Star of David. One evening, when Kahneman was no more than 7, he accidentally stayed late at a friend's house. Before starting the few blocks' walk home, he turned his sweater inside out. An SS soldier approached. "I was terrified that he would notice the star inside my sweater," Kah­neman recalled years later. Instead, the black-uniformed Nazi gave him a hug and showed him a photograph of his own son. The cognitive dissonance made a great impression on Kahneman: How was this soldier simultaneously capable of great cruelty and great affection?

After Kahneman's father was arrested in a roundup of Jews-his employer, a chemical company, somehow negotiated his release-the family fled, first to the Riviera and then to the center of France. In 1944, Kahneman's father died from untreated diabetes. The rest of the family survived the war and returned to Palestine. In an interview a few years ago, Kahneman was asked about his wartime experience. He said simply, "I was luckier than most of the children of my generation in that place in the world."

At Hebrew University, Kahneman studied psychology and math, earning a bachelor's degree in two years. In 1955, he joined the psychological-research unit of the Israeli military. Just 21, he found himself the best-trained psychologist in the young army. He was assigned to assess the psychological fitness and leadership abilities of new recruits. Mostly he watched as soldiers completed group challenges like trying to cross a six-foot-high wall using nothing but a log that couldn't touch either the ground or the wall. Kahneman made note of who took charge and who was a quitter, and was confident in his evaluations.

That confidence was misplaced. Every few months, a commander would report to him about each soldier's actual performance. It was always the same story: Kahneman's evaluation had been about as accurate as a blind guess. He noticed something else as well: He was incapable of acknowledging the full extent of his own ignorance. He didn't doubt the evidence, but he remained confident in his predictions.

Decades later, Kahneman coined a phrase for this cognitive fallacy-the illusion of validity-and applied it to the psychology of Wall Street. Fifty years of research is conclusive, he argues in Thinking, Fast and Slow: Picking stocks is a game of luck, not skill. And yet the illusion of expertise persists in the financial world-and not only there. We are all masters of self-deception, he suggests, blithely ignorant of our own ignorance.

By the mid-60s, Kahneman had joined the faculty at Hebrew University. One day Amos Tversky, a colleague, argued in a guest lecture in Kahneman's class that people are generally good intuitive statisticians. Kahneman was skeptical, having already been sensitized to his own cognitive limitations. Their debate was lively, and they decided to collaborate on a study of intuition and expertise.

Their first paper was published in Psychological Bulletin in 1971, shortly before they arrived in Oregon. It confirmed what Kahneman had suspected: Even the brains of professional statisticians are not well suited to think statistically. To determine the lead author, he and Tversky flipped a coin. Thereafter they alternated. Over the next 12 years, their research forever changed the way people think about thinking.

"When I met Danny and Amos, neither of them knew any economics," says Richard Thaler. "They couldn't have passed Econ 101." Thaler, sharp-witted and talkative, is seated in his glass-walled corner office at the University of Chicago's Booth School of Business. He props his feet on the cluttered desk, clasps his hands behind his head, and takes me back to 1976.

Thaler was then an untenured assistant professor at the University of Rochester with an unusual hobby: He collected examples of people behaving at odds with utility theory. For instance, he had a wine-collecting colleague who paid $35 for a bottle but refused to sell it for less than $100. Utility theory couldn't explain the large disparity between those prices. Thaler called these cases anomalies and tacked a list of them to his office wall.

One day a package arrived from an acquaintance. Inside were several papers, including Kahneman and Tversky's 1974 Science article on heuristics and biases. Thaler was enthralled. He tracked down an early draft of their essay on prospect theory-in which a key idea is that losses are more acutely felt than gains. Put another way: The pain of giving up a bottle of wine you own and value can be greater than the pleasure of getting an equally good bottle.

For Thaler, it was an aha! moment. "I was no longer the only crazy person in the world. There were at least two other equally crazy people," he says, grinning broadly. "Even more, they were well regarded in their field, which I was not." Kahneman and Tversky were then at the Center for Advanced Studies at Stanford University. In 1977, Thaler went to Palo Alto and stayed for 15 months. Behavioral economics had its origin story.

The once-marginal field is now booming. Consider that the top five economics journals rejected Thaler's first paper on anomalous behavior (it was finally published in 1980 by the Journal of Economic Behavior and Organization). Today he is rumored to be on the shortlist for his own Nobel. What accounts for this sea change? How did an idea-integrating psychology into economics-become a movement?

Part of the answer can be traced to Eric Wanner. Back in the mid-1970s, he edited Harvard University Press's series on cognitive science. Kahneman and Tversky were on the advisory board, and Wanner heard the buzz about prospect theory. In 1982 he left the press to join the Alfred P. Sloan Foundation, where he tried to bring economists and psychologists together to research the market implications of nonrational decision making. Kahneman and Tversky were at first skeptical, convinced that interdisciplinary work couldn't be coerced. They suggested instead that Wanner get behind the few economists then willing to listen. Sloan's first grant in that area, in 1983, paid for Thaler to spend a sabbatical year with Kahneman, who was then at the University of British Columbia. "That's when behavioral economics really crystallized in my mind," Thaler says.

A few years later, Wanner became president of the Russell Sage Foundation, which since 1986 has put $8.3-million into behavioral economics. "These are not princely sums," Wanner says, but the money has been well spent. In 1994 the foundation established a biannual summer camp for budding behavioral economists. The two-week workshop for some 30 advanced graduate students and junior faculty was Kahneman's idea. Among the graduates are several leading lights of the field, including David Laibson and Sendhil Mullainathan, of Harvard, and Terrance Odean, of the University of California at Berkeley. (Mullainathan, who received a MacArthur Foundation "genius award" in 2002, was recently appointed to lead the new Consumer Financial Protection Bureau's Office of Research.) "Dollar for dollar, says Colin Camerer, a professor of economics at the California Institute of Technology, "it's the best social-science investment any foundation has ever made."

As Kahneman and Tversky's ideas hopped from discipline to discipline-by the early 1980s, prospect theory had spilled over into medicine, law, and political science-the pattern repeated itself: An enterprising, unorthodox scholar from outside of psychology would fall into their orbit and extend their ideas in new directions. The story of how this happened in medicine is representative.

Donald Redelmeier began his residency at the Stanford University Medical Center in the 80s and became a student of Tversky's, who had joined the university's faculty in 1978. "The brightest person I ever met," Redelmeier says by phone from his office at the University of Toronto, where he is a physician and researcher. In a number of papers he wrote independently with Kahneman and Tversky, Redelmeier-called the "leading debunker of preconceived notions in the medical world" by The New York Times-explored doctor-and-patient decision making and the psychology of pain. He even put to rest the belief that arthritis symptoms are exacerbated by inclement weather. (Redelmeier and Tversky chalked that myth up to people's tendency to look for patterns even where none exist.)

"Danny and Amos didn't always see the medical connections, but they had a tremendous receptivity to people outside their domain of expertise," says Redelmeier. "When they spoke about decision sciences, I was all ears; when I spoke about medicine, they shut up and listened."

Framing-the way information is presented-is the most salient example of how a cognitive bias identified by Kahneman and Tversky can affect medical decision making. In a classic study done by Tversky and colleagues at Harvard Medical School, physicians were given two options to treat a patient with cancer: surgery or radiation. The five-year survival rate favored surgery, but the short-term risks were higher. Half the doctors in the study were told that the one-month survival rate was 90 percent, while the other half were told that there was a 10-percent mortality rate in the first month. The odds were the same, of course, but the doctors responses' were markedly different. Those told the survival rate were much more likely to choose surgery (84 percent) than those who were given the mortality rate (50 percent).

Among the medical experts who have taken note of such findings is Jerome Groopman, an oncologist at Harvard Medical School and author, with Pamela Hartzband, of Your Medical Mind: How to Decide What Is Right for You (Penguin Press, 2011). "Rational-decision analysis is so far from a doctor's reality," he says, adding that the typical consultation lasts only eight to 10 minutes. In that time, doctors must rely on intuition and pattern recognition-this symptom suggests that ailment-to reach a diagnosis. About 80 percent of the time, he says, intuition gets it right. But in the other cases, the patient is misdiagnosed or the diagnosis is delayed.

Groopman believes that heuristics and biases are often to blame. "Intuition is powerful and necessary," he says, "but if you just rely on that, you're going to get it wrong." According to Hartzband, that message is getting through to her students. "I routinely hear them using terms like anchoring," she says, adding that Kahneman and Tversky "have definitely percolated through the ranks."

Four decades after he and Tversky first cleared the way for a new understanding of the mind, Kahneman and his ideas have branched off in a dizzying array of directions. How to explain his influence? Most everyone agrees that his scholarship-especially the work with Tversky from 1971 to 1983-is just exceptionally good. Moreover, their insights are relatively easy to digest and pack a lot of explanatory power. And because they shine a light on the very stuff of thought, their ideas are relevant to just about everything.

Political scientists use prospect theory to model foreign-policy decision making. Some international-relations scholars argue that cognitive biases favor hawkish policies, making wars more likely to begin and more difficult to end. (Kahneman shares that view.) At Columbia University, an interdisciplinary group of economists, psychologists, and anthropologists is building on Kahneman's ideas about risk perception to better understand apathy about climate change. Kahneman's services are also, not surprisingly, in demand on Wall Street. Guggenheim Partners, a New York-based global financial-services firm that manages more than $125-billion in assets, has recently advertised a Kahneman-designed "proprietary approach" to help "high-net-worth investors understand their specific attitudes toward risk."

It may be in the policy world where Kahneman's ideas have gained the most recent attention and may have the most impact. In the late 1990s, a movement in behavioral law and economics emerged to challenge the assumption in conventional law and economics that judges, jurors, criminals, and consumers are rational. That school of thought, which emerged in the 70s and is most closely associated with Richard Posner, is seen as a bulwark of free-market libertarianism. If people make good choices, the thinking goes, government need only get out of their way. Critics were at a disadvantage, says Thaler. They had misgivings and arguments, but no competing theory of economic behavior. "Then Kahneman and Tversky came along," he says. "People who felt like they were being bullied now had something to hit back with."

Much of this hitting back has been done by Kah­neman's friend and collaborator Cass R. Sunstein, the Harvard Law professor who now serves as head of the White House Office of Information and Regulatory Affairs. In 1998, Sunstein and Thaler, along with Christine Jolls, of Yale Law School, published a highly influential article-"A Behavioral Approach to Law and Economics"-in the Stanford Law Review. They called on legal scholars to adopt a more realistic view of human nature. In 2008, Sunstein and Thaler built on those ideas in Nudge: Improving Decisions About Health, Wealth, and Happiness (Yale University Press), which drew from Kahneman and Tversky to design noncoercive policies that encourage people to save more, eat better, and become smarter investors.

For example, 401(k) programs are generally opt-in, meaning that the onus to join is on the employee. Many of us want to, and doing so is certainly in our self-interest, but we're human: We procrastinate, we forget. Sunstein and Thaler proposed switching 401(k) programs to automatic enrollment. Studies show how doing so increases employee participation. Moreover, because there is still an opt-out, people aren't forced to join against their will. Kahneman calls Nudge the "bible of behavioral economics." Interest in these ideas has spread across the Atlantic. The British government has established something called a Behavioural Insight Team to bring principles from behavioral economics to bear on public policy. (Thaler is an adviser.)

It now seems inevitable that Kah­neman, who made his reputation by ignoring or defying conventional wisdom, is about to be anointed the intellectual guru of our economically irrational times. For proof, look no further than the newsstand. In the December issue of Vanity Fair, Michael Lewis profiles Kahneman, who is described on the cover as the "brilliant but quirky professor who made Moneyball possible." Rumor has it that the article is a preview of Lewis's sure-to-be best-selling next book. Will Aaron Sorkin write the movie script? Will Brad Pitt star? Will Kahneman fall victim to his own illusion of expertise?

That's unlikely. Near the end of Thinking, Fast and Slow, he insists that his deep understanding of bias and blunder has not made him immune to either failing. "Except for some effects that I attribute mostly to age, my intuitive thinking is just as prone to overconfidence, extreme predictions, and the planning fallacy"-making excessively optimistic estimates of how long it will take to complete a project-"as it was before I made a study of these issues," he writes.

But Kahneman, it seems, has indeed learned something about the limits of intuitive thinking. After all, what could be more counterintuitive than a humble guru?

Evan R. Goldstein is managing editor of The Chronicle Review.

ellenhunt :

Another reason to respect T&K's work is that together they drove a stake through the heart of the Ayn Rand frootloops. Ayn Rand's novels of purified cold-hearted self-interest were literally based on a sociopath who murdered a 12 year old girl for his own entertainment. This is literally true. Her journals prove her fetid obsession with his sociopathy and her schoolgirl crush on this creep. Her own words convict her, showing how John Galt was based on this child-torturing thrill-killer monstrosity. Ayn Rand's work has as much to do with economics as snuff-film pornography has to do with child-rearing.

I must share with you this bit from today's news (excerpted from Huff-Po) regarding Ayn Rand's fecal-splatter she painted upon our world. I salute the unsung typesetter who managed this wonderful bit of monkey-wrenching from inside of the vicious machine of Rand-drivel that plagues our world.

================================================================== Atlas Productions LLC execs apologize for the error with a series of frameworthy quotes:

From CEO Harmon Kaslow:

"As we all well know, the ideas brought to life in Atlas Shrugged are entirely antithetical to the idea of 'self-sacrifice' as a virtue. Atlas is quite literally a story about the dangers of self-sacrifice. The error was an unfortunate one and fans of Ayn Rand and Atlas have every right to be upset."

And more, from Communications Director Scott DeSapio:

"It's embarrassing for sure and of course, regardless of how or why it happened, we're all feeling responsible right now. You can imagine how mortified we all were when we saw the DVD but, it was simply too late - the product was already on shelves all over the Country. It was certainly no surprise when the incredulous emails ensued. The irony is inescapable." ===================================================================

Today T&K can be cited against the brain-eating Rand as proof that her fundamental thesis is wrong. It is not the only citable work, but it is a good one. Flag

[Oct 17, 2010] How Supermodels Are like Toxic Assets by Ashley Mears

July 12, 2010 |

Coco Rocha in Bill Blass by Peter Som February 2008, Photographed by Ed Kavishe for Fashion Wire Press.jpg

(Photo: Coco Rocha in Bill Blass by Peter Som February 2008, Photographed by Ed Kavishe for Fashion Wire Press, and is licensed under creative commons.)

In 2002, a tall and skinny 14-year old girl competed in a dance contest in Vancouver, Canada. There she encountered a modeling agent, who asked her to consider going out for modeling jobs. Today, the 22-year-old Coco Rocha is celebrated as a "supermodel" (however little of its glamazon power the term retains these days), appearing on covers of Vogue and i-D magazines, on catwalks from Marc Jacobs to Prada, and as the star face for Dior, H&M, and Chanel. You might not recognize her name, but the chances are you've seen Coco Rocha in the past few years.

Coco is what economists would call a winner in a "winner-take all market," prevalent in culture industries like art and music, where a handful of people reap very lucrative and visible rewards while the bulk of contestants barely scrape by meager livings before they fade into more stable and far less glamorous careers. The presence of such spectacular winners like Coco Rocha raises a great sociological question: how, among the thousands of wannabe models worldwide, is any one 14 year-old able to rise from the pack? What makes Coco Rocha more valuable than the thousands of similar contestants? How, in other words, do winners happen?

The secrets to Coco's success, and the dozens of girls that have come before and will surely come after her, have much less to do with Coco the person (or the body) than with the social context of an unstable market. There is very little intrinsic value in Coco's physique that would set her apart from any number of other similarly-built teens-when dealing with symbolic goods like "beauty" and "fashionability," we would be hard pressed to identify objective measures of worth inherent in the good itself. Rather, social processes are at work in the fashion modeling market to bequeath cultural value onto Coco. The social world of fashion markets reveals how market actors think collectively to make decisions in the face of uncertainty. And this social side of markets, it turns out, is key to understanding how investors could trade securities backed with "toxic" subprime mortgage assets leading us into the 2009 financial crisis.


When trying to figure out how winners happen in the modeling industry, the first thing to know is that nobody knows. This was one of the most striking things I discovered over the course of researching fashion. Clients-designers, photographers, and stylists-don't know what makes one model a better choice than another. And how would they? It's an inherently uncertain task, hinging upon aesthetic preference, unknown consumer demand, and quick turnover-fashion is, after all, by definition change.

Consider the Fashion Week catwalks. There are thousands of models worldwide that vie for a chance to appear in the shows of New York, London, Milan, and Paris, and nearly all of them meet a high bar of tall, slim, and beautiful. As many as 200 models may walk through a casting director's door in a single day during show season, and typically the shows have just 15 – 40 slots to fill. That's a lot of models to sort through.

How do the clients know which models to choose for their fashion shows? Plucking the right face from the flock to fit a particular designer's look of the season is, as Prada casting director Russell Marsh told me, like finding a needle in a haystack. Russell peruses hundreds of images of women and men for potential spots in the Prada and Miu Miu runway shows and campaigns; he's a key "Mover, Shaker and Style-Maker" according to the London Independent. When I put the question to him-why this model as opposed to that one?-he threw his hands up in the air, and excitedly pointed around his studio, "Why did I decide to buy this chair and sofa? You know, for me, it ticks the box. You know, it's an internal thing!"

Like dozes of fashion producers I spoke with, Russell doesn't really know what it is about a kid like Coco Rocha that excites him. He "just knows" if a model is right for him, and further, he "knows it when he sees it." This instantaneous knowledge is what sociologist Patrik Aspers calls "contextual knowledge" that creative producers tap into as they broker otherwise "fuzzy" values like beauty and edginess. It's also what sociologist Michel Abolafia has called "gut feeling" in his study of Wall Street traders-on the trading floor, brokers have a kind of 6th sense for what's hot and cold.

But while fashionistas express this 6th sense as an internal thing, they feel it together. Here we have a paradox: Despite an abundant labor supply and uncertain criteria, there is enormous inequality in who gets to participate in Fashion Week. With my colleague, social networks expert Frédéric Godart, I studied the show reports from Spring 2007 and found that designers used a total of 677 fashion models worldwide for their shows. Coco Rocha was among just 60 other women in the entire modeling universe to walk in over 20 shows; in fact, she walked in a whopping 55 shows. In contrast, the overwhelming bulk of models, 75% in fact, were used in just 5 shows.

So our plot thickens: What's at the center of this collective "gut feeling" that happens to land on Coco, ratcheting up her popularity and hence, her economic value? The answer holds parallel lessons for how traders in finance markets were able to assign so much inflated value to relatively worthless mortgage assets now known as "toxic assets."

Coco could herself be considered toxic, depending on who you ask, and crucially, when. To the average American consumer, Coco isn't exactly good-looking. She has what industry insiders call an "edgy" look: pale and thin, with long brown hair hanging over a small face with a sharp small mouth and big almond eyes. She certainly is strikingly interesting, but a New York casting director of 14 years explained his initial reaction when he first saw her for show castings back in 2005: "Like Coco, urgh!" Making a sour face, he continued, "Ooh, like she came in and I was like, in my head I was like, 'What trailer park did she come from?'" (This might sound particularly cruel, but rest assured it's a pretty routine way for people in the industry to talk about bodies as a car mechanic might review an engine.)

A year after this casting, Coco graced the cover of Italian Vogue shot by powerhouse photographer Steven Meisel, and when Spring runway season concluded, she boasted a resume of 55 shows from Marc Jacobs to Chanel. By the time the next show season rolled around, when Coco made her way back to the initially skeptical casting director, he desperately wanted to book her.

"I can't just book any girl I want," he explained. "After I see all the girls, you know, I call the agents up and I say these are the girls that I would like for this show. And they don't normally give me girls right away. The first thing they ask you is, "Well who else is in the show?" … They want to know who else you've got. So I always have to get that one girl. If I can get, I guess this season was Coco." At this he rolls his eyes, and continues, "You know as soon as I got Coco in the show, it was like, okay now I'll book whoever I want."

Today, this casting director still cannot see what it is about Coco that makes her a winner. "But now," he explained, "it doesn't matter. It doesn't matter what I think now. Like she is, you know, it right now." As in the fable of "The Emperor's New Clothes," even if one does not believe in the legitimacy of a social order, one obeys the conventions of a social order because one believes that other people find it legitimate and will obey, a classic condition of legitimacy noted by Max Weber. Quite possibly, one may not be able grasp why a model stands out as a winner, but the label legitimates itself as other tastemakers imitate their high-status peers.

Imitation, however, is a funny thing. It's not so simple as mere mimicry of established players, because in fact, established players are just the best imitators. That is, a successful and powerful fashion client like Russell Marsh also has to know what to imitate, and crucially, the right moment. To do this, they need a little help. I found both formal and informal means of sharing information in the fashion market. Informally, producers talk. They hang out throughout the week at lunches, dinners, parties-at one point I studied booking agents in New York who had a regular karaoke party with clients and models. They talk constantly, facebooking, texting, and drinking; they even date each other. They share social and cultural space, and they pick up on the gossip, or "the buzz," this way. Naturally, social ties are important for producers to figure out what's fashionable, since there is so much uncertainty and ambiguity in their work. Lots of industries work this way: publishing, film, art, and even, sociologists have found, financial investing.

The fashion modeling market also has a formal mechanism in place, known as the "option," to ensure all tastemakers get in on the action. An option is an agreement between client and agent that enables the client to place a hold on the model's future availability. Like options trading in finance markets, an option gives the buyer the right, but not the obligation, to make a purchase. In the modeling market, it enables clients to place a hold on the model's time, but unlike finance options trading, model options come free of cost; they are a professional courtesy to clients, and also a way for agents to manage models' hectic schedules.

While the actual runway casting may take just minutes, the work of optioning models begins weeks before Fashion Week, when agencies send clients "show packages," akin to a press kit, announcing every model available for hire. Each agency can have 20 – 50 models up for the shows, given that there are at least 12 high fashion agencies in NYC alone, we're already talking 600 model cards vying for clients' attention! It's a familiar site in the months of February and September to see stacks and stacks of these cards lining the walls of casting directors' offices.

In addition to circulating model cards, this pre-Fashion Week ritual begins the important work of circulating buzz. Options serve the symbolic purpose of "signaling" the model's popularity to all other clients. During castings, clients are likely to ask models, "Which shows are you optioned for," thereby letting them know their competitors' tastes. Modeling agents drum up buzz using options as selling points too, as in, "Russell Marsh just optioned Coco Rocha for Prada!" To most fashion designers' ears, such words sound like warm honey; they greatly reduce the anxiety of having to sort Coco from 599 other striking teenagers.

These formal and informal mechanisms of gossip result in a classic cumulative advantage effect in which successful goods accrue more success (also known as "the rich get richer" phenomenon, or by Biblical reference, the Matthew Effect). Hence, a model with several show options is deemed to be in high demand, or "hot," compared to the model with no options. The opposite is also true. Thus, small differences in quality snowball into large differences in popularity-this is how, among a pool of nearly identical Sashas, Dashas, Mashas and Natashas, fashionistas can pick out a supermodel of the moment such as Sasha Pivovarova.

In the language of economic sociology, options are performative; they create what they putatively just describe. In other words, the models have agency (that's market models we're talking about, not the fashion models, heaven's no!). Options enable investors to anticipate other investors' actions, which spurs herding behavior, where actors decide to disregard their own information (i.e., "That Coco Rocha, urgh!") and imitate instead the decisions taken by others before them (but Russell Marsh optioned her).

In behavioral economics, Coco Rocha's success is a case of an information cascade. Faced with imperfect information, individuals make a binary choice to act (to choose or not to choose Coco) by observing the actions of their predecessors without regard to their own information. In such situations, a few early key individuals end up having a disproportionately large effect, such that small differences in initial conditions create large differences later in the cascade. We see such effects in fields ranging from consumer fads (think Atkins-everyone knows a meat-and-cheese diet isn't healthy for you!), science (like global warming), and technology (VHS beat BETA in the video market, though BETA was a superior machine).

Herding and cascades are rather problematic to financial markets; they leads investors to artificially bid up asset values, thereby leading to bubbles and eventual crashes, even if investors knew better all along, which, it turns out in the housing market, they largely did. But because investors, like fashionistas, react to each other as well as to the aggregate traces of fellow investors' actions (captured well in signaling instruments like options), they exacerbate systemic risk. Essentially, valuing financial goods is a matter of trying to be in fashion, which is a gamble.

In fact, the economist John Maynard Keynes likened finance markets to casinos, in that both are based in speculation. To illustrate, Keynes drew on newspaper beauty contests from the 1930s, where readers were asked to rate the contestants, but with a catch. The prize would go to the reader that could guess the highest ranked winner. So readers would rate not what they themselves thought was personally beautiful, but what they thought other readers would find beautiful. The sociologist would add that beauty is always in the eye of the socially-dominant beholder, but as a metaphor for financial markets, it should worry us, as it worried Keynes: Finance assets accrue profits not according to their actual worth, which, at the height of the housing boom we know now was vastly inflated; rather, their worth is generated in how speculators perceive what other speculators will perceive. A finance market, like a fashion market, consists of speculators chasing each other's tails in disregard for what things are really worth.

But perhaps most worrisome in the fallout of the economic crisis is our ongoing commitment to an ethos of individualism to make sense of it all. We chalk the crash up to a few bad apples and "greedy" executives gone astray-not far off, by the way, from individualist rhetoric in the fashion press celebrating the genius new beauty of Coco. Without a view of the market as a social body-composed of individuals acting in concert with each other, aided by financial models, and bound together by conventions to help them anticipate one another's actions-we can't see how participants act together. Yet their collectively attuned steps can inflate or deflate the value of assets, thus building economic values from cultural ones. Don't take Fashion Week at face value; the catwalk delivers an important sociological lesson for free market enthusiasts.

Posted by Robin Varghese at 01:00 AM | Permalink



This is a great piece. I didn't know about Keynes using the example of a newspaper beauty contest. Thanks for such a thoughtful and thought-provoking essay!

Posted by: Maeve Adams | Jul 12, 2010 9:18:42 AM


When financiers created their doomed portfolios with deeply hidden toxic assets they were very well aware of what they were doing. They were hoping to offload them to some uninformed over-optimistic dummies - and they were often pleasantly surprised.

Are the careers of 'unusual' fashion models somehow the same? Clearly not – because their attributes are very much on show, for anyone to make up their own mind.

There's no buried uber-nastiness that the punters will only discover later when it's too late. Is there?

Posted by: Martin g | Jul 12, 2010 1:03:18 PM

Martin, there might be a parallel of mutually-reinforcing valuations (of mortgage-based securities or of modelling service). But I generally agree.

Posted by: Sagredo | Jul 13, 2010 4:24:55 AM

While I think Martin is quite right to question just how close the parallel really is in the case of mortgage-backed securities, there are certainly herding effects elsewhere in the market. Behavioral economists remains new and under appreciated.

Great article, thanks!

Posted by: Cyrus Hall | Jul 13, 2010 8:31:33 AM

I was informed by this article, right up until the discussion about information cascades.

An information cascade involves a bunch of people being wrong - there doesn't seem to be anything for these people to be wrong about.

The discussion about the social convention being created by options, in part, is very interesting. But it lacks the observations about misdirection and outright deception which virtually all of these performative markets contain.

Very interesting stuff, though.

Posted by: michael webster | Jul 13, 2010 10:10:30 AM

Coco looks like any other teenager you would find in a mall. At last, fashion designers are choosing average women for their models.

Posted by: J.Hawkins | Jul 13, 2010 12:45:21 PM

@J. Hawkins:

Are they choosing average women, or, on average, are teenagers starting to look like the models?

Posted by: E. Lyons | Jul 14, 2010 12:13:44 PM

The image of Coco Rocha was taken by Peter Som and released under the Creative Commons Attribution 3.0 license. I think you found it on Wikipedia. Please could you include the license and attribution. You could even include a link to the image on Wikimedia Commons.

Posted by: Edward Betts | Jul 14, 2010 12:34:23 PM

@J. Hawkins:

Finally we have equality! Now the next step is to replace all our scientists and leaders with average people. Anyone that went to an Ivy League school must be immediately fired and replaced with someone that went to community college.

Posted by: elitist | Jul 14, 2010 12:45:19 PM

this is a nice piece. I completely agree with you,

Posted by: Sachin | Jul 14, 2010 1:03:44 PM

This post underwhelmed me with its loose logic.

Also, why is there a picture of Daul Kim?

Posted by: Anonymous | Jul 14, 2010 4:12:02 PM

What logic? You have to sex up stories about economics somehow. Even if it's just Coco Rocha.

Posted by: J.Hawkins | Jul 14, 2010 4:20:04 PM

Interesting take on the mechanisms of the fashion industry.

But you are off base with your comparison to mortgage assets. Many of those assets were not being traded by pit traders, and there was no "gut" valuation going on. It was highly formalized.

Second, information cascades occur do to bound rationality and not behavioral economics. The distinction is pretty important. Pure bayesian agents will cascade.

Posted by: Dan in Euroland | Jul 14, 2010 6:39:37 PM

As a fashion blogger who has gone to Fashion Week in the big shows and as a Wharton student, I must say this is one of the best pieces I've read in a long time. The parallels are striking and the insights rich.

Thanks so much!

Posted by: Tony Wang | Jul 16, 2010 7:41:55 PM

Books John Cassidy's How Markets Fail

"Between the collapse of communism and the outbreak of the subprime crisis, an understandable and justified respect for market forces mutated into a rigid and unquestioning devotion to a particular, and blatantly unrealistic, adaptation of Adam Smith's invisible hand."

Economist John Maynard Keynes had a weakness for rhetorical flourishes. At the end of his classic The General Theory of Employment, Interest, and Money, he wrote: "Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist." To author John Cassidy, it's a quote that applies to the practical decision-makers of our own time-and that explains the roots of our own Great Recession.

In his ambitious How Markets Fail: The Logic of Economic Calamities, Cassidy, an economics writer for The New Yorker, offers a powerful argument that the current generation of investors and policymakers has been manacled by what he calls the "utopian" free-market school of economics. In an effort to debunk that "ideology," which he sees as holding sway in academia and among policymakers in recent decades, Cassidy marshals a deep understanding of economic intellectual history, deftly explaining the principal ideas of such towering figures as Adam Smith, Friedrich von Hayek, Léon Walras, Kenneth Arrow, Milton Friedman, and Robert Lucas. This long view allows him to place in context the free marketers' notion that self-interest and competition "equals nirvana." In the author's words: "Between the collapse of communism and the outbreak of the subprime crisis, an understandable and justified respect for market forces mutated into a rigid and unquestioning devotion to a particular, and blatantly unrealistic, adaptation of Adam Smith's invisible hand." And it was this faith, he goes on to say, that led Alan Greenspan, among others, to turn a blind eye to what was happening in the real world of money and business.

Cassidy has his intellectual heroes, too. They are the advocates of what he calls "reality-based economics"-grappling with market failures, disaster myopia, speculative frenzies, and other economic complexities. John Maynard Keynes, the great scholar of economic-crisis management, is one such thinker. So are the experimental psychologists Amos Tversky and Daniel Kahneman, the mathematician Benoit Mandelbrot, and Hyman Minsky, the expert on financial manias. "Reality-based economics ... affords the concept of market failure a central position, recognizing the roles that human interdependence and rational irrationality play in creating it," writes Cassidy. "If further calamities are to be avoided, policymakers need to make a big mental shift and embrace this eminently practical philosophy."

How Markets Fail is a nuanced book. That's a major attraction in an era when shrill commentators bicker crudely about government vs. markets and liberty vs. socialism. Even the portrait of Greenspan, perhaps the closest figure to a villain in Cassidy's account, is drawn with a measure of empathy. Yet this book can provoke angry questions in the mind of the reader. Why did so many smart economists, including Robert Lucas and Eugene Fama, refrain from protesting as their ideas were hijacked and abused by demagogic politicians and messianic think tanks? The scholars knew the exceptions, the qualifications, and the heroic assumptions that lay behind their market models. Why, then, didn't they take issue with the op-ed and cable-TV table-pounders who twisted their thinking?

Cassidy agrees with free-market advocates that the market performs wonders, but he believes its reach is limited. In that spirit, he favors greater government regulation of the financial-services industry. Although he doesn't dwell much on practical ideas for reform, he argues that it's necessary to tame Wall Streetplus or minus now that financiers have learned they can privatize profits during good times and socialize losses in bad. He admires the changes that came out of the Great Depression, such as the Glass-Steagall Act, which separated banking from investment banking. Even if current legislators aren't willing to go that far, banks must be required to keep more capital on hand and be given limits on how much debt they can accumulate, he says. He considers the proposed Financial Product Safety Commission a sensible idea. "The proper role of the financial sector is to support innovation and enterprise elsewhere in the economy," he writes. "But during the past 20 years or so, it has grown into Frankenstein's monster, lumbering around and causing chaos."

The author doesn't offer the reader any juicy bits of gossip. There aren't any vivid recreations of tense negotiations over an investment bank's future. Yet he brings ideas alive. More important, the reader comes away persuaded that reality-based economics can play a critical role in what the 18th century British conservative Edmund Burke called "one of the finest problems in legislation, namely, to determine what the state ought to take upon itself to direct by the public wisdom, and what it ought to leave, with as little interference as possible, to individual exertion."

Let's hope the legislators in Washington share this principled view of their role. Cassidy makes a compelling case that a return to hands-off economics would be a disaster.

[Dec 30, 2009] Kodak, Bill Gates and efficient markets

"The market could stay wrong for a very long time. Maybe as long as some blinkered academics could continue to believe in strong versions of the efficient market hypothesis."
Bronte Capital

I am just back from my summer holidays on the New South Wales South Coast. To my (mostly) Northern Hemisphere readers I should boast about warm water, perfect waves, beaches in national parks with only one or two pairs of footprints on them and no people, fish that seem to suicide on your lines, etc – but that would just be boring.

In the middle of every day – when the heat became too much and the surf had waterlogged me I read. On my kindle of course. And some books which I had never read I read happily made easy mostly by the kindle's large font options. One of those books was Alice Schroder's too long but otherwise excellent biography of Warren Buffett. There was plenty there – I just want to share a single throw-away observation.

Warren Buffett has a group of his best investing friends get together once a year. He originally called it the Graham group in honor of his mentor Ben Graham who presented at the first annual meeting in 1968. By 1991 the group had expanded somewhat to include not only the original fabulous stock pickers but some business luminaries who could help enlighten the group on the nitty-gritty of their industries. One regular attendee was Bill Gates of Microsoft fame. From here I will quote Alice Schroder:

After a while Buffett asked everyone to pick their favourite stock.

What about Kodak? asked Bill Ruane. He looked back at Gates to see what he would say.

"Kodak is toast," said Gates.

Nobody else in the Buffett Group knew that the internet and digital technology would make film cameras toast. In 1991, even Kodak didn't know it was toast.

Gates was right of course – and since 1991 Kodak has been a terrible stock – and I would have counted Bill Gate's comments as "knowledge" in as much as a statement about markets and technology could be knowledge. But it would be an awful long time before that "knowledge" would be reflected in stock prices. Here is a graph of the stock price since 1 Jan 1990.

If you had taken Gates to heart in 1991 and shorted the stock then for almost ten years you looked like toast. If you sold the stock because of something Bill Gates said then you looked silly for six or more years unless you purchased something better.

Indeed if you had the "knowledge" probably the best thing to do with it was to use it just to avoid the photography sector altogether. That would mean you might outperform the market – but that outperformance was slight. [If avoiding that sort of catastrophe was your mechanism of making money you probably needed an enormous amount of "knowledge".]

Anyway there is little question that if you understood the implications of digital photography in 1991 you were – at least on that item – the smartest guy in almost any room. And it did not help you make (much) money.

The market could stay wrong for a very long time. Maybe as long as some blinkered academics could continue to believe in strong versions of the efficient market hypothesis.

Efficient Markets or Herd Mentality? The Future of Economic Forecasting

November 11, 2009 | Knowledge@Wharton

Ever wonder why you succumbed, yet again, to advertising hype or deceptive packaging and overpaid for a product? Or bought securities that you know were overvalued when the herd instinct was just too strong to resist?

Such irrationality is the focus of behavioral economists, who appear to be gaining greater credibility in macroeconomic circles since the housing bubble of 2008 and the ensuing global financial meltdown. They are also at the center of an age-old debate recently reignited by columnist and Nobel laureate Paul Krugman in a September 6 New York Times Magazine article titled, "How Did Economists Get It So Wrong?," which fires a salvo at the assumption underlying neoclassical economics -- namely, that free markets are inherently rational and efficient.

Krugman's article heaps scorn on so-called "freshwater economists" -- as typified by the University of Chicago economics faculty, whose ideas have dominated government policymaking since the early 1980s. In contrast, "saltwater economics" exhibits more openness to the ideas promulgated in the 1930s by Britain's John Maynard Keynes -- that free markets often behave inefficiently, are self-destructive and at times need corrective policy actions such as government stimulus spending. Rather than ascribing perfect rationality to markets, these economists say people and institutions often behave irrationally and often in ways contrary to their own interests.

While the debate between the freshwater and saltwater viewpoints in macroeconomics may sound academic, it has a significant impact far outside the ivory towers of universities. First, companies rely on macroeconomic forecasting in their strategic planning and budgeting and for gaining insight about customers and competitors. And macroeconomic theory underlies much of government policymaking. Since the late 1970s, for example, the U.S. government's deregulation of airlines, banking, utilities and communications grew out of a tacit belief in market efficiency and rationality. The Obama administration may be the first to seriously challenge efficient market assumptions since the Reagan era of the 1980s, amid its attempt to restrain executive compensation and set up a new consumer protection agency to govern credit and debit card practices.

The debate isn't limited to the U.S., either. This year's Nobel Prize in economics was awarded to Elinor Ostrom of Indiana University, a political scientist, and Oliver E. Williamson of the University of California, Berkeley, an expert in conflict resolution, striking many economists as an international rebuke of the rigidly mathematical, rational-market models. "It is part of the merging of the social sciences," Yale University economist Robert Shiller told The New York Times, echoing elements of Krugman's argument. "Economics has been too isolated, and these awards are a sign of the greater enlightenment going around. We were too stuck on efficient markets, and it was derailing our thinking."

Repositioning the Field

There is no shortage of opinion on either side of the argument, including a lengthy blog by University of Chicago professor John Cochrane, who was one of Krugman's most conspicuous targets. Cochrane's blog asserts: "The case for free markets never was that markets are perfect... [but that] government control of markets, especially asset markets, has always been much worse.... Krugman at bottom is arguing that the government should massively intervene...."

Much of the debate will indeed be played out in the public policy arena. The rational behavior framework, dominant for the past 30 years, dictates one set of public policy conclusions -- the wisdom of further deregulation, for example, coupled with fiscal restraint on the part of governments. But a new framework influenced by behavioral economics might dictate others -- tighter regulation, say, in addition to continued stimulus spending and different taxation. "There is much to recommend what the neoclassicists have been doing for 30 years," says Wharton business and public policy professor Jeremy Tobacman. "But you have to be sensible and apply some intuition."

Robert Stambaugh, a Wharton finance professor, cautions that the rational markets point of view is just a model, "and like any model, it's wrong -- because all abstractions are deficient to some degree. The greater question is, so what?" It could be that behavioral economics will be used more now to remedy the neoclassical model's flaws because it offers rich new insights into human patterns of irrationality. Even so, Stambaugh doubts it will replace the rational behavior model altogether. "It may be that relying on market-based solutions is a bad idea and leads to all sorts of terrible things, but it's like that saying about democracy -- 'the worst imaginable form of government except for all the others.' And if beating up on the rational market view of the world becomes a way of justifying a greater degree of government intervention or some theory of non-market solutions, I think we need to be suspicious."

According to Wharton finance professor Jeremy Siegel, the freshwater market view of macroeconomics has dominated academic thinking and government policymaking in recent decades in part because behavioral economists haven't been able to produce the same degree of analytical rigor as the rational economists have. Now that may be changing. Siegel sees the field of macroeconomic forecasting repositioning itself, with attempts at understanding how people form expectations and how periods of economic stability breed over-optimism and encourage high debt levels. "We may be moving toward a more behavioral, Keynesian way of viewing economic crises, and that would be a healthy change," he says.

Rational vs. Irrational?

The basic elements of the freshwater/saltwater debate are straightforward. The freshwater markets viewpoint rests strongly on the efficient markets hypothesis, or EMH, as propounded by the University of Chicago's Eugene Fama in the 1970s and later bolstered by Chicago's best-known neoclassicist, Milton Friedman. EMH argues that in any free market, competition among investors and entrepreneurs invariably drives prices to their correct levels. EMH does not assume rationality on the part of each player, merely on the part of markets as a whole. Therefore, the rationalists argue, free markets always make unbiased forecasts, even if they prove incorrect. EMH does not say the market price is always right, merely that it reflects all known information at any given moment.

Like a natural science, freshwater economics lends itself to complex, often elegant mathematical modeling. The freshwater view is that consumers, offered an array of choices, will select the one that is best for them -- a straightforward assertion that can be neatly expressed in mathematical formulae.

In contrast, many assertions made in behavioral economics are more challenging to express mathematically. "Behavioralists" argue that consumers don't always act in their own interests, especially when they fail to understand the choices on offer or succumb to irrational impulses involving those choices. For example, employers in the U.S. had been frustrated by the low participation of employees in company savings plans, despite the benefits the plans could offer the vast majority of workers. Employee participation jumped significantly when the government permitted companies to make savings plan enrollment automatic unless an employee checked a box to opt out of it. In other words, the government policy helped companies combat an employee's negative impulse -- but such impulses are inherently vague and difficult to define.

Unlike in freshwater economics, behavioral economics focuses primarily on the bounds of rationality. Behavioral economists assert that markets are often "informationally inefficient," with much of the inefficiency stemming from patterns of irrational behavior that cognitive psychology can document and measure. In an article titled "Behavioral Finance," published in the Pacific-Basin Finance Journal, Jay R. Ritter from the University of Florida notes that such patterns include:

So, does the recent economic crisis mean victory for behavioralists at the freshwater school's expense? Yes and no, according to a sampling of Wharton faculty. "It has been a crisis for the entire economics field," says operations and information professor Katherine Milkman, who specializes in behavioral decision making. Macroeconomics failed to predict last year's historic meltdown, but equally, microeconomic precepts have long been the basis for aligning executive incentives with the interests of companies and their shareholders. Milkman argues that the misalignment of interests was a major cause of last year's turmoil, but so was the immense complexity of mortgage derivatives and other financial instruments. "The assumption that we can perfectly anticipate future outcomes of highly complex systems is absurd," she says.

While agreeing that macroeconomic forecasting has relied heavily on the rational behavior model in recent decades, Milkman does not believe that dependence was entirely misplaced. "In any field, it's important to solve the biggest problems first," she notes -- and viewing people as optimal decision makers was the right way to begin. At the same time, she sees the recent failure of economic forecasting as having brought about a sea change. "Now, economics has gone from viewing humans as perfectly rational and consistent to saying, 'People are inconsistent and flawed in making their decisions, but we can analyze the inconsistencies and factor them into a new model.'"

A Call to Arms

Justin Wolfers, a Wharton professor of business and public policy, concurs that the downturn drew attention to important flaws, not just in the efficient markets model, but also more generally in macroeconomists' understanding of the marketplace. "The fact that there could be large-scale banking panics, that there was a shadow banking system that the regulators didn't have a lot to say about -- these elements have not been a large part of macroeconomic theorizing over the past two decades," he notes. However, the field of macroeconomics won't necessarily radically alter its course as a result. True, says Wolfers, "there is widespread public anger directed at macroeconomists right now, but there is also widespread anger at the meteorologists every time it rains."

According to Wolfers, "Most of the successes of economic policy of the last two decades remain intact. For example, economic theory is now widely accepted as a starting point for analyses of law, sociology, psychology and all sorts of social issues." Nonetheless, he argues, macroeconomics needs to become both more data-driven and more empirical, with greater emphasis on how consumers and investors behave and make decisions. Public disillusionment with macroeconomic forecasting, he adds, should be a "call to arms" for all economists. "It's clear that the downturn entailed important issues that all economists should be thinking about and that each subfield of economics -- not just macro -- has something to contribute."

Why Economists Failed to Predict the Financial Crisis

May 13, 2009 | Knowledge@Wharton

There is a long list of professions that failed to see the financial crisis brewing. Wall Street bankers and deal-makers top it, but banking regulators are on it as well, along with the Federal Reserve. Politicians and journalists have shared the blame, as have mortgage lenders and even real estate agents.

But what about economists? Of all the experts, weren't they the best equipped to see around the corners and warn of impending disaster?

Indeed, a sense that they missed the call has led to soul searching among many economists. While some did warn that home prices were forming a bubble, others confess to a widespread failure to foresee the damage the bubble would cause when it burst. Some economists are harsher, arguing that a free-market bias in the profession, coupled with outmoded and simplistic analytical tools, blinded many of their colleagues to the danger.

"It's not just that they missed it, they positively denied that it would happen," says Wharton finance professor Franklin Allen, arguing that many economists used mathematical models that failed to account for the critical roles that banks and other financial institutions play in the economy. "Even a lot of the central banks in the world use these models," Allen said. "That's a large part of the issue. They simply didn't believe the banks were important."

Over the past 30 years or so, economics has been dominated by an "academic orthodoxy" which says economic cycles are driven by players in the "real economy" -- producers and consumers of goods and services -- while banks and other financial institutions have been assigned little importance, Allen says. "In many of the major economics departments, graduate students wouldn't learn anything about banking in any of the courses."

But it was the financial institutions that fomented the current crisis, by creating risky products, encouraging excessive borrowing among consumers and engaging in high-risk behavior themselves, like amassing huge positions in mortgage-backed securities, Allen says.

As computers have grown more powerful, academics have come to rely on mathematical models to figure how various economic forces will interact. But many of those models simply dispense with certain variables that stand in the way of clear conclusions, says Wharton management professor Sidney G. Winter. Commonly missing are hard-to-measure factors like human psychology and people's expectations about the future, he notes.

Among the most damning examples of the blind spot this created, Winter says, was the failure by many economists and business people to acknowledge the common-sense fact that home prices could not continue rising faster than household incomes.

Says Winter: "The most remarkable fact is that serious people were willing to commit, both intellectually and financially, to the idea that housing prices would rise indefinitely, a really bizarre idea."

Although many economists did spot the housing bubble, they failed to fully understand the implications, says Richard J. Herring, professor of international banking at Wharton. Among those were dangers building in the repo market, where securities backed by mortgages and other assets are used as collateral for loans. Because of the collateralization, these loans were thought to be safe, but the securities turned out to be riskier than borrowers and lenders had thought.

The Dahlem Report

In a highly critical paper titled, "The Financial Crisis and the Systemic Failure of Academic Economists," eight American and European economists argue that academic economists were too disconnected from the real world to see the crisis forming. The authors are David Colander, Middlebury College; Hans Follmer, Humboldt University; Armin Haas, Potsdam Institute for Climate Impact Research; Michael Goldberg, University of New Hampshire; Katarina Juselius, University of Copenhagen; Alan Kirman, University d'Aix-Marseille; Thomas Lux, University of Kiel; and Brigitte Sloth, University of Southern Denmark.

"The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold," they write. "In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession's insistence on constructing models that, by design, disregard the key elements driving outcomes in real world markets."

The paper, generally referred to as the Dahlem report, condemns a growing reliance over the past three decades on mathematical models that improperly assume markets and economies are inherently stable, and which disregard influences like differences in the way various economic players make decisions, revise their forecasting methods and are influenced by social factors. Standard analysis also failed, in part, because of the widespread use of new financial products that were poorly understood, and because economists did not firmly grasp the workings of the increasingly interconnected global financial system, the authors say.

One result of this, argues Winter, who is not one of the authors but agrees with much of what they say, is to build into models an assumption that all market participants -- bankers, lenders, borrowers and consumers -- behave rationally at all times, as if they were economists making the most financially favorable choices. Clearly, he says, rational behavior is not that dependable, or else people would not do self-destructive things like taking out mortgages they could not afford, a key factor in the financial crisis. Nor would completely rational executives at financial firms invest in securities backed by those risky mortgages, which they did.

By relying so heavily on the view of humans as rational, the paper's authors argue, economists ignore evidence of irrational behavior that is well documented in other disciplines like psychology and sociology. Even if an individual does act rationally, economists are wrong to assume that large groups of people will react to given conditions as an individual would, because they often do not. "Economic modeling has to be compatible with insights from other branches of science on human behavior," they write. "It is highly problematic to insist on a specific view of humans in economic settings that is irreconcilable with evidence."

The authors say economists badly underestimated the risks of new types of derivatives, which are financial instruments whose value fluctuates, often to extremes, according to the changing values of underlying securities. Traditional derivatives such as stock options and commodities futures are well understood. But exotic derivatives devised in recent years, including securities built upon pools of mortgages, turned out to be poorly understood, the authors say. Credit default swaps, a form of derivative used to insure against a borrower's failure to repay a loan, played a key role in the collapse of American International Group.

Rather than accurately analyzing the risks posed by new derivatives, many economists simply fell back on faith that creating new financial products is good, the authors write. According to this belief, which was promoted by former Federal Reserve chairman Alan Greenspan, a wider variety of financial products allows market participants to place ever more refined bets, so the markets as a whole better reflect the combined wisdom of all the players. But because there was not enough historical data to put into models used to price these new derivatives, risk and return assessments turned out to be wrong, the authors argue. These securities are now the "toxic assets" polluting the balance sheets of the nation's largest banks.

"While the economic argument in favor of ever new derivatives is more one of persuasion rather than evidence, important negative effects have been neglected," they write. "The idea that the system was made less risky with the development of more derivatives led to financial actors taking positions with extreme degrees of leverage, and the danger of this has not been emphasized enough."

'Control Illusion'

When certain price and risk models came into widespread use, they led many players to place the same kinds of bets, the authors continue. The market thus lost the benefit of having many participants, since there was no longer a variety of views offsetting one another. The same effect, the authors say, occurs if one player becomes dominant in one aspect of the market. The problem is exacerbated by the "control illusion," an unjustified confidence based on the model's apparent mathematical precision, the authors say. This problem is especially acute among people who use models they have not developed themselves, as they may be unaware of the models' flaws, like reliance on uncertain assumptions.

Much of the financial crisis can be blamed on an overreliance on ratings agencies, which gave complex securities a seal of approval, says Wharton finance professor Marshall E. Blume. "The ratings agencies, of course, use models" which "grossly underestimated" risks.

"Any model is an abstraction of the world," Blume adds. "The value of a model is to provide the essence of what is happening with a limited number of variables. If you think a variable is important, you include it, but you can't have every variable in the world.... The models may not have had the right variables."

The false security created by asset-pricing models led banks and hedge funds to use excessive leverage, borrowing money so they could make bigger bets, and laying the groundwork for bigger losses when bets went bad, according to the Dahlem report authors.

At the time, few people knew that major financial institutions had become so heavily leveraged in real estate-related assets, says Wharton finance professor Jeremy J. Siegel. "Had they not been in that situation, we would not have had the crisis," he says. "We may not even have had a recession.... Macro economists really hadn't talked about it because these structured financial products were relatively new," he adds, arguing that economists will have to scrutinize the balance sheets of major financial institutions more closely to detect mushrooming risks.

Lessons Not Learned

Prior to the latest crisis, there were two well-known occasions when exotic bets, leverage and inadequate modeling combined to create crises, the paper's authors say, arguing that economists should therefore have known what could happen. The first case, the stock market crash of 1987, began with a small drop in prices which triggered an avalanche of sell orders in computerized trading programs, causing a further price decline that triggered more automatic sales.

The second case was the 1998 collapse of the Long-Term Capital Management (LTCM) hedge fund. It had built up a huge position in government bonds from the U.S. and other countries, and was forced into a wave of selling after a Russian government bond default knocked bond prices down.

"When there's a default in one kind of bond, it causes reassessment of all the risks," says Wharton economics professor Richard Marston. "I don't think we have really fully learned from the LTCM crisis, or from other crises, the extent to which things are illiquid." These crises have shown that market participants can rely too heavily on the belief they can quickly unload securities that decline in price, he says. In fact, the downward spiral can be so rapid that it leaves investors with losses far larger than they had thought possible.

In the current crisis, he says, economists "should get blamed for the overall unwillingness to take into account liquidity risk. And I think it's going to force us to reassess that."

Academics also are beginning to reassess business-school curricula. Wharton management professor Stephen J. Kobrin recently moderated a faculty panel that talked about a wide range of possible responses to the crisis. Among the issues discussed, he says, was whether Wharton's curriculum should include more on regulation and risk management, as well as executive education programs for regulators and other government officials.

Kobrin said he believes many academics share "an ideological fixation with free markets and lack of regulation" that should be reexamined. "Obviously, people missed the boat on a lot of the risks that a lot of financial instruments entailed," he says. "We need to think about what changes are needed in the curriculum."


Economists have largely become cheerleaders to support the crummy securities their employers sold and data point predictors and revisors of estimates on un-influential series of data. They have fallen lock step in with one another competing to predict the output of widgets in Timbuktoo or where ever and of course its global significance. As they left university they left their critical ability behind. Why? Because their employers want team players who think outside the box. At least that's what the job ad says. In reality the nonsense they spouted such as 'end to boom bust cycles' only indicated their hubris and poverty of knowledge of economic history, rendering any strategic input they have largely useless. But should we confine criticism to privately employed economists? No! Hands up the Central Banks who were blithely tightening interest rates while sailing into this storm, crushing aggregate demand to boot - not every one all at once please!

Greg C

Michael, are you implying that the central bankers of the world should have been loosening, rather than tightening, even in 2005 and 2006?


It's not only economist who are being disconnected from the real world. Same applies to many finance and possibly other professionals. Besides profit and greed considerations, I believe people from the Wall Street, who developed all these mortgage based CDOs and similar securities, have little understanding how the real estate market and the economy in general works. Most probably, these finance professionals are just sitting in front of computers and play with different models and numbers. Then they come up with some highly profitable and low risk (based purely on computer statistical models with little connection to the reality) securities, have S&P and Moody's rate these papers as AAA, and sell to the banks, funds, and investors that mostly follow strict rules like "buy AAA securities only".

This reminds me of the Soviet Union (or any planned economy for that matter). People in Moscow were making plans on what kind of shops should be operated in some remote locations without deep (or maybe little) knowledge of these regions, relying primarily on statistics. Obviously, making complex economic decisions that are detached from the reality led ultimately to the demise of the USSR. Similarly, investment bankers, economists, and other professionals who rely heavily on statistics and have little working knowledge of the subject will have difficulty in producing correct decisions in the long-run.

I agree that training in certain professions should be revised considerably. Mintzberg has a great book: "Managers Not MBAs". There, he discusses the major issues in the educational system focusing primarily on preparing MBAs. A key point from this book, for me at least, is that managers (and others in the business world) should be close to the customers and have constant interaction with the clients and reality in order to come up with the products and make decision that will provide the most value to the society.

K Subramanian

There were several factors which blinded economists. The most important was the smugness among many of them that economics had become a science comparable to Physics or Chemistry. If only they had read the last chapter of the BIS Annual Report for 2007, they would have become saner.

Its morganitic marriage with mathematics was its undoing - it added an air of certainty and extra elegance to the pretention that Economics was indeed a science. Lastly, in an era of computers and modelling, it was not only a fashion but a way of making big money to adopt "models" in day to day banking.. It is no use blaming it on the incentive structrue.

Regulatory who should have been more circumspect, ignored the warnings of Governor Gramlich, and were worhipping the 'innovations.' Bankers got the wrong mesage from the lTCM episode - they were confident that the Fed would bail them out if there were a crisis.


Why are we blaming Economists. The blame should go to all stakeholders of the economy. Any one who has little understanding of the economic activities and keep track of those data can feel that some thing was wrong with our economy in 2007. It was too much irrational optimism. Change was taking place but we did not want to notice it- story of frog in a jar. I was really feeling unconfortable with all economic indicators / data for two years culmnating in December 2007.

Yes the causes are too much dependence on Efficient Market theory, mathematical models forgeting the facts that models would generate output based on our assumptions - suiting us and finally credit creation by bank and non-banking industries.

But again our memories are weak so far finance markets go. There were many such financial / economic crises in the past but we forget them fast or don't want to heed them. Therefore in my opinion we will continue to expereince such irrational exuberance from time to tome due to animal spirits we human beings have.

K Subramanian

Unfortunately, we have to blame the economists as they have become standard bearers. It is not suggested that they should not play any role. Rather, it is the plea that they should do it with moderation and realism. They should not be carried away by ideologies (read, markets), fads and catchwords. In retrospect, it is surprsing that for nearly two decades they worshipped monetarism and lost all touch with real economy and the relationship between money and real economy. We are paying a heavy price indeed, considering the trillions of dollars going down the drain.


The con was in 5 years ago when 'finance professionals' constructed bonus lead transactions, overlaying 90 odd years of default experience across known Rating Agengy statistical models to produce paper with an 'average Rating' of AAA and a credit history of 15 years. This junk was foisted on a the gullible world. Not even close inspection was needed to reveal seriously flawed underlying portfolios.

I mean in considering an ordinary CDO (corporate bonds) would a sane money manager equally weight a AAA with a BB-? No wonder Moodys profits are down, structuctured securities are their most profitable area.

As to risk management, when all use the same risk model, all run to the exit when the risk book tells them to as the Michael above accurately observes.

Nick Choukair

Adding what has been written above is basically the politics has a main roll to the cause mainly to hamper the new administration and allot of the causes has been dumped underneath the reality carpet.

Ray Randall

In general, most of us think the anomaly will not happen. We ignore either ignore or overplay keen observations of the obvious.

Todd Hawkins

Create a mathmatical/statistical model that measures GREED at different levels (i.e. consumer, gov't, bussiness, Wall St) and you'll see the bubbles forming. I'm amused by this rationality of markets argument, outright GREED leading to over-confidence got all of us into this boat. Now FEAR is bringing us back to Earth.


That economists failed to predict the current financial crisis has not gone unnoticed by the public and has implications for the profession's image and standing in the community. For example, see Let's Rescind The Nobel Prize For Economics

Maurice Cardinal

You nailed it Todd.


Many of the other arguments here remind me of sports fans debating why an athlete zigged when he should have zagged.

The ground is wet because it's raining.

It's greed. Pure, plain and simple.

BTW, not everyone burned up in the crash. Some of us recognized the greed factor and bailed well before the plane hit the ground.


Part 1

There are more lessons than you mention in the Long-Term Capital Management (LTCM) fiasco: lessons not learned and repeated in the current financial crisis.

(1) Slack Regulation/Deception and the start of LTCM

John Meriwether, a bond trader, ran a very successful arbitrage group at Salomon Brothers. One of his traders confessed to making a false bid on treasuries. Meriwether reported it, but no disciplinary action was taken. Turned out the bonder trader had lied. It was not a one-time deviation. Meriwether took the heat and was fired. He started LTCM.

Lesson: Compliance and risk management not a priority at Salomon. (Had it been a priority LTCM would not have happened.)

Part 2

(2) 25% bonuses on Profits

The enormous success of the arbitrage group at Salomon emboldened Meriwether to demand a new form of compensation: 15% share of profits for his traders. When he started LTCM, this practice increased to 25% -- all over and above management fees. Apparently 20% is now routine.

Lessons: (a) The temptation for huge risks with other people's money when the rewards are outrageous by any normal standards of decency. (***) (b) It is the fiduciary duty for portfolio managers to maximize profits for their clients. That goal, then, should be inherent in fund management. Pocketing any percentage of the profits is completely counter to that fiduciary duty. Their compensation should come out of their management fees.

Part 3

(3) Arrogance, Academia and Theoretical Mathematical Models

The founders of Long-Term Captal Management included Myron Scholes and Robert C. Merton, who along with Fischer Black, invented the Black-Scholes fairy option pricing model. Other elite included David Mullins, once a vice chairman of the Board of Governors of the Federal Reserve System, and Eric Rosenfeld from MIT and Harvard. Myron Scholes boasted they would make money by being a vacuum sucking up nickels that no one else could see. (*) LTCM's strategy was arbitrage and relative value convergence trading – hedging systematic risk to zero, using computer and theoretical models.

Lesson: Academic models, theories and assumptions fail miserably in the real world. Academic arrogance has no place on Wall Street.

Part 4

(4) Prerequisite for Change

To change, improve and move forward, we have to first acknowledge what is wrong. I have just watched a video of Eric Rosenfeld lecturing students at MIT about LTCM. (**) In my view, his arrogant, unrepetant and delusionary view of the events is staggering -- and there he is lecturing the next generation of Wall Street.

Lesson: The government, greed, easy credit, low interest rates, housing bubble, risky derivatives, etc. have been paraded before us as the culprits of the current financial crisis. We need to add universities and teaching methods to the mix.

By the way, you say: "But exotic derivatives devised in recent years, including securities built upon pools of mortgages, turned out to be poorly understood." What do you mean by "recent years"? Mortgage backed securities have been around for over 30 years.

(***) Small portion of LTCM's investments included the partners' capital.


The academic models are based on fairly restrictive assumptions as stated before. When there is human interference returns will obey a Weibull pdf in many cases. The normality assumption breaks down. How much research has been done in this field?

How is volatility measured, over a period of 5 days, 10 days or whatever the analyst chooses?!.

John Henry

Wharton does not need to include 'regulation' in its business curriculum. It would be far more intelligent to acknowledge that free-market capitalism and central banking cannot and never have co-existed. The irrational mortgage-backed securities were a tool used by the financial industry to implement US Federal policy that everybody (without regard to individual worth) should own a home. The Federal Reserve system and the banking industry were just cogs in the machine, dutifully implementing Congressional blather. We are experiencing a failure of socialism (Keynesian economics is tool of socialism), not a failure of the free market system. If there is a central bank, there is no free market system. The idea that free-market capitalism and central banking can co-exist is a Keynsian-induced delusion; the recent past (and more to come in 2010) is the death of that delusion.


The first clue to anyone understanding economics was the deal President Clinton and his Justice Department made with banks to award house loans to the poor in order to increase "minority" home ownership. We had the government using the money of other people for low income housing which is not unusual but in this case they used the money of our bank system. How does a bank loan money to a poor person? They don't check the borrower's data on the loan application.

Anyone paying attention at the time Clinton and his bankster pals devised this plan, knew it was insane and dangerous for the financial health of the banks and a fraud for investors who bought the loans. If the banks were willing to enter into this irresponsible agreement with their investors' money you have to ask yourself, what else are the shysters doing to wreck the banking system? What leglislation was involved to enrich the banksters was involved in the deal with the politicians? Take a guess. (continued)


Corrupting the banks worked out well for Clinton and Bush who both ran on their great record of getting minorities into "home ownership." It worked for the limo liberal banksters making them look like generous gift givers to the worthy cause of making minorities "rich" by getting them into the hot market (they did not mention the bad loan deals). To liberals and "compassion conservatives" business is politics and politics is business.

Why would not the University economists toss their cookies over this fascist corruption of the banking system. Are they going to be the Democrat Party smeared racists trying to keep minorities out of home "ownership"? Hell no. The the "smart" people in America are unified corrupt cowards. (continued)

There were a few Republicans sounding the alarm in the House and eventually Bush raised an alarm. They were shouted down by Democrats (Barney Frank and the Congressional Black tribal caucus) as racists.


As you said: "It's not just that they missed it, they positively denied that it would happen,"

So true.
But I think the issue is larger than just that economists failed to see the importance of banking.

One is a theological notion, touted by Adam Smith, that the markets are governed by the "invisible hand". Although Smith's important and insightful work was deservedly highly influential, (and nevertheless can even be read and understood by ordinary persons--unlike most present day academic economic writing.) The "invisible hand" has unconsciously become part of the theological basis of academic economics. Thus it is assumed that (1)economies will naturally find an outcome in equilibrium with least imposition of any rules and (2) Whenever people follow their own self interest, this will result in the best macroeconomic outcome.

The second difficulty is the artificial abstraction imposed by the mathematical formalism imposed in the name of precision. This gives answers which can be highly precise, but where unfortunately the reality has been abstracted to the point where the real problems are obscured because they can't be easily modeled..


I say it's greed with laziness.

US had stopped innovating on tangible engineering for a few decades and was busy finding ways to make money reproduce by itself.

E.L. Beck

When I returned for my master's, I immediately recognized that very little useful knowledge would be gained from my economic classes, though I was required to take them. After years of being in business, there was a complete disconnect between economics and the real world. Nothing will change until the field of economics dumps this insane obsession with an idealized, mathematically elegant theoretical base, and starts studying what is, rather than what plugs in to differential equations. I love math, but our mathematics is not complex enough to accurately predict human behavior in all its irrational glory.


What about teaching the economics of crime aka 'real world experience'. Every economist should have an internship on Wall Street and not be so naive like Greenspan that thought corporate executives were trustworthy. Let all economists drink the kool aid hide behind the discombobulated math models aka 'the black box'. I recently took a PHD class in econometrics and once I saw what was inside the black box I laughed. Just keep adding filters upon filters and that will spit out the magic number. I agree economics must return to it's roots as a social science and begin looking at behavior rather than black box models of kool aid drinkers.

The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street (Hardcover)

Markets are mainly efficient in separation of fools and their money...
A Failed Scientific Revolution, October 24, 2009 By R. Albin (Ann Arbor, Michigan United States) - See all my reviews

This is a good, journalistic account of a failed scientific revolution with substantial public consequences. Fox's goal is not a detailed scholarly history but rather an accessible popular account that gives the general public an idea of how these ideas evolved and why they had such impact. By the late 1960s, a number of economists had accomplished work that seemed to indicate that financial markers were "rational." Specifically, this meant that stock prices reflected the actions of well informed rational agents maximizing utility and that while individuals departed from rationality, the market as a whole was rational and stock prices reflected "fundamental" features of the status of companies. From this conclusion flowed many interesting consequences. The rational market hypothesis allowed the first calculation of the value of options. In turn, this seems to have encouraged the development of financial instruments such as a variety of derivatives based on the idea that properly constructed derivatives would allow management of risk more efficiently than market regulation. The idea that CEO performance should be evaluated by stock price value is also partly a result of the basic hypothesis. Propagated throughout American departments of economics and many business schools, this tool kit of ideas was an important contributor to the deregulation of financial markets and the general enthusiasm for untrammeled markets. In the last couple of years, the failure of these ideas become apparent in a nearly catastrophic fashion.

Fox makes clear, however, that problems with this set of ideas appeared well before the present crisis. A number of important economists demonstrated flaws of different aspects of the models. The influential Joseph Stiglitz disproved the strongest form of the efficient markets idea, and Robert Schiller pointed out both logical flaws and presented data contradicting the model. Eugene Fama, one of the principal architects of the theory himself presented data undermining the model and had to introduce ad hoc modifications that compromised the integrity of the model. Many aspects of these models were based on data assumed to follow normal distributions but this assumption proved to be incorrect.

What accounted, then, for the remarkable success of this set of models in the academy, earning some of the originators Nobel prizes and generous consulting fees? Fox's answer is a combination of scientific hubris and institutional defects. He suggests that many of the originators of these ideas were simply intoxicated with their achievements and driven by what they perceived as the logical and mathematical beauty of their concepts. Many also worked within business schools where there was an emphasis on methods for investing and management, which these ideas seemed to produce, and a less rigorous intellectual environment than regular economics departments.

These are very good points, though I suspect that Fox underestimates the importance of ideological factors. As he himself points out, many of these ideas emerged from the University of Chicago, where the dominant figure was the brilliant but somewhat nutty libertarian economist Milton Friedman. In a classic vicious cycle, the efficient market idea and its progeny were both driven by and a driver of the general conservative tone of American life in the past 30 years.

While Fox does a reasonably good job of explaining the basic ideas but I think the exposition could have been improved significantly. How many people, for example, really know what constitutes a normal distribution? Fox understandably avoids equations but a few well done figures and simple equations would have enhanced understanding considerably. Fox also doesn't discuss well, I think, one of the major reasons why these ideas had such power. The last 50 years were in many respects a period of relative macroeconomic calm and stability in financial markets (The Great Moderation), at least as compared with the first half of 20th century and late 19th century. Many interpreted this relative calm as a result of success of market self-regulation. As conceded recently by Robert Lucas, himself one of the originators of this set of ideas, the relative calm had a great deal to do with the success of New Deal era regulation and activist central banking.

Very interesting history of a deeply irrational economic theory, September 17, 2009
By Richard Gibson "Rick Gibson" (Woodland Hills, CA) - See all my reviews
Amazon Verified Purchase(What's this?)

Economists tend to be love with theory. They tend not to like reality quite so much. As a rule, their odd views are confined to the academy. Once in a while, they spill out into the real world and do some real damage.

In this book, Justin Fox tells the history of one such academic attack on reality. He begins, very dramaticaly, with an account of Allan Greenspan's appearance before Congresss, in which he confessed that the Crash of '08 proved that his opinions had been deeply, deeply wrong. What were these views? Greenspan believed that the markets are always right. Thus, if real estate prices were through the roof, why then, by golly, that meant that real estate was just worth much more than it used to be worth. The market is always right. (Query. If the markets are always right, why then did the Fed under Greenspan need to prop them up, with huge infusions of liquidity, whenever they fell? Funny. In Greenspan's world, an up market is always right and should be left alone. A down market is horrifyingly wrong and calls for energetic government intervention. This is just a personal aside. Fox did not comment on this particular contradiction in Greenspan's worldview.)

To a practical person, this view sounds insane, as it was. Yes, the markets tend to be right, over a long period of time, but at any given moment the markets are almost always out of adjustment. For those tuned into reality, there is such a thing as the business cycle. In the business cycle, the market tends to push prices way above reality, in the boom, and then way below reality, in the bust. Any one who has actually done business for any length of time knows this is true, not as a matter of theory, but through his own experience. This is reality. You can argue about why it happens, but a sane person can not argue that it does not happen.

That did not stop a long line of famous and celebrated economists from arguing the contrary. Fox tells their story here. There is no business cycle, they said. Markets always get everything right, not over the long haul, but right now, faster than a speeding bullet. And, if you do not believe this, they have lots of nifty mathematical equations, which proved it.

While the story drags now and again, by and large, I thought it was fascinating. Fox brings back to life a whole parade of now mostly forgotten figures. God willing this history is now just that, history, because this particular piece of academic idiocy was so totally disproven by the Crash of '08 that no one will ever believe it again. But that gives leaves a market hole for the next piece of academic idiocy, which I am sure will be along shortly.

An Entertaining Overview of Academic Mistakes and Hubris, September 16, 2009
By Professor Donald Mitchell "Jesus Makes Me a P... (Boston) - See all my reviews

"You say to God, 'My beliefs are flawless and I am pure in your sight.'" --Job 11:4

I know of no field of study filled with more methodological errors than the study of how markets work. Someone was bound to see the humor in all the people with big egos winning global honors for ideas that someone new to the subject could point out were obviously wrong. Indeed, many professors have been wearing no clothes for a long time and were proud of it.

I'm impressed that it is a former Fortune editor who appreciated the irony of the story and wrote about it in human terms. That magazine has had a history of jumping on the band wagon of bad economic ideas. Good for Justin Fox.

The ultimate irony of this subject is that in 2059, hundreds of thousands of young business school students will probably still be taught the inaccurate theories that were finally shown to be wrong in the last two decades. I would wager that few people today realize that most of the advocates of the efficient market theory have pulled in their horns in the face of strong evidence to the contrary. Hopefully, this book will help.

It must have been a tough book to write. The key points could have been summarized in a short article. The full story would take many volumes. For the most part, Mr. Fox seems to have kept his story at the right level to show how a small club of economists happily misled those who read their work for a long time based on assumptions that no one would have agreed resembled the real world. The Capital Asset Pricing Model, for instance, had its assumptions revised every few years by academics for a long time in a vain attempt to sustain it. Yet today, I would bet that most Chief Financial Officers of major companies still make decisions based on CAPM (or its near cousins) despite the theory clearly being wrong.

The "prize-winning" economics were writing about the world as they would like to have it: human beings as rational decision-makers where the highly intelligent quickly move out those who aren't. As we have seen, smart people can also outsmart themselves . . . such as by assuming that they have no effect on markets even when they take huge positions that cannot easily be liquidated (Long-Term Capital Management was an example).

The book's main weakness is that it doesn't pay enough attention to the role of company managements relative to financial markets. Also, the silliness of much of the advice for corporations that academics and consultants have peddled for the last 50 years isn't revealed.

My own view (based on many years of unpublished research during the years when no one thought that psychology played any role in markets and wouldn't publish such research) is that the markets are more efficient than is currently believed . . . when you know how to measure them. But the current measurements are hopelessly flawed and I know of no current academic research to correct those measurement errors. It may well be that someone will be able to write an updated version of this book about the silliness of today's ideas about markets in 50 years. I don't doubt that the opportunity to do so will exist

Review of Myth of the Rational Market, August 23, 2009
By Stephen Perrenod (singapore) - See all my reviews
The author reviews the development of the quasi-scientific 'efficient market hypothesis' into the dominant financial orthodoxy and then the counter-revolution against the orthodoxy, and increasing interest in "behavioral finance." This efficient market orthodoxy has heavily influenced everything from the way mutual funds, pension funds and individual investors have invested in the market to the increasing short-term focus of CEOs and the heavy use of options as compensation incentives. Recent years have probably seen the orthodoxy perversely create more volatility and instability in the marketplace (stability breeds instability) and in the mainstream economy due to the incentives to financial institutions to pursue riskier and riskier strategies under the dangerous assumptions of non-correlated security classes and normally distributed 'random walk' style returns.

Justin Fox builds this interesting and important story over a one hundred year period beginning in the first decade of the 20th century through the present, emphasizing the key players (including many Nobel prize winners) in economic and financial theory and their contributions to and viewpoints of the topic at hand. He covers many of the repeated failures of rational market pricing assumed by the orthodoxy, including the 1929 and 1987 (and 2007-09) market crashes, the collapse of the Nobel Laureate advised Long Term Capital hedge fund, the bubble and the recent real estate bubble and subprime and CDO/CDS crisis. Even one of these events statistically had an extremely low probability - according to the 'efficient market' models - of occurring within the one hundred year period. For all of them to have occurred is statistically impossible during the lifetime of our universe - according to the models. Ergo, the models are an insufficient description of reality.

The treatment is technical (but without equations) and is a good read for those who are interested in the theories which explain and shape economic and financial history. As an astrophysicist by training, I found some of the analogies to physics somewhat misplaced, but the author has a good grasp of the subject and conveys it well for a non-technical reader. He makes the personalities and the battle of ideas come alive as well.

4.5 stars-The egregious misuse of the Normal distribution by the economics profession in order to appear " scientific ", July 19, 2009

By Michael Emmett Brady "mandmbrady" (Bellflower, California ,United States)

Fox's book represents a substantial improvement over Bernstein's " Against the Gods " in that he demonstrates the intellectual bankruptcy of a profession that is primarily interested in maintaining the appearance of being " scientific " rather than being a science.Fox covers the issue but refrains from drawing the logical conclusion that a profession that uses no goodness of fit tests or exploratory data analysis BEFORE it assumes a normal (log normal) distribution is not a science at all but a profession that wants to maintain the appearance of being scientiific.

In his 1939-40 exchange with Tinbergen over Tinbergen's use of multiple correlation and regression analysis to explain changes in investment over the business cycle,Keynes asked Jan Tinbergen very politely to apply the Lexis Q test [ Keynes dealt with the special case nature of the normal distribution ,upon which multiple correlation and regression analysis rests,in chapters 17 and 33 ( A Treatise on Probability,1921,pp.414-422 ,especially footnote 1 on p.420)] to show or demonstrate that the time series data was homgeneous, uniform and dynamically stable over time. Tinbergen's response to Keynes contained no Lexis Q test ,no goodness of fit test ,and no exploratory data analysis.Tinbergen never supplied any such analysis to support any of his Normal distribution based multiple correlation and regression results in his lifetime. The answer is that Tinbergen JUST ASSUMED Normality.Keynes has been constantly attacked by econometricians ever since because he pointed out that they were just presuming in assuming a Normal distribution .In his last address before the econometricians before he died, Schumpeter, who was well aware of the regular irregularity of the time series data on investment, had bluntly told the econometricians that their multiple correlation and regression approach ,based on the Normal distribution, would not work.Schumpeter was ignored.

Fox is to be saluted because he brings this problem ,concerning the egregious misuse of the Normal distribution by an economics profession whose main goal is to look scientific, as opposed to being scientific,into the open with his discussion of the work of Benoit Mandelbrot.Bernstein attempted to cover this up.

Mandelbrot is a scientist. His examination of the evidence overwhelmingly demonstrated that the normal distribution could not be used in any study of financial markets due to the long, thick, fat tails and extreme kurtosis of the time series data in financial markets. Osborne, a normal distribution advocate ," told his students that Mandelbrot's ideas about infinite variance (the distribution that fits the time series data best is the Cauchy distribution .Its first two moments are infinite expectation and infinite variance) were " a stew of red herring and baloney ".

Sure, there were jumps and dips in stock prices that couldn't be shoe-horned into a normal distribution...But for most purposes it was OK to ignore them " (p.135).What was the result of this anti-scientific approach by Osborne ? The result was this :" We were seeing things that were 25-standard deviation moves, several days in a row," said Goldman Sachs chief financial officer David Viniar in August 2007....Viniar's point seems to be that what had happened could not possibly have been predicted-a 25-standard deviation event should only occur every hundred thousand years.

A better explanation may be that his risk models weren't very good ."(p.316).Keynes had pointed out what was wrong with using the normal distribution as a model for financial markets in his analogy with seaworthy ships being build to withstand the relatively rare ocean storm and not just the normal ocean weather.Unfortunately,modern financial markets are NOT built to withstand financial turbulence and storms,but only "Normal" conditions.Mandelbrot's point,like Keynes's ,was that such storms occur much more often than predicted by the normal distribution.

Fox brings into the open the anti-scientific nature of the economics profession in his discussion of the efficient markets hypothesis. There are no goodness of fit tests that support the claims that the statistical time series data on price changes is normally distributed. However, this did not matter:" The overwhelming majority of research in finance in those days was no longer concerned with the question of whether markets were efficient. One just assumed that they were and proceeded from there, "(p.182).

There is a severe typographical error on p.183 in the second paragraph. Bernanke, Krugman, Summers, et. al.,are the most prominent economists of the early twenty first century, not the twentieth century.

A more important error occurs on p.319.The author incorrectly identifies Keynes's low interest rate policy recommendation for dealing with the business cycle ,from pp.321-327 of the General Theory(GT,1936), as the policy used by Greenspan from 1996-2006.Keynes's low interest rate policy includes a major second part-bank loans are not to be made to speculators and rentiers. The unsatisfied fringe of borrowers must consist of speculators and rentiers. Unfortunately, Greenspan made no effort to prevent loans from falling into the hands of borrowers who did not meet the most basic ,elementary creditworthiness standards.

In summary, Fox correctly calls into question the current foundation of neoclassical, mainstream economics, from the Black-Scholes equation, Capital Asset Pricing Model (CAPM),rational expectations, efficient market hypothesis, and Subjective Expected Utility theory to the Ptolemaic economists attempt to add more epicycles(more normal distributions) through the use of the artificially constructed ARCH,GARCH,GARCH II,FIGARCH, etc., models created by Granger and Engle in an attempt to bypass Mandelbrot's major analytic results.

All neoclassical economics is built on the assumption that the normal distribution fits the time series data best. There is no historical, statistical, or empirical evidence to support this claim. Mandelbrot has developed statistical tests that are useful in identifying when the danger signals will show up in the time series data concerning possible catastrophic results in financial markets that spread faster than a tsunami.

A great tour of economics since the 1920s, July 12, 2009
By Stephen R. Laniel (Cambridge, MA USA)

For better or for worse, the starting point for all discussions about capitalism and its failings is some sort of arbitrage principle. Let's look at the free-market argument against the possibility of racial discrimination in hiring, for instance. (I'm fairly certain I've read something like this in Posner.) Suppose you have a highly qualified black candidate who doesn't get hired, because his potential boss just doesn't like the color of his skin. The free-market response would be that someone else will swoop in and hire that person away -- may, in fact, hire him for less than an equally-qualified white candidate. Companies that are systematically racist in their hiring will be beaten by those that aren't.

There are two possible ways of interpreting the arbitrage principle in here. Either a) all companies will behave in a rational way, which would actually make racist hiring impossible, or b) some smart company will behave rationally, thereby beating its racist competitors. Inasmuch as we agree that racist hiring exists, we can rule out a). Besides, like any evolutionary-type argument, the claim isn't that all actors or all organisms act in a certain way, just that competitive pressure will eventually force a particular outcome.

In any case, even b) depends rather sensitively on the structure of the market. If there are infinitely many companies competing for customers, then even the tiniest inefficiency -- racism, say -- will be ruthlessly purged from the market. If there are only a few car manufacturers, on the other hand, then inefficiencies may last for a very long time.

You might be asking why I've even bothered to advance the infinitely-many-competitors alternative here. You might also be asking why I'm starting with an arbitrage principle rather than the rather more obvious fact there there exist racists in this world, and they don't act rationally. I think Paul Krugman hit on the answer in Development, Geography, and Economic Theory: putting the irrational elements of the human brain into a model turns out to be hard, at least if you're going to cross all your mathematical Ts and dot all your mathematical Is in the way that economists trust. Another way to put it is that the perfect-competition model fits together in a way that few rival theories have yet been able to match. The Myth of the Rational Market quotes Richard Thaler to the effect that it's the difference between being exactly wrong or being vaguely right: the alternative models know they're on to something, even if they haven't put all the pieces together yet.

I went into Myth thinking that it wouldn't understand the virtues of modeling -- that it would just be another hand-waving gesture against "those stupid economists." I have real problems with this anti-quantitative attitude. Modeling things mathematically has real virtues: speaking clearly, stating your assumptions as concisely as possible, and opening yourself up to the possibility of being proved wrong. More-orthodox economists are on to something when they suggest that behavioral economics is a collection of nice stories but nothing to build a theory on. By now it's clear to me that they're wrong about that, but their hearts are in the right place.

What's amazing about The Myth of the Rational Market is that it hits all these notes and many, many more. It explains what orthodox economists think, and why. It describes behavioral economics of the Thaler school. It describes behavioral finance of the sort that Andrei Shleifer, Larry Summers, and Brad DeLong are famous for. It describes Keynesian economics. It goes into the efficient-markets hypothesis at a decent depth. It follows Eugene Fama -- the father, if anyone can claim that title, of the EMH -- for a few decades, eventually catching him laughing at how much of a turn his own mind has taken. (Earlier, Justin Fox had found Fama praising the stock market after the 1987 crash: surely the market had just shown its genius, having collapsed quickly after it discovered new information. No one could identify what that new information might be, however. Free marketeers do often have a point that The Market Is Smarter Than You: just because an economist can't figure out why the market does something doesn't mean the economist is smarter than the market. However, it seems clear that the 1987 crash wasn't a shining hour for Efficient Market Hypothesis.)

In fact, The Myth of the Rational Market follows essentially all of the economics profession from Irving Fisher to the present, and ends ... at a draw, which is exactly where it should be. The orthodox economists are right that we need a good theoretical model of irrational behavior if we're going to do it right and if we're going to incorporate it into the successful body of rational-actor theory. The behavioral economists are right that there's too much anti-rational behavior to count it as mere diversions from "real" economics. Behavioral finance has contributed a lot to our understanding of the stock market: the concept of a noise trader, and how he interacts with a rational trader, is an important one. The fact that there are times (like now!) when arbitrageurs can't borrow as much money as they would need to capitalize on the market's irrationality, and that those times are precisely when they need money the most, is an unfortunately important one.

Fox even follows this historical evolution into places where I wouldn't have expected him to. He takes us to the Santa Fe Institute for a few paragraphs. Among other things, SFI tries to simulate, on a computer, many semi-rational economic actors buying and selling from one another, then watch the collective behavior of these simulated actors. For instance, do simulated imperfect humans ever cause a stock market to bubble and crash? Do arbitrage opportunities persist and, in fact, widen? This falls under the general heading of "microfoundations": deriving explanations for high-level phenomena out of the (partially) realistic behavior of low-level actors. If the high-level macrobehavior that fall out of the model look like the world we're used to, then that's a start. If the macrobehavior look right and the economic actors look like real, sometimes-irrational people, then we're on to something. My limited skim of the literature suggests that we're not there yet.

Whether we get the models right matters, as a glance as today's newspapers will tell you. Whether we assume that humans are perfectly rational actors feeds directly into how skeptically we view mortgage brokers: if mortgage buyers are rational, why bother protecting them from balloon mortgages? Why be concerned that they might let Enron zero out their 401(k)s? Humans need a bit of help here and there; rational actors don't.

All of this is in Fox's book, which is a page-turner intended for a wide audience. It covers a broad enough swath of the discipline that it has probably singlehandedly killed a dozen other, lesser books on a few dozen sub-areas of economics. I confess that I went into it expecting that it would be another opportunistic work, riding the coattails of behavioral economics or of the recent crash. It does neither; it will still be readable and informative and fun in a few decades. Highly recommended.

Another Victim Of The Financial Crisis by David Blitzer

JOI Articles

The financial turmoil of the past two years threatened the world's economies and markets; it also threatened theories that many believed supported markets and finance. At the top of the list of things we used to believe in is the efficient market hypothesis-the idea that markets are so complete and perfect that they incorporate all known information into stock prices so the prices are always correct. It follows that because there is nothing the market doesn't know, there is no other information available to anyone who could predict future stock prices and beat the market. Moreover, since new information arrives in a random unpredictable fashion, and since changes in stock prices depend on new information, stock prices must be random. These ideas grew up gradually over several decades and were largely codified as modern financial theory over the last 50 to 60 years.

The EMH, as the efficient market hypothesis was nicknamed, became part of the received wisdom of finance-widely taught and rarely questioned. This approach to investing led in two directions. First, the EMH joined with ideas that markets provide the best answers to numerous questions about determining values and setting prices. A corollary is that regulations that interfere with markets or shift prices are mistaken or worse. Second, as the EMH's formal description took on mathematical elegance, it sped the growth of formal mathematics within finance.

In the last year or two, the objections to the EMH have become louder and more aggressive. Looking back on the current financial crisis, people are asking how the prices could have been "correct" all the time if the market doubled from 2002 to 2007 and then dropped by more than half in 18 months; and how home prices could have been correct if they appreciated by three times in five years before crashing. Certainly there must have been some information that the market missed at the top-something like the emperor's fabled "new clothes" that, when recognized, changed things dramatically. While the events of the last two years seem, for the moment, to have sunk the EMH, there are challenges going back over two or three decades. A few that deserve mention are research showing that stock prices are far too volatile to be determined only by information on dividends; that there are times when arbitrage is limited and markets can't adjust to information; in addition to arguments that if the market is efficient, no one will pay to gather the information and the efficiency will be lost.1

Exploring either the financial crisis or the efficient market hypothesis could easily consume this entire journal, not just this short column. Rather than a complete review, the next few paragraphs focus on a few aspects of the recent developments-saving some good things from the EMH's demise, understanding where the simplification in the math became oversimplification and asking what financial economics should aspire to.

The Cliffs Notes version of the EMH is that you can't beat the market and therefore the only way to invest is to index. Whatever happens to ideas of market efficiency, indexing will continue to prosper. The success of indexing depends on two things, neither of which depend on market efficiency-if anything, market inefficiency might make indexing more attractive. First, it is difficult to beat the market. Standard & Poor's SPIVA reports, which compare mutual funds to our indices, consistently show that only two-fifths of the funds, or less, outperform over any three-year period.2 Second, as Bill Sharpe and Jack Bogle have both noted, low fees rather than market efficiency are the key to the success of indexing.

When one builds a mathematical description of some phenomenon-a market, the weather or the path for the space November/December 2009 49 shuttle to follow-there are trade-offs between making the model tractable and making it true to what is being modeled. Consider modeling something as complex and detailed as the weather-temperature, wind velocity, humidity and all their interactions point by point in three dimensions. Very quickly the scale of the problem can overwhelm. Much the same thing happens when modeling a market, and the solution in either case is to make some simplifying assumptions.

In many finance models, a common step to simplicity is to assume that every trader is independent of every other trader: No one ever buys a stock because someone bought the stock-no one ever acts on a recommendation. This independence makes it possible to model markets with the normal probability distribution, popularly called the "bell curve." While this may not seem a big deal, it is. With this bit of simplicity, the models become much easier to solve because the normal distribution is well understood. However, some crucial problems creep in. First, the normal distribution doesn't work for markets-the volatility experienced in the last year should not have occurred were the market obeying a normal distribution. Second, when we assumed that traders were independent of one another-and surely traders spend a lot of time and effort trying to figure out what other traders are doing-we assumed away some information that absolutely affects the market. Yet the EMH presumes all the information is counted.

Forgetting about the messy and inconsistent interdependence of traders in order to make the math look elegant is characteristic of a lot of financial theory. In that particular trade-off between solving the problem and assuring that the answer can be applied to reality, solving won out. We would have been better off if the answer were only approximately right but was truly applicable, instead of more accurate but not very useful. Moving the balance from elegance toward application is akin to moving from science to engineering. Science is all about building models to understand something; engineering is all about using that science to do something. While we have something called financial engineering, it has too many assumptions that make it "finance science" and leave engineering too far from reality. Markets are very messy, and the engineering models turn out not to be messy enough.

Where does this leave indexing? Index investing turns out to be successful financial engineering-no claims are made that it always beats the market or is always the best investment strategy, nor is there a guarantee that indexing explains what happens to markets. But for the practical problem of how to invest in a cost-effective way with a reasonable chance of success, indexing provides an answer that has survived numerous financial crises, including the last one.

1 Robert J. Shiller, "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?" vol. 71 No. 3, The American Economic Review (1981), pp. 421-436; Andrei Shleifer and Robert W. Vishny, "The Limits of Arbitrage," vol. 52, No. 1, The Journal of Finance (March 1997), pp. 35-55; Sanford J. Grossman and Joseph E. Stiglitz, "On the impossibility of informationally efficient markets," vol. 70, Issue 3, American Economic Review (June 1980), pp. 393-408.
2 See

Time to Bang My Head Against the Wall Some More

J. Bradford DeLong
Oh boy. John Cochrane does not know something that David Hume did--that the velocity of monetary circulation is an economic variable rather than a technological constant. Cochrane:

Fiscal Fallacies: First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can't help us to build more of both. This is just accounting, and does not need a complex argument about "crowding out"...

Let us take this slowly.

Suppose that we have four agents: Alice, Beverly, Carol, and Deborah.

Suppose that Beverly has $500 in cash that she owes Carol, due in two months. Suppose that Alice and Carol are both unemployed and idle.

In one scenario in two months Beverly goes to Carol and pays her the $500. End of story.

In a second scenario Beverly says to Alice: "I have a house. Why don't you build a deck--I will pay you $500 after the work is done. Here is the contract." Alice takes the contract and goes to Carol. She shows the contract to Carol and says: "See. I will be good for the debt. Cook me meals so I will have the strength to build the deck--here's another contract in which I promise to pay you $500 within 90 days if you cook for me." Carol agrees.

Two months pass. Carol cooks and feeds Alice. Alice goes and builds the deck.

Alice then asks Beverly for payment. Beverly says: "Wait a minute." She goes to Carol and says: "Here is the the $500 cash I owe you." Beverly pays the money to Carol. Beverly then says: "But now could I borrow the cash back by offering you a long-term mortgage at an attractive interest rate secured with an interest in my newly more-valuable house?" Carol says: "Sure." Beverly files an amended deed showing Carol's mortgage lien with the town office. Carol gives Beverly back the $500. Beverly then goes to Alice and pays her the $500. Alice then goes to Carol and pays her the $500.

The net result? (a) Alice who would otherwise have been idle has been employed--has traded her labor for meals. (b) Carol who would otherwise have been idle has been employed--has traded her labor for a secured lien on Beverly's house. (c) Beverly has taken out a mortgage on her house and in exchange has gotten a deck built. (d) Carol has the $500 cash that Beverly owed her in the first place.

Alice has more income and consumption expenditure than if she hadn't taken Beverly's job offer. Carol has more income and saving than if she hadn't cooked for Alice and then invested her earnings with Beverly. Beverly has an extra capital asset (the deck) and an extra financial liability (the mortgage) than if she had never offered to hire Alice.

A deck has gotten built. Meals have been cooked and eaten. Two women have been employed. And all this has happened without printing any extra money.

John Cochrane would say that this is impossible. John Cochrane would say:

[I]f money is not going to be printed, it has to come from somewhere. If Beverly borrows a dollar from Carol, that is a dollar that Carol does not spend, or does not lend to Deborah to spend on new investment. Every dollar of increased Beverly spending must correspond to one less dollar of Carol or Deborah spending. Alice's job created by Beverly spending is offset by a job lost from the decline in Carol or Deborah spending. We can build decks instead of fountains, but Beverly stimulus can't help us to build more of both. This is just accounting, and does not need a complex argument about "crowding out"...

John Cochrane is wrong.

You sometimes see this mistake in freshmen students in Economics 1, students who do not fully understand either the circular flow of economic activity or what a credit economy is. They think--like Cochrane--that the flow of spending must be constant unless somebody "prints money" because, you see, you need "money" in order to buy things.

The premise is true--you do need "money" to buy things--but the conclusion is false: the flow of spending is not necessarily constant. In the world in which Beverly does not hire Alice but instead pays the $500 directly to Carol, that $500 turns over only once--its velocity of circulation is equal to one. In the world in which Beverly does hire Alice, the velocity of circulation of the $500 is four--it goes from Beverly to Carol, from Carol to Beverly, from Beverly to Alice, and from Alice to Carol.

Cochrane's mistake--an elementary, freshman mistake--is because he has not thought enough about how a credit economy works to recognize that the velocity of circulation can be an economic variable and is not necessarily a technological constant. And as the velocity of circulation varies, the amount of the flow of spending varies as well: it is now longer the case that if Beverly borrows a dollar from Carol that is a dollar that Carol does not spend.

Milton Friedman knew this. Irving Fisher knew this. Simon Newcomb knew this. David Hume knew this. John Cochrane does not know this: does not know that the velocity of circulation is an economic variable rather than a technological constant.

I do want to pound my head against the wall.

I do not know what else to do...

Brad DeLong on January 26, 2009 at 03:37 PM in

Memory said...

Well done! An example so simple that it can not really be misunderstood that also highlights the fact that a credit economy is an economy of trust and institutions (the loans, promises to pay, contracts, and liens that do the lifting) rather than an economy where counting specie and physically handing it to people is the only way of creating and moving value.

Aza said...

Cochrane's paper upsets me, mostly because he's a professor of finance, and he should know what he 's talking about. It's a well-worded, long article describing something that is, in a word, misunderstood.

Yours is a good example of banking.

Commenterlein said...

I just read Cochrane's nonsense and immediately thought, why don't I check whether Brad has already reacted. And, as usual, you didn't disappoint.

Cochrane is a decent empirical asset pricer with an excessive ideological commitment to efficient markets. He has also just prove beyond any doubt that he doesn't know shit about macro economics.

notsure said...

Here is what is confusing to me about all this.

If there is one unit of labor available in a day, and you use that unit of labor to build a deck, then you cannot use that unit of labor the build a bridge. That is the aggregate resource constraint. In that world, no amount of any government policy will make that unit magically two units.

Your example seems to be: there are many units of labor available, and most of them are sitting around, so hire one unit of labor today to build a deck and have them use the promised payment to simultaneous hire someone to feed them. Everything balances out in the end.

By reading of that essay was that people are now wanting to conserve on the promises (money) and we need to make satiated with promises so that they start using them to buy things-real investments or consumption.

Is it any more complicated?

notsure said...

Sorry, I should have typed

My reading of that essay was that people are now wanting to conserve on the promises (money) and we need to make people satiated with promises so that they start using them to buy things-real investments or consumption instead of holding onto them.

ogmb said...

"If there is one unit of labor available in a day, and you use that unit of labor to build a deck, then you cannot use that unit of labor the build a bridge."

Yes you can, thanks to the miracle known as Capital, which, if invested wisely in machines, education or infrastructure, multiplies the economic output of a unit of labor via the magic wand called Productivity.

MattYoung said...

"I have a house. Why don't you build a deck--I will pay you $500 after the work is done. Here is the contract."

Beverly had an an unexpected realization that decks add value, otherwise the original $500 would carry the interest rate of the total yield for the added value of a deck.

John covers this with:

"Since we are seeing lower quantities sold and easing inflation, we must also be seeing a "demand shock," and we need to understand its source. "

Stimulus works when unexpected expectations are understood. One possibility is we unexpected realized what a dufas George Bush was, we see unexpected fraud. The other possibility is a fundamental technology shock. The third is a bunch of shocks that are utilizing this unstable moment to correct themselves.

notsure said...

OMGB you are confused.

At the beginning of the period, capital is fixed. Or if you want, replace 'one unit of labor' with 'production possibilities possible with the given inputs,' which includes capital available.

SvN said...

I would have thought that John Cochrane was trying to describe reality.

In the real world, there is a simpler explanation of why he is wrong.

"John: The US is an open economy. Increased government spending can come at the cost of private spending or by borrowing from foreigners. Increased government consumption can come at the cost of the private sector or by increasing net imports."

This does not require knowledge about the velocity of money. It just requires knowledge of the accounting identity.

mike said...

I think this is brilliant. Thank you Brad, you're a true public servant.

Anyone who want to understand this can take the time and walk through it--no need to be a PhD in economics. That kind of clarity, that kind of transparency, is what is needed in times like now.

Nick Rowe said...

"In this analysis, fiscal stimulus a roundabout way of avoiding monetary policy. If money demand increases dramatically but money supply does not, we get a recession and deflation. If we want to hold two months of purchases as money rather than one months's worth, and if the government does not increase the money supply, then the price of goods and services must fall until the money we do have covers two months of expenditure." That's a change in the velocity of circulation.

ogmb said...

"At the beginning of the period, capital is fixed."

Says who?

Robert Bell said...

What happens if I take one step back to where Carol has $500 in cash that she hasn't loaned out yet, and she has the choice of loaning to Beverly or buying a t-bill?

anonymous said...

A dollar spent by the government is a dollar spent. As opposed to, you know, what we have now.

Rob said...

No Nick it isn't.

We have MV=PY. In his example its really decreasing M by 1/2. People holding more cash with nothing injected into the system by a central bank leads to a decrease in money supply. So in order for it to work out, he saying P must decrease.

JC said...

Not disagreeing with the analysis, but a few questions as it applies to stimulus in general:

1) What if Carol $500 can be spent in two ways: construction of Beverly's deck which will provide a week's labor and meals for Alice, or capital for a business that may employ Alice full-time? To the extent that Carol's money is placed with the former project (via taxation) to fund deck construction, does this not prevent its employment in the later project?

2) Finally, what if once Carol is taxed $500 and the money diverted into Beverly's backyard Xanadu, it is determined the deck is really only worth $200. Has Carol suffered a loss of $300 due to wasted taxes? Conversely, Beverly retains full enjoyment of the deck and Alice is gainfully employed. Thus, does taxation to fund stimulus separate the risk of loss from the benefit, thereby leading to poor capital allocation?

JKH said...

"Cochrane's mistake--an elementary, freshman mistake--is because he has not thought enough about how a credit economy works to recognize that the velocity of circulation can be an economic variable and is not necessarily a technological constant."


Or maybe that's not his error at all.

Maybe he's saying as an implicit case that an increase in velocity induced by government spending will be offset by a decrease in velocity due to a reduction in private spending.

He may still be making an error, but not because he hasn't thought of velocity.

saveusobama said...

Carol has $500 that she wants to spend improving her McMansion. She pays Alice and Beverly $1000 each to build a deck on her house because she figures the house will be worth at least $2000 more next year because of the booming market. Market crashes; house value plummets. Carol walks away from house. The bank eats the mortgage. Alice and Beverly shrug and say the deck building job was good while it lasted. All vote democratic and push for higher unemployment benefits.

New Policy said...

As a current student at Berkeley (and a former student of BDL), I am sorry to discover that Cochrane earned a PhD in our prestigious economics department. Can these degrees be rescinded? How about a new campus policy--whenever an honorary degree is given out, how about we must rescind the degree of a former student. That would certainly control degree inflation, increasing the value of the degrees that have been both earned and kept.

JWV said...

A lot of people appear to be getting lost in the example, then coming up with variants that have nothing to do with its point. I think the point is that money does not cease to exist simply because it has been spent or invested. It continues to circulate, unless the most recent person to get it hoards it. I'd have thought this would be obvious to just about everybody, but I guess it isn't.

Nick Rowe said...

Rob @7.25 Yes it is a change in velocity. When Cochrane says " If we want to hold two months of purchases as money rather than one months's worth" he's talking about a change in the desired velocity of circulation from 12 to 6 times per year.

And immediately above that when he says:

"Well, suppose the Government could borrow money from people or banks who are pathologically sitting on cash, but are willing to take Treasury debt instead. Suppose the government could direct that money to people who are willing to keep spending it on consumption or lend it to companies who will spend it on investment goods. Then overall demand for goods and services could increase, as overall demand for money decreases."

Cochrane is also talking about fiscal policy causing an increase in velocity by taking money out of idle cash.

Cochrane's problem is not that he (always) assumes velocity is fixed. It's a bit more puzzling than that. As far as I can tell, he agrees that fiscal policy could work by increasing velocity, but then says that in that case, it's really just monetary policy in disguise.

It's a badly-structured paper, and I don't blame Brad DeLong for missing that section of his paper. But it is clearly not true that Cochrane thinks that velocity is a technological constant.

Luis Enrique said...

So the idea is that government intervention can engineer an increase in the velocity of money - accelerate the circulation of money and increase economic activity.

Does this rely on the existence of idle resources? Is this depression economics, or something that can be done in ordinary times?

I guess if everybody was already employed, increasing the velocity of money and raising economic activity would still be feasible so long as the intervention caused people to do more: raise productivity. We don't normally think of governments as being able to engineer an increase in productivity, but I suppose that depends on whether you see productivity as a technological constraint, supply side thing, or whether you think an injection of demand can drive an increase in productivity. How about Japan's long expansion via public works and soft loans (the inflationary effect of which was, I think but could be wrong, partially sterilized by holding export earnings as dollar assets and not converting back into yen). Could that be seen as a long duration expansion of the economic activity and the velocity of money via government sponsored demand?

In undergraduate macroeconomics, when students are taught that an expansion of aggregate demand, without shifting the supply curve, just causes inflation (eventually), is an increase in the velocity of money an alternative outcome (to inflation) or would an increase in the velocity of money amount to shifting the supply curve (because it can only come about via an increase in economic activity)?

wkwillis said...

You might do better giving an example where a new house is built instead of just adding a porch and a home equity loan advance.
Fewer people would misunderstand.
Or perhaps an water pump powered by a windmill, on a remote area of a ranch withhout access to power, so you can graze catle there and the investment is repaid in hamburgers?

Luis Enrique said...

I needed the words 'long run' in front of supply curve in my last para above.

Robert Bell said...

Maybe I'm misreading it, but I believe Dr. Cochrane's argument is that prior to lending to Beverly, there is a single decision point in time for Carol where her cash can only be used once:
a. Carol stuffs the cash in her mattress
b. Carol lends to Beverly
c. The government taxes Carol's money
d. Carol lends the government money by buying a t-bill
e. The government prints money, Carol second guesses the government and decides not to lend to Beverly because she knows eventually the government will tax her.

The notion of velocity appears when one considers subsequent small time intervals where each of the contracts are negotiated so that more employment and output are produced, but I think Dr. Cochrane is focusing on a single point in time and focusing on stocks, before subsequently addressing flows.

Hence the key questions in this world view would be:
1. Why wouldn't Carol lend to Beverly? (fear, mistrust, etc)
2. Why wouldn't Beverly build a deck (precautionary saving)
3. Why wouldn't Alice agree to build a deck for $500 (Alice may have built a previous deck for $600, Alice may not know how to build a deck, Beverly may not know Alice or know she knows how to build a deck)?
4. If the government taxed Carol or borrowed from her, they too could spawn a chain of transactions like this, but how is that any better than what Carol, Beverly, and Alice have done anyway?

El del 0.33% said...

Cochrane assumes constant velocity but you assume constant interest rates.

In your small economy, you multiply velocity by four without changes in interest rate.

mere mortal said...

I do want to pound my head against the wall.

I do not know what else to do...

Perhaps if you let Alice pound you in the head with a 2x4, you would save the damage to the wall that would otherwise have to be repaired by Carol.

Beverly could tend your wounds, earning the money to repay Carol.

You could thus simultaneously reduce the velocity of money in your example, contribute to the inflation in the medical industry, retire Beverly's outstanding debt, and occupy Alice's idle hands.

And since Deborah was doing nothing in your example, she'll remain idle in this one, unless she enjoys watching people get hit in the head by a piece of wood.

Seriously, though, it was a fine example, except I'm honestly trying to figure out what happened to poor idle Deborah. Is she Ben Stein's friend with the alimony, $2mil house, and the black hole of a small business?

Mike Rosenberg said...

You could loan Cochrane $5000 so he could enroll in college and take Econ 101.

That would increase his assets (measured in knowledge) and the college would have an additional $5000. The college could then hire a professor to teach Econ 101. That professor could then use the money to pay his daughter's college tuition at that same school. Meanwhile, with a great economist and professor teaching him, Cochrane could win the school's $5000 prize for excellence in economics and repay the money you loaned him....

Now, all we need to do is find a econ professor whose daughter's college bills are coming due.... :)

Rob said...

I disagree and my clue is the phrase "idle cash". Any cash holding shrink the money supply, taking cash holdings and investing will increase the money supply.

Of course trying to parse this model is ridiculous because its assuming a world in which the Fed targets a monetary base instead of interest rates. In the world we operate in changes in money demand are met by changes in money supply by the Fed to keep the interest rate target.

PQuincy said...

It sure is a good thing that economics is an empirical objective science -- as people from Chicago and of a similar ilk keep telling us...

Ken said...

"We don't normally think of governments as being able to engineer an increase in productivity"

Where do the transcontinental railroads, interstate highway system, hydroelectric projects, flood-control systems, and so forth fall into this? Are they not considered as increasing productivity? Or are they not considered as government projects because the government only paid for them, while private contractors supplied the materials and labor?

stefan said...

Just skimming Cochrane, isn't he just using a standard cash-in-advance model with a Leontief technology and the assumption of a constant money stock and an equilibrium in which the cash-in-advance constraint binds? Which seems like a bit of an extreme model for the situation at hand.

BB said...

I would imagine that it gets old having to explain simple ECO 101 concepts to Johnny-Come-Lately Conservative types who can't tell a multiplier from their assholes.

Luis Enrique said...


I expressed myself badly. Yes the provision public goods etc. can increase productivity, and governments do raise productivity in lots of ways. But if things were as simple as "government spends, and productivity increases", then expansionary government spending could increase output indefinitely, without inflation. We don't usually think of governments being able to do that.

geoff said...

"A" at 4:11 on January 27: You're the winner!! Of course that's correct. I'd call it an elementary economics mistake, but that would be juvenile. Brad: What happens to the $500 after Carol gets it? Does she stuff it under her mattress, or does she perhaps do something else with it? Does it matter for long or medium run economic growth whether the transfer from A to C occurs before or after the deck is built, etc.? I'd wager not, but I'd love to hear why you think otherwise.

Dhimmisoftheworldunite said...

Professor DeLong,

Cochrane's argument was made just this morning by someone from the Heritage Foundation speaking on WHYY's "Radio Times with Marty Moss-Coane" program. The pro-stimulus guest did a poor job of exposing the fallacy. I hope that you and others who understand may have opportunity to speak in more widely heard forums. That might be an alternative to head-banging. I did write to the program with a link to your site (this piece) and a suggestion that they contact you.

Thanks so much for educating the rest of us, and don't despair.


Sam Conner

stefan said...

To follow up a bit, this whole debate illustrates how bad models of money and credit are in macro models. Money in the utility function or cash-in-advance models don't get at the actual transaction and credit opportunities or constraints agents face, nor does the standard neo-keynesian model with or without money. The counter argument DeLong makes here just doesn't make sense in almost all (all?) models of money and credit in the literature, since they rule out exactly these sorts of bargains and transactions by assumption.

Neil B ☺ said...

I'm an amateur (with help from bro-in-law K. Rock at Chicago), but I thought I knew that extending credit (in the monetary system we actually have) meant in effect an increase in the "money supply" - true?

[Yes--for some definitions of the "money supply." But what that means is that the "money supply" can grow by a lot without the government actually printing any money...]

Sure some of the people in the story bargain with each other but they do get bank involvement to make it work.

jfxgillis said...

Meanwhile, Deborah lives under Beverly's deck eating the scraps leftover from the meals cooked by Carol for Alice.

Robert Bell said...

stefan: "Just skimming Cochrane, isn't he just using a standard cash-in-advance model with a Leontief technology and the assumption of a constant money stock and an equilibrium in which the cash-in-advance constraint binds? Which seems like a bit of an extreme model for the situation at hand. "

Thank you. I googled Cash In Advance models and I believe that is what I was trying to ask at January 27, 2009 at 03:58 AM.

Ken said...

Luis Enrique wrote: "Yes the provision public goods etc. can increase productivity, and governments do raise productivity in lots of ways."

OK, I see what you mean. I've just been somewhat perturbed by the attitude coming from some politicians and economists, that just because the money is being spent by the government, it must be wasted, compared to the uses to which private industry would put the same money. To me, it doesn't really matter whether a concrete-pourer's wages are paid by the government building Hoover Dam, or by a private developer putting in a new subdivision in the Inland Empire. Either way, the man is employed, and will be spending that money on other goods, employing more people.

Also - as those examples were just carefully chosen to show - government spending can improve productivity, and private spending can be misdirected to activities which turn out not to be economically useful. Not only that, but sometimes (Hoover Dam again) the government can spend money on projects that private enterprise will not, precisely because the government does not have to focus on the bottom line. (Though Hoover Dam actually made back all its construction costs, through electricity sales, but only over several decades, which was perhaps not feasible for any private contractor in the 1930s - or even now.)

rock the casbah said...

PQuincy | January 27, 2009 at 07:51 AM - you provide wonderful examples of the fundamental problem with Brad's story - capital allocation. People trapped in monetary analysis never account for opportunity costs and the lack of a market feedback loop when government monopolizes resource allocation. How much better would our Interstate system be today if Eisenhower used a private ownership model - that was being actively pursued by many States before it was ultimately squashed by the Federal government????

Ken said...

"The trouble is the government taxes and borrowing defunds the private sector sucking up funds that would have been lent and spent..."

I think this argument should be tabled until Treasury securities are earning more than 0%. Remember, those things are sold at auction; the private sector is choosing to lend their money to the government, and get zero return, rather than lend it to something more profitable (i.e., anything else).

"...and creates "jobs" that, due to political nonsense, cost twice the private sector's average wage, thereby decreasing employment."

One of my personal fascinations is with the history of Hoover Dam. I will just say that, at least in its case, your description is completely at variance with the actual project. The Six Companies even called in government troops at one point to suppress a strike by the workers demanding better pay.

[Oct 13, 2009] Ostrom & Williamson Win "Ironic" Nobel in Economics By Barry Ritholtz

October 12th, 2009 | The Big Picture

The odds favorite to win the Nobel, Eugene Fama, lost the prize to two other Americans, Elinor Ostrom and Oliver Williamson.

Ostrom & Williamson study the way decisions are made outside of markets, which is the focus of many other economists.

This award is a victory, in small part, for the Behaviorists, whose studies of our flawed wetware include such normal human foibles as irrationality, poor decision making, biases, non profit maximizing behavior.

Why? As we noted last night, the odds on favorite to win was the precise opposite of the behavioral economists - the father of the efficient market hypothesis, Eugene Fama. Users of his EMH have created various predictions markets. These markets had Fama the odds on 2 to 1 favorite to win the prize this year. There is no small degree of irony here, in that Fama's Efficient Market Hypothesis, where markets reflect all information on a given event, had so much wildly misplaced optimism on this occasion.

In a case of bizarre reflexivity, if these markets had not been so bullish on Fama's chances of winning, it would have done more to prove his theories. Instead, they gave him the best odds to win. This actually points to a major flaw in their thesis: the false belief that Humans make good decisions in groups, or that markets accurately depict the sum total of info on a given subject.

As I have argued in the past, prediction markets work best when their members mirror those of the group they are seeking to forecast. Jurors, Boards of Directors, Nobel Prize committees all are terrible groups for these markets to forecast, as their members rarely have much in common with prediction market Traders.

Perhaps the greatest irony is that Fama supporters, whose theories do such a poor job explaining bubbles and busts, were surprised by the results. Given the failure of the market itself to anticipate its own collapse, perhaps this was a very poor year to expect much in the way of recognition of the theories that supported many of the decisions that led to the collapse.

EMH proponents are apparently as tone deaf politically as they are economically.


Actually Williamson and Ostrom work in the "new institutional economics" which says essentially that the pure theory of markets ignores the factors, like rule of law, property rights, court systems, police, etc. that actually lead to the existence of markets. Several years ago the Nobel was awarded to Doug North and Bob Fogel for their study of the rise of institutions and the role of those institutions in promoting market efficiency and effectiveness. This is much more than a mere quibble as it's really an existence proof for all that EMH holds dear and which is not a historic accident but the result of millenia of careful nurturing. Another guy who should have won is Mancur Olson but his personality was such nobody wanted to award it to him and he passed on too young for time to force the issue.

[Sep 1, 2009] More On Economic Reasoning

August 11, 2009 | Thoughts On Economics
All ten of the letters in the 8-14 August issue of The Economist are responses to the critique of academic economics in the 18-24 July issue. My favorite is from Meghnad Desai:
"SIR - When I was a student we studied business cycles, but the topic disappeared with the rise of mathematical equilibrium theorising. The idea that capitalism is an equilibrium system is common among Keynesian and neoclassical economists; they only differ as to whether the equilibrium is at full employment or under employment. The grand synthesis being taught makes the equilibrium stochastic and dynamic, but that is all.

Capitalism is, however, a disequilibrium dynamic stochastic system as Marx, Wicksell, Schumpeter and Hayek have told us over the past two centuries. Richard Goodwin tried his best to present a mathematical theory of such a disequilibrium system. After the crisis we need to revive that tradition if we are not to be surprised by another crisis."

The on-line Lucas Roundtable at The Economist doesn't have any invited contributions from left-leaning non-mainstream economists.

Firefighter Arson And Our Macroeconomic Policymakers By Simon Johnson

The Baseline Scenario

Firefighter arson is a serious problem. The U.S. Fire Administration, part of Homeland Security, concluded in 2003, "A very small percentage of otherwise trustworthy firefighters cause the very flames they are dispatched to put out" (p.1). Illustrative and shocking anecdotes are on pp. 9-15 of that report, as well as here and here.

Macroeconomic policy making now has a similar issue to confront.

As the economy begins to stabilize and the financial system shows signs of recovery, accolades start to shower down on various officials, including most recently Ben Bernanke, who was rewarded this week with renomination – and almost certain confirmation – to a second term as chairman of the Federal Reserve Board of Governors.

Bernanke is widely seen as our financial firefighter in chief (BusinessWeek; USA Today) Similar terms are used to describe Treasury Secretary Tim Geithner and the entire gigantic financial rescue effort. Larry Summers, head of the White House National Economic Council and administration economic guru-at-large, is applauded as an "experienced crisis manager", which amounts to the same thing in this context.

If any of this sounds familiar, you're probably remembering the famous cover of Time magazine from November 1999, which depicted Alan Greenspan, Robert Rubin, and Summers as "The Committee To Save The World." The idea then was that crises in Asia, Latin America, and Russia had spilled over to US financial markets, most notably in the near failure of Long Term Capital Management, but disaster had been averted by – essentially – the financial firefighting abilities of this troika.

But what if the financial crises in recent decades – you can add the dotcom bubble, the S&Ls fiasco, and various emerging market debt crises to our recent housing and banking disaster – is not a sequence of random unfortunate events, but rather the product of a dangerous financial system? Given that today's firefighters also previously held responsibility for overseeing this system, both recently and as long ago as the early 1990s, this question is relevant – particularly as the very same team, in various combinations, repeatedly pronounced on the system's fundamental soundness.

Some of today's firefighters pushed hard for deregulation of derivatives markets in the 1990s, and this now proves to have been an important cause of the crisis (Summers and others). Others had responsibility for the solvency of Wall Street over the past half decade, yet disguised all potential warnings in layers of impenetrable opaqueness (e.g., Geithner; see p.91 in David Wessel's bestselling In Fed We Trust, Crown Business, 2009). Still others pronounced that there was no housing bubble exactly as things spiraled out of control and the potential costs to taxpayers rose (Bernanke and his colleagues at the Fed; again, pick up Wessel's book, p.93 is among the most damaging).

No one is suggesting that our illustrious financial firefighters deliberately triggered a crisis. But, for over two decades, they and their close mentors oversaw the operation and development of a banking and securities system with profound instability hard wired into its DNA. Don't take my word for it; review this speech by Summers in April 2009, or – in the light of what we know now – look at his talk on crises to the American Economic Association in 2000.

Perhaps that was all a legitimate mistake on their parts and they have now learned the right lessons. But how then do you explain their amazing reluctance to reform the financial system today?

President Obama said on Tuesday that Ben Bernanke helped avert a second Great Depression. That is a considerable achievement, but why then are this administration and the Federal Reserve proposing only minor adjustments in oversight and governance for the financial system that ran amok – producing "financial innovation" that harms consumers and destabilizes everything?

It makes no sense at all. Unless, of course, they are not afraid of future financial fires – despite the enormous fiscal cost (likely 40% of GDP from this round alone), the unemployment (heading to and lingering at 10%, by the administration's own revised estimates), and the millions of people hammered hard by lender abuse, house price collapse, and job losses.

You may not like the implications, but keep in mind this advice: "To ignore the problem or suggest that it does not exist will only increase the damage caused by the arson firefighters involved, as well as destroy the morale of the other firefighters in their departments" (Minnesota Fire Chief, March/April 1995 issue, quoted on p.1 of above cited report).

By Simon Johnson

A slightly edited version of this post originally appeared on's Economix, and from that version you can link directly to the referenced pages in David Wessel's book.

This post is reproduced here with permission. If you would like to use the entire post, please contact the New York Times. The usual fair use rules apply to short quotations.

Selected comments

Bill Raduchel

The Japanese have a phrase for this: Kaji-ba dora-bo. Literally thief at the scene of a fire: someone who turns the misfortune of others into his or her own benefit.
To understand the complexity of this idea read Mishima's Temple of the Golden Pavilion.
Hillbilly Daryl
See also Naomi Klein's The Shock Doctrine-The Rise Of Disaster Capitalism which takes this theory to the next level and exposes the manufacture of crisis to facilitate financial reward.
No one is suggesting that our illustrious financial firefighters deliberately triggered a crisis.

Actually, lots of people think exactly that, and although that's perhaps a conspiracy theory, it's not without evidence.

Didn't John Williamson openly say that sometimes crisies should be "deliberately provoked" in order to open up opportunities for disaster capitalism? I imagine the idea goes back as far as Chicago in the 50s.

My personal view is that they know that exponential debt and growth can from here ("here" being since the 80s at least) on be propped up only through bubbles, while disaster tactics can still reap profit from the inevitable crashes.

So this, named the "Great Moderation" in classic Orwell fashion, is the new economic model, for as long as globalization and financialization can be propped up:

1. Blow bubbles, sucking in as much rent as possible along the way.

2. Capitalize opportunistically during the crashes.

So they hardly have to commit arson when we're already always either in the flames or about to topple back into them.

Their kind of warmth demands permanently playing with fire, which is why they certainly won't willingly regulate for the next bubble.

If they can't blow another bubble, that'll be the end of corporatist growth right there. Game over for mass industrial "capitalism".

Obviously, keeping this game going as long and as profitably as they can is their only priority.

I dont' believe in conspiracies but I firmly believe in ruthless competition on who's best at screwing the "great unwashed" or at best completely disregarding their well-being. Any protest against exploitation (Ausbeutung) is nowadays successfully denounced as a longing for Soviet-style socialism

… and those who have a good chance to win the race to the top always find willing sucker-ups aspiring to the title of eminence grise, and lots of Mitläufer (along-runners, me also-s)

"Any protest against exploitation (Ausbeutung) is nowadays successfully denounced as a longing for Soviet-style socialism"
D. Christopher Leonard
In "social classes" Schumpeter noted that members of a class behave towards eachother differently than to those outside the social group boundaries. Certainly the upper echelons of the banking/finance community in NYC-London do so. They socialize together, live proximate to eachother, vacation in the Hamptons, send their kids to the same schools, and marry amongst eachother with greater frequency than with marriage partners drawn from other groups. They purchase university educations from status good schools (e.g. Oxbridge, the Ivys)to build and maintain social networks.

They certainly plan for the future in as much as they effectively lobby national governments for policies favourable to their interest (e.g. no regulation of derivatives, repeal of Glass-Steagel). So the assertion that 'people' don't plan isn't tenable.

While their are probably not formal agreements, the assumption there must be formal cabals misunderstands the nature of informal social networks in the construction and maintenance of elites.
There is at least a half century of empirical research on elite behavior – starting with C.W. Mills that belies your claims.

Try reading a history of the Warburgs, or the Wendels, or the DuPonts. Or undertake a proserpography of senior management in U.S. investment banks, money center banks, and brokerage houses (plus senior staff in treasury, Fed) and it ought to be an eye-opener. In otherwords, it doesn't have to look like a price-fixing cabal in an industrial sector to have informal but powerful coodination!

What's the mob then? What are drug cartels? What about the $200 million conspiracy in San Diego county involving 26 people and 100 properties? No conspiracies……
Ohhhhhhh R u being facetious?
Patrice Ayme
If one looks at the definition of "great depression" according to median income averaged over 20 years, it looks worse now than in the 1930s. Moreover the present crisis threatens the very core of the USA's supremacy, and that, the crisis of the 1930s never did.

One cannot have a superior nation if all that it consumes originates somewhere else.

BTW, the firefighter arsonist problem also occurs in France…

It has been argued that the 1930s depression was the a signal crisis that led to the final collapse of British global dominance, and the consequent rise of U.S. hegemony.

Of course the industrial and financial groundwork had already been laid, and of course WWII was a big part of this, but the 1930s economic crisis was certainly a watershed event that helped usher in this shift in global power relations.

I don't think it is much of a stretch to see a similar thing happening in this financial crisis, with the decline of U.S. global dominance and we can all guess which power is rising to replace it. In retrospect, this crisis may well be seen in these terms.

BTW, you're absolutely right that it occurs in France and if I'm not mistaken, French firefighters used to get "primes" or bonuses when they fought fires, which actually gave them an incentive to start them. Ideally they would be small and easy to put out, of course, but occasionally they ran out of control. I'll let others follow up on that analogy.

Patrice Ayme
It is WWI that caused the decline of Britain (and France). WWII was more of the same.

The crisis of 1929-1933 was caused by the bubble economy of 1920s, itself a result of an attempt to reflate the British economy. At least such is my understanding from my very long term memory (I bought, but did not read yet more recent books on the subject, with the exception of Niall Ferguson, who are full of unacceptable "explanations", similar to the "explanations" of that preceding historian of the Ferguson's sort, who was elected in January 1933).

Both WWI and WWII caused the ascent of the USA, and the so called "American Century" [1945-2001]. The USA profited from the wars without suffering much from them. Whereas the USSR lost more than 26.6 million people killed, and all of the rest of Europe was devastated, except for two countries which collaborated with Hitler, namely Sweden and Switzerland. The fact the later two did so well economically afterwards is a testimony to the fact that war can be highly profitable, if one avoids massive destruction while extending one's economic reach, which is what the USA did on a massive scale.

For example as International Business Machine was given the monopoly for computing in Hitler's Reich, it extended its reach in (occupied) Europe. By what some insinuate was not a miracle, none of the 35 factories of IBM in Germany was damaged enough to stop operations during the war. As Europe was liberated, Hitler's IBM ("Dehomag"), the Nazi octopus, became American IBM, the liberator octopus. And so on with many American enterprises which had collaborated with Hitler.

As Europe imploded, the European empire collapsed and were replaced by American influence, business and value system. That, too, was highly profitable.

Thus the ascent of the USA is closely related to German becoming fascist crazy (1914-1945). Russia becoming crazy with Soviet fascism did help the USA too. As Europe is rebuilding, one can suspect that the USA, left to its own instruments, will shrink back because its imperial mentality is not adapted to the loss of the artificial reason that made it so big.

The Europeans now know that materialism, imperialism, nationalism and hubris excess can lead to the destruction of civilization. But America's main stream ideology has not integrated that lesson, and thus the elite of the USA keeps running away with the worst errors, in blitheful impunity. Excess never last forever.

Patrice Ayme

Patrice Ayme
Silke: These problems are vast. You are right about the declines of other powers. Now as far the USA is concerned, it all depends upon what "USA" means. The GIs on the beaches were heroes, and so were the crews of the carrier Enterprise.

One has to get away from the national model: inside most countries, some people behaved well, and others, terribly. No doubt most Americans behaved very well in WWI and WWII, as they do now. Most Americans did not support Hitler anymore than most Americans worked at Goldman Sachs.

It may be more profitable to criticize specific ideas rather than people.

For IBM, please read "IBM and the Holocaust" (Erwin Black). I have written more than 2,000 pages on my various sites on the general subject of the factors that led to WWI and WWII, and my convictions are numerous, to the point of looking sometimes contradictory to the untrained mind.

Patrice Ayme

I am rather proud of my untrained mind.

I am aware of the IBM-book, it created quite a ruckus at the time in Germany.
there are stories galore like that

and last but not least

I meant the USA as an occupying power in Germany – it gave little me a prosperous and really good life to date

and to make the the probably most contentious point clear:

I am convinced that the bombing of German cities during WW2 was the right strategy. It made my Herrenmenschen-ancestors tired enough to not resist occupation. And I take into account that it made my first 3 years quite unpleasant – though it was mostly the British who bombed Nuremberg where I lived at the time, I am glad the US did not stop them doing it

"we can all guess which power is rising to replace it"
To me that sounds like a much too orderly sequence of events.

if the American hegemon should really go into decline my bet is on an extended period of chaos during which everybody is trying to grab a piece of the cake whether the current candidate for "succession" will eventually come out on top is a totally open gamble

- who would have thought at the time that some Arab desert sheiks would suddenly appear on the scene and manage to grab huge chunks of the former Roman empire as well as eventually East-Rome (Byzantium) also

Patrice Ayme
Silke: Happy you loved the bombing of Hitler's Germany. I agree, all the way to Hiroshima (I have some doubts about Nagasaki). I have no problem with these Anglo-Saxon heroics. Interestingly the son of ambassador Kennedy, a fascist sympathizer, died in a quasi suicidal bombing mission against the Nazis. Raffiniert ist der Herr Gott…

Aerial bombing, however atrocious, was the only way to defeat Hitler, itverpt the breaking of hubris, but it is not restrcited to Herrenmenschen, which is the subject at hand.

I once had a neighbour who was a devoted voluntary fire-fighter and paramedical to boot considered by the whole village after careful and reluctant assessment to have started quite some "good" fires, fortunately without loss of human life, albeit killing in his greatest "success" a number of cattle and pigs
it seems that in the rural areas of Germany this is not uncommon at all


Otto: Apes don't read history.
Wanda: Yes they do, Otto, they just don't understand it.
When you write that the behavior seems to be wired into the DNA you are saying the it is unavoidable in the current system. It fits the patterns of totalitarian governments, which use crises to legitimize their power. I shudder at the terms recover, reform, and re-regulate because none of these involve major changes to the system, changes that would indicate substantial cultural evolution (and thus changes in the DNA, to extend the metaphor).

I believe we are in a pre-revolutionary situation in this country. The respondants to these posts are highly educated and equally disaffected. We have lost confidence in the government to address the basic needs and concerns of the majority of the population. Obama, like many transitional administrations, seeks to please everyone by its moderate positions. Such an approach eventually fails because it fails to make radical enough changes to resolve the underlying grievances.

Simon, your comments reflect this disilluionment and cynicism that characterizes many intellectuals today. You write them as if you fail to realize how damning they really are.

I was struck by the respondant who wrote of U.S. Supremacy. We were cast in a role after WWII that may have done us more harm than good; I suggest leadership in any sphere comes from the qualities of courage, justice, and compassion. U.S. supremacy has been built on a very different foundation. If we want a strong national and global economy we learn how play fair and share the playground.

BTW I love your blog!

Carson Gross
I don't think the firefighter arsonist metaphor is a good one. The firefighter arsonist is intentionally causing an evil in order to participate in the form of a good.

Bernanke's situation is much closer to that of The Magician's Apprentice. He's playing with a system far more complicated, chaotic and reflexive than he can possibly hope to understand, model or control. And, in that sense, his failure is mixed up with the core failure of our broader academic class: a lack of humility in the face of the unspeakable complexity of the world coupled with a quasi-platonic messianism.

Cheers, Carson

This is one of the most intelligent posts on this and many blogs. But, I would quibble further with the dig at academics or "quasi-platonic…." dont even know what that means.

One of the clearest explanations of what has happened, is a system complex beyond our understanding.

Many years ago, when my son was in second grade, he entered a 'video' he'd made in a competition for students run by the Boston Computer Society. He won first place in his division, simply because there had never been another second-grader produced video.

A few months later he was happily planning his project when he got an email; there would be no next year. The society had held its annual meeting, and compared its accomplishments to its mission, and decided the mission accomplished. Instead of creating new goals - or lighting more fires - to justify continued activity, it disbanded.

(In contrast, at the same time, the Mass. Turnpike Authority met, said it's mission of paying for the Mass. Turnpike was accomplished, and invented a new, never-ending mission.)

The Boston Computer Society's action still stuns me; it's an incredibly rare thing. Most groups follow the example of the Turnpike Authority, and expand their mission, lighting new fires to put out instead of taking credit for a job well done and stepping down or stepping back.

No, I'm not libertarian and think the Federal Reserve should retire because the "recession" is over. But I do think mission creep you describe would lead to fewer fires if all public agencies had more of the "mission accomplished, let it go" mentality.

Zic: The same thing goes for private corporations, they mutate through time to justify their continued existence – their original products become obsolete, so they invent new ones. They gobble up small companies to eliminate competition etc. 'Mission creep' is a universal characteristic of human activity. It's up to others – voters or shareholders- to question the reason for the continuation of any organization.
Philip H
It makes no sense at all. Unless, of course, they are not afraid of future financial fires – despite the enormous fiscal cost (likely 40% of GDP from this round alone), the unemployment (heading to and lingering at 10%, by the administration's own revised estimates), and the millions of people hammered hard by lender abuse, house price collapse, and job losses.


I think you missed this mark just slightly. Precisely because they view themselves as the saviors in all the other crises, they believe that no reform is really needed BECAUSE they know they can save us when the relaaly big bubble bursts. Its a combination of pride, inflated egos, exagerated sense of control, and blindness to their own contributions to the problem.

Of course, it doesn't hurt that they are also mostly ex-financial sector folks who are routinely lobbied for by many in the industry. Foxes and hen houses, after all.

With all do anger to Bernanke and Greespand and the rest of the individuals who helped perpetuate bubble economics. In the end, where is the anger on the part of the populace?

Ultimately people get the governments they deserve, and while I shudder to say it, the US people deserve this government and the other inevitable consequences of inaction, laziness and ignorance.

As many posters have noted, all segments of society have lost their believe that government can do anything of value or improve their lives, yet their vote in the very same people year after year. Why on earth would the Bernanke's of the world change, they can do what they please and face little to know consequence, except the possibility of a promotion. Why would the Dem ever champion true reform when they know faking it will ensure their re-election? Until the average American gets more interested in economic policy then Michael Vicks personal activities, the state is doomed.

The people have been lulled to sleep, and they seem to love it. I have to agree with Bill Maher, the US is a dumb country, or perhaps a better way to put it is selective stupidity. While the average gun totting protester can probably name the entire staring line up of the his local college football team, who probably can't name his representative or whom the Federal Reserve Chairman is, or define interest rate. But he could probably unload and reload a rifle before you could say "screwed up priorities".

The US ridicules the UK for its monarchy, yet watch as Senators who preside in ignorance for 40 years only to retire and appoint their children to their seats. Biden and Dodd have already indicated this will be the case. They rage against healthcare yet see no connection between treating their bodies horribly. At the same time we are debating deductibles, public options, ect, KFC recently came out with a sandwich with fried chicken as bread. You can have all the public options you want, if that is what you eat, you will be unhealthy.

Finally, while I love to come to these sites and read the posts, this small group of uber-interested policy wonks are in the minority. After reading some of the comments from congressmen and the media, I am firmly convinced that we are better informed and more interested in public policy then they are. That is scary. When random internet readers can better discuss the details of banking regulation then elected public officials, your state is sunk.

jake chase
Don't blame the voters; they only give us a choice of two, and half of us haven't voted for years and years. They skunked us at the first Constitutional Convention. Only a parliamentary system can save us. Perhaps, there is a Kennedy or a Bush willing to serve as monarch? In fact, maybe we should merge with England? Replace the Supreme Court with a House of Lords? Sell titles of nobility to retired corporate poobahs and pay down the deficit?

How does the Bank of England work? Is it more to be trusted than the Fed?

After the South Sea Bubble exploded (1720) the leading finaglers were stripped of ALL their property. Makes you believe in ex post facto laws!

I will have to kindly disagree with you on the two choices part. Ross Perot came up, Nader has run forever, but no one votes for them. While neither of these men would be my personal choice, a viable third or fourth party would do wonders. But because no one believes that a third party is viable, progressives must join the democratic party.

Perhaps another option for certain parts of the US. Seriously, let the South secede. I continue to hear there is no blue America, no red America rhetoric, but believe me there is.

People in Seattle have far more in common with Canadians then with people from Texas.

Part of the US want to be a progressive, democratic country based on secular values, the embrace of science, and a more moderated version of capitalism.

The other wants to turn back the clocks, teach creationism as science, burn any book other then the bible and let the chips fall where they may. Why not let them?

As a Canadian, I invite all interested American States to join Canada. I think we all know which states would want to join, and which ones would join the sovereign Texan Republic and start a war with Mexico. Its a little cold, and you would have to embarce the metric system, but I think most would enjoy it.

"After the South Sea Bubble exploded (1720) the leading finaglers were stripped of ALL their property."

is it known how many of them made it back to positions of eminence?

Simon: Is this a personal failure by folks like Bernanke, Geithner etc. Or is it systemic? Yes some people 'saw' the bubble ahead of time, but were they mavericks? Mostly, it seems. This implies that orthodoxy failed, not just the purveyors of orthodoxy. So those firefighters cannot be blamed because they didn't realize that they were playing with matches – who knew matches start fires?

Clearly orthodox economists had no clue about the economy they were overseeing. That much we know. If they did then they are morally culpable. If they didn't they are ignorant. Either way we shouldn't trust them now.

But what choice do we have? Where is the new theory?

Yakkis mocks 'complexity' – I agree it is too often a crutch when we don't understand something – but it seems economists have simplified their models to the point, not just of irrelevancy, but of starting fires.

Is that what you are saying?

jake chase
Anyone who understood the dynamic relationship between credit and collateral could see the crisis coming, but economists focus only on published statistics and there are no statistics for collateral values.

Mainstream economists can neither explain nor predict anything, but they provide useful justification for existing power relations. They tell us GDP is up three percent. Who knows how they count it? For all they care it was buoyed by a boom in child pornography sales. When aggregates are inconvenient they stop counting, as for example with unemployment.

They define inflation out of existence by excluding things people buy out of necessity and focusing on the price of computing power.

JK Galbraith said it best: economics is the only profession in which it is possible to rise to eminence without ever once being right.

Churchill said: "Statistics are like a drunk with a lamppost: used more for support than illumination."
and "the only statistics you can trust are those you falsified yourself"
jake chase
What is interesting about the euphoria over Bernanke is that it has arisen before the development of ANY real recovery. What Bernanke saved was the power of the financial elite who have begun renewed mischief in the stock and currency markets, blowing another bubble because there is no current use for credit apart from fueling speculation.

What, no productive lending?

Why is this surprising when new construction is comatose and industry operates at 60% of capacity? No mortage lending? Who can afford one of these still overvalued houses, particularly now that he is expected to pony up a hefty down payment and perhaps even required to prove his claimed income?

It would appear the Administration is counting on reviving consumer spending by creating CONFIDENCE, but what is the basis for confidence?

We have phony statistics and inflated stock prices and artificially stimulated vehicle sales (whose primary beneficiary seems to have been Toyota), and chump change tax credits to stimulate new home purchases by anyone who somehow can still afford one.

Meanwhile, banks continue to rachet up the terms on consumer credit, and the whole fiasco continues hostage to the Treasury bond market which is expected, I suppose, to continue bubbling forever because, because why? Because lending to our federal government for ten years at less than four percent, and for thirty years at less than five, makes economic sense? To whom? Are the Chinese as gullible as Japanese real estate investors? If what we have these days is not another house of cards I will have spent forty years studying finance and economics for nothing. But the ominous question remains: what comes next?

D. Christopher Leonard
Accepting that financial elites (banking) transit to government and then back again – perhaps akin to setting the fox to watch the chickens, we might want a broader historical perspective on the behavior of American financial elites both in and out of government. Over the same period, there has been widening income inequality (v. Saez' work) and manufacturing has declined.

The U.S. exports armaments, primary agricultural products, and sovereign debt.

Over the same period, the terms of political discourse have been defined by the Reagan-ite 'government is the problem/enemy and so we have dis-invested in infra-structure, education (more broadly social capital) pensions were shifted from defined benefit to define contribution, shifting risk onto those least able to bear it.

To note that these co-occur is not to prove that they are by design linked. But it may be useful to think about why capitalist elites have felt that there needed to be a new wave of accumulation, and that the traditional bases of U.S. strength – a very well endowed, big continent,the absence of industrial competition for 30 years after WWII, and a huge national market – were diminished and 'we' were no longer internationally as competitive – except in as much as an imperial power can always exact compliance or at least deference.

Think about the boosterism of Summers, Rubin, Greenspan, etc in that light.

No one is suggesting that our illustrious financial firefighters deliberately triggered a crisis.

Exactly. Who knew that if you poured gasoline on the economy making it overheat and then lit a match that the whole thing could go up in flames?

Yakkis, you underestimate human stupidity
There is this wonderful type of stupidity where you accidentally become rich beyond anyone's wildest dreams.

because why should people who are so notoriously bad at planning and predicting be good at it when they happen to be villains – stupidity and ruthlessness/recklessness go very well together

If I hadn't seen so many utterly stupid people succeed beyond any measure of imagination I would agree with you – but so personal experience makes me wary of atrributing the power of planning this to them

nevertheless they are of course they are wholly accountable for what they did – if they claim they are not the place for them to be is the lunatic asylum (not the modern kind though- hopefully)

I find your words strangely comforting, as if I too could achieve the American dream.
Our financial system is under the control of a group of pseudo-intellectuals who've convinced themselves & everybody else that they're really smart.

They talk like they're smart, they look like they're smart, they sound like they're smart, they act like they're smart. But they're all really, really stupid.

Patrice Ayme
Chas: That is why the Greek discovered the concept of hubris: superiority pushed to the point of completely idiotic madness. The Greeks discovered it the very hard way: their civilization never came back…
Greek hubris is also supposed to make the Gods jealous
wonder who will turn out to be the Gods this time

Greek civilization came never back?
their culture survived not only in Rome but in Byzantium also and clad as an ideal to this day

Patrice Ayme
Silke: Elements of Greek culture survived in the Greco-Roman empire. Constantinople was all the opposite of Antique Greece: the demos spoke Greek, true, but had no mind.

Greek civilization is fully born again today, true, and even in Athens. But it had gone extinct, at least in Greece, for 22 centuries (from Alexander to the flight of the Ottomans).

Patrice Ayme
And, as far as jealousy is concerned (good question), the whole world has long been jealous of the USA… Yesterday's rest of the world, tomorrow's gods?
I assume you're referring to economists, especially financial economists. Peer reviewed journals helped them self-select themselves into oblivion. The trouble is: they took us with them.

They need to be held accountable. Maybe we should 'deregulate' economics: abandon tenure, open up the market for ideas, eliminate the oligopolists running the journals.

Could be fun to do to them what they did to us.

Paul Handover
Chas, echo that for politicians.

See this

In that article Jim Chanos and Paul Singer, both financial bods, come out of it pretty well.

Earl Killian
Perhaps a better analogy would have been a fire chief who fights to prevent the national electrical code from adopting rules that reduce fires caused by faulty wiring. The fire chief reasons that electricity has benefits, and so shouldn't be burdened with rules, and besides, and the fires that result can be handled by his fire department. The debate never seems to include the option that you can have the national electric code without reducing innovation in electrical products.
…where the firechief has been appointed by the local arsonists who need for the fire department not to put out the fires until there has been a total loss.
Don't count me in on the firefighter theory. The reason for our serial bubble economy is simple: Our credit driven banking regime, and our culture's unwillingness to sacrifice short-term advantages for long-term properity.

Our financial system generates money on the basis of the promissory notes accepted by the banking system. At some point in the growth of the money supply, debt will exceed the income available to service it. At that point, two options are possible:

1. Deleverage – Write-down those debts that can not be serviced and properly value assets that decline in price. (Take your medicine)

2. Re-Inflate – Pump-up different assets' market value with new banking loans that will briefly compensate for the old loans in default. (Hair of the dog)

I think that the Fire Insurance analogy is more apt. Allowing the financial industry to issue Credit Default Swaps in excess of the value of the assets being insured created the perverse incentive to bankrupt the securities.

Ted K
The thing I think is, you need someone who generally cares for other people, and the citizens of America–the "smallguy".

Everything in Lawrence Summers' demeanor, tone, and body language says he doesn't.

His whole attitude is one that can't understand why other people can't just be born in a family of wealth and privilege like he was.

His facial expression screams "Why can't everyone just draw squiggly lines on a supply and demand graph and make millions like me?" He's not only arrogant, he is PROUD of his arrogance.

We have other people like Alan Blinder and Joseph Stiglitz who can draw lines on a supply and demand graph who genuinely show more concern for the "small fry". Why do they always get lost in the mix???


And why can't we find some political candidates SOMEWHERE, to run for Congress or the Presidency, with some genuine empathy for Main Street Americans?

For the skilled workers & unskilled laborers who work hard all day every work day to produce the stuff consumed by the parasites in Congress, the Administration, at the Fed & big bank management.

"And why can't we find some political candidates SOMEWHERE"

from afar it looks like by now only Saints qualify and to get a saint who has the shrewdness of getting deals made, being devious, threatening and upright honest all at the same time, as gifted negiotators have always been, seems very improbable to me.

in some way the current job description for politicians in democracies have to be rewritten – maybe regularly confessing past and current sins with the promise of not repeating them would do

Uncle Billy the Un-Cunctator
"No one is suggesting that our illustrious financial firefighters deliberately triggered a crisis."

Are you saying that Nemo is suggesting this?

You are wrong. There are plenty who are suggesting this, just not many who have any solid evidence. The fact that they might not have a PR machine that gives them a platform does not mean they are "no one."

Refer again to Jamie Dimon's smirking comment to Charlie Rose. Something like: "Buying a house is not the same thing as buying a house on fire."

Refer again to this paper from 2002 called "Home is where the equity is" (Univ. of Chicago academic, btw) It offered a suggestion for policy - let people suck the equity out of their houses. Doesn't the title remind you of Willy Sutton's famous quip? "That's where the money is"? Willy Sutton, the bank robber? Are there lots more clever titles on papers out there that helped us blow our bubbles?

Silke, there is far more stupidity and chaos out there than conspiracy. This is not, I believe a reason to discount the possibility that our crisis(es) were engineered systematically.

as those who engineered the steps towards the abyss got paid for their "expertise" they have forfeited their right to that money just as any car salesman would forfeit his if the car deviated in a major let alone catastrophic way from the sales pamphlet.

make them bankrupt and put them on food-stamps or whatever your American equivalent of Hartz IV is and do it not only to the bonus collectors among them do it also to the professors who promoted the theory/dogma.

Whether assistant professors and clerks, journalists and TV-persons need to be included has to be evaluated.

All those who claim to have been duped, to have been unable to foresee it failed and/or cheated on the job and should make amends that amount to more than confessions.

what happens instead? Ackermann had a birthday dinner at Merkel's chancellory – Ackermann is head of Deutsche Bank who carried away 12 bn of US-bail-out money refusing at the same time German bail-out – that needs to be rewarded? doesn't it?

(I doubt that the dinner was lavish though – presently lavish is not in fashion over here -

"We have the best government money can buy". Edward Kennedy. Why would we expect them to look out for the public interest? I can't imagine why. Until we change that, the government won't be any help in loosening the stranglehold that entrenched interests have in preserving their entrenched interest.

This is true in every important area of society: Energy, Health, Education, Finance and Banking…..

For me that is the crux of the matter.

Hillbilly Dary
The first thing we do is kill all the economists (figuratively speaking).

In my view there are two types, both of which have proven to have very limited utility (to coin an economic term):

  1. The academic/research wonks that analyze data that by definition must be historical and apply historical questions and assumptions to it to attempt to make future prognostications. These folks fail because they lack the ability to ask the right questions because we haven't been there yet-tomorrow isn't yesterday until two days from now.
  2. The tinkerers that operate with the inate belief that lifting here, tucking there, adding a little botox here, triming over there, will result in a a super model. Veritable masters of the universe. Unfortunately, all too often they end up with Michael Jackson's face.

Both perpetuate the system. The academics crunch the numbers for the tinkerers. The tinkerers in turn attempt to create tomorrow's tomorrow numbers for the academics to crunch three days from now.

But the whole charade is based on linear as opposed to dynamic thinking, and is premised on the faulty logic that one can linearly influence a dynamic system that one doesn't understand, can't understand, and can't possibly ask the right questions to predict.

There is too much meddling in my view to begin with.

How Much Does the Financial Sector Cost?

The Baseline Scenario

with 35 comments

Benjamin Friedman, in the Financial Times (hat tip Yves Smith), questions the high cost (read: compensation) of our financial sector. But he does not simply say that huge bonuses for bankers are unfair. Instead, he says that the costs of financial services need to be balanced against their benefits.

The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes and what taxpayers have had to put up to supply first aid. The estimated $4,000bn of losses in US mortgage-related securities are just the surface of the story. Beneath those losses are real economic costs due to wasted resources: mortgage mis-pricing led the US to build far too many houses. Similar pricing errors in the telecoms bubble a decade ago led to millions of miles of unused fibre-optic cable being laid.

The misused resources and the output foregone due to the recession are still part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system.

In particular, Friedman wonders at the relationship between the value provided by financial services and the opportunity cost involved: "Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three. These talented and energetic young citizens could surely be doing something more useful."

This reminds me of something Felix Salmon wrote about a while back: If profits and compensation in the financial sector go up and keep going up, that's a priori evidence of inefficiency, not efficiency. Those higher profits mean that customers are paying more for their financial services over time, not less, which means that financial services are imposing a larger and larger tax on the economy. Now, it is possible that they are also increasing in value fast enough to cover the tax, but that is something to be proven.

By James Kwak

[Aug 24, 2009] Magic and the myth of the rational market By Keir Martin

August 24 2009 |

"If they see me planting too much cocoa, they'll do things to my land and my family, and they won't bear fruit; really bad things; puripuri and other witchcraft."

This was how Peter explained to me why he had only cultivated half of the three-hectare block the Papua New Guinean government had given him after he was evacuated from his home during a volcanic eruption eight years earlier. He was also providing a response to an accusation I had often heard levelled at his fellow villagers by government officials and development workers in the course of my anthropological field research: that the people were lazy or stupid because, like Peter, none had planted the whole of their blocks of land.

Such an avoidance of profit maximisation might have appeared economically irrational. But from the perspective of those villagers, putting in extra work just to make oneself a target for the jealousy of one's neighbours would be highly irrational behaviour.

Critics of untrammelled free markets have long attacked the assumption that markets are rational, driven by rational self-interested economic actors. But the question of economic rationality has returned with a vengeance in the wake of the current crisis.

Both advocates and critics of the rational economic actor model are usually keen to stress that it is a rationality that measures economic value and does not take into account the social setting. Yet, field research clearly shows that the actions of individuals vary massively depending on social context.

Living in Papua New Guinea, one is struck by the resources expended on gigantic ceremonial gift exchanges. The "big men" running such systems did not call in debts to maximise the number of pigs or modern wealth items such as money or trucks in their possession. But academics continued to assume that the aim was to profit over the long term, with the discrepancy between this assumption and the big men's actual activities being explained as the result of "selective amnesia". It was only when the assumption of economic rationality was dropped that it was possible to understand the big men in their own terms. Their aim was to increase the number of those dependent upon them, and so, like a Mafia godfather, their aim was to create debts that would never be repaid. Like Mafiosi, their actions were neither the result of what one economist described as "an inferior mentality", or a lack of rationality. They were entirely rational within a context in which building up an army of followers was at times a more pressing demand than stockpiling wealth objects.

One response to the current crisis has been a rise in the popularity of behavioural economics, which examines the psychological and emotional factors behind transactions. These models drop the assumption of the rational actor yet implicitly keep the same model of economic rationality at their heart. We may diverge from the path of rationality for all sorts of psychological reasons but only because emotion, Keynes's famous "animal spirits", clouds our judgment.

Clearly the stress, fear and excitement that run through investors' nervous systems can have as strong an impact on their investment choices as they can on gamblers caught up in the enthusiasm of a race meeting. But it is also important to remember that rationality can often be a matter of perspective and context. From a theoretical perspective it may be irrational to sell an investment for less than its true value. But, if everyone else is selling, are you going to risk your job as a professional investor holding on to those securities?

That sell decision is as rational in a Wall Street context as the Papua New Guinean's decision not to maximise the returns from his block of land are in his, even if in the long term your interests may be better served by holding on to those securities.

At certain points the interests of individual investors, investment funds and the market as a whole may coincide. At such points reaching a consensus on what is rational is rather easy. At other times, however, they will diverge. In such contexts, rather than assuming that non-textbook behaviour is the result of a fall from rationality, our understanding of how markets work may be better served by an examination of how different measures of rationality emerge in different contexts, and how to manage them when they come into conflict.

The writer is a lecturer in social anthropology at Manchester University

[Aug 23, 2009] The Limits of Arbitrage

The Baseline Scenario

Wow, it's already Friday. I'll feel that I've short-changed you if we don't do some Finance Theory before I go.

Did you see this roundtable about the state of macroeconomics in The Economist's Free Exchange? Fascinating stuff; in particular it became a bit of an odd defense of the Efficient Markets Hypthosis (EMH). A representative comment was made by William Easterly, in defense of EMH:

The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market. This applies also to other asset markets like housing prices.

This is not true, and I want us to walk through why it isn't. In March of 1997, Andrei Shleifer and Robert Vishny published a paper titled The Limits of Arbitrage (pdf) in the Journal of Finance. I think it's the most important finance paper of the past 15 years, something everyone even remotely connected to financial markets should become familiar with. It builds on and summarizes a decade long research project, research they conducted with people such as Joseph Lakonishok and Brad Delong. In it they say that arbitrageurs, the very smart and talented traders at hedge funds who will take prices that are out of line and bring them back into line, making a good fee and making prices reflect all available information, the very building block necessary for EMH to work, can't do their job if they are time or credit constrained. Specifically, if they are highly leveraged, and prices move against their position before they return to their fundamental value – if the market stays irrational longer than they can remain solvent – they'll collapse before they can do their job.

And sure enough, a year later in 1998, Long Term Capital Management, very smart highly leveraged arbitrageurs, found themselves in a situation where prices moved away from them, and they had no capital with which to keep themselves afloat, just like Limits Of Arbitrage predicted. (This is the standard narrative in finance research seminars; it also appears this way, correctly, in Justin Fox's The Myth of the Rational Market, a very excellent book that gets these details correct.)

There's an argument that says "If the market is inefficient, why aren't you rich?" This gives us the framework to understand why markets could deviate from true value but there isn't a way to capitalize on bringing them back to true value – sometimes there is risk inherent in arbitrage, and sometimes there are situations where it is difficult to get on the other side of a trade. And specifically, it's risk that isn't compensated.

Here's an example of how this works. Let's say something is trading at $5. You are positive it is going to reach $10. Positive. It must. No chance it won't at some point in the future. So you buy it, telling your boss/manager/investors you are going to make $10-$5 = $5 for free. But the price goes to $2.50. What happens? You should buy a lot more. Now you are going to make $7.50! However your boss/manager/investor thinks you are insane and have lost them all kinds of money, as they now have half of what they gave you, and wants to pull your trading funds – if you sell then, you lose money, and put downward pressure on the price. Also, depending on how you were leveraged, you may also be bankrupt. That's how this works.

This gives us a guideline for figuring out how markets can get out of alignment with value – if it is difficult to attract arbitrageurs, who are necessary to keep prices in alignment, we should expect the market to have prices that are more prone to manipulation and bubbles. What attracts arbitrageurs? The bond market – it is easy to calculate the value of a bond, and easy to realize the value quickly. Foreign exchange markets – it's relatively easy for arbitrageurs to go after central banks attempts to maintain nonmarket exchange rates.

What doesn't attract arbitrageurs as easily? The stock market. The absolute and relative value of a stock is harder to estimate, and it may take a long period of time to realize your gain. (If you are comfortable with the terms, expected alpha doesn't increase in proportion to volatility if volatility includes fundamental risk – read the paper, it's excellent!) And though it isn't covered in the paper, housing.

There's no real way to go short housing. You can go short the bank issuing mortgages, but if the bank has two internal businesses – jumbo subprime loans and boring small business loans – might it not be sensible for them to turn down the business loan division in response to the market shorting? You need to be able to exert price pressure directly onto the market itself – the more intermediaries, the more likely it is your signal is converted into noise. There's talk about how in the future we'll all trade derivatives contracts on each other's neighborhoods; depending on how that's implemented, it would be something to say "I want to go short Detroit and Peoria in my portfolio." Is there moral hazard to drive down those prices then? And life would be more interesting if the investment firm of "My Ex-Girlfriends LLC" could take out a derivative insurance contract that pays out to them if my house burns down over the next year. Thankfully that market is still some time away, if it ever gets here, so we can iron out the difficulties.

There's a lot more research to be done here, but contrary to popular belief we do have an intellectual framework to know how markets can get out of whack, one that takes the EMH are brings it to a reality where we face actual constraints over scarce resources such as time and capital.

Selected comments

  1. EMH is all nonsense. Soros explained it best: markets have thinking participants who are always biased. His track record makes it clear you can beat the market, which is not about 'value' but about psychology.

    Of course, you can lose too, which makes playing with your own money somewhat dangerous.

Why 'efficient' markets go haywire by Jim Jubak

MSN Money

So-called efficient market theory sometimes fails -- spectacularly -- to predict Wall Street's behavior, yet the theory lives on. So what's a rational investor to do?

I remember watching in horrified fascination in October 1987 as the stock market crashed. The Dow Jones Industrial Average ($INDU) dropped 22.6% as $500 billion evaporated in a single day.

As a (relatively) young business editor, I got pressed into service calling up the smartest people on Wall Street to ask them what had happened. Money managers on the Street were in shock. "This can't be happening," more than one told me. "Prices don't behave like this."

"Prices don't behave like this." That phrase connects the financial disasters of the past 20 years, from the collapse of portfolio insurance in 1987 to the collapse of mortgage-backed derivatives in 2007.

It will be the theme song for the next financial market disaster, too, because efficient market theory, the set of assumptions that underpins these events, just won't die. It may be intellectual Swiss cheese, but it's far too profitable for Wall Street to let it go.

Rational market a myth?

Justin Fox has just published an extraordinarily interesting and readable history of efficient market theory titled "The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street."

Read it and you'll understand how we got here, why Wall Street will keep recreating these disasters and how you can tiptoe around the worst of the damage.

What Fox is best at is showing the reader the assumptions behind efficient market theory from its development in the 1960s to its triumphant takeover of business schools, Wall Street and corporate boardrooms in the 1980s. (I had the key formulas of efficient market theory, models such as the capital asset pricing model, drilled into me in the year I spent in business school in the early part of that decade.)

What are some of those key assumptions?

Fox is extraordinarily fair to the great names of economics and finance who put this structure in place: Franco Modigliani, Eugene Fama, Merton Miller, Fischer Black, Harry Markowitz, Milton Friedman, Myron Scholes and others. They never come across as anything other than what they are: brilliant thinkers who knew they were making radically simplified assumptions about reality so that their models would work.

Fox's most interesting chapters are his discussions of such honest thinkers as Black, who never forgot that his theories were built on simplified versions of reality. I can't imagine being tough enough to constantly question the validity of your life's work, but some of these folks did exactly that.

Events, of course, helped them along, because reality struck back hard not too long after efficient market theory became the ruling orthodoxy. The first of these was the 1987 stock market crash, which was facilitated, if not created, by a financial product called portfolio insurance, built out of the pricing models created by efficient market theory.

Hedge fund debt disaster

Then there was the collapse of the Long-Term Capital Management hedge fund in 1998. Some of the best minds on Wall Street had devised immensely profitable strategies that exploited tiny, unjustified differences in the prices of financial assets such as Treasury bonds with 30 years until maturity and Treasury bonds with 29.75 years until maturity. In the first several years after its founding in 1993, Long-Term Capital averaged returns of 40% annually.

But by 1998, Long-Term Capital had borrowed billions -- $124.5 billion, to be precise -- to get more bang from the tiny price discrepancies its computers had identified. Then a financial crisis in Russia triggered a chain of events that led to losses at Long-Term Capital of $4.6 billion in less than four months. Prices for its portfolio assets collapsed -- which shouldn't happen in an efficient market -- and liquidity dried up -- also not part of the theory. The New York Federal Reserve Bank eventually engineered an orderly unwinding of the fund to prevent its problems from rippling out through the global financial system.

Tech stock bubble blows up

There are more recent examples, too. Then-Federal Reserve Chairman Alan Greenspan's decision not to prick the technology bubble in 1998 or 1999 led to irrationally high stock prices, which then collapsed to irrational lows. Where was the efficiency to a market that valued Cisco Systems (CSCO, news, msgs) at $80.06 a share on March 27, 2000, and at $8.60 on Oct. 8, 2002?

Surely one, or perhaps both, of these prices is better explained by the behavior of lemmings leaping into the ocean than by the rational decision-making of efficient market theory.

Debt derivatives trigger panic

And now in the current crisis, investors have received a painful refresher course in how panic -- by definition neither efficient nor rational -- can so dry up market liquidity that there are no prices, efficient or otherwise, for some assets at all. It's hard to get to price equilibrium when no one is bidding.

Fox's book also makes it depressingly clear why, despite its failures and its role in global financial disasters, efficient market theory isn't about to go away. The theory provides a set of mathematical formulas that let people on Wall Street calculate price and quantify risk for things like options and their increasingly complex descendents in the derivatives world. And the bottom line on Wall Street is that if you can price a product and give it a risk rating, you can sell it.

After watching the flood of profits created by new products that priced the risk of mortgage-backed assets, do you doubt that for a moment?

And as we know so clearly, the rewards for creating profitable instruments based on this flawed theory far outweigh the punishment for being wrong. Sure, a Lehman Bros. (LEHMQ, news, msgs) goes under, but life and bonuses go on at Goldman Sachs (GS, news, msgs) and even at Merrill Lynch.

[Jul 20, 2009] Ketchup and the housing bubble - Paul Krugman Blog

My God, how a person who is a university professor (and Eugene Fama is a university professor) can be such an idiot ?

I'm working on the relationship between economic theory and the current crisis, and one thread obviously involves the role of efficient market theory in breeding complacency. So I ran across this revealing late-2007 interview with Eugene Fama. In it, Fama dismisses the whole idea of bubbles:

Well, economists are arrogant people. And because they can't explain something, it becomes irrational. The way I look at it, there were two crashes in the last century. One turned out to be too small. The '29 crash was too small; the market went down subsequently. The '87 crash turned out to be too big; the market went up afterwards. So you have two cases: One was an underreaction; the other was an overreaction. That's exactly what you'd expect if the market's efficient.

The word "bubble" drives me nuts. For example, people say "the Internet bubble." Well, if you go back to that time, most people were saying the Internet was going to revolutionize business, so companies that had a leg up on the Internet were going to become very successful.

I did a calculation. Microsoft was an example of a corporation that came from the previous revolution, the computer revolution. It was hugely profitable and successful. How many Microsofts would it have taken to justify the whole set of Internet valuations? I think I estimated it to be something like 1.4.

And he expresses confidence over housing (rather late in the game, wouldn't you say?):

Housing markets are less liquid, but people are very careful when they buy houses. It's typically the biggest investment they're going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.

What this made me think of was an old paper by Larry Summers mocking finance economists as the equivalent of "ketchup economists", who believe that they've demonstrated market efficiency by showing that two-quart bottles of ketchup always sell for twice the price of one-quart bottles.

In the case of housing, buyers do carefully compare prices - with the prices of other houses. That is, they make sure that two-quart bottles of ketchup are the same price as one-quart bottles. As we've seen, however, they don't do a very good job of checking whether the overall level of housing prices makes sense.

Yes, it was a bubble - and as Larry said way back when, the ketchup test just isn't enough.

[Jul 17, 2009] Economics What went wrong with economics The Economist

Jul 16th 2009 | Economist

Rational fools

These important caveats, however, should not obscure the fact that two central parts of the discipline-macroeconomics and financial economics-are now, rightly, being severely re-examined (see article, article). 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.

So there were caveats aplenty. But as insights from academia arrived in the rough and tumble of Wall Street, such delicacies were put aside. And absurd assumptions were added. No economic theory suggests you should value mortgage derivatives on the basis that house prices would always rise. Finance professors are not to blame for this, but they might have shouted more loudly that their insights were being misused. Instead many cheered the party along (often from within banks). Put that together with the complacency of the macroeconomists and there were too few voices shouting stop.

[Jul 7, 2009] In defence of EMH by Neil Hume

Jul 06 | FT Alphaville

Marco Annunziata, chief Economist at UniCredit Group, has fired a couple of rounds at critics of efficient markets hypothesis, including Soc Gen's GMO's James Montier and the FT's Gillian Tett.

He says simplistic attempts to throw EMH out of the window will not help improve our understanding of financial markets or strengthen institutions to limit the risk of future crisis.

The full piece (including a useful bibliography) can be found in the Long Room, but this summary provides a good overview of his argument.

To sum up: it is disingenuous to argue that universal and uncritical acceptance of the EMH was at the root of the crisis. The EMH has been challenged and criticized for the last thirty years, in a controversy that is still unresolved, and will not be resolved by the current crisis either. If anything, the crisis has been fuelled by behaviors that displayed a blatant disregard for the EMH.

The latest bubble confirms that markets can be frighteningly efficient at amplifying periods of collective madness with disastrous consequence, and that the ideas of behavioral finance, bounded rationality and evolutionary psychology among others are extremely relevant to the analysis of financial markets.

But the EMH's basic underlying notion that if there are obvious opportunities to earn excess risk-adjusted returns people will flock to exploit them until they disappear is as reasonable and common-sense as anything put forward by the EMH critics. Systematically beating the market remains awfully hard, and the EMH remains an extremely useful working hypothesis. Augmenting it and improving it is extremely desirable, discarding it as hopelessly flawed and irrelevant would be just plain stupid.

Related link:
The Dead Parrot of Finance - Long Room
Promote one who welcomes the death of EMH - FT Alphaville

This entry was posted by Neil Hume on Monday, July 6th, 2009

  1. PiotrC Jul 6 21:20

    The idea of fully efficient market is inherently contradictory. In order to remove market inefficiencies we must have traders who are motivated to exploit them. But if the market is perfectly efficient there is no possibility to make excess profits. While efficiency might be true at first order, it cannot be true at second order: There must be on-going violations of efficiency that are sufficiency large to keep traders motivated. The misconception of efficient market is even obvious now than ever before, because it was the intervention of the authorities that prevented financial market from the total meltdown, not the market themselves. Indeed non-equilibrium nature of the markets is especially visible in the sharp price movements occurring at the booms and (especially) crashes which are accompanied with massive price jumps.

  2. ! Report

    DavidG Jul 6 21:03

    The efficient markets hypothesis is not wrong, just oversold. Like Value-At-Risk, it's true most of the time, but probably not true when you need it the most. This body of thought is great for daily risk management, but not useful for estimating losses in market dislocations.
  3. ! Report

    Ginger Yellow Jul 6 15:53

    "the EMH's basic underlying notion that if there are obvious opportunities to earn excess risk-adjusted returns people will flock to exploit them until they disappear "

    That's a very, very weak version of the EMH, though, to the extent that it's almost a tautology. For the EMH to have any explanatory power, it has to incorporate some variation of the idea that markets price in all available information as a result of the sorts of arbitrage described above, not just obvious ones. I mean, even a stupid central planner can spot obvious opportunities.

  4. ! Report

    Carlomagno Jul 6 15:48

    He's trying to have his cake and eat it too. Doesn't make sense.

[Jul 4, 2009] Woefully Misleading Piece on Value at Risk in New York Times

naked capitalism

Anonymous said...

I always thought that the EMH is exactly that the market is a discounting mechanism. A classic MBA Finance problem is: Company X announced that their earnings dropped by 5%, yet the market value of the firm rose by 10%. How is that consistent with the semi-strong version of the EMH?

The answer is 'Because the market expected that the earnings would drop by 15%, so a 5% drop is good news, causing the price to rise.'

I am not defending the EMH here or arguing that it is true in reality, but instead saying I don't understand how the discounting mechanism point is inconsistent with the EMH. So I am confused, not arguing. Maybe I just don't know what you mean by the discounting mechanism.

[Jul 4, 2009] Deprogramming the cult of the Efficient Market

February 25, 2009 | Information Processing

Another great EconTalk podcast, this time a discussion with Alan Meltzer of CMU, a leading expert on monetary policy and the history of the Federal Reserve, and a confidante of officials like Alan Greenspan.

At about minute 45 of the podcast we are treated to a revealing 10 minute dialog between Meltzer, a member of the cult of Efficient Markets (EM), and recovering cult member Russ Roberts (host of EconTalk and GMU econ professor), who is starting to realize that reality diverges from the teachings of the cult. Meltzer's thesis is that reckless behavior by bank executives was largely driven by expectations that they would be bailed out in case of disaster. He claims this crisis was caused by moral hazard and the banksters knew full well the risks they were taking. (And the pension funds and sovereign wealth funds that also bought the toxic stuff? Were they expecting a bailout too?) Russ wonders whether top executives really understood the structured finance of mortgages, perhaps neglected fat tail events, perhaps were irrationally overconfident. Roberts' points sound very "behavioral" and not at all EM.

Meltzer cannot bear to admit that the market is not all-knowing. Throughout most of the podcast he steadfastly maintains that current share prices of banks give an implicit (and more accurate than any other) valuation of the complex mortgage securities on their books. This is about as nutty as the thinking that got us into the crisis in the first place! The markets have been valuing CDO tranches from the beginning; why did they get it so wrong for so long? Now people trading bank equity have got it right? (How many are just gambling on probabilities of different rescue / nationalization outcomes?) Meltzer even mentions that the Fed rescue of LTCM was a source of moral hazard, neglecting the fact that the investors and principals were completely wiped out in the rescue.

Russ has made great progress in his thinking during the last few years of doing EconTalk interviews. It's a tribute to his intellectual honesty and common sense that he can, at this advanced age, overcome the conditioning he received from his education within the Chicago EM cult. Most cult members are more like Meltzer. He cannot abandon the faith, even in the face of a market failure of these historical proportions.

But of course it is Meltzer I see on national TV, holding forth with utter certainty on the crisis. For some reason it is he, not Russ, who gets to make expert predictions.

Posted by Steve Hsu at 1:10 PM 10 comments Links to this post

Labels: behavioral economics, economics, efficient markets, expert prediction, finance

The Myth of the Rational Market By Barry Ritholtz

June 6, 2009

In this morning's NYT, Joe Nocera takes on one of my favorite subjects: Why the market is neither rational nor efficient.

He does a nice job, interviewing both Jeremy Grantham and Burton Malkiel. Along the way, he mentions Justin Fox's new book, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.


"In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices - meaning that perhaps the market isn't quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.

These days, you would be hard-pressed to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient. Yet Mr. Grantham, who was a critic of the efficient market hypothesis long before such criticism was in vogue, has hardly been mollified by its decline. In his view, it did a lot of damage in its heyday - damage that we're still dealing with. How much damage? In Mr. Grantham's view, the efficient market hypothesis is more or less directly responsible for the financial crisis.

I prefer Res Ipsa Loquitur, but hey, its all Latin to me.

I am about halfway through The Myth of the Rational Market, and so far, its good wonky fun. (Justin, there's your pull quote: good wonky fun"). When I'm finished, I will post a review, though I expect my experience in writing a book to have eliminated all objectivity when it comes to reviewing other books.

Poking Holes in a Theory on Markets
NYT, June 5, 2009

[Jun 5, 2009 ] Talking Business - Poking Holes in a Theory on Markets - By JOE NOCERA

June 5, 2009 |

For some months now, Jeremy Grantham, a respected market strategist with GMO, an institutional asset management company, has been railing about - of all things - the efficient market hypothesis.

"Our default reflex is that the world knows what it is doing," says Jeremy Grantham, a market strategist with GMO.

You know what the efficient market hypothesis is, don't you? It's a theory that grew out of the University of Chicago's finance department, and long held sway in academic circles, that the stock market can't be beaten on any consistent basis because all available information is already built into stock prices. The stock market, in other words, is rational.

In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices - meaning that perhaps the market isn't quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.

These days, you would be hard-pressed to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient. Yet Mr. Grantham, who was a critic of the efficient market hypothesis long before such criticism was in vogue, has hardly been mollified by its decline. In his view, it did a lot of damage in its heyday - damage that we're still dealing with. How much damage? In Mr. Grantham's view, the efficient market hypothesis is more or less directly responsible for the financial crisis.

"In their desire for mathematical order and elegant models," he wrote in his firm's quarterly letter to clients earlier this year, "the economic establishment played down the role of bad behavior" - not to mention "flat-out bursts of irrationality."

He continued: "The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. 'Surely, none of this could be happening in a rational, efficient world,' they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking."

(Mr. Grantham concluded: "Well, it's nice to get that off my chest again!")

I couldn't help thinking about Mr. Grantham's screed as I was reading Justin Fox's new book, "The Myth of The Rational Market," an engaging history of what might be called the rise and fall of the efficient market hypothesis.

Mr. Fox is a business columnist for Time magazine (and a former colleague of mine) who has long been interested in academic finance. His thesis, essentially, is that the efficient marketeers were originally on to a good idea. But sealed off in their academic cocoons - and writing papers in their mathematical jargon - they developed an internal logic quite divorced from market realities. It took a new group of young economists, the behavioralists, to nudge the profession back toward reality.

Mr. Fox argues, echoing Mr. Grantham, that the efficient market hypothesis played an outsize role in shaping how the country thought and acted in the last 30-plus years. But Mr. Fox parts company with him by also arguing that the effect wasn't necessarily all bad. As for the question of whether an academic theory hatched in Chicago led to the financial crisis, suffice it to say that some questions can never be answered definitively. Which isn't to say they shouldn't be asked.

"There are no easy ways to beat the market," Mr. Fox said when I spoke to him a few days ago. If you want to point to the single best thing the efficient market hypothesis taught us, that is the lesson: we can't beat the market. Indeed, the vast majority of professional money managers can't beat the market either, at least not on a regular basis.

As Mr. Fox describes it, much of the early academic work that led to the efficient market theory was aimed at simply showing that most predictive stock charts were glorified voodoo - just because a pattern had developed didn't mean it would continue, or even that it had any real meaning. Dissertations were written showing how 20 randomly chosen stocks outperformed actively managed mutual funds. (Hence the phrase "random walk," to connote the near impossibility of beating the market regularly.) Mr. Thaler, the Chicago behavioralist, says that evidence on this point - "the no free lunch principle," he calls it - is clear and convincing.

In time, this insight led to the rise of passive index funds that simply matched the market instead of trying to beat it. Unless you're Warren Buffett, an index fund is where you should put your money. Even people who don't follow that advice know they should.

As it turns out, Mr. Grantham was an early advocate of index funds, mainly for unsophisticated investors who have no hope of beating the market. But he also believes that professionals should do better precisely because, as he puts it, "the market is full of major league inefficiencies."

"There are incredible aberrations," he told me over lunch not long ago. "The U.S. housing market in 2007. Japan in the 1980s. Nasdaq. In 2000, growth stocks were three times their fair value. We were quoted in The Economist in 2000 saying that the Nasdaq would drop by 75 percent. In an efficient world, you wouldn't have that in a lifetime. If the market were truly efficient, it would mean that growth stocks had become permanently more valuable."

As Mr. Grantham sees it, if professional investors had been willing to acknowledge these aberrations - and trade on the fact that the market was out of whack - they should have been able to beat the market. But thanks to the efficient market hypothesis, no one was willing to call a bubble a bubble - because, after all, stock prices were rational.

"It helped mold the 'this time it's different' mentality," he said. Indeed, professional money managers who tried to buck the tide wound up losing their jobs - because everybody else was making money by riding the bubble for all it was worth. Meanwhile, government officials, starting with Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble. "Our default reflex is that the world knows what it is doing, and that is extravagant nonsense," Mr. Grantham said.

But as much as I've admired Mr. Grantham's writings over the years, I think the truth, in this case, is a little more subtle. Given the long history of bubbles, I suspect this crisis would have taken place with or without the aid of the efficient market hypothesis. People thought "it's different this time" in the 1920s, long before anyone was writing about efficient markets. And over the course of history, professional money managers have been just as fearful of bucking the trend as they were during the Internet bubble.

Mr. Fox sees it somewhat differently. On the one hand, he says, the efficient market theoreticians always assumed that smart market participants would force stock prices to become rational. How? By doing exactly what they don't do in real life: take the other side of trades if prices get out of whack. Their ivory tower view reflected an idealized market that simply doesn't exist.

On the other hand, Mr. Fox says, what was truly pernicious about the efficient market hypothesis is the way it allowed us to put asset prices on a pedestal that they never deserved. Stock options - supposedly based on a rational price - became prevalent in part because higher stock prices were supposed to be the rational reward for good performance.

Or take the modern emphasis on market capitalization. "At some point in the early 1990s (or maybe it was in the late 1980s), market capitalization became accepted as the best measure of a company's importance," Mr. Fox wrote me in an e-mail message. "Before then it was usually profits or revenue. I think that's a classic example of the way efficient market theory seeped into popular discourse and shaped how we perceived the world. It wasn't entirely stupid - profits and revenue are flawed, limited measures, and market value does tell you something useful about a company. But it was another one of the ways in which asset prices came to rule the world, which eventually turned out to be a bad thing."

A few days ago, I called Burton G. Malkiel, the Princeton economist, to ask him what he thought of Mr. Grantham's theories. Mr. Malkiel is the author of "A Random Walk Down Wall Street," surely one of the greatest popularizers of any academic theory that's ever been written.

"It's ridiculous" to blame the financial crisis on the efficient market hypothesis, Mr. Malkiel said. "If you are leveraged 33-1, and you're holding long-term securities and using short-term indebtedness, and then there's a run on the bank - which is what happened to Bear Stearns - how can you blame that on efficient market theory?"

But then we started talking about bubbles. "I do think bubbles exist," he said. "The problem with bubbles is that you cannot recognize them in advance. We now know that stock prices were crazy in March of 2000. We know that condo prices were nuts."

I thought to myself: if a smart guy like Burton Malkiel had to wait for the Internet bubble to end to realize we had been in one, then maybe Mr. Grantham has a point after all.

See also

Pointing Fingers by JUSTIN FOX

Good Times

After a year of epic financial crisis, 2009 will - if all goes well - be a time for digging ourselves out of the mess and figuring out how to prevent a repeat. Before we can do that, we have to have some idea of what went wrong. People are still arguing about what caused the Depression of the 1930s, so don't expect a definitive diagnosis anytime soon. But here's my current list of blame, or at least the first dozen items on it, in descending order of culpability.

Hardly anyone expected things to go wrong because things hadn't gone truly, pants-wettingly, oh-my-god wrong on the financial front in the U.S. since the 1930s. Yes, there had been deep stock-market slumps in the 1970s and early 2000s, real estate busts in the 1980s and early 1990s, and occasional short-lived financial scares like the Asian crisis of 1997. But the U.S. hadn't been through a serious panic in the memories of most everyone on Wall Street and in government.

We began to behave as if one couldn't happen; we were told it couldn't. Blithe behavior begat trouble. The upside is that everybody is now so shell-shocked that we probably don't have to worry about a repeat anytime soon.

Alan Greenspan

It was to smother financial panics that Congress created the Federal Reserve in 1913. During Alan Greenspan's tenure as chairman, the Fed jumped in to keep the 1987 stock-market crash, the 1998 Long-Term Capital Management scare and the 2000-01 tech-stock collapse from spiraling into something worse. But that very successful firefighting fostered the risk-ignoring attitudes that brought on a conflagration. There are some - like 2008 presidential candidate Ron Paul - who argue that the lesson here is that we'd be better off without the Fed. A more palatable interpretation is that if the Fed is going to step in to prevent panics, it needs to do more to deflate the bubbles that inevitably precede those panics. Fed policy over the past quarter-century has been asymmetrical: it bailed institutions out of trouble but did ever less to restrain them during fulsome times. That has to change.

Twisted Regulation

What has happened in the financial sector since the 1970s isn't exactly deregulation. Banks have remained as closely supervised as ever. But new institutions that grant mortgages, lend money, fund deals - businesses once monopolized by banks - have been allowed to grow with little oversight. Lawmakers and regulators responded in the 1990s not by setting parameters for these new players - investment banks, hedge funds, private-equity funds, etc. - but by giving bank-holding companies more freedom to enter underregulated lines of business. The perverse result was that the new and untested gained an unfair advantage over the tried and true.

Wall Street

The shift of financial activity from bank balance sheets to the off-balance-sheet realm of securitization and derivatization loosely defined as Wall Street wouldn't have been such a disaster if it had actually worked as advertised - spreading risk, encouraging innovation, bringing the best minds to bear on the biggest financial problems. Instead, Wall Street's leaders did an atrocious job - rewarding the foolhardy, steering capital to the least productive uses and running away from responsibility for their errors. And they got paid tens of millions of dollars a year for it.

The Homeownership Obsession

During the 2008 election campaign, Republicans attempted to pin blame for the crisis on the Community Reinvestment Act (CRA) and mortgage giants Fannie Mae and Freddie Mac. Nice try: there's virtually no evidence to back up the CRA charge, and while Fannie and Freddie aren't blameless, they were mostly sidelined during the worst of the mortgage frenzy, from 2003 to 2006. But the decades-long bipartisan government effort to encourage homeownership - of which CRA, Fannie and Freddie were but a small part - did tragically overshoot the mark. Homeownership generally is a good thing. Massively subsidizing it via the tax code might not be so smart. And turning a blind eye to crazy lending practices because they seem to encourage it definitely is not.

Too Much Money

Lots of people worried for years that the gigantic trade deficits the U.S. ran up with first Japan and then China were hurting domestic manufacturers. But the flip side of those trade deficits - gigantic capital flows into the U.S. - may have been even more dangerous. It was the capital gusher from China in particular that inflated the 2000s real estate bubble.

The Myth of the Rational Market

For decades, the accepted academic response to concerns that the economy might be on an unsustainable trajectory was that financial markets knew best. Got a backup? Markets are spectacularly efficient processors of information and opinion. But they also have a tendency (by now well documented) to overshoot on both the upside and the downside.

You and Me

None of this would have happened if millions of us hadn't come to believe we could get something for nothing by taking on debts we couldn't repay. That this misconception was fostered by lenders and politicians is a partial excuse but not a complete one. Thanks to the Panic of 2008, though, we can count on nobody making this mistake again, at least not for a while.

George W. Bush

A lot of the government decisions that led to our current pass were bipartisan. Some were the doing of Democrats. But you can't be a two-term President with your own party in charge of Congress for most of your time in office and escape blame for an economic debacle that unfolds as you prepare to leave town. The specific Bush act that probably contributed most to today's difficulties? His reckless disregard for sound fiscal policy, as his tax cuts and war spending combined to turn budget surpluses into chronic deficits.

Commodity Futures Modernization Act

If you had to pick a single government move that did more than any other to muck things up, it was probably this bill, passed by a Republican Congress and signed into law by lame-duck President Bill Clinton in December 2000. It effectively banned regulators from sticking their noses into over-the-counter derivatives like credit default swaps. There's no guarantee that regulators would have sniffed out the dangers in time. But banning them from even looking sent a pretty clear anything-goes message to OTC derivatives markets.

The Rating Agencies

Their failings were part of the larger inability of Wall Street to do securitization right, and their employees didn't get paid nearly as much as the investment-bank guys engineering the dodgy investment products they rated. That's why the rating agencies aren't in the top 10. But the willingness of Moody's, S&P and Fitch to grant top ratings to untested new securities like collateralized debt obligations made possible a lot of staggeringly dumb deals that otherwise would never have seen the light of day.

Letting Lehman Go

This is a hard one, given that I've already taken the Fed to task for bailing us out so often. But once the precedent had been established with Bear Stearns, Fannie Mae and Freddie Mac, letting Lehman go under in disorderly fashion in September shocked markets and seems to have led to the near financial meltdown that followed. It's not clear exactly how the Fed and Treasury could have managed a better Lehman conclusion, given the laws in place at the time and the lack of a buyer. But what we got was pure bad news.

Refuted economic doctrines #1: The efficient markets hypothesis by jquiggin

January 2, 2009

I'm starting my long-promised series of posts on economic doctrines and policy proposals that have been refuted or rendered obsolete by the financial crisis. There will be a bit of repetition of material I've already posted and I'll probably edit the posts in response to points raised in discussion.

Number One on the list is a topic I've covered plenty of times before (in fact, I was writing about it fifteen years ago), the efficient (financial) markets hypothesis. It's going first because it is really the central microeconomic issue in a wide range of policy debates that will (I hope) be covered later in this series. Broadly speaking, the efficient markets hypothesis says that the prices generated by financial markets represent the best possible estimate of the values of the underlying assets.

The hypothesis comes in three forms.

The hypothesis can be tested in various ways. First, it is possible to undertake econometric tests of its predictions. Most obviously, the weak form of the hypothesis precludes the existence of predictable patterns in asset prices (unless predictability is so low that transactions costs exceed the profits that could be gained by trading on them). This test is generally passed. On the other hand, a number of studies have suggested that the volatility of asset prices is greater than is predicted by semi-strong and strong forms of the hypothesis (note to readers - can anyone recommend a good literature survey on this point).

While econometric tests can be given a rigorous justification, they are rarely conclusive, since it is usually possible to get somewhat different results with a different specification or a different data set. Most people are more likely to form their views on the EMH on the basis of beliefs about the presence or absence of 'bubbles' in asset prices, that is, periods in which prices move steadily further and further away from underlying values. For those who still believed the EMH, the recent crisis should have shaken their faith greatly. But, although the consequences were less severe, the dotcom bubble of the late 1990s was, to my mind, are more clear-cut and convincing example of an asset price bubble. Anyone could see, and many said, that this was a bubble, but those, like George Soros, who tried to profit by shortselling lost their money when the bubble lasted longer than expected (perhaps long-dated put options would have provided a safer way to bet on an eventual bursting of the bubble, but Soros didn't try this, and neither did I.)

More important than asset markets themselves is their role in the allocation of investment. As Keynes (allegedly) said, this job is unlikely to be well done when it is a by-product of the activities of a casino. So, if the superficial resemblance of asset markets to gigantic casinos reflects reality, we would expect to see distortions in patterns of savings and investment. The dotcom bubble provides a good example, with around a trillion dollars of investment capital being poured into speculative investments. Some of this was totally dissipated, while much of the remainder was used in a massive, and premature, expansion of the capacity of optical fibre networks (the fraudulent claims of Worldcom played a big role here). Eventually, most of this "dark fibre" bandwidth was taken up, but in investment allocation timing is just as important as project selection.

The dotcom bubble was just one component of a massive asset price bubble that began in the early 1990s and is only now coming to an end. Throughout this period, patterns of savings and investment made little sense. Household savings plunged to zero and below in a number of developed countries (including nearly all English-speaking countries) and the resulting current account deficits were met by borrowing from rapidly growing poor countries like China (standard economics would suggest that capital flows should go in the other direction). The massive growth of the financial sector itself, which accounted for nearly half of all corporate profits by the end of the bubble, diverted physical and particularly human capital from the production of goods and services.

Finally, it is useful to look at the actual operations of the financial sector. Even the strongest advocates of the EMH would not seek to apply it to, say, the Albanian financial sector in the 1990s, which was little more than a series of Ponzi schemes. They would however want to argue that the massively sophisticated global financial markets of today, with the multiple safeguards of domestic and international financial regulation, private sector ratings agencies and the teams of analysts employed by Wall Street investment banks is not susceptible to such systemic problems, and is capable of correcting them quickly as they arise, without any need for large-scale and intrusive government intervention. I'll leave it to readers to make their own judgements (maybe with some links when I get around to it).

Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century. More to follow!

28 Responses to "Refuted economic doctrines #1: The efficient markets hypothesis"

  1. costa

    Nice Post John.

    The EMH never really recovered from the collapse of Long Term Capital Management in the late 90's staffed by some of the modern portfolio theory academics. In fact the writing was on the wall back in the 1987 market crash where portfolio insurance (using black and scholes replicating strategies) contributed to a market meltdown.

    I think it also shows why Eugene Fama has yet to win a nobel prize. But your last sentence is a bit of a leap of faith from EMH to mixed economy. As a general statement - yes, but I think we can agree not too much or perhaps too little. This is the art of a modern mixed economy.

    I think the various financial crises since deregulation enables competing views like behavioural finance, Minsky and even good old Keynes to make a comeback from the likes of Friedman and Schumpeter. I guess it is a good case of mean reversion in Economic theory!

  2. Joseph Clark

    I can't see how this kind of empirical "refutation" of EMH has any practical value. If you misrepresent EMH as a scientific theory then you can't fail to refute it. There will always be some price that does not adjust correctly – for any number of reasons. The fact that anybody is able to earn high wages or profits for any length of time is itself sufficient to disprove that prices are always efficient.

    So what? What makes EMH interesting and useful is its implication that inefficient prices provide opportunities for profit; how quickly or perfectly they adjust to these opportunities is a separate empirical issue. The standard argument that EMH is "falsified" so markets don't work and capitalism is bad (or similar) completely misses the point.

  3. Michael of Summer Hill

    John, recent events suggest 'subsidies' will be part of the government's fiscal armoury necessary to maintain economic growth and/or prop up businesses which are in dire straits. Take for example Russia, the government there has pledged over $200bn this financial year to prop up some 1,500 flagging companies which account for 85% of Russia's GDP. For this very reason I have to agree with you that a 'mixed economy' seems to be more plausible than any other economic system.

  4. P.M.Lawrence

    "Once the EMH is abandoned, it seems likely that markets will do better than governments in planning investments in some cases (those where a good judgement of consumer demand is important, for example) and worse in others (those requiring long-term planning, for example). The logical implication is that a mixed economy will outperform both central planning and laissez faire, as was indeed the experience of the 20th century."

    That's a non sequitur, based on a hidden assumption about the wisdom of state direction in state run areas. It is entirely plausible that the central planning side would also fail, possibly through different causes - and 20th century experience bears this out too (Five Year Plans, anybody? The Groundnut Scheme?). As to whether humbler central planning within a mixed economy worked out better, that's still an open question bearing in mind claims that today's problems were partly driven from that side of things and merely showed up on the private side. I do think it could work - if everybody (central planners included) knew what they were doing, which is another way of doubting it. Failing that, muddling along with some intellectual humility on all sides seems the best bet. Someone once modernised the three laws of thermodynamics as "you can't win, you can't even break even, and you can't get out of the game".

  5. Jim BirchIs there any theoretical justification for the EMH that doesn't sound like it came off the back of a corn flakes packet? As far as I can see it's pure religion: another simple "sounds-good" explanation for something that's actually more complicated than the human brain can handle. It's possibly even a case of a "why the sun comes up every day" superstition that allows you to sleep at night, ie, we're all engaged in this activity so it just can't be crazy.

    Mathematically, EMH says that even though any individual choice may be whacky the (dollar) weighted average choice must somehow be correct. It doesn't follow, does it?

  6. Sinclair Davidson

    Classic evidence on the EMH here. More evidence here.

  7. gerard

    Steve Keen had what I thought was a very good discussion of the EMH in his Debunking Economics book.

  8. Brendan

    PM Lawrence. To illustrate the failure of mixed economies, can you come up with better counter examples than "Five Year Plans, … The Groundnut Scheme"? Otherwise I think you should be less dismissive of JQ's premise.

  9. Brendan

    PM Lawrence, my apologies for thinking you were arguing the examples above were meant to be about a mixed economy- I misread your comment and now see they were not but part of some other thread about the wisdom of central planning.

  10. P.M.Lawrence

    I gave the counterexamples to purer central planning cases since the failures there clearly relate to the central planning, thus showing that planning per se also fails. I then pointed out that mixed approaches may well have failures stemming from that that show up on the private side. Inherently, that would be a lot harder to trace.

  11. jquiggin

    Sinclair, thanks for the refs. The Fama article is useful and stands up surprisingly well after 40 years. I'd agree with his conclusion that weak form efficiency is well supported, strong form implausible and semi-strong important but much harder to test. Still, I'm looking for something more recent than 1969.

  12. jquiggin

    PML, the frequency with which I've seen references to the Ground Nut Scheme (a failed exercise in development assistance 60 years ago) leads me to suspect that there can't be many such extreme failures. Interestingly, Wikipedia gives a see also to a private sector comparator

    But if there is one lesson that ought to have been learned back at Sydney Cove is that governments and agriculture don't mix very well.

  13. Sinclair Davidson

    There is a 1991 follow up piece (by Fama) in the Journal of Finance - December issue (log in would be required for non-uni users) there is a ungated version at SSRN but its down for maintainence over new year.

  14. Brendan Says:
    January 2nd, 2009 at 6:32 pm

    #10 "thus showing that planning per se also fails" … that's drawing a fairly long bow - but then why not go a bit further and say all planning is bound to fail?

  15. Peter Wood

    Evidence that news and volume play a minor role in stock price jumps here.

    Evidence that financial analysts show pronounced herding behaviour is here. According to the abstract - "These results add to the list of arguments suggesting that the tenets of Efficient Market Theory are untenable."

  16. mp Says:
    January 2nd, 2009 at 7:01 pm

    #12 - you can question the degree of the failure, but other examples of govt failure could include WA Inc, the Pyramid Building Society (which had an almost explicit govt guarantee), the Christmas Island Spaceport and the Queensland Magnesium plant.

    On a related point:
    It is clearly a non sequitur to argue that market failure means government intervention will result in a welfare improvement.
    I for one agree that financial markets are clearly imperfect, but governments are far worse at allocating capital.

  17. rog

    Whilst attributing blame for an event to a hypothesis, in this case the GFC to the EMH, is easy it doesn't go to the root cause of the GFC.

    The cause of the GFC is government.

  18. Alanna Says:
    January 2nd, 2009 at 7:08 pm

    How so Rog? The cause of the GFC is government? Please elaborate. I rather thought it was lack of government myself.

  19. Peter Wood

    rog, it does not make sense to talk about the 'root cause' of the GFC. Markets are have complex networked relationships with feedbacks. For complex systems such as these it is difficult to talk about causality, and even more difficult to talk about something as complex as the GFC having a single 'root cause'.

    For example, if governments regulate markets poorly, and this leads to some wild fluctuations, does this mean that government is the cause, or something in the market is the cause? Maybe you could say that government is the cause because if government didn't exist, the GFC wouldn't happen. BUt I suspect that if government didn't exist, the global financial market wouldn't either.

  20. Alanna

    I think mostly everyone would acknowledge government failures in supporting markets that were essentially unviable in the past, or supporting markets for their own political self interest by the quite common porkbarrelling. No one would surely suggest that governments are free of human imperfections. The inadequacies of governments are not under dispute by me - yet what I do dispute (and strongly) is the notion that markets do not fail (or that the markets are free of human imperfections either) and that markets are superior in all aspects to any form of government intervention or planning. We swing from one extreme to another without recognising that governments and markets are not, and should not be considered adversaries. They should progress in an orderly and complementary fashion like shoes and socks. The purpose of government intervention and planning is to assist the smooth functioning of markets which is desirable. Intervention when it is required to protect competition or infrastructure and no intervention when no intervention promotes genuine competition and entrepreneurial abilities. By this I don't mean promotion of the entrepreneurial abilities of only the largest (and already established / concentrated / monopolistic) firms. The encouragement of smaller entrepreneurs is much needed and has been somewhat lacking (what unnecessary time does a BAS take to a builder starting out??). There has been far too much government kow towing to firms with the financial wherewithall to lobby hard, and not nearly enough assistance given to small businesses.

  21. kitchenslut

    I think its good to see some acknowledged concensus here on the weak form of the EMH as its a theory which has always been poorly presented and abused in the media ie: it means the market is always correct …. which it doesn't at all.

    This has also been used as a reason to use index funds however my perception is that this would have also led you into the biggest bubbles ie Nasdaq 2000. There is a reference above to analysts herding being a refutation of EMH which I would have thought is no refutation at all and may in fact be confirmation from another perspective?

    Not sure how the Dimenmsional Funds are travelling these days but as far as I know were associated with Fama (quoted above) and I used to regard these as "EMH with a brain"?

  22. Marginal Notes

    Presumably the EMH is meant to apply to rural land values as well, but casual observation suggests that rural property values pretty much factor in a long-term projection of the current price for the commodity in question, especially on a rising market - witness the boom in sugar land values in Queensland in the 1990s. Since the most optimistic (least far-sighted?) bidder makes the purchase, how can the 'market' be rational? It is bound to overshoot.

  23. rog

    As EMH is a hypothesis it has yet to be properly tested.

  24. rog

    There has been no failure of the market - it has efficiently priced the risk as it became known. As govts increase their intervention we can be assured of greater price movements - govts are not known for their efficiency.

  25. d4winds

    (1) a pure "animal spirits" explanation of stock market fluctuations (inclusive perhaps but not necessarily requisite of "herding") with no or an extremely tenuous relationship between the real economic value of capital resources and stock prices can be consistent with semistrong or weak EMH.
    (2) EMH efficiency is a pure TRADING efficiency argument, that is necessary for but by no means sufficient for economic efficiency in capital allocation.
    (3) The jump from EMH to allocative efficiency of markets ("..they're better than any other possible capital allocation method…") is not prima facie false, owing to (2), but neither is it justified, owing to (1).

  26. Will

    Perhaps the problem is not with our ability to determine prices but the whole idea that the secondary market prices of financial assets are important or even relevant. Is the EMH something we should even care about?

    Financial assets represent the right to receive a series of cash flows over some extended period of time, and which are ultimately generated by some real productive enterprise. Maybe the financial system would be in better shape today if it was recognized that the relevant test of an investor is how the actual long term cash flow compares with it's original expectations.

    This is quite different from investment performance based on the secondary market price of financial assets, which is a second order property of the assets affected by many factors other than just the underlying real productive enterprise.

    To say that short-termism is bad is not simply a slogan; financial assets like shares and bonds are long term, and it is ultimately wrong for short term investors to be buying them if they can't hold them for the long term. In other words, why should short term investors expect that someone else will always be willing to buy them out of their long term investments? Ponzi, anyone?

    If you have a short term investment horizon, as many people do, then we have banks to intermediate deposits into long term loans, through the magic of the law of large numbers (average deposit inflows and outflows should be relatively constant over the long term) and the presence of a lender of last resort.

  27. Carl Futia

    If you substitute the words "no free lunch" for "efficient markets" you typically find much more public acceptance of the hypothesis. After all, it's main prediction is that markets rarely make EXPLOITABLE mistakes, i.e. mistakes that can be recognized as such when they occur and that can be exploited via some investment strategy that is spelled out in advance.

    As far as I can tell this prediction has enormous empirical support.

    The hypothesis that public officials can outguess the financial markets because they know more about the future course of the economy has exactly zero evidence to support it.

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