Were economists wrong because of economic incentives ?
Matthew Yglesias writes
Ragu Rajan … his explanation of why economists didn’t predict the crisis:
I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.
Rajan glosses a leading alternative hypothesis thusly:
Finally, an answer that is gaining ground is that the system bribed economists to stay silent.
Obviously bribe-based theories of human behavior are crude and rarely capture reality. But how about translating this into economics? How about incentives? Rajan says it’s not individual corruption that led to a lack of insight, it’s structure features of the way the profession is organized. That makes a lot of sense to me. But what explains that structural organization? Is it really unrelated to the financial basis of the economics profession? Or are economists supposed to be immune from the factors that influence human behavior in other instances?
I will try to guess if the system is bribed to stay silent. I am technically an economist, but not part of the system (that is not an elite economist). To start with my conclusion, I don’t think that the blindness of elite economists can be explained as a rational or semi rational response to incentives. I think that Rajan happens to be right about what went wrong this time.
I explain why I believe this after the jump.
Very few economists saw it coming (and they might have just guessed right or strategically made an extreme prediction which is like buying a lottery ticket). I’d say two things blinded economists, the EMH and DSGE (acronyms explained below). Neither was paid for by firms or rich individuals.
First the Efficient Markets Hypothesis (EMH) which holds that all assets always sell for the same price they would have if everyone had rational expectations. Basically it says there are no bubbles even in housing *and* that if there is a housing bubble then mortgage bonds and CDOs of mortgage bonds and CDSs on CDOs of morgage bonds are all correctly prices. Clearly no advocate of the EMH could see it coming.
For some reason, the EMH remains the default position of many academic economists. Worse, one exception at a time is allowed, so people see if one asset is correctly priced assuming all other assets are correctly priced. There is no way this approach could lead to a prediction that the recent crisis was even possible.
Also, iit would be a total catastrophic disaster for the financial services industry if the general investing public believed the EMH. If anyone took it seriously when investing (as opposed to when writing academic articles) then the financial services industry couldn’t make much money dealing with that person. If one believes in the EMH and doesn’t have private information (not a strategy or algorithm or theory but knowledge of relevant facts which almost no one knows) then one should buy and hold the market portfolio. This means low trading volume and low fees. This means you buy equal amounts of all tranches of CDOs (except you already have the pool of underlying assets so you don’t bother). This means you don’t pay someone to manage your money unless that person has private information.
The Financial services Industry makes its huge profits at the expense of suckers who think they can beat the market. Partly by charging them fees and partly by betting against them (since the EMH is false financial professionals can make money with simple rules). Belief in the EMH would kill the goose that lays the golden eggs.
Yet academic economists have been promoting the EMH for decades. This just couldn’t be the effect of being bribed *or* of some indirect influence of group interests on sincere beliefs or anything. The bought off hypothesis just doesn’t fit the facts.
The use of DSGE (dynamic stochastic general equilibrium) models also guarantees failure to see it coming. It also has nothing to do with consulting. There is a sharp devision between academic macroeconomics and macroeconomic forecasting. It is done by different people. Some people are paid for forecasts. Clearly they have all sorts of interesting incentives which have been analysed at gruesome length by academic economists who, contra Yglesias, pay attention to incentives of forecasters. They don’t use DSGE models. They missed it too, but they aren’t the people Rajan was writing about. As far as I know, there is no rich or concentrated group which promotes DSGE models. People who pay macroeconomists pay completely different macroeconomists who do completely different things. They don’t know or care what DSGE stands for.
I may be overstating my claim. It may be that DSGE models tweaked to give the same forecasts as atheoretic models are used. But no one has an interest in paying the middle man (the tweaked theory).
I’d say the way in which money has influence economics is by promoting in general a right wing slant (compared to view best supported by the evidence). Many prominent economists are very right wing. If asked, they advise people to vote for Republicans. Now I note that US economists are on average a bit to the left of the US center (the general academic thing beats the field specific thing). My view that the profession is slanted right compared to the evidence just means I am to the left of most of the profession.
In any case this has almost nothing to do with missing the warning signs.
I think there is a huge difference in missing the housing bubble which was obvious and not knowing how deeply leveraged said bubble was to the whole financial system. Meaning if you modle a firm to maximize profits by hedging and the firm says it is hedging, its hard to believe that it isn’t hedging.
I think the issue is that there are two different time constants involved here. The markets are clearly inefficient in the short term (up to months) but in the long term (all be it as Keynes said we are all dead) they do become efficient. The long term is years at a minimum. Note that if you read more money than god you find that hedge funds find an inefficency in the market and exploit it. However everyone figures out the technique and low and behold the inefficency becomes minimal at best since everyone knows how to exploit it.
The post of course echos Boogle in saying you can’t beat the market, so just keep your costs low, but that would make Manhattan a ghost town (perhaps a good idea) as the financial services industry implodes due to no revenues. Its interesting that everyone wants people to trade trade trade, because its more of a cut for the house.
I think I agree. But I’d argue that the “efficiency” of the markets is more of a pious tautology than a useful statement to guide policy. For one thing, the efficient markets would “discount” government at least as unemotionally as it discounts gravity and the second law of thermodynamics… that is, these are just facts of nature and normal costs of doing business… and frequently the source of profit.
But the economists who ALWAYS cry out about the efficiency of markets, and the need to avoid, at all costs (sic), government action, have at least blinded themselves if not sold their souls, and they can no more think rationally about the economy than an engineer could think about buildings or engines if he believed in a god in every machine.
I think it is correct that the average participant cannot do better than by assuming the EMH (and thus buying the market, instead of second guessing it). It isn’t correct that the market is efficient, but you need to know a lot across many disciplines to do better than assuming it is. And by and large, trying to place a bet by selecting someone you think does have a better understanding of correct prices is a zero sum proposition, less transaction fees and scams costs.
“you need to know a lot across many disciplines to do better than assuming it is”
But we’re all from Lake Wobegone, so we do more than most people.
“First the Efficient Markets Hypothesis (EMH) which holds that all assets always sell for the same price they would have if everyone had rational expectations.”
No, it doesn’t. The EMH is much, much, less than that, to the point that it’s almost a tautology.
It states that, when setting prices in a marketplace markets are efficient at processing the information available to said market about what prices should be in the market.
And that’s it. It doesn’t say that prices are “right”, that prices assume rational expectations or anything else. Simply that markets are efficient at processing information.
Now, some do go on to say that because markets are efficient at processing information and that all information possibly available (ie, “strong EMH”), including insider information will be processed, then only new information can change those prices.
But that’s still not making the assumptions that you are stating it does.
“It is very difficult to make a man understand something when his salary depends on his not understanding it.” -Upton Sinclair
The funniest (Okay the only funny) parts of Inside Job are the sections in the last 3rd where the interviewer has the temerity to ask various academic economists and some academic chairs at major universities to explain why they shouldn’t be required to disclose their consulting relationships to their schools or communities. The chairs of the economics departments of both Harvard and Columbia come off rather badly as I recall as they stammer and bluster pitiful excuses on why that information is quite properly confidential.
I agree. The housing bubble was very obvious years before it deflated. It was easy to predict that there would be a bubble collapse and a lot of people were going to lose wealth and it would create a large recession. The degree of BigF leveraging based on housing bubble “wealth” was not publicly known and could only be known to the BigF firms. Even within firms, compartmentalization may have hidden the degree of leverage so that those who knew the positions did not know how to interpret the data.
The biggest mistake that economists made was thinking that the need for insurance in banking was not necessary, or somehow the shadow banks were above needing insurance.
My flim flam is right, your flim flam is wrong, except if my flim flam is wrong, then your flim flam is right. If both of our flim flams are right, then neither is wrong, but if both are wrong, then neither is right. As for who is paying me for my opinion, that’s none of your business. Does this mean that economists were created to put a face on the fact that the stock market is nothing more than a Ponzi sceme, a crap shoot, What?
I too agree. I’d also note that not all economists missed the housing bubble. The number one name in “something to do with the price of houses” is Robert Shiller and he noted the bubble. Also Krugman. As I argued in the post, a large number of extremely prominent economists were bound to miss the bubble, because they insist that there can’t be bubbles (or rather when pressed that we should start by focusing on models without bubbles for the time being, that “time being” being all of time).
I’m note sure one could predict a large recession when the bubble burst. I still don’t know if just the bursting without reckless bets by banks would have done it. With a passive Fed, there would have been a big recession. I’m not sure there wouldn’t have been only a small recession (think 2001) with effectively 0 safe short term nominal interest rates as soon as the bubble burst.
Some of the reckless bets were detectable. The ratings of CDO are explained publicly and ar nonsense. The amount of CDS written by AIG was visible in its balance sheet. I agree it was hard to see the vulnerability of Lehman. But I didn’t notice any of it. It wasn’t my field of interest.
The post does not say that you can’t beat the market. It says that if the EMH were true, then you couldn’t beat the market. It also says “since the EMH is false financial professionals can make money with simple rules.” Evidently you missed that part.
Your claim that the efficient markets hypothesis is true in the long run is a claim of fact based on a theoretical argument. You have a story which makes sense to you, so you assert that it must be true.
If you had any clue as to what science is, you would understand that you have to confront your hypothesis with data and, only if it is not rejected, consider if it might be true. Clearly you have read the empirical finance literature as carefully as you read my post. Anomalies have lasted for decades.
Of course you can always define the long term as centuries. Then your hypothesis, which you assert as a fact, can’t be refuted.
First, Economic models are never predictive, they are not truly testable. If they were, then we would see science develop with well-established principles. Economics is so infested with politics and self-interest that it never rises to any kind of objectivity.
Second, Economic models never even closely approximate real conditions–any business man can tell you this. Run a company if you want to see how it works.
Third, Economic academia is primarily corperate funded; there’s your bribe, if you want to call it that. There are vested interests funding the “research” and the “teaching” of “accepted” truths–all of which are convenient truths for corporate interests, which rarely ever coincide with public interests.
I have watched the present fiasco for a number of years now. I have repeatedly said it is going to be a bumpy road down to the bottom, but to the bottom we are headed. Jobs? There is no serious discussion of job creation. We all know that the 2001 recovery was jobless, just as the present so-called recovery is essentially jobless.
An interesting note: Economists held a world forum the year before the crash, during which they praised the financial institutions of the West as innovative and far superior to the dusty old conservative ways. Nouriel Roubini was one of the authors of the final report. I had to laugh.
And the trade deficit? Well, been going on for some time now. Yet corporations are doing well! How is that? Do you not think that a long, well established trade deficit will not bleed even the greatest of nations to death? Ok, quiz time: What was the last year in which the U.S. had a trade surplus? Do you think those corporations that lead the charts care about the U.S. trade deficit?
The answer is, “No.” And why not? duh
“the rational expectations hypothesis” (REH) and “processing information efficiently” mean the same thing.
I can’t make any sense at all of your comment. I fear I must point out that the REH is not the same as the perfect foresight hypothesis. Also that the REH does not imply the strong form EMH (I meant semi strong form EMH when I wrote EMH and should have added the “semi strong” — I claim that this is now standard usage).
YOu assert that the EMH does not imply that prices are what they would be under the REH. If you are right, it is possible to find an example which satisfies the semi strong form EMH but gives prices different from those under the REH. I note that you don’t claim to give such an example.
Rather you assert I am wrong and then make a series of abstract statements which prove no such thing. I challenge you to present an example or retract your accusation of error.
Were economists wrong because of economic incentives?
Some were. Those that worked for banks, mortgage companies, realtors, etc. had a strong interest in keeping the money train chugging on down the tracks.
Other economists, mostly non mainstream, were warning real estate was overvalued since about 2000. They were viewed as turds in the punch bowl, and furthermore were bured by the data. This created the herd mentality that is the key ingredient to a Bubble.
well, i certainly read lyle differently than robert did.
The problem is always the same, to call the recession requires standing in front of the runaway train coming straight at you. No one wants to hear it. And, no one thanks you afterwards, by which time you are out of a job. It even works in reverse, if Treasurer believes economy is headed to hell after a devaluation or “crisis”, and the economist is blowing bubbles and being upbeat, out you go. When people say they want a one-handed economist, I have found in my experience, that they are liars…..
I don’t in fact make abstract statements there. I explain, simply and clearly, what the EMH is.
REH and processing information efficiently do not mean the same thing at all. REH states that errors are random, not systematically wrong. Specifically, that errors made by the agents within a system are randomly, not systematically, wrong.
It’s the EMH which states that markets process information efficiently.
As an example of how the two differ.
Imagine a scenario in which US nationwide house prices had never declined all at the same time. We’d had regional falls, but never national.
The information efficiently processed by the market was, as under the EMH, efficiently processed. All knew that we’d never had such a nationwide fall and thus this knowledge was encompassed in prices.
Now, as we know, this in fact led to erroneous prices. Because while this had never happened before, it did now happen. Which means that the REH was not in fact correct: the errors of the agents in the market were not randomly wrong, they were systematically wrong. If agetns behaviour had been randomly, not systematically, wrong then the bubble wouldn’t have formed/wouldn’t have been as large as it was, for some errors would have been above and others below “true” value.
But if that had happened then the EMH says that that information would still have been efficiently processed.
Indeed, the EMH says that whatever people’s expetations were, behaviour, whether rational or entirely doolally, the markets would still have processed this information effieicntly. And that’s all it does say.
Gotta agree with you Stormy. And just to remind the readers and new readers I posted the following 12/12/07: http://www.angrybearblog.com/2007/12/its-big-one-honey-i-know-it.html I got the title correct. The chart shows the cross over of income below consumption as of 1996. That’s all any economist had to be watching to see this coming. You know, consumer driven economy and all. Had they looked at the early years when income crossed over consumption, and thus the big boom and hay days of America started, they would have had even more of a clue. NBER announced on 12/1/08 that the recession started 12/07. Hey, remember the discussion here at AB as to whether one’s home was a saving bank or not?
Now, let’s go a little further. 2/26/08: http://www.angrybearblog.com/2008/02/how-are-we-going-to-fix-money-from.html
We still have not answered the title of the post. Which leads to this nice little bit of history that shows what also needs to be reset:
First 43 years doubling: GDP 8.6 yrs, 99%’ers 10.75 yrs, 1%’ers 14.3 yrs.
Next 32 years doubling: GDP 10.6 yrs, 99%’ers 11 yrs, 1%’ers 8 yrs.
Can’t keep taking money out of the economy faster than it can produce it. To date, I see nothing policy wise and worse yet nothing discussion wise as to this issue. It is the prime data set that should be instructing all policy ideas.
The economics profession on whole missed it because they have become focused on the efficiency of money and not the efficiency of people’s lives.
Lyle: “I think the issue is that there are two different time constants involved here. The markets are clearly inefficient in the short term (up to months) but in the long term (all be it as Keynes said we are all dead) they do become efficient.”
Long term efficiency is meaningless. Long term, markets are unpredictable. That does not equal efficiency. 🙂
Yes in the long term it may well be that efficient markets are a tautology, i.e. the price eventually averages around the right value.
Some of the long term issues is that in the long term demand must equal supply, if you build to much housing for a while there will be a period of less building to absorb the surplus.The fundamental error of the efficient market group is that they assume that the actors are emotionless calculating machines, not humans subject to lots of emotions. Even Adam Smith recognized this, economists as physicistswannbes assumed humanity out of the equation.
Tim is right that the EMH just states that the market incorporates the known information.
This is not to say that the “known information” is correct.
So the market can by efficient and wrong at the same time.
A bubble like we saw going into the crash is a form of mass hysteria where the market and the overwhelming majority of everyone concerned — investors, regulators, the press, the political system, etc.– convince themselves that something is true that turns out not to be true. It was received wisdom that US national housing prices had never fallen and that the markets and system had become better and better. Because so many people believe this, and had a vested interest in believing this, the warnings that the belief is a mass hysteria go unheeded. Sure there were certain people that were right and probably the most respected was Robert Shiller who had previously correctly forecast that the stock market was overvalued and vulnerable now turned his attention to the housing market and made the same call. He was respected and had the ear of the Fed, the stock market and the press. Yet, his warnings went unheeded because few wanted to believe he was right — it is different this time is the most powerful and the most dangerous comment in investing.
I’ve made my living selling an econometric market strategy service to professional portfolio managers for about 30 years. My best call was going bearish before the 1987 market crash and over the years my buy recommendation have significantly outperformed the market and my sell recommendations have underperformed. I had built into my system that we were building about a half million too many homes each year in the early 200s, but i did not realize the banking systems was as over-leveraged and vulnerable as it was. After the crash of 1987 I lost most of my clients and over the years I have lost many more clients for being right than for being wrong. The overwhelming majority of professional portfolio managers are more interested in managing their career and firm than their clients money. If they do what everyone else is doing and lose their clients money they will probably keep the client and be OK financially and their firm and keep growing. But if they go out on a limb and lose money it is a disaster for them personally. They will lose clients like crazy and their firm will hemorrhage clients. If you do not believe this look at what has happened to Jeremy Grantham’s firm — he has been dead right on the bear markets but his firm is only about half the size it once was. His bearishness has cost his firm many, many clients even when he has been right.
This is why most of the analysis of the recent market -economic crash is pure bull and has little or no basis in reality. It is mostly individuals spouting their individual political-economic beliefs and has little basis in reality. Bubbles happen because of a form of mass hysteria, and this dates all the way back to Roman times. Regulation can work so long. The damage in the 1930s was so bad that the regulation system prevented another bubble for about 50 years. But eventually everyone will come to believe in the new paradigm –regulators, investors and the public — and slowly but surely the safeguards against bubbles will be dismantled and new bubbles will emerge. Moreover, this is just as true of the right wing beliefs that market failure will prevent bubbles as it true of left wing beliefs in new regulation systems.
The United States today reminds me of the Soviet Union in the mid-70s, around the time their empire stopped being profitable, but became a burden. If you wanted a good career, you spouted the party line. It wasn’t simple bribery, though that was part of it. You didn’t really have to believe the party line, but you had to repeat it. Worse, you had to let it guide your decision making. That was the beginning of the end, though the empire lasted another 15 years or so. Some empires lingered a lot longer based on less.
Admiral Woodward, who led the British task force that retook the Falkland Islands, was always on the lookout for his officers sanity. When Hollywood has an officer go nutcase, they have him chew the scenery, but in the real world, he just stops processing the changing situation. In many ways it is worse. It’s hard to miss an officer trashing the chart room. It’s easy to miss when one goes reality blind.
I think a lot of it is about profit, but there is also a certain kind of madness.
well, the tautology
is in assuming there is a “right” value. the price is what it is, given all the factors that determine price. if you are only interested in the game of predicting prices, well and good, but that is not the same as saying what the price “should” be…. or would be, if some other factor was brought into the equation.
I feel like I ought to copy that down and give it to my friends to read. It seems to apply to a number of things beyond selling stocks.
The behavior you describe seems to fit all corporate, bureaucratic, and social behavior I have observed over about sixty years.
a kind of madness, perhaps. but i think it is more like normal human cognitive functioning, given the limits of human perception and the social realities described by you and Spencer. Trouble is when I try to point out to commenters on Angry Bear that they are “suffering” from this very common syndrome, they think i am calling them names and get mad at me.
I have never been in the American Navy, but I’ve read a few things that make me think they are like Woodward… officially aware of the problem and as on the look out for it as people caught up in it can be.
it seems to me you are correct, but the people who run around talking about “efficient markets” always seem to mean that the price is “right.” which only amounts to saying that the price is what it is. if the price was “right” in the sense implied, it would not suddenly become “wrong” tomorrow when it changes.
now if i need to buy a house today, i am pretty much stuck with today’s price. but if i am buying the house expecting to make money from it tomorrow, or at least not lose money, the “efficient market” doesn’t help me at all.
Ah, well…who are these “people”?
I have two alternatives for you.
1) The economists who say that the EMH shows only that markets are efficient at processing information.
2) Those who, for whatever reason, don’t like markets and equate “efficient” with “right”.
1) are those who are correct, 2) are those who are drivelling idiots for political reasons.
Apply as you wish to those who talk about the EMH……