Re: From an Economist -- How Did Economists Get It So Wrong?

[David Farber <dave () farber net>]

Begin forwarded message:

From: Dave Wilson <dave () wilson net>
Date: September 7, 2009 12:20:17 PM EDT
To: dave () farber net
Cc: ip <ip () v2 listbox com>
Subject: Re: [IP] From an Economist -- How Did Economists Get It So  
Wrong?

For a very different take on this issue (one that supports Krugman's
position) I recommend a recent book, "The Myth of the Rational Market"
by Justin Fox (Time magazine), which details the decades-long flight
from economic theory based on observable fact toward economic theory
based on behavioral modeling. If you're wondering how it is that banks
had no trouble giving million dollar mortgages to people who likely
would not earn that much over the course of their lifetimes, it's
because the models said it was perfectly safe.


On Mon, Sep 7, 2009 at 9:53 AM, David Farber<dave () farber net> wrote:
> Begin forwarded message:
>
> From: "Faulhaber, Gerald" <faulhabe () wharton upenn edu>
> Date: September 7, 2009 9:10:37 AM EDT
> To: David Farber <dave () farber net>
> Subject: RE: [Dewayne-Net] How Did Economists Get It So Wrong?
>
> Dave [for IP if you wish]
>
> I'm an admirer of Krugman; he's a great economist.  However, as a  
> columnist,
> he gets a bit fevered at times, and this is one of those times.
>
> The breast-beating and mea culpa in this article has a long history in
> economics; we are always baring our soul about how imperfect we are,  
> more
> than any other discipline.  But let me add a little balance here.
>
> First, economics is not good at predicting dynamics; we are pretty  
> good at
> discerning when things are out of whack ("out of equilibrium" as we  
> say) but
> we don't have good predictive models that tell us exactly what will  
> happen
> and when if we are out of equilibrium.  Now in fact economists have  
> known
> for at least a decade that we were in bubbles: the stock boom of the  
> mid-90s
> (remember Alan Greenspan's "irrational exuberance"?), the Internet/ 
> telecom
> boom, and the housing bubble.  If you didn't hear the warnings, you  
> were not
> listening, because many, many economists and even analysts were  
> warning of
> it.  But no one can predict when the s--t will hit the fan; that is  
> not
> within our technology to do this.  Don't like this?  Well, you can  
> always
> find someone, maybe an economist, who will supply a prediction if  
> you demand
> one...for a price.  Now you know what it's worth.  But don't tell me
> economists didn't know we were in a housing bubble.  Did we know how  
> bad it
> would be when it burst?  No.  Largely because the data on systemic  
> risk in
> banking was simply not available.  'Nother story.
>
> Second, economists are not really very smug about what we can do.   
> We are of
> the view that we are much better than other social sciences, because  
> our
> results are all empirically based and quite rigorous, for what they  
> do.
>  While sometimes we get complacent (witness Krugman's quotes), most  
> of us
> are aware that a "black swan" event will take us far from where we can
> confidently say we know what's going on.  We do study carefully the  
> Great
> Depression black swan, but it's only one data point.
>
> Krugman's notion that economists fell in love with beautiful  
> mathematical
> models is simply nonsense.  Economists, including macroeconomists,  
> have been
> strongly empirically based for decades and have been prepared to  
> jettison
> theories that the data rejects.  Rational expectations models,  
> associated
> with the Chicago School, may still have some adherents on the shores  
> of Lake
> Michigan, but they have generally been rejected by the data.  We  
> must also
> understand that empirically based analyses are always based on what we
> observe, and what we have been observing over the past five decades is
> Not-Depression.  So when a Depression-sized events occur, we are  
> forecasting
> outside the sample, which means we are forecasting into ignorance.   
> All good
> economists know this: we are in uncharted waters  which our previous  
> data
> (except 1930-1940) doesn't cover at all.
>
> The notion that the government plays an absolutely crucial role in the
> economy is almost unquestioned by modern economists (except for the  
> Ayn Rand
> aficionados).  The interesting and difficult question is what role 
> (s) should
> it play?  Topic for another day; class dismissed.
>
> Professor Emeritus Gerald Faulhaber
> Business and Public Policy Dept.
> Wharton School, University of Pennsylvania
> Philadelphia, PA 19104
> Professor Emeritus of Law
> University of Pennsylvania
> -----Original Message-----
> From: David Farber [mailto:dave () farber net]
> Sent: Saturday, September 05, 2009 3:16 PM
> To: Faulhaber, Gerald
> Subject: Fwd: [Dewayne-Net] How Did Economists Get It So Wrong?
>
>
>
> Begin forwarded message:
>
> From: dewayne () warpspeed com (Dewayne Hendricks)
> Date: September 5, 2009 1:19:13 AM EDT
> To: Dewayne-Net Technology List <xyzzy () warpspeed com>
> Subject: [Dewayne-Net] How Did Economists Get It So Wrong?
>
> September 6, 2009
> How Did Economists Get It So Wrong?
> By PAUL KRUGMAN
> <http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?partner=rss&emc=rss&pagewanted=all
> >
>
> I. MISTAKING BEAUTY FOR TRUTH
>
> It's hard to believe now, but not long ago economists were
> congratulating themselves over the success of their field. Those
> successes - or so they believed - were both theoretical and practical,
> leading to a golden era for the profession. On the theoretical side,
> they thought that they had resolved their internal disputes. Thus, in
> a 2008 paper titled "The State of Macro" (that is, macroeconomics, the
> study of big-picture issues like recessions), Olivier Blanchard
> ofM.I.T., now the chief economist at the International Monetary Fund,
> declared that "the state of macro is good." The battles of yesteryear,
> he said, were over, and there had been a "broad convergence of
> vision." And in the real world, economists believed they had things
> under control: the "central problem of depression-prevention has been
> solved," declared Robert Lucas of the University of Chicago in his
> 2003 presidential address to the American Economic Association. In
> 2004, Ben Bernanke, a former Princeton professor who is now the
> chairman of the Federal Reserve Board, celebrated the Great Moderation
> in economic performance over the previous two decades, which he
> attributed in part to improved economic policy making.
>
> Last year, everything came apart.
>
> Few economists saw our current crisis coming, but this predictive
> failure was the least of the field's problems. More important was the
> profession's blindness to the very possibility of catastrophic
> failures in a market economy. During the golden years, financial
> economists came to believe that markets were inherently stable -
> indeed, that stocks and other assets were always priced just right.
> There was nothing in the prevailing models suggesting the possibility
> of the kind of collapse that happened last year. Meanwhile,
> macroeconomists were divided in their views. But the main division was
> between those who insisted that free-market economies never go astray
> and those who believed that economies may stray now and then but that
> any major deviations from the path of prosperity could and would be
> corrected by the all-powerful Fed. Neither side was prepared to cope
> with an economy that went off the rails despite the Fed's best  
> efforts.
>
> And in the wake of the crisis, the fault lines in the economics
> profession have yawned wider than ever. Lucas says the Obama
> administration's stimulus plans are "schlock economics," and his
> Chicago colleague John Cochrane says they're based on discredited
> "fairy tales." In response, Brad DeLong of theUniversity of
> California, Berkeley, writes of the "intellectual collapse" of the
> Chicago School, and I myself have written that comments from Chicago
> economists are the product of a Dark Age of macroeconomics in which
> hard-won knowledge has been forgotten.
>
> What happened to the economics profession? And where does it go from
> here?
>
> As I see it, the economics profession went astray because economists,
> as a group, mistook beauty, clad in impressive-looking mathematics,
> for truth. Untilthe Great Depression, most economists clung to a
> vision of capitalism as a perfect or nearly perfect system. That
> vision wasn't sustainable in the face of mass unemployment, but as
> memories of the Depression faded, economists fell back in love with
> the old, idealized vision of an economy in which rational individuals
> interact in perfect markets, this time gussied up with fancy
> equations. The renewed romance with the idealized market was, to be
> sure, partly a response to shifting political winds, partly a response
> to financial incentives. But while sabbaticals at the Hoover
> Institution and job opportunities on Wall Street are nothing to sneeze
> at, the central cause of the profession's failure was the desire for
> an all-encompassing, intellectually elegant approach that also gave
> economists a chance to show off their mathematical prowess.
>
> Unfortunately, this romanticized and sanitized vision of the economy
> led most economists to ignore all the things that can go wrong. They
> turned a blind eye to the limitations of human rationality that often
> lead to bubbles and busts; to the problems of institutions that run
> amok; to the imperfections of markets - especially financial markets -
> that can cause the economy's operating system to undergo sudden,
> unpredictable crashes; and to the dangers created when regulators
> don't believe in regulation.
>
> It's much harder to say where the economics profession goes from here.
> But what's almost certain is that economists will have to learn to
> live with messiness. That is, they will have to acknowledge the
> importance of irrational and often unpredictable behavior, face up to
> the often idiosyncratic imperfections of markets and accept that an
> elegant economic "theory of everything" is a long way off. In
> practical terms, this will translate into more cautious policy advice
> - and a reduced willingness to dismantle economic safeguards in the
> faith that markets will solve all problems.
>
> II. FROM SMITH TO KEYNES AND BACK
>
> The birth of economics as a discipline is usually credited to Adam
> Smith, who published "The Wealth of Nations" in 1776. Over the next
> 160 years an extensive body of economic theory was developed, whose
> central message was: Trust the market. Yes, economists admitted that
> there were cases in which markets might fail, of which the most
> important was the case of "externalities" - costs that people impose
> on others without paying the price, like traffic congestion or
> pollution. But the basic presumption of "neoclassical" economics
> (named after the late-19th-century theorists who elaborated on the
> concepts of their "classical" predecessors) was that we should have
> faith in the market system.
>
> This faith was, however, shattered by the Great Depression. Actually,
> even in the face of total collapse some economists insisted that
> whatever happens in a market economy must be right: "Depressions are
> not simply evils," declared Joseph Schumpeter in 1934 - 1934! They
> are, he added, "forms of something which has to be done." But many,
> and eventually most, economists turned to the insights of John Maynard
> Keynes for both an explanation of what had happened and a solution to
> future depressions.
>
> Keynes did not, despite what you may have heard, want the government
> to run the economy. He described his analysis in his 1936 masterwork,
> "The General Theory of Employment, Interest and Money," as "moderately
> conservative in its implications." He wanted to fix capitalism, not
> replace it. But he did challenge the notion that free-market economies
> can function without a minder, expressing particular contempt for
> financial markets, which he viewed as being dominated by short-term
> speculation with little regard for fundamentals. And he called for
> active government intervention - printing more money and, if
> necessary, spending heavily on public works - to fight unemployment
> during slumps.
>
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