Leech the economy

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.

Game theory often looks silly

From Tim Harford’s blog:

“Game theorists know all about the centipede game:

One instance of the centipede game is as follows. A pile of $4 and a pile of $1 are lying on a table. Player I has two options, either to “stop” or to “continue.” If he stops, the game ends and he gets $4 while Player II gets the remaining dollar. If he continues, the two piles are doubled, to $8 and $2, and Player II is faced with a similar decision: either to take the larger pile ($8), thus ending the game and leaving the smaller pile ($2) for Player I, or to let the piles double again and let Player I decide. The game continues for at most six periods. If by then neither of the players have stopped, Player I gets $256 and Player II gets $64. Figure 1 depicts this situation. Although this game offers both players a very profitable opportunity, all standard game theoretic solution concepts predict that Player I will stop at the first opportunity, getting just $4.

Except, nobody really thinks this is the way players would behave in reality. The optimal strategy seems sociopathic; isn’t it worth playing cooperatively in the hope that the other player will do the same thing? (Unlike much real human interaction, standard game theory does not accomodate the “hope” that someone else will play suboptimally: optimal play is to be expected at all times. )”

Game theory is very clever and very useful, but often seems very naive. When it’s used in economics, it’s arguably the part of economics most hamstrung by the scattershot application of the “money=utility” fallacy. If you want your game theoretic result to be predictive or descriptively powerful, you must (must must) try really hard to make the payoffs reasonably accurate; in Harford’s quoted example the assumption is that the players care only about cash and that, as Harford says, they aren’t willing to take a shot on the other player prolonging the game. At the risk of being tautologically critical: can you read the setup of that game and not entertain the idea of waiting? I remember being taught the centipede game in David Myatt’s excellent game theory course as an undergrad; he showed us the ‘crazy centipede’ variant, which wondered exactly that: what chance of you choosing to continue the game is enough to make me also want to continue?

The kicker to me is that ‘game theoretic predictions’ are overwhelmingly often not as successful for the players as alternative strategies, even when we’re just measuring ‘success’ in the same cash-payoff terms as the theory. This is just what Harford goes on to describe:

But Ignacio Palacios-Huerta (best known to Undercover Economist readers as discovering that strikers and goalkeepers play optimal strategies in penalty-taking) and Oscar Volij gave the centipede game to skilled chess players. They found that the chess players were far more likely to play optimally; grandmasters always played optimally and took the $4. Hyper-rationality can be a disadvantage. (Or did the experiment discover something else: that chess grandmasters are sociopaths?) Palacios-Huerta and Volij don’t speculate. My guess is that they have discovered something about the rationality rather than morality or empathy of chess players, but I may be wrong.

It really does just beg for the ‘behavioral economics’ explosion: if predictions aren’t great, and in any case are less profitable than reality, we’re up the creek without a paddle or a boat.

Economists’ political preference

While we’re sitting in the old ivory tower, some economists are out there in the real world. They’re very different from the academics, in their work and their demographics. The Wall Street Journal runs periodic surveys of private-sector economic forecasters; here’s a bit from January:

“On the political front, most of the respondents expect a Democrat to be elected president this year, although they personally prefer a Republican.”

Contrast this with the academic economists; here’s the summary from a 2003 survey of members of the American Economic Association, one of the big “trade groups” of academic economists:

“The responses show that most economists are supporters of safety regulations, gun control, redistribution, public schooling, and anti-discrimination laws. They are evenly mixed on personal choice issues, military action, and the minimum wage. Most economists oppose tighter immigration controls, government ownership of enterprise and tariffs. In voting, the Democratic:Republican ratio is 2.5:1.

The academics seem like “social liberals”, but I’d bet both the academics and the private-sector economists are “fiscal conservatives” (with apologies for possibly bastardizing the political terminology). Perhaps it relates to the liberal-friendly character of academia, the subject of the study I cited here. Here’s another result from the survey of the forecasters:

“Some 56% of the economists disapproved of President Bush’s stewardship of the economy, while 44% approved. That is especially startling considering 59% of the economists said the stock market performs better under Republican presidents, compared with 28% who said it favored Democrats.”

The Republican preference of the private-sector economists does seem to be grounded in their beliefs about the effect of the political climate on the financial sector. Academic economists, by and large, don’t care a lot about what’s happening in the financial sector (or, indeed, about anything that might be identified as “economics” by a layperson). The first-guess potted conclusion is probably that the non-academics care about the financial ship – which is indeed their livelihood – enough that they want a Republican to steward it, while the academics care more about politics that isn’t economic policy, where they prefer Democrats.