“How Did Economists Get It so Wrong?”

Krugman wrote a piece for the New York Times Magazine last week entitled “How Did Economists Get It so Wrong?”. This is unlikely to be news to anyone interested in economics. As usual with any of his efforts, it’s received a lot of attention, most of it favourable.

He’s always an enjoyable read; no one who writes so consistently well could be anything but. Still, I thought his analysis as notable for what it missed as for the depth of his insight. Over the weekend, I hemmed and hawed a few times about trying to write something and in the end let it slide. Too hard, too many interminable arguments would result etc etc.

Today, though, I happened upon an article that kind of covers my reservations, and does so in a brief and readable fashion. In short, an easy way out. Here’s the opening:

So Paul Krugman gets a lot of ink, and everyone goes gaga for it.  I dont buy his arguments for two reasons:

– He misdiagnoses the cause of the current crisis.  He thinks it is too much of the free markets.  Rather, it was predominantly profligate monetary policy.  Secondarily, it was poor banking regulation.  Monetary policy necessarily involves banking regulation in a fiat money system, because credit is what drives the economy.  A failure to limit the ability of regulated institutions to issue credit is just another form of loose monetary policy, whether it results in measured price inflation or not.

– Keynesian economics and Neoclassical economics do not consider the debt structure of the economy to be relevant for policy purposes.  Ive written about this already in this blog post: Waiting for the Death of the Chicago School, and the Keynesian School also. Debt structure is more relevant than any other factor at present.  Economies with high levels of indebtedness are inherently fragile, because booms and busts are amplified by the financial leverage.

If that appeals, the full article can be found here. If nothing else, it broadens the discussion in a useful fashion by making some major points of disagreement relatively clear.

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senex
12 years ago

An interesting snippet Ingolf

He thinks it is too much of the free markets. Rather, it was predominantly profligate monetary policy.

I take it that ‘profligate’ in this case means that Interest Rates were tightened too quickly and often unnecessarily.

A failure to limit the ability of regulated institutions to issue credit is just another form of loose monetary policy, whether it results in measured price inflation or not.

This seems to fit well with my view that the financial crisis stems largely from inefficient regulation or as I would put it ‘excessive deregulation’. This would also fit with the “too much of ‘free markets’ ” theory. However, I am only a complete amateur analyst of this stuff.

Keynesian economics and Neoclassical economics do not consider the debt structure of the economy to be relevant for policy purposes.

I have been reading a lot of Bill Mitchell lately and he draws heavily on the Keynesian view that in a fiat currency, and to use his words Australia “is sovereign in its own currency and is not revenue-constrained.”

I looked at the link about waiting for the death of these two schools of thought

My view is that we eventually have to give our currency some backing and get the government out of the money business.

Is that an argument for a return to a gold standard and elimination of fiat currency? Or at least the backing of something tangible?

Richard Tsukamasa Green
Richard Tsukamasa Green(@richard-green)
12 years ago

Senex – He means rates were too low, the profligacy was the increase in the money supply. The critique is mainly from the Austrian perspective, whom have an especial dislike for fiat currency. His basic conclusion isn’t really a lack or not of regulation or excessive deregulation, but the presence of a financial instrument (fiat currency) that would involve the government at all.

I have a number of problems with the Austrian macro theory, which I won’t go into here in great details. The arguments have been well tread, especially here, and the Austrians remain unconvinced by non-Austrian critique and vice versa.

For you, an amateur newcomer (hopefully eager to explore all views!), I will show you these two critques of Austrian business cycle theory. This one by Krugman from a decade ago, which typically Krugman is easily readable but somewhat acerbic, and this slightly more conciliatory one from John Quiggin, whom Bill Mitchell once told me was one of only two other full Economic Professors in Australia that he liked.

The generous showing of Austrians here will hopefully give you a few layman articles of their own.

senex
12 years ago

I thought he may have meant “too low” with the ‘profligate’ remark but it seemed incongruous with these turbulent times which is why I went for the opposite end of the spectrum.

Richard, I take merit where I can find it (or determine it). I do not buy the Austrian school of thought as valid throughout but some of the cases they make have plenty of merit. I started with Quiggin’s blog initially and have graduated to Mitchell’s ;)

From a lay point of view, connecting currency to gold or something else tangible makes a lot more sense. However understanding fiat currency is quite new to me (I once got lost trying to understand Bretton Woods on Wikipedia in an age gone by) but I’m sure I will assimilate the knowledge eventually.

Thank you for your clarification, Ingolf.

Richard Tsukamasa Green
Richard Tsukamasa Green(@richard-green)
12 years ago

I should stree that I only use the terms in a descriptive, rather than prescriptive sense. I use “Austrian” to describe a set of ideas that keep rearising.
There’s a good reason they keep reappearing, they seem intuitive and superdificially describe macro phenomena…until you start looking at the figures and the underlying logic.

If I call it Austrianism, its mainly to point out that the ideas aren’t new, and that macroeconomics has been dealing with them for ages.

Its a interesting way to talk about several topic though, to think about what a recession is exactly, or the creation of falsifiable hypotheses in economics…provided of course it comes up because of the apparent intuitiveness rahter than prior faith.

pedro
pedro
12 years ago

You might enjoy this comment on Krugman’s article

http://blogsandwikis.bentley.edu/themoneyillusion/?p=2292

pedro
pedro
12 years ago

PS, I should mention that Scot Sumner (whose blog I linked to) believes that the GFC is the result of tight money. Read his blog before you scoff.

Alphonse
Alphonse
12 years ago

Merkel concludes like this:

Why did macroeconomics fail us? Bad theory in the two main schools of Neoclassical economics Chicago and Keynesian. There was an inability to appreciate the effects of overindebtedness on an economy. Time to send both schools to the junkyard.

… which sounds very like Steve Keen and pretty much every other debt-conscious economist who gets a guernsey from Dirk Bezemer.

Alphonse
Alphonse
12 years ago

A shorter piece from Dirk Bezemer here.

derrida derider
derrida derider
12 years ago

Yeah, yeah – everyone agrees it was slack regulation. But what they miss is that good regulation of financial markets is much, much harder than it appears:

– firstly, bad regulation is endogenous to booms. When the champagne is flowing no-one is gonna support a drinks limit. Not only will the regulators be under-resourced and less competent (the more competent will be busy getting champagne for themselves, not trying to regulate it), they are very likely to themselves be drunk. Champagne swilling will be so popular that politicians will very soon be found to declare that champagne is good for everybody and that “socialist” regulation is stopping the good times rolling.

– secondly, Goodhart’s Law reigns supreme. Markets are very, very good at finding profitable new products – after all, that’s what drives technological progress. But that innovation includes new techniques that no regulator has yet thought of. All that goes treble if the market is in incredibly complex products, like derivatives.

I think boom and bust is an absolutely inevitable part of capitalism. We’ve been fooling ourselves if we think otherwise – but of course the fooling ourselves is part of those animal spirits.

pedro
pedro
12 years ago

Ingolf, Sumner’s particular claim is that a serious problem was being worked out slowly until the Fed tightened and caused the crash. So I don’t think you can accuse him of ignoring the debt problem.

Here is what Tyler Cowan says about him:

“Here is my latest column, on the monetary proposals of Scott Sumner. You probably know Sumner from his blog TheMoneyIllusion and in my view he has become possibly the most astute commentator on monetary policy at this time. ”

http://www.marginalrevolution.com/marginalrevolution/2009/08/the-monetary-economics-of-scott-sumner.html

I’m not sure what you mean by the free lunch crowd.

Alphonse
Alphonse
12 years ago

So Ingolf, what I’ve been asking myself is how rising debt relates to increasing economic inequality.

Clearly, if there is more excess wealth looking for investment returns and there are more borrowers looking to maintain a standard of living that their income no longer enables, then aggregate debt will rise – possibly to untenable levels (harking back to Bezemer)

How much is the GFC (essentially a debt problem) therefore an inequality problem? What does this say about tax policy?

Butterfield, Bloomfield & Bishop
Butterfield, Bloomfield & Bishop
12 years ago

when you get to a Depression or Depression like conditions monetary policy becomes inoperable.

The velocity of money which is never really all that stable suddenly fall off a cliff so the increase in the monetary base becomes irrelevant.

Add to this conditions such as M3 falling whilst the Monetary base was rising in the US during the Great Depression as well as the Taylor rule showing interest rates should be NEGATIVE in most Western Countries then you have an arguable case to use Fiscal policies and liquidity traps abound.

Keynes is vindicated as all sensible people realised.

pedro
pedro
12 years ago

“The financial system is the Achilles heel of modern market economies. Most other things seem to muddle along pretty well but credit periodically runs wild and sends everything into a spin (and, of course, in the process tarnishes the whole idea of free markets). As you say, there isnt much of a constituency for restraint and prudence, mores the pity.”

I think you have to start from the proposition that the financial system is the lubricant and part of the fuel for the market economy. No credit, much much lower growth. but yes, there can be large problems. Krugman says that the source of the problem is excessive saving in the trade surplus countries and he is not the only person to make that point (our own PJK is another). The hot money will always find a home.

With respect to targeting NGDP, Sumner is not just suggesting that the cure is found in more of the disease; he is saying that monetary expansion is necessary to provide space for the adjustment in the US housing market, which he says started in 2006 and was proceeding in a relatively safe fashion until the monetary squeeae he says happened in 2008. Contra Homer, Sumner is saying that monetary policy remains viable despite the apparent liquidity trap and is a better policy than fiscal expansion. Both Sumner and Krugman are simply recommending different ways of keeping economic activity going while the problems work out.

I don’t want to be a shill for Sumner, but he is saying some interesting and different things and he is providing an alternative story to the Keynsians. Most notably, he has taken issue with a lot of Krugman’s pronouncements by quoting Krugman’s own work back at him, and without getting a reply.

Butterfield, Bloomfield & Bishop
Butterfield, Bloomfield & Bishop
12 years ago

Pedro,
If monetary policy could do its job then the Central Banks of the US, UK and Europe would not be indulging in creative ways of boosting the money supply.

They are only doing this because interest rates cannot be cut to a negative figure.

In other words we have a classic liquidity trap.

Keynes after all only advocated the use of fiscal policy because monetary policy was made ineffective.

pedro
pedro
12 years ago

Yes yes yes homer, you’ve said that before. All I did was point to a monetary economist who reckons that fiscal policy was not the only option (and incidentally claimed support from the work of Krugman). He is not saying that interest rates can be cut. Sumner is making that argument (and not all alone) so you should address what he says.

Ingolf, you might like this article with a similar theme to your post:
http://www.american.com/archive/2009/september/regulation-and-the-financial-crisis-myths-and-realities

pedro
pedro
12 years ago

Not tedious at all Ingolf. As I said, I don’t shill for Sumner, but I do like to read different views and especially at a time when old fashioned keynsianism seems to have taken hold.

Tel_
Tel_
12 years ago

If monetary policy could do its job then the Central Banks of the US, UK and Europe would not be indulging in creative ways of boosting the money supply.

They are only doing this because interest rates cannot be cut to a negative figure.

At least in the US, the central bank (and friends thereof) does make a profit from expanding the money supply. After all, free markets only work with a competitive market and in the case of a central bank they are (by definition) monopolies, therefore uncompetitive. I’m not sure about how the UK works but in Germany the central bank has been much more cautious with regards to expanding monetary supply and the Euro seems to be gaining value as compared with the USD right now.

In other words we have a classic liquidity trap.

Or a good old fashioned conflict of interest.

When the GFC struck I, as a quasi-Austrian, thought Aha! Now at last people will realise that crackpots like yours truly werent total cranks after all!

I’m guessing that a taste of inflation will wake up a few more quasi-Austrians.

Getting back to Krugman’s question, does the question actually have any meaning?

What is the objective measure of “got it wrong”? If the measure of an economist is to be able to predict future economic events, then I would argue that they always do “get it wrong” so nothing surprising has happened.

Possibly we should measure economists by the policy advice they give to governments, in which case we would like to repeat the experiment with different policy advice to see the other outcomes (sadly impossible) but at any rate, there are always ample supplies of economists willing to give whatever policy advice you might require (especially if you pay them) so this also makes a poor objective measure of the profession.

If your measure is the ability to sooth the general public into a comfortable belief that everything is in the best of hands right up to the minute it all falls apart, then no one “got it wrong”, the job was done perfectly.

Butterfield, Bloomfield & Bishop
Butterfield, Bloomfield & Bishop
12 years ago

Pedro,
The use of monetary policy is futile as interest rates cannot be negative.
End of story. There is a liquidity trap.

Evidence of this is what Central banks are doing now however given what has happened to the velocity of money it is problematic whether they will succeed in the short-term.

Hence only fiscal policy is available

Alphonse
Alphonse
12 years ago

#17 – Ingolf:

Interesting questions, Alphonse, and not ones Ive thought through properly.

I sometimes get the feeling I’m the only person on the planet asking them. To me they just seem so painfully obvious, but then I’m not an economist.

I gather that Chicagoans and Keynesians (and Austrians?) alike have assumed that the market would determine the optimal size of the financial sector, or that its relative size is an irrelevance; and that these assumptions explain the absence from their models of its separate quantification. But surely there’s been some re-thinking along these lines since Lehmans went down.

Tel_
Tel_
12 years ago

I have no problem with the concept of making successful prediction the measure of scientific progress, and even qualified predictions are helpful if qualified in a sensible manner, and if they actually work. A structural engineer can give you a reasonably good idea as to how far you can safely load up a bridge, but predicting the exact straw that will cause it to collapse is much more difficult.

http://en.wikipedia.org/wiki/Savings_and_loan_crisis

The US government ultimately appropriated 105 billion dollars to resolve the crisis. After banks repaid loans through various procedures, there was a net loss to taxpayers of approximately $124 billion dollars by the end of 1999.[18]

How many economists predicted it?

When it comes to predicting catastrophe, economists have some unique problems not faced by physical scientists. Mainly, there are always economists predicting every outcome in every situation… that’s just how it is. There are always people predicting various ways in which the world will come to an end, more or less. In a marketplace where people have enough free choice to steer away from perceived danger, a sufficiently large number of economists predicting disaster is likely to avert the disaster. Ultimately it becomes a matter of opinion whether there really was a danger. Lucky you, I just saved you from getting stomped by that pink elephant, I’ve chased him away, too quick for you to see.

A small handful of economists predicting disaster (like Jacques for example) will no doubt be considered crackpots, until it happens, then we learn that no one likes a smarty pants.

Thus, I can reliably predict that future economic disasters will happen, and mainstream economists will be caught by surprise, like they are with every disaster (so long as you don’t want me to predict exactly when and how this happens). Our system of keeping score guarantees this outcome.

Tel_
Tel_
12 years ago

The use of monetary policy is futile as interest rates cannot be negative.
End of story. There is a liquidity trap.

Any attempt to inject an error-cancelling signal into a system (which is the heart of Keynesian strategy) requires the ability to predict at least a little bit ahead of the current situation. Whacking it after the fact won’t help.

The effort to develop noise-cancelling headphones ran into this problem, it isn’t as easy as it looks, and turning the volume up louder is not the answer.

The correct way to drive through a corner is to brake early, select a suitable speed based on judgement of the corner, the wrong way is to get halfway through, realise you are going too fast then hammer the brakes.

If a juggler drops a ball, catching the next ball harder does not save the broken one.

What I am saying here is that monetary policy will work, only if it’s done right (mind you a gold standard will also work, with less effort, but more discipline). Doing the monetary policy wrong, then asking for a bigger mallet because you don’t like the tool that didn’t work for you certainly does not fill me with confidence.

Of course, any economy depends foremost on physical intrinsics so liquidity is only an afterthought behind that… people will trade if they want to and have good reason to, they barter, make agreements for payment, use whatever comes to hand as currency. But people will refuse to trade if they don’t trust the system and have low confidence in the future.

Alphonse
Alphonse
12 years ago

Ingolf said:

Alphonse: My impression is that households generally only take on excessive debt when an asset boom (usually in real estate) lulls them into a false sense of complacency and provides a suitable rationale

Subprime sure took the limelight, but what about credit card and other consumer debt? That was ramping up big time not from any boom time hope of capital gains but from, I suspect, desire to maintain a standard of living while incomes were falling behind cost of living.

So again, among the inexplicably tiny minority of economists who actually consider debt levels to be relevant, who are examining the debt/inequlity relationship; and if the answer is no-one, why?

pedro
pedro
12 years ago
pedro
pedro
12 years ago

Here is John Cochrane’s reply

“Many friends and colleagues have asked me what I think of Paul Krugmans New York Times Magazine article, How did Economists get it so wrong?
Most of all, its sad. Imagine this werent economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a creationist, a stalwart that maybe continents dont move after all.”

Find it here http://faculty.chicagobooth.edu/john.cochrane/research/Papers/krugman_response.doc

Paul Frijters
Paul Frijters(@paul-frijters)
12 years ago

Alphonse,

thanks for the link to the paper by Dirk Bezemer on all this. I found it really useful and constructive. He argues that one group of economists did see it coming and that was the group looking at debt structures. He gives 12 respectable names the accolade that ‘they saw it coming’, where he selects on those whose predictions included some degree of timing, who gave a theoretical reason why, and who published it before the fact on some open forum.

Dirk’s essential recommendation is to now take the debt structure of an economy more seriously and to incorporate more of what one might call ‘accountancy economics’ into mainstream macro-models and policy advise. Its not the most exciting bit of economics and more resembles bean counting and sifting through large volumes of accounting law rather than showing how clever one is in terms of general equilibrium modelling, but Dirk’s extensive literature study suggests they were the ones who got it right and should thus be taken more account of. That sounds a very sensible strategy to me: when a shock occured most economists (including me) didnt see coming, elevate the position of the group that did see it coming, at least until that group gets the next one wrong.

pedro
pedro
12 years ago

No, it’s not a big increase Ingolf, and Krugman has been complaining about it for yonks. I only posted that link cause of the earlier suggestion that household credit was increasing because incomes were retreating. They are not retreating except in a relative sense (which could be enough to explain the debt boom). But even sensible people on median incomes now can afford a standard of living that would have seemed astonishing to me as a (lowish middle class) child in the 60s and 70s. How would it be if housing costs were less?

“Dirks essential recommendation is to now take the debt structure of an economy more seriously and to incorporate more of what one might call accountancy economics into mainstream macro-models and policy advise.”

The more sensible recommendations I have seen involve 2 things. First try and fix some rules about leverage for banks. Second, try not to let banks grow super huge. Some of the same people believe that the regulators can never get ahead of the game for very long.

Tel_
Tel_
12 years ago

Imagine this werent economics for a moment. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid 1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programs, presented at its conferences, summarized in its graduate textbooks, and rewarded with the accolades a profession can bestow, including multiple Nobel prizes, is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be a global-warming skeptic, an AIDS-HIV disbeliever, a creationist, a stalwart that maybe continents dont move after all.

Summary: we’ve been working hard so we must have achieved something, and look over there — shiny thing, over there, look!

Each of those issues (AIDS, climate, evolution, continental drift) are all separate issues, very little to do with each other and absolutely nothing to do with global trade. Playing word association games.

Ever does economics try to dance along behind the physical sciences, hoping that juggling a bit of algebra and having the right trappings will get them into the club. Coolness by association. Sorry guys, you have to go out and find your own coolness. Stop pretending. Stop the big effort to fit in and spend the effort instead understanding why economics is a fundamentally different type of study, that can borrow some of the tools of the physical sciences, but also needs to find it own objective measure of success, at least enough to say, “yes that worked” or “no, that was rubbish”. Even this basic concept of self evaluation has not yet been achieved.

pedro
pedro
12 years ago

You might like this Ingolf

“Perhaps the most glaring failure, thus far little discussed in the commentary on the financial meltdown, was the absence of Federal regulation requiring stringent downpayment requirements on residential mortgages. This is particularly ironic because the Feds Regulations T, U, and X have long regulated margin requirements for stock market credit. Low 10 percent margin requirements were a culprit in the 1929 stock market bubble and crash (in contrast with 50 percent margin requirements on equities today), and the absence of tight regulations on residential mortgage down payments played a parallel role in the 200306 housing bubble and crash. The absence of U. S. regulation on down payments shows a striking failure at Regulation 101 and baffles observers from other countries that maintain stiff down payment requirements of 20 or 30 percent.6

http://faculty-web.at.northwestern.edu/economics/gordon/GRU_Combined_090909.pdf

Tel_
Tel_
12 years ago

May I just add, that the closer I study Cochrane’s essay, the less I like the man. For fear of being accused of quoting him out of context, I’m stuck with the obligation of posting something longer than I should.

Krugman hints at dark conspiracies, claiming dissenters are marginalized. Most of the article is just a calumnious personal attack on an ever-growing enemies list, which now includes new Keyenesians such as Olivier Blanchard and Greg Mankiw. Rather than source professional writing, he plays gotcha with out-of-context second-hand quotes from media interviews. He makes stuff up, boldly putting words in peoples mouths that run contrary to their written opinions. Even this isnt enough: he adds cartoons to try to make his enemies look silly, and puts them in false and embarrassing situations. He accuses us of adopting ideas for pay, selling out for sabbaticals at the Hoover institution and fat Wall street paychecks. It sounds a bit paranoid.

… followed a bit later by …

So what is Krugman up to? Why become a denier, a skeptic, an apologist for 70 year old ideas, replete with well-known logical fallacies, a pariah? Why publish an essentially personal attack on an ever-growing enemies list that now includes practically every professional economist? Why publish an incoherent vision for the future of economics?

The only explanation that makes sense to me is that Krugman isnt trying to be an economist, he is trying to be a partisan, political opinion writer. This is not an insult. I read George Will, Charles Krauthnammer and Frank Rich with equal pleasure even when I disagree with them. Krugman wants to be Rush Limbaugh of the Left.

I’m curious about many schools of economics, but I have no time for the “when it suits me” school of logic. If Cochrane has genuine ideas and a bit of style then he can deliver something better than this. Maybe it’s some sort of insider joke or something, I for one, don’t get it.

Not a unique example either:

Its fun to say we didnt see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences.

… backed up by …

Its the central prediction of free-market economics, as crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what fundamental value is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism would have worked.

… which somehow flips over to …

First, he argues for a future of economics that recognizes flaws and frictions, and incorporates alternative assumptions about behavior, especially towards risk-taking. To which I say, Hello, Paul, where have you been for the last 30 years? Macroeconomists have not spent 30 years admiring the eternal verities of Kydland and Prescotts 1982 paper. Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviors, especially new models of attitudes to risk, and comparing the resulting models, quantitatively, to data. The long literature on financial crises and banking which Krugman does not mention has also been doing exactly the same.

So there’s a fundamental principle that makes markets unpredictable, but how about this excellent work we have done with quantitative modelling of markets achieving such a clean fit to the measured data? What does our model actually do? Nothing whatsoever! Have a listen to me, markets are unpredictable!

Cochrane seems to believe that because he has theoretical proof that markets are efficient (in some abstract world that he later admits does not really exist), therefore anything that happens in any market must be therefore the result of efficiency. Thus, no physical evidence can ever possibly contradict the proof because all outcomes are the most efficient outcome.

This is exactly the sort of thinking that I was complaining about in #30 above, but whereas I saw it as a serious problem, Cochrane sees is as an opportunity. A discipline without the need for discipline. What could be more ideal?

Finally, Cochrane sets off my number one idiot buzzer; he argues against an idea on the basis that the idea is old. This is an insult to anyone who has done even the most cursory study of history. I like to think that I don’t live in the past, but I do at least devote some small energy to understanding and respect for what has been done before me. Let me be clear: money is old. The Sumarians traded government-issued baked-clay tokens that were surprisingly similar to our modern fiat currency, and this happened 5000 years before the birth of Christ. If Cochrane’s best argument against Keynesian ideas is that those ideas are old, then might as well argue against wheels, shoes, marriage, and haircuts!

It would require a gnarled and world wise Hungarian sailor to deliver language appropriate to this so called argument.

And yes, economics does very much need an anchor in this world.

pedro
pedro
12 years ago

I think that “efficient” must be one of those dumb terms, like rational, that economists use and thus confuse a good percentage of themselves and almost everyone else.

I like how Mises said that people act purposefully. Much better way of describing things than “rationally”. When it comes to the EMH, it is easy to find accusations that various people have some dumb idea about efficient markets and much harder to find that dumb idea actually being expressed. The only think to take from the EMH as far as I can tell, and all Cochrane seems to be saying, is that in the long run you can’t beat the market and at any time as many people will likely be wrong as right. Not exactly, but on average. The simple message being that you can’t keep the ship afloat with the tiller and engines. You need a some thing like a plimsoll line and ballast requirements, such as a the minimum required equity rule mentioned above.

Krugman’s first paragraph talks about how everyone was smug and self-assured that the central problem of preventing depressions had been solved. His next line is the gotcha “Last year, everything came apart.” Well, we didn’t get a depression so how has the first claim been falsified by events?

Then he says:

“During the golden years, financial economists came to believe that markets were inherently stable indeed, that stocks and other assets were always priced just right.”

Well where is the evidence for this?

Alphonse
Alphonse
12 years ago

Paul @37,

Glad to be of service. What amazes me is that Bezemer’s 12 were, as you note, not being especially clever. They were basically just distinguishing between the financial sector and the real economy, unlike the rest of the profession.

The blindness of the mainstream to that distincton could hardly be simple mindedness. It must be a reasoned corollary to one or more axioms of conventional economic theory. What would that axiom / those axioms be?

Paul Frijters
Paul Frijters(@paul-frijters)
12 years ago

Alphonse,

there are many reasons mainstream economists are not able to really deal with the financial sector, but I think the important reasons is that it is mathematically too hard to come up with a truly sensible model and that the one model of the whole economy we think we can understand by necessity needs to presume the financial sector plays no role anyone else would recognise. To start with the technical reasons why the mathematics is too hard:

1. It is mathematically too hard to work out an elegant model in which money actually appears to have a role. In first year econ we teach the students that money has a role because bartering runs into indivisibilities (you cant exchange half a live cow for something else: the cow would be dead and no longer produce milk); goods perish after a while making it hard to save them (i.e. consumer goods’ qualities change over time); and they are bulky (transport costs and protection costs are non-negligible). Each of these reasons is already quite difficult to model. To then tie a model in which such elements arise to a wider model of the macro-economy has so far eluded the best mathematicians in the business.

2. It is even harder to come up with a model where money plays a role and financial intermediation plays a role. you dont need information problems to create a role for money, but to create a role for financial intermediation (i.e. your loan is with a bank, not with the person who lends to the bank) does immediately need imperfect information. True imperfect information, i.e. a model where the possibility arises that people may actually be wrong, is easy to work with in a simple micro-model, but becomes exceptionally hard to work with in a model difficult enough to also allow a role for money, and becomes sheer impossible if you then want to tie that into a model in which there is an actual need for finance (i.e. people cannot self-finance but need bulky investments in order to produce): to have an actual need for finance needs an increasing-returns-to-scale technology somewhere in the production of goods. Tie all these difficulties together for producing the minimal set of conditions you need to even meaningfully speak in a model sense about financial intermediation: perishable goods, information asymmetry, the existence of information investments (the bank invests in ties with many), increasing returns to scale in production. You then have a minimal model that is already far too complicated to yield analytical clean solutions. One can set up such a model, but there would be no way to work out within such a model what the ‘rational things to do is’, meaning that you’d have to start to specify an exact process for how people in this model come up with expectations on which they base their decision. You then have a model of such baffling specificity and complexity that you can really only simulate its outcomes under various parameter values. This sort of thing can be done (and maybe has been done, I dont know), but because the model will be so dependent on a whole host of fairly arbitrary choices the model-maker has to make (the exact production function, the search space, the flow of information people do have access to, etc.), the output is not going to change anyone’s mind. Indeed, no journal of standing would consider publishing it, even if it were the best representation of reality simply because the few who are mathematically smart enough to work through it would undoubtedly find the model too specific and ‘ugly’ to allow to pass through. Its virtual career suicide to even work on such models.

Hence the mathematics are simply too hard. What do you then do as a profession when you know you basically cannot generate an internally-consistent view of a process? One popular strategy is then to pretend that it doesnt exist. Another view, called the efficient market hypothesis, is that it doesnt exist but that it via some unknown miraculous process nevertheless yields what you want it to yield, i.e. an efficient outcome. You get several Nobel prizes for such trivia, become famous and rich, appreciated by those who value beauty in their models, and the fact that it has nothing to do with reality remains unimportant till your dying day.
A second strategy is to muddle through, i.e. to recognise that you’re only scratching the surface of its understanding, making dubious assumptions that you hope capture something of the underlying complexities, gather data that is at best vaguely related to what you really want to know, and make brave predictions which will more often be wrong than right. Unfortunately also, you are then dealing with such imprecise and fuzzy knowledge that is so grounded in your own life’s experiences and teaching, that almost no-one else will be able to judge the value of what you have done. You may be right and be one of the few misunderstood geniuses, but more likely than not you are one of the tens of thousands of full-time muddlers who werent smart enough to compete with the creators of beauty. If you’re lucky, you can get such things in second-tier journals. Within policy land, you may find more willing ears, but only if you somehow manage to scrape a reputation doing other stuff so that they too know you’re not another wannabee. Muddling through is what people who actually have to make decisions need to do all the time, so you will find more muddlers in decision land than amongst the ivory towers where beauty is of greater importance than some vague association with some vague ‘truth’.

And, despite the latest crises and the bleating that invariably follows such crises, the basic incentive structure above have not changed one bit, hence you would be a fool to expect anything major to change within economics in the next few years. Indeed, this crisis has been a boon for economics as a profession. We’ve never been so popular and influential. What do you think the odds are under those circumstances that famous people are going to willingly give up the human capital they have created over the last decades in order to be more ‘vaguely right’ than they were before? And who do you think will end up deciding this: the people who got famous under the old regime and have the ear of the public and policy makers, or the muddlers under the surface who were right all along but have no audience? Take a wild guess. Then look at what, during this crisis, the majority of the textbooks teach taught to the next generation, and take a wild stab at what is going to resurface as the dominant stream of thought within economics in the coming decades.

pedro
pedro
12 years ago

Krugman flailed from an unexpected direction. At taste:

“But let’s turn to what you say are our deeper failures. We “turned a blind eye to the limitations of human rationality that often lead to bubbles and busts.” It makes me feel physically ill that a distinguished economist could be so ignorant of his own profession. As a random example, how about my student Felipe Zurita’s thesis on speculation written in 1998? There are endless papers written about bubbles and busts – some assuming rationality, some not. Some are experimental, some are theoretical, some are empirical. There are economists who have devoted their entire careers to studying bubbles. There is a fellow named Stephen Morris. He isn’t what you would call a fringe member of the economics profession – he’s the editor of Econometrica which, as you know, is one of the leading journals in economics. He has written extensively about bubbles. I take it you aren’t familiar with his work. Perhaps you should walk down the hall and stick your head in his office and ask him about it? Each crisis – in Mexico, in South-east Asia, in Argentina – had generated hundreds of papers examining how and why the crisis took place.”

Read more at: http://www.huffingtonpost.com/david-k-levine/an-open-letter-to-paul-kr_b_289768.html

Tel_
Tel_
12 years ago

They let you cite HuffPo around here? Should have told me earlier.

http://www.huffingtonpost.com/2009/09/07/priceless-how-the-federal_n_278805.html

The Fed keeps many of the influential editors of prominent academic journals on its payroll. It is common for a journal editor to review submissions dealing with Fed policy while also taking the bank’s money. A HuffPost review of seven top journals found that 84 of the 190 editorial board members were affiliated with the Federal Reserve in one way or another.

“Try to publish an article critical of the Fed with an editor who works for the Fed,” says Galbraith. And the journals, in turn, determine which economists get tenure and what ideas are considered respectable.

The pharmaceutical industry has similarly worked to control key medical journals, but that involves several companies. In the field of economics, it’s just the Fed.

Being on the Fed payroll isn’t just about the money, either. A relationship with the Fed carries prestige; invitations to Fed conferences and offers of visiting scholarships with the bank signal a rising star or an economist who has arrived.

Affiliations with the Fed have become the oxygen of academic life for monetary economists. “It’s very important, if you are tenure track and don’t have tenure, to show that you are valued by the Federal Reserve,” says Jane D’Arista, a Fed critic and an economist with the Political Economy Research Institute at the University of Massachusetts, Amherst.

Good to see some properly bitter comments coming out :-)

I would have to agree with Paul Frijters, except (obviously) I would advocate computer simulation as far cheaper and easier than attempting any analytical solution. Simulation can handle the time dynamics, demonstrate stability (or instability) in the solution, produce statistical profiles, etc.

Computer simulation also allows the insertion of comparatively complex decision-making steps with regard to the “rational” actors (more complex than any analytical approach, less complex than humans).

TheSteelGeneral
TheSteelGeneral
9 years ago

How did John Cochrane get it so wrong?

Well he employs a number of straw men, frankly.

Krugman never attacks the EMH in the way Cochrane says:

EMH comes down to: ya can’t beat the market, over a long period of time, everything evens out.

This DOES too presuppose, rational economic actors.
Krugman thinks that that is wrong.
Cochrane doesn’t address this. Except to say that if corporations are irrational, government people are too, and they aren’t held to any standard. Which is dumb, since politicians are under far more scrutiny than corporations, via elections.

If Big Corp is to be disciplined by the market, how come all these CEO’s make out like bandits? And their bonus receiving lackeys.
Doesn’t make sense.
Small business is disciplined by the market, yes, but big corp? NO.

Krugman is basically arguing for a return to Glass-Steagall. Cochrane kinda ignores that, and comes with a ridiculous statement that Keynes’ writings are 80 years old, so we shouldn’t use his insights.
Cochrane conveniently forgets:
1. The constitution is much older than Keynes.
2. More relevantly, Ricardo and Smith are also older than Keynes, yet he likes them
3. oldness doesn’t matter, applicability does. Keynes was used to combat the Great Depression, since we have similar situation, we can use him again.

Just cause you haven’t called the Fire Dept in forever, they’re pretty useful in putting out fires.
EVEN if they use a bucket chain, when you have nothing else.

Perhaps Krugman does ad hominems, but Cochrane SURELY does that, so he isn’t any better. You can’t decry a tactic, but then use it yourself.