The real trouble with economics

I pretty much agree with everything Mark Thoma says here in pointing to sociological factors within academic economics as the source of recent problems. Anyone who has read this blog knows I'm not so sanguine about the supposed "sophistication" of the analytical models currently used in macroeconomics, but, that to one side, Thoma is right that the real problem has been a lack of imagination and willingness to build models (probably messy and inelegant ones) that would inform us in a practically useful way about possible market instabilities:

 "I talked about the problem with the sociology of economics awhile back -- this is from a post in August, 2009:

In The Economist, Robert Lucas responds to recent criticism of macroeconomics ("In Defense of the Dismal Science"). Here's my entry at Free Exchange's Robert Lucas Roundtable in response to his essay:

Lucas roundtable: Ask the right questions, by Mark Thoma: In his essay, Robert Lucas defends macroeconomics against the charge that it is "valueless, even harmful", and that the tools economists use are "spectacularly useless".

I agree that the analytical tools economists use are not the problem. We cannot fully understand how the economy works without employing models of some sort, and we cannot build coherent models without using analytic tools such as mathematics. Some of these tools are very complex, but there is nothing wrong with sophistication so long as sophistication itself does not become the main goal, and sophistication is not used as a barrier to entry into the theorist's club rather than an analytical device to understand the world.

But all the tools in the world are useless if we lack the imagination needed to build the right models. Models are built to answer specific questions. When a theorist builds a model, it is an attempt to highlight the features of the world the theorist believes are the most important for the question at hand. For example, a map is a model of the real world, and sometimes I want a road map to help me find my way to my destination, but other times I might need a map showing crop production, or a map showing underground pipes and electrical lines. It all depends on the question I want to answer. If we try to make one map that answers every possible question we could ever ask of maps, it would be so cluttered with detail it would be useless, so we necessarily abstract from real world detail in order to highlight the essential elements needed to answer the question we have posed. The same is true for macroeconomic models.

But we have to ask the right questions before we can build the right models.

The problem wasn't the tools that macroeconomists use, it was the questions that we asked. The major debates in macroeconomics had nothing to do with the possibility of bubbles causing a financial system meltdown. That's not to say that there weren't models here and there that touched upon these questions, but the main focus of macroeconomic research was elsewhere. ...
The interesting question to me, then, is why we failed to ask the right questions. For example,... why policymakers didn't take the possibility of a major meltdown seriously. Why didn't they deliver forecasts conditional on a crisis occurring? Why didn't they ask this question of the model? Why did we only get forecasts conditional on no crisis? And also, why was the main factor that allowed the crisis to spread, the interconnectedness of financial markets, missed?

It was because policymakers couldn't and didn't take seriously the possibility that a crisis and meltdown could occur. And even if they had seriously considered the possibility of a meltdown, the models most people were using were not built to be informative on this question. It simply wasn't a question that was taken seriously by the mainstream.

Why did we, for the most part, fail to ask the right questions? Was it lack of imagination, was it the sociology within the profession, the concentration of power over what research gets highlighted, the inadequacy of the tools we brought to the problem, the fact that nobody will ever be able to predict these types of events, or something else?

It wasn't the tools, and it wasn't lack of imagination. As Brad DeLong points out, the voices were there—he points to Michael Mussa for one—but those voices were not heard. Nobody listened even though some people did see it coming. So I am more inclined to cite the sociology within the profession or the concentration of power as the main factors that caused us to dismiss these voices.

And here I think that thought leaders such as Robert Lucas and others who openly ridiculed models they disagreed with have questions they should ask themselves (e.g. Mr Lucas saying "At research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another", or more recently "These are kind of schlock economics"). When someone as notable and respected as Robert Lucas makes fun of an entire line of inquiry, it influences whole generations of economists away from asking certain types of questions, some of which turned out to be important. Why was it necessary for the major leaders in macroeconomics to shut down alternative lines of inquiry through ridicule and other means rather than simply citing evidence in support of their positions? What were they afraid of? The goal is to find the truth, not win fame and fortune by dominating the debate.

We need to take a close look at how the sociology of our profession led to an outcome where people were made to feel embarrassed for even asking certain types of questions. People will always be passionate in defense of their life's work, so it's not the rhetoric itself that is of concern, the problem comes when factors such as ideology or control of journals and other outlets for the dissemination of research stand in the way of promising alternative lines of inquiry.

I don't know for sure the extent to which the ability of a small number of people in the field to control the academic discourse led to a concentration of power that stood in the way of alternative lines of investigation, or the extent to which the ideology that markets prices always tend to move toward their long-run equilibrium values caused us to ignore voices that foresaw the developing bubble and coming crisis. But something caused most of us to ask the wrong questions, and to dismiss the people who got it right, and I think one of our first orders of business is to understand how and why that happened.

I think the structure of journals, which concentrates power within the profession, also influence the sociology of the profession (and not in a good way)."

The political problem

Several years ago, immediately post-crisis, I wrote a short article for Nature exploring new ideas about modelling economic and financial systems. I wrote about agent-based models and other similar ideas, nothing all that earth shaking really. In an early draft, I recall adding a section toward the end of the piece making the point that, of course, better models, better science, etc., would never be enough because ultimately policy making has an irreducible political element; financial crises can almost always be traced back to the political influence of powerful forces who shape policies to help themselves (or to try to do so), with little thought for the welfare of others. To my surprise, my editor at Nature took that section out saying something like "we'd like to stick to the science."

I thought that was unfortunate and hugely misleading. Corruption is real, and I really do think that no amount of better economics will eliminate financial and economic crises, because of the reality of politics. No avoiding it. Simon Wren-Lewis has a great post on this topic today, looking at why it would not actually be that hard -- conceptually -- to make the financial system more stable. The only barrier is the intimate connection between finance and politics ("quite frankly, the banks own this place" as U.S. Senator Dick Durbin once put it), which means that banks won't actually have to do things that might help the public good and the nation as a whole:

There is one simple and straightforward measure that would go a long way to avoiding another global financial crisis, and that is to substantially increase the proportion of bank equity that banks are obliged to hold. This point is put forcibly, and in plain language, in a recent book by Admati and Hellwig: The Bankers New Clothes. (Here is a short NYT piece by Admati.) Admati and Hellwig suggest the proportion of the balance sheet that is backed by equity should be something like 25%, and other estimates for the optimal amount of bank equity come up with similar numbers. The numbers that regulators are intending to impose post-crisis are tiny in comparison.

It is worth quoting the first paragraph of a FT review by Martin Wolf of their book:

“The UK’s Independent Commission on Banking, of which I was a member, made a modest proposal: the proportion of the balance sheet of UK retail banks that has to be funded by equity, instead of debt, should be raised to 4 per cent. This would be just a percentage point above the figure suggested by the Basel Committee on Banking Supervision. The government rejected this, because of lobbying by the banks.”

Why are banks so reluctant to raise more equity capital? One reason is tax breaks that make finance using borrowing cheaper. But non-financial companies, that also have a choice between raising equity and borrowing to finance investment, typically use much more equity capital and less borrowing. If things go wrong, you can reduce dividends, but you still have to pay interest, so companies limit the amount of borrowing they do to reduce the risk of bankruptcy. But large banks are famously too big to fail. So someone else takes care of the bankruptcy risk - you and me. We effectively guarantee the borrowing that banks do. (If this is not clear, read chapter 9 of the book here.  The authors make a nice analogy with a rich aunt who offers to always guarantee your mortgage.)

The state guarantee is a huge, and ongoing, public subsidy to the banking sector. For large banks, it is of the same order of magnitude as the profits they make. We know where a large proportion of the profits go - into bonuses for those who work in those banks. The larger is the amount of equity capital that banks are forced to hold, the more the holders of that equity bear the cost of bank failure, and the less is the public subsidy. Seen in this way it becomes obvious why banks do not want to hold more equity capital - they rather like being subsidised by the state, so that the state can contribute to their bonuses. (Existing equity holders will also resist increasing equity capital, for reasons Carola Binder summarises based on the work of Admati and Hellwig and coauthors.)

This is why the argument is largely a no brainer for economists. [1] Most economists are instinctively against state subsidies, unless there are obvious externalities which they are countering. With banks the subsidy is not just an unwarranted transfer of resources, but it is also distorting the incentives for bankers to take risk, as we found out in 2007/8. Bankers make money when the risk pays off, and get bailed out by governments when it does not.

So why are economists being ignored by politicians? It is hardly because banks are popular with the public. The scale of the banking sector’s misdemeanours is incredible, as John Lanchester sets out here. I suspect many will think that banks are being treated lightly because politicians are concerned about choking off the recovery. Yet the argument that banks often make - holding equity capital represents money that is ‘tied up’ and so cannot be lent to firms and consumers - is simply nonsense. A more respectable argument is that holding much more equity capital would translate into greater costs for bank borrowers, but David Miles suggests the size of this effect would not be large. (See also Simon Johnson here, John Plender here and Thomas Hoenig here.) In any case, public subsidies are bound to be passed on to some extent, but that does not justify them. Politicians are busy trying to phase out public subsidies elsewhere, so why are banks so different?

There is one simple explanation. The power of the banking lobby (and the financial industry more generally) is immense, from campaign contributions to regulatory capture of various kinds. It would be nice to imagine that the UK was less vulnerable than the US in this respect, but there are good reasons to think otherwise. [2] As a result, the power and influence of banks and bankers within government has hardly suffered as a result of the Great Recession that they played a large part in creating.

This point bears repeating -- indeed, it ought to be repeated every day for the rest of the year. All the technical and semi-technical articles now being published about measures for getting at systemic risk and improved schemes for weighting capital and so on, however clever and interesting they may be, actually only serve to draw attention away from this most serious problem, which is institutionalized corruption plain and simple. If every finance professor wrote one article on this topic -- after all, shouldn't this really be THE main topic in finance today? -- we might one day get somewhere with fixing the financial system.

What has nature done for us?

I had the opportunity last week to speak at the Edinburgh International Festival of Books alongside Tony Juniper, British environmentalist and former head of Friends of the Earth. I highly recommend his new book, What has nature ever done for us?, which examines the many ways that the natural world contributes to our well being considered in economic terms. "Many ways" is of course an absolutely absurd understatement, as the natural world essentially provides everything that makes our lives possible. But if you turn off your brain, swallow hard and actually do calculations of environmentally produced economic value -- sadly, it seems that only this approach has influence in our world where everything comes down to economic costs and benefits -- you find (without any surprise) that the value of "ecosystem services" on a yearly basis is many times current global GDP.

Personally, I think it is obvious that this is a vast underestimate, but if it is necessary to convince people who cannot think in any other terms, then so be it. The Earth's ecosystems produce the oxygen we breath. How much value is there in that? I would say it is pretty much infinite, although I'm sure someone will argue that we could, with the right hypothetical technology, produce our own oxygen and so replace those messy natural resources with industry based on our own knowledge, perhaps we'd even boost the economy in the process! Bollocks. Juniper's book is a beautifully written corrective to such nonsense.

We've evolved in delicate interdependence with our natural world; we didn't create ourselves above and beyond nature with rational thought and technology, although this is the modern illusion. Although it comes from a very different context -- A Recipe for Happiness by Rabbi Ari Kahn (courtesy of Mitch Julis of Canyon Partners) -- I think the following words hold great wisdom:

Modern man, intoxicated with his own success, is prone to hubris. He sees himself as a self-made man, and worships his ‘creator’ every time he glances in the mirror... Like Narcissus gazing into the water while perched on a rock, modern man no longer recalls where he came from, and his own self-absorption mesmerizes him. He is isolated, and because he has forgotten the past, he has no humility, no perspective, no context. At the same time, he jeopardizes his connection with the future: Only when we transmit historical consciousness to our children, and live beyond the narrow confines of the present, do we stand a chance of being appreciated by our children – rather than being rejected, in turn, as a relic from the past.

Why Homo economicus isn't very smart

I'm getting back tomorrow from extended travels in Poland and the UK and hope to resume some more frequent blogging. Just a quick note today to clarify my recent column in Bloomberg on Homo economicus and the payoffs to friendly types in Prisoner's Dilemma games. Several people commenting on Bloomberg have suggested that what I've said was known 20 years ago or was all evident from the famous work of Robert Axelrod on the iterated Prisoner's Dilemma. They don't seem to have taken a look at the specific paper I referred to in the piece, which is very recent, but maybe that's my fault as I didn't spell out what is new about this work as well as I could have.

This study by Thomas Grund and colleagues does not JUST look at the iterated Prisoner's Dilemma or point out that mechanisms of group selection can support the evolution of altruists. This is indeed already known and has been known for a while. However, these mechanisms are also subject to limitations depending on various factors such as group mixing. The current study looks at a situation in which individuals CAN care about the payoffs for others with whom they interact (their utility function has an other-regarding component). It assumes that this does NOTHING for their reproductive fitness, however, this being totally distinct from utility and depending on an individual's own payoff. In other words, the model assumes that helping behavior is costly.

So, why would someone come to care for about the payoffs to others? Why indeed. This is where the story gets interesting. Just let this be possible by giving everyone a "friendliness" parameter F reflecting how much they care about others (0 = no caring, 1 = a lot of caring). What the study shows is that, even if everyone starts out with F = 0, this situation is unstable to the evolution of caring behavior. If individuals pass on their friendliness (genetically or culturally) to offspring, then random variations in friendliness values, caught on the wing by selection, can spread through the population. In effect, friendliness, even though it matters not for actually fitness, can provide an organizational scaffolding that makes it easier for cooperators to find cooperators. The mere possibility of friendliness (you can call this arbitrary variable anything you like) allows a spatial segregation of the population that enables much higher levels of cooperation.

This is, I think, quite new and very different from earlier studies. It introduces an essentially new element. Homo economicus, in this world, suffers because he is not capable of responding as flexibly as are others in the population (i.e. making decisions on the basis of matters that have no link whatsoever to his fitness). Those who are more flexible -- and apparently unreasonable -- can come to dominate quite quickly in the right circumstances. From the paper:

However, why does this transition happen in just a few generations (see Fig. 1B), i.e. much faster than expected? This relates to our distinction of preferences and behaviour. When an ‘idealist’ is born in a neighbourhood with friendliness levels supporting conditional cooperation, this can trigger off a cascade of changes from defective to cooperative behaviour. Under such conditions, a single ‘idealist’ may quickly turn a defective neighbourhood into a largely cooperative one. This implies higher payoffs and higher reproduction rates for both, idealists and conditional co-operators.

The intriguing phase transition from self-regarding to other-regarding preferences critically depends on the local reproduction rate (see Fig. 2). The clustering of friendly agents, which promotes other-regarding preferences, is not supported when offspring move away. Then, offspring are more likely to encounter defectors elsewhere and parents are not ‘shielded’ by their own friendly offspring anymore. In contrast, with local reproduction, offspring settle nearby, and a clustering of friendly agents is reinforced. Under such conditions, friendliness is evolutionary advantageous over selfishness.