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Wall Street Journal Admits Economists Were Wrong, But Fails to Discuss their INCENTIVE for Being Wrong
The Wall Street Journal admits this week that economists blew it:
The pain of the financial crisis has economists striving to understand precisely why it happened and how to prevent a repeat...
The
crisis exposed the inadequacy of economists' traditional tool kit,
forcing them to revisit questions many had long thought answered, such
as how to tame disruptive boom-and-bust cycles...
"We could be looking at a paradigm shift," says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.
That shift could change the way central bankers do their job, possibly
leading them to wade more deeply into markets. They could, for example,
place greater emphasis on the amount of borrowing in the economy,
rather than just the interest rates at which borrowing is done. In boom
times, that could lead them to restrict how much money various players,
ranging from hedge funds to home buyers, can borrow
I have repeatedly pointed out the flaws in mainstream economics. See this, this, this, this and this.
But the Journal makes it sound like the policy-makers and economists who deployed faulty models were innocently ignorant of any larger truths:
The
models "were not able to draw up the red flags," says Tim Besley, a
professor at the London School of Economics who served on the Bank of
England's policy-making committee until recently.
Barry Ritholtz has an excellent criticism of the article, pointing out:
There
are many areas I would have liked to see the [journal's] article
explore: The lack of Scientific Method, the mostly awful performance of
economists, its misunderstanding of the value of modeling, the bias
inherent in Wall Street variant of economics, and lastly, the
corruption of economics by politics...
Let’s start
with the basics. Hard “science” — Physics, Biology, Chemistry, and all
variants thereto — begins humbly. They try to describe the universe
around us by creating theories, and then testing them. These theorems
are always preliminary. Even when testing validates them, Science is
always prepared — even eager — to replace them with newer theories that
are proven to be even more valid.
The humility of science begins with an admission: We know nothing.
We seek to learn through experiment and logic, and constantly evolve
more and more accurate explanations. Scientific belief evolves
gradually over time. Nothing is assumed, presumed, or hypothesized as
true. Indeed, research is a presumption that current theories are
inadequate or incomplete. The practice of science is a an ongoing
search for better explanations, more proof, further verification — for
Truth.
Science is the ultimate “show me” state.
Economics
has a somewhat, shall we call it, less rigorous approach. Indeed, the
arrogance of economics is that it is the polar opposite of Science. It
begins with a few basic assumptions, many of which are obviously
untrue; some are demonstrably false.
No, Mankind is not a
rational, profit maximizing actor. No, markets are not perfectly, or
even nearly, efficient. No, prices do not reflect the sum total of all
that is known about a given market, sector or stock. Those of you who
pretend otherwise are fools who deserve to have your 401ks cut in half.
That is called just desserts. The problem is that your foolishness helped cut nearly everyone else’s 401ks in half. That is called criminal incompetence.
Where was I? Ahhh, our sad tale of the practitioners of the dismal arts.
Starting
from a false premise that fails to understand the most basic behaviors
of the Human animal, economics proceeds to build an edifice of cards on
a foundation of sand. (How could that possibly go astray?)
Like a moonshot off by a few inches at launch, by the time the we reach
further into time and space, the trajectory is off by millions of miles
. . .
Economics ... creates an illusion of precision where none
exists. The belief in their models led to all manner of mischief, from
subprime to derivatives to risk management...
The Behaviorists
have been fighting the mainstream for decades now, trying to correct
the errors of the basic building blocks of the dismal science.
But
I would go further in my criticism of the economic profession by
arguing that the decisions to use faulty models was an economic and
political choice, because it benefited the economists and those who hired them.
For
example, the elites get wealthy during booms and they get wealthy
during busts. Therefore,t he boom-and-bust cycle benefits them
enormously, as they can trade both ways. Specifically, as Simon
Johnson, William K. Black and others point out,
the big boys make bucketloads of money during the booms using
fraudulent schemes and knowing that many borrowers will default. Then,
during the bust, they know the government will bail them out, and they will be able to buy up competitors for cheap and consolidate power. They may also bet against the same products they are selling during the boom (more here), knowing that they'll make a killing when it busts.
But economists have pretended there is no such thing as a bubble. Indeed, BIS slammed the Fed and other central banks for blowing bubbles and then using "gimmicks and palliatives" afterwards.
It
is not like economists weren't warning about booms and busts. Nobel
prize winner Hayek and others were, but were ignored because it was
"inconvenient" to discuss this "impolite" issue.
Likewise, the entire Federal Reserve model is faulty, benefiting the banks themselves but not the public.
However, as Huffington Post notes:
The
Federal Reserve, through its extensive network of consultants, visiting
scholars, alumni and staff economists, so thoroughly dominates the
field of economics that real criticism of the central bank has become a
career liability for members of the profession, an investigation by the
Huffington Post has found.
This dominance helps explain how,
even after the Fed failed to foresee the greatest economic collapse
since the Great Depression, the central bank has largely escaped
criticism from academic economists. In the Fed's thrall, the economists
missed it, too.
"The Fed has a lock on the economics world,"
says Joshua Rosner, a Wall Street analyst who correctly called the
meltdown. "There is no room for other views, which I guess is why
economists got it so wrong."
The
problems of a massive debt overhang were also thoroughly documented by
Minsky, but mainstream economists pretended that debt doesn't matter.
And - even now - mainstream economists are STILL willfully ignoring things like massive leverage, hoping that the economy can be pumped back up to super-leveraged house-of-cards levels.
As the Wall Street Journal article notes:
As they did in the two revolutions in economic thought of the past century, economists are rediscovering relevant work.
It
is only "rediscovered" because it was out of favor, and it was only out
of favor because it was seen as unnecessarily crimping profits by, for
example, arguing for more moderation during boom times.
The powers-that-be do not like economists who say "Boys, if you don't slow down, that bubble is going to get too big and pop right in your face". They don't want to
hear that they can't make endless money using crazy levels of leverage
and 30-to-1 levels of fractional reserve banking, and credit
derivatives. And of course, they don't want to hear that the Federal Reserve is a big part of the problem.
Indeed, the Journal and the economists it quotes seem to be in no hurry whatsoever to change things:
The
quest is bringing financial economists -- long viewed by some as a
curiosity mostly relevant to Wall Street -- together with
macroeconomists. Some believe a viable solution will emerge within a
couple of years; others say it could take decades.
- advertisements -
At the lowest level, everyone sees it coming:
1. Practical economic advice for savings - more risk if you are younger because we assume there will be many business cycles before you need your cash. Less risky investments if you are older since you may need your loot during an inevitable downturn.
2. Long term return has a strong relationship to the P/E of your initial investment. This is a strong example of anticipating business cycles.
3. The typical business cycle for real estate, a situation where prices increase rapidly because of popular enthusiasm is well known to those in the real estate and construction trades. The real problem is that builders really enjoy building houses and will keep building well into a housing recession, and folks will purchase too much house, because it's fun to have a big house.
4. What is different today is this. Money makes a huge difference in the success of a political campaign, largely because media advertising works so well. This means that all politicians, especially legislators need massive amounts of loot, and hence are open to soft bribery. Consider how tough it is to regulate derivatives. All of the important legislators have been bought off by lobbyists.
5. There has always been risky debt. You could always buy the bonds of some third world country for 10% of value. What is new in this recession is the degree of criminal mislabeling of products, calling toxic assets, "AAA rated" and selling them to retirement funds, and the systematic sale of home loans with no hope of ever being repaid.
6. Economics is not a science as much as an academic discipline and job, using lots of elaborate math, but in the end, a study of human behavior around money, with extremely informal standards of proof. Hence, it can be completely corrupted by the interests of the paymasters, which I guess was the point of the original column. Physics and Chemistry can be equally corrupt, but there is a mechanism, scientific method and peer-reviewed publication to weed out the junk.
My Bacholor's education in economics seemed absurd. Some of the formula's I was given was just plain ol' wrong: interest rates go lower means umeployment goes lower. Yet in the past couple of years we have seen interest rates drop and unemployment rise. The fact that Saving=Investment was also a bunch of hogwash. After supply of demand, the macro stuff was just plain wrong in most cases.
GW gets it!
GW gets it!
They should just learn TA and draw some trendlines.
http://www.zerohedge.com/forum/market-outlook-0
Don't rely upon others: Do your own thinking and live in the now. Blaming others for you action or inaction is counterproductive. Make your own decisions and bear the consequences. Econ, philosophy, etc. provide just great entertainment and should be treated as such.
maybe a useful start would be the realization that control is an illusion
Excellent point, 120554.
Eventually the abnormal becomes normal....... on a long enough timeline, that is.
being an establishment economist or being a witch doctor is basically the same profession.....lots of hoopin and hollerin of a bunch of gibberish with smoke and dances which impress only a primitive mind...
economists are quacks who should be sued for mal practice...they have paid 100s of thousands for cracker jack box diplomas which are no better than a deed to the london bridge....and whose failure rates make the madagascar basketball team look like an international powerhouse.....
they are bought and paid for whores of the rockefeller / rothschild axis of evil who invent foolish differential equations and elaborate rube goldberg economic models which would make wylie e. coyote jealous...
it's an elaborate charade to justify the totalitarian state through such inventions as central banking, keynesian quackonomics, and fascist economic development....
the classical economists, though not infallible, are to be far preferred over the grand frauds of today with their idiot-savant malarky.....modern economists have a string of failures a mile long and mile wide who could be outwitted by a dart board and a game of rock scissors paper....
being an establishment economist or being a witch doctor is basically the same profession
I happen to disagree. Experiences in living have made it plain that these two hardly equate. What does not equate with me is the profession of economics having anything to do with rigorous application of the scientific method. Or with any science, including social science.
There is, in some cases, something called willful ignorance.
Dick Cheney's only equals in being able to grasp economics, according to Greenspan, were Nixon and Clinton. The
corruption of economics by politics might also apply
to the personal friendship between Greenspan and Cheney.
As we all know the Fed is often not independent of the
administrations it operates(with)under. How do we take that
nugget of realism and apply it to a long time operating friendship between the Chairman of the Fed and the de facto President. I hate to ask, did Cheney know? If so when?
I then ask the question does "drowning the beast" come
into play? If something could have been done would
Cheney have done anything to stop the meltdown? I hate
to even think about it.
Deficits don't matter. Remember? Besides, a way needed to be found to raise the aggregate value of assets in society in order for them to be leveraged so that other priorities could be pursued. The perfect symbiotic relationship.
It's card-check time for the economics profession. Reinholtz has it somewhat correct when he says "[economics] fails to understand the most basic behaviors of the Human [being]." Mises wrote an entire book on Human Action. And this article reads like Hayek's Pretense of Knowledge speech given in 1974 to the Nobel committee. The problems with Bretton Woods were fully explained by Henry Hazlitt. And Rothbard showed us the path back to a comprehensive approach of property rights, liberty, and the free exchange between individuals. They named names and were unyielding in the consistent argumentation over several decades. There's still plenty of economic theories left to be discovered. The Austrian methodology has yielded significant discovery since the late 19th century.
It's really time for the history, philosophy, anthropology, psychology, and sociology departments to claw economics departments out of business schools and back into the social sciences where it belongs. And while they're at it, everyone of these mathematical economists needs to be held to the coals on their dissertations and fancy modelling formulae. They can't run with hard sciences and can't prove a priori their theories to anyone in the social sciences. Also, anyone calling themselves a "macroeconomist" needs to link it back to "microeconomics".
There is a difference between ignorance and stupidity. If the best trained minds on economics can miss the law of the street then it is time for academia, and those that nominated these folks to be the leaders of learning to hit the bricks and learn a little about survival.
The Austrains got it right.
Plain and simple.
+1
Thanks for preparing this absolute must read article George. A wonderful expose of the human condition that deserves to be read and reread again.
I pity the guy who only gave you 4 stars...
Read up on Austrian economics. Mises's theory of the business cycle in particular.
Ludwig von Mises is a total moron pretending to sound intelligent by simply recylcing ideas from Adam Smith forwarded two centuries before him as far as monetary policy is concerned, including fractional reserve lending and monetary debasement. What on earth did Mises say that was new?
Oh, I forgot. Take his idiotic Anticapitalist Mentality (1956), where his brilliance shines through in passages such as the following:
Never mind that the "capitalists" are the "aristocrats." His struggle to then justify inherited wealth borders on the absurd, as of no particular advantage, in order to remain consistent with his notion that "everybody’s station in life depends on his own doing," and those who don't recognize this "fact" do so "in order to render inaudible the inner voice that tells them that their failure is entirely their own fault." I imagine the "fault" of an African slave or an infant beaten from birth and locked in a room for 12 years and repeatedly raped.
30 pages later he completely contradicts himself:
"More wearisome and less remunerative"? Excuse me while I vomit.
The horseshit gets even thicker in Mises' fundamental error that there is a "difference between a status society and the capitalistic society." Sorry, Mises, the motives of men are are non-economic in nature. Polanyi, Bertrand Russell et al already spanked your sorry charlatan ass on that one.
I don't think I have read anything as stupid as Mises in my entire life.
Mish repeats this Austrian crap ad nauseum, yet one more reason why I read ZH. It affects his analysis so deeply that he believes the PPT does not exist.
Thanks ZH.
What exactly is the point of this post?
1)Royalty and Official Titles are not market phenomena.
2)Rich kids are not guaranteed success.
Somehow you disagree with these concepts?
Of all of Mises' writings and theories, these two extraneous paragraphs are what you hold up as your "proof" that one of the greatest thinkers of the 20th century was a "total moron"?
The point is that that Mises' views are predicated on the fact that "everybody’s station in life depends on his own doing." ZH continually exposes this vacuous philosophy for the lie that it is.
As GW cited above and in many other posts:
There are a multitude of forces at work against innocent people, those Mises calls mere "filing clerks," (attacking Lenin) who don't "benefit" from said policies and don't even know decisions are being made or are lied to and kept purposefully in ignorance. Mises would like you to believe that these very people ("newcomers," like those fresh off an African slave ship, or in modern American society, debt serfs from the the ghettos) have the same oppotunities as the children of "aristocrats," i.e. modern capitalists. How can you take this garbage seriously?
Have the "Austrians" reminded people of fractional reserve lending which began in the 13th Century? Surely, but I'm just pointing out concerns with holding them up as gods and their erroneous philosophy of pretending that a purely "free market" can somehow exist. Or their pretending that labor is somehow a commodity like any other. That detroying unions is somehow benevolent, when in fact they are a check to unbridled power. As Polanyi reminds us, "[t]he chief obligation of labor is be almost continually on strike. The proposition could not be outbidden for sheer absurdity, yet it is only the logical inference from the commodity theory of labor.” [Great Transformation (1944), pp.230-1]
A perusal of Adam Smith would also have saved you money:
What exactly did "one of the greatest thinkers of the 20th century" write that was so revolutionary? Maybe it was this:
Where in the world can you find "a market not hampered by the interference of external forces"? It is not even a remote possibility except in the fantasy inside Mises confused mind. These are precisely the tendencies which form the entire modern capitalist system. How is buying government bonds not part of "capitalism"?
The merits of various political systems have been debated here on ZH, yet a complex society must have some form of government and protections for the pernicious influences of capitalist greed rooted in "power" and "status," non-economic motives.
And therefore a means to check this "desire for power and glory" must be the goal of any government with a pretense to democratic representation.
What the world is lacking as a result in part of so-called "Austrian" economic thinking is sympathy for other human beings who played no part in their undoing. Bombing Iraqi and Afghan cities (among hundreds of others in the last 100 years) a case in point. Mises says move on, nothing to see here folks.
The Anticapitalist Mentality nicely highlights the ignorance which permeates the "Mises" doctrine.
With all due respect, pray tell what he wrote that was original and how one may reconcile these important contradictions?
You're not even worth debating. You won't even begin to ackowledge facts; a common condition amoung socialists.
Do you nothing anything about Austro-libertarianism? These were the some of the only people standing up to the Bush Administration right after 9/11, the US Patriot Act, the invasion of Iraq and Afghanistan. And for that they were labled "extremists" "right-wing" and "terrorist sympathizers". Anti-war.com is run by an Austrian, go check that one out and say they have no sympathy for other people.
On the contrary, not one of my assertions about Mises was answered.
For the mainstream Mises, see this:
http://www.amazon.com/New-Dare-Discipline-James-Dobson/dp/0842305068/ref...
All I know is that the Austrian economists saved me a bunch of money. I'm glad I listened to them a couple of years ago instead of others. Also, it seems historically, the Austrians were the only ones warning of an imminent failure when others were saying all was well.
So, how good have your market predictions been?
Read up on Austrian economics. Mises's theory of the business cycle in particular.
Thank you for a very useful essay.
I am a chemist with more than 100 publications in referred journals including the Journal of the American Chemical Society, Science, and Analytical Chemistry.
I agree with the bulk of your essay. However, all science is based upon postulates, including chemistry and physics. As an example, do a google search for quantum mechanics postulates. For a specific example for those not willing to be bothered, we assume that all laws of physics apply uniformly throughout the universe. This postulate cannot be tested, but it underlies all estimates of the size and age of the universe.
You are spot on when you note that scientific proof is based upon the scientific method. The scientific method includes a carefully designed experiment to answer a carefully constructed question with either a "yes" or a "no". The design of the experiment must include positive and negative controls and a sufficient number of measurements so that experimental error can be defined. Other than perhaps under the Nazis, I am unaware where any truly controlled experiments that have been performed involving human subjects. The use of control groups in statistical studies is a rather anemic attempt to correct this problem. Yet, many variables remained uncontrolled. Genetics and environment being a couple of examples, even with the Nazis.
Once adequate precision has been attained, repeating the same experiment does not improve the accuracy. I have reviewed more than one laboriously generated manuscript that was very precisely wrong.
If you want to test the accuracy, ask the question in a differt way, with a different set of experiments to answer the question. It is much more convincing (at least to me) to have three replicates each of two independent means of testing the same question (6 total measurements) that agree than 600 replicate measurements of the same experiment.
One of the great sources of difficulty in economics (or any of the other psuedo-sciences, aka "soft" sciences) is the inability to conduct controlled experiments. Rather, there is a general reliance on statistical analysis. Demonstrating a correlation, no matter how precisely, is not the same thing as proving cause and effect unless postive and negative controls can be provided.
As an illustration, I have read numerous articles noting the high inverse correlation between SPY and the USD, many accompanied by the assertion that the weak dollar is driving the stock market rally. While this assertion may be true, I have yet to see convincing data to prove that to be the case. So, it is just as valid to postulate that the stock market rally is driving the value of the dollar down. Or, the two have no direct relationship at all. Rather, both are being affected, but in opposite and equal ways, by a third, as yet unidentified, factor. In this case, liquidity provided by good ole BB is a reasonable candidate. Should the relationship between BB's activities and either of the above change, those trading using the SPY:USD correlation are probably going to lose some money.
My $0.03 (Overtime after 6 pm)
So, to wrap up, we agree that flawed basic postulates necessarily result in flawed models and thus enormous human suffering. My hope is that we will move our analysis beyond R^2, etc. to the clear statement and careful testing of the underlying postulates. Further, that we move our understanding beyond correlation to true cause and effect.
fotokemist
Try not to think too much, Foto, until the fix is "OFF".
LOL.
On some days I think of economists as charlatans. On other days I think of them as whores.
Or are they whores who are charlatans, or perhaps charlatans who are also whores?
Somehere within the concepts of charlatan and whore lies the perfect description of America's leading economists.
I would appreciate any suggestions from ZH's reading audience.
Read up on Austrian economics. Mises's theory of the business cycle in particular.
It's called academic capture! That's how we ended up with the glittering jewel of colossal ignorance known as Krugman!
Economists used to act like a wet blanket for any crazy schemes out of Washington. Now the majority spurs it on. We're left with a couple of decent economists and a few money managers having to help them out. You can count the wet blankets on one hand. It's amazing.
I smell B.S. I graduated college in 2003 with a degree in ECON and Finance. I have been a registered rep since then. Let's just say that my initial thinking in 2003 that things were out of wack was more than a fishy smell.
Many have smelled the same fish going back decades. But it was normally just one or two loosely directed schools of fish washing up on the beach. In the 70s, it was about the fix on oil, followed by sugar and coffee. A Hunt Brothers silver scam. All moderate crimes.
Today , the super computer has brought the smell of fish to a new level of aroma. Electricity, oil, water , housing, .....all tradeable commodities. And corruption has become institutionalized and internationalized, which is the saddest development of all.
Your youth will serve you well in trying to fix this mess.
The seat of authority. It always doubles as an electric chair.
DEAD FISH EVERYWHERE!
People with hidden agendas obfuscate, people in denial wish to stay there. Nick
Someone over at NakedCapitalism wrote:
I agree, but I'm waiting for an economist to say this. Any economists? Bueller ?
Several years ago, I heard the same point made in reference to quantum physics. Several leading physicists were asked, 'What happened to the Einsteins? Where have they all gone?"
Their answer, not surprisingly, was that they still exist, but they are being ignored. Why? They are outside the establishment and their papers (if even reviewed) are discredited because they don't conform to prevailing theories.
A perfect example of this is Chris Langan, the man with the highest IQ that never graduated college. Every time I think about Langan, I want to cry. What could he and others like him create to propel humanity forward? (If they choose to, I might add.)
Wikipedia Langan if you're not familiar with his story. Tragic that we don't do more to cultivate these extremely scarce resources.
Very interesting guy (Langan), but he lost me when he started talking about the existence of invisible sky-pixies.
I'll take it a step further and say you could make this statement about most theory-based academia, including 90% of the social sciences and highly-abstract physics/mathematics. Dissent voices are silenced in favor of a convenient "consensus" about what's true or worth studying, and grad students that try to buck the hierarchy are quickly abandoned.
title="Black Swans and What We Don't Know"> Nassim Taleb has some very good points on all this. Looking forward to his new book.
Ya but it's all in being perfectly and correctly wrong.
http://www.youtube.com/watch?v=ovH46-o0rLw