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March 26, 2009

Economist's View - 8 new articles

"The Culture of the Financial Sector Has to Change"

Sach at The Compulsive Theorist looks at the case for behavioral reform in financial markets, and argues that fixing balance sheets without fixing norms and culture is unlikely to provide a permanent solution to the problems these markets face:

Why the culture of the financial sector has to change, the Compulsive Theorist: I want to say a little about business and cultural norms in the financial sector, how they affect tangible outcomes we all care about, and why they need to change. Norms are inherently less tangible than items on balance sheets, so it can be hard to see the role they play. I want to focus on norms in the financial sector, but to bring them out of the background I'll start with a comparison to another field. Doctors and bankers are alike in that they can inflict enormous damage by doing a bad job, doctors with a flick of the scalpel, bankers with a click of the mouse. Both are therefore subject to regulation which tries to trade-off costs of enforcement against risk of damage. But there's a huge difference in the way doctors and bankers view their work. ... [...continue reading...]

The "Zig Zag Windings of the Flowery Path of Literature"

The article by Anatole Kaletsky I posted earlier today, Goodbye, homo economicus, did not get the best reception here and elsewhere, and there were also protests that arrived by email. Here's a follow-up on one aspect of the article, the use of formal mathematical models in economics. This article is by David Colander:

Marshallian General Equilibrium Analysis, by David Colander: In an assessment of Alfred Marshall, Paul Samuelson (1967) writes that "The ambiguities of Alfred Marshall paralyzed the best brains in the Anglo-Saxon branch of our profession for three decades." In making this assessment he carried on a tradition of Marshall-bashing that has a long history in economics, dating back to Stanley Jevons and F. Y. Edgeworth, who accused Marshallian economists of being seduced by "zig zag windings of the flowery path of literature." (Edgeworth, 1925)

These harsh assessments of Marshall and his approach to economics have had their influence on the modern profession and, other than historians of economic thought, few young economists know much about him. Fewer still would see themselves as Marshallians.[1]

Today, Marshall is best remembered for his contribution to partial equilibrium supply and demand analysis.[2] For the true economic theorists of the 1990s, however, this contribution is de minimus; the partial equilibrium approach is for novice economists with no stomach for real economic theory—general equilibrium. The profession's collective view of Marshall in the 1990s is that Marshall is passé--at most a pedagogical stepping stone for undergraduate students, but otherwise quite irrelevant to modern economics.

The motto of recent 20th century economics has been:

Marshall is for kids and liberal arts professors; real economists (professors at universities) do Walras.

Since Marshall's name is synonymous with partial equilibrium analysis, the title of this paper will seem strange to many. (One well known economist, upon hearing it, labeled the title an oxymoron.) Most economists think of general equilibrium analysis as synonymous with Walrasian general equilibrium analysis. In this paper I argue that this is not true. Marshall was centrally concerned with general equilibrium analysis; he was, after all, a classical economist, and he drew on, and saw his work as extending, the work of Adam Smith, David Ricardo, and John Stuart Mill, all of whom were concerned with general equilibrium, not partial equilibrium, issues.

I shall also argue that the profession's negative assessment of Marshall is wrong. Specifically, I shall argue that, conceptually, Marshallian general equilibrium analysis is at a much higher level than Walrasian general equilibrium analysis, and, because it is, is far more compatible with modern developments in economics than is Walrasian general equilibrium.

Thus, Marshall's work is not a stepping stone to Walras, but is instead a stepping stone beyond Walras. It is consistent with a fundamentally different conception of general equilibrium, one which recognizes that the mathematical formulation of a meaningful general equilibrium model is much more intractable than those with which Walras and later Walrasians dealt.


To make my point clear, let me continue the Paul Samuelson attack on Marshall with which I started this talk.

Samuelson writes:

I have come to feel that Marshall's dictum that "it seems doubtful whether any one spends his time well in reading lengthy translations of economic doctrines into mathematics, that has not been done by himself" should be exactly reversed. The laborious literary working over of essentially simple mathematical concepts such as is characteristic of much modern economic theory is not only unrewarding from the standpoint of advancing science, but involves as well mental gymnastics of a peculiarly depraved type. (Samuelson, 1955. pg 6. )

In the 1940s and 1950s, in certain aspects of economics Samuelson was, I have no doubt, right. At that time there were many issues to be cleared up, and his Foundations did clear up numerous issues. But the fact that there then existed some poor intuitive literary economic analysis should not condemn all intuitive literary economics, just as the fact that today that there is some poor mathematical economics should not condemn all mathematical economics.

What I am arguing is that there is a symbiotic relationship between intuitive literary economics and formal mathematical economics. Both are necessary; both can advance our knowledge. Some aspects of good literary economics of a period become the core of good formal economics of a later period. But we will only know which aspects when the formal math catches up with the intuition. The ideal would be a peaceful coexistence of the two.

But peaceful coexistence does not seem to be a stable equilibrium and instead the profession seems to experience these cycles when Marshal's Dictum or Samuelson's Dictum predominates. (Consider, for example, the Ricardo-Mill cycle.) Whether Samuelson's Dictum or Marshall's Dictum is relevant depends on what part of the cycle we are in. The 1930s-50s was a time for formal mathematical economics to export ideas to intuitive economics. In my view, the 1990s is a time for the reverse. More and more top economists are accepting that we have come as far as we can with static Walrasian general equilibrium.

The new reality of the 1990s is an acceptance that the general equilibrium system relevant to our economy is formally complex. Because that is the case, in the 1990s, Samuelson's condemnation of Marshall needs to be reversed. Thus, for the 1990s I suggest that the pendulum has swung and the following reworking of Samuelson's above quotation is relevant.

Specifically: "The laborious mathematical working over of essentially simple intuitive concepts such as is characteristic of much modern economic theory is not only unrewarding from the standpoint of advancing science, but involves mental gymnastics of a peculiarly depraved type." "The intuitive ambiguities of Walras's general equilibrium, and Samuelson's expansion of it, have paralyzed the best brains in economics for the last five decades." It is only now that the profession is returning to the understanding of economic issues that Marshall had at the turn of the century


1Until recently Chicago economists, especially Milton Friedman, saw themselves as working in a Marshallian tradition. More recently, however, younger Chicago economists know little of Marshall, and work in the same Walrasian general equilibrium framework as does the majority of the profession.

2 Even here, Marshall's contribution is questioned. As Humpries and (to come) (1994) argue, Marshall was neither first, nor clearest, in his presentation of partial equilibrium supply and demand.

With the breakdown of our formal models lately, this may be one of those times when we need to return to intuitive analysis until "the formal math catches up with the intuition." But to abandon the mathematical, formal model approach altogether would be a mistake, and a large step backward.

Update: Link (jstor) to Edgeworth's 1889 article in the EJ, "On the Application of Economics to Political Economy."

Update: I probably should have noted Paul Krugman's Two Cheers for Formalism.

Quick Note

I'll was on KPFA-FM in Berkeley from 12:00 - 12:30 p.m.(PST) today to talk about the Geithner plan and the financial crisis more generally. The show is archived here.

Fed Watch: Looking for a Bottom

Are we about to reach bottom? If and when we do, will we bounce back upward and recover, or will we bounce along the bottom in a series of fits and starts as the economy stagnates at a sub-par equilibrium?

Tim Duy:

Looking For a Bottom, by Tim Duy: Given the length and depth of the current recession, it is natural for analysts to start looking for a bottom. In such an environment, bad news will be ignored while the seemingly good news is overblown. For example, the most recent initial unemployment claims report indicates that labor markets continue to deteriorate; we have yet to see a turning point consistent with improved conditions. Likewise, the durable goods report was heralded as a positive sign, but the jump in this volatile series needs to be taken in context of the severe drop the previous month. The chart of nonair/nondefense new orders is not particularly encouraging:


That said, things will eventually get less worse, if only because some sectors, such as new residential housing, will hit a bottom. And that bottom is not likely to be zero, and, I suspect, that bottom will be late this year or, at worst, early next year. That should not, however, be confused with an optimistic outlook, as the durability and strength of the eventual recovery is in doubt. I am confident that the economy will not spiral downward endlessly; I am more worried that the we will be left at a suboptimal equilibrium chiefly characterized by low growth and persistently high unemployment.

San Francisco President Janet Yellen outlined the "optimistic" case in a speech Wednesday:

However, I am well aware that my views are strikingly more optimistic than those I hear from the vast majority of my business contacts. They tend to see conditions as dire and getting worse. In fact, many of them can't believe I would even suggest what they see as such a patently rosy scenario! So why is it that so many of us who prepare forecasts seem to be more optimistic than many others? I think there are several reasons. First, as forecasters, we distinguish between growth rates and levels....Second, it takes less than many people think for real GDP growth rates to turn positive. Just the elimination of drags on growth can do it. For example, residential construction has been declining for several years, subtracting about 1 percentage point from real GDP growth. Even if this spending were only to stabilize at today's very low levels—not a robust performance at all—a 1 percentage point subtraction from growth would convert into a zero, boosting overall growth by 1 percentage point...

The key point, often lost to the general public, is that data patterns can quickly reverse when the economy hits bottom. Still, job growth can remain largely nonexistent, similar to the 2001-2003 period. Next:

Third, policies are in place that could jump-start the economy, including the fiscal stimulus package, the Administration's housing program, and a growing list of Federal Reserve and Treasury credit programs that aim to improve financial market function and the flow of credit.

A significant amount of stimulus will be flowing into the economy, and while it is not enough to fill the output and credit gaps, it is not negligible. Finally:

Finally, at some point, negative feedback loops can turn positive. For example, if federal government and Federal Reserve policies were to jump-start the economy, credit losses of financial institutions could diminish and lenders might increase the supply of credit available to finance spending. More credit, and better consumer and business confidence, could further boost the economy and employment, which would feed back positively on credit conditions. In other words, the negative feedback loop that is currently in play could be replaced by self-reinforcing positive dynamics.

I am less optimistic that negative feedback loops will soon turn positive. Again, while the amount of stimulus flowing into the economy is significant, credit worthiness looks to be deteriorating at a faster rate. As noted early, the employment picture is not yet turning rosier (Yellen expects unemployment to rise into 2010), households are already choking on debt, and, as reported in the Wall Street Journal, commercial real estate loan delinquencies are rising. I suspect that Richmond Fed President Jeffrey Lacker is close to the mark when he said today:

One popular notion is that the credit market disruptions we have seen over the last year or so impede the financial sector's ability and willingness to extend credit to households and business firms, thereby creating an additional drag on spending. But causation can flow in the opposite direction as well. When overall economic activity seems poised to contract, the outlook for household income and business revenues deteriorates as well, and borrowers become less creditworthy, all else constant. Moreover, consumer and business demand for lending declines when they cut back on discretionary outlays. My reading of current conditions is that the economy is holding back credit markets much more than credit markets are holding back the economy.

The lack of creditworthy borrowers, especially considering more reasonable underwriting standards, strikes me as a significant impediment to the Fed's plans for restarting securitization markets via TALF. (Lacker also looks for positive signs, notably the recent retail sales data, and appears more optimistic, but like Yellen highlights downside risks). That said, the willingness of monetary and fiscal authorities to pump massive amounts of money into the financial sector has staved off a collapse - and thus created another sort of bottom.

Still, despite the prospects for bottoming, the key in my mind remains the subsequent path of activity. On that Yellen says:

...for some time to come, disinflation, and even deflation, will represent greater risks than inflation. With economic activity weakening, economic slack is likely to be substantial for several more years. We need to be sure that we avoid the kind of deflation that Japan experienced during its lost decade. While I don't think such an outcome is likely, it should be on our list of concerns.

Likewise, I am not optimistic on the longer term. The US economy is suffering the aftereffects of a credit bubble, and this will have lingering effects on the growth path. This is especially the case given the depth and breath of the global downturn; indeed, few others are pursuing stimulus as aggressively as the US, promising to prolong US weakness with continued pressure on exports.

In short, analysts should be looking for the bottom, and it would not be a surprise to get a strong bounce in the data soon after hitting the bottom. But I think sustaining that bounce will be difficult. Expectations of a rapid return to sustainable, high growth path are likely to be met with disappointment. Hitting the bottom is inevitable. It is the subsequent pace of growth that should be the focus of concern.

Fear and Greed

A "formalization of Summer's hypothesis":

Larry Summers on Fear and Greed, macromania: I used to think that Larry Summers was a reasonable sort of fellow. By here is some evidence proving that spending too much time in administration and politics can rot even the best mind; see White House: Greed Will Help. Here are some quotes:

"In the past few years, we've seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying," Summers said Friday in a speech to the Brookings Institution. "Today, however, our problem is exactly the opposite."

Borrowing, you see, is evidently linked to greed; especially if one borrows too much. I am reminded of university students who mindlessly accumulate too much student debt. The greedy bastards. Or of poor people mindlessly borrowing to finance a home purchase. The greedy SOBs. There is too much borrowing; too much spending; there is too much greed. Saving, on the other hand, is evidently linked to fear. Fear is a virtue (as in the fear of God). As when all those virtuous savers bid up the NASDAQ to 5000. Whoops; this doesn't sound right. Perhaps he means saving in virtuous assets, like government treasuries (backed by virtuous/coercive taxation; rather than the prospect of future cash flow from a successful enterprise). Yes, fear is a virtue...unless there is too much fear. Then fear is bad.

To summarize then: greed is vice; fear is a virtue. Unless there is too much fear, which is not a virtue. Not enough greed is a virtue; but not a good virtue...which is to say it is a vice. I am getting confused. Let me consult the article again.

"While greed is no virtue, entrepreneurship and the search for opportunity is what we need today."

OK, this clears things up. Make no mistake: greed is no virtue. But we do need more of it at a time like this.

So to sum up, greed (borrowing) is bad and fear (saving) is bad (unless there is not enough of either). In the world economy (a closed system), we know that borrowing = saving. And this proves that greed is always balanced by fear. Wait a second, I am confused again. Perhaps what we need is a "new generation" IS-PC-TR like model to help policymakers confront the difficult economic choices they face in balancing fear and greed. Assume that the policymaker has a quadratic loss function in deviations of actual fear and greed around some socially optimal level of fear and greed (we will let Woodford provide the microfoundations for this social welfare function). Accordingly, let us write this loss function as,

L(t) = 0.5(f(t) - f)^(1/2) + 0.5(g(t) - g)^(1/2)

Here, (f,g) are the socially optimal levels of fear and greed. f(t) and g(t) are the prevailing levels of fear and greed at date t. The policymaker wishes to minimize the fluctuations in fear and greed around their socially optimal levels. We need more restrictions. Let's see. It seems natural to suppose that fear is influenced in some manner by endogenous variables and an exogenous shock; let's say

f(t) = a*f(t-1) - b*y(t) + e(t)

where y(t) is the output gap; and e(t) is the shock (like a "fear" markup shock in New Keynesian models). Greed, on the other hand, is influenced by the interest rate and exogenous factors; e.g.,

g(t) = c*g(t-1) - d*r(t) + u(t)

where r(t) is the interest rate, set by monetary policy. Lowering r(t), the way Greenspan did, results in an increase in greed. Seems right. Now, the policymaker wishes to choose an interest rate rule that minimizes the loss function, given the stochastic processes (estimated as the residuals from a mindless OLS or VAR) governing the fear and greed shocks. Yes, I can see how the New Keynesian model, so widely used by central banks to justify the policies they follow, will no doubt be replaced by my formalization of Summer's hypothesis. The implications for policy design are likely to prove equally enlightening. Anyone care to coauthor this paper with me? Fame (or notoriety) is virtually guaranteed!

What Academic Economists Do and the Need for Better Data

Let me follow-up on the post below this one with a couple of quick thoughts.

First, academic economists have taken a lot of grief for not predicting the crisis, but realize that very few academic economists do forecasting. There are two uses of economic and econometric models, one is to use the models to understand how the world works, the other is to use the models to forecast. And while, of course, one of the goals of understanding the economy is to be able to predict it, it is simply not something most academic economists do (and the best models for forecasting are not necessarily the same as the best models for learning about how the economy works). Business economists do lots of prediction and forecasting, but academic economists? Not so much. We come along long after events have occurred - e.g. we're still analyzing the Great Depression to some extent - and try to use those events (as well as data from normal times) to try to understand how the economic world works, how policy can improve performance, etc.

Second, the economists who do forecasting need better data. If we are we are going to forecast the immediate future accurately, we need data that are timely and informative. There can be big differences between forecasts made using the initial data releases, and those made once the data is revised, often months later. We simply do not have an accurate picture of aggregate activity over, say, the last month or two, even longer in some cases, due to data collection lags and other problems, and without accurate contemporaneous data, it's not possible to produce accurate forecasts (e.g. GDP data are three months old when you get them, and they are revised three months later, then again even later than that though those adjustments tend to be smaller. So we don't get a good picture of GDP until six months after it happens). It's like being asked what the weather will be like tomorrow, but only having weather data that is a month or more old.

I've been wondering if I should call for enhanced investment in data collection as part of the response to this crisis. However, much of the problem is that the data come from reports that are filed quarterly, annually, etc., and the data collection agencies must wait for those reports before they can produce initial estimates or revisions. Those delays are fairly lengthy relative to our data needs, and it's not clear to me that more money can overcome these lags in the process. Assembling these reports accurately, then interpreting them properly and then turning them into macroeconomic aggregates takes time.

But there must be some way we can get a better picture of what is going on contemporaneously than we have now, and I think we need to investigate how to make that happen. The data as they exist now are fine for academic researchers who are looking backward and do not necessarily need the very latest months worth of data, though even in this setting this is sometimes a problem, but for forecasting our data are inadequate. Maybe with some investment in the process there would be a way to go out and collect contemporaneous data from all the electronic sources of sales and other information that didn't exist in the past, or to sample more traditional data sources in a more timely fashion. Obviously, I don't have the exact answer to this problem, but I do think it's something we should put some thought into, and if there's a way to do substantially better at getting an accurate picture of the current economy than we have now, something that would be of great benefit to policymakers, forecasters, and people trying to make economic decisions in the private sector, it would be well worth pursuing.

"Goodbye, Homo Economicus"

Via an email suggestion (there's much, much more in the full version):

Goodbye, homo economicus, by Anatole Kaletsky: Was Adam Smith an economist? Was Keynes, Ricardo or Schumpeter? By the standards of today's academic economists, the answer is no. Smith, Ricardo and Keynes produced no mathematical models. Their work lacked the "analytical rigour" and precise deductive logic demanded by modern economics. And none of them ever produced an econometric forecast (although Keynes and Schumpeter were able mathematicians). If any of these giants of economics applied for a university job today, they would be rejected. As for their written work, it would not have a chance of acceptance in the Economic Journal or American Economic Review. The editors, if they felt charitable, might advise Smith and Keynes to try a journal of history or sociology.

If you think I exaggerate, ask yourself what role academic economists have played in the present crisis. Granted, a few mainstream economists with practical backgrounds—like Paul Krugman and Larry Summers in the US—have been helpful explaining the crisis to the public and shaping some of the response. But in general how many academic economists have had something useful to say about the greatest upheaval in 70 years? The truth is even worse than this rhetorical question suggests: not only have economists, as a profession, failed to guide the world out of the crisis, they were also primarily responsible for leading us into it. ...

Academic economists have thus far escaped much blame for the crisis. Public anger has focused on more obvious culprits: greedy bankers, venal politicians, sleepy regulators or reckless mortgage borrowers. But why did these scapegoats behave in the ways they did? Even the greediest bankers hate losing money so why did they take risks which with hindsight were obviously suicidal? The answer was beautifully expressed by Keynes 70 years ago: "Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

What the "madmen in authority" heard this time was the distant echo of a debate among academic economists begun in the 1970s about "rational" investors and "efficient" markets. This debate began against the backdrop of the oil shock and stagflation and was, in its time, a step forward in our understanding of the control of inflation. But, ultimately, it was a debate won by the side that happened to be wrong. And on those two reassuring adjectives, rational and efficient, the victorious academic economists erected an enormous scaffolding of theoretical models, regulatory prescriptions and computer simulations which allowed the practical bankers and politicians to build the towers of bad debt and bad policy. ...

Which brings us to the causes of the present crisis. The reckless property lending that triggered this crisis only occurred because rational investors assumed that the probability of a fall in house prices was near zero. Efficient markets then turned these assumptions into price-signals, which told the bankers that lending 100 per cent mortgages or operating with 50-to-1 leverage was safe. Similarly, regulators, who allowed banks to determine their own capital requirements and private rating agencies to establish the value at risk in mortgages and bonds, took it as axiomatic that markets would automatically generate the best possible information and create the right incentives for managing risks. ...

The scandal of modern economics is that these two false theories—rational expectations and the efficient market hypothesis—which are not only misleading but highly ideological, have become so dominant in academia (especially business schools), government and markets themselves. While neither theory was totally dominant in mainstream economics departments, both were found in every major textbook, and both were important parts of the "neo-Keynesian" orthodoxy, which was the end-result of the shake-out that followed Milton Friedman's attempt to overthrow Keynes. The result is that these two theories have more power than even their adherents realise: yes, they underpin the thinking of the wilder fringes of the Chicago school, but also, more subtly, they underpin the analysis of sensible economists like Paul Samuelson.

The rational expectations hypothesis (REH), developed by two Chicago economists, Robert Lucas and Thomas Sargent in the 1970s, asserted that a market economy should be viewed as a mechanical system that is governed, like a physical system, by clearly-defined economic laws which are immutable and universally understood. Despite its obvious implausibility and the persistent attacks on it, especially from the left, REH has continued to be regarded by universities and funding bodies as the most acceptable foundation for serious academic research. In their recent book Imperfect Knowledge Economics, two American professors, Roman Frydman and Michael Goldberg, complain that "all graduate students of economics—and increasingly undergraduates too—are taught that to capture rational behaviour in a scientific way they must use REH." In Britain too the REH orthodoxy has remained far more powerful than is often realised. As David Hendry, until recently head of the Oxford economics department, has noted: "Economists critical of the rational expectations based approach have had great difficulty even publishing such views, or maintaining research funding. For example, recent attempts to get ESRC funding for a project to test the flaws in rational expectations based models was rejected. I believe some of British policy failures have been due to the Bank accepting the implications [of REH models] and hence taking about a year too long to react to the credit crisis." ...

To make matters worse, rational expectations gradually merged with the related theory of "efficient" financial markets. ... This was the efficient market hypothesis (EMH), developed by another group of Chicago-influenced academics, all of whom received Nobel prizes just as their theories came apart at the seams. EMH, like rational expectations, assumed that there was a well-defined model of economic behaviour and that rational investors would all follow it; but it added another step. In the strong version of the theory, financial markets, because they were populated by a multitude of rational and competitive players, would always set prices that reflected all available information in the most accurate possible way. Because the market price would always reflect more perfect knowledge than was available to any one individual, no investor could "beat the market"—still less could a regulator ever hope to improve on market signals by substituting his own judgment. ...

Why did such discredited theories flourish? Largely because they justified whatever outcomes the markets happened to decree—laissez-faire ideology, big salaries for top executives and billions in bonuses for traders. And, conveniently, these theories were regarded as the gold-standard by academic economists who won Nobel prizes.

So what is to be done? There are two options. Either economics has to be abandoned as an academic discipline, becoming a mere appendage to the collection of industrial and social statistics. Or it must undergo an intellectual revolution. ...

Economics today is a discipline that must either die or undergo a paradigm shift—to make itself both more broadminded, and more modest. It must broaden its horizons to recognise the insights of other social sciences and historical studies and it must return to its roots. Smith, Keynes, Hayek, Schumpeter and all the other truly great economists were interested in economic reality. They studied real human behaviour in markets that actually existed. Their insights came from historical knowledge, psychological intuition and political understanding. Their analytical tools were words, not mathematics. They persuaded with eloquence, not just formal logic. One can see why many of today's academics may fear such a return of economics to its roots.

Academic establishments fight hard to resist such paradigm shifts, as Thomas Kuhn, the historian of science who coined the phrase in the 1960s, demonstrated. Such a shift will not be easy, despite the obvious failure of academic economics. But economists now face a clear choice: embrace new ideas or give back your public funding and your Nobel prizes, along with the bankers' bonuses you justified and inspired.

Update: Paul Krugman comments on the use of models in Keynes' General Theory.

links for 2009-03-26

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