Saturday, January 09, 2010

The Chicago School and the financial crisis

New Yorker economics correspondent John Cassidy has a very balanced piece about the impact of the credit crisis on thinking at The Chicago School. He also uses the term apostasy to describe Posner's turn toward Keynes.

In the article, Heckman, Becker and Rajan seem the most reasonable. Fama is obviously clinging to his priors and Lucas refused to talk to Cassidy.

Cassidy makes additional remarks on his blog, and promises in the near future to publish more detailed notes on the interviews he did with the Chicago economists.

... For people interested in the subject, and there seems to be a lot of you, the good news is that I’m planning on posting here much fuller versions of the interviews I did in Chicago, with the likes of Gene Fama, Gary Becker, and Richard Posner, who recently converted to Keynesianism. It’s the nature of long-form magazine journalism that a lot of interesting stuff gets left out of the finished article, but, thanks to the Web, there’s no reason it shouldn’t appear in some form. Plus, I think it’s a good time to let the Chicago economists speak for themselves. Over the last couple of years, they have taken a battering at the hands of myself, Paul Krugman, Joe Stiglitz, and others. Having just finished writing a book entitled “How Markets Fail,” I went to the Windy City eager to learn first hand how the critiques of Chicago economics were being received. Some of what I was told, I don’t agree with, but at this time of intellectual tumult I think it makes fascinating reading.

In the article Posner notes that few economists knew anything about how real financial markets work. This is certainly true in my experience. In particular, they were naive about individual incentives within the system (see Greenspan comments), and very few academics (with perhaps one or two exceptions; video) had any idea what a CDO or CDS was before 2008. I can't resist a little sniping here. If you want to ask someone about electrons, or how to build a quantum logic gate, or how to fabricate nanostructures, you can't do much better than to head to your local research university and talk to a physics professor. Strangely, if I wanted to learn something about credit markets or securitization or the risk from speculative bubbles, I would have been better off talking to a former physicist on Wall St. than to almost any professor in an economics department or business school. I'm not exaggerating -- I've done both many times. Posner also says:

"Well, one possibility is that they [the economists] have learned nothing [from the financial crisis] ... Because -- how should I put it -- because market correctives work very slowly in dealing with academic markets. Professors have tenure. ... It takes a great deal to drive them out of their accustomed way of doing business."

For more, see my talk on the financial crisis.


Ian Smith said...

"Posner's turn toward Keynes"

"Richard Posner, who recently converted to Keynesianism"

"this time of intellectual tumult"

These people are absurd. The real job of freshwater profs is party ideologist.

"few economists knew anything about how real financial markets work"

Exactly! Reality can't be allowed to get in the way of ideology.

These people could be taken more seriously as modern art critics.

Seth said...

Cassidy's article is quite a good piece of journalism. Well above the usual run of economic journalism I see. It actually brings you into contact with a diverse set of opinions articulated by their prominent advocates without degenerating into a content free story about people emoting at each other.

There are several quite telling remarks from Cassidy's 'witnesses'.
Fama for instance falling back on:
"We don't know what causes recessions." It's like saying "of course I was wrong, none of us have a clue!"

And his 'just so story' about income growth stalling (mysteriously)and then causing defaults which caused the financial crisis is a characteristic bit of Chicagoan sophistry. If I borrow far more than I can afford to pay except under the very best possible market conditions, is it really so 'mysterious' that I wind up unable to pay? If I build a bridge that depends on 'no earthquakes' to stand up, would you accept a 'stuff happens' shrug from me after it falls down?

To my mind, Fama has confessed to being an intellectual grifter. He knows his academic work is not particularly connected to reality, but so what? Academics are just players in elaborate language games. Not members of an engineering discipline that might be capable of reliably producing value. (Shocked! Shocked! I know :)

As for why recessions happen, has any economist thought to ask "why are there waves in the ocean"? Why do equilibrium conditions ever fail to hold? Cassady also quotes Raghuram Rajan attributing the 'fault' to economists' failure to examine what he calls the "plumbing". Economists tend to call this 'institutional economics' and it certainly seems to have gotten too little attention in recent years. And for quite self-interested reasons: it's too controversial, too political, too risky. (Maybe too hard, as well.)

One other excellent point was Cassady's explanation of Lucas' take on persistent mass unemployment. Keynes wrote famously of "stickiness" of prices, particularly wages. Explaining this stickiness by saying workers chose not to accept lower bids isn't to deny stickiness! It really isn't a disagreement with Keynes at all. Just a reflexive insistence that the little guy must be at fault.

But an institutional perspective might help one to realize that when the market for labor has become *illiquid*, there may not BE a lower bid to 'hit'. If your theory depends on deep, liquid markets for its very logical coherence, then it behooves you to notice when the necessary conditions are not met.

Gee, economics isn't a hard science. In other news today, Generalissimo Francisco Franco is STILL dead :)

AlchemX said...

Attacks against free-market academics are always funny. History has shown that the markets with the most freedom always prevail.

Cassidy's ideas might hold if the U.S. were in a vacuum with its regulations on the free market. At least our inefficiencies could not be exploited by another nation. But that game is changing in the Post-Cold War era. China and India are relaxing their control and making Keynesian ideas and central planning much more costly.

Keynesian economics is good for a short term boost, but in the long term it creates inflation, which leads to another bust (sometimes in sporadic areas). The idea that the free market caused the bust is stupid. A lot of regulations were introduced, even after Glass-Steagall was repealed. And a lot of collusion (aka crony capitalism) has occurred.

Asking free market economists to comment on all the terminology of Wall St. is like asking an astronomer how palladium couplings work. The Keynsians lose the forest for the trees everytime.

Free market economists don't see a free market in today's world. Today's economy is one infused with government subsidies, regulations, collusion and institutions that have made it a ticking time bomb.

AlchemX said...

Well, I'll let a Chicago guy explain it.

Seth said...


I'm relieved to hear you aren't a fan of despotism. Me neither. Please don't beat your spouse, either. It's not nice.

Keynes was a free-market economist. Just not so inclined to harp on the evils of government while ignoring the human failings of private corporations. The tendency to collude (hey, it's sometimes easier than competing!) hardly requires government assistance. At least as often it requires government to look the other way. "Militant Miltonianism" (to coin a phrase) is a time-tested technique for directing attention toward the evils that governments sometimes do and away from whatever unethical anti-market collusion private institutions might be involved in at the moment.

The economic policies (eg the Obama administration's stimulus bill) which you ascribe to Keynes haven't really been proven to be the ideal response. It's far from clear to me, however, that any response HAS been tested in a way that could give us real confidence. Many point to 1920-21 as a case where "The One True, Holy and Correct Free Market Approach (tm)" was better approximated than many others. But even allowing that, I think there are a couple of long and rather painful episodes in the 19th century for which "TOTHCFMA(tm)" ought also to answer.

We each enjoy our cherry picking while the ongoing lack of repeatable experiments makes idiots of all of us :)

As for the reasonableness of expecting certain Chicagoans (Fama, Cochrane, especially) to understand Wall Street minutia? They deny being macro-economists because that's not their department. What IS their department? FINANCIAL economics. Modeling financial markets. Pricing and hedging of securities. All that arcane Wall Street stuff. Their prestige has derived in part from the perceived triumph of our super-duper financial innovations, etc. etc.

That's why a lot of people are annoyed with these guys. The aren't just total innocent bystanders. They have been very helpful in getting the cops off the beat. They may not have been exactly IN on the rip-offs all along the mortgage securitization gravy train (at least in any indictable way), but they provided convenient intellectual cover for the scams.

AlchemX said...

Free market economists do leave much to be desired. They don't like government action, which is in style today. They sound brutal, because they want to give everyone the freedom to succeed AND fail. Which is scary for a lot of people.

We are so convinced that the greedy businessmen will take advantage of us, but at lease we can just stop buying what they are selling. Not so with govt action. If it doesn't work, I still gotta pay taxes for it.

Milton Friedman was not militant. The government interventionists are far more militant actually, follow their rules or go to jail. Don't like it? Well here's some lead. Milton was very much against any use of force. Taxes are imposed by force.

Most people who advocate govt intervention have incredibly good intentions. But the consequences are disastrous: Govt Education, Drug War, ICC, FAA, FEMA, Dept Ed., Dept Homeland Security, farm subsidies, etc. Their cost and inefficiencies grow by leaps and bounds every year.

But the interventionists will just chime in with "We need the right guy" or "We need reform" and even worse "We need another president!"

But that has gotten us into a peculiar situation. One law that regulates economic activity always deserves two more. Ever check the Federal Register lately? Compare 1936 to 2008.

Free markets have a way of winning that is straight forward. Lower taxes and less regulation in another country will eat up business in a more regulated nation. It's really hard to beat that pattern.

The U.S.'s advantage throughout history has always been it's relatively free market, democracy was second place. Let's not abandon the concept so readily.

Seth said...

The Militancy I'm talking about is rhetorical. It's the "watch me beat the living daylights out of this straw man with your name on it" school of "debating". If you don't think mega-corporations should have license to jerk consumers around without any accountability at all, then "OMG! You must be AGAINST FREEDOM!" "eeeek! I'm being mugged by a government interventionist!"

Milton Friedman was a valuable economist and a highly effective popularizer. He was capable of co-writing a monster academic tome like "A Monetary History of the U.S., 1867-1960" and also doing TV evangelism for free market thinking. To the extent he dampened enthusiasm for government being overly 'helpful' in various markets, so much the better.

But Milton (eg in the YouTube clip you linked) was very capable of violating Godwin's Law in his more heated polemical moments. Poor Donohue weakly tries to beg for some vague concession about the abstract possibility of corporate misbehavior and ... WHAM! ... "Hitler!", "Stalin!" He did it with a nice smile, which made it more effective, but not less fundamentally disingenuous.

Gee, here I thought we were talking about stuff like bankers playing Enron-style accounting games with SIVs/CDOs to hide leverage (even from themselves) and how maybe the SEC or somebody should take action under existing laws to investigate or something, and I'm now instantly demoted into the Hitler/Stalin Hall of Shame. Nobody has a gun on the internet. We have to rely on rhetorical (brow)-beatings.

"Democracy was second place [to markets]" in accounting for our past success? To paraphrase an old saying: "The optimist believes markets are more important than democracy. The pessimist fears this is true." If you are right, we may both be saying good bye to liberties as R and D politicians try to keep up with the authoritarian state capitalists of China and elsewhere.

Dave Backus said...

I mean this in the nicest possible way, but having a physicist respond to a book written by a journalist who thinks math has been bad for economics seems a little strange to me, a practicing economist. I don't mind it -- any publicity is fine by me -- but it's not esp enlightening. You also see, if you know the field of economics, lots of people using it as a chance to flog their own work, esp the behavioral economists. If you appreciate irony, it's hard to find a better example of self interest at work.

The crisis has, in fact, triggered lots of good work. I was a minor player in the NYU group, whose work is
There's no shortage elsewhere.

Steve Hsu said...

Dave: well, of course I can't offer anything other than the views of an outsider. But I will be interested to read Cassidy's interview transcripts. I'm interested in how this crisis is changing your field, although I suppose one could guess how it is going to go.

If you look at early posts on this blog, e.g., in 2004-2005, you can see that I was already worried about the housing bubble, systemic risk, CDOS, CDS, etc. At the time it was very hard to find any academic economists who were up to speed on recent developments in financial markets. (Your colleague Nouriel is an exception, as are Gary Gorton and some others.) Yet my quant friends all had in their Bayesian mental models a nonzero probability for Big Problems down the road. So, I think it is fair to say that one group was a lot more surprised by what happened than the other. Or, put another way, one group had a much better grasp of reality than the other.

Note Crotty's view of how the financial system works, and the role of regulation, is in my experience much closer to that of actual practitioners than the view of non-heterodox economists and especially Chicago types ...

In the short run, all fields (including physics) are voting machines. Hopefully, in the long run, some are weighing machines.

Dave Backus said...

I agree with your earlier post that we should be humble about what we know, esp the "micro" aspects like Lehman, AIG, CDOs, etc. I'd add that I think we understand the broad outlines pretty well -- and we should, since financial crises have been with us for a centuries. Also agree that much of what passes for analysis has been name-calling at best.


Ian Smith said...

"non-heterodox economists"

Do you mean orthodox economists Steve?

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