Deconstructing a Faulty Paradigm

I'm only too happy to see the multiple efforts underway to tear down the myth of the "rational market" and of a all-knowing, calculating homo economicus.

Here's a bit from an article by Robert Shiller making this very point:

The widespread failure of economists to forecast the financial crisis that erupted last year has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come.

As George Akerlof and I argue in our recent book Animal Spirits, the current financial crisis was driven by speculative bubbles in the housing market, the stock market, energy and other commodities markets. Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying and hence further speculative price increases — until the crash comes.

You won’t find the word “bubble,” however, in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of “bubbles” even being mentioned. Indeed, the idea that bubbles exist has become so disreputable in much of the economics and finance profession that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.

The fundamental problem is that a generation of mainstream macroeconomic theorists has come to accept a theory that has an error at its very core — the axiom that people are fully rational. As the statistician Leonard “Jimmie” Savage showed in 1954, if people follow certain axioms of rationality, they must behave as if they knew all the probabilities and did all the appropriate calculations.

So economists assume that people do indeed use all publicly available information and know, or behave as if they know, the probabilities of all conceivable future events. They are not influenced by anything but the facts, and probabilities are taken as facts. They update these probabilities as soon as new information becomes available and so any change in their behavior must be attributable to their rational response to genuinely new information. If economic actors are always rational, then no bubbles — irrational market responses — are allowed.

Abundant psychological evidence, however, has now shown that people do not satisfy Savage’s axioms of rationality.

In fact, people almost never know the probabilities of future economic events. They live in a world where economic decisions are fundamentally ambiguous, because the future doesn’t seem to be a mere repetition of a quantifiable past. For many people, it seems that “this time is different.”

I'm happy with science trying to push back the borders of ignorance. But that needs to be built on foundations of solid science. The myths that drove economic theory for the last 30 years were laughable. But they were above reproach because so many bought into it. It is a sad commentary on the illusions of academics. They love their math more than they love the truth.

It should be noted that one of the most poignant criticisms of string theory in physics is that these scientists are more in love with their math than the truth. So this is a common ailment and not simply localized to economists.

John Emerson in his blog Trollblog goes into a frenzy while making the point that contemporary economics has a corrupted foundation:

Akerlof and Schiller ask, “Why did most of us utterly fail to foresee the current economic crisis?”, and their answer is that we failed to take animal spirits into account.

My own response is: “What do you mean ‘we’, white man?” Lots of us were uneasy about the twenty-year boom/crash cycle we found ourselves stuck in, but few of us are economists. Lots of people also tried to tell the economists that their models were dangerously unrealistic, but economists were securely protected by tenure and were being rewarded very well by the malefactors who controlled the economy, so why should they care what anyone else said? Economists are smarter than anyone know tons and tons of math, you know.

What are “animal spirits”? According to Keynes (A&S, p.3) animal spirits are the “spontaneous urges to action” of large numbers of people which have unpredictable effects on the greater economy, whereas for Akerlof and Schiller (p. 4) they are “the restless and inconsistent element in the economy”. Thus stated, “animal spirits”, whatever it is that causes the economy to behave erratically, might seem merely to be the active equivalent of the dormitive element in morphine — a big fudge-factor, and just a way of kicking the can over to the psychologists and saying “We didn’t do it! The Second Great Depression is your fault, not ours!” However, in fairness, it’s not quite as bad as that. Akerlof and Schiller do describe several of the factors interfering with economic rationality: variations in levels of confidence, considerations of fairness, bad faith, the money illusion, and the ways people understand their world by means of constructing and telling stories:

But the current crisis bears witness to the role of such changes in our thinking. It was caused precisely by our changing confidence, temptations, envy, resentment, and illusions — and especially by changing stories about the nature of the economy. [A&S, p. 4]

They seem to think of these factors primarily as impurities or contaminants which unfortunately have disrupted the otherwise perfect descriptive / prescriptive rational economy which economists discovered / created / imposed, rather than as evidence that the economic model they’ve been working with for fifty years is no damn good. Almost sixty years ago, in the “Introduction” to Positive Economics, Milton Friedman claimed philosophically that scientists can make shit up and get away with it. For decades this has been professional dogma, and economics grad students who have had trouble believing this have been weeded out. As one consequence of this, during the last several decades economists have been working with a risible notion of individual economic rationality which is neither empirical nor normative, and which was chosen purely because it makes mathematical modeling possible.

Emerson may be extreme, but there is going to have to be a lot of fundamental re-work done before economists can walk in the sunshine again. They have failed miserably. All that mountain of "research" and so little of it of any use in the real world. That's not science. The test of science is the powers it gives us over nature. As scientists, economists are a pathetic failure.