Tuesday, September 29, 2009

Alan Kirman on What's Wrong with Economics

Alan Kirman, one of our contributors, was unable to post this himself for technical reasons:

The first thing that comes to mind, as one reads through the various postings about the crisis, is that economic theory was locked into a bubble which has now burst--and that the reactions have either to ignore this (John Cochrane) or to herald the return of one of our old heroes, Keynes (Paul Krugman). Economists seem to have been victims of extremely short memories and an incapacity to anticipate what the next theoretical developments will be. We periodically come to believe that we have hit upon the "right model" and that all previous efforts can be consigned to the waste basket of history. When the current model turns out to be completely at odds with reality, the reflex reaction seems to go back to the previous model and to chide the modernists for having lost sight of it. Dave Colander has tried to add a little historical perspective, but the debate remains very short sighted and ideologically motivated.

All of this seems to be misplaced. Supposing that we accept that economic theory, like the economy, is a complex adaptive system. Then we should expect to see it continually evolving and being modified to take into account both new theoretical insights and the evolution of the economy itself. We will not see theory evolving toward a given model which more closely represents the economy, since the economy itself is changing.

However, we might expect theory to evolve to at least be able to envisage the occurrence of the major crises that periodically shake the economy. We might then avoid the usual habit of falling back on the standard equilibrium notions and claiming that some major exogenous shock has hit the system. The latter sort of claim rarely identifies the shoc,k and as Bouchaud has shown, almost every significant turning point in all of the major stock price indices was accompanied by no notable news, and hence shock, at all.

Thus these large and abrupt movements must be due to the endogenous dynamics of the system. What has become the standard macroeconomic model--Dynamic General Stochastic Equilibrium (DGSE), for insiders--is justified by its proponents on the grounds that it has more "scientific" foundations than its predeceesors. By this is meant that it is based on rational maximising individuals. But there are two problems with this. First, we have known since the mid-70s that aggregating the behaviour of lots of rational individuals will not necessarily lead to behaviour consistent with that of some "representative agent." Second, the axioms that are used to define "rationality" are based on the introspection of economists and not on the observed behaviour of individuals. Thus, we have wound up in the weird position of developing models which unjustifiably claim to be scientific because they are based on the idea that the economy behaves like a rational individual, when there is a wealth of evidence to show that the rationality in question has little or nothing to do with how people behave.

Why do I say we do not look back far enough? Consider the Efficient Markets Hypothesis which has ruled the roost for some years in finance. Its originator was, by common accord, Bachelier, who developed the notion of Brownian motion at the turn of the twentieth century. His argument that stock prices should follow this sort of stochastic process, after years of being ignored, was acclaimed by economists both for analytic and ideological reasons. Yet, shortly after having written his report on Bachelier’s thesis, the great French mathematician Henri Poincaré observed that it would not be sensible to take this model as a basis for analysing what happens on financial markets. As he said, individuals who are close to each other, as they are in a market, do not take independent decisions, they watch each other and it is always herd behaviour that persists. Thus Poincaré clearly envisaged one of the most prevalent features of financial markets long before modern economists took this theme up to explain "excess volatility."

With regard to modern macro models, the same Poincaré wrote to Walras and chided him for his assumptions of infinite farsightedness and infinite selfishness. The latter he could believe at a pinch, but the former he found dubious, to say the least. Yet, while in other areas of economics we have moved on from these assumtptions,we are still faced today with macro models in which these two assumptions are central.

This brings me to my second point. Why are we so reluctant to envisage different models and different tools? As somebody said, we went through the twentieth century developing and perfecting a model based on nineteenth century physics; perhaps in the twenty first century we could move on to a model based on twentieth century physics. But as Paul Krugman has pointed out, the vested interests are strong and to ask economists to take up a new set of tools is probably asking too much. To discard equilibrium in the standard sense and to move on to study out of equilibrium dynamics is perhaps too big a step. To place externalities, the influence of one person’s actions on another, at the centre of the action rather than to regard them as "imperfections" in our equilibrium model is a necessary step. But if we argue that the interaction between individuals is important, then we have to specify the structure of that interaction. This means that we have to study the structure and fragility of the networks which govern the interaction between individuals and again to make this central in our analysis and not just a peripheral, albeit fascinating, topic.

Such changes are essential if we are to progress, but the inertia in the economics profession is strong and whilst the economy has shown that it is capable of sliding rapidly into a new phase, economists may well self organise to prevent this from happening to them in the immediate future. But in the end we will move on, for as Max Planck said, "A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it."

--Alan Kirman

Thursday, September 24, 2009

The Basel Rules & the Crisis

Here is (believe it or not!) a very illuminating blog discussion (illuminating blog discussions are a bit like black swans) regarding whether bank-capital regulations, even if they did help cause the crisis, can justly be blamed on the regulations themselves or on the bankers who took advantage of them to "leverage up." The discussion was prompted by my post here last week and was begun by Mike Konczal of the Atlantic business blog. All credit to him for pushing me on whether a regulatory inducement (as opposed to a command) constitutes a form of deregulation, not regulation.

Also relevant: an article on bank capital from today's Financial Times.

Frydman and Goldberg on "Rationality"

A very important piece on the impossible standards of economic rationality that lead, in reaction, to claims of "irrationality"; coauthored by Roman Frydman of NYU and Critical Review contributor Michael Goldberg of the U. of New Hampshire.

Wednesday, September 23, 2009

Sunday, September 20, 2009

Posner on Friedman on Posner on the Crisis

I invited Judge Richard Posner--who will be contributing a postscript to the book version of Critical Review's special issue on the causes of the crisis--to post a reply to my review in The Weekly Standard of his book, A Failure of Capitalism (Harvard, 2009). And here it is:

I fear that my book may not have conveyed with adequate clarity my views about the economic crisis. The depiction of those views in Jeffrey Friedman’s review does not correspond to what I thought I was saying. He says that the “heart of Posner’s case against ‘capitalism’ is the…theory…[that] perverse incentives, created by banks’ executive-compensation systems, caused the crisis.” That is not my position at all. For one thing, I do not mount a “case against ‘capitalism.’” I believe in capitalism. I merely argued that capitalism is apt to run off the rails without (and here I am quoting from Friedman’s review) “active and intelligent government.” I attribute the financial collapse of last September that deepened a recession into something grave enough to warrant the name of “depression” to unsound monetary policy by the Federal Reserve and to excessive deregulation, coupled with lax regulation, of the financial services industry. Friedman I think agrees, at least about regulation (he doesn’t mention monetary policy at all), as when he remarks that banks’ leverage ratios are regulated by law and “this law, unmentioned by Posner, was probably the main cause of the crisis.” The decision by the SEC in 2004 to allow broker-dealers (Merrill Lynch, Goldman Sachs, Lehman Brothers, etc.—major components of the “shadow banking” system, which played a bigger role in the financial collapse than the commercial banks) to increase their leverage is an example of excessive deregulation, which was indeed, as I emphasize throughout the book, a main cause of the crisis.

Friedman appears to agree that regulatory ineptitude created an environment in which rational self-interest drove bankers to take risks that were excessive from a macroeconomic standpoint. That and unsound monetary policy were the main causes of the crisis—as I argued, I thought clearly and indeed emphatically, in the book (as in my subsequent blogging on the crisis in my Atlantic blog, which is also called “A Failure of Capitalism”).

I never said, by the way, as Friedman thinks I did, that the banks were “heedless of the risk” of risky lending. I said they took risks that seemed appropriate in the environment in which they found themselves. They probably were heedless of macroeconomic risk, but as I explain in the book it is not the business of private business to avoid actions that create external costs, such as the costs borne throughout the economy when the financial system collapses. The responsibility for controlling those costs are the government’s, and it was discharged poorly.

I do think executive-compensation practices played a role in the crisis, and Friedman does me the courtesy of describing my theory of how the practices affected the behavior of banks “logical.” But he is incorrect to suggest that I think the practices “caused” the crisis. They were a causal factor, but not a principal one; the main ones, as I thought I had made clear in my book, were as noted above.

He does make the good point that to test the theory would require correlating different banks’ compensation schemes with different banks’ losses; I don’t believe that that’s been done.

He points out correctly that banks structured as partnerships would be more risk averse than banks that are structured as corporations (because of the limited liability of shareholders), but it is unrealistic to suppose that banks of the scale of the major modern banks could attract sufficient equity capital as partnerships—precisely because of the greater financial risk borne by a partner than by a shareholder. Friedman’s example of a financial company organized as a partnership—Brown Brothers Harriman—has partnership capital of only about $500 million. Goldman Sachs’s market capitalization of almost $100 billion is 200 times greater.

But I agree that the tax laws are among the deep underlying causes of the economic crisis, in particular the deductibility of mortgage and home-equity interest (but not other interest) from personal income tax, which encourages risky investment in housing, and the favorable treatment by the tax code of debt versus equity, which encourages leverage. I do not dwell on these causes of the crisis in my book because they will not be changed. In contrast, improvements in monetary policy and in regulation are at least within the realm of the possible, though perhaps unlikely.

--Richard A. Posner

Has the Recovery Been "Unstimulated"?

In James Hamilton's reply to the Scott Sumner article linked below, Hamilton raises a separate issue in pointing out that in October 2008, "the Fed began paying interest on reserves, in effect borrowing directly from banks, and creating an incentive for banks to hold the newly created deposits as a staggering burgeoning of excess reserves . . . preventing its actions from increasing the value of M1." Hamilton is suggesting that the monetary stimulus could not have worked, since the huge wave of liquidity created by the Fed was sequestered inside the banks.

In conjunction with the John Taylor article posted below, which argues that the fiscal stimulus did not work, the implication of Hamilton's point would seem to be that the current economic recovery has occurred as a "natural" process, unstimulated either by fiscal or monetary policy.

Was It Actually a Monetary Crisis?

In the first post in a debate on Cato Unbound, Scott Sumner argues that contrary to the general consensus of the papers in Critical Review, the crisis was indeed "macro"--caused by contractionary monetary policy in the summer and fall of 2008--rather than being a "financial" crisis caused by banks' misinvestments in mortgage-backed securities.

Monday, September 14, 2009

Three Myths about the Crisis: Bonuses, Irrationality, and Capitalism

With a year having passed since the start of the greatest economic crisis in our lifetimes, you’d think we would know a lot more now than we did then about what caused it. Yet by the spring of 2008, a three-part conventional wisdom about the crisis had taken hold that still governs mainstream thinking about what happened and why—even though there was never any evidence in favor of the conventional wisdom, and there is now much evidence against it.

The Myth of Irrational Exuberance

The first part of the conventional wisdom began to make its way into public consciousness soon after September 15, 2008, when most people thought of the crisis as a burst housing bubble. Bubble talk naturally leads to visions of “irrational exuberance,” and the notion that home buyers, bankers, and investors had irrationally thought that house prices would keep rising forever quickly took hold.

But in reality, very sober housing experts and economists (including Ben Bernanke) agreed that there was no bubble, and there was nothing “irrational” about this consensus. After all, housing prices had risen steadily since the Depression as the U.S. population grew and its affluence increased. Why shouldn’t people keep buying bigger, more expensive homes? There had never been a significant nationwide housing bubble, and housing speculation in “hot” markets such as Miami and Las Vegas could be quite rationally dismissed as localized. Those who dismissed the bubble may have been wrong--but they had good reasons for their error; there was nothing irrational about it. Likewise for those who participated in the bubble. For instance, Peter Wallison points out that in most states, “no-recourse” laws effectively removed penalties from home buyers and house flippers who walked away from their mortgages if their investments went sour.[1] So there was a legally sanctioned incentive to gamble on rising prices, and it was hardly irrational for people to take advantage of this incentive by buying into the bubble.

Although careful scholars have grouped psychologically established behavioral biases under the term "irrationality," in the present context the term can easily become an emotionally satisfying but non-explanatory explanation for people’s mistakes. In retrospect, housing investments premised on ever-rising prices can be labeled “irrational,” but the label explains nothing about why people actually made their mistakes.

The Myth of Bankers’ Bonuses

Eventually scholars and pundits began to realize that even a burst housing bubble was not enough to have caused the crisis,[2] since what we were experiencing was a banking crisis (albeit one that was triggered by a burst housing bubble). Many banks had invested heavily in triple-A rated tranches of subprime mortgage-backed securities, and when delinquencies and defaults on subprime mortgages began to spike, the price of these tranches began to fall, calling into question the solvency of banks that had invested in them. But since nobody knew which banks had the biggest subprime investments, or how far the value of these investments would eventually fall, the effect of the sudden re-evaluation of their soundness was to trigger interbank panic, a lending freeze, and the recession; or so most scholars now believe.

How can the banks’ investments in subprime mortgage-backed securities be explained? Here, too, "irrationality" could be invoked, since it can be used as an all-purpose tool to "explain" any error. But self-interest, i.e., "greed," is always the most popular explanation among economists—and the general public. So a new idea took root: Far from being irrational, bankers knew how risky these investments were, but made them anyway because they were paid big bonuses for short-term profits.

This “executive compensation” theory of the crisis is now the keystone of the conventional wisdom, having been embraced by President Obama, the leaders of France and Germany, and virtually the entire financial press. But if anyone has evidence for the executive-compensation thesis, they have yet to produce it. It’s a great theory. It “makes sense”—we all know how greedy bankers are! But is it true?

The evidence that has been produced suggests that it is false.

For one thing, bankers were often compensated in stock as well as with bonuses, and the value of this stock was wiped out because of the investments in question. Richard Fuld of Lehman Brothers lost $1 billion this way; Sanford Weill of Citigroup lost half that amount. A study by Rüdiger Fahlenbrach and René Stulz [3] showed that banks with CEOs who held a lot of stock in the bank did worse than banks with CEOs who held less stock, suggesting that the bankers were simply ignorant of the risks their institutions were taking. Journalists’ and insiders’ books about individual banks[4] bear out this hypothesis: At Bear Stearns and Lehman Brothers, for example, the decision makers did not recognize the risks until it was too late, despite their personal investments in the banks’ stock.

Perhaps the most powerful evidence against the executive-compensation thesis, however, is that 81 percent of the mortgage-backed tranches purchased by banks were rated AAA[5], and thus produced lower returns than the double-A and lower-rated tranches of the same mortgage-backed securities that were available. Bankers who were indifferent to risk because they were seeking higher return, hence higher bonuses, should have bought the lower-rated tranches universally, but they did so only 19 percent of the time. And most of those purchases were of double-A rather than A, BBB, or lower-rated, more-lucrative tranches.

The Myth that Capitalism Caused the Crisis

Both the myth of irrational exuberance and the myth of bankers’ bonuses have contributed to the notion that the excesses of capitalists—whether irrational excesses or self-interested ones—were the root cause of the crisis. Without the first two myths, however, the “Capitalism Did It” thesis itself begins to look more like a myth than a reality. Obviously capitalists were involved in the crisis—bankers were not government officials. But with irrationality and bonuses out of the way, the question is why bankers bought those triple-A mortgage-backed securities, and the answer may well lie in the regulations promulgated by government officials.[6]

Had bankers been looking for the safety connoted by triple-A ratings, they could have bought Treasurys, which were even safer. If they were looking for yield, they could have bought double-A or lower-rated bonds. And why mortgage-backed bonds? The answer seems to be an obscure rule enacted by the Fed, the FDIC, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision in 2001: the Recourse Rule, an amendment to the Basel I accord that governed banks' capital minima.

Under the Recourse Rule, an AA- or AAA-rated asset-backed security, such as a mortgage-backed bond, received a 20-percent risk weight, compared to a zero risk weight for cash and a 50-percent risk weight for an individual (unsecuritized) mortgage. This meant that commercial banks could issue mortgages—regardless of how sound the borrowers were—sell them to investment banks to be securitized, and buy them back as part of a mortgage-backed security, in the process freeing up 60 percent of the capital they would have had to hold against individual mortgages. Capital held by a bank is capital not lent out at interest; by reducing their capital holdings, banks could increase their profitability.

To be sure, banks that bought mortgage-backed securities to reduce their capital cushions were, indeed, knowingly increasing their vulnerability if the investments turned out badly. But absent the Recourse Rule, there is no reason that banks seeking a safe way to increase their profitability would have converged on asset-backed securities (rather than Treasurys or triple-A corporate bonds); thus, they would not have been so vulnerable to a burst housing bubble. The Recourse Rule artificially boosted the profitability of a certain type of investment that the Fed, the FDIC, and the other regulators thought was safe.

We know in retrospect that the capitalists who took advantage of the Recourse Rule, such as those at Citibank, were making a mistake. But not all capitalists made this mistake, even though it was costly for them to turn down the higher profits offered by the Recourse Rule. JPMorgan, for instance, recognized the danger and escaped destruction. None of these capitalists were irrational; all were self-interested; yet they had different perceptions of how to pursue their self-interest, based on different perceptions of risk.

In relatively unregulated markets, this diversity of viewpoints is precisely what makes capitalism work. One capitalist thinks that profit can be made, and loss avoided, by pursuing strategy A; another, by pursuing strategy B. These heterogeneous strategies compete with each other, and the better ideas produce profits rather than losses. In a complex world where nobody really knows what will work until it is tried, competition is the only way that people’s endless capacity for error can be checked, and loss is the regrettable but inescapable result.

In the banking industry, however, bankers’ heterogeneous strategies were homogenized (although not entirely) by the Recourse Rule, which loaded the dice in favor of the regulators’ ideas of where risk did and did not lie.

The regulators thought that AA or AAA tranches of asset-backed securities were 60-percent safer than individual mortgages. To be sure, this was not an “irrational” theory, either: The tranching structure created by Moody’s, Standard and Poor, and Fitch had a lot to be said for it, and even the little-known fact that the SEC had effectively conferred oligopoly status on these three rating companies[7] did not guarantee that disaster would follow from placing further official weight on their ratings. But the crucial fact is that however reasonable it seemed at the time, the Recourse Rule imposed a new profitability gradient over the bankers’ calculations, producing the same effect that is intended by all regulations: The regulatory carrot altered the behavior of those being regulated, the better to align it with the regulators’ ideas about what would make for prudent banking. By thus homogenizing the heterogeneous competitive process, the regulators inadvertently made the banking system more vulnerable--if, in fact, the regulators’ theory turned out to be wrong.

If we seek the sources of a systemic failure, a logical place to look is among the legal rules that govern the system as a whole. Unfortunately, being legal mandates, these rules--unlike the different strategies pursued by competing capitalists--aren't subjected to a competitive process. So if they are based on mistaken ideas, we all suffer the consequences. That turned out to be the case with the Recourse Rule.

Contrary to popular belief, then, the crisis of 2008 is best described as a crisis of regulation—not a crisis of capitalism.

--Jeffrey Friedman, Editor, Critical Review


[1] Peter J. Wallison, “Cause and Effect: Government Policies and the Housing Crisis,” Critical Review 21(2-3), 372. See http://www.criticalreview.com/crf/special_issue.html

[2] Although judging from his recent New York Times Magazine article, Paul Krugman has not yet realized this. See my earlier post on this blog, "Is Macroeconomics Relevant?"

[3] "Bank CEO Incentives and the Credit Crisis." Social Science Research Network.

[4] The best of these is William D. Cohan’s House of Cards, which shows that the chief executives and subordinate players at Bear Stearns had full faith in the triple-A ratings of the subprime securities in which they had invested. Lawrence G. McDonald and Patrick Robinson’s A Colossal Failure of Common Sense, about Lehman Brothers, inadvertently makes the same point, despite the authors’ conviction that “common sense” should have revealed to the decision makers that they were mistaken. Gillian Tett’s Fools’ Gold, conversely, shows that at JPMorganChase, Jamie Dimon and his subordinates saw great risk in mortgage-backed securities and largely avoided them.

Evidence from the Cohan and Tett books is assembled in my “A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure,” Critical Review 21(2-3): 127-84, available online.

[5] Viral V. Acharya and Matthew Richardson, "Causes of the Financial Crisis." Critical Review 21(2-3): Table 1. (See http://www.criticalreview.com/crf/current_issue.html.)

[6] We won't know with any certainty, however, that bankers did buy these securities because of the Recourse Rule until somebody actually asks them, in confidence. This research is being undertaken by Wladimir Kraus of the University of Turin.

[7] Lawrence J. White, "The Credit-Rating Agencies and the Subprime Debacle." Critical Review 21(2-3): 389-99. (See http://www.criticalreview.com/crf/current_issue.html.)

Saturday, September 12, 2009

Pretence and Economic Knowledge

Paul Krugman critiques the economics profession for widely shared views that failed to anticipate and ill prepared us for an economic crisis that promises to be the worst since WWII.

Hayek made a similar charge in his Nobel Lecture of December 11, 1974, The Pretence of Knowledge: “… the economists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.” Although Hayek saw the problem as stemming from an inappropriate "scientistic" attitude, he explicitly wanted “…to avoid giving the impression that I generally reject the mathematical method in economics.” Rather, his main message was that “If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible…The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men's fatal striving to control society - a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.”

Economic scientists have precious little understanding of this rule governed complex order, and how to keep it on its demonstrated long term path of growth and human betterment without suffering too irreparably from the kind of unpredictable reverses that we are now mired in. Less pretence and a commitment to learn from the new data being generated as I write, will be both humbling and informative, after the inevitable human political impulse to blame one’s long standing political adversaries has run its course.

What is most impressive in the current crisis is that even those who find bubbles unsurprising, and who had warned of the housing bubble debacle, did not anticipate its ability to undermine the financial system so decisively and thereby to devastate a good performing economy. This is revealed in a fairly crisp timeline: residential home prices started their decline in 2006; mortgage market collapse in July-August, 2007 (which kick-started the Fed into taking “enhanced liquidity” measures); the fourth quarter 2008 events—the Treasury, Fed, FDIC joint announcement of crisis action, unprecedented extensions of FRB credit to holders of all varieties of underwater assets in implicit recognition that the financial system was under reserved and insolvent, not just illiquid.

Economists and policy makers have been learning as we go, and no one can be sure how long that process has yet to go.

The Failure of Economists to Account for Complexity

Testimony of David Colander submitted to the Congress of the United States, House Science and Technology Committee, for the Hearing on “The Risks of Financial Modeling: VaR and the Economic Meltdown,” September 10, 2009

Mr. Chairman and members of the committee: I thank you for the opportunity to testify. My name is David Colander. I am the Christian A Johnson Distinguished Professor of Economics at Middlebury College. I have written or edited over forty books, including a top-selling principles of economics textbook, and 150 articles on various aspects of economics. I was invited to speak because I was one of the authors of the Dahlem Report [revised and republished in Critical Review vol. 21, nos. 2-3, Spring-Summer 2009] in which we chided the economics profession for its failure to warn society about the impending financial crisis, and I have been asked to expand on some of the themes that we discussed in that report. (I attach that report as an appendix to this testimony.)

One year ago, almost to the day, the U.S. economy had a financial heart attack, from which it is still recovering. That heart attack, like all heart attacks, was a shock, and it has caused much discussion about who is to blame, and how can we avoid such heart attacks in the future. In my view much of that discussion has been off point. To make an analogy to a physical heart attack, the US had a heart attack because it is the equivalent of a 450-pound man with serious ailments too numerous to list, who is trying to live as if he were still a 20 year old who can party 24-7. It doesn’t take a rocket economist to know that that will likely lead to trouble. The questions I address in my testimony are: Why didn’t rocket economists recognize that, and warn society about it? And: What changes can be made to see that it doesn’t happen in the future?

Some non-economists have blamed the financial heart attack on economist’s highly technical models. In my view the problem is not the models; the problem is the way economic models are used. All too often models are used in lieu of educated common sense, when in fact models should be used as an aid to educated common sense. When models replace common sense, they are a hindrance rather than a help.

Modeling the Economy as a Complex System
Using models within economics or within any other social science, is especially treacherous. That’s because social science involves a higher degree of complexity than the natural sciences. The reason why social science is so complex is that the basic unit in social science, which economists call agents, are strategic, whereas the basic unit of the natural sciences are not. Economics can be thought of the physics with strategic atoms, who keep trying to foil any efforts to understand them and bring them under control. Strategic agents complicate modeling enormously; they make it impossible to have a perfect model since they increase the number of calculations one would have to make in order to solve the model beyond the calculations the fastest computer one can hypothesize could process in a finite amount of time.
Put simply, the formal study of complex systems is really, really, hard. Inevitably, complex systems exhibit path dependence, nested systems, multiple speed variables, sensitive dependence on initial conditions, and other non-linear dynamical properties. This means that at any moment in time, right when you thought you had a result, all hell can break loose. Formally studying complex systems requires rigorous training in the cutting edge of mathematics and statistics. It’s not for neophytes.

This recognition that the economy is complex is not a new discovery. Earlier economists, such as John Stuart Mill, recognized the economy’s complexity and were very modest in their claims about the usefulness of their models. They carefully presented their models as aids to a broader informed common sense. They built this modesty into their policy advice and told policy makers that the most we can expect from models is half-truths. To make sure that they did not claim too much for their scientific models, they divided the field of economics into two branches—one a scientific branch, which worked on formal models, and the other political economy, which was the branch of economics that addressed policy. Political economy was seen as an art which did not have the backing of science, but instead relied on the insights from models developed in the scientific branch supplemented by educated common sense to guide policy prescriptions.

In the early 1900s that two-part division broke down, and economists became a bit less modest in their claims for models, and more aggressive in their application of models directly to policy questions. The two branches were merged, and the result was a tragedy for both the science of economics and for the applied policy branch of economics.

It was a tragedy for the science of economics because it led economists away from developing a wide variety of models that would creatively explore the extraordinarily difficult questions that the complexity of the economy raised, questions for which new analytic and computational technology opened up new avenues of investigation.[1] Instead, the economics profession spent much of its time dotting i’s and crossing t’s on what was called a Walrasian general equilibrium model which was more analytically tractable. As opposed to viewing the supply/demand model and its macroeconomic counterpart, the Walrasian general equilibrium model, as interesting models relevant for a few limited phenomena, but at best a stepping stone for a formal understanding of the economy, it enshrined both models, and acted as if it explained everything. Complexities were just assumed away not because it made sense to assume them away, but for tractability reasons. The result was a set of models that would not even pass a perfunctory common sense smell test being studied ad nauseam.

Initially macroeconomics stayed separate from this broader unitary approach, and relied on a set of rough and ready models that had little scientific foundation. But in the 1980s, macroeconomics and finance fell into this “single model” approach. As that happened it caused economists to lose sight of the larger lesson that complexity conveys —that models in a complex system can be expected to continually break down. This adoption by macroeconomists of a single-model approach is one of the reasons why the economics profession failed to warn society about the financial crisis, and some parts of the profession assured society that such a crisis could not happen. Because they focused on that single model, economists simply did not study and plan for the inevitable breakdown of systems that one would expect in a complex system, because they had become so enamored with their model that they forgot to use it with common sense judgment.

Models and Macroeconomics
Let me be a bit more specific. The dominant model in macroeconomics is the dynamic stochastic general equilibrium (DSGE) model. This is a model that assumes there is a single globally rational representative agent with complete knowledge who is maximizing over the infinite future. In this model, by definition, there can be no strategic coordination problem—the most likely cause of the recent crisis—such problems are simply assumed away. Yet, this model has been the central focus of macro economists’ research for the last thirty years.

Had the DSGE model been seen as an aid to common sense, it could have been a useful model. When early versions of this model first developed back in the early 1980s, it served the useful purpose of getting some intertemporal issues straight that earlier macroeconomic models had screwed up. But then, for a variety of sociological reasons that I don’t have time to go into here, a majority of macroeconomists started believing that the DSGE model was useful not just as an aid to our understanding, but as the model of the macroeconomy. That doesn’t say much for the common sense of rocket economists. As the DSGE model became dominant, important research on broader non-linear dynamic models of the economy that would have been more helpful in understanding how an economy would be likely to crash, and what government might do when faced with a crash, was not done.[2]

Similar developments occurred with efficient market finance models, which make similar assumptions to DSGE models. When efficient market models first developed, they were useful; they led to technological advances in risk management and financial markets. But, as happened with macro, the users of these financial models forgot that models provide at best half truths; they stopped using models with common sense and judgment. The modelers knew that there was uncertainty and risk in these markets that when far beyond the risk assumed in the models. Simplification is the nature of modeling. But simplification means the models cannot be used directly, but must be used judgment and common sense, with a knowledge of the limitations of use that the simplifications require. Unfortunately, the warning labels on the models that should have been there in bold print—these models are based on assumptions that do not fit the real world, and thus the models should not be relied on too heavily—were not there. They should have been, which is why in the Dahlem Report we suggested that economic researchers who develop these models be subject to a code of ethics that requires them to warn society when economic models are being used for purposes for which they were not designed.

How did something so stupid happen in economics? It did not happen because economists are stupid; they are very bright. It happened because of incentives in the academic profession to advance lead researchers to dot i’s and cross t’s of existing models, rather than to explore a wide range of alternative models, or to focus their research on interpreting and seeing that models are used in policy with common sense. Common sense does not advance one very far within the economics profession. The over-reliance on a single model used without judgment is a serious problem that is built into the institutional structure of academia that produces economic researchers. That system trains show dogs, when what we need are hunting dogs.

The incorrect training starts in graduate school, where in their core courses students are primarily trained in analytic techniques useful for developing models, but not in how to use models creatively, or in how to use models with judgment to arrive at policy conclusions. For the most part policy issues are not even discussed in the entire core macroeconomics course. As students at a top graduate school said, “Monetary and fiscal policy are not abstract enough to be a question that would be answered in a macro course” and “We never talked about monetary or fiscal policy, although it might have been slipped in as a variable in one particular model.” (Colander, 2007, pg 169).

Let me conclude with a brief discussion of two suggestions, which relate to issues under the jurisdiction of this committee, that might decrease the probability of such events happening in the future.

* Include a wider range of peers in peer review
The first is a proposal that might help add a common sense check on models. Such a check is needed because, currently, the nature of internal-to-the-subfield peer review allows for an almost incestuous mutual reinforcement of researcher’s views with no common sense filter on those views. The proposal is to include a wider range of peers in the reviewing process of NSF grants in the social sciences. For example, physicists, mathematician, statisticians, and even business and governmental representatives, could serve, along with economists, on reviewing committees for economics proposals. Such a broader peer review process would likely both encourage research on much wider range of models and would also encourage more creative work.

* Increase the number of researchers trained to interpret models
The second is a proposal to increase the number of researchers trained in interpreting models rather than developing models by providing research grants to do that. In a sense, what I am suggesting is an applied science division of the National Science Foundation’s social science component. This division would fund work on the usefulness of models, and would be responsible for adding the warning labels that should have been attached to the models.

This applied research would not be highly technical and would involve a quite different set of skills than the standard scientific research would require. It would require researchers who had an intricate consumer’s knowledge of theory but not a producer’s knowledge. In addition it would require a knowledge of institutions, methodology, previous literature, and a sensibility about how the system works. These are all skills that are currently not taught in graduate economics programs, but they are the skills that underlie judgment and common sense. By providing NSF grants for this work, the NSF would encourage the development of a group of economists who specialized in interpreting models and applying models to the real world. The development of such a group would go a long way toward placing the necessary warning labels on models, and make it less likely that fiascos like a financial crisis would happen again.

Colander, David. 2006. (ed.) Post Walrasian Macroeconomics: Beyond the Dynamic Stochastic General Equilibrium Model. Cambridge, UK. Cambridge University Press.

Colander, David. 2007. The Making of an Economist Redux. Princeton, New Jersey: Princeton
University Press.

Solow, Robert. 2007. “Reflections on the Survey” in Colander 2007.

[1] Some approaches working outside this Walrasian general equilibrium framework that I see as promising includes approaches using adaptive network analysis, agent based modeling, random graph theory, ultrametrics, combinatorial stochastic processes, cointegrated vector autoregression, and the general study of non-linear dynamic models.

[2] Among well known economists, Robert Solow stands out in having warned about the use of DSGE models for policy. (See Solow, in Colander, 2007, pg 235.) He called them “rhetorical swindles.” Other economists, such as Post Keynesians, and economic methodologists also warned about the use of these models. For a discussion of alternative approaches, see Colander, ed. (2007). So alternative approaches were being considered, and concern about the model was aired, but those voices were lost in the enthusiasm most of the macroeconomics community showed for these models.

Beyond Krugman's Morality Tale

Paul Krugman has become the voice of economists for many businessmen, politicians, and lay people. Thus, when he writes an article entitled “How did Economists Get It So Wrong?” (The New York Times Magazine, September 6), it’s big news. Over the past week I’ve been continually asked by acquaintances what my view is of what he had to say. It’s difficult to respond; he’s a wonderful writer, and there’s some parts of the story he tells that are nicely expressed. But there are other parts that, from my viewpoint as an historian of economic thought and an economist watcher, he got quite wrong—sufficiently wrong to warrant a response.

The biggest general problem with the story Krugman tells is that it’s so black and white. There’s the good guys—the Keynesian gang, and bad guys—the Classical/Chicago gang. That, in my view, is seriously wrong. The real story is one of shades of grey, and full of nuances; it is a story in which it is hard to tell who are the good guys and who are the bad guys. The real story is one of systemic failure of the large part of the academic economics profession which led them to pretend, and some of them to actually believe, that they understood a complex system that they did not, and still do not, understand. It’s a story of the economics profession’s failure to express their ideas and arguments with the humility with which they deserve to be told. It’s a story of a profession that has lost the enormous insights of past economists—both Keynesian and Classical.

There are three places where I'd say Krugman gets it wrong. The first is that he does a hatchet job on Classical economics. He misses the depth of Classical understanding. The second is that he doesn't make clear what Keynesian economics he is talking about when he says that Keynesian economics is the future of macro. If he is saying that the Keynesian economics of the discredited IS/LM variety is the future of macro--I think he is quite wrong. The third place where he gets it wrong is where he seems to claim that mathematics is to blame for the crisis. It isn't the mathematics; it's the use of the mathematics. See the Dahlem's group's response to Tony Lawson which can be found at: http://www.paecon.net/PAEReview/issue50/DahlemGroup50.pdf

--David Colander

Monday, September 7, 2009

Is Macroeconomics Relevant?

Paul Krugman's New York Times Magazine article argues for the superiority of Keynesian rather than efficient-markets explanations of...what, exactly? Sometimes his dependent variable seems to be bubbles, other times recessions/depressions. But the topic is supposed to be the financial crisis of 2008. How does Keynesianism explain that?

As near as I can tell, here is Krugman's answer, in the fourth paragraph from the end of the article: "...prices of assets such as real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole." Is that really what brought the world economy to its knees--the unemployment of construction workers in California, Nevada, and Florida?

There is no place in Krugman's scenario for banks; Krugman is describing what we have just endured as if it were a standard-issue recession, or depression (as understood by a Keynesian), but as a practical matter, this seems to require assuming that what we just suffered was *not* a "financial" crisis.

I am a mere political scientist. But to judge from most of the economists' research published in the (widely acclaimed!) issue of CRITICAL REVIEW that gave rise to this blog, Krugman's story is, at best, incomplete. If I'm not mistaken, every one of our contributors argues (or assumes?) that this was a banking crisis--albeit one triggered by the popping of the housing bubble. According to them, the sources of the housing bubble and of its deflation are important, but these factors did not directly cause an economic calamity of worldwide scope. Instead, the popped housing bubble caused a sharp drop in the perceived value of mortgage-backed securities held by banks, leading to a severe credit crunch--and *that* is what led to the recession.

So I wonder if Krugman has managed to escape the abstraction from reality that he criticizes as typical of economics. Perhaps part of the urge to abstraction is the tendency to assume that all recessions are alike, and so can be subsumed under one or another macro theory--in turn, perhaps, part of the economists' conviction that they are only "scientists" if they discover economic "laws."

By contrast, our contributors suggest (in my reading of them anyway) that even if a decline in aggregate demand was an end result, the cause of the crisis was a series of "micro" factors that contributed to the concentration of toxic housing debt in the banks. These factors, according to our authors, ranged from bank-capital regulations (see the papers by Viral Acharya and Matthew Richardson and by Juliusz Jablecki and Mateusz Machaj) to the rating of mortgage-backed securities as AA or AAA (Lawrence J. White) to financial deregulation (Daron Acemoglu, Amar Bhide, and Joseph Stiglitz). Even the federal and state housing policies discussed by Peter Wallison, and the monetary factors emphasized by Steven Gjerstad and Vernon Smith, Joseph Stiglitz, and John Taylor are seen by the authors as having had their effect at the micro level--by making mortgages more affordable to subprime borrowers.

Maybe macroeconomics is useful in explaining "normal business cycles" or the Great Depression, but was the Crisis of 2008 in one of these two categories?

Jeffrey Friedman
Editor, Critical Review

The "Causes of the Crisis" blog

Welcome to "Causes of the Crisis." It is an experiment in scholarly discourse using what is usually the worst venue for careful discussion--the blog.

The Critical Review Foundation, the nonprofit foundation that is the blog's sponsor, hopes to encourage reflection on what caused the financial crisis, and on what the implications are for the financial system, the economy, the study of economics, the polity, and the study of politics. We hope to discourage polemics and ideological posturing, so these will be ruthlessly hunted down if they appear in the Comments section.

The distinguished contributors to this blog published articles in CRITICAL REVIEW vol. 21, nos. 2-3 (Spring-Summer 2009), a special issue on the causes of the crisis. Consistent with an ancient editorial policy of CRITICAL REVIEW, the special issue focused only on the past--what caused the crisis?--not on the future--what should be done about it? This self-imposed constraint is consistent with Max Weber's view of the proper role of social science, which is to understand, not to advise.

That will be the aim here, too. There is all too much policy advocacy in the world today, and it tends to engage emotions and "priors"--pre-existing beliefs about what has caused major social problems. So we shall confine ourselves to addressing the basis of future "priors" about the crisis by asking what did, in fact, cause it. We will leave the policy recommendations to the pundits.

This does not mean that our focus will be narrow or inaccessible, however. Factors that have been identified as possible causes of the crisis range from glitches in financial technology to normal business-cycle movements to major problems in financial capitalism and/or in attempts to regulate it. Big factors as well as small ones will be our concern.

The authors of articles in the special issue of Critical Review, all of whom have been given authorization to post blogs, are:

Daron Acemoglu (MIT)
Viral V. Acharya (NYU)
Amar Bhide (Columbia Univ.)
David Colander (Middlebury Coll.)
Michael Goldberg (Univ. of New Hampshire)
Steven Gjerstad (Chapman U.)
Michael Goldberg (U. of New Hampshire)
Armin Haas (Postdam Inst.)
Juliusz Jablecki (Polish Central Bank)
Katerina Juselius (U. of Copenhagen)
Alan Kirman (Univ. d'Aix Marseille III)
Thomas Lux (U. of Kiel)
Mateusz Machaj (U. of Wroclaw)
Matthew Richardson (NYU)
Brigitte Sloth (U. of Southern Denmark)
Vernon L. Smith (Chapman U.)*
Joseph E. Stiglitz (Columbia U.)*
John B. Taylor (Stanford U.)
Peter J. Wallison (American Enterprise Inst.)
Lawrence J. White (NYU)

* = Nobel laureate in economics

--Jeffrey Friedman (U. of Texas, Austin)
Editor, Critical Review