The follies of economics?
Massimo Pigliucci has a post up, Economics learns a thing or two from evolutionary biology. There are many points within the post which I would agree or disagree with, but, I get the sense that the current economic morass is precipitating these sorts of criticisms of “economics.” I’m not one to disagree on the importance of behavioral economics, and I believe a serious engagement with the reality that rationality is bounded will only benefit the human sciences. That being said, it seems to me that the current problems are not ones of economics or the economics profession as much as the particularities of the finance profession in terms of its incentive structure. By analogy, imagine blaming zoologists and botanists for the actions of agribusiness (e.g., excessive utilization of antibiotics so as to maximize short term firm productivity at cost to a risk of a high negative externality). Rather than suggest that economics needs to learn from the life sciences (I think this is happening), I believe that you need to look to public choice theory and other extant frameworks available off the shelf.
Labels: Economics
If there’s a problem with economics as a discipline it’s that too much effort is wasted dinking around with pseudo-problems and untangling conceptual messes created by the biases people bring to the table in any subject dealing with political implications. Psychology suffers from the same problems, and for that matter so does medical science, but at least the economists can say they have a body of semi-coherent theory to work with. There’s no shortage of useful lessons to be learned from even vanilla neoclassical theory, but the fact is that much like population genetics it’s very rare that people actually use it to solve problems.
The difference between econ and micro bio is that many of the high priests of economics were at the steering wheel during this fiasco and encourage policies that created the mess (Greenspan, Scholes, Manikw, Rubin, etc.). Some have yet to issue their mea culpas. Several people have argued that *economic theory* is the problem (c.f. Taleb).
I am not aware of a single prominent microbiologist or infectious disease specialist that would excuse agri-businesses practices. so your analogy seems incorrect to me.
Greenspan, Scholes, Manikw, Rubin, etc.)
i don’t consider greenspan or rubin part of the economics profession.
to follow up: if a biologist goes and works for a private sector company, their actions are not solely dictated by their scientific background. so i’m skeptical of just attributing the faults of those with economic backgrounds who are in areas where they affect public policy and are directly or indirectly subject to political pressures.
An alternate way to look at is this: suppose the agribusiness’ team of PhDs had come to believe that unleashing a plague of locusts would be a great way to boost harvests in the coming years. In that case something might be wrong with education and theory at the graduate level.
Similarly for economics. If econ was forced by this to take more h-bd factors into account at the graduate level, that would be great and long overdue. I’m not holding my breath though.
An alternate way to look at is this: suppose the agribusiness’ team of PhDs had come to believe that unleashing a plague of locusts would be a great way to boost harvests in the coming years. In that case something might be wrong with education and theory at the graduate level.
too extreme. there was a proximate upside to the real estate bubble, some people got out in time. i know “little people” who assumed that the property bubble was a bubble, but played the game, and came out on top by cashing out before it burst (how long people held property was sometimes contingent on tax laws depending on state, so this was a game with serious risk). on the net it did not create wealth, but some people did well. as for the “big people,” many fucked up up, but no one’s going to be asking for bonuses back, and certainly many of the more idiotic predictions aren’t going to result in the predictors going into penury. henry blodget isn’t in the poor house after all. and some of the same .com bulls came back for the real estate bubble. if the past tells us anything, they’ll probably come back for the next bubble. in any case, the problems of individual short-term incentives within large “firms” seems a separate problem from the blind-spots of the economics profession, which were obvious before the bubble burst, remain the same after. also, i thought quantitative finance was dominated by people without conventional econ backgrounds anyway.
razib — I think you’re making an arbitrary distinction on Greenspan. A leader in oncology can work for Genetech or the NCI; a leader in tech can work for Google. Just because someone is not associated with an academic institution doesn’t mean they are prohibited from constituting the leadership of an academic field. You can feel free to exchange him for gnxp favorite, lawrence summers if you wish.
BTW Greenspan, Rubin, Summers et. al. WERE the political pressure for deregulation and encouraging the growth of derivatives.
I think taleb would make the same argument blah made — basically economists lead grad school equipped with weapons of mass destruction.
I agree with you that the incentive structure for finance is messed up and contributed significantly to the mess. However, that’s obviously not the sole determinant — its not like people realized how f’d we were in 2007, when arguably several people were sounding alarm bells. Hell, even 2 months ago, the magnitude was unclear.
A leader in oncology can work for Genetech or the NCI; a leader in tech can work for Google. Just because someone is not associated with an academic institution doesn’t mean they are prohibited from constituting the leadership of an academic field. You can feel free to exchange him for gnxp favorite, lawrence summers if you wish.
if a world renowned genomicist starts up a company, you’d take his predictions relating to the bottom line of his firm with a grain of salt, right? that’s all i’m saying. as for economists in gov., they say what their paymasters tell them to say, within bounds (they can’t look too stupid). there was in fact a funny statement to that effect by joe biden’s top economic adviser:
q: are we going to have a recovery soon?
a: well, now that i have this position, of course there is going to be a recovery soon!
IOW, he was nodding to the fact that economists who are part of government have a rather different brief from those who work outside of government. vox retard, vox dei and all.
re: greenspan, i don’t concede that he is a really top-flight economist. after all, he didn’t even complete his ph.d. summers, yes, obviously. rubin, well, he has an undergrad econ degree, and a law degree, not a ph.d. in econ.
i agree that obviously most economists didn’t “call it.” there’s plenty of criticism that can, and is, leveled. but my main objection to massimo’s point is that i think he is conflating the problems which have emerged from mistaken assumptions within finance, which includes economists as a subset, with economists. many financial professionals are economists, but many economists are not financial professionals, and many financial professionals are not economists.
a few years ago we linked to this piece, Renaissance hedge fund: Only scientists need apply:
“We hire physicists, mathematicians, astronomers and computer scientists and they typically know nothing about finance,” Simons said in a keynote address at the International Association of Financial Engineers annual conference. “We haven’t hired out of Wall Street at all.”
here’s an interesting datum in renaissance today:
Jim Simon’s Renaissance Technologies has had a pretty good year, all things considered. His flagship $8 billion Medallion fund is up 58% on the year as of last quarter, which makes its 5% management and 44% performance fees very tolerable. Too bad that this fund is pretty much limited to only former and current Renaissance employees. Simons other funds, which are open to other investors, the Institutional Futures and Institutional Equities funds are -15.6% and -14.8% year-to-date respectively. Mr. Simons recently testified before Congress with numerous other hedge fund managers. Renaissance is ranked #4 in the hedge fund rankings.
a final follow up: i think massimo’s characterization of “economics” is a caricature. there are plenty of economists who aren’t in the business of financial prediction. if they are in the business of financial prediction, they’d be retarded to work in academia and make their methods known to all. perhaps there is a secret cabal of psychohistorians laughing their way to the bank. who knows.
“vox retard, vox dei”
Oh! I’ll steal that!
Chaos chaos chaos. The thing about chaos is that the same equations produce radically different results depending on the values of scalar parameters. In other words, getting the values of these parameters wrong (i.e. predictions) does not imply that the equation itself should be thrown out the window.
Pretty much everyone serious (and others, e.g. Bush and McCain) knew that what was going on with Freddie and Fannie was wrong and dangerous. What they (for the most part) didn’t get right was the scale of the danger.
As for easy money, most people were primarily afraid that it would cause inflation. Since it didn’t, they thought that it was likely the right policy to counter the dot-com crisis. A few small changes in the magnitude of various scalars would have changed their predictions significantly.
And with all due respect to biologists, nobody expects them to make predictions about the future direction of evolution. So I think some modesty is called for.
which makes its 5% management and 44% performance fees very tolerable
I presume that that doesn’t mean a 44% rebate when the value of the fund goes down. (I am guessing here, but AFAIK it is universally true of other funds.) That is a flawed incentive structure which alone can explain what happened (depending on the value of those pesky scalars, that is).
The greatest distinction in intellectual affairs is between those disciplines where you can perform controlled experiments and those where you can’t. In those disciplines which are merely observational, the most important distinction is between systems that are dilute and those which aren’t, with “dilute” implying a lack of substantial interaction.
P.S. Merry Xmas, chaps.
i don’t consider greenspan or rubin part of the economics profession.
Economics is the only one of the social sciences in which there’s a revolving door from “top” academic departments into Federal policy positions, in particular the individuals and committees that advise the President. This enforces intellectual orthodoxy and a reluctance to criticize the performance of anyone in the good-ole-boy network. Whatever the credentials of Greenspan and Rubin, no “professional” economist will criticize them because it would ruin the chance for a nice slot at the White House, Treasury or the Fed. Thus, the same people who drive the economy into the ditch have the plum jobs under Obama. Ditto for the people who drove foreign policy into the ditch (and our moral position into the toilet).
Greenspan is an economist. He’s an ABD, but at a certain point his career was accepted as a dissertation. To all intents and purposes, the American economy is Greenspan’s dissertation. His dissertation is our lives.
Very few professional economists would denigrate Greenspan. Notably, the liberal Democrat Brad DeLong all but worshipped Greenspan up until a year or so ago.
Public choice theory has tended to be much more skeptical of the government than of business, and opposed to regulation of business, but the perverse incentives we’re facing were within business, and more and better government regulation might have prevented some of these problems.
Nobody knows quite what happened or why, but I think that it will be concluded that aggressive deregulation was a major contributor. I also believe that a sort of giddy cheerleader mood made the problem worse (“Dow 35000″). Many or most economists deny that psychological or group psychological phenomena can have economic consequences, but I think that they’re wrong. The market corrects for some kinds of error, but not for every kind of error.
The market corrects for some kinds of error, but not for every kind of error.
It corrected for this kind of error too. We are in the correction.
The implicit assumption behind all of the “Economics is crap” stories is that the current crisis somehow falsifies economic assumptions of behavior.
For an alternate view, see Equity Private. A host of government incentives–Fannie/Freddie, no capital gains tax on housing appreciation, mortgage deductions, loose monetary policy–pushed up the demand for housing here and elsewhere (across a broad range of regulatory regimes), which then crashed and caused a crisis. It would take extremely irrational actors to produce results different from those observed, and the failure of economists to warn otherwise reflects their ignorance (perhaps, as Razib suggests, a profitable ignorance) of the incentives involved, rather than a breakdown of responses to incentives.
Economics is about aggregated outcomes of the behavior of large numbers of individuals. Economists so far haven’t really had a theory of individual behavior so far, they’ve just made unempirical simplifying assumptions about individual behavior. Tyler Cowen recently wrote a piece about six definitions of the word “rational”, and seemed to think at all but on of them (the common-sense one) could be used as needed by economists. Amartya Sen has rejected the most common economist’s definitions of rationality and has tried to come up with a definition which is neither tautological or in gross violation of common sense.
David, when we hear that the market is self-correcting, it’s a way of saying that we get optimal results without any government interference. We’re not getting optimal results now.
All economists knew something bad was going to happen, but they didn’t think it would be this bad and they still don’t know why it played out exactly the way it did.
What I’ve read seems to say that there were perverse incentives both in the housing industry and in finance, and that the leveraging done in finance (trading in bad loans) multiplied the intensity of the crash. As for the housing boom, the killer bad loans weren’t the Fannie Mae / Freddy Mac loans, but other loans made by other financial institutions regulated differently: home equity loans on overvalued houses, upscale houses by people who couldn’t really pay for them, and speculators leveraging to buy multiple houses for resale.
My common-sense interpretation, which may easily be far off the mark, is that it was a pathology of optimism (possibly fuelled by amphetamines and anti-depressants) which at the policy level led to sacrificing security for growth — the same kind of thing that happens when an individual gambles their retirement money on high risk / high return investments.
There is one point of view (Taleb and others) that the quants contributed to the problem. They themselves usually had a limited understanding of economics, and the people they worked for couldn’t understand the quants’ math, so what they all were doing was like a real-world real-time experiment on a big chunk of the world economy.
One kind of perverse incentive is “a rising tide floats all boats”. When the stock market is rising, everyone wins, and whichever gambling system they happen to be using seems to be verified. (An error Popper pointed out a lifetime ago, but never mind). If a bunch of superstitious gamblers (the only kind) started gambling out of a box of tickets which was unnaturally full of winners, at the end of the day every single one of them would think that their own personal superstition, whatever it was, was infallible.
I’ve only known low-level stock market players, and few of them were more rational than lottery players. The low level players didn’t make anything happen on the big scale, of course, but I wouldn’t be surprised if some of the investment systems used by big time players didn’t turn out just to be superstition dressed up in high-powered math.
I haven’t seen anyone else talk about this, but economists (Greenspan, Keynes) sometimes talk about group-psychology effects causing bubbles and crashes. Perhaps this can only happen in economic structures of a certain type, and might be preventable by some kind of safer laissez-faire structure which would automatically pop bubbles and reinflate depressions. But obviously we don’t have that system in place.
On the other hand, if unpredictable group psychology factors really can have consequences as big as this, then economics as a science is cripplingly deficient. After all, the biggest economic events are booms and busts.
blah:
Boost harvests? Of course not!
But—boost prices? Now yer talkin’!
To go on, economics is an academic science, but it’s so intimately linked with practical policy applications (public and private) that the whole profession is shaped by that. And there’s not really a clear separation between theoretical and applied economics, the way there is between, e.g. physics and mechanical engineering.
It’s also hard to see how there could be, either. The subject matter of economics is all practical and applied. There’s no area of economics which doesn’t have real-world significance; economics is the study of one very large type of real-world significance. By contrast, when a physicist or mathematician chooses a project, he doesn’t necessarily know whether it will have real-world tech or economic significance.
But if an economist decides to escape from that by making his work very formal and abstract, to a great extent he’s able to do that only by renouncing the possibility of experiment, since any major experiment (e.g., in fiscal policy or regulation/deregulation) will have weighty consequences. Part of the reason why economics can’t run controlled experiments is just that any real experiment will effectively be a real-world application. (Contrast a microbiologist who sends the fruits of his experiment to the autoclave to be exterminated.)
The entire concept of “bounded” rationality is merely attempted rescue of those wishing to argue
against the plain reality that human action, insofar as it is not merely physiologic and reflexive, is determined by mens’ reason. It would be fairer, from an argument/debate point of view, to speak of “bounded irrationality” in recognition of the fact that some men (or maybe even all men under some circumstances) are able to “get hold” of even normally reflexive responses and bring those responses within the realm of choice, of ends and means, of reason.
To raise the varying inadequacies presented by less than perfect cognition (whether of the problem itself or the various possibilities for its resolution) or of processing capabilities is to misunderstand, almost as grossly as possible,the nature and, indeed, the function of reason in the arsenal of survival mechanisms of the species Homo sapiens.
The function of reason is dual but with a unified function: to render as successful as possible future-oriented, purposive action in the face of an uncertain future. Reason can have no use to a being for whom the future were certain. Those who see reason and its employment as “bounded” or otherwise imperfect (and varying between individuals in the degree of that imperfection) are not seeing incorrectly but, rather, misunderstanding what they see. Reason conveys to acting man information (stimuli)concerning the relationships of external phenomena (and, for a man’s purposes, his own body is one of those external phenomena). On the one hand, reason conveys some (necessarily incomplete) idea of alternative eventualities, some idea as to the relative attainability and desirability of those alternatives, and, further, suggests actions (means) to be employed in nearer portions of the future (down to the most immediate we call the present). In beginning this paragraph, I spoke of a “dual” function of reason. The second (actually a part of the first) is the use of the same process of reason to enlarge the scope of knowledge concerning the relationships in our environment relevant (or which seem to portend relevance) for chosen ends.
I agree with McIntosh that there is a good deal to be learned from plain vanilla neoclassical economics — ie, the so-called marginal revolution. Unfortunately most economists barely know the subject. You doubt me? There was a study of the profession a decade or so ago that was published by the American Economics Review — the flagship of the profession — which found exactly that. The reason was that most aspiring professional academic economists spent almost all there time trying to master the kind of advanced math that is featured in the typical economics journal — math that was really beyond them by about 20 iq points, and that in fact has almost no relevance to real economic problems. Of course if you don’t understand the math it is hard to judge its usefulness.
Personally I would like to get back to ordinary language political economy as it was practiced in the 18th and 19th centuries, and by Keynes and Friedman for that matter. Equations verboten!
Posting one more time, the problem isn’t that econ modeled itself on physics. The problem is that it modeled itself on Newtonian physics. (Philip Mirowski, “More Heat Than Light”). Reversible time, equilbrium, conservation principles.
Starting in the middle of the Nineteenth Century and developing through Poincare, Onsager, Kolmogorov, and others, the physics of thermodynamics would have been a much more usable model, but it wouldn’t have given the beautifully controlled and orderly results Newtonian physics did. Samuelson ridiculed the idea that entropy could be found in economics. General equilibrium was taught for decades after it was proven mathematically fallacious.
You don’t really need to talk about chaos or fractals or complexity. Just recognizing that economics is more like thermodynamics than it is like fundamental physics would have taken you a long way.
Much has been written (here and elsewhere) about the alleged insufficiency of the science called Economics to provide satisfactory, reality-based information on which public policies maybe based. The truth is much different.
The truth is that political leadership (everywhere and at all times) has never seen in Economics anything other than an array of impediments to the future realities that they hope to achieve (or have promised to achieve) through the exercise of the legitimate force entrusted to them. They (political leaders) seek not economists who can convey to them accurate and unbiased assessments of the likeliest consequences of various policies but rather, at the subaltern level, technicians trained in the cobbling together of specific measures and, at the policy-making level, nimble (or obfuscatory) apologists for whatever happens to be the current malaise. Most of what have proved unsuccessful economic realtionships over the entire world and which have led to waste and destruction (including hundreds of millions of lives) have been vigorously and consistenly opposed and condemned by just those economists (and I refer here to the Austrians) as are never found in the employ of governments and almost as rarely in the opinion-molding service of the academic profession.
At this point, I see not the slightest chance that greater attention shall be paid in the future to what can be derived from the study of Economics. At the same time, the propensity of men to better their conditions through technologic means and the further refinement of the division of labor which makes the existence of each more interrelated with that of all others brings all closer to even more catastrophic events than have ever occurred in the past.
The historian Paul Veyne has argued that none of the social sciences are really scientific*, on the model of the hard sciences, and that they’re all just different kinds of history — studying different areas and aspects, or using different methods. If you add scientific methods to history, what have is still history unless you can make a claim that your scientific theory is adequate to the material, which so far it never has been.
I don’t think that economists have nothing to say or that their policy advice is necessarily bad. I’m just saying that when economists claim precedence over other scholars on grounds of being more scientific, their claim is not valid. And that sometimes their scientific commitments lead them into error (e.g. entropy-free Newtonianism.) And that the whole field is confused about theory vs. application vs. experiment and that these misunderstandings are consequential.
“We’re smarter and use more and harder math” isn’t a real argument. The superiority has to appear in the work done.
The fact of never having been applied to policy-making doesn’t make Austrian econ seem more convincing.
*Actually Veyne granted econ’s scientific claims; I’ve gone a step further.
John Emerson, at Brad DeLong’s you described something Tyler Cowen said as “vicious”. Can you explain?
David, when we hear that the market is self-correcting, it’s a way of saying that we get optimal results without any government interference. We’re not getting optimal results now.
Are you familiar with the Nirvana fallacy?
Basically I think that Cowen is a.) wrong and b.) using an enormous financial disaster, the worst since 1929, as an opportunity to push the same old ideas, in a way that will be c.) destructive.
A.) and c.) are obviously the essential ones. Many people are pushing their same old ideas at the moment, though some seem really shaken.
On the “Nirvana fallacy” — are you saying that deregulation was good but not perfect? Because it looks to me as though financial deregulation brought us to a disaster, not to a lesser good.
I’ve been dubious about trade, fiscal, and financial policy since sometime in the first Clinton administration, but I haven’t been able to do anything but watch.
John Emerson,
Modern finance is down with thermodynamics and has been for 30 years. The Black-Scholes formula for option pricing is usually derived from the differential equation for diffusion or the spread of heat in an object, which is hard core thermo. (The first derivation depended on an artificial position with identical payoff, but someone pointed out the equivalence to the physical model.)
The problem, if it has physical analogies, is in the departures from the Gaussian distribution summarized by “fat tails”, some examples of which were studied by Mandelbrot. But this was well known before the current bubble burst. There’s a book on option pricing from the 70′s in which the author notes that market makers had noted empirically that Black-Scholes underpriced far out-of-the-money options by a small amount and routinely applied a correction. The 87 Crash and LTCM were once in 1000 year type events, and everyone knew about them.
I’ve mentioned options, but the same models were used for other derivatives, including mortgage-backed paper and swaps.
Everyone who writes a book about this will have an axe to grind, so we’ll never had a complete account. But I suspect the problem isn’t insufficient intellectual horsepower or antiquated physics. There was a selection process down at the level of the quants. Those who came up with models justifying risk were rewarded. Those who didn’t, weren’t. At the upper levels, the CEO’s of a dozen institutions walked away with salaries and bonuses in the 100′s of millions. To justify that, the next levels got an order of magnitude less. Und so weiter. To justify all the booty, an order or two more of risky paper had to be generated. The appropriate physical model is the formation of a supernova.
The empirical test might be to compare a country which had a housing bubble but didn’t lever up bad mortgages and hand the proceeds to executives. I expect you’d find some institutions in deep trouble, but not the wholesale implosion of the financial sector that we’ve witnessed. An appropriate example might be Spain.
Thorfinn
I can’t see how your argument makes sense. You blame the evil government for some interventions (Fannie/Freddie, no capital gains tax on housing appreciation, mortgage deductions, loose monetary policy) that produced incentives for the bubble, then claim that economists were ignorant of the incentives. There are several problems with this. Except for the low interest rate, all those features of the economy had been in place for decades. And everyone, economists included, understood that the policy reason for the first three was to promote home ownership.
When a system shows new behavior, scientists generally look for novel factors for an explanation. The changes have been well described, and they’re not acts of the evil government. One was the practice of securitizing mortgages. Another was permitting the large investment banks to lever themselves 30:1 or more. The ballooning of the credit default swap market was another. These all produced the incentive for a CEO to run the enterprise into the ground, walking away with a nine figure fortune. The incentive for academic economists was not to rock the boat.
I looked at the site you linked to, and it is gibberish.
The 87 Crash and LTCM were once in 1000 year type events, and everyone knew about them.
I absolutely do not believe this, unless you are being sarcastic. Somebody missed something.
I agree that a structure of perverse incentives is a big part of the story.
I’ve been told that Canada has escaped most of these problems.
On thermodynamics, I’m mostly following Mirowski. As he tells the story, people patched bits of thermodynamics into a fundamentally erroneous Newtonian theory, and never really paid attention to Mandelbrot. Critics of economics talk a lot about ad hoc kludges, shims, and adapters rescuing a sacrosanct but erroneous theory.
This is part of a general tendency to pigeonhole the consequences of thermodynamics as abstruse technical problems which can be ignored in practice, which is what Samuelson did. Or — Poincare’s three body problem has been there for over a century, and it’s generally been ignored.
Whenever I get into this argument someone always tells me that someone somewhere already said that. But unless these various someones actually convinced the rest of the profession, it means little.
I groused a bit about discussion of “deregulation” here. I don’t know too much about the details behind the crash, but in the rare instance in which someone gives a specific example of deregulation responsible for it it seems to be Gramm-Leach, which if anything ameliorated the crash.
I brought up the Nirvana fallacy because you were using the term “optimal”. A theoretical optimal is not a sensible comparison. What you should be comparing it to is a better regulatory regime. My understanding is that much of western Europe (often pointed to as an example of a more and better regulated region) has been hit even worse than us, so recommendations should be specific rather than “more and better”. Because so many politicians seemed to be pushing for the housing boom I find it unlikely that incentives will align property for the public choice problem to be overcome and appropriate legislation adopted.
The post Brad was responding to that you called “vicious” was itself a response to calls for fiscal stimulus in reaction to the crash. It wasn’t the sort of Disaster Capitalism Naomi Klein talks about of viewing that event as an opportunity. Tyler was saying that there is very little evidence that deficit spending is an effective way of recovering an economy and that the burden of proof is on its proponents. It’s quite possible he’s wrong (macro is something of a mystery to me) but I am really puzzled that anyone could describe such talk as “vicious”.
Roger, you discuss fat-tails and Nassim and others often bring up “black swans”, but it seems an odd fit to this situation to me. A typical example of a “black swan” or high-impact low-frequency event is 9/11. The recent crash wasn’t caused by a one-off like that. There was a huge number of people all gambling on continually increasing housing prices. It was a bubble, which requires not a freak disaster to pop but simply an exhaustion of inputs or a realization that the party is over. The financial meltdown is the result of lots of companies gambling on such mortgages and the securities created from them, and counting on insurance issued by companies counting on the same sector of assets for collateral. If they had been extremely diversified to hold a random sample of the assets of the economy and a large enough number of them just coincidentally happened to go south, that would strike me as a low probability high impact event, but the bursting housing bubble was foreseen long before even if the aftermath wasn’t. I haven’t actually read Taleb’s book, so I could be getting this wrong, but I wanted to get this off my chest. I’ll point out to John that while Black Swans may be inherently unavoidable (because they’re impossible to predict), the version of events I’ve got in my head would make for a better case for a market failure (or government failure for those who want to blame everything on them).
John Emerson,
Of course I was being sarcastic, or cryptically brief. What I was trying to say is that people were well aware that the models said the 87 Crash and LTCM could occur only over time spans of millenia. Yet they had happened within recent memory. It wasn’t a failure to appreciate subtleties of contemporary physics that led to the disaster. One critique is that the models all contain the assumption of independence. In 1987 it was that multiple actors could “insure” themselves because the other actors would behave as mindless Brownian particles. With LTCM, it was the assumption that dozens of markets would behave independently so that they were placing hundreds of small bets, rather than one huge bet. In both cases, a phenomenon of collective behavior kicked in. Collective behavior is difficult to quantify, but it involves no arcana of recent physics.
I’ve read books by Mandelbrot and by Taleb. I don’t think their ideas are really explanatory. The analogy to the financial crisis views the institutional structure as a vast structure like a particle accelerator tended by disinterested, priestly casts of professors and technicians. But there are subtle quantum effects that lead to episodic failure, effects appreciated only by the cognoscenti. In the real world that wasn’t the problem. If the quants who priced the paper had given greater weight to the tails of the distributions, they’d have set higher prices and done more swaps for protection, which wouldn’t have mattered. Or they would have come up with infinite prices and killed the market for derivatives. Also not a desirable outcome, since derivatives may have social utility in spreading risk. Also a fantasy. Nobody would have listened to quants who came up with that answer. All the PTB wanted out of the quants was the imprimatur of formulas with integral signs on paper they could peddle to justify their bonuses. Quants who went along got their own modest bonuses.
TGGP
You misunderstood my position, if my meanderings can be characterized as a position. I think Taleb and Mandelbrot are interesting but not especially relevant to the situation. I agree with your summary.
I looked at your links and disagree with your position on Gramm-Leach-Bliley. You’ve set up that straw man argument that it was totally responsible for the debacle. In one link, there’s the argument that it paved the way for the formation of AIG, C and Bank of America, which saved the day by taking over Bear, Lehman et al. Huh? It’s clear that AIG and C would be defunct without massive government transfusions and BAC is possibly in the same situation.
I know that Iceland is the European nation worst hit, and they were a deregulation success story only a couple years ago.
Roger, Poincare was a century ago, not recent. The three-body problem was “arcana” because people didn’t want to deal with it. (Besides, you talk about subtle quantum effects). It’s one of the numerous arguments against the kind of atomistic description of a society of unrelated individuals used by economics.
I’m pretty much at the end of what I know. I’m an outside observer when it comes to economics. My main point is that we seem to have had some sort of culpable system failure, and that the economics profession collectively didn’t serve us very well. It seems that when things go well, they take credit, and then when things go badly, they hide. (I include liberal economists like Krugman and DeLong in this). They’re really working with a partial and inaccurate model, but that doesn’t make them shy or modest when the time comes to make policy prescriptions. And they certainly are smarter than me, but they have to be right too. It’s not like power is an end of the year award to be given to the smartest student.
It seems to me, though, that for a variety reasons a comparable medical disaster would have been handled better by the medical profession than this disaster was by the economics profession. I think that economics should have a diinished and more realistic status for that reason.
I know that Iceland is the European nation worst hit, and they were a deregulation success story only a couple years ago.
Roger, Poincare was a century ago, not recent. The three-body problem was “arcana” because people didn’t want to deal with it. (Besides, you talk about subtle quantum effects). It’s one of the numerous arguments against the kind of atomistic description of a society of unrelated individuals used by economics.
I’m pretty much at the end of what I know. I’m an outside observer when it comes to economics. My main point is that we seem to have had some sort of culpable system failure, and that the economics profession collectively didn’t serve us very well. It seems that when things go well, they take credit, and then when things go badly, they hide. (I include liberal economists like Krugman and DeLong in this). They’re really working with a partial and inaccurate model, but that doesn’t make them shy or modest when the time comes to make policy prescriptions. And they certainly are smarter than me, but they have to be right too. It’s not like power is an end of the year award to be given to the smartest student.
It seems to me, though, that for a variety reasons a comparable medical disaster would have been handled better by the medical profession than this disaster was by the economics profession. I think that economics should have a diinished and more realistic status for that reason.
If Iceland had a property bubble, it may be small in relation the big problem which was that their banks were stuffed with toxic paper and their balance sheets had ballooned to way more than the central bank.
It would be interesting to see a table showing the bubble by country, broken down into property valuation, mortgages, mortgage-backed securities etc. My superficial impression is that the US, GB and Spain all had property valuation bubbles, but the Spanish generated less bad paper and less damage to the banking system. I don’t know if this is due to better regulation or failure to takke advantage of the wonderful free market.
I’ve long been a Poincare fanboi. But I don’t see the relevance of the 3-body problem. Yes, there’s no closed-form analytic solution. Yes, there’s sensitivity to initial conditions. But I don’t think economists claim to have solved an analogous system. The problems with their models seem to be simple-minded assumptions necessary to apply the math. E.g. no correlation between mortgage default rates in different states. Duh.
I once took a course in microeconomics by a self-important graduate of the London School of Economics (wooh wooh). The high point of the course (and almost all its substance) was a list of the eight Pareto conditions for an efficient market. But it was almost worth the time and trouble. Going through the list, you realize that there’s no perfect market. They could all be improved by some regulation and tweaks. In many cases, the cost of the treatment is greater than the benefit of the cure. But it tends to make one less sympathetic to idiots babbling about “the free market”. I can’t find the list on wikipedia, but it’s worth paying attention if you come across it.
I don’t recall anyone pointing to Iceland as a deregulation success story. I do remember this Guardian article where they use Iceland to claim that righties have been proved wrong about the Scandinavian model and welfare state (I would add to the article by pointing out that pretty much all Scandinavian countries have lower corporate tax rates than the U.S though most do indeed have higher personal income taxes or sales taxes).
Roger Bigod, the point of the link is that companies that were both commercial and investment banks (which Gramm-Leach permitted) has not failed at the time but on the contrary were taking over companies about to go under, and that doing so was only possible because of Gramm-Leach (the government actually ran into problems when they tried to do some stuff prohibited by earlier regulations). I agree with you that a lot of companies wouldn’t be around without government intervention, but the problem was NOT any more severe due to Gramm-Leach. The problem was among banks not going beyond Glass-Steagal and so we can say that the same thing would have happened if it had not been amended.
I’ve read too much Robin Hanson to have as high a regard for the medical profession as John!
Nobody knows quite what happened or why, but I think that it will be concluded that aggressive deregulation was a major contributor.
My superficial impression is that the US, GB and Spain all had property valuation bubbles, but the Spanish generated less bad paper and less damage to the banking system. I don’t know if this is due to better regulation or failure to takke advantage of the wonderful free market.
The empirical test might be to compare a country which had a housing bubble but didn’t lever up bad mortgages and hand the proceeds to executives. I expect you’d find some institutions in deep trouble, but not the wholesale implosion of the financial sector that we’ve witnessed. An appropriate example might be Spain.
For what it’s worth, Australia had/has a housing bubble but is apparently* one of the few OECD nations that’s still tracking (barely) to avoid a recession. (As of Dec 15, rates of 1.75% for 2008-9 and 2.5% for 2009-10 were forecast**)
The Labor government is saying that this is due to the relatively stringent regulatory structure here, and I’m not aware of any local commentators trying to argue the contrary.
*www.abc.net.au/news/stories/2008/11/26/2429657.htm
**www.bloomberg.com/apps/news?pid=20601081&sid=aB_M7zBVQDCo
Iceland as a deregulation success story.
When you go to the doctor, you don’t worry that maybe he’s on the side of the disease. On the other hand, in any case there will be one lawyer working for you and another one working against you. Economists are more like lawyers. You need economists on your side, because you know that the other side has them.
Bigod,
The capital gains reduction happened in 1997, and is linked to an immediate increase in housing transactions. The scale and scope of Fannie/Freddie’s interventions drastically increased as well in response to political pressures. And of course monetary policy deviated from the Taylor rule substantially. Other countries affected by a housing bubble exhibit similar trends.
CDOs are new but it’s not at all clear what independent role, if any, they played. Felix Salmon has a lot to say on this topic, but whenever you see trillions of dollars in assets disappear, problems are going to happen, even if banks keep all mortgages on the books rather than parceling them out. Spain does have some nice regulations that limit leverage, saving Banco Santander, as well as downpayment requirements, but many of their other financial institutions are in trouble. Investment Banks have been highly levered for some time now; their big problem was going public which led to their stock price being a barometer for ‘trust.’ Counterparty concerns seem to play a big role in their downfall.
I wouldn’t say this means that *only* the government is responsible; clearly markets failed to price risk and economists failed to point that out. Better banking and housing regulations along Spanish lines are needed as well as stricter leverage controls. Macroeconomics in particular has fared very poorly, and financial models need to incorporate linkages. But as TGGP says, blaming financial deregulation is an unsatisfying story. The best explanations for the housing bubble I can find are economic, rather than psychological or physics-related, in nature and relate government-induced incentives to an unsustainable shock in the housing stock.
John Emerson:
Reread (your most recent comment) the third paragraph; it is exemplary. Above all, it consists of honest (and accurate) general assessments of conditions you observe and a general conclusion (linking the conditions to the theories and practices of leading lights and authorities in the “economics profession”). Though not “scientific” in the ordinary sense, it is, indeed, in its simplicity, not unscientific. Nor even does the characterization of the conditions (as undesirable or “bad”) disqualify (any more than would a similar statement about the end result made by a pathologist describing the progression of an untreated case of rabies).
But, best of all, you’ve started out with a frank recognition that “I’m at the end of what I know,” omitting only the inescapable corollaries (which I am sure you will now admit to the body of observation) that “what I think I know may be all wrong” or, what amounts to very much the same thing, that which makes sense (is logical) is vitiated by being built on faulty underlying premises (or theory).
John Emerson:
Now that you’ve had a chance to mull the foregoing comments, I’ll add a few more, along with a suggestion.
Whether or not various of those prominent in the economics profession are smarter than you or not is pretty much beside the point; being either right or wrong on any given matter is related only indirectly to either intelligence, subject-specific education, or even relevant experience. I am reasonably what is called “smart” and I recognize, in the discussions and considerations of those posting and commenting here at GNXP, a substantial majority quite capable of internalizing a sound understanding of at least broad outlines and basic relationships involved in economic science. What is more (and I here state my opinion but one, nonetheless, based on a long chain of so-far irrefutable reasoning undertaken not originally by myself but by those scholars–known as the “Austrian School”–with whose theories, primarily those of Von Mises, I find no appreciable fault).
But far more weighty (I would judge) than my merely personal recommendation (no matter how well-expressd or not) should be the gist of your own observations and the similar opinions (though differing in prescription) of other commenters here (or in other public fora). You, at least, have the marked advantage of realizing some woeful inadequacy in the totality of your knowledge of the subject. The “experts” in the field are “beyond hope” first, by virtue of lifetimes under the influence of demonstrably faulty theoretical (and epistemological) bases but also by the plain fact of their individual personal investments (termed “rent-seeking” in what passes for new knowledge of phenomena long-known and understood) in the various brands of mumbo-jumbo peddled as authoritatively and fervently as by any (and rightly ridiculed) religious charlatan.
You are an historian. I want to couch my concluding comments (and the suggestion I promised) in terms that should be not only be understandable but welcomed by one such. I’ll do so follwing.
TGGP
You appear not to have heard of a company with the pretentiously tarted-up name “Citigroup”. Because of the repeal of Glass-Seagal it was able to branch out from the boring business of taking customer deposits to constructing mortgage-backed securities and other derivatives. One result of unleashing the creative powers of the market is that the actual value of the company is considerably less than zero. A few weeks ago, the Federal Government bailed them out with a special ad hoc rescue whose potential price tag is $250 billion or so.
This raises questions about the mind-set that finds C a wonderful example of the free market at play while sputtering with outrage over the UAW getting a few extra bucks.
John Emerson:
What we call “history’ is never pretended, especially by historians, to be either a complete or faithful recapitulation of the past; it is, rather, in all cases, a recapitulation of those events–(including prevalent ideas and opinions) of specific portions of the past–deemed relevant by the practicing historian, whether layman or professional.
There can be no recognition of history or even of the singularity of the phenomena we experience as events (or even, more simply, as stimuli) absent a pre-existing structure for their reception, identification, and categorization and arrangement. Were there not some underlying structure (what we call “mind,” or “reason,” and whose structure we call “logical”) amounting to a biologic characteristic of the species Homo sapiens, no “sense” whatever could be made of such stimuli. Some stimuli evoke responses quite independent of anything we call “mind”; at lower temperatures, many of the animals we call “warm-blooded” begin to shiver, in a manner we call “reflexive.” Some also move in a manner, less reflexively, tending to reduce their exposure to the lower temperature. Like some animals, man does both of those things; but he may do more, such as clothing himself, building a shelter, or starting a fire. Even further, the man may even attempt to control the immediate, reflexive behavior in an effort to render the other type successful, or at least, more successful. We call such behavior rational, i.e., guided by the natural, universal characteristic of humankind: reason. Whether some other animals also reason or do so to some lesser degree is unimportant. Reason may well be seen as the characteristically instinctual behavior of Man. To men, mind, logic, consciousnes, thinking, and reason are inseparable; and, to men, the construction (and later “testing” and corrective modfication) of “theory” is inescapable, whether that be according to the original logical pattern (what we refer to as “cause and effect”) or as the result of new information (experience, usually) suggesting inadequacy of previous theory. The “takeaway point” is that theory, or at least its indwelling form, is both logically and temporally precedent to experience; it is certainly possible for experience to cast doubt on the validity of a theory and suggest its critical review but where the elements of that theory, on examination, do not admit of any “weak link” in the causal chain, it must be to the experience itself (or, likely, its interpetation) to which we must look for the source of error.
What has all this all to do with the study of history? I could point out that the marginalized and often-ridiculed Austrian School (especially in the person of Mises) rather accurately predicted both world wars and their eventual outcome, the inevitability of recurring “boom and bust” cycles wherever government had appreciable control (especially of quantity) of monetary affairs, and the eventual collapse (“like a house of cards,” quoted directly from Mises, 1920!!), while allowing, in the very same passage, that the application of force might mean the elapse of quite some time before that came about. But note that only one U.S. president (Reagan, who read Mises regularly, according to a 1976 interview and his remarks to Mises’ widow), to my knowledge, has ever paid the slightest attention to Austrian economic views.
The Mises book to which I would first recommend you is THEORY AND HISTORY; it’s relatively modest in size (less than 400 smaller-than-normal pages) and relatively less focused on purely economic relationships. If suitably impressed, you could then “graduate” to the substantially more exhaustive HUMAN ACTION.
One more thing I’d add. LTCM was seen (unanimouly, by Austrians) as a disaster waiting to happen. But, of course, nobody, even Austrians, could predict when. To most, their failure was in having an incorrect or insufficiently comprehensive “formula” or “model.” To Austrians, the matter is simpler: there are no such (models or formulas) capable of prediction because, in an environment of data where there are no invariables, no variable may be predicted. The clearly proven (many times over) danger in all mathematical approaches to economics is not to be seen in the faults of equations or computations: it is to be seen, rather, in the power of the symbols to persuade the manipulator or practitioner using those symbols that they represent something closely approaching (or equivalent) to reality. Nobody needs anything more than a rudimentary knowledge of mathematics to comprehend most of the entirety of economic science; conversely, the most exhaustive knowledge of mathematics or skill in its application will suffice in the slightest to convey understanding or predictive power.
I would also remark that men such as Greenspan (and, before him, Friedman) can certainly be considered to have vast economic knowledge. But, once they have taken on the jobs working directly for or advising policymakers in government (anything other than STOP! QUIT! GO BACK THE OTHER WAY BEFORE IT’S TOO LATE!!), they have “sold out” and are, in their own ways, even guiltier and more responsible for havoc than the frankly concupiescent and predatorily deceptive.
This raises questions about the mind-set that finds C a wonderful example of the free market at play while sputtering with outrage over the UAW getting a few extra bucks.
I think you’ve constructed a bit of a staw man there. Can you really find many examples of people being pleased with Citigroup’s bailout who oppose the car company bailouts?
At any rate, there is a substantial qualitative difference in the financial institution bailouts and the auto industry bailouts: if GM goes bust, people won’t actually find that their Chevy’s were vaporized in their driveways.
Can you really find many examples of people being pleased with Citigroup’s bailout who oppose the car company bailouts?
How about the Congress of the US, in particular the Republican Senators. I don’t recall a lot of complaint about C, but they voted down the bailout. Oh, and the President.
At any rate, there is a substantial qualitative difference in the financial institution bailouts and the auto industry bailouts: if GM goes bust, people won’t actually find that their Chevy’s were vaporized in their driveways.
Also, it was difficult to get around the fact that some of the auto bailout would go to middle- or worse, lower-middle-class folks, but it was easy to hide the billions in bonuses to the right kind of people.
Thorfinn
I wasn’t aware of the 1997 change and confused it with a provision that exempts capital gains on houses if there’s a purchase within a year. At least that was the status several years ago, when I looked into it. The point remains that the tax code favored home ownership long before the bubble.
I’m no fan of Fannie/Freddie but I don’t buy the right-wing theory that they contributed to the bubble by making unsound loans to the lower classes because of CRA.
If we’d only had a housing bubble, there would be some dud mortgages on the books of some financial institutions. But running them through multiple layers of leverage lad to the destruction of several large financial institutions. And regulation could have prevented this. Deregulation played a role, but Greenspan refused to use regulatory powers he already had.
I have to agree with Gene, but go a little bit further … John Emerson’s comments here have been some of the best comments I’ve read on blogs: informative, insightful, links to books/authors I haven’t heard of, and he admits to the limits of his knowledge and opinion (WHO does that on the blogosphere anymore?).
Really great stuff. Gene’s comments are great too.
Bigod,
The Fed regulates leverage requirements at banks. The problem here was regulatory arbitrage; banks used SIVs and other off-balance accounting to load up on leverage elsewhere. Spain seems to do a better job of keeping track of banks’ overall leverage. But it’s not as if Bush changed these requirements or even that he kept them the same despite mounting pressure. No one really cared, which is bad since leverage is common to all financial crises.
Spain is still in bad shape. Massive destruction of housing wealth will still lead to huge problems even if you don’t lever up.
The tax code may have favored housing before, but if it starts to favor housing by a *greater* amount just at the point when Fannie/Freddie plus low interest rates start sloshing a lot of money into that sector, then it may be a part of the explanation. Housing prices also seem to have taken off much higher in places with more housing regulation, or where buyers are fleeing those places. The CRA point is bogus, but it’s clear that housing lenders felt greater pressure to lend to more people at least partially because of Fannie/Freddie.
You should also look at why banks up and decided to take advantage of leverage. Fundamentally, that decision was driven by prevailing low interest rates which encouraged ‘doubling up’ and more on existing assets to extract every pound of yield. This part is key to Austrian explanations too. Hedge Funds are highly levered as well, and are unregulated, but if anything they have weathered the crisis better than most.
Thorfinn
IIRC there was a specific meeting or administrative ruling that increased the permmitted leverage at investment banks to something like 20 or 30. It may not have mattered that much because they could run higher levels during the month and cut back for the one day the leverage was reported. But it did communicate an attitude. The decision wasn’t at the Presidential level, so Bush isn’t directly responsible.
I’ve seen multiple accounts of the pressures on Fannie/Freddie and why they wound up with so much bad paper. I’d believe they lowered their standards to maintain market share in the face of reckless competitors. But they used the mission of helping lower-income people as an excuse, rather than acting out of liberal do-gooder idealism.
There have been a lot of stories about hedge funds going under, so I think the jury is out on whether they have fared better than the banks. The simplest view is that it shouldn’t matter to the general public welfare if a hedge fund overlevers and goes bust. They’re big boys and they are supposed to know their level of risk. Obviously there are secondary effects, as LTCM illustrated.
Mihizon:
Thanks for your comments. Actually, it is precisely due to my appreciation for John’s scholarship that I went into such detail with regard to economic science. Few unacquainted with economics (and Austrian School economics in particular) can begin to compehend just how vital such knowledge is to proper understanding of historical events. The decline of ancient civilization is my favorite example and I’ve mentioned it here before but there are even more recent examples in which commonly-accepted accounts of events are better explained on the basis of economic understanding (WW I and II, for example). Another is the development of local production and trade as the result of foreign trade (rather than t’other way ’round, as is the naive view).
Lest I haven’t made myself perfectly clear, I’m pushin’ Mises. Verstehen?