Economists begin to wonder -- are financial markets inherently unstable?

Justin Fox has a nice piece in the Harvard Business Review looking at how economics and finance have changed in the years since the onset of the crisis. He offers several conclusions, but one is that financial economists are now, much more than before, coming to accept the notion that financial markets are by their nature inherently unstable. Can you imagine that? From the article:

Before the late 1950s, research on finance at business schools was practical, anecdotal, and not all that influential. Then a few economists began trying to impose order on the field, and in the early 1960s computers arrived on college campuses, enabling an explosion of quantitative, systematic research. The efficient market hypothesis (EMH) was finance’s equivalent of rational expectations; it grew out of the commonsense observation that if you figured out how to reliably beat the market, eventually enough people would imitate you so as to change the market’s behavior and render your predictions invalid. This soon evolved into a conviction that financial market prices were in some fundamental sense correct. Coupled with the capital asset pricing model, which linked the riskiness of investments to their return, the EMH became a unified and quite powerful theory of how financial markets work.

From these origins sprang useful if imperfect tools, ranging from cost-of-capital formulas for businesses to the options-pricing models that came to dominate financial risk management. Finance scholars also helped spread the idea (initially unpopular but widely accepted by the 1990s) that more power for financial markets had to be good for the economy.

By the late 1970s, though, scholars began collecting evidence that didn’t fit this framework. Financial markets were far more volatile than economic events seemed to justify. The link between “beta”—the risk measure at the heart of the capital asset pricing model—and stock returns proved tenuous. Some reliable patterns in market behavior (the value stock effect and the momentum effect) did not disappear even after finance journals published paper after paper about them. After the stock market crash of 1987, serious questions were raised about both the information content of prices and the stability of the risk measures used in finance. Researchers studying individual investing behavior found systematic violations of the premise that humans make decisions in a rational, forward-looking way. Those studying professional investors found that incentives cause them to court tail risks (that is, to follow strategies that are likely to generate positive returns most years but occasionally blow up) and to herd with other professionals (because their performance is judged against the same benchmarks). Those looking at banks found that even well-run institutions could be wiped out by panics.

But all this ferment failed to produce a coherent new story about how financial markets work and how they affect the economy. In 2005 Raghuram Rajan came close, in a now-famous presentation at the Federal Reserve Bank of Kansas City’s annual Jackson Hole conference. Rajan, a longtime University of Chicago finance professor who was then serving a stint as director of research at the International Monetary Fund (he is now the head of India’s central bank), brought together several of the strands above in a warning that the world’s vastly expanded financial markets, though they brought many benefits, might be bringing huge risks as well.

Since the crisis, research has exploded along the lines Rajan tentatively explored. The dynamics of liquidity crises and “fire sales” of financial assets have been examined in depth, as have the links between such financial phenomena and economic trouble. In contrast to the situation in macroeconomics, where it’s mostly younger scholars pushing ahead, some of the most interesting work being published in finance journals is by well-established professors out to connect the dots they didn’t connect before the crisis. The most impressive example is probably Gary Gorton, of Yale, who used to have a sideline building risk models for AIG Financial Products, one of the institutions at the heart of the financial crisis, and has since 2009 written two acclaimed books and two dozen academic papers exploring financial crises. But he’s far from alone.

What is all this research teaching us? Mainly that financial markets are prone to instability. This instability is inherent in assessing an uncertain future, and isn’t necessarily a bad thing in itself. But when paired with lots of debt, it can lead to grave economic pain. That realization has generated many calls to reduce the amount of debt in the financial system. If financial institutions funded themselves with more equity and less debt, instead of the 30-to-1 debt-to-equity ratio that prevailed on Wall Street before the crisis and still does at some European banks, they would be far less sensitive to declines in asset values. For a variety of reasons, bank executives don’t like issuing stock; when faced with higher capital requirements, they tend to reduce debt, not increase equity. Therefore, to make banks safer without shrinking financial activity overall, regulators must force them to sell more shares. Anat Admati, of Stanford, and Martin Hellwig, of the Max Planck Institute for Research on Collective Goods, have made this case most publicly, with their book The Bankers’ New Clothes, but their views are widely shared among those who study finance. (Not unanimously, though: The Brunnermeier-Sannikov paper mentioned above concludes that leverage restrictions “may do more harm than good.”)

This is an example of what’s been called macroprudential regulation. Before the crisis, both Bernanke and his immediate predecessor, Alan Greenspan, argued that although financial bubbles can wreak economic havoc, reliably identifying them ahead of time is impossible—so the Fed shouldn’t try to prick them with monetary policy. The new reasoning, most closely identified with Jeremy Stein, a Harvard economist who joined the Federal Reserve Board last year, is that even without perfect foresight the Fed and other banking agencies can use their regulatory powers to restrain bubbles and mitigate their consequences. Other macroprudential policies include requiring banks to issue debt that automatically converts to equity in times of crisis; adjusting capital requirements to the credit cycle (demanding more capital when times are good and less when they’re tough); and subjecting highly leveraged nonbanks to the sort of scrutiny that banks receive. Also, when viewed through a macroprudential lens, past regulatory pressure on banks to reduce their exposure to local, idiosyncratic risks turns out to have increased systemic risk by causing banks all over the country and even the world to stock up on the same securities and enter into similar derivatives contracts.

A few finance scholars, most persistently Thomas Philippon, of New York University, have also been looking into whether there’s a point at which the financial sector is simply too big and too rich—when it stops fueling economic growth and starts weighing on it. Others are beginning to consider whether some limits on financial innovation might not actually leave markets healthier. New kinds of securities sometimes “owe their very existence to neglected risks,” Nicola Gennaioli, of Universitat Pompeu Fabra; Andrei Shleifer, of Harvard; and Robert Vishny, of the University of Chicago, concluded in one 2012 paper. Such “false substitutes...lead to financial instability and could reduce welfare, even without the effects of excessive leverage.”

I shouldn’t overstate the intellectual shift here. Most day-to-day work in academic finance continues to involve solving small puzzles and documenting small anomalies. And some finance scholars would put far more emphasis than I do on the role that government has played in unbalancing the financial sector with guarantees and bailouts through the years. But it is nonetheless striking how widely accepted in the field is the idea that financial markets have a tendency to become unhinged, and that this tendency has economic consequences. One simple indicator: The word “bubble” appeared in 33 articles in the flagship Journal of Finance from its founding, in 1946, through the end of 1987. It has made 36 appearances in the journal just since November 2012.

Too bad this shift didn't take place 20 years ago, or maybe 40 years ago.

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Shiller, Fama and all that...

I couldn't help but write a little in my latest Bloomberg column on the strange choice for this year's Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. For readers of the column I wanted to give a few more links here to some stuff I've written before on the Efficient Markets Hypothesis, an idea that I think has been cause for an enormous waste of intellectual energy over 40 years or so. It has many versions. They are either 1) clearly false and so uninteresting or 2) clearly and unsurprisingly true, and hence uninteresting. That's my opinion in short; links to more extended discussions below.

The aforementioned Prize certainly involves a weird juxtaposition of two names -- Robert Shiller and Eugene Fama -- that you wouldn't normally think of seeing together. The one, Shiller, is a great enthusiast for markets, but also a staunch realist who thinks markets can and do go awry in lots of ways, creating bubbles, wasting resources, etc. The other, Fama, is a great enthusiast for markets who thinks they never go wrong, ever, and have an almost magical capacity to steer investments wisely (I think, but it's pretty hard to know exactly what he believes). So wait -- I guess they are clearly linked after all by the label "market enthusiast." There the similarity ends.

I've written previously on a number of occasions about the dreadfully long and confused arguments over the Efficient Markets Hypothesis. See here for a general introduction, here for some very recent evidence that pretty much kills the idea in one swoop, and here for a discussion of the perversions of normal logic often used by defenders of the EMH to prop the idea up in the face of all evidence. If writing papers about the EMH was banned I think finance would immediately take a step in the right direction. I just don't think it is interesting. Saying that the "market is hard to beat" and is therefore "efficient" in some peculiar sense isn't saying much at all.

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Playing dice with our future

I have a new column out in Bloomberg. Touch on politics, I've learned, and you get an order of magnitude more comments than you do otherwise, and this is proof again (not that I choose my topics this way). Many of the comments seem particularly vicious, but I did venture to wade into the Tea Party/Government Shut Down saga, so there's no surprise.

The article is motivated by my perception -- right or wrong? -- that many people in the Tea Party movement (and many Republicans in general, perhaps) have a naively safe view of the world. They seem to believe in the inherent superiority of America and the American System -- in American Exceptionalism, if you want -- and find it hard to imagine that we could easily slip way down in the world relative to other nations. This belief persists despite all kinds of statistics showing that our standing in things like education, public health, life expectancy, quality of life, etc. has indeed dropped way down in recent decades.

This kind of naive belief in a guaranteed good future breeds, I think, dangerous complacency regarding current policy. We can reduce taxes, disregard investment in infrastructure, not worry about trying to improve the healthcare system, etc., because we are, after all, NUMBER 1, aren't we! Well no, and keeping standards high in anything from education to communications infrastructure demands investment and hard work, not just slogans and tax breaks. And defaulting on the debt might actually be quite a good way to screw up our economy quite quickly.

Anyway, my article may tries to make this point in an unusual way -- with reference to evolution, adaptation and extinction -- but that's how my brain works. The 239 comments so far make it clear that quite a few people think I'm pretty daft, although roughly half seem to agree.

BTW, for interesting perspective on what lies behind the Tea Party furor, I highly recommend this fascinating article by Thomas Edsall in the New York Times.  The word cloud at the top of this post shows the words used most frequently by people in Tea Party focus groups when talking about the country and Obama. They really seem deeply frightened that Obama is trying to turn the US into a Soviet state where old style (white) Americans won't be welcome and a majority gay/black/hispanic/other immigrant population of slackers will live entirely off government programs. As Edsall notes:

Among Greenberg’s other findings from his focus groups:

• The participants “are very conscious of being white in a country that is increasingly minority.”
• Republican voters are threatened by Obama and the Democratic Party, but they are angry at their own party leaders. “The problem in D.C. is not gridlock; Obama has won; the problem is Republicans failing to stop him.”
• Together, evangelicals and Tea Party supporters comprise more than half the party. Moderates, about a quarter of Republicans, “are very conscious of being illegitimate within their own party.”

 I find all of this quite disconcerting. Fear + ignorance generally spells trouble.

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Republicans: destroy planet if need be to stop OBAMACARE

A gem from the Borowitz Report:

WASHINGTON (The Borowitz Report)—Senator Ted Cruz (R-Texas) raised the ante in the battle over the Affordable Care Act on Sunday, telling CNN’s Candy Crowley that “destroying the entire planet is really the best and only way to stop Obamacare.”

“Look, I’m in favor of shutting down the government and not raising the debt ceiling, but let’s not kid ourselves. Those are only half measures,” he told Crowley. “If we are really serious about stopping Obamacare, we’ll destroy the entire planet.”

Explaining his proposal to a visibly alarmed Crowley, Senator Cruz said, “Obamacare is like a parasite that needs a host to feed on. If you want to kill the parasite you kill the host, and in this case that means killing this planet. As long as there’s a planet Earth, the nightmare of Obamacare could always come screaming back to life.”

While he was not specific about how he would go about destroying the planet, Cruz said, “This is something that my colleagues and I have been working on for some time.”

The Texas senator refused to speculate on whether there were enough votes in Congress to support his proposal of obliterating Earth, but he ended his interview on a personal note: “Candy, I don’t want my children and my children’s children to live in a world with Obamacare. And the best way to guarantee that is by destroying the world.”

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Ross Douthat explains the conservative movement

Today's column by Ross Douthat in the New York Times is a must read, as it is a kind of confession of what the Conservative Movement really wants, according to Douthat. What really has them so angry, he says, is the history of the last 40 years or so during which, even when the Republicans were in power, they were unable to roll back the various programs they hate so much that were established from the 1930s to the 1960s. Mostly because they discovered, quite inconveniently, that most people in America want those programs. He quotes Conservative Dave Frum from the early 1990s:

However heady the 1980s may have looked to everyone else, they were for conservatives a testing and disillusioning time. Conservatives owned the executive branch for eight years and had great influence over it for four more; they dominated the Senate for six years; and by the end of the decade they exercised near complete control over the federal judiciary. And yet, every time they reached to undo the work of Franklin Roosevelt, Lyndon Johnson and Richard Nixon — the work they had damned for nearly half a century — they felt the public’s wary eyes upon them. They didn’t dare, and they realized that they didn’t dare. Their moment came and flickered. And as the power of the conservative movement slowly ebbed after 1986, and then roared away in 1992, the conservatives who had lived through that attack of faintheartedness shamefacedly felt that they had better hurry up and find something else to talk about …

The Conservative Movement is really upset, it turns out, because the policies they long for are more or less completely out of tune with what most Americans want. Or, as Douthat prefers to rather crazily phrase it , "American political reality really does seem to have a liberal bias." (Isn't reality, by definition, unbiased??) In other words, if most people don't agree with me, they must be biased.

I recommend reading some of the comments, where NYT readers chop Douthat into little pieces. Here are a few of my favorites for amusement:

• Don Duval, North Carolina

What Mr. Douthat apparently fails to grasp is in democracies, majorities matter, and Americans have repeatedly--in both elections and opinion polls--indicated that there isn't just majority support--but super-majority support for maintaining and even strengthening the programs that formed the heart of the New Deal (Social Security) and the Great Society (Medicare)"

The right's passionate hatred for both programs--and for the true believers' obsession with dismantling both--is not shared by anyone outsider their base.

Equally bogus is their belief that conservative ideas and ideals have never Ben given a chance--if you look at Romney's--and the right's economic policy--compared the economic, tax and governance policies of Coolidge and Hoover, in the 12 years that Mellon served as Treasury Secretary--one could be forgiven for wondering why Mellon's heirs are not suing the right for plagiarism.

An America without Social Security?

That's not a new idea--we tried that for two centuries.

Ditto for a society where seniors were forced to depend upon charity for healthcare at the time in their lives where there was a high need for medical care and virtually no chance for employment that offered health benefits.

The right fights because they are convinced that a bygone era was a golden time in this nation--when all was right in America.

Far right.

• Jeff G, Atlanta

If these foolishly romantic right wingers actually got a truly smaller government, what do they imagine would fill the vacuum? Do they expect an 18th century agrarian society to spring up spontaneously? This small government fantasy might have made sense in the early twentieth century, when they were opposing FDR. It was even a silly but excusable delusion through the late twentieth century. But now it's clear that the era of the rugged individual, small town values, and decentralized authority is long gone. In its place we have an interdependent worldwide economy, multinational corporations with revenues larger than the gdp of most nations, global terror networks capable of engaging in effective asymmetrical warfare, and a rising foreign middle class competing with us for jobs and resources while our own middle class is shrinking.
There's certainly a case to be made for limiting government's growth, and for continuing to seek greater efficiencies in its dealings, and keeping markets reasonably unfettered, and protecting individual liberties. But government actually gets smaller (enough to drown it in Grover Norquist's bathtub for instance) whatever accretion of power takes it place will certainly be much less humane, enlightened, or accountable to the masses than what we have now. Some fighting for this small government fantasy are well aware that they are really fighting for corporate plutocracy (such as the Kochs) but most have just been duped.

• RDG,  Cincinnati

"But to many conservatives, the right has never come remotely close to getting what it actually wants, whether in the Reagan era or the Gingrich years or now the age of the Tea Party."

Maybe because that is because the "right", meaning the far-right of the GOP, wants a national government that resembles 1912. And that far-right are in the driver's seat.

Meantime,"American political reality really does seem to have a liberal bias." True enough. The American people don;t want Wall Street brokers handling their Social Security or vouchers for their Medicare and seem to like what the ACA (as opposed to "Obamacare") has to offer so far.

They want clean water, safe food, drugs and bridges. Leaving those and other issues to the mercies of the private sector is not always the answer.

Cut spending? How about no tanks for an Army that doesn't want them, streamlined but still effective regulation, tax loopholes that don't only benefit the very well off, the end of fee-for-service medical practices, farm subsidies to folks averaging $250 in annual income and some tightening up of welfare outlays without hurting those who really need the help.

Acting as wreckers rather than governing to make what is in place better and more cost efficient in serving the people is why the GOP enjoys the reputation it enjoys today...outside its gerrymandered districts, that is.

 Read more here.

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Some conspiracies are real...

I wrote a while back in Bloomberg about the mystery of how so little has changed in economics and finance, despite the crisis. I mentioned there the great new book, “Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown,” by economic historian Philip Mirowski. It reads a little like a conspiracy theory, as he argues that defense of the academic status quo in economics and finance also serves an array of interests in business and finance for whom the “markets always work best” mantra paves the way to profit. Hence, the profession’s claim that nothing is seriously wrong with economic thinking has found ready allies, especially in conservative and libertarian-leaning think tanks and foundations.

 The picture above is of Polish economist Michael Kalecki, who died in 1970. Lars Syll points out that Kalecki had some very wise things to say -- and not all that different from Mirowski -- about the convenience of many "principles" of economics for industrial interests:

Every widening of state activity is looked upon by business with suspicion, but the creation of employment by government spending has a special aspect which makes the opposition particularly intense. Under a laissez-faire system the level of employment depends to a great extent on the so-called state of confidence. If this deteriorates, private investment declines, which results in a fall of output and employment (both directly and through the secondary effect of the fall in incomes upon consumption and investment). This gives the capitalists a powerful indirect control over government policy: everything which may shake the state of confidence must be carefully avoided because it would cause an economic crisis. But once the government learns the trick of increasing employment by its own purchases, this powerful controlling device loses its effectiveness. Hence budget deficits necessary to carry out government intervention must be regarded as perilous. The social function of the doctrine of ‘sound finance’ is to make the level of employment dependent on the state of confidence.

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What do we know about climate?

Sad to say this is only my second post of September. I have been busy with other things... extensive travel.... re-roofing a barn... the usual. Anyway, just a couple of links I'd like to mention in connection to my most recent Bloomberg column, which appeared yesterday.

The point of my column was to emphasize just how complex the science of the Earth's climate really is. I was struck by two recent articles in Nature, both of which are worth reading. One, an excellent feature by Nicola Jones, describes a few of the counter-intuitive effects of climate, for example, how the sea can rise (or fall) in different ways in different places. Water doesn't just spread out, as you might intuitively think. It has mass, and inertia, gets blown by winds, etc., and can pile up. A short taste:

When Jeff Freymueller, a geophysicist at the University of Alaska Fairbanks, visited Alaska's Graves Harbor more than a decade ago, his marine charts showed three isolated little islands; what he saw, instead, were three grassy peninsulas connected to the mainland. That was because water levels in some parts of Alaska are dropping — by up to 3 centimetres per year.

The ground there is lifting upwards, in a slow-motion rebound that has been going on for 10,000 years, since the glacial ice sheet that once weighed down the continent receded at the end of the last ice age. Gravitational influences on the oceans are also at work: as local glaciers recede and the Greenland ice sheet melts, their gravitational pull is subtly reduced, allowing more ocean water to slop southwards.

Trends in local sea level can differ strongly from the global average, which is increasing by around 3.2 millimetres per year. “Some places, sea-level rise is ten times faster than the average,” says Jerry Mitrovica, a geophysicist at Harvard University in Cambridge, Massachusetts.

One side of this equation is the movement of the land. Canada's Hudson Bay, for example, was once buried under more than 3 kilometres of ice, and the release from that load is now causing the land to rise at about 1 centimetre per year. As that part of North America moves upwards, land to the south is being levered down: the US east coast is dropping by millimetres per year.

Subsidence can cause some areas to sink much faster. Compaction of river sediments and hollowing out of the earth by groundwater extraction, for example, are causing parts of China's Yellow River delta to sink at up to 25 centimetres per year⁴.

Adding to the complexity, the oceans do not rise evenly all over the world as water is poured in. Air pressure, winds and currents can shove water in a given ocean to one side: since 1950, for example, a 1,000-kilometre stretch of the US Atlantic coast north of Cape Hatteras in North Carolina has seen the sea rise at 3–4 times the global average rate⁵. In large part, this is because the Gulf Stream and the North Atlantic current, which normally push waters away from that coast, have been weakening, allowing water to slop back onto US shores.

Finally, waters near big chunks of land and ice are literally pulled up onto shores by gravity. As ice sheets melt, the gravitational field weakens and alters the sea level. If Greenland melted enough to raise global seas by an average of 1 metre, for example, the gravitational effect would lower water levels near Greenland by 2.5 metres and raise them by as much as 1.3 metres far away.

Scientists and engineers are only just starting to wrangle all these effects into local projections. In June, the New York City Panel on Climate Change updated its estimates of sea-level rise by including the local effects of gravitational shifts⁶. Panel members concluded that they expect to see 30–60 centimetres of rise by 2050. Finding and combining the right data sets took about six months; the exercise should pave the way for other cities to do the same, says Cynthia Rosenzweig, a climate-impact researcher at NASA's Goddard Institute for Space Studies in New York City. “We really are working to get the best science.”

Equally interesting and informative, in a very different way, is a commentary piece in the same issue by K. John Holmes. This looks at the history of the use and management of the arid lands in the central and western US. Sounds a little boring, but Holmes argues that the process then was just as messy, just as fraught with hysteria and massive disinformation, as is the current debate over climate change and what to do about it:

When nineteenth-century explorer William Gilpin travelled across the Great Plains, the expanse that covers much of the central and western United States, he marvelled at the “great pastoral region”, the dry climate of which was “favorable to health, longevity, intellectual and physical development”¹. Great cities could be built there, he imagined, taking advantage of the wealth of local resources — rivers, forests and even gold.

Geologist John Wesley Powell saw things differently. Moving from the humid east to the arid west would affect agricultural practices, occupations, social interactions and political customs, he contended^{2, 3}. Dry-land agriculture could not support a large population; any towns built in the west would need appropriate designs, irrigation and resource management. A controversy erupted.

The ensuing debates about how the arid lands should be settled hold lessons for us today on adapting to a changing climate. At their heart was a development plan for the region that Powell published in 1878 (ref. 2). It called for detailed scientific and engineering surveys, and analysis to inform land-use plans and laws. Although it addressed a spatial change in conditions caused by westward population expansion, Powell's coupling of physical and human dimensions was a forerunner to the assessment approach used today by the Intergovernmental Panel on Climate Change (IPCC).

Powell's plan was never implemented in its entirety, but it began an era in which large-scale environmental and natural-resources assessments became central to the policy process in the United States⁴. Stalled by misinformation, political controversy and recessions, legislation for allocating resources in the arid lands took decades to enact. Then, as now, the assessments and their validity became part of the debate. Eventually, extreme weather, including long droughts, pushed policy-makers to act.

Read the whole thing here. 

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Undoing the pretzel logic of finance

My latest column in Bloomberg came out a few days ago. The article looks at some recent work of young MIT economist Alp Simsek that considers how new derivative instruments influence market stability. He comes to a conclusion that most ordinary people would find utterly unsurprising:

Financial markets in recent years have seen a proliferation of new …financial assets such as different types of futures, swaps, options, and more exotic derivatives. According to the traditional view of …nancial innovation, these assets facilitate the diversi…cation and the sharing of risks. However, this view does not take into account that market participants might naturally disagree about how to value …financial assets. The thesis of this paper is that belief disagreements change the implications of …nancial innovation for portfolio risks. In particular, market participants’' disagreements naturally lead to speculation, which represents a powerful economic force by which fi…nancial innovation increases portfolio risks.

There you go. Because not all people have the same views on the future, derivatives can be used to speculate and gamble. This increases risks in the market. More derivatives and more complete markets is not always a good thing, as standard financial theory would have it.

To be clear, I'm not poking fun at Simsek's work. Not at all. I think this work should be spread far and wide. That this idea comes as news to the academic finance community shows how deeply confused they have become by the received wisdom of market completeness as an ideal. They (at least many) do believe that UP = DOWN, and so news to the contrary sounds radical. In the article I've mentioned several other earlier studies (I've written about them here before, just search on "derivatives") that point to the same conclusion: more derivatives in general leads to more market instability (again, as most people already believe).

It's nice to see some influential young economists picking up and exploring this idea.

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The real trouble with economics

I pretty much agree with everything Mark Thoma says here in pointing to sociological factors within academic economics as the source of recent problems. Anyone who has read this blog knows I'm not so sanguine about the supposed "sophistication" of the analytical models currently used in macroeconomics, but, that to one side, Thoma is right that the real problem has been a lack of imagination and willingness to build models (probably messy and inelegant ones) that would inform us in a practically useful way about possible market instabilities:

 "I talked about the problem with the sociology of economics awhile back -- this is from a post in August, 2009:

In The Economist, Robert Lucas responds to recent criticism of macroeconomics ("In Defense of the Dismal Science"). Here's my entry at Free Exchange's Robert Lucas Roundtable in response to his essay:

Lucas roundtable: Ask the right questions, by Mark Thoma: In his essay, Robert Lucas defends macroeconomics against the charge that it is "valueless, even harmful", and that the tools economists use are "spectacularly useless".

I agree that the analytical tools economists use are not the problem. We cannot fully understand how the economy works without employing models of some sort, and we cannot build coherent models without using analytic tools such as mathematics. Some of these tools are very complex, but there is nothing wrong with sophistication so long as sophistication itself does not become the main goal, and sophistication is not used as a barrier to entry into the theorist's club rather than an analytical device to understand the world.

But all the tools in the world are useless if we lack the imagination needed to build the right models. Models are built to answer specific questions. When a theorist builds a model, it is an attempt to highlight the features of the world the theorist believes are the most important for the question at hand. For example, a map is a model of the real world, and sometimes I want a road map to help me find my way to my destination, but other times I might need a map showing crop production, or a map showing underground pipes and electrical lines. It all depends on the question I want to answer. If we try to make one map that answers every possible question we could ever ask of maps, it would be so cluttered with detail it would be useless, so we necessarily abstract from real world detail in order to highlight the essential elements needed to answer the question we have posed. The same is true for macroeconomic models.

But we have to ask the right questions before we can build the right models.

The problem wasn't the tools that macroeconomists use, it was the questions that we asked. The major debates in macroeconomics had nothing to do with the possibility of bubbles causing a financial system meltdown. That's not to say that there weren't models here and there that touched upon these questions, but the main focus of macroeconomic research was elsewhere. ...
The interesting question to me, then, is why we failed to ask the right questions. For example,... why policymakers didn't take the possibility of a major meltdown seriously. Why didn't they deliver forecasts conditional on a crisis occurring? Why didn't they ask this question of the model? Why did we only get forecasts conditional on no crisis? And also, why was the main factor that allowed the crisis to spread, the interconnectedness of financial markets, missed?

It was because policymakers couldn't and didn't take seriously the possibility that a crisis and meltdown could occur. And even if they had seriously considered the possibility of a meltdown, the models most people were using were not built to be informative on this question. It simply wasn't a question that was taken seriously by the mainstream.

Why did we, for the most part, fail to ask the right questions? Was it lack of imagination, was it the sociology within the profession, the concentration of power over what research gets highlighted, the inadequacy of the tools we brought to the problem, the fact that nobody will ever be able to predict these types of events, or something else?

It wasn't the tools, and it wasn't lack of imagination. As Brad DeLong points out, the voices were there—he points to Michael Mussa for one—but those voices were not heard. Nobody listened even though some people did see it coming. So I am more inclined to cite the sociology within the profession or the concentration of power as the main factors that caused us to dismiss these voices.

And here I think that thought leaders such as Robert Lucas and others who openly ridiculed models they disagreed with have questions they should ask themselves (e.g. Mr Lucas saying "At research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another", or more recently "These are kind of schlock economics"). When someone as notable and respected as Robert Lucas makes fun of an entire line of inquiry, it influences whole generations of economists away from asking certain types of questions, some of which turned out to be important. Why was it necessary for the major leaders in macroeconomics to shut down alternative lines of inquiry through ridicule and other means rather than simply citing evidence in support of their positions? What were they afraid of? The goal is to find the truth, not win fame and fortune by dominating the debate.

We need to take a close look at how the sociology of our profession led to an outcome where people were made to feel embarrassed for even asking certain types of questions. People will always be passionate in defense of their life's work, so it's not the rhetoric itself that is of concern, the problem comes when factors such as ideology or control of journals and other outlets for the dissemination of research stand in the way of promising alternative lines of inquiry.

I don't know for sure the extent to which the ability of a small number of people in the field to control the academic discourse led to a concentration of power that stood in the way of alternative lines of investigation, or the extent to which the ideology that markets prices always tend to move toward their long-run equilibrium values caused us to ignore voices that foresaw the developing bubble and coming crisis. But something caused most of us to ask the wrong questions, and to dismiss the people who got it right, and I think one of our first orders of business is to understand how and why that happened.

I think the structure of journals, which concentrates power within the profession, also influence the sociology of the profession (and not in a good way)."

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The political problem

Several years ago, immediately post-crisis, I wrote a short article for Nature exploring new ideas about modelling economic and financial systems. I wrote about agent-based models and other similar ideas, nothing all that earth shaking really. In an early draft, I recall adding a section toward the end of the piece making the point that, of course, better models, better science, etc., would never be enough because ultimately policy making has an irreducible political element; financial crises can almost always be traced back to the political influence of powerful forces who shape policies to help themselves (or to try to do so), with little thought for the welfare of others. To my surprise, my editor at Nature took that section out saying something like "we'd like to stick to the science."

I thought that was unfortunate and hugely misleading. Corruption is real, and I really do think that no amount of better economics will eliminate financial and economic crises, because of the reality of politics. No avoiding it. Simon Wren-Lewis has a great post on this topic today, looking at why it would not actually be that hard -- conceptually -- to make the financial system more stable. The only barrier is the intimate connection between finance and politics ("quite frankly, the banks own this place" as U.S. Senator Dick Durbin once put it), which means that banks won't actually have to do things that might help the public good and the nation as a whole:

There is one simple and straightforward measure that would go a long way to avoiding another global financial crisis, and that is to substantially increase the proportion of bank equity that banks are obliged to hold. This point is put forcibly, and in plain language, in a recent book by Admati and Hellwig: The Bankers New Clothes. (Here is a short NYT piece by Admati.) Admati and Hellwig suggest the proportion of the balance sheet that is backed by equity should be something like 25%, and other estimates for the optimal amount of bank equity come up with similar numbers. The numbers that regulators are intending to impose post-crisis are tiny in comparison.

It is worth quoting the first paragraph of a FT review by Martin Wolf of their book:

“The UK’s Independent Commission on Banking, of which I was a member, made a modest proposal: the proportion of the balance sheet of UK retail banks that has to be funded by equity, instead of debt, should be raised to 4 per cent. This would be just a percentage point above the figure suggested by the Basel Committee on Banking Supervision. The government rejected this, because of lobbying by the banks.”

Why are banks so reluctant to raise more equity capital? One reason is tax breaks that make finance using borrowing cheaper. But non-financial companies, that also have a choice between raising equity and borrowing to finance investment, typically use much more equity capital and less borrowing. If things go wrong, you can reduce dividends, but you still have to pay interest, so companies limit the amount of borrowing they do to reduce the risk of bankruptcy. But large banks are famously too big to fail. So someone else takes care of the bankruptcy risk - you and me. We effectively guarantee the borrowing that banks do. (If this is not clear, read chapter 9 of the book here.  The authors make a nice analogy with a rich aunt who offers to always guarantee your mortgage.)

The state guarantee is a huge, and ongoing, public subsidy to the banking sector. For large banks, it is of the same order of magnitude as the profits they make. We know where a large proportion of the profits go - into bonuses for those who work in those banks. The larger is the amount of equity capital that banks are forced to hold, the more the holders of that equity bear the cost of bank failure, and the less is the public subsidy. Seen in this way it becomes obvious why banks do not want to hold more equity capital - they rather like being subsidised by the state, so that the state can contribute to their bonuses. (Existing equity holders will also resist increasing equity capital, for reasons Carola Binder summarises based on the work of Admati and Hellwig and coauthors.)

This is why the argument is largely a no brainer for economists. [1] Most economists are instinctively against state subsidies, unless there are obvious externalities which they are countering. With banks the subsidy is not just an unwarranted transfer of resources, but it is also distorting the incentives for bankers to take risk, as we found out in 2007/8. Bankers make money when the risk pays off, and get bailed out by governments when it does not.

So why are economists being ignored by politicians? It is hardly because banks are popular with the public. The scale of the banking sector’s misdemeanours is incredible, as John Lanchester sets out here. I suspect many will think that banks are being treated lightly because politicians are concerned about choking off the recovery. Yet the argument that banks often make - holding equity capital represents money that is ‘tied up’ and so cannot be lent to firms and consumers - is simply nonsense. A more respectable argument is that holding much more equity capital would translate into greater costs for bank borrowers, but David Miles suggests the size of this effect would not be large. (See also Simon Johnson here, John Plender here and Thomas Hoenig here.) In any case, public subsidies are bound to be passed on to some extent, but that does not justify them. Politicians are busy trying to phase out public subsidies elsewhere, so why are banks so different?

There is one simple explanation. The power of the banking lobby (and the financial industry more generally) is immense, from campaign contributions to regulatory capture of various kinds. It would be nice to imagine that the UK was less vulnerable than the US in this respect, but there are good reasons to think otherwise. [2] As a result, the power and influence of banks and bankers within government has hardly suffered as a result of the Great Recession that they played a large part in creating.

This point bears repeating -- indeed, it ought to be repeated every day for the rest of the year. All the technical and semi-technical articles now being published about measures for getting at systemic risk and improved schemes for weighting capital and so on, however clever and interesting they may be, actually only serve to draw attention away from this most serious problem, which is institutionalized corruption plain and simple. If every finance professor wrote one article on this topic -- after all, shouldn't this really be THE main topic in finance today? -- we might one day get somewhere with fixing the financial system.

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What has nature done for us?

I had the opportunity last week to speak at the Edinburgh International Festival of Books alongside Tony Juniper, British environmentalist and former head of Friends of the Earth. I highly recommend his new book, What has nature ever done for us?, which examines the many ways that the natural world contributes to our well being considered in economic terms. "Many ways" is of course an absolutely absurd understatement, as the natural world essentially provides everything that makes our lives possible. But if you turn off your brain, swallow hard and actually do calculations of environmentally produced economic value -- sadly, it seems that only this approach has influence in our world where everything comes down to economic costs and benefits -- you find (without any surprise) that the value of "ecosystem services" on a yearly basis is many times current global GDP.

Personally, I think it is obvious that this is a vast underestimate, but if it is necessary to convince people who cannot think in any other terms, then so be it. The Earth's ecosystems produce the oxygen we breath. How much value is there in that? I would say it is pretty much infinite, although I'm sure someone will argue that we could, with the right hypothetical technology, produce our own oxygen and so replace those messy natural resources with industry based on our own knowledge, perhaps we'd even boost the economy in the process! Bollocks. Juniper's book is a beautifully written corrective to such nonsense.

We've evolved in delicate interdependence with our natural world; we didn't create ourselves above and beyond nature with rational thought and technology, although this is the modern illusion. Although it comes from a very different context -- A Recipe for Happiness by Rabbi Ari Kahn (courtesy of Mitch Julis of Canyon Partners) -- I think the following words hold great wisdom:

Modern man, intoxicated with his own success, is prone to hubris. He sees himself as a self-made man, and worships his ‘creator’ every time he glances in the mirror... Like Narcissus gazing into the water while perched on a rock, modern man no longer recalls where he came from, and his own self-absorption mesmerizes him. He is isolated, and because he has forgotten the past, he has no humility, no perspective, no context. At the same time, he jeopardizes his connection with the future: Only when we transmit historical consciousness to our children, and live beyond the narrow confines of the present, do we stand a chance of being appreciated by our children – rather than being rejected, in turn, as a relic from the past.

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Why Homo economicus isn't very smart

I'm getting back tomorrow from extended travels in Poland and the UK and hope to resume some more frequent blogging. Just a quick note today to clarify my recent column in Bloomberg on Homo economicus and the payoffs to friendly types in Prisoner's Dilemma games. Several people commenting on Bloomberg have suggested that what I've said was known 20 years ago or was all evident from the famous work of Robert Axelrod on the iterated Prisoner's Dilemma. They don't seem to have taken a look at the specific paper I referred to in the piece, which is very recent, but maybe that's my fault as I didn't spell out what is new about this work as well as I could have.

This study by Thomas Grund and colleagues does not JUST look at the iterated Prisoner's Dilemma or point out that mechanisms of group selection can support the evolution of altruists. This is indeed already known and has been known for a while. However, these mechanisms are also subject to limitations depending on various factors such as group mixing. The current study looks at a situation in which individuals CAN care about the payoffs for others with whom they interact (their utility function has an other-regarding component). It assumes that this does NOTHING for their reproductive fitness, however, this being totally distinct from utility and depending on an individual's own payoff. In other words, the model assumes that helping behavior is costly.

So, why would someone come to care for about the payoffs to others? Why indeed. This is where the story gets interesting. Just let this be possible by giving everyone a "friendliness" parameter F reflecting how much they care about others (0 = no caring, 1 = a lot of caring). What the study shows is that, even if everyone starts out with F = 0, this situation is unstable to the evolution of caring behavior. If individuals pass on their friendliness (genetically or culturally) to offspring, then random variations in friendliness values, caught on the wing by selection, can spread through the population. In effect, friendliness, even though it matters not for actually fitness, can provide an organizational scaffolding that makes it easier for cooperators to find cooperators. The mere possibility of friendliness (you can call this arbitrary variable anything you like) allows a spatial segregation of the population that enables much higher levels of cooperation.

This is, I think, quite new and very different from earlier studies. It introduces an essentially new element. Homo economicus, in this world, suffers because he is not capable of responding as flexibly as are others in the population (i.e. making decisions on the basis of matters that have no link whatsoever to his fitness). Those who are more flexible -- and apparently unreasonable -- can come to dominate quite quickly in the right circumstances. From the paper:

However, why does this transition happen in just a few generations (see Fig. 1B), i.e. much faster than expected? This relates to our distinction of preferences and behaviour. When an ‘idealist’ is born in a neighbourhood with friendliness levels supporting conditional cooperation, this can trigger off a cascade of changes from defective to cooperative behaviour. Under such conditions, a single ‘idealist’ may quickly turn a defective neighbourhood into a largely cooperative one. This implies higher payoffs and higher reproduction rates for both, idealists and conditional co-operators.

The intriguing phase transition from self-regarding to other-regarding preferences critically depends on the local reproduction rate (see Fig. 2). The clustering of friendly agents, which promotes other-regarding preferences, is not supported when offspring move away. Then, offspring are more likely to encounter defectors elsewhere and parents are not ‘shielded’ by their own friendly offspring anymore. In contrast, with local reproduction, offspring settle nearby, and a clustering of friendly agents is reinforced. Under such conditions, friendliness is evolutionary advantageous over selfishness.
 

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The macho of rationality

There seems to be a strange communal notion in the economics profession that one should always try to get by with the idea of complete human rationality; that any weakening of this assumption in one's theory is unseemly and more or less tantamount to cheating, as if you're not keeping a stiff upper lip and soldiering on like the rest of your colleagues who are trying to explain things with the rationality handicap fully in place and without making any concessions to reality. I don't know why economists don't agree to theorize with one hand tied painfully behind their back, or maybe with red hot needles inserted into their eyes, just to make the competition even tougher. The best economist is the most macho.

I recall seeing this attitude expressed forcefully in a paper from several years ago by UC Berkeley finance professor Mark Rubinstein. I wrote about that here and I might as just quote one bit:

"Rubinstein asserts that his thinking follows from what he calls The Prime Directive. This commitment is itself interesting:

When I went to financial economist training school, I was taught The Prime Directive. That is, as a trained financial economist, with the special knowledge about financial markets and statistics that I had learned, enhanced with the new high-tech computers, databases and software, I would have to be careful how I used this power. Whatever else I would do, I should follow The Prime Directive:

Explain asset prices by rational models. Only if all attempts fail, resort to irrational investor behavior.

One has the feeling from the burgeoning behavioralist literature that it has lost all the constraints of this directive – that whatever anomalies are discovered, illusory or not, behavioralists will come up with an explanation grounded in systematic irrational investor behavior.

Rubinstein here is at least being very honest. He's going to jump through intellectual hoops to preserve his prior belief that people are rational, even though (as he readily admits elsewhere in the text) we know that people are not rational. Hence, he's going to approach reality by assuming something that is definitely not true and seeing what its consequences are. Only if all his effort and imagination fails to come up with a suitable scheme will he actually consider paying attention to the messy details of real human behaviour."

There are multiple things I fail to get about this, the first being that this is not actually a good way to explain anything. Think of this. Suppose you observe some real world thing X (some market behavior) and you want to explain it. You assume A (rationality), build a model, and show that X comes out. Great! But then, your explanation really only hangs together is A is true. If someone rightly objects that A isn't true, then you've really explained nothing. The mystery stands: how is it that in a world in which A is not true, X can happen? You might say "well, A is almost true, so this is an approximate explanation." Maybe, but it would then be much better to go back and try again with assumption B (people are fairly rational with shortcomings of this or that specific sort) and show that X comes out. That would be an explanation one could believe. Rubinstein's presciption holds that this should only be a last resort, perhaps an admission of defeat. Oddly, the Prime Directive, it seems to me, holds that economists should stop seeking an explanation before they've actually found one (at least in cases, as is typical, in which A, rationality, is not true..... in really simple cases in which that assumption is plausible, games of tic-tac-toe and such, then sure.)

Anyway, Floyd Norris has a nice essay today touching on the thoughts of Ben Bernanke, Steve Keen and others, and exploring various topics including the widely held delusion prior to the crisis of how stability and efficiency were guaranteed by the wonders of modern financial engineering. As part of it, Bernanke makes more or less the same statement as Rubinstein (I've put it in bold, part way down):

The intellectual framework [FED economists prior to the crisis] used simply could not cope with the idea that financial stability can itself become a destabilizing factor, as investors and bankers conclude that it is safe to take on more and more risk.

For a time, the period before the collapse was known as the “Great Moderation,” a term that Mr. Bernanke helped to publicize in a 2004 speech. Low levels of inflation, long periods of economic growth and low levels of employment volatility were viewed as unquestioned proof of success.

And what brought on that success? In 2004, Mr. Bernanke, then a Fed governor, conceded good luck might have helped, but his view was that “improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation.”

In 2005, three Fed economists, Karen E. Dynan, Douglas W. Elmendorf and Daniel E. Sichel, proposed an additional explanation for the Great Moderation: the success of financial innovation.

“Improved assessment and pricing of risk, expanded lending to households without strong collateral, more widespread securitization of loans, and the development of markets for riskier corporate debt have enhanced the ability of households and businesses to borrow funds,” they wrote. “Greater use of credit could foster a reduction in economic volatility by lessening the sensitivity of household and business spending to downturns in income and cash flow.”

At least Mr. Bernanke’s hubris was not as great as that of Robert E. Lucas Jr., the Nobel Prize-winning University of Chicago economist. In 2003, he began his presidential address to the American Economic Association by proclaiming that macroeconomics “has succeeded: Its central problem of depression prevention has been solved.”   

In his speech last week, Mr. Bernanke cited several assessments of the Great Moderation, including the one by the Fed economists. None questioned that it was wonderful.

The Fed chairman conceded that “one cannot look back at the Great Moderation today without asking whether the sustained economic stability of the period somehow promoted the excessive risk-taking that followed. The idea that this long period of calm lulled investors, financial firms and financial regulators into paying insufficient attention to building risks must have some truth in it.”

One economist who would have expected that development was Hyman Minsky. In 1995, the year before Minsky died, Steve Keen, an Australian economist, used his ideas to set forth a possibility that now seems prescient. It was published in The Journal of Post Keynesian Economics.

He suggested that lending standards would be gradually reduced, and asset prices would rise, as confidence grew that “the future is assured, and therefore that most investments will succeed.” Eventually, the income-earning ability of an asset would seem less important than the expected capital gains. Buyers would pay high prices and finance their purchases with ever-rising amounts of debt.

When something went wrong, an immediate need for liquidity would cause financiers to try to sell assets immediately. “The asset market becomes flooded,” Mr. Keen wrote, “and the euphoria becomes a panic, the boom becomes a slump.” Minsky argued that could end without disaster, if inflation bailed everyone out. But if it happened in a period of low inflation, it could feed upon itself and lead to depression.

“The chaotic dynamics explored in this paper,” Mr. Keen concluded, “should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm.”

When I talked to Mr. Keen this week, he called my attention to the fact that Mr. Bernanke, in his 2000 book “Essays on the Great Depression,” briefly mentioned, and dismissed, both Minsky and Charles Kindleberger, author of the classic “Manias, Panics and Crashes.”

They had, Mr. Bernanke wrote, “argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behavior.” In a footnote, he added, “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.”

It seems to me that he had both Minsky and Kindleberger wrong. Their insight was that behavior that seems perfectly rational at the time can turn out to be destructive. As Robert J. Barbera, now the co-director of the Center for Financial Economics at Johns Hopkins University, wrote in his 2009 book, “The Cost of Capitalism,” “One of Minsky’s great insights was his anticipation of the ‘Paradox of Goldilocks.’ Because rising conviction about a benign future, in turn, evokes rising commitment to risk, the system becomes increasingly vulnerable to retrenchment, notwithstanding the fact that consensus expectations remain reasonable relative to recent history.”

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Young economists -- go for it!

I'm really glad to see some economics students standing up for what they believe and taking action to start pushing their field in a better direction. This recent conference in Germany wasn't organized by the elders in economics, the esteemed and deserving (??) Nobel Prize winners of "greed, rationality and equilibrium" who OUGHT to be desperate to find better ideas and to lead the way, but by students acting on their own (with some help from INET). I'm encouraged by their energy and willingness to think openly:

Who are we? As students of economics at the University of Tübingen, Germany, we are organizing the second Rethinking Economics conference, in order to broaden our insights into modern economic thinking. As the summer conference in 2012 has shown that university education puts too little attention on issues of epistemology and the history of economic science, this year’s conference aims to stress the methodological plurality of recent economic research. Therefore we are seeking to promote the exchange with new economic thinkers of all strands and like-minded economics students.

Why rethink economics? Most of current economic research considers economics as a self-equilibrating system populated by rational individuals. It lacks interactions that can endogenously explain crises that we have seen in the real world. Alternative approaches, however, offer inspiring new perspectives to economic phenomena and provide ideas how the deficiencies of current economic paradigms may be solved. Frictions and irrationalities in general, and, for example, the nature and political economy of financial markets and systemic instability in particular, are not treated as unattractive deviations from theoretical ideals, but are incorporated as main features of the model. These theories show that aside from neoclassical approaches there are different ways of thinking about economics, which allow understanding economic dynamics better.

What is our objective? There has been an intense debate on the direction of economic research since the outbreak of the financial crisis. Our summer conference aims to offer an insight into modern strands of economics and to promote and accelerate new economic thinking among young students of economics. The conference will cover Complexity Economics, Agent-Based Modeling, Neuroeconomics, Postkeynesian Economics, and Behavioral Economics. These theories will be applied to topics such as non-equilibrium economics, contagion in the banking sector, instability of preferences, the links between the financial sector and the real economy, and empirical evidence on neoclassical assumptions from psychology, sociology, anthropology, and neuroscience.

Who can participate? The conference addresses students of economics and neighboring fields.  We invite open-minded economic thinkers of all semesters, and will therefore provide workshops that do not assume many previous knowledge of the topic discussed. Every lecturer will provide a reading list, which enables the participants to prepare themselves in advance. The conference will be complemented by a panel discussion open to the public, dealing with the future of economic modeling.

 Good for them.

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Economics and Evolution

There's a minor dust up brewing over how much economists can learn from evolutionary theory, stimulated by this special issue of the Journal of Economic Behavior and Organization, entitled "Evolution as a General Theoretical Framework for Economics and Public Policy". I haven't yet read the papers in the issue, although they certainly look to be well-motivated, focused on policy relevant questions, and eager to draw insights from long study of evolution, which I think is a good idea as evolution is, in general, a lot smarter than we are. But it seems that Mark Thoma isn't impressed by the idea, or at least finds a Scientific American article discussing the special issue irritating in making a number of sweeping statements about economics that aren't justified.

In that Thoma is right (and I do often agree with him). For example, economists do have a huge body of work studying tragedies of the commons, their origins and how they might be avoided, and the article implies otherwise. He makes other criticisms as well, more or less justified, although he also seems rather touchy about the idea that economists haven't woken up to the deeper insights that evolutionary theory has to offer and remains stuck on restrictive game theoretical notions of equilibrium. One of the editors of the Special Issue, Barkley Rosser, offers a considered response:

Mark Thoma at economists view http://economistsview.typepad.com/economistsview/2013/07/revolutionizing-economics-by-evolutionizing-it.html , has linked to a post by Jag Bhalla at Scientific American, who in turn links to the Evolution Institute, http://evolution-institute.org/node/144 , where one finds a link to a special issue of the Journal of Economic Behavior and Organization (JEBO) that I have coedited with David Sloan Wilson and John M. Gowdy.  The special issue makes a play for increasing the use of evolutionary theory in economics.  Bhalla argues that this involves arguing that economics should not necessarily involve assuming people rationally maximize utility or that equilibrium analysis should be the focus of analysis.  Mark is unhappy about this characterization and disses the argument pretty hard.  Of course, he is welcome to his view.

Furthermore, he invokes Paul Krugman, quoting in full a speech that PK gave in 1996 to the European Society for Evolutionary Political Economy (while I am into such things, I know nothing of this group).  One can directly access PK's speech at http://www.pkarchive.org/evolute.html , if one does not want to go through Mark's link.  It may well be that Krugman would now disavow parts of this speech, or at least pull his punches a bit, but it is a place where he puts on his neoclassical hat full force and defends orthodox economics full bore.  This may well not be inconsistent with his current stance as the critic of new neoclassical synthesis views, given that one can view him to some degree as an advocate of the old MIT-Samuelson "neoclassical synthesis" that adopted a neo-Keynesian ISLM approach to macro while essentially maintaining a position of full orthodoxy in microeconomics.  Let us grant that this orthodoxy includes emphasizing agents who are fully rational and maximize their well-defined utility that interacts with other economic agents to lead reasonably quickly to equilibrium, with this being the appropriate focus of analysis.

In any case, I think that PK's presentation of both evolutionary economics and evolutionary theory are seriously narrow and misleading.  He essentially argues that evolutionary theory is all about maximization and equilibrium and that those who focus on other approaches, including Stephen Jay Gould and Stuart Kauffman, are just peripheral losers within established evolutionary theory, which is represented by the work of Richard Dawkins.  He emphasizes the importance of evolutionary game theory developed by Maynard-Smith and then introduced into economics, where it is now more or less a part of standard economics.  He even notes that Hamilton and others allow for rewards for cooperation.  This is all true, and can even be viewed ironically as a form of microfoundations of macroevolution within evolutionary theory, although it is not the whole story.

One important point is that there are and have been many different branches of evolutionary economics.  Of course, economics influenced evolutionary theory from the beginning, notably through the influence of Malthus on Darwin and Wallace.  Some forms of evolutionary economics have always been completely consistent with fully orthodox neoclassical economics, most notably the arguments regarding firm survival and the pressure to maximize profits due to natural selection pressures within competition, as emphasized in the famous 1950 paper by Armen Alchian, followed up by Milton Friedman in his Essay on Positive Economics. 

Of course, Krugman and probably Thoma probably dismiss the oldest evolutionary school, the old institutionalists, who founded the AEA and once ran it, only to be overcome and replaced by the MIT neoclassical synthesis of Samuelson.  It is easy to dismiss them, but they have made many insights and continue to offer more, most notably through the Journal of Economic Issues.  An irony is that the person who coined the term "neoclassical economics" was none other than Thorstein Veblen, founder of the institutionalist evolutionary school.  I suspect that Krugman and Thoma probably consider many of his ideas to be quite relevant to our current situation.

Another evolutionary economics school, vaguely referred to by Krugman, is the neo-Schumpeterian school whose main leaders have been Nelson and Winter and their followers.  This school continues with many followers and journals such as Journal of Evolutionary Economics and Industrial and Corporate Change.  I do not see anybody seriously questioning that they have had much to offer regarding the study of technological change.

Krugman dismisses Stephen Jay Gould and his punctuated equilibrium view as some sort of evolutionary equivalent of John Kenneth Galbraith, an idea popular among the public, but dismissed within evolutionary theory itself.  I think that Krugman is seriously off on this characterization, and the idea of multiple equilibria and dynamic discontinuities is one that is certainly of great relevance in economics.  Just what is going on when we see major financial crashes?

Finally, there is the new complexity evolutionary theory, which is associated with Kauffman of the Santa Fe Institute, whom Krugman also dismisses.  This approach is deeply linked with what is probably the most serious competitor to the DSGE model in macro analysis, namely agent-based modeling.  Many of those models use genetic algorithms, and evolutionary ideas such as emergence are taken very seriously in this approach.  Indeed, this is an alternative way of doing micro foundations of macro, an issue that Krugman simply does not address at all, which does not necessarily depend on the old orthodoxy of rational agent utility maximization or convergence on equilibria within dynamic evolutionary processes.

Barkley Rosser

I would definitely further that point. I read that Krugman speech several years ago and enjoyed it; Krugman is someone who, it seems to me, reads widely and is open to ideas from other areas of science, although he admitted in the speech that he is "basically a maximization-and-equilibrium kind of guy". Rosser mentions Stephen Jay Gould and the idea of punctuated equilibrium. From my readings of Gould, that idea remained more or less qualitative with him and his co-author (Eldridge I think), but was subsequently developed in more detail by others such as physicist Per Bak. Their view was that ecosystems and ecologies aren't in a static equilibrium of any sort, but in a much more dynamic state through which vast avalanches of change occasionally ripple for perfectly ordinary reasons and having NOTHING to do with external shocks to the system. This is more at the forefront of our understanding of whole-system dynamics than is the old idea of evolutionary stable states and Nash equilibria (although these are still useful on shorter timescales for understanding interactions between a small number of species).

But the point Gould is perhaps more famous for is emphasizing that if one assumes that species have evolved to maximize their (local) fitness, then you open yourself to potentially huge errors of misinterpretation. You might try to interpret everything you see is an optimal solution to some problem, even if some of it, or even most of it, might have nothing to do with optimality. Sure enough, it turns out that an awful lot of what happens in evolution is driven not by genetic changes that increase fitness at all, but rather to changes that are entirely neutral; in essence, most evolution is random drift! If something like this were true in economics, the we might be making systematic errors in assuming the marketplace victory of one firm, technology, computer device or idea over another generally has something to do with its inherent superiority. It may simply reflect a series of random accidents. In principle, this might not be an odd or unusual thing, but the general rule across the board. Taking this possibility seriously would be a big shift for economics, I think, and something it would learn from evolution.

I won't drone on. The most important thing is that the evolutionary theory currently used in economics as a source of metaphor and mathematical models has been/is being cast aside in evolution and ecology by a richer mathematical framework that goes well beyond equilibrium. I hope some of this will be discussed in the special issue. Lots of us who aren't biologists haven't kept up with what is going on in biology and we're quite a bit out of date. For example, genes flow down through the generations, don't they, transmitted vertically from one generation to the next? There is no sideways or horizontal flow of genes between different organisms; we all know that. Indeed, that was the lore for 50 years at least and I only know that this idea is wrong because New Scientist a few years ago asked me to write an article about something called "horizontal gene transfer," which is one of the greatest recent discoveries in biology. 

We probably still know very little about evolution, but what we do know I expect will be a treasure of useful ideas about economics.

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Economics As Religion

My latest Bloomberg column came out last night. It was stimulated in part by this recent paper by economists Daron Acemoglu and James Robinson, which I learned about from this short discussion by James Kwak. The paper is an excellent corrective to overconfidence in making simple-minded policy pronouncements based on incomplete theories. (The discussion brings to my mind Naseem Taleb's amusing and I think largely legitimate comment that society at large would be better off if most economics classes were immediately cancelled and replaced with something more benign, such as classes in gardening!).

The argument of Acemoglu and Robinson is fairly simple, but I think far reaching. They point out that economists in practice spend a lot of time thinking about market failures and how to prevent them, and derive much of their policy advice from this recipe. Of course, such analyses inevitably tap into the analytical machinery for welfare analysis (which, I admit, I find hard to take very seriously, but that's another story) and consider how some policy intervention, by removing obstacles to possible exchanges in the market, can improve welfare and economic efficiency. The trouble, they point out, is that the conceptual framework used in such analyses often simply dismisses as irrelevant other non-economic impacts of such policies, even though these may have huge societal ramifications. Here's how they describe one example:

Faced with a trade union exercising monopoly power and raising the wages of its members, many economists would advocate removing or limiting the union’s ability to exercise this monopoly power, and this is certainly the right policy in some circumstances. But unions do not just influence the way the labor market functions; they also have important implications for the political system. Historically, unions have played a key role in the creation of democracy in many parts of the world, particularly in western Europe; they have founded, funded, and supported political parties, such as the Labour Party in Britain or the Social Democratic parties of Scandinavia, which have had large effects on public policy and on the extent of taxation and income red istribution, often balancing the political power of established business interests and political elites. Because the higher wages that unions generate for their members are one of the main reasons why people join unions, reducing their market power is likely to foster de-unionization. But this may, by further strengthening groups and interests that were already dominant in society, also change the political equilibrium in a direction involving greater effifi ciency losses. This case illustrates a more general conclusion, which is the heart of our argument: even when it is possible, removing a market failure need not improve the allocation of resources because of its effect on future political equilibria. To understand whether it is likely to do so, one must look at the political consequences of a policy—it is not sufficient to just focus on the economic costs and benefits.

The paper goes on to analyze this problem in much greater generality, looking at the push to privatization in Russia, and the drive to deregulate financial markets over the past three decades in Western nations, and how both led to huge shifts in the wealth and political power of different social groups. In both cases, much of the intellectual groundwork for making these changes came from analyses that were ridiculously oversimplified and carried out with considerable disregard for the larger complexity of society. No doubt there were economists out there arguing against this kind of thing (Joseph Stiglitz comes to mind), but their voices certainly weren't loud enough nor were their arguments amplified well enough by others. [Note: To be clear, I am not at all against studying oversimplified models. But those who do should always make it clear that we know very little about what such models teach us about a real world that is vastly more complex.]

I've also referred implicitly or explicitly to a couple of other things in my column, which you might like to read for greater understanding or just for the sheer (and strange) pleasure of being pissed off and utterly baffled at the strange and arrogant things some people can believe. In the latter category, I strongly suggest this paper from a decade ago by U. of Chicago economist Edward Lazear entitled Economic Imperialism. He's fully in favor of it and sees the day not too far away when all the social sciences will have been set right by jettisoning older nonsense and adopting a consistent economic focus on the maximizing behavior of rational individuals which leads them to a social equilibrium. For Lazear, this seems to represent the path to wisdom every bit as much as the Bible does to a fundamentalist Christian. Lazear is (or was, at least), in particular, fond of everything done by his Chicago colleague Gary Becker. (On a related point, see Lars Syll, who quotes Daniel Kahneman remembering Becker's way of thinking: "I once heard Gary Becker [argue] that we should consider the possibility of explaining the so-called obesity epidemic by people’s belief that a cure for diabetes will soon become available.")

But on the more productive side, I really do highly recommend economist Robert Nelson's Economics As Religion as one of the most insightful books on economics I have read. His main point is to explore how economic analyses typically rest on hidden value judgements, even though they are presented as the product of a supposedly "value neutral" way of thinking. I think this is still true today as it was in 2001 when the book was published. When economists start talking about policies that will be "socially optimal", you should open your eyes wide and ask: on what conceivable grounds can you make such a pronouncement? You will inevitably find that what follows is a flurry of algebra the main purpose of which is to give a "sciency feel" to the argument and to obscure some hidden value judgements on which the entire conclusion depends (see the issues over the discounting of future costs, for example). Those judgements often enter in cost-benefit calculations where the economist decides which kinds of costs to include and which to ignore.

But maybe I'm too cynical. I would guess that most economics graduate students have probably read Nelson's book and know better today, but I don't know. I hope so.

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