Everyone’s talking about this Paul Krugman essay on where economics, as a discipline, went wrong. Partly, “going wrong” means the failure to appreciate the risks in our financial system, and the corresponding failure to predict the crash we’re currently trying to deal with. But from an insider’s perspective, something else has happened: an uneasy consensus between two different approaches to economics has been shattered. One, which Krugman labels the “saltwater” approach, is associated (in the U.S.) with some variety of post-Keynesian analysis, generally identified with some willingness to have the government intervene in the economy over and above the Fed’s control of the money supply. The other, the “freshwater” approach favored by the Chicago School and other inland economists, is more purely free-market and non-interventionist. (Truth in advertising: I am not an economist.) These camps could more or less get along when everything was going fine, but have dramatically different reactions to a crisis. To the extent that you find freshwater economists claiming that unemployment is currently high, not because there aren’t many jobs, but because there are too many incentives for people not to work.
One of the reasons it’s a great essay is that it’s a wonderful example of popularizing science. You can debate all you like about whether economics counts as a science, but there’s little doubt that Krugman does an amazing job at explaining esoteric ideas in non-technical language, and is so smooth about it that you hardly realize difficult ideas are even being discussed. I wish I could write like that.
One part of the essay worth commenting on, or at least musing about, is the punchline. Krugman thinks that a major factor leading to the failures of economics to understand the mess we’re currently in was the temptation to think that beautiful models must be right.
As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.
Without knowing much of anything about the relevant issues, I nevertheless suspect that this moral might be a bit too pat. Sure, people can fall in love with beautiful theories, to the extent that they overestimate their relationship to reality. But it seems likely to me that the correct way of understanding all this, once it’s properly understood, will look pretty beautiful as well. General relativity is widely held up as an example of a beautiful theory — and it is, when understood in its own language. But if you put the prediction of GR in the Solar System into the language of pre-existing Newtonian physics (which you could certainly do), it would look ugly and ad hoc. Likewise, Newton’s theory itself is quite elegant, when phrased in the language of potentials on a fixed spacetime background; but if you express the theory in terms of differential geometry (which you could certainly do), it looks like a mess. Sometimes the beauty/ugly distinction between theoretical conceptions is more a matter of how well we understand them, and less about their intrinsic qualities.
So my counter-hypothesis would be that it wasn’t beauty that was the problem, it was complacency. If you have a model that is beautiful and works well enough, you’re tempted to take pride in it rather than pushing it to extremes and looking for problems. I suspect that there is a very beautiful theory of economics out there waiting to be developed, one that understands perfectly well that individuals aren’t rational and markets aren’t perfect. One that has even more impressive-looking equations than the current favored models! Beauty isn’t always a cop-out.
way too much playing with words is killing the internet! Hey! There are better things we can all do!
While I am a firm believer in beauty in mathematics, I feel that it is not the answer, or the theory that requires beauty, but the questions. Are the questions you can answer simple, elegant, and deep? Are they new ideas, or rehashing the same material answered in other theories, just recast in new mathematics?
Beauty in mathematics and physics can get us far, but it is not the ultimate decider of truth. Experiment is.
Did Krugman predict it ? Or is ne ‘not even wrong’ .
They do not even pay attention to common sense – as in
all those advertisements on TV for big loans, regardless
of whether you are in jail, are broke, etc. Multiply that
by millions and you have a trillion dollar problem.
In “Where Mathematics Comes From” Lakoff takes on the “romantic myth” of mathematics to demolish the platonic assertion that numbers are external and real that underlies the notion articulated by Keats that beauty iff truth. Krugman’s “romance with the idealized market” comment echoes Lakoff . Supporting a beautiful concept with math makes it true in the Platonic world.
Chemicalscum’s point that economics reflects ideology make a good deal of sense if you assume that any mathematical model derives from concepts in embodied brains. Math as the invariable, rigorous “exists in the universe” truth reflects pretty well on the economic conceptualization. However, If both have conceptual foundations the harder work of establishing the mappings needs to be done. Unfortunately doing this work may expose the ideology and/or outright flim-flam.
Physicists, string theorists among others, seem to get Lakoff’s point. It’s hard to find someone knowledgeable who claims string theory is true, or even representative of reality. It might be. Conceptualizing the idea by following the beauty of the math or adding new conceptualizations to existing ones move the project forward. But saying it mathematically or scientifically doesn’t make it true.
It’s worth noting that some mathematicians and economists are far from the only or worst caught in the platonic romance. Consider the sad case of literal biblical creationists who embrace the romance so completely that to deny that their beliefs are scientific (begotten not made son of math?) is to deny them personally.
I disagree with Krugman (as usual). The freshwater economists had a lot of impressive data and empirical agreement with models in the 70s and 80s. This is why it became such a huge fad in the biz and absolutely not vacuous (incorporating game theory and other beautiful mathematics). Meanwhile it was the post Keynsian models that seemed incompatible with data at the time (and were subsequently tweaked).
People who disagree with the efficient market scenario have a huge burden of proof on them, it makes after all, explicit predictions. Assume that it wasn’t the case, then you could in principle gather sufficient information to consistently beat the market. Do you think there is a behavioral crisis in the market? Fine, then put your money down, short the stocks (or whatever market you choose) when it becomes appropriate in your model and proceed to make millions.
Alas, no one has consistently had a model that does this longer than some standard deviation or two, and all have failed abysmally over say 20 year intervals, even mutual funds seem to underperform say generic indices over time. So while no one actually takes the assumptions too literally (its more like imperfect markets with inpenetrable fog), its sort of like a thermodynamic limit which is a surprisingly good approximation to reality in many cases.
Sean said:
Complacency on whose part?
If seen from certain perspective, capitalistic approaches might deem necessity of action as if “revenues were to be affected,” while from an electoral position, people might think and wonder who is supporting governmental infrastructure?
This then might filter down to who and what is necessary for economic purpose(dynamics) in order to sustain, and then evocatively it had always been an ole thinking machine who thought to say this form of economics has always been beautiful, while in essence, not much had changed over the many years since the thirties.
Steve Hsu had some reporting to this end.
Best,
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Haelfix wrote: “The freshwater economists had a lot of impressive data and empirical agreement with models in the 70s and 80s. ”
Krugman’s answer to that point would seem to be: “To be fair, finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive. But this evidence was of an oddly limited form. Finance economists rarely asked the seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings. Instead, they asked only whether asset prices made sense given other asset prices. Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient.”
Any physicist can see the fallacy in this argument by Haelfix:
“People who disagree with the efficient market scenario have a huge burden of proof on them, it makes after all, explicit predictions. Assume that it wasn’t the case, then you could in principle gather sufficient information to consistently beat the market.”
No, the market just has to be sufficiently chaotic for no amount of information to be sufficient to be able to consistently beat it.
I think Haeflix is confusing the various forms of the efficient market hypothesis. I guess the weak form has problems, but the strong form seems unsupportable.
What made Newtonian physics work so well was that it idealized the physical processes – frictionless surfaces, perfectly elastic collisions, etc. ; it separated the pristine ideal from the messy real. In some situations, like celestial mechanics, the ideal dominates over the messy; conversely, for most Earthbound purposes it is the messy that dominates. So when it comes time to translate the theoretical into the practical that messy real part has to be considered – that is the realm of engineering. The tack most often used is to figure out a way to reduce the impact of the messy part and make whatever you are doing operate as close to the ideal as you can, hence ball bearings and lubrication.
For economics systems there is much much more messy parts than ideal parts – and while there are lots of Economic Theorists out there, there seems to be a dearth of economic engineers. (The current economy could certainly use a Scotty about now.)
Jdhuey,
I cannot disagree with you. However, there are macroeconomic constraints which hold to the last penny. Very powerful conclusions can be made from these identities. The identity is
G – T = S – I + M -X
comprising the Government Spending, Taxes, Saving, Investment. iMports and eXports. It says if imports are much higher than exports, and if the LHS is small then private net saving (S-I) will be less or negative. Economists simply do not understand this accounting identity.
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Relativity is among the worst possible available examples for an idealized mature science. It’s probably the last great scientific discovery which will ever be built largely from reasoning from first principles (with numerous experimental clues, but still). It’s beautiful and elegant because it can be. Very little contemporary science has this luxury.
A better example would be that other profoundly successful modern physical theory, the Standard Model of particle physics. It’s not beautiful or elegant. But it’s both mature and true.
It’s important to understand that there’s a good reason why physics and math are the most mature and most successful sciences: they’re easy. That’s the low-hanging fruit. The natural phenomena that we restrict to the domain of the science we call “physics” are—as natural phenomena go—uncluttered, simple, and easy to abstract because they are already close to abstraction, anyway.
That said, the last hundred years have seen the development of analytical techniques and tools which have allowed complex systems to be studied usefully in abstraction—the rise of the science of statistics is certainly the best example of this.
And so, yes, it’s both possible and likely that certain characteristics of economies will be described by beautiful and elegant theories. But not reductively so, which is what the comparison to relativity brings to mind and is certainly the quixotic hope of certain varieties of economists. Economists would be doing better to emulate biologists than physicists. They’ll learn this sooner or later.
Arun, thats sort of the point. The EMH was originally stated as a sort of random walk model. That doesnt say that share prices are not wrong or always in equilibrium, only that no participant can actually systematically pick out the innefficiences and profit from them on average.. eg, no information exists in the historical record, behavior of humans or accumulated time series such that you could price them better (read the only extra information is inherently chaotic). The recent stock crash is a perfect example of this. You had a lot of computer analysis that had been consistently beating the market for about a decade, only to have their gains completely wiped out in one downswing.
In order to beat the *weak* form of the EMH (which is what most people consider close to being valid), you have to outperform an index with some deterministic model over a long timeframe.
No one has yet to accomplish that, despite tens of thousands of attempts.
People have tried to model the market as small pertubations away from the ideal, with varying innefficiences persisting longer than relaxation time scales. Others have tried to put in the ‘animal spirits’ by hand, so we are talking about a market that is subject to *momentum* according to some behavioral finance model, business cycle or boom/bust period. Also failed to beat the market. And so on and so forth.
The present state of economics can be compared to the three body problem. While this presented a difficulty in classical physics, physicists did not sweep it under the rug but pursued it, in spite of the difficulties. On the other hand, economic models typically rely on ceteris paribus, even though keeping all things equal in a dynamic system is not possible. This is like solving for two bodies “with anomalies to be ignored for the purpose of simplification.” As Ramanan observes, until economists shift from easily to handle stocks to difficult to model flows, economics will remain in its infancy. In other fields this has been the transition from emphasizing structure to focusing on function. For example, in biology and medicine, the body is not very well modeled as a machine. A living organism is more than the sum of its parts and their relative positions. Treating a person is not like fixing a car.
Of course behavior is messy, but one doesn’t get around this by pretending it is not. Cognitive and behavioral scientists are working on this, and there are maths that are applicable. Interesting research reveals that cities resemble brains in communications flow. Markets likely do, too, since brains generate them. As we learn more about how human beings operate neurologically, we are likely to be able to model economic conditions better than we are doing now — and having to pay for.
As George Lakoff has observed, most are still captured by the 18th century idea of disembodied reason and are thereby misled by a concept that cognitive science has disproved. Unless we update out thinking, we are going to be biased by reinforcing outdated neurological pathways that have become set through a process of miseducation.
Interesing article by Barry Eichengreen on where economics went wrong (it didn’t really, the people using it did) and where it is heading (inductive rather than deductive).
The Last Temptation of Risk
Moreover, readers of Karl Denninger’s The Market Ticker, ZeroHedge, The Baseline Scenario, and similar blogs know that a great deal if not most of the reason for the crisis (and the correspponding “crisis in economics”) has little to do with economics and everything to do with unethical and even fraudulent behavior, capture of the state by a plutocratic oligarchy, intentional mispricing of risk, and other shadow factors leading to systemic breakdown. Where there is money, there will be cheaters and crooks in suits. No amount of modeling can overcome these kinds of problems, anymore than economics can anticipate exogenous shocks.
Check this out:
A Tale Of Two Capitalisms: Research Into Homicide Rates And The Link To Political Economies
“Relativity is among the worst possible available examples for an idealized mature science. It’s probably the last great scientific discovery which will ever be built largely from reasoning from first principles”
I might not be time to, metaphorically, close the patent office quite yet. What, exactly, are first principles? The axioms of a theory seems like a good guess, like F=ma. Reasoning from them would give the exposition of that theory. What relativity did was create some new ‘first principles’ by looking at the problem in a different way.
The pattern of relativity is one that ought to repeat: given a theory, what doesn’t it cover? what doesn’t it get quite right? The big advances are in changing or extending what one might think of as first principles in some way. There seems no reason why molecular biology couldn’t produce similar effects.
Efficient markets imply no free lunch, but it does not follow that no free lunch implies efficient markets. Haelfix and numerous freshwater economists seen unable to grasp this simple logical truth.
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Beauty?
I think that too many individuals mistake beauty for insight. What makes general relativity so “beautiful” is that it leads to a deeper insight, in this case that the laws of physics are the same in every frame of reference. With this one assumption everything falls into place. This one assumption helps us to better understand all the details that fill our everyday life.
What insight has the Chicago School of economics provided? That the government is bad? In fact their simple minded view is a sickness that purveys libertarian thought. Instead of explaining all the details of our lives it simply ignores them.
Sure a simple view is easier to comprehend, and it may be beautiful (on paper), but it anything but insightful.
your model would have to deal with the fact that after some time
people learn to game the system. Then your model is worthless
for predicting anything.
GR is not beautiful. It is a perfectly ugly theory. The assumption of general equivalency is a brilliant condition to place on the universe that completely breaks down at predictable limits. That GR can provide predictions of those limits is truly remarkable, but GR itself gives us a false sense of confidence. It convinces us that we have an understanding of physics when in reality we are poking around in the dark turning little knobs that we don’t understand.
What GR tells us is that below a certain energy scale, if we make the assumption of general equivalence, we can reduce the number dials that we need to take into consideration. So while general equivalency is a brilliant assumption, the product of that assumption is a theory that does not have the power to explain much of the phenomena of the universe.
As far as I can tell, Krugman’s principal message is that we should return to the lessons of classical Keynesianism, which seems to boil down to more fiscal stimulus by the central government. (I thought that Keynes theory was originally counter-cyclical and I don’t know whatever happened to the ‘counter’ part because it seems that for the last 70 years or so government has always spent as much as it could get its hands on.)
Krugman gives a short history of macro-economic theory “From Smith to Keynes and Back”. But he leaves out an important economic school of thought that had a lot to say about business cycles, which correctly made important predictions, and which does have a rational and understandable view of economic affairs. That is the Austrian school. (Ever since reading Karl Popper I hate to advocate ‘schools’ of thought because they should be assimilated and not simply defended in a static form – but these guys haven’t been assimilated at all.)
http://en.wikipedia.org/wiki/Ludwig_von_Mises
http://en.wikipedia.org/wiki/Friedrich_Hayek
http://en.wikipedia.org/wiki/Austrian_economics
So how do these people differ from Krugman and Keynes?
For one thing they don’t much believe in classical mathematical models of the economy. They don’t think the economy is anything like classical mechanics. They claim that economies are just way too complicated to model or simulate in a classical manner. They think that economic actions spring from individual human actions (why von Mises titled his major book ‘Human Action’) and to simulate an economy you would have to essentially simulate the behavior of a large set of neurons in each person’s brain in addition to other things. Course-graining doesn’t work well.
This idea of the Austrians is also boosted by some modern ideas of computation. An interesting book on this is ‘The Lifebox, The Seashell, and the Soul: What Gnarly Computation Taught Me About Ultimate Reality, The Meaning of Life, And How To Be Happy’, by Rudy Rucker. This has quite a bit about Stephen Wolfram’s ideas. The idea is that we can view the world as a computation and sub-computations. Most of these computations are what he calls “Gnarly”. Basically, a gnarly computation is one that does not have a shortcut to the answer. With non-gnarly computations, like classical physics say, one can derive formulas that give the answers. With gnarly computations one has to go through the whole messy detail step by step. There are no shortcuts. Simulating an economy is almost certainly a gnarly computation.
There is certainly a difference between Krugman and the Austrians when it comes to markets and prices. The Austrians do not believe there is such a thing as an objective value of something that should underlie its price (such as the amount of labor that went in to make it.). Prices represent subjective values and there may even be many prices existing for the same object or service. But, more importantly, prices (including interest rates) represent information about what people are willing to do. And that is why they put a great emphasis on free markets (and freedom in general!). People cannot reasonably plan their actions without that information. On the other hand Keynes and Krugman see markets as “a casino” and “irrational” and crazy and generally they don’t see them, and the “information” they convey as much worthwhile.
(There is an old cold-war joke. An American and a Russian General are conversing. The Russian says: “When the entire world except New Zealand is Communist…” The American interrupts, “What do you mean? Why not New Zealand?” “Well, we need someplace to obtain market prices.”)
Von Mises wrote a book in the 1920’s, ‘Socialism’, in which he predicted the ultimate fall of the Communist state because they could not successfully plan an economy. Was he right or wrong? I suppose we could argue about it.
The Austrians and Krugman also differ as to the cause of business cycles. Krugman blames it on irrational markets, crazy investors, “capitalism running off the rails” and in general private people not buying enough. The Austrians put the major blame on governments, central banking and artificial credit expansions. Also, with governments interfering with market mechanisms and prices, such that prices no longer represent what people want to do or are capable of doing.
For example:
1) The central government forces low interest rates through flooding the banking system with ‘easy’ money, or allowing banks to issue more money on fewer reserves.
2) This sends the wrong information to everybody. People save less because there is less return. Entrepreneurs start more projects, especially long term projects, because it is easy to finance them.
3) But since people are not saving more, and are actually consuming more, the resources for carrying out these projects are not actually there. You have a fair amount of mal-investment and there is no way to get around this or pretend that it didn’t happen. Someone, somewhere is going to be worse off for it.
This is not quite the same as Tulip Mania in Holland during the 1600’s. That was an extremely limited thing. It was confined to one city and a small group of people. It had no chance of bringing down the whole economy. But when governments create a systemic credit bubble they also bring about the inevitable systemic reaction.
The Austrian ‘cure’ for a credit bubble is:
1) Let deflation take place. It clears the markets and provides lower prices for ordinary people, who dearly need it.
2) Let real interest rates rise. It increases real saving and generates the resources to get the economy going again.
The Krugman prescription is just the opposite. He wants to maintain the high prices that were generated during the credit expansion. He wants houses to stay at their high prices. He wants builders to continue building. He wants individuals not to save more but to continue buying houses and shopping. Falling demand is a problem and fiscal stimulus must be used to shore it up. In other words, he wants conditions at the peak of the bubble to continue. It seems to me a little bit like trying to turn back the tide or “the hair of the dog that bit you.”
The Austrians don’t like central banking. Krugman thinks the Fed has done a wonderful job. From 1790 to 1910 there were inflations and deflations but basically prices ended up about where they started. The Fed was created in 1913 and since then the dollar has lost 96% of its value. Oh, but the Fed has kept the economy on an even keel hasn’t it? Well, what about the major recession of 1920 (more about that in a bit) or the Great Depression of 1929 to 1946, or the present situation that may also be a Great Depression? It doesn’t seem like a wonderful record to me.
In 1920-21 there was a severe crash. Industrial production fell by over 20%, Unemployment was quite high. Farm prices crashed. What to do about it? Warren Harding, as a deliberate matter of informed policy and not as an oversight or through “meanness” did nothing. It was all over in a year. You never hear of the Great Depression of 1920-21. Everybody has forgotten about it.
As for the Great Depression itself there definitely was a credit expansion in the 1920’s. And I think people like Hayek warned about it. I think there are a lot of myths associated with the Great Depression. It is not true that Hoover did nothing. He did a lot of stimulus spending, started the Reconstruction Finance Corporation, and many programs that Roosevelt built on. (By the way, there was a significant market rally in 1930.) Many people say that Roosevelt got us out of the depression. I don’t see how people can say that. The economy never recovered during his lifetime. I don’t think even Krugman claims that. What Roosevelt did was get us into a major war. Krugman says that WWII got us out of the depression. I don’t agree with that either. Economic conditions, and most other things, were miserable during WWII. There were shortages and rationing. No new cars, no new refrigerators, no new nothing but armaments. We really pulled out of the depression in 1947 when Truman cut government spending by 66% and cut taxes. The Keynesians were furious! They said we would be right back in the depression if government didn’t keep up the fiscal stimulus.
It is interesting, and greatly worrisome, that during our present economic problems you hear NO SUGGESTION on the mainstream media, or from Krugman, that we might cut spending on our overseas wars or armaments programs and return it to ordinary people or use it to bolster social programs. If anything, it is just the opposite. People believe that WWII got us out of the depression, so it would seem counter-productive to cut war spending.
I don’t know for certain that Krugman is wrong and that the Austrians are correct. It is possible that there is something to economics that is very complex and counter-intuitive, and that I am just not smart enough or educated enough to understand. But barring that, I suspect that the worse is not over by a long shot. I don’t see how anything fundamental has been done to put the economy on a better track. It looks like the people who caused the problem are being rewarded and one more massive attempt to inflate the bubble is underway, with some very minor temporary success.
And there is one more thing I would like to finish up with. The very legitimacy of government is under question. In my view there is such corruption and arrogance in D.C. that you couldn’t even cut it with an ax. People ought to read some history of the French Revolution. One reason the Austrians put such importance on freedom is that people who are not free just don’t give a damn. There is a lot of justified but dangerous unrest. The political elites don’t care what people think. When the populace was 99% against the bailouts they did it anyway. If people are against all the wars they do it anyway. If people are against the infringements of civil rights they infringe anyway. You can see the anger at the “town meetings” on health care. Nobody knows what the bill will have in it and most people believe, probably rightly so, it won’t be good for them. The meetings just provide an outlet for the anger.
We need new debate on what things government can actually do. We need more consideration of limited governmental powers based on the rule of law. We need a government that obeys the law. Otherwise there are going to be pretty horrible problems.
GR looks beautiful, until it bumps against quantum theories. QCD looks beautiful, until one try to use it to figure out the simplest things, like where all mass comes from. Or where any particle comes from for that matter.
Theories can be utterly beautiful and wrong of course. It is wiser to operate that all theories have some degree of incompleteness. Because theories are created by humans.
Economic theories, the most dismal of all science, is sure to be mostly wrong. But nevertheless we have the case where in the USA, an entire finance industry, famous central banker, big time politicians, big biz CEOs, government regulators, and most esteemed gang of economists, all worshiping a single economic theory. They bet the whole farm of eggs on the darn thing and now don’t even have an omelet to enjoy.