Tuesday, August 18, 2009

God save the Queen, and the economists

Richard Posner writes in the Atlantic. Read the whole thing!

I doubt academic economists are to blame for the crisis in any direct sense -- the real perps are on Wall Street and Main Street -- but they do deserve blame for the "ideological capture" of regulators and policy makers, many of whom, through years of indoctrination in undergraduate and professional school courses have come to believe in a semi-strong version of efficient markets (see below). The academics also deserve blame for intellectual dishonesty if they fail to admit that we know almost nothing about macroeconomics and that the profession itself cannot agree on what caused the crisis and how best to recover.

Will Economists Escape a Whipping?

It is remarkable how economists have been able to deflect blame for the economic crisis that erupted last September with the sudden collapse of the international banking industry and that continues to afflict the world's economies. Last November, Queen Elizabeth visited the London School of Economics and asked the faculty why "nobody [had] noticed [before September 2008] that the credit crunch was on its way?" ...

Yesterday, another letter to the Queen, this one dated August 10 and signed by ten English and Australian economists, was released ..., also responding to the Queen's question ... The August 10 letter states that "their overall analysis is inadequate because it fails to acknowledge any deficiency in the training or culture of economists themselves." The nub of their criticism is that "in recent years economics has turned virtually into a branch of applied mathematics, and has...become detached from real-world institutions and events." They criticize economics education as excessively narrow, "to the detriment of any synthetic vision," and fault Besley and Hennessy for saying nothing about "the typical omission of psychology, philosophy or economic history from the current education of economists" and for mentioning neither "the highly questionable belief in universal 'rationality' nor the 'efficient markets hypothesis.'"

A more focused criticism would, in my opinion, be more effective. The Queen was asking about the failure to foresee the financial collapse of last September, rather than about the health of modern economics in the large. That failure was I think due in significant part to a concept of rationality that exaggerates the amount of information that people have about the future, even experts, and to a disregard of economic factors that don't lend themselves to expression in mathematical models, or are intractable to formal analysis. The efficient markets theory, when understood not as teaching merely that markets are hard to beat even for experts and therefore passive management of a diversified portfolio of assets is likely to outperform a strategy of picking underpriced stocks or other securities to buy and overpriced ones to sell, but as demonstrating that asset prices are always an adequate gauge of value--that there are not asset "bubbles"--blinded most economists to the housing bubble of the early 2000s and the stock market bubble that expanded with it. In modeling the business cycle, economists not only ignored, because difficult to accommodate in their mathematical models, vital institutional detail (such as the rise of the "shadow banking industry," which is what mainly collapsed last September)--often indeed ignoring money itself, on the ground that it doesn't really affect the "real" (that is, the nonfinancial) economy. They also ignored key concepts in Keynes's analysis of the business cycle, such as hoarding and uncertainty and business confidence ("animal spirits") and worker resistance to nominal (as distinct from real) wage reductions in depressions. Lessons of economic history were ignored, too, leading to a belief that there would never be another depression, let alone a collapse of the banking industry. Even when the collapse occurred, in September, many macroeconomists denied that it would lead to anything worse than a mild recession; the measures that the government has taken to recover from what has turned into a depression owe little to post-Keynesian economic thinking; and the economists cannot agree on what further, if anything, should be done, and which of the government's recovery measures has worked or will work.

Besley and Hennessy's letter, when first published, was described in some quarters as a letter of "apology" by English economists. It was not that; nor is the August 10 letter--the latter is a denunciation of mainstream economics.

The notion of a profession's apologizing for its failure in a letter to the monarch is charming, however. It would be an apology to the nation, personified in its monarch. The English monarch does not exercise political power, but does personify the nation, and it is easier to write a letter to a person than to a nation.

The English economics profession failed the United Kingdom; the American economics profession failed the United States. Not that the profession should be equated to its macroeconomic and financial divisions. The study of business cycles is only a small part of modern economics. Other areas of economics bear significantly on the study of business cycles, such as labor economics, without being implicated in the failures of response to the current crisis. But the control of the business cycle had until the present crisis been regarded as a principal triumph of modern economics and justification for regarding economics as the queen of the social sciences. We have no monarch; the President is not a personification of the nation but rather the head of the national government; there is no one to write the letter of apology to. No matter. The urgent need is for the part of the profession that concerns itself with business cycles to acknowledge its inadequacies and reorient its training and research.


Economic Perspectives from Kansas City said...

See also an interesting post "Keynes's Relevance and Krugman's Economics" on the blog Economic Perspectives from Kansas City.

The link to the post is

The blog is http://neweconomicperspectives.blogspot.com/

Carson C. Chow said...

As I posted on my blog recently, I think this thing you call intellectual dishonesty is due to a faulty prior. In that sense it is less dishonesty as it is having a world view that may be at odds with reality. I also don't think that once set the prior can be corrected. Our only hope is for a new generation with a new prior to take over.

Unknown said...

The U. of Chicago school in particular has revealed itself to be a complete fraud, and is in the deepest state of denial.

Steve Hsu said...


Perhaps I misunderstood your example, but it seems to me that having exactly zero probability in your prior for a particular state of the world is intellectually dishonest. How would someone justify that assumption to a colleague (or in a meta-analysis), except to admit that they were an ideologue?

Carson C. Chow said...

My whole point was that if you ever had a zero in your prior that can never be rescued. So, you can call it dishonest if you wish but the whole point is that they can never be convinced. To me dishonesty, would be knowing you are wrong but not admitting it. I think the first generation may have been dishonest in that respect but the second and third generations actually have it built into their priors.

Ian Smith said...

Economists will never be able to predict the future unless no one believes their predictions or no one hears them. Expectations affect the outcome in economic matters. In matters of natural science they have no effect. Soros calls this "reflexivity".

The efficient market bias has a deeper motivation than ideology. That is, if the market is efficient academic economists have an excuse for not being rich.

Soros and Paulson understand more on economic matters than any professor.

CW said...

Carson Chow: "... the whole point is that they can never be convinced."

I would think one must define intellectual honesty in science to encompass a readiness to consider seriously what would signal a faulty prior.

Carson C. Chow said...

I understand your sentiment but I would call it intellectual dysfunction rather than dishonesty.

CW said...

PS: Steve, the article link is to TheAtlantic.com, and does indeed appear to point to Posner's piece. Did I miss something in the reference to the FT?

Steve Hsu said...

Chris: Oops, fixed.

LondonYoung said...

The Wikipedia Page "United States Housing Bubble" was created on 21May2005. "British Property Bubble" was created 21Jun2004.
The very first version of British Bubble pointed out that many analysts were warning of a collapse. In November of 2004, as floating rate mortgages flooded the market and revolving credit blossomed, economist-in-chief Alan Greenspan said that anyone not hedging their exposure to short term credit conditions "obviously is desirous of losing money". This same dude described equity levels before the internet crash as being "irrationally exuberant", and indeed, they had gone back up to those levels again.

One of Steve's themes here, I think, is that market prices are not good indicators of "fair value" - and amen to that. But I am not sure what Posner is looking for economists to have done that they didn't do. I strongly disagree with Posner that there was a consensus claim that "control of the business cycle" had been achieved.

knappador said...

Paul Ormerod wrote "The Death of Economics" quite a few years back. I think he's gained quite a bit of prestige from the last year.

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