Thursday, March 26, 2009

Economists to blame for crisis?

Keynes once famously wrote that “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

A recent article in Prospect Magazine argues that much modern policy and many practices amongst investors were influenced by the two “false theories” of rational expectations and efficient markets, which

[…] are not only misleading but highly ideological, have become so dominant in academia (especially business schools), government and markets themselves. While neither theory was totally dominant in mainstream economics departments, both were found in every major textbook, and both were important parts of the “neo-Keynesian” orthodoxy, which was the end-result of the shake-out that followed Milton Friedman’s attempt to overthrow Keynes. The result is that these two theories have more power than even their adherents realise: yes, they underpin the thinking of the wilder fringes of the Chicago school, but also, more subtly, they underpin the analysis of sensible economists like Paul Samuelson.

[…]

As David Hendry, until recently head of the Oxford economics department, has noted: “Economists critical of the rational expectations based approach have had great difficulty even publishing such views, or maintaining research funding. For example, recent attempts to get ESRC funding for a project to test the flaws in rational expectations based models was rejected. I believe some of British policy failures have been due to the Bank accepting the implications [of REH models] and hence taking about a year too long to react to the credit crisis.”

[…]

Although there was never any empirical evidence for REH, the theory took academic economics by storm for two reasons. First, the assumptions of clearly-defined laws and identical expectations were easily translated into simple mathematical models—and this mathematical tractability soon came to be viewed as a more important academic objective than correspondence to reality or predictive power. Models based on rational expectations, insofar as they could be checked against reality, usually failed statistical tests. But this was not a deterrent to the economics profession. In other words, if the theory doesn’t fit the facts, ignore the facts. How could the world have allowed such crassly unscientific attitudes to dominate a serious academic discipline, especially one as important to society as economics?

The article also claims that this was desirable for ideological reasons:

That government activism was doomed to failure was exactly what politicians, central bankers and business leaders of the Thatcher and Reagan periods wanted to hear. Thus it quickly became established as the official doctrine of the political and economic establishments in America—and from this powerful position it was able to conquer the entire academic world.

And for efficient markets:

To make matters worse, rational expectations gradually merged with the related theory of “efficient” financial markets. This was gaining ground in the 1970s for similar reasons—an attractive combination of mathematical and ideological tractability. This was the efficient market hypothesis (EMH), developed by another group of Chicago-influenced academics, all of whom received Nobel prizes just as their theories came apart at the seams. EMH, like rational expectations, assumed that there was a well-defined model of economic behaviour and that rational investors would all follow it; but it added another step. In the strong version of the theory, financial markets, because they were populated by a multitude of rational and competitive players, would always set prices that reflected all available information in the most accurate possible way. Because the market price would always reflect more perfect knowledge than was available to any one individual, no investor could “beat the market”—still less could a regulator ever hope to improve on market signals by substituting his own judgement. But if prices perfectly reflected all information, why did these prices constantly fluctuate and what did such movements mean? EMH cut this Gordian knot with a simple assumption: market movements are meaningless random fluctuations, equivalent to tossing a coin or a drunken sailor’s “random walk.”
This anarchic-sounding view was actually very reassuring. If market movements were really like coin-tosses, they might be totally irregular in the short term, but very predictable over longer periods, like the takings of a casino. Specifically, the coin-tossing and random walk analogies could be shown to imply what statisticians call a “normal” or Gaussian probability distribution. And the mathematics of Gaussian distributions (plus what is called the “law of large numbers”) reveals that catastrophic disturbances are vanishingly unlikely to occur. For example, if the daily fluctuations on Wall Street follow a normal distribution, it is possible to “prove” that the odds of a one-day movement greater than 25 per cent are about one in three trillion. The fact that at least four statistically “impossible” financial events occurred in just 20 years—in stock markets in 1987, bonds in 1994, currencies in 1998 and credit markets in 2008—would by normal standards, have meant the end of EMH. But as in the case of rational expectations, the facts were rejected while the theory continued to reign supreme, albeit with some recalibration.

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