Goodbye, Homo Economicus

Here we have Anatole Kaletsky, giving us his version of the Buiter rant: Goodbye, Homo Economicus.

Who is Anatole Kaletsky? Evidently, he is an "economist." Well, more like a journalist-economist-consultant-forecaster. That is, he is a snake-oil salesman; which is to say, he is richer than you or I.

In this fine piece, Kaletsky argues that economists must take the blame for the current financial crisis. Well, not all economists, of course. Not economists like Kaletsky, for example. Not the "talking head" economists, or the economists who like to forecast things. The blame lies with academic economists...like me. Well, I am sorry. I am truly sorry for causing the crisis.

The fault lies with academics who plant crazy ideas into the minds of people (adults who cannot possibly be held responsible for what they learn). Crazy ideas like efficient markets, the glory of capitalism, blah, blah, blah. One can certainly see how these crazy ideas have manifested themselves as unbridled capitalism run amok (it is inconvenient here to observe that the financial sector is by far the most heavily regulated sector in any "well-developed" economy).

To flash his eruditeness, Kaletsky offers us the following quote from Keynes:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

I like this quote and agree with it. Kaletsky evidently believes that the economist is to blame for this; rather than the madmen who adopt their ideas. Evidently, Kaletsky must have skipped some classes at Cambridge. I see that Keynes (1923) also said:

The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions.

This is something that Kaletsky evidently does not understand. He certainly shows none of the humility that academic economists demonstrate when it comes to understanding the world around them. For example, take a look at Kaletsky's bold predictions for the economy (made January 2008), Goodbye to all that: the worst is over for the global credit crunch.

His predictions are as follows:

[1] The global credit crisis is now almost over;
[2] There will be no U.S. recession;
[3] Stock markets around the world will rise in 2008;
[4] There will be a "decoupling" between the U.S. and Asia;
[5] The sterling will fall against every other major currency

Incredibly, every single one of his predictions failed to materialize. This takes an incredible amount of skill (generally, bullshit forecasts can expect to be correct 50% of the time). But I suppose that the fault here again lies with academic economists. Shame on all of you!

Larry Summers on Fear and Greed

I used to think that Larry Summers was a reasonable sort of fellow. By here is some evidence proving that spending too much time in administration and politics can rot even the best mind; see White House: Greed Will Help. Here are some quotes:

"In the past few years, we’ve seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying," Summers said Friday in a speech to the Brookings Institution. "Today, however, our problem is exactly the opposite."

Borrowing, you see, is evidently linked to greed; especially if one borrows too much. I am reminded of university students who mindlessly accumulate too much student debt. The greedy bastards. Or of poor people mindlessly borrowing to finance a home purchase. The greedy SOBs. There is too much borrowing; too much spending; there is too much greed.

Saving, on the other hand, is evidently linked to fear. Fear is a virture (as in the fear of God). As when all those virtuous savers bid up the NASDAQ to 5000. Whoops; this doesn't sound right. Perhaps he means saving in virtuous assets, like government treasuries (backed by virtuous/coercive taxation; rather than the prospect of future cash flow from a successful enterprise). Yes, fear is a virture...unless there is too much fear. Then fear is bad.

To summarize then: greed is vice; fear is a virtue. Unless there is too much fear, which is not a virtue. Not enough greed is a virtue; but not a good virtue...which is to say it is a vice. I am getting confused. Let me consult the article again.

"While greed is no virtue, entrepreneurship and the search for opportunity is what we need today."

OK, this clears things up. Make no mistake: greed is no virtue. But we do need more of it at a time like this. So to sum up, greed (borrowing) is bad and fear (saving) is bad (unless there is not enough of either). In the world economy (a closed system), we know that borrowing = saving. And this proves that greed is always balanced by fear. Wait a second, I am confused again. Perhaps what we need is a "new generation" IS-PC-TR like model to help policymakers confront the difficult economic choices they face in balancing fear and greed.

Assume that the policymaker has a quadratic loss function in deviations of actual fear and greed around some socially optimal level of fear and greed (we will let Woodford provide the microfoundations for this social welfare function). Accordingly, let us write this loss function as,

L(t) = 0.5(f(t) - f)^(1/2) + 0.5(g(t) - g)^(1/2)

Here, (f,g) are the socially optimal levels of fear and greed. f(t) and g(t) are the prevailing levels of fear and greed at date t. The policymaker wishes to minimize the fluctuations in fear and greed around their socially optimal levels.

We need more restrictions. Let's see. It seems natural to suppose that fear is influenced in some manner by endogenous variables and an exogenous shock; let's say

f(t) = a*f(t-1) - b*y(t) + e(t)

where y(t) is the output gap; and e(t) is the shock (like a "fear" markup shock in New Keynesian models).

Greed, on the other hand, is influenced by the interest rate and exogenous factors; e.g.,

g(t) = c*g(t-1) - d*r(t) + u(t)

where r(t) is the interest rate, set by monetary policy. Lowering r(t), the way Greenspan did, results in an increase in greed. Seems right.

Now, the policymaker wishes to choose an interest rate rule that miminizes the loss function, given the stochastic processes (estimated as the residuals from a mindless OLS or VAR) governing the fear and greed shocks.

Yes, I can see how the New Keynesian model, so widely used by central banks to justify the policies they follow, will no doubt be replaced by my formalization of Summer's hypothesis. The implications for policy design are likely to prove equally enlightening. Anyone care to coauthor this paper with me? Fame (or notoriety) is virtually guaranteed!

CDO Squared, Anyone?

Along with Martin Hellwig, I think that the other bright light in the field of finance is Gary Gorton of Yale. He has published several very interesting papers on historical banking panic episodes; see here. He gives a detailed account of the subprime mortgage market and the financial innovations associated with it in his paper entitled "The Panic of 2007."

In this paper, he describes the nuances of subprime mortgages; in particular, how their particular design made them very sensitive to the underlying asset price (unlike conventional mortgages). Evidently, this was by design (there was no other way for creditors to make money servicing this particular demographic).

He goes on to describe how these subprime mortgages were packaged into mortgage backed securities (MBS). This is a common form of securitization (although, the design of these also differed in a subtle, but important manner, from standard securitizations). As with other securitizations, mortgages were pooled and then tranches were formed; e.g., a senior tranche, a mezzanine tranche, and an equity tranche.

This type of securitization has an economic rationale. Higher rated tranches can be sold to insurance companies and pension funds (whose liabilities are longer term in nature). In principle, the originator of the MBS should could then hold on to the junior (equity) tranche. This gives the originator the incentive to construct a sound MBS; as the originator is the first in line to potential losses.

What I do not understand is what followed. These MBS were then used as backing for new securities, called Collateralized Debt Obligations (CDOs). For example, the mezzanine tranche of the MBS (rated BBB) would then be divided into senior, mezzanine, and junior tranches. The mezzanine tranche of this CDO would then be divided again into senior, mezzanine, and junior tranches (a CDO squared). The senior tranches of the CDO squareds would be assigned AAA ratings!

I do not understand the economic rationale for this further subdivision of the original MBS. I presume that there must be one (perhaps to get around some government regulations?). Is there an expert in finance out there that can help me out? I have had little luck in finding anything that explains the motivation for why CDOs exist.

Martin Hellwig on the Financial Crisis

Tired of all that sanctimonious drivel spewing from the likes of Dani Rodrik and Willem Buiter? Head aching from the cacophony of shrill voices rejoicing at the end of the world?

Then consult the good doctor Martin Hellwig; see here.

He also has a very nice article entitled "International Contagion: The Result of Information or Rhetoric?" that is well worth reading.

Would be interested to hear what people think.

Brad DeLong: Bad Economist, Good Historian?

In the lead up to his debate with Michele Boldrin on fiscal policy, DeLong cannot hide his sense of pride in proclaiming that "I am not a macroeconomist; I am an economic historian."

As the debate unfolded, he (unintentionally, no doubt) supplied us with ample evidence confirming his lack of theoretical training (to be more precise, his reliance on those "really useful ad hoc models" that appear sufficient to organize anyone's thinking on macroeconomic phenomena).

At one point, for example, he presented some data showing that employment was falling even in states that were not heavily exposed to subprime mortgages. The implication we were presumably to draw from this fact is that the current downturn is nothing more than an old-fashioned decline in "aggregate demand" (the cause of which is conveniently ignored, as this requires some deep-thinking). The corollary is that a large government fiscal stimulus is obviously desirable to mitigate the (unexplained) decline in private-sector "demand."

There are, of course, competing theories that are consistent with what an historian (or econometrician) might interpret as an "exogenous decline in aggregate demand." Many of these theories are no more or less crazy than DeLong's preferred theory (his Econ 101 macroeconomics principles course notes). He apparently does not feel the need to temper his opinion by the humility that any good scientist should feel by the difficulty associated with discriminating among several competing hypotheses. Yes, there is no doubt that DeLong is a bad scientist.

But then, DeLong is not a scientist; he is a self-proclaimed historian. Someone who documents previously unknown facts and provides data that challenges preconceived notions. Someone like Joel Mokyr, for example (read his delightful The Lever of Riches). I am sure that DeLong has made useful contributions in his field (actually, I really enjoyed reading his piece on America's peacetime inflation). But I now have a little cloud of doubt over whether we should trust him even here.

I am not an economic historian; but I have done some reading on economic history. And in particular, I have done a fair bit of reading on Herbert Hoover; whose opinions and policies were shamelessly distorted by DeLong in his debate with Boldrin. Bob Murphy drives this point home splendidly. Consider, for example, what DeLong said:

"Now Prof. Boldrin is following a very old trail, all right, his trail was in fact the ruling theory behind the Hoover Administration's policies in the 1930s. And to quote from President Herbert Hoover's autobiography, during his administration economic policy was made by quote "the leave-it-alone liquidationists headed by my Secretary of the Treasury Mellon, who felt the government must keep its hands off the economy and let the slump liquidate itself."

Inexplicably, DeLong fails to inform his audience of what follows this quote in Hoover's autobiography:

"But other members of the Administration, also having economic responsibilities- Under Secretary of the Treasury Mills, Governor Young of the Reserve Board, Secretary of Commerce Lamont and Secretary of Agriculture Hyde--believed with me that we should use the powers of government to cushion the situation."

Any good (or honest) economic historian must know that Hoover was no laissez-faire apologist. As the world's foremost mining engineer at the turn of the last century, Hoover saw first-hand and disapproved strongly of the speculative manias that frequently arose in his industry. As head of the Belgian Relief effort of WW1, Hoover orchestrated a massive interventionist effort that literally saved the lives of tens of millions Europeans. As Secretary of Commerce in the 1920s, he lobbied frequently for banking reform (lobbying efforts that were repeatedly quashed by the Governor of New York; none other than FDR) and warned of a growing mania in stock prices. His interventionist tendencies in the early days of the Great Depression were frequently blocked by the Democratic Congress (FDR accused him of being a reckless spendthrift). Most of "FDRs" New Deal policies were lifted wholesale from Hoover himself. If you do not believe this, then consider this quote from one of FDR's early advisors (Raymond Moley, writing in Newsweek, June 14, 1948):

"When we all burst into Washington...we found every essential idea (of the New Deal) enacted in the 100-day Congress in the Hoover administration itself. The essentials of the NRA, the PWA, the emergency relief setup were all there. Even the AAA was known to the Department of Agriculture. Only the TVA and the Securities Act was drawn from other sources. The RFC, probably the greatest recovery agency, was of course a Hoover measure, passed long before the inauguration."

Is DeLong a good economic historian? I'll let you be the judge.

Multiplier Mischief

The current debate over the size of the "government spending mulitiplier" is a perfect measure of the sway that conventional economic theorizing continues to grip the minds of people who should know better.

At the center of the theorizing is the income-expenditure identity: Y = C + I + G. This identity is not a theory; it is something that is true by definition. The theory comes in by way of behavioral assumptions that are imposed on C and I. All that is left is to determine how an exogenous change in G manifests itself as a change in Y. The government spending multiplier is dY/dG. Now all economic historians have left to do is to try to estimate the size of dY/dG. They frequently "discover" that dY/dG > 1. That is, it appears that for every dollar the government spends, the national income appears to increase by more than a dollar. Conclusion: Obama's stimulus package is a good idea.

There you have it. The only puzzle remaining is why it takes 4 full years of training to receive a PhD in macroeconomic theory; and why it should take a further 6 years to become a tenured professional by publishing papers examining what we all know to be the self-evident truth embedded in this "really useful ad hoc model."

Unfortunately, I am apparently one of few who have trouble absorbing this simple theory. But perhaps there is still some hope for me. I just need a few questions answered.

[1] What does this theory predict concerning the optimal level of Y? Is more Y always to be preferred to less? When Y was expanding rapidly above trend during WW2, were people really made materially better off? Were people made happier by their long hours employed in military manufacture and European adventures? Did people really enjoy the rationing of foodstuffs and gasoline associated with the increase in G? Was the general destruction of capital (both physical and human) during WW2 really associated with increasing wealth levels?

[2] Do *measured* increases in Y associated with increases in G correspond in any meaningful way to *true* increases in Y? Do we not know that when the government pays for something, the "value" of this purchase is measured by cost (instead of market-value) by the National Income and Product accountants? Is this not a serious problem in assessing the "true" value of an increase in G? Are measured government spending multipliers simply a figment of this questionable accounting exercise?

[3] What are we to make of multiplier estimates that are above unity? Is this a linear approximation? Does it represent the value of the marginal dollar spent? (If it does not, then is the implication that the entire economy should simply be nationalized?).

[3] Do the "microeconomic" details concerning the added G not matter at all? Does it matter, for example, that almost $100 million in "stimulus" money is being directed to the Milwaukee Public School system to construct new schools (a district that has been closing schools as a result of declining attendance; see here)? Are people still willing to argue that "digging up holes and filling them in" is a wise use of economic resources?

[4] What does this simple theory identify as the "cause" of recession? An exogenous decline in private sector "sentiment?" What does this mean? Is this purely pyschological? Can we not expect private sector agents to make estimates of the future based on the best information available? Does the government have better information? If so, why does it not make it available? Can declining consumer and business sector "confidence" not be reasonably interpreted as a symptom, rather than a cause, of any economic downturn? How can we know, one way or the other? What evidence can be brought to bear on the idea that recessions are "inefficient?" Is the arrival of a harsh winter that freezes construction to a halt also inefficient? Should the government promote construction activity during a freezing winter?

[5] What is the government spending multiplier in Japan since 2000?

[6] Should we follow Christina Romer's advice and take employment as a metric of economic welfare? Has she not studied economic theory? (Actually, I know the answer to this last question--it is no). I recall reading an article from the TASS news agency, published in 1957 that "the unemployment rate in the Soviet Union, as in previous years, was equal to zero." Should we seek "full employment" along the old Soviet model? Is this how we are to measure success?

I have many more questions, but these will do for now. Of course, some of these questions are rhetorical in nature. But many are not; I genuinely do not know the answers to them. Evidently, the likes of Romer, DeLong and Krugman do know the answers to them. But perhaps this is because none of these esteemed academics are macro theorists. They likely view my ignorance on these matters as evidence supporting their proposition that too much macroeconomic theory distorts the mind. Thank goodness we have these clear-thinking folk around to set me straight!

Willem Buiter: Economicus Ignoramus

Oh my, this is rich. Here we have Willem Buiter, self-proclaimed genius and mediocre economist extraodinaire, suddenly discovers that there is a problem with the development of "Anglo-American" macroeconomic theory. See his little diatribe here.

We all have our own pet peeves with the way macroeconomic theorizing has progressed over the last few decades. My own is with the the so-called "New-Keynesian" paradigm (Woodford); which is clearly the "mainstream" view adopted by most policymakers (until recently, that is).

My beef with the NK paradigm is this in a nutshell. It is a model that ignores money and typically, financial markets too. It embeds unexplained "frictions," like sticky prices. It embeds conceptually vacuous "shocks" like "mark-up shocks" or "inflation shocks." It focusses on the policy problem of "stabilizing" the economy in the face of these little itty-bitty shocks. It is not a model designed to understand financial crisis. It is a model designed to legitimize what central bankers always believed they should be doing in the first place: adjust the short-term interest rate to stablize the economy around a predetermined long-run trend. This is why the NK model is the dominant paradigm; and this is why those that promote this view land all the cushy consulting jobs. Among those that promote this view include our very own Herr Buiter. Here are some links to the courses he teaches on the subjects: see here. Good job, Willem. One can easily see how your students (and yourself) were well-prepared to deal with the current financial market crisis with your "very useful ad hoc models" of the economy.

Of course, most economists who have worked to develop the NK paradigm are honest researchers with a sincere desire to understand how the economy works and how policy might be designed to meet worthy social objectives. Evidently, Herr Buiter has a different view:

Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck.

I presume that he is talking about himself here; he should not attribute his own objectives to others in this manner.

Let's see what else he has to say...

The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’.

This is clearly evidence that he has no idea of what he is talking about. The complete markets paradigm is the Arrow-Debreu model; and this is patently not what "New Classical" and "New Keynesian" theories assume.

In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity - both funding illiquidity and market illiquidity - are also impossible, unless the guilt-ridden economic theorist imposes some unnatural (given the structure of the models he is working with), arbitrary friction(s), that made something called ‘money’ more liquid than everything else, but for no good reason. The irony of modeling liquidity by imposing money as a constraint on trade was lost on the profession.

No, Mr. Buiter, the irony of modeling liquidity by imposing money as a constraint was not lost on the profession (see the work of Neil Wallace and Randall Wright, for example); it was lost on a subset of the profession of which you belonged.

It is clear that, when searching for an appropriate simplification to address the intractable mess of modern market economies, the starting point of ‘no markets’, that is, autarky or no trade, is a much better one than that of ‘complete markets’.

The conclusion, boys and girls, should be that trade - voluntary exchange - is the exception rather than the rule and that markets are inherently and hopelessly incomplete. Live with it and start from that fact. The benchmark is no trade - pre Friday Robinson Crusoe autarky. For every good, service or financial instrument that plays a role in your ‘model of the world’, you should explain why a market for it exists - why it is traded at all. Perhaps we shall get somewhere this time.

Oh thank you Professor Buiter; thank you for this. Let us begin by modeling exchange by assuming an economy populated by a single Robinson Crusoe. Yes, this should help. And let us model the exchange process as "involuntary" exchange instead of voluntary exchange. Perhaps we will get somewhere this time indeed. Good luck. I'm sure that you will lead the way.

Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many key asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. eduction.

And so where is Herr Buiter's theory that would replace the EMH? I am very much looking forward to my de-programming from such an enlightened and worldly individual.

The EMH is surely the most notable empirical fatality of the financial crisis. By implication, the complete markets macroeconomics of Lucas, Woodford et. al. is the most prominent theoretical fatality. The future surely belongs to behavioural approaches relying on empirical studies on how market participants learn, form views about the future and change these views in response to changes in their environment, peer group effects etc.

Clearly, he does not understand the EMH. We probably do have some things to learn from behavioral approaches; but I would not want this ignoramus to lead the charge.

I believe that the Bank has by now shed the conventional wisdom of the typical macroeconomics training of the past few decades. In its place is an intellectual potpourri of factoids, partial theories, empirical regulaties without firm theoretical foundations, hunches, intuitions and half-developed insights. It is not much, but knowing that you know nothing is the beginning of wisdom.

I too hope that central banks are now led to place less weight on the "conventional wisdom" expoused by Buiter and others. It is indeed a good thing to be humbled by the realization of the limits of our theorizing. But to expouse a program of ignorance "without firm theoretical foundations" is going too far. Too far that is, unless you are Willem Buiter, economicus-ignoramus ready for hire.