LARS P. SYLL

Chicago economists — people who have their heads fuddled with nonsense

“Fisher Says Prices of Stocks Are Low,” said a headline in the New York Times on October 22, 1929, referring to economist Irving Fisher. Two days later, the stock market crashed, and by the end of November the New York Stock Exchange was down 30 percent from its peak. Fisher had based his statement on strong earnings reports, few industrial disputes, and evidence of high investment in research and development (R&D) and in other intangible capital. But since market prices fell dramatically so soon after Fisher’s statement, most analysts and economic historians concluded that Fisher was wrong: in October 1929 stocks were overvalued.

In this paper, we use modern growth theory to evaluate this conclusion. When stocks of corporations are correctly priced, this theory says, their market value should equal the value of corporations’ productive assets, what we will call the fundamental value of corporations.2 Productive assets include both tangible and intangible assets. We have direct measures of corporate tangible capital and land and of the tax rates that affect the prices of these assets. We also have measures of profits and the growth rate of the economy which, together with the tangible capital measures, allow us to infer the size of the stock of intangible capital in the corporate sector. We thus can compare the total value of corporate productive assets to the actual market value of corporate stocks at the time of the crash.

Our results support Fisher’s view. A conservative estimate of the fundamental value of U.S. corporations in 1929—which assumes as low a value for intangible capital as observations allow—is at least 21 times the value of after-tax corporate earnings (or 1.9 times gross national product or GNP). The highest estimate of the actual 1929 market value of corporate stocks (based on samples of publicly traded stocks) is 19 times the value of after-tax corporate earnings at their peak in 1929 (or 1.67 times GNP). This is strong evidence that Fisher was right: stock prices in the fall of 1929 were a little low relative to fundamental values.

Ellen McGrattan & Edward Prescott

I think we better leave the commenting​ on this “research” to Robert Solow:

Suppose someone sits down where you are sitting right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tactics at the battle of Austerlitz. If I do that, I’m getting tacitly drawn into the game that he is Napoleon. Now, Bob Lucas and Tom Sargent like nothing better than to get drawn into technical discussions, because then you have tacitly gone along with their fundamental assumptions; your attention is attracted away from the basic weakness of the whole story. Since I find that fundamental framework ludicrous, I respond by treating it as ludicrous – that is, by laughing at it – so as not to fall into the trap of taking it seriously and passing on to matters of technique.

Robert Solow

Italy — shows why the euro has to be abandoned if Europe is to be saved

Investors had until recently been widely expected the European Central Bank to signal at its next meeting in two weeks’ time that it would wind down QE later in the year. Now, questions are growing about how feasible it will be to withdraw the ECB’s buying power at a time when investors are already driving Italian debt costs higher. Nearly half a decade ago, the Greek debt crisis turned into a crunch point for the bloc as a whole. The sheer scale of both the Italian economy and its bond market make it much more of a systemic challenge to the bloc than Greece was. Some commentators have dubbed Italy “too big to fail and too big to bail”. “On a number of levels — by challenging political cohesion, by raising public and private borrowing costs, and ultimately, through growing eurosystem imbalances — events in Italy could destabilise the euro area,” said Marchel Alexandrovich, senior European financial economist at Jefferies.

Financial Times

The euro has taken away the possibility for national governments to manage their economies in a meaningful way — and in Italy, just as in Greece a couple of years ago, the people have​ had to pay the true costs of its concomitant misguided austerity policies.

The unfolding of the repeated economic crises in euroland during the last decade has shown beyond any doubts that the euro is not only an economic project​ but just as much a political one. What the neoliberal revolution during the 1980s and 1990s didn’t manage to accomplish, the euro shall now force on us.

But do the peoples of Europe really want to deprive themselves of economic autonomy, enforce lower wages and slash social welfare at the slightest sign of economic distress? Is increasing​ income inequality and a federal überstate really the stuff that our dreams are made of? I doubt it.

History ought to act as a deterrent. During the 1930s our economies didn’t come out of the depression until the folly of that time — the gold standard — was thrown on the dustbin of history. The euro will hopefully soon join it.

Economists have a tendency to get enthralled by their theories and model​​ and forget that behind the figures and abstractions there is a real world with real people. Real people that have to pay dearly for fundamentally flawed doctrines and recommendations.

The ‘European idea’—or better: ideology—notwithstanding, the euro has split Europe in two. As the engine of an ever-closer union the currency’s balance sheet has been disastrous. Norway and Switzerland will not be joining the eu any time soon; Britain is actively considering leaving it altogether. Sweden and Denmark were supposed to adopt the euro at some point; that is now off the table. The Eurozone itself is split between surplus and deficit countries, North and South, Germany and the rest. At no point since the end of World War Two have its nation-states confronted each other with so much hostility; the historic achievements of European unification have never been so threatened …

Anyone wishing to understand how an institution such as the single currency can wreak such havoc needs a concept of money that goes beyond that of the liberal economic tradition and the sociological theory informed by it. The conflicts in the Eurozone can only be decoded with the aid of an economic theory that can conceive of money not merely as a system of signs that symbolize claims and contractual obligations, but also, in tune with Weber’s view, as the product of a ruling organization, and hence as a contentious and contested institution with distributive consequences full of potential for conflict …

Now more than ever there is a grotesque gap between capitalism’s intensifying reproduction problems and the collective energy needed to resolve them … This may mean that there is no guarantee that the people who have been so kind as to present us with the euro will be able to protect us from its consequences, or will even make a serious attempt to do so. The sorcerer’s apprentices will be unable to let go of the broom with which they aimed to cleanse Europe of its pre-modern social and anti-capitalist foibles, for the sake of a neoliberal transformation of its capitalism. The most plausible scenario for the Europe of the near and not-so-near future is one of growing economic disparities—and of increasing political and cultural hostility between its peoples, as they find themselves flanked by technocratic attempts to undermine democracy on the one side, and the rise of new nationalist parties on the other. These will seize the opportunity to declare themselves the authentic champions of the growing number of so-called losers of modernization, who feel they have been abandoned by a social democracy that has embraced the market and globalization.

Wolfgang Streeck

The ultimate takedown​ of teflon-coated defenders of rational expectations

James Heckman, winner of the “Nobel Prize” in economics, was inteviewed by John Cassidy in 2010.

What about the rational-expectations hypothesis, the other big theory associated with modern Chicago? How does that stack up now? …

It became a kind of tautology that had enormously powerful policy implications, in theory. But the fact is, it didn’t have any empirical content. When Tom Sargent, Lard Hansen, and others tried to test it using cross equation restrictions, and so on, the data rejected the theories. There were a certain section of people that really got carried away. It became quite stifling …

What about you? When rational expectations was sweeping economics, what was your reaction to it? I know you are primarily a micro guy, but what did you think?

What struck me was that we knew Keynesian theory was still alive in the banks and on Wall Street. Economists in those areas relied on Keynesian models to make short-run forecasts. It seemed strange to me that they would continue to do this if it had been theoretically proven that these models didn’t work.

What about the efficient-markets hypothesis? Did Chicago economists go too far in promoting that theory, too?

Some did. But there is a lot of diversity here. You can go office to office and get a different view …

So, today, what survives of the Chicago School? What is left? …

When Friedman died, a couple of years ago, we had a symposium for the alumni devoted to the Friedman legacy. I was talking about the permanent income hypothesis; Lucas was talking about rational expectations. We have some bright alums. One woman got up and said, “Look at the evidence on 401k plans and how people misuse them, or don’t use them. Are you really saying that people look ahead and plan ahead rationally?” And Lucas said, “Yes, that’s what the theory of rational expectations says, and that’s part of Friedman’s legacy.” I said, “No, it isn’t. He was much more empirically minded than that.” People took one part of his legacy and forgot the rest. They moved too far away from the data.

Yes indeed, they certainly “moved too far away from the data.”

In one of the more well-known and highly respected evaluation reviews made, Michael Lovell (1986) concluded:

it seems to me that the weight of empirical evidence is sufficiently strong to compel us to suspend belief in the hypothesis of rational expectations, pending the accumulation of additional empirical evidence.

And this is how Nikolay Gertchev summarizes studies on the empirical correctness of the hypothesis:

More recently, it even has been argued that the very conclusions of dynamic models assuming rational expectations are contrary to reality: “the dynamic implications of many of the specifications that assume rational expectations and optimizing behavior are often seriously at odds with the data” (Estrella and Fuhrer 2002, p. 1013). It is hence clear that if taken as an empirical behavioral assumption, the RE hypothesis is plainly false; if considered only as a theoretical tool, it is unfounded and selfcontradictory.

For even more on the issue, permit me to self-indulgently recommend reading my article Rational expectations — a fallacious foundation for macroeconomics in a non-ergodic world in real-world economics review no. 62.

Behavioural economics — still too devoted to ideas it is supposedly attacking

Behavioral economics is still ‘in a relationship’ with orthodox economics and, in a relationship, one makes compromises …

We all know how stubborn the other side in this relationship is: standard economics will always ‘rationalize’ behavior wherever it can and will only recognize ‘irrationality’ when there is clear and convincing evidence of it. Understandably, behavioral economics devoted itself to finding this evidence – the “anomalies”, in the words of Thaler (1988), which are “difficult to “rationalize”. And surely, it has done an impressive job in finding them.

However, accepting this burden of proof remains problematic, for several reasons. Firstly, it will lead to false positives; ‘rationalizing’ behavior where rationality might, in reality, be absent. What’s more, in doing this, the field will repeatedly lend credence to the flawed concept of the homo economicus. Secondly, it will lead to false negatives; failing to observe ‘irrationality’ (like altruism) when clear and convincing evidence of it is lacking, or perhaps even impossible to produce, thereby ignoring the complexity of human motives …

All of the above is not meant to downplay the achievements of behavioral economics … It is to argue that behavioral economics should not let its “symbiotic relationship” with standard economics limit its own ambitions. This relationship “works well as long as small changes to standard assumptions are made”. We should not fear bigger changes.

Alexander Beunder

Although discounting empirical evidence cannot be the right way to solve economic issues, there are still, in my opinion, a couple of weighty reasons why we perhaps shouldn’t be too excited about the so-called ’empirical revolution’ that behavioural economics has brought about in mainstream economics.

Behavioural experiments and laboratory research face the same basic problem as theoretical models — they are built on often rather artificial conditions and have difficulties with the ‘trade-off’ between internal and external validity. The more artificial conditions, the more internal validity, but also less external validity. The more we rig experiments to avoid the ‘confounding factors’, the less the conditions are reminiscent of the real ‘target system.’ The nodal issue is how economists using different isolation strategies in different ‘nomological machines’ attempt to learn about causal relationships. One may have justified doubts on the generalizability of this research strategy since the probability is high that causal mechanisms are different in different contexts and that lack of homogeneity and invariance doesn’t give us warranted export licenses to the ‘real’ societies or economies.

If we see experiments or laboratory research as theory tests or models that ultimately aspire to say something about the real ‘target system,’ then the problem of external validity is central (and was for a long time also a key reason why behavioural economists had trouble getting their research results published).

A standard procedure in behavioural economics — think of e.g. dictator or ultimatum games — is to set up a situation where one induce people to act according to the standard microeconomic — homo oeconomicus — benchmark model. In most cases, the results show that people do not behave as one would have predicted from the benchmark model, in spite of the setup almost invariably being ‘loaded’ for that purpose. [And in those cases where the result is consistent with the benchmark model, one, of course, have to remember that this in no way proves the benchmark model to be right or ‘true,’ since there, as a rule, may be many outcomes that are consistent with that model.]

For most heterodox economists this is just one more reason for giving up on the standard model. But not so for mainstreamers and many behaviouralists. To them, the empirical results are not reasons for giving up on their preferred hardcore axioms. So they set out to ‘save’ or ‘repair’ their model and try to ‘integrate’ the empirical results into mainstream economics. Instead of accepting that the homo oeconomicus model has zero explanatory real-world value, one puts lipstick on the pig and hope to go on with business as usual. Why we should keep on using that model as a benchmark when everyone knows it is false is something we are never told. Instead of using behavioural economics and its results as building blocks for a progressive alternative research program, the ‘save and repair’ strategy immunizes a hopelessly false and irrelevant model.

By this, I do not mean to say that empirical methods per se are so problematic that they can never be used. On the contrary, I am basically — though not without reservations — in favour of the increased use of behavioural experiments and laboratory research within economics. Not least as an alternative to completely barren ‘bridge-less’ axiomatic-deductive theory models. My criticism is more about aspiration levels and what we believe that we can achieve with our mediational epistemological tools and methods in the social sciences.

The increasing use of natural and quasi-natural experiments in economics during the last couple of decades has led several prominent economists to triumphantly declare it as a major step on a recent path toward empirics, where instead of being a deductive philosophy, economics is now increasingly becoming an inductive science.

Limiting model assumptions in economic science always have to be closely examined since if we are going to be able to show that the mechanisms or causes that we isolate and handle in our models are stable in the sense that they do not change when we ‘export’ them to our ‘target systems,’ we have to be able to show that they do not only hold under ceteris paribus conditions and a fortiori only are of limited value to our understanding, explanations or predictions of real economic systems.

‘Ideally controlled experiments’ tell us with certainty what causes what effects — but only given the right ‘closures.’ Making appropriate extrapolations from (ideal, accidental, natural or quasi) experiments to different settings, populations or target systems, is not easy. ‘It works there’ is no evidence for ‘it will work here.’ Causes deduced in an experimental setting still have to show that they come with an export-warrant to the target system. The causal background assumptions made have to be justified, and without licenses to export, the value of ‘rigorous’ and ‘precise’ methods is despairingly small.

So — although it is good that people like Kahneman and Thaler are rewarded ‘Nobel prizes’ and that much of their research has vastly undermined the lure of axiomatic-deductive mainstream economics, there is still a long way to go before economics has become a truly empirical science. The great challenge for the future economics is not to develop methodologies and theories for well-controlled laboratories, but to develop relevant methodologies and theories for the messy world in which we happen to live.

The follies and fallacies of Chicago​ economics

Gier auf Geld

Mainstream economics — peddling fake knowledge

Based on the [quantity theory of money equation MV = PQ] holding the money velocity constant, if the money supply (M) increases at a faster rate than real economic output (Q), the price level (P) must increase to make up the difference. According to this view, inflation in the U.S. should have been about 31 percent per year between 2008 and 2013, when the money supply grew at an average pace of 33 percent per year and output grew at an average pace just below 2 percent. Why, then, has inflation remained persistently low (below 2 percent) during this period? …

During the first and second quarters of 2014, the velocity of the monetary base2 was at 4.4, its slowest pace on record. This means that every dollar in the monetary base was spent only 4.4 times in the economy during the past year, down from 17.2 just prior to the recession. This implies that the unprecedented monetary base increase driven by the Fed’s large money injections through its large-scale asset purchase programs has failed to cause at least a one-for-one proportional increase in nominal GDP. Thus, it is precisely the sharp decline in velocity that has offset the sharp increase in money supply, leading to the almost no change in nominal GDP (either P or Q).

So why did the monetary base increase not cause a proportionate increase in either the general price level or GDP? The answer lies in the private sector’s dramatic increase in their willingness to hoard money instead of spend it. Such an unprecedented increase in money demand has slowed down the velocity of Money …

And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues:
•A glooming economy after the financial crisis
•The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds.

Yi Wen & Maria Arias (St. Louis Fed)

Anyone still believing in Say’s Law? Just wondering …

Chicago delirium VSOP

Macroeconomics was born as a distinct field in the 1940s (sic!), as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.

Robert Lucas (2003)

In the past, I think you have been quoted as saying that you don’t even believe in the possibility of bubbles.

Eugene Fama: I never said that. I want people to use the term in a consistent way. For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down—I guess that is what they call a bubble. People have become entirely sloppy. People have jumped on the bandwagon of blaming financial markets. I can tell a story very easily in which the financial markets were a casualty of the recession, not a cause of it.

That’s your view, correct?

Fama: Yeah.

John Cassidy

Suppose someone sits down where you are sitting right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tactics at the battle of Austerlitz. If I do that, I’m getting tacitly drawn into the game that he is Napoleon. Now, Bob Lucas and Tom Sargent like nothing better than to get drawn into technical discussions, because then you have tacitly gone along with their fundamental assumptions; your attention is attracted away from the basic weakness of the whole story. Since I find that fundamental framework ludicrous, I respond by treating it as ludicrous – that is, by laughing at it – so as not to fall into the trap of taking it seriously and passing on to matters of technique.

Robert Solow