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Friday, June 5, 2009

Bad Economics Links

How economics lost sight of real world

By John Kay

Published: April 21 2009 20:51

The past two years have not enhanced the reputation of economists. Mostly they failed to point out fundamental weaknesses of financial markets and did not foresee the crisis, and now they disagree on appropriate policies and on the likely future course of events. Although more economic research has been done in the past 25 years than ever before, the economists whose names are most frequently referenced today, such as Hyman Minsky and John Maynard Keynes, are from earlier generations.

Since the 1970s economists have been engaged in a grand project. The project’s objective is that macroeconomics should have microeconomic foundations. In everyday language, that means that what we say about big policy issues – growth and inflation, boom and bust – should be grounded in the study of individual behaviour. Put like that, the project sounds obviously desirable, even essential. I confess I was long seduced by it.

Most economists would claim that the project has been a success. But the criteria are the self-referential criteria of modern academic life. The greatest compliment you can now pay an economic argument is to say it is rigorous. Today’s macroeconomic models are certainly that.

But policymakers and the public at large are, rightly, not interested in whether models are rigorous. They are interested in whether the models are useful and illuminating – and these rigorous models do not score well here.

Indeed, at an early stage of the project Robert Lucas, one of its principal architects, who received the Nobel prize for his contributions, developed what is known as the Lucas critique. He argued that ordinary standards of statistical validity should not be applied to the project’s predictions. According to his colleague Thomas Sargent, Lucas was concerned that such tests rejected “too many really good models”.

Economists, like physicists, have been searching for a theory of everything. If there were to be such an economic theory, there is really only one candidate, based on extreme rationality and market efficiency. Any other theory would have to account for the evolution of individual beliefs and the advance of human knowledge, and no one imagines that there could be a single theory of all human behaviour. Not quite no one: a few deranged practitioners of the project believe that their theory really does account for all human behaviour, and that concepts such as goodness, beauty and truth are sloppy sociological constructs.

But these people discredit themselves by opening their mouths. That people respond rationally to incentives, and that market prices incorporate information about the world, are not terrible assumptions. But they are not universal truths either. Much of what creates profit opportunities and causes instability in the global economy results from the failure of these assumptions. Herd behaviour, asset mispricing and grossly imperfect information have led us to where we are today.

There is not, and never will be, an economic theory of everything. Physics may, or may not, be different. But the knowledge we can hope to have in economics is piecemeal and provisional, and different theories will illuminate different but particular situations. We should observe empirical regularities and – as in other applied subjects such as medicine and engineering – we will often find pragmatic solutions that work even though our understanding of why they work is incomplete.

Max Planck, the physicist, said he had eschewed economics because it was too difficult. Planck, Keynes observed, could have mastered the corpus of mathematical economics in a few days – it might now have taken him a few weeks. Keynes went on to explain that economic understanding required an amalgam of logic and intuition and a wide knowledge of facts, most of which are not precise: “a requirement overwhelmingly difficult for those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of comparatively simple facts which are known with a high degree of precision”. On this, as on much else, Keynes was right.

A flawed first draft of history

By Lionel Barber
Financial Times

Published: April 21 2009

These are the best of times and the worst of times to be a financial journalist. The best, because we have a once-in-a-lifetime opportunity to report and analyse the most serious financial crisis since the Great Crash of 1929. The worst, because the newspaper and television industries are suffering, not only from the shock of a recession but also from the structural shock of the internet revolution.

Now comes a third shock. The financial media are accused of mis­sing the global financial crisis. Asleep at the wheel. Head in the clouds. No cliché has been left unturned as reporters, commentators – yes, even editors – have been castigated for failing to warn an unsuspecting public of impending disaster. Do these charges add up? To paraphrase the killer question from the Watergate hearings: what did the press know and when did it know it?

First, by way of mitigation, journalists were not the only ones to fall down on the job. Political leaders were happy to break open the champagne at the credit party; many lingered long after the fizz had gone. Regulators in the US, UK and continental Europe all failed to identify and contain the risks building within the system. Many economists, too, fell short. Only a few – such as Nouriel Roubini, now celebrated as the thinking man’s prophet of doom – identified pieces of the puzzle, even if they failed to piece them together.

Why did financial journalists not pay more attention to these warnings? First, the financial crisis started as a highly technical story that took months to go mainstream. Its origins lie in the credit markets, coverage of which in most news organisations counted as a backwater. Most reporters working in this so-called “shadow banking system” found it hard to interest their superiors who controlled space and who were more interested in broadcasting the “good news” story of rising property prices and economic growth.

A second related problem with the credit derivatives story was that it took place in an over-the-counter market with little disclosure and very little day-to-day news. Inevitably, the temptation was – and still is – to run with the stories that are much less opaque such as public company earnings. Yet the big innovations and the big money came in the credit markets.

The second criticism is that the media were too interested in building up a good news story. The comedian Jon Stewart’s on-air demolition of the booster-turned-doomster Jim Cramer shows there is a case to answer. Mr Stewart went so far as to suggest that CNBC, which hosts Mr Cramer’s Mad Money show, overlooked market shenanigans as it was too close to its core community: Wall Street traders and investment bankers. Danny Schechter, writing in the British Journalism Review, is equally critical alleging that newspapers had no interest in pursuing scandals in mortgage lending for fear of alienating property advertisers.

Journalists routinely face tensions between relying on their sources and burning them with critical coverage. Think of the White House press corps, the British “lobby” press that covers parliament or sports journalists assigned to a team. The incentive to “go along” to “get along” is always present, in competition with a journalist’s instinct to speak truth to power.

In the final resort, there can be little debate that the financial media could have done a better job. In this spirit of self-criticism, I identify four weaknesses in the coverage.

First, financial journalists failed to grasp the significance of the failure to regulate over-the-counter derivatives that formed the bulk of counterparty risk in the explosion of credit following the dotcom bubble. Alan Greenspan was opposed to such regulation, but how many commentators took the former Fed chairman to task and warned of the risks? For the most part, journalists were too enamoured with the prevailing tide of deregulation.

Second, journalists, with a few notable exceptions, failed to understand the risks posed by the implicit state guarantees enjoyed by Fannie Mae and Freddie Mac, the mortgage finance giants. Here, we should tip our hats to the now much-maligned Mr Greenspan. He raised alarms early about the risks. Of course, it was hard for journalists to attack the ideal of broader home ownership in America, but that is no excuse.

Third, journalists failed to grasp the significance of the growth in off-balance sheet financing by the banks, its relationship with the pro-cyclical Basle II rules on capital ratios, and the overall concept of leverage. How many news organisations reported on the crucial Securities and Exchange Commission decision in 2004 to loosen its regulations on leverage? The explosive growth of structured investment vehicles at the height of the credit boom was also woefully under-reported.

Fourth, financial journalists were too slow to grasp that a crash in the banking system would have a profoundly damaging impact on the real economy. The same applies to regulators and economists. For too long, too many experts treated the financial sector and the wider economy as parallel universes. This was fundamentally wrong.

Many of the most important developments of the past decade – the rise of radical Islamic terrorism, the opening of the Chinese economy as well as two credit bubbles – have largely been unanticipated or failed to attract the attention they deserved. Journalists, in this respect, have a crucial role to play. Flawed they may be, but they still have the capacity to be the canaries in the mine. Long may it be so.

There were exactly five people who foresaw this crisis
Mark Thoma's Economist's View

Daniel Kahneman on economic models:

Irrational everything, by Guy Rolnik, Haaretz: Prof. Daniel Kahneman has dozens, perhaps hundreds, of stories about people's irrational behavior when it comes to making economic decisions. ... But the story Kahneman recalls when asked about the economic models at the root of the current financial crisis is actually taken from history, not an experiment. It concerns a group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.

They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, "We suddenly found a map." The officer looked at the map and said, "You found a map, all right, but it's not of the Alps, it's of the Pyrenees."

According to Kahneman, the moral of the story is that some of our economic models, perhaps those of the investment world, are worthless. But individual investors need security - maps of the Pyrenees - even if they are, in effect, worthless. ...

"In the last half year, the models simply didn't work. So the question arises: Why do people use models? I liken what is happening now to a system that forecasts the weather, and does so very well. People know when to take an umbrella when they leave the house, or when it will snow. Except what? The system can't predict hurricanes. Do we use the system anyway, or throw it out? It turns out they'll use it."

Okay, so they use it. But why don't they buy hurricane insurance?

"The question is, how much will the hurricane insurance cost? Since you can't predict these events, you would have to take out insurance against many things. If they had listened to all the warnings and tried to prevent these things, the economy would look a lot different than it does now. So an interesting question arises: After this crisis, will we arrive at something like that? It's hard for me to believe."

The financial world's models are built on the assumption that investors are rational. You have shown that not only are they not rational, they even deviate from what is rational or statistical, in predictable, systematic ways. Can we say that whoever recognized and accepted these deviations could have seen this crisis coming?

"It was possible to foresee, and some people did. ... I have a colleague at Princeton who says there were exactly five people who foresaw this crisis, and this does not include ... Ben Bernanke. One of them is Prof. Robert Shiller, who also predicted the previous bubble. The problem is there were other economists who predicted this crisis, like Nouriel Roubini, but he also predicted some crises that never came to be."

He was one of those who predicted 10 crises out of three.

"Ten out of three is a pretty good record, relatively. But I conclude from the fact that only five people predicted the current crisis that it was impossible to predict it. In hindsight, it all seems obvious: Everyone seemed to be blind, only these five appeared to be smart. But there were a lot of smart people who looked at the situation and knew all the facts, and they did not predict the crisis." ...

The interesting psychological problem is why economists believe in their theory, but this is the problem with the theory, any theory. It leads to a certain blindness. It's difficult to see anything that deviates from it."

We only look for information that supports the theory and ignore the rest. "Correct..." ...

Let's end with your story of the Swiss soldiers and the map of the Pyrenees. I know why the map helped the soldiers: it gave them confidence. But why didn't they use a map of the Alps? Why don't we use the right economic models, ones that are relevant to extreme cases as well?

"Look, it's possible that there simply is no map of the Alps, that there is nothing that can predict hurricanes."

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