Acemoglu: The Models are Broken

Simon Johnson summarizes an essay by Daron Acemoglu discussing lessons to be learned from the "crisis of 2008":

Causes: Economics, by Simon Johnson: We ... should listen when a leading expert on a large set of influential models says (1) they are broken, and (2) this helped cause the crisis and - unless fixed - will lead to further instability down the road.

This is an important part of what my colleague, Daron Acemoglu, is saying in a new essay, “The Crisis of 2008: Structural Lessons for and from Economics.” ... To me there are three major points in his essay.

1. The seeds of the crisis were sown in the Great Moderation... Everyone who patted themselves or others on the back during that time was really missing the point... The same interconnections that reduced the effects of small shocks created vulnerability to massive system-wide domino effects. No one saw this clearly.

2. The predominant view was that the US and other relatively rich countries had pretty good institutions ... and that these institutions would prevent powerful people from the kind of abuse that endanger social systems in many parts of the world... That view was incorrect. (Speaking personally, I had no illusions about the power of the strongest on Wall Street - particularly after my experience on the SEC’s Advisory Committee on Market Information in 2000-2001. But I didn’t have the right mental model of how this power aggregated up, i.e., the way in which these people, and the firms they controlled, had created or recreated a deeply unstable system.)

3. The way we think about reputation, including how it is acquired and maintained, is way off base... You walk into a grocery store with a mental model that is based on the premise that the individuals all through the production chain operate in a control structure designed to build brands and make you think their products are healthy and tasty. Such reputations are costly to build and not readily squandered. But, Daron points out, this is too simple. In particular, we should no longer make the mistake of saying “the company” wants this or that. There are no companies in any kind of behavioral sense. There are people, struggling to get ahead, and it is their interactions that can lead - particularly in finance - to products that are really terrible for you and your neighbors (and even quite bad for themselves).

Daron also urges that we not lose track of longer term economic growth issues... If the bailout process ... slows down or even freezes the reallocation of resources out of the financial sector, we have a problem. We need to move, at least somewhat, out of a bloated financial sector and back into the kind of nonfinancial technology-developing sectors that have primarily driven growth in the US since the 1840s.

This is not an argument against a comprehensive stimulus package. But it recognizes the legitimacy of any backlash both against the models that brought us here and many of the sweet deals for leading financial figures...  Beginning with designing, arguing about, and implementing the stimulus, we need to think more clearly about the economics and politics of how we rebuild the financial system. If we recreate something fundamentally unfair and unstable, that will also undermine growth.

Comments

[Lee A. Arnold]

Great essay by Acemoglu.

[reason]

But for that to happen we need massive currency reallignment (otherwise those real sectors will have no customers). And given that some foreigners are doing all they can to stop that happening, I think we need sort of international financial redesign. Why isn't this on the table?

[Gegner]

Everyone latches on to their own little piece, so here's mine:

The 'nothing new under the sun conundrum' which is at the crux of the current 'market saturation' crisis.

We can split atoms but we still don't know what gravity, light or electricity is...and nobody is looking very hard to find out.

Because the focus of research has turned inward.

Is this the product of puritan interests? Has science stopped seeking to learn nature's secrets because the price of 'playing god' has proven too costly?

Humanity was on a real tear there for fifty years then all of a sudden research came to a screeching halt.

There is much to be gained by cracking the three mysteries noted above...but the will to go there is, um, lacking.

Cracking the secrets of gravity alone holds the promise of revolutionizing society but there have been no 'breakthroughs' for over fifty years and we can only wonder why?

Is it lack of curiosity or lack of funding?

At what point does an existing industry's profitability stand in the way of progress?

[reason]

Gegner
huh? Since when has science been trying to understand the nature of things (rather than things consistent behaviour)? And why do you think that the nature of such things is understandable? There is no guarantee that our brains can understand more than analogies to what they are programmed to perceive.

[reason]

Not that I am against science - far from it. Or that I think there aren't massive problems with how it is financed. But I read the Scientific American regularly, and I think it is far too concerned with sky in the pie speculation about the universe, rather than the sort of bit by bit marginal progression that makes the most difference to people.

[calmo]

What a wunderlust you are Gegner...if I were your wife, I'd strap you down to the bed at night and lock the windows. That's the latchin I'd do:Everyone latches on to their own little piece, so here's mine: And then I'd torment you with this:Cracking the secrets of gravity alone?.... hold[ing] the promise of revolutionizing society [again after they nearly stoned you to death last time?!!] but there have been no 'breakthroughs' for over fifty years and we can only wonder why? [thank me for constantly strappin you down.]

[Beezer]

Wall Street will play a significantly smaller role going forward. First, Obama will strap them all down and restore regulations that weren't broke to begin with. Politically and practically a no-brainer.

And finance is going to be dominated by govt/taxes etc. This will spur a lot of research because a decent chunk of this funding will involve energy research, etc. etc. We're talking stimulative spending in the multiple trillions over the next four years.

With some luck, a little serendipity, there will be some important research breakthroughs. But who knows what they'll be, you can't stop working with what you have in order to wait for science to bail your behind out. That thinking means you'll never move.

[Robert Bell]

"In particular, we should no longer make the mistake of saying “the company” wants this or that."

Surely no one who has read "Barbarians at the Gate" would have this view. A more interesting question is whether there are useful models with interesting predictions that posit employees (including CEO's) as predators, shareholders as paying for protection (i.e. corporate governance institutions)

Perhaps one of your readers knows!

[paine]

worth reading

imagine bruce w as a growth gnome

[paine]

robert bell

i prefer to see the mass of innocent stockholders as unsecure first in last out creditors
with no pre determined stream of coupon payments
or point(s) of big p pay back

[paine]

"international financial redesign"

might as well pray for world peace while we're at it

you'd think total system failure creates opportunity
for real change at the foundational level ....

in this light
the example of the early 30's is not encouraging to review

[paine]

"Wall Street will play a significantly smaller role going forward"

ah
the stuff dreams are made of ....
i submit :
if you turn over the obama recovery plan
its labeled
" made on the left side of wall street "

[ken melvin]

No Moses here, the man, still in the box peeking out a pin hole, has but a mere glimmer of the problem. Same w/ Obama. Neither he nor his cadre have a clue what is really go on. He needs to get the Krugmans, Wrays, Hudsons, Bakers, Stiglitzs, Roubinis, the Indian fellow, ... all in a room together until they come up with the answer. We need futurists not historians.

[Noni Mausa]

I just heard a pundit yesterday (in Canada) declaring we would know the economy was recovering when we saw the stock market recovering. I am tired of this sort of thinking. The fellow in question is a business commenter, and his views are so predictable that he must find writing his pieces a snap.

Since 1980 we have seen the decoupling of the health of the "economy" from the prosperity of the great majority of the people. The recovery of the economy in this sense cannot be trusted to also benefit them. Our latest unemployment stats show another shift from full time to part time positions.Deepening economic gloom cost Canada 34,400 jobs last month –12,200 more than economists had been forecasting – with the big hit coming to full-time positions, especially in construction, Statistics Canada said Friday.

[...]

In December, the creation of 36,200 part-time jobs mitigated the carnage in the full-time classification, where 70,700 jobs were cut.Personally I look to the signs of recovery to include things like people not sleeping on each other's sofas or in their basements, and haunting the library's newspaper room checking the classifieds.

[ken melvin]

Dean Baker noted that the lowered stock market meant that the rich were skimming less.

[Panic in the Streets]

"Such reputations are costly to build and not readily squandered."

In most sectors, companies with longevity carefully nurture good reputations with the public, because companies with bad reputations go out of business. Over time, this selection process leaves mostly only companies that treat the public with respect. In the financial sector, companies with bad reputations are bailed out. They can treat the public with total disrespect, and get away with it. Over time, this leads to a financial sector with many companies that wantonly fleece the public, mixed in with a few that treat others honorably.

[mrrunangun]

The great insight of this essay is its observation that the powerful individuals in Wall Street were unsupervised and behaved in reckless but self aggrandizing ways and in so doing were left free to jeopardize the public. The government is now easily suborned by big political contributors such as Wall Street titans. It is obvious that large political contributions have the largest ROI of any business expense, at least to those who can afford them. They bring rents protected by law and/or freedom from effective legal oversight, depending on what is desired. This feature of American political economy has permitted the financial and legal professions to grow from a small fraction of the economy whose functions were lending efficiency to the economic system into the enormous parasites on it that we see today.

[ken melvin]

Don't know the ROI for the Bush Admin. Was about 1,000 to 1 for Ronnie, i.e, a local developer gave Meese $50K and got $50M fed funding for a road.

[roger]

Mark - another interesting article about the models being broken is in the Economix blog at the NYT this morning by Uwe Reinhart:

Fewer than a dozen prominent economists saw this economic train wreck coming — and the Federal Reserve chairman, Ben Bernanke, an economist famous for his academic research on the Great Depression, was notably not among them. Alas, for the real world, the few who did warn us about the train wreck got no more respect from the rest of their colleagues or from decision-makers in business and government than prophets usually do.

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 made popularized by the social psychologist Irving L. Janis. In his book “Groupthink” (1972), the latter had theorized that most people, even professionals whose career ostensibly thrives 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.”

He goes on like that for quite a bit, ending with this graf:

"And thus the economics profession slept comfortably as Wall Street was imploding. One can only hope that the medical profession would do better, should America ever be struck by a serious epidemic."

This sounds about right. A poetic schema in which the Government is inexplicably assigned the role of the devil has come all undone. Almost as if the Great Moderation were a fraud.

[roger]

Oops - Quote marks at "Fewer...

[kthomas]

I'll bet Bernanke DID know this was going to happen. It was in his own best interest to pretend not to.

Besides, the bankruptcy laws were changed early in the Bush admin. ALOT of people knwe this was going to happen. They're just lying when they repeat the line "nobody could have known". The next politician or gov employee that says that should be tarred and feathered.

[roger]

I do think that one vocabulary change would immensely improve the economic business. I'd propose calling "models" poems - since, after all, they are "poems". This would clear off the pseudo-scientific cobwebs that impede thought in this area. Thus, for instance, rephrasing Daron Acemoglu's question as: why have the poems failed - would give us a sense that we are dealing with art and religion, here.

[don]

If Paulson had any integrity at all, he would return a big part of the funds being held in his blind trust and a good many financial executives should do the same with prior year bonuses, following the recent example of some European fianacial execs.

[Alex Tolley]

Nice essay, but I wonder why the the economics profession is so apparently blind to the lessons history. It's not like economists don't know history, and there are plenty of economists who have written aspects about this e.g. Kindleberger. Pick almost any mania,panic or even collapse (Diamond) and the text is ripe with commentary on self interested individuals and groups. Is history seen less as a model and more as light relief [we're too sophisticated for those problems today]. Is it that history and social systems are so quishy that it is difficult to model? Axelrod's models on social systems seems to indicate that at least broad outlines are tractable, so it can't be that.

I would have thought that the rich historical precedents would be fertile ground for economic study, but apparently this is not the case if I understand the original Acemoglu essay correctly.

[Eric Dewey, Portland, Oregon]

Mark, thanks for posting this - great stuff. Very helpful to us non-economists trying to understand more about the dismal science...

[Eric Dewey, Portland, Oregon]

One point from Acemoglu's article that needs to be imprinted on the brains of economists and policymakers:

"The risk that the belief in the capitalist system may collapse should not be dismissed...A backlash is inevitable. The question is how to contain it...It is one thing for the population at large to think that markets do not work as well as the pundits promised. It is an entirely different level of disillusionment for them to think that markets are just an excuse for the rich and powerful to fill their pockets at the expense of the rest. But how could they think otherwise when the bailouts have been designed by bankers to help bankers and to minimize damage on those responsible for the debacle in the first place?"

It's clear from the tactics used by the Republican right-wing in the past several elections that if the Obama administration fails to bring us out of this mess, they will not hesitate to use any means necessary to regain power. Further, based on the failure of the Republican party in power from 2000-2006 to control deficit spending, it's reasonably clear that economic rationality is no longer the driving force behind their politics.

It seems entirely possible IMHO that 35-45% of the American people would have willingly elected a totalitarian protectionist right-wing government in 2008 for the same reasons that the German people did in 1933.

It's no longer a huge swing for that group to get over 50%.

Those who would not wish to see this happen need to get their brains wrapped around this possibility, and to use their hearts to find a way to avoid it.

[calmo]

I share that view of Bernanke, kt, [somewhat like this] I'll bet Bernanke DID know this was going to happen. [But] It was in his own best interest[job description, primarily prescribed by his predecessor's performance] to pretend not to.
Anso...to tie it to this Daron Acemoglu article, (one of the most intelligent things I've read in awhile), this "Alexander the Great" problem of "pretty good (nearly heister-free...until recently) institutions" and in particular, this bit that reminded me of Kashkari, the chump before the Senate Committee: we should no longer make the mistake of saying “the company” wants this or that. There are no companies in any kind of behavioral sense. There are people, struggling to get ahead, and it is their interactions that can lead - particularly in finance - to products that are really terrible for you and your neighbors (and even quite bad for themselves).
Coming dangerously close to condemning the legal fiction that companies are (that allows for real persons to misbehave with impunity)...but that (ideological item) is not the main item on my plate of "off" beans.
No, it is about the trust in that brand of beans which was not established over-night, no matter how good they tasted the first few times. If there were a history of any incidence of bad beans, you would have switched brands or even gone off beans altogether...and has there been a history of poor oversight in the bean factory over these past 8 years? So bad that rancid cans and whole batches have not been reported it turns out...explaining the instantaneous nature of the failure rather than the gradual deterioration...more amenable to maintenance and repair.

[mrrunangun]

By the way, I read this week that $20 bbbbillion in bonuses were distributed by the investment banking houses at the end of 2008 to their deserving employees. Here's a big THANK YOU MR AND MRS AMERICAN TAXPAYER on behalf of the people who got us into this mess. Couldn't have done it without the TARP because the IBs would be bust by now without it. Lack of expressions of outrage in the mainstream press on this one is queer. Maybe NYT reporters don't want to emparrass their friends and neighbors. Bernie Madoff disappeared $50 bbbillion and they're all over him. IBs disappeared hundreds of $bbillions and millions of jobs and the taxpayers cough up without a squeak.

[Meh]

roger - I'd add that realistically the economics profession is not a particularly free system. Peer review in non-experimental subjects easily turns into a mechanism for censoring alternate views...

[mrrunangun]

Without a squeak from their tribunes in the press, that is. And the NYT wonders why it lacks popular support.

[jult52]

Daron writes: "3. The way we think about reputation, including how it is acquired and maintained, is way off base... You walk into a grocery store with a mental model that is based on the premise that the individuals all through the production chain operate in a control structure designed to build brands and make you think their products are healthy and tasty. Such reputations are costly to build and not readily squandered."

There hasn't been a rash of nonfinancial companies shredding their product and image for individual gain during this crisis. He is muddling the differences between the roles and performance of financial services firms and nonfinancial ones.

A serious weakness in his rethink. The two other conclusions are obvious and have been touted in newspapers and blogs across the land for a while now.

[Mezzanine]

Can anyone tell me why the left have almost a religious zeal about "stimulus package" that only props up the current bloated mess? If you want to fix the situation, you don't keep feeding the drug addict more drugs. Eventually he overdoses and dies. This is common sense thinking, but in short supply here.

[ken melvin]

The nation's economy seems too often confused with the personal, financial, or business model.

[Adam]

Simon's rewrite of Daron seems a lot more on point than Daron's original essay. Daron central point is that deregulation got us into this mess, "In our obliviousness to the importance of market-supporting institutions we were in sync with policymakers. They were lured by ideological notions derived from Ayn Rand novels rather than economic theory." What, Ayn Rand? I don't think Ayn would have advocated the Community Reinvestment Act, Fannie and Freddie, fiat Fed money, or special tax breaks on homes. Nobel prize winning theory also played a key role--It was the economic theory of options and financial insurance that led to the creation and breakdown of the derivatives markets.

No, Daron is way off the mark. It was bad economic theory, bad legislation, bad regulation, and the moral hazards engendered by the latter that lead to the housing and derivatives bubbles. As economists, we need to read more of Smith, von Mises, Hayek, and, yes, even Ayn Rand to mend our minds. Men of system, such as Daron appears to be, will only lead us down the primrose path to error, poverty and serfdom.

Best,

Adam

[gordon]

Other commenters have gotten in first with most of this, but maybe there is a little bit new here...

Acemoglu: “…No one saw this clearly…”

The idea of the unpredictability of the financial crisis is widespread, despite various people saying (rightly) that they themselves (like Prof. Rosser) or others predicted it. Acemoglu’s reiteration of this belief reminds me of this piece in the WSJ’s Real Time Economics blog (from a reference by Prof. Krugman in his blog). At the 2005 Federal Reserve conference Raghuram Rajan presented a paper on the risks involved in securitisation. This presentation was apparently widely condemned at the conference. In the paper, Rajan made the following remarks:

"Both behaviours [taking severe but low-probability risks and engaging in herd behaviour] can reinforce each other during an asset price boom, when investment managers are willing to bear the low-probability tail risk that asset prices will revert to fundamentals abruptly, and the knowledge that many of their peers are herding on this risk gives them comfort that they will not underperform significantly if boom turns to bust".

This condemnation at a high-profile conference involving leading economists indicates that Rajan’s analysis can be applied not only to the financial world but also to the behaviour of economists themselves. As a group, economists are prepared to “go along” with an unstable and high-risk situation so long as they see other economists doing the same.

Parallelism between the behaviour of investment managers and economists in these behaviours leads one to ask about possible parallels betweeen the behaviours of investment managers and economists when the eventual bust arrives. We have seen that investment managers demand bail-outs. What do economists do? They insist (in the face of evidence to the contrary) that the bust was unpredictable.

So now we see the origin of the “unpredictable crisis” myth. It is the economists’ version of a bail-out.

[All Mi T]

sec and wall street just revolving doors