Everyone’s talking about this Paul Krugman essay on where economics, as a discipline, went wrong. Partly, “going wrong” means the failure to appreciate the risks in our financial system, and the corresponding failure to predict the crash we’re currently trying to deal with. But from an insider’s perspective, something else has happened: an uneasy consensus between two different approaches to economics has been shattered. One, which Krugman labels the “saltwater” approach, is associated (in the U.S.) with some variety of post-Keynesian analysis, generally identified with some willingness to have the government intervene in the economy over and above the Fed’s control of the money supply. The other, the “freshwater” approach favored by the Chicago School and other inland economists, is more purely free-market and non-interventionist. (Truth in advertising: I am not an economist.) These camps could more or less get along when everything was going fine, but have dramatically different reactions to a crisis. To the extent that you find freshwater economists claiming that unemployment is currently high, not because there aren’t many jobs, but because there are too many incentives for people not to work.
One of the reasons it’s a great essay is that it’s a wonderful example of popularizing science. You can debate all you like about whether economics counts as a science, but there’s little doubt that Krugman does an amazing job at explaining esoteric ideas in non-technical language, and is so smooth about it that you hardly realize difficult ideas are even being discussed. I wish I could write like that.
One part of the essay worth commenting on, or at least musing about, is the punchline. Krugman thinks that a major factor leading to the failures of economics to understand the mess we’re currently in was the temptation to think that beautiful models must be right.
As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but 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. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.
Without knowing much of anything about the relevant issues, I nevertheless suspect that this moral might be a bit too pat. Sure, people can fall in love with beautiful theories, to the extent that they overestimate their relationship to reality. But it seems likely to me that the correct way of understanding all this, once it’s properly understood, will look pretty beautiful as well. General relativity is widely held up as an example of a beautiful theory — and it is, when understood in its own language. But if you put the prediction of GR in the Solar System into the language of pre-existing Newtonian physics (which you could certainly do), it would look ugly and ad hoc. Likewise, Newton’s theory itself is quite elegant, when phrased in the language of potentials on a fixed spacetime background; but if you express the theory in terms of differential geometry (which you could certainly do), it looks like a mess. Sometimes the beauty/ugly distinction between theoretical conceptions is more a matter of how well we understand them, and less about their intrinsic qualities.
So my counter-hypothesis would be that it wasn’t beauty that was the problem, it was complacency. If you have a model that is beautiful and works well enough, you’re tempted to take pride in it rather than pushing it to extremes and looking for problems. I suspect that there is a very beautiful theory of economics out there waiting to be developed, one that understands perfectly well that individuals aren’t rational and markets aren’t perfect. One that has even more impressive-looking equations than the current favored models! Beauty isn’t always a cop-out.
I’ve been reading this blog since before it became part of Discover Magazine. Looking at the Math and Physics section of discovermagazine.com, the top article has a tag line from 2005: “Scientists hunt for the unseen matter that glues together the cosmos. But some wonder whether it even exists. ” This is actually a terrible article. Any article that tries to sew doubt about the existence of dark matter should at least mention the Bullet Cluster, which completely rules out certain kinds of dark-matter-free theories which were becoming popular up until August 2006.
Moving down the page, one of the four highlighted articles is “biocentric universe” bullshit from a “stem-cell guru”. Next, an ordinary article about large-scale quantum effects observed in biological systems entitled “Is Quantum Mechanics Controlling Your Thoughts?”.
Recently, Paul Krugman mentioned this post of yours as “Discover”. Sean, you stopped associating with bloggerheads.tv for a reason. Do yourself a favor and dissociate yourself from:
“Biocentrism should unlock the cages in which Western science has unwittingly confined itself. Allowing the observer into the equation should open new approaches to understanding cognition, from unraveling the nature of consciousness to developing thinking machines that experience the world the same way we do. Biocentrism should also provide stronger bases for solving problems associated with quantum physics and the Big Bang. Accepting space and time as forms of animal sense perception (that is, as biological), rather than as external physical objects, offers a new way of understanding everything from the microworld (for instance, the reason for strange results in the two-slit experiment) to the forces, constants, and laws that shape the universe. At a minimum, it should help halt such dead-end efforts as string theory.
Above all, biocentrism offers a more promising way to bring together all of physics, as scientists have been trying to do since Einstein’s unsuccessful unified field theories of eight decades ago. Until we recognize the essential role of biology, our attempts to truly unify the universe will remain a train to nowhere.”
hackenkaus has it exactly right here, and I’m only upset bc I didn’t read this post earlier in the week. I suspect it’s not exactly an accident that Sean either didn’t see or didn’t wish to comment on this analogy (well, I don’t really expect him to BELIEVE it’s valid, let’s be clear on that).
I’ve been thinking about this overnight and would like to take a more optimistic view. I’m beginning to think there is a beauty in economic theory – if one is inclined to the Austrian theory.
They are saying that in order to have a well functioning economy it is necessary to have exchange of information (including information about our wishes and desires), cooperation and (most of all) freedom. We may not be able to predict the outcome because it is gnarly, and most of all because we cannot predict the problems the economy and the whole society will have to solve in the future.
I think it is rather nice that this theory says that freedom is central to economic and societal success, that it depends on mankind’s better nature, and that it values the free flow of information. I think that it is also rather nice that empirical observation backs this up. When people are enslaved or compelled, when information is choked off, blocked or distorted, when solutions are imposed from the top by small groups of elites, then again and again we see failure.
The results may not be perfect. We don’t know how to solve all problems now. The desires and preferences of other people may not be in accord with our views of what is best or with our tastes. There may be all kinds of missteps and messiness but it is the economic theory that works. And it is not that different from what makes science work.
Hi,
There is a parallel to physics in the area of String Theory. Lee Smolin in “The Trouble with Physics” brilliantly details how this elegant but ultimately useless theory came to supplant all other approaches in this field. And the parallels are striking: String Theory flourished not because of what it explained, (ultimately nothing) but because it was beautiful math. Look at these equations, they give a beta function! The theory must be true! Well, no.
Explaining things is hard, solving math problems is easy. Both physics and economics stuck their heads in the sand and simply stopped trying. It is fascinating that two fields that were hotbeds of intellectual advancement mid twentieth century gave way to degenerative abstraction. A generation lost, at who knows what cost.
The beauty of general relativity was not obvious to the physics community of 1910-1920.
Today we can say that trading one absolute (an absolute reference frame for the space-time continuum) for another (the speed of light is always the same) was a perfectly elegant (and even beautiful) way of resolving an important issue in physics. I can look at Maxwell’s equations and say they contain no implication of any particular reference frame.
But at the time Newtonian physics looked much more beautiful. The simplicity of F=ma had been mathematically extended to cover any system for which the Lagrangian was known. General relativity threatened to tear down that beautiful edifice until Einstein went to Prague and learned to use Hamiltonians to describe his new system in much the way Lagrange had done for Newtonian mechanics.
Einstein could see the beauty of his new assumption, but for much of the physics community he was upending the entire beautiful edifice of the science in order to explain (in a fairly arbitrary manner) the results of the Michelson-Morley experiment. It was only after he had shown that edifice could be rebuilt on the new assumption that others began to see the beauty of his new edifice. Especially when he showed that new and different predictions could be made based on this new edifice and we could determine which one was right.
We could say that neo-classical economics now finds itself at the Michelson-Morley crossroads, with its predictions in ruins after the current downturn in the economy. We could say that economists are now tasked with rebuilding their beautiful edifice on some other set of assumptions.
But that would be unfair to Newtonian mechanics. Neo-classical economic thought has never enjoyed the real-world success that physics did before Einstein. It has always been more of a formalization of pre-existing biases than a true science. Excuses are its primary modus operandi. However beautiful its theory, its motivations have always been base and unenlightening.
It is time for a real science of economics, one that is not founded in the biases (left-wing biases as well as right-wing biases) of its creators, one that takes simple assumptions (preferably premises more believable than those of the neo-classicists) and proceeds to predict ALL of the behaviors of all of the markets we can observe in the real world. If you cannot predict extraordinary popular delusions, much less the madness of crowds, you cannot come to the table of true science.
In response to David McCorkHill: Economics or sociology will never be able to predict extraordinary popular delusions. What we can do is set up systems that limit their destructiveness. Such systems would promote the free flow of information, give people the freedom to speak out and expose delusions, and limit the power of small groups of people to impose their delusions on society as a whole.
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As discussed in the new book “Life, the Universe, and the Scientific Method”, sciences come in many forms with all sorts of questions and ways of approaching them. What they have in common (and what their methods must have if they are to capture the power of a true science) is a mechanism by which an advocate is forced to abandon a treasured theory. In some sciences, experiments do this. In others, observations. Even so, scientists (being human) will often (and probably more often than not) ignore contradictory observations or experimental results, rather than abandon their favorite theory. Then, in a functioning scientific community, this is pointed out, and we inch towards a model for reality.
The problem with macroeconomics is that it has no mechanism accepted by its community that forces advocates to abandon their theories. Macroeconomic observations are largely few-variable correlations in a high variable space, with controlled experiments essentially impossible. Thus, Krugman, Reich and others on the left (and their counterparts on the right) can choose their position based on whatever (ideology, morality, the like) and then pick and choose the data that they need to advocate that position. Just like lawyers, who select and ignore data to get to their desired conclusion (“my client is innocent”).
Krugman’s blog is hilarious in this respect, from global climate change to stimulus spending, to economic theory. He selects data to support his view, ignores data that oppose it, the bloggers pile on with attacks of hypocrisy. and he wraps it up calling everyone who disagrees with him mentally ill. The entertainment value of this is priceless, but so is its value to illustrate the difference between science and non-science.
Now, in my community (biomedical research), if I published data that supported my theory and buried data that did not, I would be disbarred by my community. Economics has no such community. Hence the problem.
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On to Psychohistory!
David Park #49 says:
Not quite everyone has forgotten about it. My grandfather was a farmer during that time, and my father was growing up, later to become an accountant because farming was such hard work for such small returns. The truth is farm prices remained depressed until about 1927, and even then remained low. They returned to pre-1920 levels in 1929, just in time to be devastated by the next collapse. In fact, this was brought up in my Economics 101 class in 1960, when the professor started to introduce Keynes. Government intervention after World War II did a lot to make medium-sized farms (300 acres or so) prosperous until they were absorbed by huge agribusinesses in the 1980’s and 90’s. The Department of Agriculture’s County Agents did tremendous work in increasing productivity and improved marketing practices.
When I began reading about the Efficient Markets Hypothesis I was astonished that people couldn’t see it was insane.
Full disclosure: I’m not an economist either. But I’d like to submit a variation to your counter-hypothesis. It wasn’t complacency, exactly, so much as indifference, or to be less charitable, arrogance. One of the political winds Krugman alluded to began with the Reagan administration. When they took office they were facing some very tough decisions about how to deal with an economy stuck in stagflation. Instead of taking a step back and retrenching, they bifurcated the economy with supply side economics. So instead of dealing with the economy as a whole, they focused on policies that would help the investment class, assuming the rest of the economy would come into line eventually if rich people were investing. What this meant was that all retrenching would be done by people whose income was primarily through their paychecks. Investors would move forward. Clinton had an opportunity to make some changes, but he went with Rubin over Reich and tended to favor supply side policies. The result was a top-heavy economy with more and more money flowing into increasingly unstable and mysterious instruments. But at least we didn’t discourage financial creativity. By the time the economy crashed we’d had 30 years of commitment to a mirage, upon which entire careers had been built. As well, an entire generation had grown up and incorporated this outlook into their political identification. Consequently, you can’t call prevailing economic ideas into question without threatening the security of those who hold them. All the people who count were of a mind. In order to be a person who counts, you had to subscribe to the mirage, too, otherwise you were ignored. In other words, if you commented on the emperor’s bare backside, you were making yourself irrelevant. Despite the fiasco of the last two years, it still appears that those making policy are committed to sustaining the status quo, with bandaides.
“We should have a recession. People who spend their lives pounding nails in Nevada need something else to do.”
….context would be nice. its hard to imagine a context that this is a remotely gracious comment.
…not surprising ive heard talk in pubs where the words “finance” and “lynching” have been in same sentence.
dunken chat i know, but many a true word spoken in jest and all that…..
I think Krugman is spot on. Physicists tend to forget that it is quite impossible to consistently reduce human behavior to a few parameters.
Some random thoughts:
Economics has to get rid of, once and for all, the notion that risk as a concept can be fully accounted for by variability. They’re trying to take the easy way out on that one.
I suspect that Econonomics fell in love with the idea of the Invisible Hand, which posits that people behave rationally, besides the more obvious and traditionally emphasized angle. While often true it is not always so.
One thing I think economists rely upon is that the individual players in the markets are themselves fungible. There are no elephants. This is demonstrably not true–regulators and central banks have great powers, as do some corporations and investment groups.
Austrian Economics is religion not Economics.
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Haelfix
just wanted to point out -there is considerable evidence to prove that efficient market theory especially the strong version of it is a load of bull.
For starters
-Read the lecture by Warren Buffett titled ‘ The Superinvestors of Graham and Doddsville’. Its about the group of investors who are his friends also who consistently beat the market not over years but decades
-Secondly read Drermans paper on how low PE stocks constantly beat the market
and finally a personal word of advice – if you want to get rich, dump EMT real quick
the 2 ways to get rich are read Krugman for Macro and follow Klarman for Value Investing
Cheers
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