Author: jdc

Leech the economy

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Anatole Kaletsky’s evisceration of “old economics” in the London Times may be consistent with the general backlash during the current recession, but it’s half-baked.


Today’s academic approach prevented economists from thinking about a world that is, by its very nature, unpredictable and inconsistent… others may revive the literary and anecdotal traditions of the great economists of the past… Smith and Hayek produced no real mathematical models. Their eloquent writing lacked the “analytical rigour” demanded by modern economics. And none of them ever produced an econometric forecast.

To wish simultaneously for a return to an “anecdotal tradition” and for theories to be “tested against reality” is perverse. The economy is indeed a complex system, and to draw correct conclusions on the relationships in a complex system requires more than anecdote. As epidemiology is to medicine, so econometrics is to economics; a
patient’s recovery after leeching does not prove leeching effective, and folk inference in economics would be just as counterproductive, in its own way. The “analytical rigour” so disdained by Mr. Kaletsky represents the struggle to understand and draw inference from the very real complexity that to rely on anecdote risks ignoring.

The first idea, known as “rational expectations”, maintained that capitalist economies with competitive labour markets do not need stabilising by governments.

The second idea — “efficient markets” — asserted that competitive finance always allocates resources in the most efficient way, reflecting all the best available information and forecasts about the future.

The specific “theories” attacked by Mr. Kaletsky are also grossly misrepresented. Hell, the concept of a theory is being misrepresented. An economic theory is an if-then statement, and this is not a matter of mathematics, which is after all just a language like any other. No theory, no matter how it is expressed, can ever do more than suggest the outcome that would pertain under a given set of conditions. No theory, then, can “[maintain] that capitalist economies… do not need stabilizing by governments”, or “[assert] that competitive finance always allocates resources in the most efficient way”. To attack the assumptions underlying these theories is good and rigorous; to either attack the value of their existence is to distort the purpose of academic inquiry. It is precisely because
theories are if-then that any single conclusion can be given an ‘if’ and be co-opted and championed by the politically powerful of the moment, but the “assertions” come always from the interpreter, not from the theorem.

Literary and cross-disciplinary approaches to economics can have great value in conveying economic ideas and in complementing other forms of research. What would be unacceptable, however, would be the abandonment of valuable tools to help us to understand the way things are. Perhaps attacking economists makes us feel better, but this is like blaming the shipbuilder, engineer or mathematician for a drunk captain’s crash.

And finally, because that felt a bit too serious, I must mention these:

Today’s academic economics reverses this process: if models disagree with reality, it is reality that economists want to change.

Policymakers who turned to academic economists for guidance in last year’s crisis were told in effect: “The situation you are dealing with is impossible: our theories prove that it simply cannot exist.”

This is garbage.

It’s called "the ivory tower"

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Here’s a thoughtful antidote to “boo economists!” by Barry Eichengreen at The National Interest. Perhaps the most forceful point is this:

What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.

Eichengreen notes that business schools, for example, are part of the production line of financial labor and ideas and so have no inventive to rock the boat; however, he also directs a lot of fire at academic economists for being part of the stitch-up. I accept that the author surely knows better than me the “pecuniary and psychic” benefits to academics from the use of their work, but a counter-hypothesis would be ignorance rather than malice, a sin of omission, not commission. How many in economics departments know what’s going on in industry – or even business schools? Is it enough to claim a quorum of the profession?
There’s probably analog to the hard sciences here. Newspaper science (cf. Bad Science, for example) is to natural science research as financial industry models are to economics research, or something like that. Imagine a house full of economists (reality show idea?) – every so often one wanders out to hand some obscure technical document to someone from the outside world, and something inevitably gets lost in translation. 

More navel-gazing

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Since there are now, I estimate, more articles on the economics profession’s predictions/responses to the recession than there are atoms in the known universe, replying to them all would presumably take a very long time. One example will probably suffice. 

In the Financial Times yesterday, John Kay talks about “How economics lost sight of real world”. 
The past two years have not enhanced the reputation of economists. Mostly they failed to point out fundamental weaknesses of financial markets and did not foresee the crisis, and now they disagree on appropriate policies and on the likely future course of events.

As I have (almost) argued before, this is – for better or for worse – not in the job description of the vast majority of academic economists. It is precisely like attacking a physics professor because there was a blackout last night. More importantly:
Economists, like physicists, have been searching for a theory of everything. If there were to be such an economic theory, there is really only one candidate, based on extreme rationality and market efficiency…. a few deranged practitioners of the project believe that their theory really does account for all human behaviour, and that concepts such as goodness, beauty and truth are sloppy sociological constructs.

I have addressed the “economists don’t feel feelings” argument before. And, by the way, I guess you can color me deranged. Economics is a theory of everything! 
First: the assumption of “rationality” that is central to economic theory is a modeling assumption and makes no restriction on behavior whatsoever. The auxiliary assumptions of what people care about – the things that they “rationally” try to achieve with their limited resources – are restrictive. Second: “market efficiency” is neither a theory or a modeling assumption. It is either a metric (one of many) by which we can evaluate outcomes (i.e. is this “efficient”?) or a result of an economic theory, which, like all economic theories, will probably require many assumptions. 
I would agree with the proposition that it is wrong to assume that markets are “efficient” (and what does that even mean?). Economists do not make such an assumption. I would agree with the proposition that it is wrong to assume that people care only about their own material wellbeing. Economists do not make such an assumption.
Academic economists did not predict this recession because that is not what academic economists are “supposed” to do with their time. 

Learning from your mistakes

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The big policy lesson from our current recession is: save money in good times to see you through the bad. Obvious? Apparently not, especially in Britain, where the government spent the unprecendentedly long expansion period from the late 90s to 2007 running deficits. But it’s good to know that we can learn from our mistakes, right? 

But [Alistair Darling] made clear his plans depended on a rapid economic bounce-back – with a forecast of 1.25% growth next year rising to 3.5% in 2011. [link]
The IMF World Economic Outlook (WEO) report predicts the UK economy will shrink by 4.1pc in 2009, with the downturn expected to continue into next year when the economy will fall by 0.4pc. [link]
This is unacceptable. After years of squandering prosperity by running deficits in boom years, now the government proposes to dig even deeper. 
My university, Brown, is cutting staff right now. By anecdote, it is far from alone in the higher education world in doing so. Why is it that a bad year means the operating budget is slashed? Why was the financial plan based on an assumption of constant, unlimited growth in the endowment (i.e. a constant, unlimited rise in stock prices)? Why were national governments operating under the same assumptions? 

Experimental philosophy, experimental economics

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Interesting article at Prospect Magazine called Philosophy’s Great Experiment, about the rise of ‘experimental philosophy’. Doubly interesting to me, because it could equally well be talking about experimental economics, albeit a few years too late. Or about “neuroeconomics“; the philosophers in the article are using fMRI machines “to look for patterns of neuronal activity when subjects are presented with philosophical problems”, just like the researcher who does the same for resource allocation – economics – problems. But here’s the rub:

Some philosophers quietly dismiss the movement as a cynical step by researchers to appear cutting edge and to tap into scientists’ funding.

Indeed, it’s easy to feel this way about the kind of experiments in which economists step on psychologists’ toes. The drive toward empiricism in philosophy that the article talks about seems to be symptomatic of social sciences’ and humanities’ desire to be taken “seriously” as science.
And as we know, that means we need something falsifiable or verifiable. “There is no article in Prospect Magazine called Philosophy’s Great Experiment” is falsifiable, because I can find such an article and falsify the statement. “There is at least one article in Prospect Magazine called Philosophy’s Great Experiment” is verifiable, because I can find such an article and verify the statement. 
In experimental economics, often it seems (at least to this observer) that we’re replicating, or at least mirroring, psychology experiments. Unfortunately, the economics experiment is much less likely to be “scientific”, not because of the method or the issue at hand, but because of the specific question. This is precisely what Lawrence Boland discusses in the paper “On the futility of criticizing the neoclassical maximization hypothesis” (pdf), which I read as a welcome withering put-down to all of those who claim to “disprove rationality“, etc etc. He says:
Properly stated, the neoclassical premise is: ‘For all decision makers there is something they maximize’… The person who assumed the premise is true can respond: ‘You claim you have found a consumer who is not a maximizer but how do you know there is not something which he is maximizing?’

For experimental economists and experimental philosophers alike, the challenge is to pose a scientific question; without that, no method will save us. “Are people ethical?”, for example, is equally a dead end as “are people rational?”. 

Failures of imagination?

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There’s an excellent (long) article on the role and response of academic economists in the current crisis/recession/apocalyse/trendy-noun over at the Boston Globe. Not a lot of it is tremendously surprising, but it does interview a lot of big names in the profession to get their opinions. The rub is this: why didn’t economists see all this coming, and what now for the profession?

There are (at least) two distinct kinds of failure that are possible here. The first one is a failure in reality, a failure to see things coming. The second is a failure of imagination, a failure to imagine what would happen as a result of that unforseen thing. In today’s terms, the first would be a failure to predict that everything would go all to hell, while the second would be a failure to predict the consequences if things had gone to hell.
If you ask me, the first one is forgiveable. The article quotes Laurence Ball as saying “Nobody ever sees anything coming,” he says. “Nobody saw stagflation coming, nobody saw the Great Depression coming, nobody saw Pearl Harbor or 9/11 coming. Really big, bad things tend to be surprises”, which might be a tad extreme but is a sentiment I can agree with. It takes an extreme fatalist to think that we can see everything coming if we just try hard enough. 
However, the second might not be forgiveable at all. It represents a failure of contingency planning. One might stem from the other: if I think it’s very, very unlikely to rain, I might not want to waste too much time planning my umbrella strategy. If, however, we believe the article’s claim that “some warned of a housing bubble, but almost none foresaw the resulting cataclysm. An entire field of experts dedicated to studying the behavior of markets failed to anticipate what may prove to be the biggest economic collapse of our lifetime”, then we should be a bit perturbed. Again, the failure to see something coming is forgiveable, but to see it coming and fail to imagine the consequences is just plain strange. 
This is a little scary, but I confess I have very little idea of how I, an economist, would be able to attack macroeconomic questions. I disagree with the first half of this (though not the second, which is that failure of imagination again):
“We have a very restrictive set of language and tools, and we tend to work on the problems that are easily addressed with those tools,” says Jeremy Stein, a financial economist at Harvard. “Sometimes that means we focus on silly questions and ignore greater ones.”
Similarly, I’m sceptical of this:
“…many of the models used to explain and predict the dynamics of financial markets or national economies have been scrubbed clean, in the interest of theoretical elegance, of the inevitable erraticism of human behavior. As a result, the analytical tools of the trade offer little help in a crisis, and have little to say about the sort of collapses that led to this one.”
I am a believer in the predictive and descriptive power of the abstract model. Instead, the view I relate to is that of Jeffrey Kling:
“What we’re experiencing now is a good old-fashioned financial panic… This is perhaps the biggest scale, but on some level it’s not that different.”

I think the economist’s toolbox – the one that contains no doctrine, no assumption, just method – is well equipped to understand most everything. Unfortunately, the principle of ‘garbage in, garbage out’ applies to economics as much as it does to computer programming; perhaps the real failure is not of the discipline of economics, but the imagination of those who practice it. We are, of course, not rewarded by universities or journal editors for asking questions like “if there is a housing bubble, and if it bursts, then what?” Those questions aren’t “research”; they’re not rewarded and we don’t have time for them. How can we be surprised that we were surprised?

Christmas redux

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It’s Christmas time again. Tim Harford’s on the case of that gift-giving economics article I talked about back in January, with typical accuracy:

“Waldfogel’s work is often misinterpreted as suggesting that gift-giving is pointless. That is not true. He explicitly excluded the sentimental value of gifts from his calculations, and, of course, the sentimental value is part of the purpose of giving presents.”

More than that, though; his positivist reading of the original article leads to some very sensible, common-sensical normative prescriptions:
“the economists Sara Solnick and David Hemenway have discovered that we prefer unsolicited presents to those we have specifically requested… All this points to the optimal gift-giving strategy: you need to minimise the deadweight loss while maximising the sentimental value. This suggests buying small gifts and striving for emotional resonance. Look for something inexpensive, and consider supplementing it with a letter, a photo, or time spent together.”

Prescriptions we can all relate to.

More ultimatum game ignorance

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I wonder what it is about the ultimatum game that makes for journalistic error? More of the same from Emily Yoffe in Slate:
We like to think we go through life as rational beings. Much of economic theory is based on the notion that humans make rational choices (which may mean that economists don’t get out much). 
“Rationality” is a model, and admits any form of behavior. It does not say how someone “should” behave.
In 1982, some economists came up with a little game to study negotiating strategies. The results showed that rationality is subservient to more powerful drives—and demonstrated why human beings so easily conclude they are being wronged. The idea of the “ultimatum game” is simple. Player A is given 20 $1 bills and told that, in order to keep any of the money, A must share it with Player B. If B accepts A’s offer, they both pocket whatever they’ve agreed to. If B rejects the offer, they both get nothing. Economists naturally expected the players to do the rational thing: A would offer the lowest possible amount—$1; and B, knowing $1 was more than zero, would accept. Ha!
This is the Nash Equilibrium of the game, if both players cared only about money. It has nothing to do with “rationality”. 
In the years the game has been played, it’s been found that almost half the A’s immediately offer to split the money—an offer B’s accept. When A offers $9 or even $8, B usually says yes. But when A’s offer drops to $7, about half the B’s walk away. The lower A’s offer, the more likely the B’s are to turn their backs on a few free dollars in favor of a more satisfying outcome: punishing the person who offended their sense of fairness. This impulse is not illogical; it is essential. 
Only the hypothetical economists in the article found it illogical, and they’re not real. Once more: rejection of a lowball offer in the ultimatum game is rational under the entirely realistic assumption that people care about more than money. Please stop attacking the straw economist who disagrees with that statement.  

Economist versus economist

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This mostly innocuous entry at the Freakonomics blog is comparing the rejection of offers in the ultimatum game (where I propose a division of some money, you either accept or reject, we get the money if you accept but don’t if you reject, and then we go home) to the rejection of the ‘bailout’ of the financial sector. It raised my ire with this:

Many economists cannot understand why they’d do such a thing. To an economist, an offer of even 1 percent would be worth accepting since it is free money, and because for the second player it is ultimately irrelevant how much money the first player takes home.

But most people do not think like economists. When offered 10 percent or 20 percent or even 30 percent of the total, they are disgusted by the inequity — and willing to pay the price for that disgust by rejecting the offer.

Show me a scrap of evidence that “many economists cannot understand why they’d do such a thing.” Pardon my language, but that’s bullshit. Really, what the hell. In fact, it’s so infuriatingly ridiculous that I’m going to be forced to actually say something as clearly and calmly as I can, but I’m going to have to do it in boldface:
Economists are capable of feeling things.

Phew. No, seriously, the quotation claims that:
  1. Economists don’t understand that people care about things.
  2. Economists don’t feel feelings.
  3. Economists do not conduct life in the same way as people who actually care about things.
Give me a break.