"Fundamentalists versus Realists"

Paul Romer says some fundamentalists need to get real:

Fundamentalists versus Realists, by Paul Romer: Debate among economists about the $700 billion Paulson plan reveals a deep divide between realists and fundamentalists. ...

The formal, model-based approach of the fundamentalists has contributed much to progress in economic analysis. At key junctures, it has also made important contributions to policy. The challenge is to maintain an intellectual environment that leaves space for ... realists as well. In complicated policy contexts where models don't yet capture key forces, the realists have much to offer...

The key difference lies in the relative weight each side gives to formal models as opposed to judgment.

Fundamentalists have an unswerving faith in models. Policies should always be derived from the best available model. Data should be filtered through a model. If an observation does not fit within the context of a model, it should be excluded from consideration. Realists are more conscious of the limits of models and more comfortable with a division of labor between the researcher who improves the models and the clinician who makes policy decisions. They recognize that the power of models comes precisely from a commitment to abstraction that filters out potentially important complexity. They believe that useful evidence can accumulate with direct experience as well as through the research process of testing and refining models. They believe that researchers should consider the possibility that the fault lies with the model when its predictions diverge from clinical judgment and that policies should draw on both sources of evidence.

Many times, the confidence fundamentalists have had in abstract models turned out to be well founded and the objections raised by realists who were more focused on details were misplaced. The fundamentalists were right that an airline industry could still function even if airlines could set their own fares; that people could still talk to each other even if they purchased phone service from different companies. The realists pointed to all the complicated details that arise in such markets, details that simple models could not capture. Fundamentalists, correctly, ignored the detail and pushed prescriptions based on the textbook model of competition.

Other times, the models are missing something that is too important. In the study of macroeconomic fluctuations, real business cycle theorists and their descendants, the dynamic stochastic general equilibrium modelers, are the quintessential fundamentalists. Their models are a useful way to make research progress, but in macroeconomic policy making, the great depression, which these models cannot explain, is a decisive data point warning us that the models are incomplete and have to be supplemented by clinical judgment.

In the current crisis, the astonishing and unexpected consequences of the Lehman Brothers bankruptcy should serve as a similarly decisive data point. On the Thursday and Friday before Lehman filed for protection, I was at a conference on the financial crisis. Everyone there expected them to file on Monday. We repeated for each other all the fundamentalist arguments: "Everyone had been given time to prepare." "The courts handle bankruptcies all the time." None of us expected that putting Lehman through a court managed bankruptcy would be much different from arranging a forced sale of Bear Stearns. We were all wrong. Within days, AIG was insolvent. Runs were developing on Goldman Sachs, Morgan Stanley, and the entire money market fund industry. Banks had stopped lending to each other in the Fed Fund market. Rates on Treasuries approached zero.

In response, the Treasury, Fed, and market regulators took drastic steps that the fundamentalists would surely have opposed had there been time for debate. ... Looking back, it appears that they had enough sand bags to hold back the flood and stop the panic, but perhaps just barely enough. This is not a data point that can be dismissed as an outlier. It is the kind of observation that should make the fundamentalists just a bit less confident in their models and a bit more willing to listen to the realists who are willing to defer to the policy makers on the front lines. ...

Comments

[Bruce Wilder]

It is worth remembering that, without an adequate theory, the so-called realists have a tendency to fall back onto a combination of mindless moralism and cruel sadism.

People, who are secure and ignorant, are sure that austerity is called for. "Entitlements" is a problem that the politically courageous would tackle.

It is really only a functional understanding of how policy is connected to its consequences that keeps us marginally rational and humane. Without scientific knowledge, people are inclined to sacrifice to propitiate the gods.

Without formal economic theory and analysis, we are liable to retreat into thinking that the economy is something, like the weather, over which we have no control. The "realists" will counsel acceptance and, later, sacrifice.

Politicians and statesmen will be assigned roles in the great drama, but no one will examine the content of policy or program. This is how leaches become a "popular" remedy, and the gold standard gains adherents.

[a]

So the fundamentalists consider themselves right because of the airline industry - I guess they haven't asked airline industry workers, who have seen their lives gutted.

It also seems to me rather facile to identify realists with policy makers. Our policy makers are, certainly, down in the trenches. But they are like well-scrubbed members of the bourgeoisie who are afraid of the dirt and the sound of guns, panicking at every turn and about to get the entire regiment killed.

[esb]

The dog is the derivatives book. The tail is everything else.

It is the dog that is wagging the tail.

Unless the political leadership comes to understand this the system moves ahead into the abyss.

Oh, and the story of the hour is that RBS and three other UK banks have invited the government to perform partial nationalizations.

Its just a matter of a few days before a group of US banks makes the same pitch to Paulson.

[hari]

I suspect the notion attached to *fundamentalism* must be discarded when discussing monetary and fiscal policy. Otherwise we're back to arguments about Libertarian mindset and how it deters intelligent development of policy going forward.

Global policy on trade and development is not based on ideology (fundamentalism or what) but factual data base and its trends.

Of course, (knowledgeable) idiots are known to confuse policy issues by using sacreligious terminology for sake of egregious arguments - as in this thread.

[K Ackermann]

The problem with models is their discontinuous nature. They have a clearly delineated domain and problems that lie close to an edge extend out to places the model can't see.

Models can break down at the fringes, which ironically is where they are needed the most at times.

[ken melvin]

At the core is some concept of what should be.

[cas127]

I wonder why this realist/fundamentalist analysis is seldom if ever applied to the operation of government.

Demographically dysfunctional Social Security system controlling 15%+ of US wages - hem haw hem...

Insane levels of medical price inflation caused by Medicare price floors - hem haw hem...

Perpetually counterproductive farm subsidies that exist only to buy political votes - hem haw hem...

The list runs to the hundreds of items and we all know it.

Why is government given a pass when it taxes and inflates its way out of crises of its own making?

Where is the discussion (and *effective* action) surrounding "political failure" - to match endless discussions of "market failure"?

I wonder if the fact that most academics are in the employ of the state (or heavily subsidized by the state - via the tax free status of college endowments) is at least partially behind this partial blindness...

[Alan]

Airline deregulation was a few decades ago, and my memory may have faded, but I don't recall it as a dispute between fundamentalists and realists. Almost all economists supported it, as did politicians left and right. At most, one could say that some economists were more impressed with the theoretical reasons for deregulation, while others relied more on the empirical studies of intrastate, nonregulated air traffic, especially in California.

What I found most striking, reviewing the testimony a few years later for a conference presentation, was how no one forecast two of what seemed to be the most striking changes brought about by deregulation -- the development of hubs and the efforts to develop brand loyalty through frequent flier programs. My conclusion was that it is very difficult even for well-trained and informed persons to predict the outcomes of economic policies.

[Julio]

From the article:

"Fundamentalists have an unswerving faith in models...
If an observation does not fit within the context of a model, it should be excluded from consideration."

"The fundamentalists were right that an airline industry could still function even if airlines could set their own fares; that people could still talk to each other even if they purchased phone service from different companies."

Gee, and after drawing this caricature, he concludes that they should be more "realistic", meaning, I guess, looking at the facts and then using their hunches. Go figure.

But let me try to take this seriously.
The "realists" as described also have their mental model. As Bruce Wilder points out, it is not often pretty, and does its own filtering of reality. I don't hang around economists, so I may be commenting on what's basically a family dispute; but the dynamics (trying to fit the facts into a model: explicit and therefore arguable; or subconscious) occurs everywhere and in every activity. Nothing new here.

[Paul R. Dorasil]

I think you're drawing a false dichotomy. I would think it difficult to find a group of people who specifically do not identify themselves as "realists." When reality seems to systematically disagree with the predictions of models, this is not an indictment of the process of creating predictions from models. Rather, it is an indication that the model should be improved.

[Roger Chittum]

Romer's post made me laugh. He is credited with getting technological change into the standard mathematical growth model, instead of treating it as exogenous for a century even though everybody knew technological change is critical.

Now Romer has proposed a policy development model in which model-haters are endogenouos. This means, I assume, that if the fundamentalists accept the model they can communicate seriously with realists. But what if the realists don't want to be endogenous to a fundamentalist model?

[SGC]

Roger, Some would say that this captures the essence of intellectual advancement: the process of deconstruction. There is a dominant view (a.k.a. center) that is challenged by outsiders (a.k.a. the periphery). When the challenge becomes sufficiently strong, it breaks down the dominant view -- only to be coopted by it over time. A new dominant view develops that incorporates yesterday's periphery -- and will be challenged by the new outsiders.

[Patricia Shannon]

Paul R. Dorasil says...

I think you're drawing a false dichotomy. I would think it difficult to find a group of people who specifically do not identify themselves as "realists."

You sound like a rational person. Not everybody is.
Our current president ran on a platform that put down the Democrats for having reality-based policies.

[BJ Feng]

"Of course, they immediately suggest the standard point, which the report makes very clearly: good policy requires good governance. Little of this, however, has been taken seriously enough by mainstream fundamentalist academics. In these circles, discussions of industrial policy or structural exchange rate policies are still disreputable (or perhaps dangerous,) so the possibility that effective governance combined with activist policies can lead faster growth than passive policies is not given serious consideration."

Who are the realists here? Romer assumes that policies and governance will be executed to perfection. Is this at all realistic? And where is the realistic assessment of the policy makers and regulations leading up to this crisis. That Greenspan's policy to keep the real FED funds rate at or below zero for an extended amount of time fueled the real estate bubble, and that Lehman, WaMu, and Wachovia HAD regulators that could have forced them to stop their activities before they destroyed themselves.

Is it realistic to assume that regulators will be omniscient or that it was lack of policy that led to our current crisis? These "realists" assume that policy makers and regulators have some sort of insight that participants do not. They assume, furthermore, that these regulators are competent enough and shielded enough from political pressure to do what seems obvious in HINDSIGHT. Reign in Fannie and Freddie before they jumped into subprime mortgages, but could a regulator stand a grilling from Barney Frank? Is it realistic to expect a regulator to have the courage to say, "screw you Barney, this is dangerous and Fannie isn't going to make these subprime loans. Furthermore, it is going to either have to lower the amount of loans it guarantees or raise a lot more capital, stuff it Barney"?

No, these "realists" should be called surrealists. Frankly, I don't understand what the author is talking about, where is the distinction, how do we distinguish a realist from a fundamentalist? Is this just code and we should interpret realist as leftist instead? He should be more real and just come out and say it then.

[Worker]

Another way of saying the same privatize profit/ socialize risk business model formerly known as "the street".

The fundamentalists built models to justify 20x leverage short on volatility and long on housing.

The realists assumed that since all of their big time buddies were doing it, the risk they were taking would be socialized.

Dick Fuld's performance today reminded us why the Fed/ treasury was right to rebut that logic.

[Worker]

Rebut that logic in Lehman's case at least...

There is at least some justice in the comeuppance of Bear and Lehman.

They were the cool guys dealing to their friends. Then they got hooked on the smack. Highly functional addicts for awhile, but dead from OD nevertheless.

Still gotta give credit to Jimmy "J" Cain (great name by the way) for still hitting the pipe into his 70's, at least during bridge tournaments in the midst of financial crises.

[melvin]

The recent release of government funds can only increase the ability to lend but those with a lack of confidence in the future will refuse to borrow. A media campaign might trick potential consumers into believing that things will soon get better resulting in a jump start for the economy. But The public has been frightened by reports of banks going under and a depression looming on the horizon. Ordinary people are now in a panic and are holding onto their money like a shipwrecked sailor holds onto a life raft. It is difficult to cure a person that has been tramutized by the fear of becoming homeless and then forced to stand in a soup line. The economy will remain depressed until consumers regain confidence through time or the help of a good psychiatrist
.

[donna]

Any model is NOT reality. Some models are more realistic than others. But all of them are wrong to some extent.

As I learned in high school (yes, I had a very good high school, they made us read stuff, including an entire class based on reading stuff like "Language in Thought and Action"):

The symbol is not the thing symbolized. The word is not the thing. The map is not the territory.

However, Ponzi schemes are always POnzi schemes, and always fail. Our markets were not based on reality but on creating "money" out of debt.

It was a bad, bad idea.

[ken melvin]

'Tis but an abstract.