Saturday, November 28, 2009

Magical Thinking vs. the Austrian Middle Ground

One positive effect of the financial crisis is that it has made it more fun than ever to be an economist. There's no end of fascinating material to study, more than enough examples of hubris deflated, and hardly a better example of what an "unforeseen contingency" is.

Of course, a number of economists did sound the alarm early (e.g. Roubini, Shiller, Rogoff, and Steele*) but the crisis blindsided far too much of the profession. That led Paul Krugman to write a thoughtful and provocative piece discussing where macroeconomics went wrong. I'm no fan of Krugman, but much of his attack on the EMH & REH crowd is on target and well-deserved. (That's "efficient market hypothesis & rational expectations hypothesis"). This was the macro I studied at NYU, and while I think these models do have some sense and some use (mostly for exploring what a logically consistent equilibrium would look like), if one thinks this is all there is to macro, one has... umm... well... what's a nice way to say "a completely crazy view of the world?"

But Krugman's alternative, behavioral irrationality, is no alternative at all, and neither is Old Keynesianism. Old Keynesianism is internally inconsistent and empirically discredited, and irrationality isn't a coherent basis for economic theory... nor does behavioral economics actually demonstrate irrationality.

Roman Frydman and Michael D. Goldberg have an extremely nice little post on Roubini's Global Economics Monitor that goes straight to the point on this issue: real world humans are rational, and they face enormous problems of knowledge. Markets can't possibly be "perfectly efficient," because they are "mechanisms" for discovery and testing of imperfect personal knowledge, and for communicating this knowledge. They are the method by which we cope with our sheer ignorance and unforeseen contingencies, and are ultimately able to coordinate our behavior into productive channels.

Of course, this position isn't mainstream at all. It certainly doesn't fit with the EMH crowd, and for that matter not with any economics that focuses entirely on equilibrium. It's what first Roger Garrison and then Israel Kirzner identify as the "Austrian Middle Ground." While they were speaking of a reasonable medium between the "equilibrium always" crowd and the "kaleidic world" view of Ludwig Lachmann and co., it fits equally well here. In the "perfect rationality" vs. "irrationality" debate, the only rational position is the "neither of the above, rationality is bounded."

Oddly but unsurprisingly, Alan Greenspan had been a devotee of the former position. I recently heard him on BBC replying to the question "where did you go wrong?" His reply was that he hadn't realized that people, and markets, are inherently irrational.

What a wild swing, from one extreme to another, missing the one solid spot of sanity. Alan, as one NYU alumnus to another, won't you please read this book, finally? It will do your soul good.


*I've now even found notes from a lecture I gave at Montana State in Spring 2006 in which I warned of growing U.S. fiscal imbalances, foreign borrowing, the housing bubble, and an eventual nasty unwinding.

Right on, Charles, thanks for that! I'll pass this post on to a few people.
Charles, do you know Roger Koppl? I'm reading his Big Players book at the moment, and it seems to me to have a lot useful to say about the rationality and efficiency (or otherwise) of markets.
Indeed I know him. He's a good man.

I was the discussant on for his presentation of what I believe was his first paper (written with Leland Yeager) on this subject, at the Eastern Economics Association meetings some time back.

I was doubtful about some of the conclusions, but it is interesting stuff. I had better check out his book.

Meanwhile, I have pestering him for his defense of Paul Samuelson in the comments on "Think Markets."
I agree with you about Samuelson. But I do like the way Roger tries to find something of value in the work of people with a different perspective, even if he has over-stretched his generosity in this case.

I suspect one reason Austrian economics is so marginalized is that it is so exclusive. I've been as guilty of that as anyone in the past, but his example has encouraged me to try to be more accommodating, without compromising on the truth. So, for instance, I like the way he finds something of value even in Keynes (the concept of "reflexivity"), even though no one could accuse him of being a Keynesian. That sort of olive branch may persuade a small number of Keynesians to similarly open their minds to the Austrian perspective. And that has to be a good thing.

I thought it was interesting that, when I recommended his book to a couple of economists with strong Austrian sympathies at the IEA, they immediately dismissed it when I described some of the empirical and mathematical content, and suggested that a similar approach might be applied usefully to the behaviour of the FTSE100 before and after May 1997. I think they have failed to distinguish between (a) the derivation of theory by empirical and mathematical means, which is clearly wrong in my opinion, and (b) the falsification (or otherwise) of aprioristically-derived theory, which I believe is valid if approached rigorously and responsibly. I don't think (b) would have disturbed Mises and Hayek. Mises was very interested in how his theories corresponded with real-world experience. Their purism (as they saw it) was, in my opinion, not only mistaken but counter-productive. If they can count even Koppl amongst the enemy, what chance do they have of gaining a critical-mass of support for Austrian ideas?
Just to be clear "their/they" in the last sentences refers to the IEA guys, not Mises and Hayek.
I was discussing the challenge of recent events to EMH and REH with Paul Woolley, whose Centre for Capital Market Dysfunctionality at the LSE is also trying to get to grips with this problem, albeit from a more neo-classical perspective. Paul is focusing on the role of agents, and believes that EMH and REH can be defended if one takes account of the different incentives facing investors and their agents. I pointed out that, if I asked my father to handle my investments, he would effectively be my agent, but his incentives, knowledge and effects on the market would be very similar to my own. So it isn't the handing-off of economic choices to another party that makes the big difference, but the handing-off to institutions so large that their incentives, knowledge and effects on the market are very different to my own. In other words: Big Players. Paul doesn't buy it, but I can't see that he has anything if he is focused simply on agents of all types. After all, we've had agents in that role during good times and bad. Roger's emphasis on the effect of influential individuals (Big Players) provides a credible explanation of apparently-irrational behaviour in markets, which explanations such as Paul's or the "animal spirits" brigade fail to explain. It also fits very well with my commercial experience.
Thanks for these thoughtful messages. I concur re Koppl, although I thought his defense of Samuelson went way overboard, well beyond what can be defended. Keynes builds his system on eloquently stated fallacies, and Samuelson makes them "rigorous" with eloquent mathematics. Both entirely avoid any serious consideration of government failure.

Trying "to find something of value in the work of people with a different perspective" is the way Kirzner taught History of Economic Thought at NYU, and is without doubt the proper perspective. I think it is not recognized, but Mises does this in Human Action; there are numerous places where he points out errors in "Austrian" thought (a term he laments) and endorses the corrections developed by non-Austrians. Mises was trying to get it right, not be an "Austrian" purist.

Mathematics: I have no particular opposition to math in economics. Math is a very good way of expressing some things, e.g. describing a general equilibrium, and thus has its place. IMO it can even throw new light on Austrian ideas -- such as sheer ignorance (Modica & Rustichini's models of "unawareness") or capital theory (Caballero's models of "capital specificity."

Regarding big players, failures of strong EMH, etc. ... I'm increasingly convinced that William Black is correct that much of what we observe in asset bubbles is fraud, and that economists (among others) have missed this entirely. His book on the U.S. S&L crisis was quite eye-opening for me, and quite convincing as it described the same sort of fraudulent deals we observed in post-Soviet Russia and Ukraine. When market players can become rich by engaging in fraud, creating doomed "assets," and putting firms on course for certain bankruptcy, the EMH isn't going to hold much water.
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