Academic economics in the Dark Ages
Posted in Uncategorized by demandside on March 17th, 2009 Plus Steve Forbes - Idiot of the Week
The state of academic economics is beyond the pale. Three decades of rational expectations, efficient markets, supply side, monetarist, market fundamentalist shuffleboarding on the deck did not keep the economic ship from hitting the iceberg.
There is no way for me to impress upon you how completely academic economics has missed the boat, from the early assumptions in 101 about complete competitiveness to the high-end mathematics that created risk management tools that magnified, rather than reduced risk, and led by the Chicago School, academic economics has performed just as well as the navigators on the Titanic.
That discussion, including text from Paul Krugman, Brad DeLong and Mark Thoma, comprises most of today’s podcast. We also have idiot of the week with Steve Forbes, the history note, and this brief look at the news to Wednesday March 18.
More people were confused than enlightened last week with my medititation on money. To clarify, the reasoning is this: We have the same people, plant, resources and so on that we have had up to now. The money and credit system is the medium of exchange. To constitute a more full use of productive capacity — as opposed to letting people fail — we need only reconstruct the mechanism of exchange. Lying in the road is the institutional self-interest of the banks, including the Federal Reserve, that brought us to this point to begin with.
Do we need to mak whole the bad bets of the cowboy capitalists? No. We need to provide credit and liquidity to the real economy and manage the disappointment of many of the financial claims on that economy.
News
Single-family starts were at 357 thousand in February; just above the record low in January (353 thousand).
Permits for single-family units increased in February to 373 thousand, suggesting single-family starts could increase in March.
As Calculated Risk says, one month does not make a trend. He expects, though, that we will find the bottom soon. Caution. CR has also made the point that no matter a rebound in housing, residential real estate is not going to be the engine of recovery from this recession.
This displays that the consumer in any form is not going to be the engine of recovery. The implications for advertising, media, trade and so on should be the subject of your consideration. Without the consumer, we do not have a return to the form of capitalism we enjoyed up to this point. This also has implications for consumer-driven inflation that many have projected — see Cato’s Steve Hanke on next week’s idiot.
And finally, Ben Bernanke appeared on 60 Minutes this week. That is news in itself. It is not news that his advice and forecasts are still much sought after so many disappointments and failures. His projection that the economy will recover if the financial sector is fixed is poignant, since the financial sector is his territory of responsibility, he had since the summer of 2006 to avoid a collapse, and he failed. Or at least succeeded only with trillions of dollars in bandages.
Now to
Steve Forbes
It is no great trick to look back a year at Forbes Magazine and find six or eight examples of completely missing the curve, crashing through the guardrail and falling into the abyss of ignorance. But Steve Forbes does not age well at all, so we took something from last week, by way of Bloomberg’s On the Economy with Tom Keene.
FORBES
Remember, this was just from last week. There is too much to choose from even in this short piece of nonsense. Just from the beginning
FORBES
Not everybody was surprised. By any means. Roubini, Stiglitz, Krugman, Demand Side, just to name a few. Of course, as another notable economist once observed, it was either Galbraith or Keynes, it is not important for economists to be right, it is more important and acceptable to be wrong in a conventional and respectable manner.
As for the humility which visited “everyone:” It didn’t stick to Forbes very long. Rather than admit cowboy capitalism has run the system into the ground again, and taking his lumps as one of the chief Supply Siders. Supply Side likely wouldn’t have survived to today without his sponsorship. Instead of doing that, Forbes begins to blame everybody else.
It is absolutely amazing how the least intrusive government in modern history, that of George W. Bush and the Republican Right, has somehow become the bogeyman for intrusiveness. The attack on Fannie and Freddie is completely out of left field. There were mistakes, but none germane to the crash.
Next week on Idiot we have rival Fortune Magazine displaying their at-sea-ness in relation to the commodities bubble. But for today, that is, Steve Forbes, Idiot of the Week.
Dark Ages Economics
Friedman and Schwartz were wrong
http://krugman.blogs.nytimes.com/2009/03/02/friedman-and-schwartz-were-wrong/
It’s one of Ben Bernanke’s most memorable quotes: at a conference honoring Milton Friedman on his 90th birthday,
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.
He was referring to the Friedman-Schwartz argument that the Fed could have prevented the Great Depression if only it has been more aggressive in countering the fall in the money supply. This argument later mutated into the claim that the Fed caused the Depression, but its original version still packed a strong punch. Basically, it implied that no fundamental reforms of the economy were necessary; all it takes to avoid depressions is for central banks to do their job.
But can we say that recent events appear to disprove that claim? (So did Japan’s experience in the 1990s, but that lesson failed to sink in.) What we have now is a Fed that is determined not to “do it again.” It has been very aggressive about monetary expansion. Here’s one measure of that aggressiveness, banks’ excess reserves:
And yet the world economy is still falling off a cliff.
Preventing depressions, it turns out, is a lot harder than we were taught.
Krugman
Postwar
Among the sources of distress that would appear in the good times of the later 1940s and the 1950s was the revival of faith in the magic of monetary policy. In 1951 the Treasury Accord, a conspiracy, in our opinion, set up the Federal Reserve as the fourth branch of government.
Galbraith’s trenchant summary of the postwar use of monetary policy is worth repeating.
Monetary policy would again be used as a weapon against inflation and recession. Not to be relied upon in the serious exigency of war, it would again have a role in the less pressing problems of peace. No course of public action would be so successful in surviving disappointment about its efficacy and even its forthright failure.
Unquote.
Krugman and Brad DeLong are concerned with the Chicago School’s witless advocacy of the crowding out theory, which postulates that even in the worst of times, if government spends, it merely substitutes for private spending.
If, for example, government contracts for the building of a road, and the private contractors hire a bunch of folks to build it, and these people buy food, cars and houses, and nobody else is competing for their labor, or investing in anything, it is still a wash. No increase in economic activity will be seen.
It is not oversimplifying the position, except to omit that the Chicago School imagines somebody will be investing. They see the ghosts of earth movers cast up by their simple models.
http://economistsview.typepad.com/economistsview/2009/03/the-unfortunate-uselessness-of-most-state-of-the-art-academic-monetary-economics.html
“The Unfortunate Uselessness of Most ‘State of the Art’ Academic Monetary Economics” from Economist’s View by Mark Thoma
Willem Buiter on “’state of the art’ academic monetary economics”:
The unfortunate uselessness of most ’state of the art’ academic monetary economics, by Willem Buiter:
Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best.;
Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes; rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability.; So the economics profession was caught unprepared when the crisis struck.
Complete markets
Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered.; They did not allow such questions to be asked. …
[M]arkets are inherently and hopelessly incomplete.; Live with it and start from that fact. … Perhaps we shall get somewhere this time.
The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. …
The Auctioneer at the end of time
In both the New Classical and New Keynesian approaches to monetary theory (and to aggregative macroeconomics in general), the strongest version of the efficient markets hypothesis (EMH) was maintained.; This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation.
Demand Side: How stupid is this? The efficient market hypothesis is unraveled several times over just in the two or three decades since it won its promoters the Nobel Prize. The absurd contention that all economic actors have perspicacity beyond measure and all come to the same conclusions, which are right.
As Buiter says
…
But in a decentralised market economy there is no mathematical programmer imposing the terminal boundary conditions to make sure everything will be all right. … The friendly auctioneer at the end of time,
…
No wonder modern macroeconomics is in such bad shape. …; Confusing the equilibrium of a decentralised market economy, competitive or otherwise, with the outcome of a mathematical programming exercise should no longer be acceptable.
Linearize and trivialize
If one were to hold one’s nose and agree to play with the New Classical or New Keynesian complete markets toolkit, it would soon become clear that any potentially policy-relevant model would be highly non-linear
…
Macroeconomists are brave, but not that brave; So they took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.; This was achieved by completely stripping the model of its non-linearities and by … mappings into well-behaved additive stochastic disturbances.
Those of us who have marvelled at the non-linear feedback loops between asset prices in illiquid markets and the funding illiquidity of financial institutions exposed to these asset prices through mark-to-market accounting, margin requirements, calls for additional collateral etc.; will appreciate what is lost: Threshold effects, non-linear accelerators - they are all out of the window. Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads at the insistence of the mainline models that all uncertainty is exogenous and additive.
…
The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models … was a major step backwards.; I trust it has been relegated to the dustbin of history by now in those central banks that matter.
Mark Thoma reacting to Buiter
Models are built to answer questions, and the models economists have been using do, in fact, help us find answers to some important questions. But the models were not very good (at all) at answering the questions that are important right now. They have been largely stripped of their usefulness for actual policy in a world where markets simply break down.
The reason is that in order to get to mathematical forms that can be solved, the models had to be simplified. And when they are simplified, something must be sacrificed. So what do you sacrifice?
…
The models we built were very useful for asking whether the federal funds rate should go up or down a quarter point when the economy was hovering in the neighborhood of full employment, or when we found ourselves in mild, “normal” recessions. The models could tell us what type of monetary policy rule is best for stabilizing the economy. But the models had almost nothing to say about a world where markets melt down, where prices depart from fundamentals, or when markets are incomplete.
Demand Side has to interject that this condition occurs most of the time. At a minimum, the condition of asymetry of information — as Joseph Stiglitz has pointed out — occurs virtually all of the time.
Further, the models did not predict the breakdown of the markets, which Thoma now turns to.
The reason the Keynesian model is finding new life is that it specifically built to answer the questions that are important at the moment. The theorists who built modern macro models, those largely in control of where the profession has spent its effort in recent decades, did not even envision that this could happen, let alone build it into their models. Markets work, they don’t break down, so why waste time thinking about those possibilities?
So it’s not the math, the modeling choices that were made and the inevitable sacrifices to reality that entails reflected the importance those making the choices gave to various questions. We weren’t forced to this end by the mathematics, we asked the wrong questions and built the wrong models.
But it IS the math.
Mathematics doesn’t work on economics. Calculus, the second derivative. Value at Risk. As John Maynard Keynes said, “It is better to be approximately right than precisely wrong.” Yet a great deal of economics is math-based efforts to be precise. Statistical models are built with far too few observations, and assume for example, a reversion to a mean as if it were the natural movement of the tides.
It is human behavior, for God’s sake. While similar episodes may behave similarly, we have wars and radically varying regulatory frameworks, demographics, and variables that are not internally consistent.
Let’s take this last point. The interest rate is not a molecule that will behave consistently, much less have a consistent effect on other similar variables. Economic variables like the interest rate are aggregates of different parts at different times. The interest rate, for example, combines central bank action, competition for money, availability of savings, risk aversion, perceptions of currency strength, perceptions of the future, and so on. The interest rate can be high because the supply of money is low or high because there is too much money and inflation threatens returns. If each of the internal parts of the interest rate could be given its own vector, it might be possible to form a useful variable out of the interest rate. But even this is impossible.
You only have to look at how the Federal Reserve treats all inflation as demand-pull inflation to be remedied with higher interest rates to see how much they are operating in a hypothetical universe. Mathematically precise. Practically useless.
Thoma continues:
Real Business Cycle theorists also use equilibrium models with rational agents and complete markets, and they look at whether supply-side shocks such as shocks to productivity or labor supply can, by themselves, explain movements in the economy. They largely reject demand-side explanations for movements in macro variables.
The fight - and main question in academics - has been about what drives macroeconomic variables in normal times, demand-side shocks (monetary policy, fiscal policy, investment, net exports) or supply-side shocks (productivity, labor supply). And it’s been a fairly brutal fight at times - you’ve seen some of that come out during the current policy debate. That debate within the profession has dictated the research agenda.
What happens in non-normal times, i.e. when markets break down, or when markets are not complete, agents are not rational, etc., was far down the agenda of important questions, partly because those in control of the journals, those who largely dictated the direction of research, did not think those questions were very important. Some don’t even believe that policy can help the economy, so why put effort into studying it?
I think that the current crisis has dealt a bigger blow to macroeconomic theory and modeling than many of us realize.
Mark Thoma
I hope so.
When asked if what Buiter says is true, Brad DeLong says:
Well, actually, that is not all. Buiter is a little bit too mean to us “new Keynesians”, who were trying to solve the problem of why it is that markets seem to work very well as social planning, incentivizing, and coordination mechanisms across a range of activities and yet appear to do relatively badly in the things we put under the label of “business cycle.”
I, at least, always regarded Shiller, Akerlof, and Stiglitz as being fellow “New Keynesians.” As Larry Summers put it to a bunch of us graduate students l around the end of 1983, Milton Friedman’s prediction in 1966 that the post-WWII economic policy order would break down in inflation had come true and that that had given the Chicago School an enormous boost,
Demand Side: Preposterous. Friedman predicted an inflation based on monetary stresses. We got an inflation based on oil prices. Somehow this validated the conceptually vapid Monetarist booshwah. DeLong continues
In fact, Buiter’s column I read as a commentary on General Theory chapter 12: “The State of Long-Term Expectation.” Collectively, I think we made a compelling intellectual case–but we were completely ignored and dismissed by Chicago.
But, yes, on the big things Buiter is right.
end DeLong
return to Thoma
I think that’s right, and as they come to this realization, we can expect these economists to flail about defending the indefensible, they will be quite vicious at times, and in their panic to defend the work they have spent their lives on, they may not be very careful about the arguments they make. I don’t know if the defenders of the classical faith have come to this realization yet, at least beyond the subconscious level, and the profession will most likely move in the same old direction for awhile due to research inertia if nothing else. But I think what has happened will have a much bigger impact on the profession and the models it uses to describe the world than most economists currently realize:
The end of it all is that economics is a pathetic failure in the current situation. The most prominent economists did not predict the current market failure. It has left the market fundamentalists and monetarists with only one defense. “The government did it.” These academically prominent but conceptually irrelevant academics did it by ascribing to the market an efficiency and sophistication it simply does not have.
The policy think tanks such as the American Enterprise Institute, the Heritage Foundation and the Cato Institute are left floating in a Bermuda Triangle of their own making. Their compasses and maps are useless, and unfortunately they are still trying to tell the rest of us where to go.
3.18 history note Swedes
A last note on the Depression.
One is the experience of Sweden. Following from John Kenneth Galbraith, early in the 1930s a group of Swedish economists, including Myrdal, Ohlin, Lindahl, Lundberg and Dag Hammarskjold led policy out of an earlier conservative tradition. They determined that mitigation of the depression could come only from government action.
They proposed government borrowing and public employment, contingent on commitments to return to more conservative finance after recovery. They also espoused currency devaluation, support to farm prices and greatly strengthened social insurance — pensions and unemployment compensation.
This program, as Galbraith says, was carried into effect early in the decade of the 1930s, well before dissemination of Keynesianism. By the latter part of the decade the depression was over in Sweden because of thir actions. Nor did the Swedish recovery depend on mobilizing a war machine. In a just world, quoting Galbraith, reference would be not to the Keynesian but to the Swedish revolution.
ON TAP FOR OUR NEXT PODCAST:
As we mentioned, Fortune magazine is found in Idiot of the Week, and we take a look at the paper mache boat the market fundamentalists forced developing countries to use during their own economic troubles, also known as the Washington Consensus and Neoliberalism.
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