Economics: A Million Mutinies Now
Monday, February 27, 2012
In August of 2008, Olivier Blanchard, a dean of establishment economics (now serving as chief economist at the International Monetary Fund), produced a working paper that surveyed the field of macroeconomics. He described what he saw as a stable consensus, concluding with the pronouncement, “The state of macro is good.”1
A month later, the financial crisis took a turn for the worse, the economy fell into its worst slump since the Great Depression, and economists are not so smug any more. There are now so many versions of “what's wrong with the economics profession” that, with apologies to V.S. Naipaul, I could describe the state of economics as one of a million mutinies.
What I want to do in a series of essays is provide an overview of the various factions. They are listed in the table below. For each perspective, I give a short “bumper sticker” that indicates the main thrust of their point of view.
This is not an exhaustive list, by any means. I will devote part one of this series to the conspiracy theorists and the behavioral economists, saving the rest for later articles. Also, the reader should be warned that I am in the Anti-modernist camp, which may limit my ability to provide a charitable treatment of the other factions.
Charles Ferguson is the producer of the documentary film Inside Job, in which economists are portrayed as tools of evil bankers. Although many economists were offended by what they saw as a Michael Moore-style attack, the film did serve to raise the issue of disclosing the sources of funding for research. At its most recent convention, the American Economics Association adopted a code of ethics that calls for such disclosure.
The conspiracy theorists see economists as the paid lackeys of entrenched interests. In this view, if economists were not corrupted by private funding, they would produce research that points out more clearly the flaws in markets.
In my view, the issue of private funding for economic research is a red herring. Most funding for economists comes from the government. This funding tends to support regulation. For example, some of the most lucrative work in healthcare economics has been in designing government interventions. Having said that, I do not believe that the economists undertaking this work have anything other than sincere convictions grounding their research.
The intellectual development of economists takes place in graduate school. There, we form strong opinions that are not going to be swayed by private funding sources.
I can imagine that, on a topic that is really isolated and obscure, a large share of the research could be driven by private interests. However, on topics such as financial regulation or macroeconomic policy, the overwhelming majority of economists examining the problems are expressing beliefs that are sincerely held. Disagreements about modeling strategy and empirical methods are honest and substantive.
The issue of private funding for economic research is a red herring.
Economists attempt to follow the scientific method when conducting research. Regardless of whether you consider the end product to be “science” (the anti-modernist view is skeptical), there are commonly understood standards. Two economists who conduct a study in the same way will obtain identical results, although they may disagree about interpretation.
In principle, a study's soundness relative to the scientific method is independent of the source of funding. A study funded by an interest group could, if conducted rigorously, produce results that are highly robust. Conversely, a study funded out of pure scientific curiosity could, if poorly designed, produce results that are totally unreliable.
However, it is true to some extent that different research procedures lend themselves to different results. Therefore, the scientific method does not necessarily represent a check on individual researchers' biases. However, when research is widely read, there are likely to be enough reviewers with different points of view to ensure that flawed analysis is subject to criticism. Once again, as long as a topic is widely studied, the impact of funding sources on the conclusions of most economists is likely to be minimal.
Behavioral economics is also often presented as a devastating attack on conventional economics. Behavioral economists claim that mainstream economics ignores many demonstrated instances of consistent irrationality by individuals making economic decisions.
Even though individuals and markets may behave irrationally at times, policymakers are not in a position to detect and correct the mistakes of the market.
Behavioral economics is often contrasted with the Efficient Markets Hypothesis (EMH), which concerns the information and decision-making efficiency that individuals employ when trading in asset markets (such as the stock market or the housing market). The debate is confusing, because EMH can be distorted into a straw man by those who wish to take it down uncharitably.
The straw man version of the EMH is that “markets never make mistakes in pricing financial assets.” You do not need behavioral economics to beat up this straw man.
The more robust version of the EMH is that “there is no method of predicting asset prices that can reliably outperform the market.” That version is much harder to discredit.
In October 2011, a diverse cross-section of economists was polled about these two versions of the EMH. 100 percent either strongly agreed or agreed with the robust version. None of them agreed with the straw man version.2
This is important, because the robust version of the EMH implies that even though individuals and markets may behave irrationally at times, policymakers are not in a position to detect and correct the mistakes of the market. Like everyone else, policymakers cannot reliably outperform the market.
For example, if you ask me today, I will tell you that the market valuation of long-term U.S. Treasury securities is not rational. I believe that prices should be lower and interest rates should be higher.
Behavioral economists claim that mainstream economics ignores many demonstrated instances of consistent irrationality by individuals making economic decisions.
Even if it turns out that my assessment of the bond market is correct, mine is not a reliable assessment. As of right now, it is simply a hypothesis. To base policy on my assessment would probably be unwise. Still, suppose that at some point over the next several years there is a big rise in interest rates that reduces the values of bonds held in today's portfolios. If that happens, it will be tempting for people to say, “Kling was right. Low interest rates were a bubble. Policymakers should have listened to Kling.”
In short, behavioral economics does not challenge the robust version of the Efficient Markets Hypothesis. Its proponents might try to score points by knocking down the straw man version. But in the end, it is not valid to infer that behavioral economics offers insights into financial markets that could enable regulators and policymakers to prevent bubbles or otherwise achieve dramatic improvements in market performance.
The conspiracy theorists and behavioral economists appeal to those who dislike economics. As economists, we remind people of some unpleasant truths. Such unpleasant truths are deserving of respect, even if not all economists are.
One unpleasant truth is that resources are finite. As individuals, we would each like unlimited access to medical services without having to pay for them. But economists will point out that this is not possible, and instead hard choices must be made. It would be easier to make health policy if resources were not finite, and people are understandably resentful when the consequences of finite resources are spelled out.
Another unpleasant truth is that the “intention heuristic” does not work on a large scale. The “intention heuristic” is to judge the morality of a policy by its intentions, without regard to its consequences. Instead, an economist will point out that a higher minimum wage might harm low-skilled workers, even though the intention is the opposite. It would be a lot easier to assess policy if the “intention heuristic” were reliable, and people are understandably resentful when the problems with that heuristic are exposed.
When research is widely read, there are likely to be enough reviewers with different points of view to ensure that flawed analysis is subject to criticism.
The theory that economists were corrupted by special interests is an example of the “intention heuristic.” It suggests that economics failed to prevent the financial crisis because of bad intentions on the part of economists. With better intentions we would reach a wiser consensus.
I wish to argue against the view that bad intentions were at the root of economists' positions on macroeconomics prior to the crisis. The simple conspiracy theory that implies that economics failed because of bad intentions on the part of economists or their funding sources is not the correct diagnosis of the problem. Every instance of poor ethics in economic research could be eliminated, and we still would be no closer to being able to prevent financial crises and recessions.
Instead, I believe that the earlier consensus was flawed and fragile because the analytical challenges are more difficult than mainstream economists appreciated. Issues that ten years ago were thought to be either unimportant or well understood are now open to inquiry, and disputes that were thought to be resolved have resurfaced. These will be explored in later columns in this series.
Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He writes for EconLog.
FURTHER READING: Kling also writes “The Case for an Executive Re-Organization,” “The Political Implications of Ignoring Our Own Ignorance,” and “What If Middle-Class Jobs Disappear?” Michael Auslin offers “Wanted: A User's Manual for Capitalism.” John H. Makin asks “Why Are Interest Rates Presently so Low?” Stephen D. Oliner explains “Why a Little Fed Transparency Could be Dangerous.”
1. Olivier J. Blanchard, “The State of Macro,” MIT Department of Economics Working Paper No. 08-12.
2. See the Initiative on Global Markets Experts Panel.
Image by Rob Green / Bergman Group