Krugman bashes economics field's irrational belief in collective rationality

While studying for my economics Ph.D., I always hated the economics field’s refusal to acknowledge that human skulls contain not supercomputers but 3-pound lumps of mush with severe perceptual limitations, constrained (and often faulty) memory capacity, “irrational” emotions, arbitrary decision heuristics, contradictory beliefs, false beliefs (at most one of the world’s many religions can be right, for example), etc.

Most economics models (in my day, anyhow) presume people possess perfect knowledge of the world around them and that every person on the planet makes completely rational, self-serving decisions at all times. Real-world facts clearly contradicted this, but most economists believed the rationality assumption held to a first approximation and that “a theory of irrationality” would be impossibly complex, so they didn’t bother trying.

So I was doubly excited today to discover Paul Krugman’s trashing of his field’s embrace of individual and collective rationality. He says his fellow economists were blinded to reality by their theories (which are devoid of human emotion or irrationality) and remain in denial:

In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted… .” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains.

Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.”

… Greenspan’s assurances… weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”

Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified.

Krugman offers finance as an example of economists falling in love with their theories:

Finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive. But this evidence was of an oddly limited form. Finance economists rarely asked the seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings. Instead, they asked only whether asset prices made sense given other asset prices. Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient.

To be fair, not ALL finance professors thought this way. A few years ago, I began watching online NYU business school lectures on valuation and corporate finance by the wonderful Aswath Damodaran (website: Damodaran Online). He repeatedly emphasized:

  • A stock may be undervalued relative to similar companies but still be overvalued because the market is systematically overvaluing the industry as a whole

  • If you think market valuations are always correct, leave this class now because we begin by assuming that systematic application of valuation techniques can produce value estimates superior to the current market price

Damodaran understood that individuals can be irrational, as can markets (which are not supernatural beings but collections of flawed, irrational human beings).

Though I always believed microeconomists misunderstand human thinking (and totally ignore human emotion), I found significant explanatory power in micro theories. But I always thought many of the macroeconomic theories I learned were rubbish. I was so turned off by macroeconomics that I couldn’t bring myself to attend the required macro classes. (Interestingly, when I showed up for the final exam, the professor handed me the exam and asked, “Are you IN this class?” …yet I scored higher on that test relative to my peers than on many others.) Perhaps after reading Krugman’s description of macro, you’ll understand my reason for being unable to stomach those lectures:

In the 1970s the leading freshwater macroeconomist, the Nobel laureate Robert Lucas, argued that recessions were caused by temporary confusion: workers and companies had trouble distinguishing overall changes in the level of prices because of inflation or deflation from changes in their own particular business situation. And Lucas warned that any attempt to fight the business cycle would be counterproductive: activist policies, he argued, would just add to the confusion.

By the 1980s, however, even this severely limited acceptance of the idea that recessions are bad things had been rejected by many freshwater economists. Instead, the new leaders of the movement, especially Edward Prescott, who was then at the University of Minnesota (you can see where the freshwater moniker comes from), argued that price fluctuations and changes in demand actually had nothing to do with the business cycle. Rather, the business cycle reflects fluctuations in the rate of technological progress, which are amplified by the rational response of workers, who voluntarily work more when the environment is favorable and less when it’s unfavorable. Unemployment is a deliberate decision by workers to take time off.

Put baldly like that, this theory sounds foolish — was the Great Depression really the Great Vacation? And to be honest, I think it really is silly. But the basic premise of Prescott’s “real business cycle” theory was embedded in ingeniously constructed mathematical models, which were mapped onto real data using sophisticated statistical techniques, and the theory came to dominate the teaching of macroeconomics in many university departments. In 2004, reflecting the theory’s influence, Prescott shared a Nobel with Finn Kydland of Carnegie Mellon University…

Chicago’s Casey Mulligan suggests that unemployment is so high because many workers are choosing not to take jobs: “Employees face financial incentives that encourage them not to work … decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).” Mulligan has suggested, in particular, that workers are choosing to remain unemployed because that improves their odds of receiving mortgage relief. And Cochrane declares that high unemployment is actually good: “We should have a recession. People who spend their lives pounding nails in Nevada need something else to do.”

Posted by James on Friday, September 04, 2009