"What's Wrong with Economic Theory as Presented to the Public?"

Robert Waldmann:

What's Wrong with Economic Theory as Presented to the Public?, by Robert Waldmann: I have a very low opinion of economic theory. I think that its survival is the result of a bait and switch where the core principles (roughtly Nash equilibrium) can't be proven false, because they have no implications, and, given the fact that they have not been proven false, economists attempt to convince people of the joint implications of the core principles and further assumptions which are known to be false. Fortunately, very few people pay much attention to economic theory.

To continue the diatribe, the implications of economic theory as presented by right wing economists are the implications of models which are about 50 years old now. They depend on assumptions which no one claims are approximately valid. In particular, the traditional application to finance of economic theory, that is general equilibrium theory, (generically) gives the standard results only if markets are complete -- that is there is a contingent claim for every conceivable contingency (including say this pays 1 unit of numeraire good if it is snowing on Mars or if Robert Waldmann stubs his toe between 6:55 EST of October 3 2008 and 7 EST).

With incomplete markets, the market outcome is generically (that is except for a set of economies with measure zero) constrained Pareto inefficient (that means that there are legal restrictions on peoples positions in financial markets which make everyone better off).

Also, there is no claim based on economic theory that financial market prices reflect fundamentals. A large set of general equilibrium economies *with complete markets* have multiple equilibria. Which equilibrium occurs is not determined by fundamentals (tastes and technology). With incomplete markets payoff irrelevant signals (sunspots) can affect prices in general (I think generically).

The conclusions of economic theory as presented by many or perhaps most economists do not follow from current economic theory, but rather from the 50 year old efforts at mathematical economic theory.

Thus the New York Times Op-ed page is not to be blamed for publishing an op-ed full of false claims about economic theory written by Mark Buchanan a physicist. I won't excerpt, read it if you want.

Bachman has no idea what he is talking about.

First he has no idea of what economists mean when we say "equilibrium". He just assumes that we mean stable steady state (which is what we used to mean 50 years ago). Now we mean Nash equilibrium or Walrasian General equilibrium which is nothing of the kind. He should check on recent developments in general equilbrium theory in the past 30 years. He will find the word "sunspot". He will find that general equilbrium theorists argue that there are "equilibria" in which market prices jump around ... based on irrelevant news that has nothing to do with tastes or technology... That is, the view of general equilibrium theorists is the exact opposite of the view Buchanan attributes to them.
 
He will also note that general equilibrium theorists conclude that market equilbria are generically not constrained Pareto efficient -- the theorists who showed that are Herakles Polimarchakas and John Geanokoplos (hey where did I just read that name ?).
 
Finally the bit about how economists don't use computer simulations is, if possible, even more wrong than the rest of the op-ed. It is like saying economists refuse to use mathematics or have no use for the theory of statistics.
 
I'd say that Buchanan demonstrates complete ignorance about what economic theorists have been doing in the ... past 30 to 50 years. ...

The problem is, I think, that when they talk to non economists, many economists pretend that traditional economic theory is a good approximation to reality. By "traditional" I mean 50 year old. The fact that the conclusions are the result of strong assumptions made for tractability and are known to not hold without these assumptions is irrelevant. In the case of financial market equilibrium, the assumptions are not just the core assumptions of rationality and old assumptions of perfect competition but the totally crazy assumption of complete markets....

Buchanan should have talked more to Geanakoplos before shooting his keyboard off. The Times should have checked claims about current economic theory with an economist before printing them, but I think the worse problem is that economists who are also libertarian ideologues are lying about the current state of economic theory, not only its very weak scientific standing, but the fact that, even if it were all absolutely true, their policy recommendations do not at all follow from current economic theory.

Comments

[BJ Feng]

"Also, there is no claim based on economic theory that financial market prices reflect fundamentals."

I wasn't aware that economists still made this claim. When you get down to it, and depending on what you mean by "fundamentals", it may not be possible for us currently to know what the "true" value of anything moderately complex. For the stock market, we would need to know what the future terminal P/E ratio will be, that is how much people would be willing to pay for each unit of earnings 10, 20, or 30 years from now, to figure out the true value of an asset today. We would also need to know the dividend growth rate, and the discount rate among others. Otherwise we can't know for certain if stocks are overvalued or undervalued, we can only make a good guess.

It's sorta like physics on the quantum level where we don't know exactly where a particle is and how fast it is moving, so we can't predict exactly where it will be in the future, we can know after the fact, but until then, we can only give probabilities.

That doesn't mean we can't make general rules that are "wrong", but work well enough to be useful. F=MA is wrong, it doesn't account for relativistic effects, and as we approach the speed of light, it becomes more and more wrong. However it's a good start and useful enough that engineers employ this "wrong" equation in their calculations.

As for the market, it might not be "right" all the time, but we don't know of any consistently more accurate alternative. And even if you strongly suspect the market is "wrong" you still might not be able to take advantage. A person shorting tech stocks in the late 90's could easily have gone bankrupt before the tech bubble finally burst. And if you listened to Shiller on housing prices, sorry, but you're still waiting to buy because housing prices are still up from when he first issued his warning.

[Tom Palley]

The economic theory that the public knows is the ordinary textbook. By that standard Buchanan's criticisms are entirely justified because textbooks still sell the basic message of general equilibrium theory. In macro it is called the natural rate of unemployment.

If economists were dentists or doctors they would face a class action suit from former students for misrepresentations. That seems to be the implication of Robert Waldman's piece.

The trouble with Mr. Waldman's piece is he has a gripe with "economic theory", when the real problem is the economists who populate economics. It's the awful sociology of the profession and its deep intellectual intolerance that needs to be exposed. Pointing to a few enlightened margins of the profession & calling that economics does not wash with me.

[Dual]

So maybe its time to update policy. A multi decades old dual mandate is not the most efficient way to organize an economy. It is based upon outdated theories.

[Robert Waldmann]

I think actually that Tom Palley agree. However, I would like to add one thing. The arguments against economic theory as it is presented to the public are not at the margins of economic theory. They are all now and have been for decades standard results in general equilibrium theory.

In a way, this corresponds to Tom Palley's argument as general equilibrium theorists have become fairly marginal to the economics profession. At least I know that 10 years ago it was very hard to convince economics departments to hire young economists who had just completed dissertations on general equilibrium theory (that's what David Cass told me anyway).

I'd say, roughly, that the economics profession decided that general equilibrium theory was no longer interesting when, after relaxing the complete markets assumption, general equilibrium theorists stopped getting nice neat results and more or less concluded that anything can happen even if all agents are rational price takers.

I haven't gone to many seminars on general equilibrium theory in the past decade or so (and not because I choose to skip them, there just aren't many). The last ones include

1) Pareto worsening financial innovation by David Cass -- except for a set of measure zero of economies, it is possible to come up with a new asset the introduction of which makes everyone worse off.

2) the generic dimensionality of sunspot equilbria in ...

Not only can sunspots matter but they generally can cause a large infinity of equilibria.

3) partially revealing rational expectations equilibria -- No one had any clue what that one was about.

In other words the two which I understood directly contradicted the claim made about "equilibrium theory" by Buchanan.

All, of course, concerned incomplete markets. No one has ever suggested that real world markets are complete or approximately complete.

Oh the point of my post (such as it was) was not that economic theory is no good (I think that but just felt obliged to admit that I think that when arguing that Buchanan was making invalid criticisms of economic theory). The problem, in my view, as in Palley's is with the sociology of the profession where inconvenient facts bow to elegant theories and elegant theories bow to simpler models and everything bows to ideology.

Still, it's not so important. Politicians don't listen to use anyway, they listen to lobbyists and wingnut welfare hacks instead.

[bakho]

Economic theory is NOT the problem. Policies based on "discredited ideology" instead of "economic theory applied to evidence" is the problem. Many people who speak to the public about economics start with ideology. They cherry pick facts and models to support their ideological arguments and the policy proposals that they favor for reasons of politics and financial self-interest.

There is a difference between abusing economic theory to support ideological policies and using economic theory and evidence to inform economic policy decisions. Ideology requires IGNORING a lot of evidence. The best models are consistent with ALL the evidence and are predictive.

[Mark]

Robert Waldmann says: "The problem, in my view, as in Palley's is with the sociology of the profession where inconvenient facts bow to elegant theories and elegant theories bow to simpler models and everything bows to ideology."

As a non-economist, I'm curious as to what ideology holds sway within the economics profession. My casual sense is that there is a good deal of heterogeneity within the profession, particularly if you look beyond academia. Is my perception incorrect or superficial? Is there a shared bedrock of faith-based "truth" that is unquestioned within the economics profession? If it is simply "free-marketism", then what accounts for the focus on market failures?

[hari]

Either we discard the dismal (social) science, once and forever OR we insulate ourselves from emergence of state capitalism - a la Chinese.

Economic theory has given me, in my active professional and management life, a lot of problems. So much so, that at one crucial stage, I decided to exclude staff economists with theoretical background from taking part in institutional decision-making. Instead, I got them to agree to become the implementors of the final decision.

Economic theory, in terms of current globalized world, is a non-starter whether one is considering JVs and/or technology transfer. It's principally staff with practical know-how and experience who matter in managing globalization.

So, back to the planning board to diagnose what's matter and how to remedy it, if at all possible, given the state of economic knowledge today.

[Keith]

"So much so, that at one crucial stage, I decided to exclude staff economists with theoretical background from taking part in institutional decision-making."

Yeah, the banks who ran those mortgage security valuation models decided to assume that housing prices would just always grow at 3%. Those arid economists who said you have to imbed an actual model of housing prices into the mortgage security models were totally ignored, because they had "given , in active professional and management life, a lot of problems."

And ignoring those economists worked out great, as we can all see.

[Keith]

The primary problem with economics (and economists) is that they rely on models that assume that everybody is as smart as an economist.

Economists have to incorporate the fact that most other people are dumber than they are into their models. Behavioral economics is addressing this issue, so I'm hopeful for the future of economics.

For example, any professor I knew would kill a grad student for just throwing ad hoc assumptions about housing prices into a model of mortgage security valuations, instead of modeling housing prices, and the possible feedback effects of mortgage lending practices on housing price volatility.

But some of these same professors might then turn around and assume these firms that were valuing mortgage securities in such a dumb way were somehow rational profit maximizers. It just don't add up.

Basically, we have two major problems. If properly doing something requires a lot of knowledge and expertise, firms may in fact screw it up, and not listen to the guys who really know what they're doing.

In addition, from what I've seen in life, a lot of the guys (often economists) who are smart enough to figure out which end is up are timid little wimps, and assume that somehow they must be wrong if some morons disagree with them. Among economists, the assumption that people are rational likely exacerbates this tendency.

Basically, we economists need to get more arrogant, pronto!

[Patrick]

Roles reversed, everyone would recognize the absurdity of an economist pissing on the Standard Model. But for some reason economics is perceived as an intellectual pursuit that anyone from any background can master in a weekend.

[Mark]

Keith says... "Basically, we economists need to get more arrogant, pronto!"

I've had the good fortune of working in (separate) places dominated by economists and MDs. My personal experience did not suggest that economists exhibit a lack of arrogance, but perhaps this was because I was on their "home turf." To some extent, my view was that _some_ economists wear their models like _some_ MDs wear their white coats. To those outside the guild, these adornments proclaim "I'm the smartest person in the room, defer to my judgment." Within the guild, no such deference, and the lack of intellectual civility and humility can be shameful. That being said, I've learned a lot in both environments.

[Alex Tolley]

patrick: "Roles reversed, everyone would recognize the absurdity of an economist pissing on the Standard Model. But for some reason economics is perceived as an intellectual pursuit that anyone from any background can master in a weekend."

You cannot learn astrology in a weekend either, but that doesn't make it correct.

[Lafayette]

Consider an airplane or a bicycle, both propelled, that is "general equilibrium", meaning it continues on a straight path unless some external force is applied.

In fact, the plane is far from equilibrium or stasis. All sorts of forces are acting upon it. There is considerable vibration, there is motor torque that may or may not be equilibrated, so the pilot must make in-flight rudder adjustments.

But, for all practical purposes, the plane is in equilibrium. Practical purposes means:
- Supply more or less meets demand at whatever price. Quick, some economist give me a supply and demand analysis of washing machines. Can't, can you? It depends, doesn't it?
- Prices are jumping in small amounts, often erratically, but they move around a general equilibrium value and that value progresses, and is called inflation.
- Investment follows demand, both up and down, its intent being to help both suppliers meet demand and consumers able to buy goods/services.

Like flying an airplane, there are events that happen:
- Sometimes the plane hits a downdraft, or an air hole, and drops suddenly. The downdraft was unforeseeable on radar, the decent was swift, but finally, the plane meets a cushion of air, its wings develop lift -- and it DOES NOT CRASH.
- The pilot must regain attitude so the throttle is opened and the plane climbs, once again.
- Sometimes one of the motors shut down and the plane loses lift. The pilot must correct the lateral disequilibrium by compensating with the rudder (interest rates) and creating more lift by deploying the flaps (tax breaks) – but the plane still flies at a lower speed and it DOES NOT CRASH.
- When an economy crashes, it does so just like an airplane -- because the pilot believed their instinct and not the information right before their eyes.

Enough of this silly analogy.

I enjoyed what I learned decades ago in economics courses, particularly the accounting mechanism. It was simple accounting of gross national product. It made sense. I enjoyed the concepts of supply and demand curves, but I never ever expected anyone to ask me to develop one for any given product or industry.

Hey, it’s the best we’ve got. And, if anyone thinks it is a sophisticated econometric model, then I wish them luck. Because, I don’t. It is more, to me, like a painted landscape of the economy than a detailed photograph.

But, it will do towards understand what is going on in what has become an amazingly complex world in only 20 years.

[Robert Waldmann]

Mark. I'm pretty sure there is no prevailing ideology among economists. Polls suggest most are Democrats and oh roughly as far left as Obama. Many extremely influential economists have far right views on economic policy (well beyond anything even Bush has done). When I wrote that ideology wins, I didn't mean that the profession reaches a consensus based on shared ideology. I meant that the profession reaches no consensus as we each stick to our preferred ideology.

For example, my views on economic policy are basically identical to those I had when I took my first economics course.

Keith the standard rational expectations assumption is that economic agents understand the economy much better than economists do. Why would anyone make such a crazy assumption ? Ahhhh the rational expectations assumption can't live with it can't live without it.

By the way I sure haven't noticed any shortage of arrogance among economists.

[Alex Tolley]

BJ Feng: That doesn't mean we can't make general rules that are "wrong", but work well enough to be useful. F=MA is wrong, it doesn't account for relativistic effects, and as we approach the speed of light, it becomes more and more wrong. However it's a good start and useful enough that engineers employ this "wrong" equation in their calculations.

There is a huge difference between the Newtonian model that works extremely well for our frame of reference and the extreme conditions that require relativity. Furthermore, simple transforms for the Newtonian equation to account for relativity work. Waldeman seems to be saying that if he was a biologist, he would be arguing that evolutionary processes are incorrect.

[Alex Tolley]

waldeman: ...where the core principles (roughly Nash equilibrium) can't be proven false...

If this is a core principle and it cannot be falsified, then I think it is fair to reopen the debate about whether (or what parts of) economics are science and which are not.

[Alex Tolley]

waldeman: "Bachman has no idea what he is talking about."

Do you mean just his straw man characterization of economic theory, or are you including his approach to economics using agent models? If the latter, can you elaborate further?

[a]

Don't know, but the post seems to look at one small part of economic theory and says, "Aha, there's the problem."

IMHO the problem is the methodology. It takes a simple model of a complex system and draws conclusions based on this model. These conclusions cannot be falsified, because one can never run an experiment. So its conclusions and theories are Google-like: it accepts those theories which are most accepted by its practioners.

[Winslow R.]

If economists knew what they were talking about, they'd be the richest sector of the economy. Greed would insure it happened to the benefit of us all :)

Obviously the finance guys have a leg up on economists.

The author's point focuses on models of leverage and how that leverage distorts the economy. Reminds me a bit of Minsky.

Economists have their Taylor-rule based monetary policy tool, which everyone (almost) can understand. It fails because it depends upon destabilizing leverage. Time to rework the model to include both policy tools with stabilizers, fiscal and monetary policy based on a ground up approach (Job Guarantee and Loan Guarantee).

The financial guys understand this. They just tend to be too greedy to make it work. Economists serve a higher purpose, right?

[robertdfeinman]

I think the problem is that there are two types of "economics" - popular/political and academic.

The popular type is discussed in the press, used by partisan think tanks (especially the libertarian and free market ones) and cited by politicians as justifications for whatever they favor.

The academic type is discussed by those in the professions and occasionally some results leak into the popular sphere, especially when some study confirms the prejudices of one group or another. This group is too closely associated with their professional colleagues and has a myopic view of the other aspect.

Whether the dominant free market, laissez faire ideology of the past 40 years was based upon sound theory, or obsolete theory or even wishful thinking makes no difference. What is important is that it has been the driver of actual government policy. The result has been a wild swing into unfettered speculation, in commodities and currencies, in lending, in internet startups, etc. The area of speculation shifts over time, but the basic bubble philosophy remains. This is because the basis of modern investing is one of looking for quick, excessive, returns rather than favoring long-term sustainable investments.

One only has to compare the success of Warren Buffet, who still operates under the old rules, with the go-go firms now in the news.

So, while it may matter to academic economists that their profession be characterized properly, it is of no interest to the public which is being sold another bill of goods called the "bailout" even as we speak.

Ideologically based planning hasn't just been restricted to economic planning, it has informed our foreign policy since the end of WWII. A succession of bogeymen have been created and used as justification for imperial overreach. This is needed because the permanent government which runs the country is based upon militarism and needs continuing justifications for its spending policies.

What we have here is someone defending "academic economics" while what is being criticized is "public economics". If the academics don't like their work being mischaracterized then it is up to them to get it out before the public in a form which makes sense and is relevant to the current concerns.

[Julio]

Alex Tolley:

"waldeman:

...where the core principles (roughly Nash equilibrium) can't be proven false...

If this is a core principle and it cannot be falsified, then I think it is fair to reopen the debate about whether (or what parts of) economics are science and which are not."

This is exactly what struck me too. If you can't disprove the core principles, then the rest of the article becomes a discussion of the influence of pseudo-science on political decisionmaking.

[swells]

B J Feng, good post. It's the old Humean question of how to get to ought from is. Observing facts of reality don't really give you much basis for normative statements. I think it makes a lot more sense to look at these questions from an evolutionary perspective. Then, the onus for explaining is placed where it belongs; i.e., on the doubters. Markets have evolved to resolve questions of valuation. Doubters really need to explain why they would have evolved if they aren't relatively efficient in their context.

[John V]

RDF,

Whether the dominant free market, laissez faire ideology of the past 40 years was based upon sound theory, or obsolete theory or even wishful thinking makes no difference. What is important is that it has been the driver of actual government policy.

I doubt many free market types you are criticizing would agree. You give them far too much credit.

They would laugh and point to poor regulations, bureaucracies, subsidies, corporate welfare, quotas, tariffs, special interest protectionism and any number of market-perverting institutions and incentive structures as far as the eye can see. They're sort of amazed things work as well as they do...all things things considered.

You think Libertarian Academia has Washington's ear? That's new to me.

Part of the problem with this analysis you always give about murky notions of "free-market" this and "laissez-faire" that is that you willfully lump thoughtless hacks with a microphone and serious academics and scholars into one group. You attribute nonsensical propaganda to people who don't espouse it simply because because some moronic Republican said XYZ. You lower what they supposedly think or say down to the lowest common denominator based on your capricious filtering of what you read and where you read it from.

[robertdfeinman]

John V:
Why is it that you find a continual need to attack me personally rather that address the substance of my remarks?

I'll return the favor and state once again that you are an ill-informed troll, on this site and on all the others where you masquerade under a variety of screen names.

Apparently the backers of Cato, Heritage, Hoover, etc. think they are getting their money's worth. Their game is to fund groups who spout libertarian, laissez-faire nonsense which is then used as cover ("talking points") by those in the pockets of big business (the same group - Koch, Scaife, et al). While they are preaching free-market ideology they are actually lobbying for tax breaks and other favors which, indeed, violate the credo. That's the scam - why is this so hard to understand?

It's the same scam used by the preachers who promote sacrifice by their parishioners while living high on the hog off their donations. Of course the fat cats don't believe the libertarian ideology, they depend upon useful idiots like you to provide the cover while they play the system for their own benefit.

Wake up already.

[John V]

Why is it that you find a continual need to attack me personally rather that address the substance of my remarks?

huh? I did address the substance.

you masquerade under a variety of screen names.

Huh? Such as? I'm always "John". I think you're confusing me with someone else.

While they are preaching free-market ideology they are actually lobbying for tax breaks and other favors which, indeed, violate the credo. That's the scam - why is this so hard to understand?

That's quite a charge. Care to explain?

The rest? Empty.

[foo]

Let me weigh in as one of the great unwashed non-economist masses. Three years ago you couldn't find an economist who would say there was a housing bubble. Eight months ago, you couldn't find an economist who would say we're in a recession.

Never mind what your theories or models are, if they couldn't get you to conclusions that were pretty obvious to any reasonably well-informed lay person, there's something seriously wrong with them.

It's roughly like me as an engineer saying engineering theory predicts that your PC-based web server will support 100 million people connecting simultaneously, and continuing to say that even as no-one can load your pages. Then complaining that people don't know what they're talking about when they say I'm an idiot.

[John V]

Three years ago you couldn't find an economist who would say there was a housing bubble.

I suggest you do a little research.

[rufus]

Robert Waldmann says... "Ahhhh the rational expectations assumption can't live with it can't live without it."

The one inexorable economic truth :)

[Doug]

BTW, Bush knew were in a recession 9 months ago but refused to admit it for political purposes. No GOP politician is this environment is ever going to admit a recession until the facts are so obvious that no one can deny it. Except for McCain 3 weeks ago - "The fundamentals of the economy are good..."

[ndd]

Swells:
Markets have evolved to resolve questions of valuation. Doubters really need to explain why they would have evolved if they aren't relatively efficient in their context.

Slavery has evolved to resolve questions of labor. Doubters really need to explain why they would have evolved if they aren't relatively efficient in their context.

Monarchies have evolved to resolve questions of government. Doubters really need to explain why they would have evolved if they aren't relatively efficient in their context.

[bakho]

"Three years ago you couldn't find an economist who would say there was a housing bubble." HUH?

Krugman: 2005

That Hissing Sound
http://www.nytimes.com/2005/08/08/opinion/08krugman.html

[Zipf]

This article is interesting to me as someone with a background in theoretical statistical physics who works in finance.

I would say that Waldmann is correct when he writes, "Bachman has no idea what he is talking about." However, equally valid is Bachman's implicit critique of economics. For the most part in my work I have witnessed two driving approaches to economics:

1. A top-down approach based on axiomatic thinking, e.g., equilibrium, efficient and competitive markets, etc.
2. Application of standard tools like GLS, copulas, etc..

The insight of those who work in statistical physics or agent based modelling is that abandoning the above approaches in favor of more microscopic view can yield a new "texture" to the results of the theory. In physics, when a new "texture" is discovered, it is called new "physics". Sometimes it is manifest as a phase transition or self-organied criticality, or something new entirely. However, what is clear to physicists is that methods #1 and #2 rarely yield that new texture.

That is why both Bachman and Waldmann are correct.

[me]

John V says...

> Three years ago you couldn't find an economist

You're the same guy who makes the same kind of statement about climate, I'll bet.

Same answer. Google could be your friend.
Learn to look for evidence rather than just state beliefs.

[kthomas]

Zipf, great post. Now I'm going to go shoot myself!

[notsneaky]

Um, why can't you falsify Nash Equilibrium? Don't experimental economists do that sort of thing all the time? Didn't Nash try it out himself? Or do you mean that you can't do it because we can't observe the underlying preferences?

[quixote]

As a biologist with an ordinary investor's interest in economics, it's only recently that I discovered economists don't speak English. I don't blame the physicist for thinking they mean "equilibrium" when they say "equilibrium." I blame the economists for thinking they're Humpty Dumpty and they own the words. So would most people who aren't economists.

Granted, all disciplines come up with their own ingroup call signs. But if I insist that symplesiomorphies are an inherent issue of phenetic species concepts that render the technique invalid, nobody cares. (Well, unless it leads to loss of species status for an endangered one, and the parking lot gets built on top of it after all.) Economists, however, deal with money. People care. We care in the worst way. Pretending to speak English and not actually doing it is a Bad Idea. It makes people angry once they find out.

Which brings me to the asinine things that pass for theory among economists. Rational actors? Worse yet, equally and perfectly informed actors? Even worser, freely competitive markets? What planet do these people live on? I walked around boggling for days when I found out that economists were building whole careers and economies on obvious fairy stories. You can hang as much math on it as you want. It's still GIGO.

So that's an outsider's view of the field. One of the few encouraging signs I've seen is the emergence of people like Krugman and Thoma and the writer of the piece quoted. People who speak both English and economics. People who can bring a desperately needed dose of reality to the system. Keep at it! You can see how much we need you.

[John V]

me,

look closely. I didn't say what you quoted. I responded to it.

[John Emerson]

Give it up, Waldmann. Economics isn't going to listen. Academic disciplines are invulnerable to criticism, whether from the inside or from the outside, and economists are doubly impervious because they're by far the best paid and most powerful social scientists. And they use lots of math, so you know that what they say is true. Economists have no reason to listen.

It's true that, as you said, economics really isn't a profession, or at least, there's no definite connection between the science and the policy advice. (Contrast medicine, where there's always a best practice). Economists bend their advice to their ideologies, and there's nothing in their science or their ethics to prevent them from doing that. There's no there there, but because laymen can't understand the math, they can be ignored and ridiculed.

Some time ago I decided that economists were primarily highly skilled advocates, like lawyers. If you can afford them, they can help you out a lot, because they really do know something -- and they have connections too. But most people can't afford an economist.

[anne]

"What's Wrong with Economic Theory as Presented to the Public?"

The problem is that after carefully reading the fine essay, and again, I have no idea of what the writer's answer is. I have heard Einstein's equation e=mc2 taken apart historically down to the = sign and made easily understandable, so I suggest the answer to the question may rest in how some or many economists present theory to the public.

Who is Pareto, and did she like dogs and was she good to her mother as her mother grew older? And, why was she so excited by being in equilibrium anyway? Was it the dogs, and what kind of dogs were they that she liked, Pareto that is?

[robertdfeinman]

This article by Peter Dorman may be of interest:

What would a scientific economics look like?

Sciences are loosely characterized by an agenda to describe the mechanisms by which observable outcomes are brought about and the privileging of propositions that have been demonstrated to have negligible risk of Type I error. Economics, despite its pretensions, does neither of these and should not be regarded as scientific in its current form. Its subject matter, however, is no more recalcitrant to scientific procedures than that of many other fields, like geology and biology. The benefit of bringing economics into greater conformity with other sciences in its content and method would be twofold: we would be spared the embarrassment of unfounded dogma, and over time economics could assemble an ever larger body of knowledge capable of being accepted at a high level of confidence. A scientific economics would take Type I error far more seriously, would study mechanisms rather than a succession of states, would be more experimental and would attach greater value to primary data collection.

[foo]

Ok, I admit my unwashed masses hyperbole in saying NO economists thought there was a housing bubble. Let me re-phrase by saying the overwhelming consensus among economists, and particularly economists talking to the general public, was that there was no bubble.

There are even economists who would say this today, eg http://tinyurl.com/4rswak

My point remains. All the theory and modelling led economists as a group to tell the general public something that was completely and totally wrong. That affects the credibility of economists in general, and explains why non-economists write scathing op-eds.

It would be better for us all for economists to adjust their thinking and their modelling so that it better informs us about the current situation and the future outlook. You're the experts after all.

[kthomas]

I knew we had a bubble when Chairman Greenspan went in front of Congress and reassured America is was only "froth".

[robertdfeinman]

Dorman's paper sounds a lot like one of mine from the beginning of this year:
Non-Adiabatic Economics

[Ken]

Keith wrote: "Basically, we have two major problems. If properly doing something requires a lot of knowledge and expertise, firms may in fact screw it up, and not listen to the guys who really know what they're doing."

Winslow R wrote: "If economists knew what they were talking about, they'd be the richest sector of the economy. Greed would insure it happened to the benefit of us all :) Obviously the finance guys have a leg up on economists."

Is there any reason to think that the large financial players are making any use of theoretical economics? I have the impression that most of their staff just plug numbers into spreadsheets, without having any idea what calculations are done, much less what underlying economic models justify them. Also, even the people who develop those spreadsheets are often strongly motivated to get the desired answer, regardless of the underlying theory. I'm basing the latter on the reports on the rating agencies, in particular the cases where they fiddled the programs until the desired AAA rating popped out.

Of course, my original question can also be asked in the opposite sense: Is there any reason to think the operation of these firms follows the assumptions of economics? For example, if the rewards system is entirely based on short-term performance, every individual can be rational and (personally) profit-maximizing, but the aggregate is not necessarily so.

[bob mcmanus]

All an honest economist has to say to the public is the truth:

"Your money is not safe."
"Your assets can go to zero."
"You can lose your job."

These events are not predictable or controllable, and losing in the rigged assymetrical information game is not your responsibility or your fault. You cannot protect yourself from Paulson or Skilling or Mozilla, and economists should not expect you to protect yourself.

Only government can protect you.

[bob mcmanus]

Can any economist really guarantee the buying power of any long term private investment? Houses? 20 yr treasury bills?

Do we know what inflation will be 5-10 years from now? Yes, we do, with Peak Oil coming.

This is the insight Keynes drew from the first World War thru the Great Depression. Given Time, shit happens. That's a lock.

[BJ Feng]

Foo, you have the power of hindsight and what psychologists call hindsight bias (you remember only selective facts that support your conclusion). If it was so obvious, then why did so many people buy homes that were overvalued? The situation is more complex, if home prices continue to stay overvalued or become more overvalued, then the purchaser will still be better off. He has to wait for the market to drop, and how does he know when housing prices have returned to "fundamental" values?

That's why I said we need to know future preferences in order to know the "fundamental" value of an asset today. So only in hindsight, when we know what preferences are in 2008, can we say that the housing market was fundamentally overvalued in 2005. But back in 2005 we didn't have 2008 information, we could take a sound guess, but what you seem to be saying is that it was obvious, and it wasn't. Look at the stock market's incredible run from 1982-2000. We can only say in hindsight that it became overvalued in 1999, but during the run, it was impossible to know for certain if we were overvalued or not. According to historical mean and median P/E levels, we're still overvalued and have been since the late 1980's/early 1990's.

I think we're arguing over different things. Let me use physics as an example again. The physicist cannot determine the location of a particle, nor can he say with any certainty where that particle will be a second, or even a millisecond from now. He can say it is very likely, but he can't make any guarantees or say anything other than there's a good chance this particle will be here in the next second. The physicist also claims there are "virtual" particles all around us, and we can turn them into "real" particles if we give them energy. Wow, this sounds like complete B.S. to the average layman. He might think, how can a person who can't even tell me where a particle is, or tell me where it is going, be anything other than a complete con artist and wacko? But even if physics can't tell us where particles are or where they are going, it can still make very useful and accurate enough predictions.

Economics can't account for every single variable nor can it make 100% precise predictions, but like physics, it can still make predictions that are useful and good enough to be used in our reality.

So can we say lowering taxes will have a positive impact on GDP? Yes, just as we can say increasing the moon's mass will affect Earth's orbit. If you get into details, you can point out flaws in theory, physics has cannot account for gravity at the quantum level, so if you ask a physicists exactly how adding X particles to the moon will effect X particles on Earth, he can't explain very well. He'll have to give an unsatisfactory answer like, we think this electron transmits a "graviton" particle that we've never seen and may not exist, we don't really know exactly how gravity works. Regardless, we can make general statements that are true, even if we can't be precise or don't have total understanding of all the variables at work.

[bob mcmanus]

"So can we say lowering taxes will have a positive impact on GDP? Yes"

Speak for yourself, dude. Words are failing me right now.

[Bruce Wilder]

Truly a master rant from Robert Waldmann. And, the contrasting edge is all the sharper for arguing against the foil of Buchanan's "I've got a hammer" naivete.

I might demur in favor of 50 year old economic theory, as a way of mastering essential analytical concepts and logical relationships. But, Waldmann is correct: economic theory has no implications -- as a body of analytical concepts, it contains no synthetic proposition about reality. No analytical theory does.

The fault is not that economic theory lacks content. Analytical theories always lack content. That's in the nature of a priori, analytical reasoning.

The fault is the fraudulent "bait and switch", whereby the implications of the accumulated product of research and investigation of the world are hidden, instead of exposed.

Organizing frameworks matter a lot in science. Darwin's theory was a great theory, because it rationalized one of the greatest organizing frameworks for empirical research: Linnaean taxonomy. Linnaeus' embrace of the sexual principle and obsession with genitalia, which had so scandalized the 18th century, suddenly made eminent sense.

Economics had in Samuelson a Euclid to organize its conceptual apparati, but no Linnaeus. I don't think most economists actually know much about the economy, per se, outside the narrow confines of their own empirical research interests, assuming they have empirical research interests. There's no framework, which would give them ready access to the research of others, and allow them to make some sense of that research. So, it is not surprising, really, that, when asked for generalization, they fall back on the only broad framework they have, even if it is 50 years old, and at odds with reality as economic reality is known to scholarly researchers.

The fact that there is a well-funded group of irresponsible hacks, actively exploiting economics to draw caricatures and write bumperstickers supporting a plutocrat's libertarianism, would be incidental, if there were not also a number of prominent economists among the hacks.

The plutocratic subsidies for hackery aside, there's a tension between the systematic coherence of even a "wrong" theory, and the apparently ad hoc arbitrariness of Dani Rodrik's "second-best" economics, at sea without a framework.

In my own field of industrial organization, the IO I learned in the early 1970's was the product of a half dozen master storytellers, who could make up highly persuasive narratives relating industry "structure" to corporate business behavior and performance. A bit of handwaving and we were all entranced; it was the economics equivalent of cotton candy and a magic show at the carnival. Game theory was going to replace the storytelling with analysis. What game theory taught us was that structure was an on-going product of how the game was played, and behavior and performance were unpredictable by-products of . . . behavior and performance. Eegad!

Still, I think real expertise consists of knowing how to do something, how to interact with the subject of study and get predictable results. Economics needs the ballast of something like engineering design and test, or biological fieldwork. Whatever the merits of simulations as a method(ology), Buchanan's implicit advocacy of building economic knowledge by designing markets and testing the designs, seems to me to have merit.

Knowledge of economics ought to include a healthy dose of expertise in the workings of the actual economy. Rather than conceptual airy fairy talk of "The Market", there ought to be some awareness of the peculiar and particular in actual markets. General analysis of the particular ought to start with tests, like, "Does this market have an equilibrium? What kind of equilibrium?" Etc., in place of the usual, "First, let us assume a can opener . . ."

Then, we might think about how 50 years of accumulated knowledge ought to feed back on a 50 year-old theory, in revision. Then, economics might begin to remove the intestinal blockage, which Samuelson's achievement became.

[John Emerson]

"Economics can't account for every single variable nor can it make 100% precise predictions, but like physics, it can still make predictions that are useful and good enough to be used in our reality."

That's crap. Physics and economics are contrastive in that respect, not similar. In many or most areas of physics (though not all) very precise and reliable predictions can be made. But not in economics. That's why physics sets the standard for science, while economics tags pitifully along behind.

[Lafayette]

The only valid argument against a prevailing philosophy, whatever its nature, is one that replaces it logically, rationally and empirically and explains better the phenomenon under observation. Methinks.

[Roger Chittum]

Attaboy, Bruce Wilder. I endorse your whole comment above. BTW, somebody using your name was much more theory-bound and a lot less reality based here.

The whole fascinating discussion made me realize that the problem may be less with the professional economists, many (most?) of whom recognize the limitations of their models, than with the millions of people who believe that what they learned in Econ 101 adequately describes the situations they will encounter in real life and who now collectively make up the Conventional Wisdom. Can't the economists who write the textbooks and teach the courses avoid teaching a "standard model" that will ossify the minds of decision makers and thought leaders decades after the professional economists have rejected it and moved on?

Separate point: Although I believe it's true that economists warned about the real estate bubble years ago, I don't recall any concern about the systemic risk that was being built into the financial system with securitization and credit default swaps. To the contrary, there seemed to be a consensus that spreading risks was good (based on marginal utility theory, or whatever). But, as Buchanan pointed out, highly integrated systems are more subject to catastrophic failure affecting the whole system. We socialized $700 billion of those systemic costs today. Do economic scientists take the view that these costs should be disregarded until they have computer models that that can quantify them?

[James Kroeger]

So can we say lowering taxes will have a positive impact on GDP? Yes, just as we can say increasing the moon's mass will affect Earth's orbit.No, Feng, we can't say that because it is generally not true. It is simply one more of the myths promoted by Republican economists that has never been supported by evidence.

You see, any true scientist will take pains to determine the impact that specific changes in particular economic variables will have on the overall economy. That can really only be done if---conceptually---we assume that all other economic variables remain unchanged when the particular variable of interest is either increased or decreased.

So what is the direct result of a tax cut? It is a reduction in government spending because revenue that the government would have been able to spend is no longer available to the government. If G wants to continue its spending levels it must do something else, but that something else is a change in another economic variable and that is not something that is allowed when we are assuming all other variables are held constant.

If a reduction in government spending was the only impact of a tax cut, then it would be clear that all tax cuts are contractionary, because it reduces government spending. But there is something else that happens when taxes are cut. The recipients of the tax cut will either spend the money or they will save it. If all taxpayers end up spending all of their tax rebate, then the net effect of a tax cut is NO CHANGE IN GDP. When the total increase in C+I = the total decrease in G, then it is illogical to state that a tax cut is expansionary. The effect is neutral.

Another possibility is that some of money received by taxpayers after a tax cut is saved. When money is saved, it is removed from the economy. It is not spent. GDP is a measurement of SPENDING. Any time that any portion of a tax cut is saved, then the increase in C+I that it leads to will be LESS THAN (almost always contractionary. The only time tax cuts are not contractionary is when they neither increase nor decrease GDP.

Now, let's address the reasoning behind your claim that tax cuts will have a positive impact on GDP. When you make this claim, you assume that another economic variable is also changed at the same time. You assume that G will maintain its spending levels by spending borrowed money. The spending of borrowed money is a completely separate economic variable that is not necessarily connected to the practice of cutting taxes. The G can borrow and spend money when it is cutting taxes, or it can borrow and spend when it is raising taxes, or it can borrow and spend when it is doing nothing to taxes.

ANY time the G spends borrowed money, the net effect is an economic stimulus. That is because it is a fiscal policy initiative that takes money that was removed from the economy and spends it, instead. If there is EVER a positive impact on the economy when taxes have been cut, it is because a truly expansionary initiative---like borrowing money---is taken at the same time.

I have always thought that is has been a good idea for economists to use the methodoloy of science to analyze economic phenomena. The problem is that economists are often very bad scientists. The example I have just given illustrates this point well, I think. Many economists casually claim that tax cuts are stimulative, and others mindlessly acquiesce, even though the claim is based not on their success in isolating the effects of changes in that particular variable, but rather on their disingenuous efforts to claim a relationship that doesn't actually exist, by obfuscating the facts.

So yes, I applaud the goal of embracing scientific methodology to determine the effects of particular economic variables. Unfortunately, most economists are very lousy scientists, so motivated are they by political ideology.

[John Emerson]

The only valid argument against a prevailing philosophy, whatever its nature, is one that replaces it logically, rationally and empirically and explains better the phenomenon under observation. Methinks.

This amounts to defaulting in whatever philosophy happens to be established and enforced on graduate students. As Mark Twain said, "I don't have to redeem your counterfeit for you". A negative result is still a result, and if the established theory is wrong, it's wrong. No one has to replace it with an equally ambitious theory that's right. You just return to go and start over. If we don't understand something, we don't understand it.

In any case, a lot of the real work of economics is done on a sort of ad hoc basis using kludges and shims and adapters and baling wire, without help from the established theory.

[Jrossi]

I don't know much (or anything) about modern economic theory, but I listened to a debate on NPR a week or so ago between John Taylor and Lawrence Summers. One said that McCain's plans would cost trillions more than the other did. They disagreed in the starkest possible terms. Wow. Quite funny, really. And if Summer (the one I happened to believe) always talks that way, I can see why they got rid of him at Harvard. He needs some people skills, Anyway, I can't imagine two highly respected persons (to lay people, at least) in my profession disagreeing on something so basic (diphtheria is viral! No, diphtheria is bacterial!). Take what economists say with several grains of salt.

[Steb]

In my own trading, all I do is make mathematical models of how markets behave on historical data. I do statistical analysis. I don't even try to come up with a theory to explain why the markets behave as they do. I'm not hip on the new theories in economics. I gotta give economists credit for trying to figure it out. It's like scientists that can explain and understand quantum physics, pi orbitals of electrons and such. The old science of newton laws of physics and similar classical theories of economics never really modelled or explained reality.

In this column you say the following which I cannot agree with more if I tried.

...the worse problem is that economists who are also libertarian ideologues are lying about the current state of economic theory.

That actually is the main thing I'm banking on in making money in this market. I'm not sure I'll be able to do it. I think every financial trader/hedge fund/money manager worth his salt knows that the libertarian model of economies is completely false.

[Lafayette]

BW: Buchanan's implicit advocacy of building economic knowledge by designing markets and testing the designs, seems to me to have merit.

Excellent idea, notionally.

Something along the lines of Second Life virtual-world could fictionalize a market situation. Get participants to play with Monopoly Money, but with some real dollar prize that makes "winning" (however that may be measured and perhaps the metric is not pre-announced) worth the effort of trying.

It would be a great effort in market model simulation, but I suspect it could be done. Would the results be valid? Interesting question, but unforeseeable until done.

Designing such a model real-time, in some state somewhere in the US is implausible. I can't imagine how it would be done.

[Ryan]

As I was leisurely conducting my somewhat bi-weekly skimming of this blog, I was almost shocked to find a post that is ostensibly about complexity economics.

The merits and possibilities of using virtual economies and computerized models for analysis is something you rarely hear about, even on Econonerd blogs.

Lafayette,

Instead of a prize package, simply having the virtual currency have some real world value (even if at an incredibly marginal exchange rate) would introduce consequence to the experiment (which I believe is the parameter you are trying to impose).

[Barkley Rosser]

Robert Waldman,

OK, so Mark Buchanan, not "Bachman," oversimplified the state of theoretical economics, which is often a problem with econophysicists who have not read enough economics. However, there is nothing all that wrong with the three models and their approaches he discusses.

I have just returned from Europe where I saw Frank Westerhoff present a paper that discussed the results from his model that studies the effects of a Tobin tax. As a journal editor I have published papers by Westerhoff, who happens to be an economist at Bamberg University, not a physicist, and a pretty good one. The use of heterogeneous interacting agents models is not a bad way to go to study some of these phenomena and related policy issues. He also happens to be aware of the fact, not mentioned in Buchanan's column, that under alternative specifications of the model somewhat different results may come out, including the fascinating one that a Tobin tax might reduce variance but increase kurtosis.

It is a bit ironic that real general equilibrium theorists in some sense dropped out of the whole discussion because they had no answers. Anything can happen, but the readers of journalism and mass media and the politicians want answers. So, the economists prepared to hand those out got the publicity, often based on older, more simple-minded models that are full of silly assumptions like ratex.

BTW, to foo and some others. While the mainstream media has had a tendency for years to quote a subset of economists who denied the existence of a housing bubble, there were plenty of ones going around publicly saying there was one, including Robert Shiller, Dean Baker, Noriel Roubini, and me, in a variety of fora. Shiller got some attention when the second edition of his Irrational Exuberance came out in 2005 that provided probably the best documentation of why there almost certainly was a housing bubble, and as near as I can tell serious people at the Fed knew this and that in conbination with the explosion of globally interlinked, high level derivatives markets, we were in serious trouble, as was clearly hinted at in the famous Sept. 06 speech by Timothy Geithner (not a professional economists, btw, but I suspect Bernanke knew by then as well). But, his speech said they did not know what to do, and it is still the case that we do not, unfortunately.

[Lafayette]

Ryan: Instead of a prize package, simply having the virtual currency have some real world value (even if at an incredibly marginal exchange rate) would introduce consequence to the experiment (which I believe is the parameter you are trying to impose

I am not sure how it would work. Gamers seek rewards, which is not necessarily the objective of the model proposed.

I was thinking of a means for modelling market interactions at a microscopic level. Traditional models do so macroscopically.

Besides, Business Games have been employed for a great many years to teach people the arcane practices of the business world. Putting them into a model and enlarging the participation (i.e., the kinds of participants, not just purveyors but consumers), might produce some interesting results.

Methinks.