Monday, September 7, 2009

Did Krugman Get it Right on How the Economists Got it Wrong?

Since this is about economics, the answer has to be “Yes and No”, and in fact it is.

I won’t rehash his points; if you haven’t already read his essay you should right now. But here’s what I think:

Krugman Gets it Right

Economists are much too enamored of elegance in their models. The shortest path to elegance turns out to be a pernicious set of assumptions—that the economy can be represented entirely as a nexus of instantaneous exchanges, that the people and organizations who make these exchanges have a single goal that they maximize with unfailing precision, that all decisions are made in perfect isolation from one another and are not subject to social dynamics, and that all functions (production, utility) in the economy are as well-behaved as North Korean schoolchildren at a patriotic pageant. Drop those assumptions and the math gets messy—and probably unpublishable.

There are authoritarian dynamics within the economics profession itself. The nice concept of rival theories competing with evidence and arguments doesn’t apply; debates are settled with coercion and ridicule.

Somehow finance disappeared from macroeconomics. The instability of financial institutions and other credit intermediaries was shunted off the table and out of sight. You can read macro textbooks from the principles level on up to grad school and see nary a mention of balance sheets in any context other than money multipliers. This takes its most extreme form in Miller-Modigliani (firms) and Ricardian Equivalence (government): debt or equity, borrow or tax, it’s all the same. And it is all the same if balance sheets don’t matter.

Krugman Gets it Wrong

The zero lower bound for interest rates in a financial crisis is a red herring. Real interest rates can easily go negative, and have repeatedly, if inflation can be stoked by monetary authorities. The deeper problem has to do with default risk, as Stiglitz showed in his Nobel-worthy work on credit markets. In fact, bringing default back into economic modeling is the point behind reintroducing balance sheet analysis.

At a general level, however, I think Krugman missed the key piece of the story: economics does not respect the most important criterion that separates science from non-science, the drive to minimize Type I error (false positives). Neither in modeling nor in econometrics do economists ever ask, what would constitute a critical test of my hypothesis—a result that would hold only if my hypothesis were true? Instead, a much lower standard is commonplace: what result would be consistent with my hypothesis? This loose standard has allowed absurd, readily falsifiable propositions to dominate economic thinking and classroom instruction for decades. Worse, being caught in a Type I error has no apparent career consequences for economists. Can you think of a “cold fusion” episode in economics that ended with researchers being disgraced and humiliated?

Not even a global financial crisis can have this effect.

25 comments:

  1. Krugman: "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. . .

    I guess that anyone who attempts to describe the failings of economics in these terms is likely to be regarded as a spin doctor.

    I'm sure that hegemonic powers desperately want the public to believe that the crisis was one of 'the market'. Because if they observed the reality:

    -- of oil and geopolitical wars, coups etc sponsored by empire;

    -- the public being largely disbarred from bidding for even a small part of their country's natural resources;

    -- the World Bank pushing more and more loans to many dozens of insolvent nations;

    -- the immense concentration in the ownership of productive wealth around the globe.

    Well, if they saw the awful spectre of Government-corporate power exerting itself mafia-like across the world they might move away from their TV sets and start to engage in politics. Then again, they might not....not until a major catastrophe lands in their lap.

    For those exasperated lone voices, the wait won't be long.

    In the meantime, Krugman would be wise to put his spin talents toward the promotion of sustainable energy. Then, at least, his children may have a future.

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  2. You sound like Nassim Taleb on economics as cargo cult science. But I agree with you that Paul got it wrong on this one.

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  3. http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip.html

    Above, in all it beauty, is the crux of Mr. Krugman's fallacy: that there is only one application of Keynes insights into the economy.

    Although Paul fails to accurately portray history and needlessly reduces Schumpeter to a flat earther, his real mistake is to direct progressive economics into a cul-de-sac: dependence on government induced financial manipulation in the guise of stimulating employment.

    The Washington-Wall Street faction of the field of economics will safely ignore you when your ideas are inconvenient, and exploit your ideas when it fattens the purses of investment banks.

    As in the thoroughly sterile debate over the "public option" in health care reform, dependence on one interpretation of Keynes theory is marginalizing you once again.

    You can only fix this among yourselves.

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  4. Note that an important reason that most economists do not try to "minimize Type I errors" is that so few economists see their job as providing cause and effect explanations of what is actually going on in the economy.

    They are, in simple terms, not doing science, so its not surprising that they fail to act as scientists do.

    After all, no field in which "this is/isn't science" was the first cut filter for publication would see the publication of rational addiction theory.

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  5. This is a comment I made at an earlier post of Brenda:

    "Shag from Brookline said...

    Krugman's article in the NYTimes Magazine yesterday (9/6/09) was submitted for publication perhaps over a week ago. Consider the lead front page article in the Sunday NYTimes with which the Magazine was included:

    "New Exotic Investments Emerging on Wall Street - Packaging Life Insurance Policies, Despite Fallout From Mortgage Crisis" (by Jenny Anderson)

    and how it fits in with Krugman's article. Is this an example of creative destructionism? Is there any securitization after death?

    September 7, 2009 6:50 AM"

    I just reread Section III. Panglossian Finance of Krugman's article with this front page article in mind. What will macroeconomists have to say about this proposed exotic financial product and will the herd of investors follow? What are the realities of finance for this product?

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  6. Other social sciences (Wissenschaften) that rely upon statistics suffer from the same problem. Standard statistical hypothesis testing does not test the hypothesis that is in question. Rather it tests a null hypothesis that, in most cases, nobody believes anyway. If the data are sufficiently inconsistent with the null hypothesis, then that is taken as support for the hypothesis in question. But, of course, the fact that the null hypothesis is "rejected" supports any hypothesis except the null. Popper is turned on his head.

    -- Min

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  7. Well, that's not quite correct. The null hypothesis in any well structured research project/experiment should be stated and examined in such a way that it is effectively the contrary to the actual hypothesis. The two must be mutually exclusive. Part of the art of experimental design is being able to develop a conclusive null hypothesis.

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  8. There was a brief discussion on Krugman's paper in response to an earlier post by Brenda Rosser.

    PK says nothing in this article false positives but earlier on his blog he has approvingly quoted from Jeff Frankel's Search for Perfect Nothingness paper:

    " It used to be that the goal in econometric work was to get results that were statistically significant, to reject the null hypothesis. In order for an author to stand up in front of a conference proudly, or to expect to publish his paper in a journal, he or she sought to get significant results. This is difficult to do in macroeconomics. The world is a complicated place; it is unlikely that the few key variables that emerge from the particular theory that one has developed will actually go far toward explaining a real-world time
    series. So what we have done -- quite cleverly -- is to redefine the rules. Now the goal is to fail to reject the null hypothesis, to get results that are statistically insignificant -- in essence, to find nothing. It is far easier to find nothing than to find something. Typically one fails to reject many hypotheses every day, even in the shower or on the way to work. "

    PK referred to Olivier Blanchard's 2008 State of Macro paper. Skimming that paper I got the impression that Blanchard was clearly unhappy with the state of contemporary macro. He (OB) was particularly critical of DSGE models and macro-economists' cavalier attitude towards evidence.

    From Blanchard's conclusion:

    "There is, however, such a thing as too much convergence. To caricature, but only slightly: A macroeconomic article today often follows strict, haiku-like, rules: It starts from a general equilibrium structure, in which individuals maximize the expected present value of utility, firms maximize their value, and markets clear. Then, it introduces a twist, be it an imperfection or the closing of a particular set
    of markets, and works out the general equilibrium implications. It then performs a numerical simulation, based on calibration, showing that the model performs well. It ends with a welfare assessment.
    Such articles can be great, and the best ones indeed are. But, more often than not, they suffer from some of the flaws I just discussed in the context of DSGEs: Introduction of an additional ingredient in a benchmark model already loaded with questionable assumptions. And little or no independent validation for the added ingredient."

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  9. The writers on this blog, which has been probably the most interesting of its type on the web, seem content to avoid the tough questions posed by Paul Krugman's article:

    1. Is it true that pre-war economists generally believed, or had faith, in the market, or did they generally believe, as Schumpeter stated, that market economies were self-destructive?

    2. Did John Maynard Keynes rely exclusively on a fiscal policy approach to the problem of unemployment, or did he call this a short run solution which must ultimately be addressed by reducing hours of work?

    3. Did Schumpeter accurately forecast an inflationary regime, and deregulation as the ultimate result of relying on Keynes short term response to the problem of unemployment, or was he wrong?

    4. Is the crisis we face at this point a failure of the market, or is it a failure of the policies put in place to avoid the allowing the market to adjust to the technological changes which have taken place in the economy?

    Focus as you will on the side-show of the DSGE model, and such nonsense, however this is the crux of the issue and you know it!

    The fact is Ohanian attempted to be wrong and succeeded, Krugman attempted to be right and failed. Can you learn more from success or failure?

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  10. Anonymouse wrote: [Krugman's] "real mistake is to direct progressive economics into a cul-de-sac: dependence on government induced financial manipulation in the guise of stimulating employment."

    Yes. Corporacracy induced economic 'recovery'. Noting the frightening dependence our societies now have on the production and sales machines of giant corporations (now largely funded by government).

    I've often felt a sense of despair as I look into so many suburban yards to see not a single food-producing plant in the great majority of them. How can anyone be so nonchalant about their total dependency on forces mostly outside of their control? To give up the power and creativity within oneself?

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  11. Anonymous states that Krugman failed to be right. ou neglected to point out that Krugman being right or wrong in regards to his opinions is solely a matter of your interpretation and ideology(theoretical inclination, if you prefer.) An opinion can't succede or fail. It can only be argued. So lets try to keep the logic straight.

    Ohanian's presentations are little more than opinions either. So while we can't say that he failed in giving his opinions, we can say whether he has presented both a factual representation of historical facts and if his measures are a true representation of his concepts (you know, good operational definitions for his measured variables). Sadly, in economics even those issues may be little more than opinions.

    In a nuit shell, welcome to philosophical trends in economics.
    Maybe we need to stop refering to all such work as science and start to differentiating between the expression of opinion (regardless of the elaborate manner of presentation) and efforts to operationally define econommic parameters and subject measures of said parameters to rigid hypothesis testing.

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  12. Jack,

    Ohanian makes his argument using a fancy model, along with some historical discussion. Both are flawed, but they are not just "his opinion."

    The biggest lacuna and flaw in the Krugman article was his complete ignoring of any heterodox input to the discussion, most egregiously, leaving out any mention of Hyman Minsky, Mr. More Relevant Than Anybody on this one. Apparently in a post on his blog, Krugman states his "regret" that he let Minsky get "squeezed out" due to space constraints, but that simply reinforces the fact that Krugman for a long time only pays attention to people sitting at the very top schools. The only person who "called it" that he even mentions is Robert Shiller, who is at Yale.

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  13. Do I detect from some of the comments that Krugman'a article is fiction? For some of us non-economists who have been closely following the financial events of the past several year, much of what Krugman has put together has been disclosed previously by not only Krugman but by several others. (I could name some of the latter, but if I fail to disclose one, perhaps a negative comment will result.) Krugman provides quotes from economists he has named. I haven't fact-checked these and don't plan to as there are too many out there that seem to dislike Krugman prepared to do so.

    But let's assume that the quotes are correct. Surely those who dislike Krugman, ideologically and otherwise, might then say that the quotes are taken out of context. But they may not make an effort to demonstrate just how the quotes are out of context. It is so easy to say that something is out of context. But it takes time and effort to demonstrate such.

    Over time, perhaps there may be detailed critiques of Krugman's article. I look forward to them - and Krugman's responses thereto. Perhaps these critics would like to blame Krugman for the financial crises that erupted during the Bush/Cheney years - or blame Bill Clinton - or Jimmy Carter - or Lydon Johnson - or Jack Kennedy - or go back to FDR.

    Perhaps these critics of Krugman challenge the title to his article and are prepared to state "How The Economists Actually Got It So Right." Maybe Anonymous (or his/her many varieties) may wish to use that title and produce a detailed response to Krugman.

    I am also a critic of Krugman regarding this article. I wonder how, if at all, he may have contributed to these financial crises and the events leading up to them. I wish he had addressed this in his article. Mea culpa, I perhaps contributed to this mess as part of the herd that enjoyed the ride I got with my securities and real estate, with the Bush tax cuts, etc. I could not understand why this was happening and how long it would last. But I enjoyed the parade and didn't wish to rain on it - apparently just like some economists did not want to.

    Even though Schiller was not alone in questioning what was happening, he was there on a monthly basis for many years demonstrating what was happening in real estate.

    As for the subprime contribution, look at the proposed financial products involving life insurance that I referenced in an earlier comment. Same old, same old. Fool me once, shame on you, fool me twice, shame on me.

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  14. Barkley,

    What is a "flawed model" if not an opinion? That opinion may be shared by others and it may be the result of the individual searching wide and deep on the subject matter. It is little more than an hypothesis that the individual has failed to support in a substantive manner. That's little more than an educated opinion. And, as I understand, from the many comments concerning Ohanian's most recetn work concerning Hoover's labor policies, he has his history a bit distorted.

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  15. Shag,

    The problem is not that the article is fiction. The real problem is that is a) old hat, and b) not really on top of what happened. His story about freshwater and saltwater is a hoary old distinction made back in the 1980s by Robert Hall. Until recently nobody had used it for some time, partly because some of the players moved to the wrong sort of water (Robert Barro to the east coast, and others).

    The other part is that since the New Keynesians essentially missed the boat, the supposedly smarter saltwater types really did not get it either. The whole discussion is at some level a waste of time.

    He should have spent more time talking about who did get it. The only one he mentioned was Shiller, with whom I have no problem, but he was the only one. There was a post here earlier by me about heterodox economists getting it. The "list of 11" who were named by Dirk Bezemer included two "mavericks with mainstream backgrounds" out of the 11. They were Shiller and Nouriel Roubini, who is at NYU, but that is probably not quite upper drawer enough for Krugman to mention him.

    Otherwise, the dead Minsky? the live Keen? the rest? No mention. Mostly all these irrelevant rambling about this leftover squabble between self-important fresh and saltwater economists, just about none of whom "got it."

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  16. RosserJB:

    At page 39 of the NYTime Magazine, Krugman states:

    "There was a telling moment in 2005, at a conference held to honor Greenspan's tenure at the Fed. One brave attendee, Raghuram Rajan (of the the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentionally dangerous levels of risk. He was mocked by almost all present - including, by the way, Larry Summers, who dismissed his warnings as 'misguided.'"

    So perhaps you can add Rajan's name to that of Schiller. I'll recheck to see if there are others to add.

    What the article raises for me, a non-economist, is a jaundiced eye with respect to professional economists going back decades. So I ask you, "How Did Economists Get It So Wrong?" Or do you think the economists got it so right? What is the defense for the economists on what happened during their watch? OOPS! is not an answer.

    Krugman was not addressing the economics profession with this article. Rather, it was addressed to the public, to understand that so-called experts got things wrong. Perhaps economists will respond, in time, more objectively than seems to be case here. (A "meow" is surely in order.)

    Anonymous: The link you provided is not readily readable on screen because of the black background, which may also describe the soul of its unnamed stalker.

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  17. Krugman in August 2002: ...This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble. Judging by Mr. Greenspan's remarkably cheerful recent testimony, he still thinks he can pull that off….

    Krugman in September 2009: ....It may be that Greenspan and Bernanke also wanted to celebrate the Fed’s success in pulling the economy out of the 2001 recession; conceding that much of that success rested on the creation of a monstrous bubble would have placed a damper on the festivities...

    But, of course, Krugman puts the dominant finger on the 'efficient market hypothesis' because it's all so terribly convenient to do so. The hegemony demands its right to continue fiddling.

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  18. Dateline 1837, Hans Anderson writing in the Denmark Dispatch this AM has reported that the crowds surrounding the Emperor during his annual stroll amongst the commons were astonished to see that he was attired in a new and handsome set of fine clothes. There were several naive by standers that wondered what all the fuss was about, noting that they did not think that the Emperor ought be strutting about so inappropriately dressed for the occasion. That opinion was soundly abused by the Emperor's Council of Advisers all of whom were certain that anything that was good in the eyes of the Emperor was certainly good enough for them. The consensus of opinion seemed to be that the Emperor certainly was finely dressed and that these were the best of times. Few had seen that it was clearly the case that the Emperor was ill prepared for the worst of times.

    It's an old story. Advisers to power do not frequently speak truth to power. When the issue is of uncertain detail any reasonable interpretation can be acceptable. When the Advisers serve the purpose of those in power they come to be seen as the portrayers of the truth. Krugman gave only short shrift to the influence of financial rewards and professional
    esteem in his description of the fairy tale that often parades as economic science.

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  19. Jack said:

    "Krugman gave only short shrift to the influence of financial rewards and professional
    esteem in his description of the fairy tale that often parades as economic science."

    As Krugman has pointed out at his NYTimes Blog, this was an article, not a book. Perhaps an investigative reporter or two or three could dig into public (and private?) records to take a look at how certain "advisors to power" have personally increased their investment portfolios that might have benefitted a tad from their advisory roles, sort of like "insider trading." Some public information is out there about Larry Summers, who avoided Senate scrutiny in getting his job in the Obama Administration. A recent Truthout article focuses upon Robert Rubin and how he may have cashed in. But surely that's not Krugman's role. For what it's worth, there's an old Italian saying (as claimed by an Italian American friend years ago) that if you're rich, you're not only smart but you're good looking too. Alas, too many economists strive to be celebrities.

    But one of the most impressive parts of Krugman's article is that economics and economists are not "neat" with solutions. Reread the closing paragraph of his article. Perhaps there is no Holy Grail - or mathematical formula - with the answers.

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  20. The task of discerning the Krugman (and other) spin and to trace the evolution of the crisis from 2002 onwards seems straight forward. It would be interesting to go back further to, say 1994, when the US Fed had the printing presses running full bore. That's when the banks lost their monopoly on originating housing mortgages I understand.

    …When Greenspan and Japan effectively lowered interest rates into negative territory (inflation at 3% and interest rates at 1% = 2% negative interest rates) investment plans around the world were thrown into turmoil. Negative interest rates compounding at a rate of 1 percent a year are very unattractive so it challenges the investors to reach for yields which entail poorer risk return ratios. Investors which had been very comfortable buying highly rated bonds which yielded 6 to 8% over the last twenty years or more suddenly couldn't do it. Using the rule of 72 [explained further ] to determine how long it took to double using compounding we know at 6% an investment doubles every 12 years, at 8% every 9 years, and at 9 it doubles 8 years. For the biggest money in the world such as retirement funds, institutions and insurance companies which only wants the return of their money with a return of 2% after inflation, these bonds represented safe and actuarial predictable returns. With 1 percent interest rates those returns increasingly evaporated, when a government or AAA rated bond only garners 4.5% the time span zooms to 16 years [BR: doubling every 9-12 years wasn’t good enough]. At first the long end did not crumble, and “Longer term” returns stayed decent, but as the trade and budget deficits of the G7 grew and they printed the money to pay for them, so did the numbers of bidders for the safest categories of investments so the conundrum of low long term bond interest rates was created as it got very crowded as bidders tried to stay safe. The more billions and trillions were printed and created the lower to return on them as they were widely available. The more money available for capital investment the lower the returns you (or the lender) can expect, when money is scarce returns for capital are higher. These currency holders eventually were forced into riskier investments and Wall Street “ENGINEERED” them due to the incredible demand for them. Structured products were born! When you solve problems for large numbers of people you get paid a lot. The more problems you solve the more you are paid. It's as simple as that, look no further than Microsoft to see what you are paid for solving problems. The Money center and Investment banks solved the problems for investors who held something widely available “infinite amounts of fiat currencies” and increased the returns on it. They disguised the risks in opacity, illiquidity, complexity and in concert with the ratings agencies which succumbed to the siren song shareholders for “MORE PROFITS”. Real inflation was running away while reported inflation was low so public servants could “COVER UP” their irresponsibility. …”

    The Insolvency Crisis: How we got here, and what to expect
    Saturday, 11 August 2007 Written by Garrett Johnson
    http://www.bitsofnews.com/content/view/5955/

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  21. By the way, Greenspan lowered interest rates from 6% to 1% in 2001 and 2002. (Correct me if I'm wrong).

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  22. The Huffington Post features Ryan Grim's "Priceless: How the Federal Reserve Bought the Economics Profession," posted 9/7/09. The article seeks to answer Krugman's conclusion that "[e]conomics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system." Grim (in Reaper fashion) asks:

    "So who seduced them?

    The Fed did it."

    Perhaps the recent financial crises have replaced trial attorneys as the villains of so many things with economists. How about applying "Physician, heal thyself" to economists. No need to fall on your swords, as that might make medical care even more expensive. Maybe, just maybe, the herd mentality applies to economists.

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  23. Peter: I'm not sure I agree with you that the lower bound on i is a "red herring." Creating inflationary expectations in the middle of a slump is no walk in the park! But I think Krugman might have made the point as part of the more basic idea that, contrary to years and years of dogma, falling prices and a falling rate of inflation are not necessarily stabilizing factors - the point that the system is not self-correcting. The zero-bound is just a special case of this more general point. Also, I would have pushed the idea that we need to embrace models with multiple Pareto-ranked equilibria and finally take Keynes' idea of an unemployment EQUILIBRIUM seriously.

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  24. Shag,
    It is not an issue of people cashing in when the cashing was good. The issue that needs to be addressed, and is only superficially referred to
    by Krugman and other critics, is that the career path, and rewards that occur along that path, are the incentives to follow the leader and hold to the party line. An academic is chosen by a university because of the outline of his/her work. Too many universities seem to have the advise and consent of a group given various names in the selection of their academic staffs.
    Endowed chairs and special privately funded "programs" within departments provide even greater rewards for the good work.

    The so-called think tank industry is an additional source of reward and recognition. Why one even gets to be referred to as a Scholar or an Associate of a privately funded organization that seems to have high standards for the scholarly work. Most seem to be within the total control of a corporate funding process. Rich rewards buys a great deal of influence, but everyone seems to describe the entire activity as scholarship.

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  25. I've always found economics theory to be curiously stateless. It was like trying to do electronics without charged particles. Sure, you could do simple resistor circuits with Ohm's Law, but it ignored real world circuits full of inductors and capacitors. That's an EE agreeing with your statement that economic theory lacks balance sheets.

    Right now economics is where astronomy was with Galileo and genetics was with Lysenko. The field and its theories are essentially political, and arguing that the earth goes around the sun or that acquired characteristics are not inheritable is arguing against the political structure and potentially dangerous.

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