11.1.09

CRASHED FOR LACK OF A THEORY. Princeton's Uwe Reinhart reflects on economics, and the recent national conference in San Francisco.

If, like every university, the American Economic Association had a coat of arms, its obligatory Latin banner might read: “Est, ergo optimum est, dummodo ne gubernatio civitatis implicatur.” (“It exists, therefore it must be optimal, provided that government has not been involved.”)

With only minor injustice, one may take this as the overarching mantra to which the core of the economics profession marches. Government is accorded a beneficial role in this vision only to provide purely public goods, such as national defense; to remove private-market imperfections, such as monopoly power on either side of the market; or to deal with so-called spillover effects from private decisions, which economists call “externalities.” These exceptions aside, unquestioned belief in the sagacity, efficiency and beneficence of private markets reigns supreme.

Those exceptions are non-trivial, but yes, one can put together a coherent manual for public policy framed by market "failures" that "warrant" government correction, and more than a few majors become Democratic Party operatives based on that formulation.

As long as up-and-coming economics stars can get their work onto the prestigious conferences and into the top journals by ringing changes on those received models, they will.These thoughts occurred to me as I attended the American Economic Association’s annual conference in San Francisco over the weekend.
It offered a humongous smorgasbord of eloquent theory, clever econometric tricks, illuminating empirical insights and a few standing-room-only panel discussions on the shocking surprises the real economy served up as the economics profession was otherwise preoccupied during the past two decades or so.
Perhaps the research that anticipated the surprises didn't get written, because the Ph.D. students who could write it were steered into writing the kind of work that extended the hot topics (every so often, somebody comes up with a meaningful extension, for the most part it bores interviewers to death). Perhaps it didn't get written because the information sets don't easily qualify as sigma-algebras, and the payoffs can't be set up to exploit the topological tricks that fill the pages of Econometrica and Journal of Economic Theory. Or perhaps it got written, but because the authors weren't at the forty claimants to top ten status, the articles were rejected.

To Professor Reinhart's credit, he recognizes that informal status hierarchies reinforce the existing research traditions.

How could the economics profession have slept so soundly right into the middle of the economic mayhem all around us? Robert J. Shiller of Yale University, one of the sage prophets, addressed that question in an earlier commentary in this paper. Professor Shiller finds an explanation in groupthink, a term popularized by the social psychologist Irving L. Janis. In his book “Groupthink” (1972), the latter had theorized that most people, even professionals whose careers ostensibly thrive on originality, hesitate to deviate too much from the conventional wisdom, lest they be marginalized or even ostracized.

If groupthink is the cause, it most likely is anchored in what my former Yale economics professor Richard Nelson (now at Columbia University) has called a ”vested interest in an analytic structure,” the prism through which economists behold the world.

This analytic structure, formally called “neoclassical economics,” depends crucially on certain unquestioned axioms and basic assumptions about the behavior of markets and the human decisions that drive them. After years of arduous study to master the paradigm, these axioms and assumptions simply become part of a professional credo. Indeed, a good part of the scholarly work of modern economists reminds one of the medieval scholastics who followed St. Anselm’s dictum “credo ut intellegam”: “I believe, in order that I may understand.”

For the most part, the approach works reasonably well. Theorizing produces sufficient conditions under which observed behaviors occur as a consequence of optimization subject to constraint. The testable implications of such work are sometimes difficult to evaluate. (The econometrics often gets in the way. A reviewer can raise an objection based on a deep theorem of statistical inference, which can sink the paper for lack of an easy test. And when there is a relatively easy test, the researcher might still have to develop his own algorithm to perform the test. I had a pleasant conversation one afternoon with a very good econometrician, who was a bit surprised that somebody was actually going to implement the test he had so laboriously developed. Go figure.)

Professor Reinhart notes part of the problem in that "hesitate to deviate too much from the conventional wisdom, lest they be marginalized or even ostracized." His mentor, Richard Nelson, has held positions at top departments despite being a dissenter from the mainstream. There might be some institutional research somewhere to the effect that departments will prefer a middling-ability researcher who sticks to safe topics (yielding a dependable flow of publications) to a middling- or middle-high-ability researcher who takes more risks.

An inference drawn from the profession’s credo is that private markets invariably are self-correcting and are driven by rational human beings whose careful decisions serve to allocate scarce resources efficiently — that is, these decisions maximize a nebulous thing economists call “social welfare.”

“Social welfare” in this view is thought to increase when those who gain from a change in the economy — e.g., a corporate restructuring or deregulation of the financial sector or increased foreign trade — gain more from the change than those who lose from it, even if the gainers had already been wealthy before the change and the losers poor. Thus, few economists were troubled by the explosion of executive compensation on Wall Street or elsewhere in corporate America. It was just the efficient market at work, rewarding these executives for the “value” they were creating. With their model of how the economy works, economists seem to have great difficulty recognizing bubbles in asset values and often are the last to recognize such bubbles, which is why the Fed has never addressed them.

Here Professor Reinhart is on less firm ground. We have regulatory error of omission and of commission, neither of which lend themselves to easy treatment under the standard welfare-theoretic models, or to precise analysis by heterodox methods.

The column leads Kip Esquire to a spot-on conclusion.
And we wonder why most college graduates, despite taking at least one economics course as undergraduates, are worse than illiterate when it comes to economic policy analysis.
A survey of economics that offers the Readers Digest Condensed Version of Keynesian economics, or Old Chicago price theory, or Market Failure Warrants Government Intervention, is scant preparation for a career as policy analysis. One only gets good at evaluating conflicting claims by evaluating conflicting claims and observing the outcomes. Here Mr Esquire goes astray.

But who is guiltier of invoking the fiction of “social welfare” as the basis for economic policy prescriptions — neoclassical defenders of laissez faire or neo-Keynesian defenders of unbridled income redistribution and economic interventionism? Economist, heal thyself!

Finally, note that there is another, far more powerful defense of capitalism than the “unquestioned axioms and basic assumptions” of neoclassical economics and its “social welfare” predictions. And that is the moral defense of capitalism: the remarkably modest suggestion that an economy based to the greatest extent possible on voluntary exchange among competent consenting adults rather than on government coercion (i.e., majoritarian looting) might — just might — be “the greatest good for the greatest number” regardless of what the economic data (or the economists who parse them) might otherwise suggest.

There is at least one "greatest" too many in that formulation -- sorry to have to go math jock on you -- but the real kicker is in that "competent consenting". A bank offers a low-interest loan with no money down in the expectation that house values will continue to double in five years, and an individual with a spotty job history signs the papers. Let's play Spot The Incompetent.

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