LARS P. SYLL

Mainstream economics in denial

We’d gathered at Downing College, Cambridge, to discuss the economic crisis, although the quotidian misery of that topic seemed a world away from the honeyed quads and endowment plush of this place.

Equally incongruous were the speakers. The Cambridge economist Victoria Bateman looked as if saturated fat wouldn’t melt in her mouth, yet demolished her colleagues. They’d been stupidly cocky before the crash – remember the 2003 boast from Nobel prizewinner Robert Lucas that the “central problem of depression-prevention has been solved”? – and had learned no lessons since. Yet they remained the seers of choice for prime ministers and presidents. She ended: “If you want to hang anyone for the crisis, hang me – and my fellow economists.”

What followed was angry agreement. On the night before the latest growth figures, no one in this 100-strong hall used the word “recovery” unless it was to be sarcastic. Instead, audience members – middle-aged, smartly dressed and doubtless sizably mortgaged – took it in turn to attack bankers, politicians and, yes, economists. They’d created the mess everyone else was paying for, yet they’d suffered no retribution.

…

Yet look around at most of the major economics degree courses and neoclassical economics – that theory that treats humans as walking calculators, all-knowing and always out for themselves, and markets as inevitably returning to stability – remains in charge. Why? In a word: denial. The high priests of economics refuse to recognise the world has changed.

In his new book, Never Let a Serious Crisis Go to Waste, the US economist Philip Mirowski recounts how a colleague at his university was asked by students in spring 2009 to talk about the crisis. The world was apparently collapsing around them, and what better forum to discuss this in than a macroeconomics class. The response? “The students were curtly informed that it wasn’t on the syllabus, and there was nothing about it in the assigned textbook, and the instructor therefore did not wish to diverge from the set lesson plan. And he didn’t.”

Something similar is going on at Manchester University, where … economics undergraduates are petitioning their tutors for a syllabus that acknowledges there are other ways to view the world than as a series of algebraic problem sets.

Aditya Chakrabortty/The Guardian

[h/t Jan Milch]

Robert Shiller agrees to disagree with Fama

Professor Fama is the father of the modern efficient-markets theory, which says financial prices efficiently incorporate all available information and are in that sense perfect. In contrast, I have argued that the theory makes little sense, except in fairly trivial ways. Of course, prices reflect available information. But they are far from perfect. Along with like-minded colleagues and former students, I emphasize the enormous role played in markets by human error, as documented in a now-established literature called behavioral finance …

Actually, I do not completely oppose the efficient-markets theory. I have been calling it a half-truth. If the theory said nothing more than that it is unlikely that the average amateur investor can get rich quickly by trading in the markets based on publicly available information, the theory would be spot on. I personally believe this, and in my own investing I have avoided trading too much, and have a high level of skepticism about investing tips.

But the theory is commonly thought, at least by enthusiasts, to imply much more. Notably, it has been argued that regular movements in the markets reflect a wisdom that transcends the best understanding of even the top professionals, and that it is hopeless for an ordinary mortal, even with a lifetime of work and preparation, to question pricing. Market prices are esteemed as if they were oracles.

This view grew to dominate much professional thinking in economics, and its implications are dangerous. It is a substantial reason for the economic crisis we have been stuck in for the past five years, for it led authorities in the United States and elsewhere to be complacent about asset mispricing, about growing leverage in financial markets and about the instability of the global system. In fact, markets are not perfect, and really need regulation, much more than Professor Fama’s theories would allow …

We disagree on a number of important points, but there is nothing wrong with our sharing the prize. In fact, I am happy to share it with my co-recipients, even if we sometimes seem to come from different planets.

 Robert Shiller

Fama and Shiller — an odd couple indeed

I would love to be in the audience watching the body language at this year’s “Nobel” ceremony for economics. Robert Shiller, who is far too polite a person to make it obvious, will nonetheless at least fidget as he listens to Eugene Fama’s speech, since Fama continues to dispute that bubbles in asset prices can even be defined. Shiller, in contrast, first came to public prominence with his warnings in the early 2000s that the stock and housing markets in the States were displaying signs of “irrational exuberance” …

How can two such diametrically opposed views receive the Nobel Prize in one year? The equivalent in physics would be to award the prize to one research team that proved that the Higgs Boson existed, and another that proved it didn’t …

Shiller is a worthy recipient for a number of reasons. First and foremost, he has emphasised the need for long term empirical data in economics, and he has provided it as well  … He also maintains (though he didn’t originate) a stock market index which compares the price of stocks now to their accumulated earnings over the previous decade …

These two contributions in effect make him the Tycho Brahe of economics, and for those alone, I support the award to him. Economics generally behaves as a pre-Galilean discipline in which observation comes a very poor second to theoretical beliefs. Shiller has instead always emphasized that the data must be considered—especially when it contradicts beliefs, which is so often the case in economics.

Fama has received the award for proving “that stock prices are extremely difficult to predict in the short run, and that new information is very quickly incorporated into prices”.

Poppycock. Years before Fama promoted the “Efficient Markets Hypothesis” as an equilibrium-fixated explanation for the obvious fact that it’s “extremely difficult to predict in the short run”, Benoit Mandelbrot had developed the concept of fractals which gave a far-from-equilibrium explanation for precisely the same phenomenon. Economics ignored Mandelbrot’s work completely …

On the intimidation front, Fama’s outspoken championing of an equilibrium approach to modeling asset markets was the exact opposite of Shiller’s brave resistance to the groupthink of American economics. He has been an enforcer of conformity to mainstream thought who has stuck with his equilibrium beliefs despite evidence to the contrary.

Shiller, on the other hand, has been willing to accept that the messiness of the real world is indeed reality, even if it conflicts with the mainstream economics preference for believing that everything happens in equilibrium.

The Odd Couple indeed. Give me Robert Shiller’s messy Oscar over Fama’s anally retentive Felix any day.

Steve Keen

Simon Wren-Lewis on rational expectations — so wrong, so wrong

Oxford professor Simon Wren-Lewis tries — again — to defend the rational expectations hypothesis:

To put it simply, the media help cause changes in public opinion, rather than simply reflect that opinion. Yet, if you have a certain caricature of what a modern macroeconomist believes in your head, this is a strange argument for one to make. That caricature is that we all believe in rational expectations, where agents use all readily available information in an efficient way to make decisions …

Some who read my posts will also know that I am a fan of rational expectations. I tend to get irritated with those (e.g. some heterodox economists) that pan the idea by talking about superhuman agents that know everything. To engage constructively with how to model expectations, you have to talk about practical alternatives. If we want something simple (and, in particular, if we do not want to complicate by borrowing from the extensive recent literature on learning), we often seem to have to choose between assuming rationality or something naive, like adaptive expectations. I have argued that, for the kind of macroeconomic issues that I am interested in, rational expectations provides a more realistic starting point, although that should never stop us analysing the consequences of expectations errors.

It’s easy — and I think this also goes for those who are not “heterodox economists” — not to be exactly impressed by this kind of argumentation. If Wren-Lewis and other macroeconomic modellers don’t “believe in rational expectations,” then why use such a preposterous assumption? The only “caricature” here, is the view of science that the advocates of rational expectations give.

Those who want to build macroeconomics on microfoundations usually maintain that the only robust policies and institutions are those based on rational expectations and representative actors. As yours truly tried to show in a paper in Real-World Economics Review last year —Rational expectations — a fallacious foundation for macroeconomics in a non-ergodic world –there is really no support for this conviction at all. On the contrary. If we want to have anything of interest to say on real economies, financial crisis and the decisions and choices real people make, it is high time to place macroeconomic models building on representative actors and rational expectations-microfoundations where they belong – in the dustbin of history.

For if this microfounded macroeconomics has nothing to say about the real world and the economic problems out there, why should we care about it? The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than hand waving that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around.

“To engage constructively with how to model expectations, you have to talk about practical alternatives,” writes Wren-Lewis. And of course there are alternatives to neoclassical general equilibrium microfoundations. Behavioural economics and Roman Frydman and Michael Goldberg’s “imperfect knowledge” economics being two noteworthy examples that easily come to mind. In one of their recent books re rational expectations, Frydman and Goldberg write:

The belief in the scientific stature of fully predetermined models, and in the adequacy of the Rational Expectations Hypothesis to portray how rational individuals think about the future, extends well beyond asset markets. Some economists go as far as to argue that the logical consistency that obtains when this hypothesis is imposed in fully predetermined models is a precondition of the ability of economic analysis to portray rationality and truth.

For example, in a well-known article published in The New York Times Magazine in September 2009, Paul Krugman (2009, p. 36) argued that Chicago-school free-market theorists “mistook beauty . . . for truth.” One of the leading Chicago economists, John Cochrane (2009, p. 4), responded that “logical consistency and plausible foundations are indeed ‘beautiful’ but to me they are also basic preconditions for ‘truth.’” Of course, what Cochrane meant by plausible foundations were fully predetermined Rational Expectations models. But, given the fundamental flaws of fully predetermined models, focusing on their logical consistency or inconsistency, let alone that of the Rational Expectations Hypothesis itself, can hardly be considered relevant to a discussion of the basic preconditions for truth in economic analysis, whatever “truth” might mean.

There is an irony in the debate between Krugman and Cochrane. Although the New Keynesian and behavioral models, which Krugman favors, differ in terms of their specific assumptions, they are every bit as mechanical as those of the Chicago orthodoxy. Moreover, these approaches presume that the Rational Expectations Hypothesis provides the standard by which to define rationality and irrationality.

…

In fact, the Rational Expectations Hypothesis requires no assumptions about the intelligence of market participants whatsoever … Rather than imputing superhuman cognitive and computational abilities to individuals, the hypothesis presumes just the opposite: market participants forgo using whatever cognitive abilities they do have. The Rational Expectations Hypothesis supposes that individuals do not engage actively and creatively in revising the way they think about the future. Instead, they are presumed to adhere steadfastly to a single mechanical forecasting strategy at all times and in all circumstances. Thus, contrary to widespread belief, in the context of real-world markets, the Rational Expectations Hypothesis has no connection to how even minimally reasonable profit-seeking individuals forecast the future in real-world markets. When new relationships begin driving asset prices, they supposedly look the other way, and thus either abjure profit-seeking behavior altogether or forgo profit opportunities that are in plain sight.

Beyond Mechanical Markets

And in a more recent article the same authors write:

Contemporary economists’ reliance on mechanical rules to understand – and influence – economic outcomes extends to macroeconomic policy as well, and often draws on an authority, John Maynard Keynes, who would have rejected their approach. Keynes understood early on the fallacy of applying such mechanical rules. “We have involved ourselves in a colossal muddle,” he warned, “having blundered in the control of a delicate machine, the working of which we do not understand.”

In The General Theory of Employment, Interest, and Money, Keynes sought to provide the missing rationale for relying on expansionary fiscal policy to steer advanced capitalist economies out of the Great Depression. But, following World War II, his successors developed a much more ambitious agenda. Instead of pursuing measures to counter excessive fluctuations in economic activity, such as the deep contraction of the 1930’s, so-called stabilization policies focused on measures that aimed to maintain full employment. “New Keynesian” models underpinning these policies assumed that an economy’s “true” potential – and thus the so-called output gap that expansionary policy is supposed to fill to attain full employment – can be precisely measured.

But, to put it bluntly, the belief that an economist can fully specify in advance how aggregate outcomes – and thus the potential level of economic activity – unfold over time is bogus …

Roman Frydman & Michael Goldberg

The real macroeconomic challenge is to accept uncertainty and still try to explain why economic transactions take place – instead of simply conjuring the problem away by assuming rational expectations and treating uncertainty as if it was possible to reduce it to stochastic risk. That is scientific cheating. And it has been going on for too long now.

Micro vs Macro

John Quiggin had an interesting post up yesterday on the microfoundations issue:

The basic problem is that standard neoclassical microeconomics is itself a macroeconomic theory in the sense that it’s derived from a general equilibrium model as a whole. The standard GE model takes full employment (in an appropriate technical sense) as given, and derives a whole series of fundamental results from this. Conversely, if the economy can exhibit sustained high unemployment, there must be something badly wrong with standard neoclassical microeconomics.

Yours truly totally agrees — there exist overwhelmingly strong reasons for being critical and doubtful re microfoundations of macroeconomics — and so let me elaborate on a couple of them.

Microfoundations today means more than anything else that you try to build macroeconomic models assuming “rational expectations” and hyperrational “representative actors” optimizing over time. Both are highly questionable assumptions.

The concept of rational expectations was first developed by John Muth (1961) and later applied to macroeconomics by Robert Lucas (1972). Those macroeconomic models building on rational expectations microfoundations that are used today among both New Classical and “New Keynesian” macroconomists, basically assume that people on the average hold expectations that will be fulfilled. This makes the economist’s analysis enormously simplistic, since it means that the model used by the economist is the same as the one people use to make decisions and forecasts of the future.

Macroeconomic models building on rational expectations-microfoundations assume that people, on average, have the same expectations. Someone like Keynes for example, on the other hand, would argue that people often have different expectations and information, which constitutes the basic rational behind macroeconomic needs of coordination. Something that is rather swept under the rug by the extremely simple-mindedness of assuming rational expectations in representative actors models, which is so in vogue in New Classical and “New Keynesian” macroconomics. But if all actors are alike, why do they transact? Who do they transact with? The very reason for markets and exchange seems to slip away with the sister assumptions of representative actors and rational expectations.

Macroeconomic models building on rational expectations microfoundations impute beliefs to the agents that is not based on any real informational considerations, but simply stipulated to make the models mathematically-statistically tractable. Of course you can make assumptions based on tractability, but then you do also have to take into account the necessary trade-off in terms of the ability to make relevant and valid statements on the intended target system. Mathematical tractability cannot be the ultimate arbiter in science when it comes to modeling real world target systems. One could perhaps accept macroeconomic models building on rational expectations-microfoundations  if they had produced lots of verified predictions and good explanations. But they have done nothing of the kind. Therefore the burden of proof is on those macroeconomists who still want to use models built on these particular unreal assumptions.

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