Monday, September 14, 2009

Pandering parading as analysis

Economist John Cochrane has been taking on himself to speak up for mainstream economics against various reactions to the global financial crisis and consequent recession as can be seen from various papers and contributions. Notable among these is his paper on fiscal stimulus. In a recent paper, he critiques Paul Krugman's piece on what went wrong with (macro)economics in the NYT.

Krugman-the-columnist is a notoriously partisan pundit, as can be seen from his partisanship rankings from 2002 and 2003, having been the most partisan-Democrat top commentator from 2002 to 2005, though he has dropped back in recent times due to being underwhelmed by Barack Obama. But Paul Krugman is also a prominent economist: Nobel Laureate indeed. So, if he is writing about economics-as-such in a newspaper is he being serious economist or partisan pundit?

Cochrane's answer is clearly the latter:
Most of all, it’s sad. ... It’s a disservice to New York Times readers. They depend on Krugman to read real academic literature and digest it, and they get this attack instead. And it’s ineffective. Any astute reader knows that personal attacks and innuendo mean the author has run out of ideas.
In part, what Cochrane does in his response to Krugman is explain and defend what economists have developed, particularly the efficient market hypothesis.

The efficient market hypothesis is very easily misconstrued. In particular, that it is some sort of claim that markets are perfect, which is nonsense. No human institution can be perfect, because no human institution can have all desirable qualities. In Cochrane's words:
There is nothing about “efficiency” that promises “stability.” “Stable” growth would in fact be a major violation of efficiency.
All the efficient market hypothesis (EMH) says is that markets use all available information. Which does not sound like much until one works through the implications. One of which is, as William Easterly states, economists correctly predicted that they could not correctly predict.
In Cochrane's words:
It’s fun to say we didn’t see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is huff and puff about his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer.
Given that there are a lot of predictors out there, it is always possible to find someone who apparently got it right. The trick is then to go back and check what their general success in prediction is. The EMH does not bar someone doing better than the market on any given occasion, or even several occasions: just doing it persistently and reliably as other than chance (unless they have information persistently not available to other participants, such as this study of US Senator's share holdings doing unusually well [pdf], remembering that such people's actions also transmit information to the market).

On the stability point:
It is true and very well documented that asset prices move more than reasonable expectations of future cashflows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is lower in bad economic times. As Gene Fama pointed out in 1970, these are observationally equivalent explanations. ... Crying “bubble” is empty unless you have an operational procedure for identifying bubbles, distinguishing them from rationally low risk premiums, and not crying wolf too many years in a row.
I must confess, that while I take the point about identifying such things at the time, nevertheless, it seems clear enough that there is such a phenomena as asset price bubbles.

Information and the limitations thereof is crucial:
It’s the central prediction of free-market economics, as crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what “fundamental” value is. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism would have worked. ... The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse.
There is nothing about being a regulator or political decision-maker which improves matters. On the contrary:
Remember, the SEC couldn’t even find Bernie Madoff when he was handed to them on a silver platter. Think of the great job Fannie, Freddie, and Congress did in the mortgage market. Is this system going to regulate Citigroup, guide financial markets to the right price, replace the stock market, and tell our society which new products are worth investment? As David Wessel’s excellent In Fed We Trust makes perfectly clear, government regulators failed just as abysmally as private investors and economists to see the storm coming. And not from any lack of smarts.
In fact, the behavioral view gives us a new and stronger argument against regulation and control. Regulators are just as human and irrational as market participants. If bankers are, in Krugman’s words, “idiots,” then so must be the typical treasury secretary, fed chairman, and regulatory staff. They act alone or in committees, where behavioral biases are much better documented than in market settings. They are still easily captured by industries, and face politically distorted incentives.
Careful behavioralists know this, and do not quickly run from “the market got it wrong” to “the government can put it all right.”
A lot of what has been going on is wishful thinking. Of not wanting to look into the implications of congenial framings:
If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it. Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income. The analogy is even closer. Madoff didn’t just take money from his savers, he essentially borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt.
If you believe the Keynesian argument for stimulus, you don’t care how the money is spent. All this puffery about “infrastructure,” monitoring, wise investment, jobs “created” and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up.
If you believe in Keynesian stimulus, you don’t even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume.
Then there is the question of what ideas policy makers are actually using:
The sad fact is that few in Washington pay the slightest attention to modern macroeconomic research, in particular anything with a serious intertemporal dimension. Paul’s simple Keynesianism has dominated policy analysis for decades and continues to do so. From the CEA to the Fed to the OMB and CBO, everyone just adds up consumer, investment and government “demand” to forecast output and uses simple Phillips curves to think about inflation. If a failure of ideas caused bad policy, it’s a simpleminded Keynesianism that failed.
There are lots of ways our thinking can go wrong and the more abstract, or the more emotional, or both, the more ways it can go wrong. Which is why external tests and sources of rigour are so useful:
No, the problem is that we don’t have enough math. Math in economics serves to keep the logic straight, to make sure that the “then” really does follow the “if,” which it so frequently does not if you just write prose. The challenge is how hard it is to write down explicit artificial economies with these ingredients, actually solve them, in order to see what makes them tick. Frictions are just bloody hard with the mathematical tools we have now.
The problem is, it is very congenial to think you just know what other people should do. Particularly if it gives jobs, influence and power to people like you and takes such away from people not like you. Ideas which get in the way of that are deeply irritating.

It is made worse by the sheer difficulty of some of the issues, particularly monetary economics.
The power of a simple narrative, of simple framings, is not to be underestimated. Fiscal stimulus is a very simple idea. Monetary policy is much more complex to get one's head around.

That all problems in markets are "market failures" is another simple idea. That regulations and interventions have market effects is a more complex idea.

That good people believe X and bad people believe Y is another simple idea. Krugman is pandering to a lot of powerful simple ideas. Which are made even more powerful if one can pass them off as showing how clever and knowledgeable one is. I understand John Cochrane's irritation.

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