Economics After the Crisis

Last month, David Brooks wrote an OpEd in the New York Times on the evolution of modern economics: The Return of History.  Like so many of us, Brooks is trying to come to grips with the failure of economists, - many of whom have been so publicly famous and influential over the past several decades, - to anticipate a financial crisis of this magnitude.  “Some brilliant scholar has to write a comprehensive history of modern economics because the evolution of this field is clearly one of the most consequential things happening in the world today,” he says.

Brooks speculates that this modern history of economics will consists of five acts, starting with “ . . . the era of economic scientism: the period when economists based their work on a crude vision of human nature (the perfectly rational, utility-maximizing autonomous individual) and then built elaborate models based on that creature.”  Paul Krugman called such models, an “idealized vision of an economy in which rational individuals interact in perfect markets . . . gussied up with fancy equations” in a recent NY Times Magazine article, How did Economists get it so Wrong?

Act II is when “brave economists” started to question this idealized, abstract view of economics.  Such brave economists started to point out that people are not really perfectly rational and do not always make totally objective decisions.  Some human behaviors cannot simply be explained in terms of narrow self-interest, like having children and behaving altruistically.

Act III is the ongoing global economic crisis.  “This act is a climax of sorts because it exposed the shortcomings of the whole field.  Economists and financiers spent decades building ever more sophisticated models to anticipate market behavior, yet these models did not predict the financial crisis as it approached.  In fact, cutting-edge financial models contributed to it by getting behavior so wrong - helping to wipe out $50 trillion in global wealth and causing untold human suffering.”

This then brings us to Act IV, “the period of soul-searching that we are living through now.  More than a year after the event, there is no consensus on what caused the crisis. Economists are fundamentally re-evaluating their field.”  Brooks, then gives his prediction for how the story concludes:

“In Act IV . . .  economists are taking baby steps into the world of emotion, social relationships, imagination, love and virtue.  In Act V, I predict, they will blow up their whole field.  Economics achieved coherence as a science by amputating most of human nature . . . [but] the moral and social yearnings of fully realized human beings are not reducible to universal laws and cannot be studied like physics.  At the end of Act V, economics will be realistic, but it will be an art, not a science.”

I very much liked David Brooks’ OpEd, but I don’t quite agree with his Act V epilogue.  In my opinion, the moral of this story is not that economics is more art than science.  What we are seeing here, is another manifestation of the arrogance of power that we all have to guard against because it inevitably leads to trouble.  We have often seen that if we are not careful, power will invariably lead us humans to arrogance and pride, whether we are successful business executives, politicians, athletes, academics . . . or economists.

The ancient Greeks used the term hubris to describe the kind of overconfident pride that gets such powerful people in trouble.  Hubris was typically responsible for the downfall of heroes in Greek tragedy.  It is difficult to find people, especially those whose accomplishments have helped them achieve success, wealth and power, who do not exhibit feelings of arrogance to a greater or lesser degree.  These feelings often lead to a distorted view of the reality around them and of their own capabilities to deal with the troubles that inevitably lurk ahead.

By the 1980s, the Act I economists David Brooks refers to were at the top of their game.  A number of them had received Nobel Prizes and other major awards.  Their theories, - including the advocacy of a  nearly universal trust in markets and a very limited, circumscribed role for government, - provided the intellectual underpinnings for governments around the world, especially in the UK with Margaret Thatcher and in the US with Ronald Reagan.  The mood of the times is perhaps best captured by President Reagan’s famous phrase in his first inaugural address:  “Government is not the solution to our problem; government is the problem.”  

One of their own, Alan Greenspan presided over this economic order when he became chairman of the Federal Reserve Bank in 1987.  Fifteen years later, Greenspan had come to believe that derivatives and other financial instruments created by the private sector were so good at distributing risks, that there was less of a need for regulating the increasingly complex financial markets.

“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient,” he said in 2004.  He apparently held these views until October of 2008, when in testimony before Congress, he finally acknowledged that he was partially wrong in opposing regulation: “Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity - myself especially -  are in a state of shocked disbelief.”

But, around the same time that these Act I economists were enjoying such great success, the winds of change that would eventually culminate in the financial crisis were starting to gather.  A new, global digital economy was rapidly emerging, driven by a combination of technology advances like the Internet and the forces of globalization. 

Something like creative destruction, - the concept popularized by Austrian economist Joseph Schumpeter to describe the process of transformation that accompanies radical, disruptive innovation, - was starting to impact those aspects of economics that no longer worked, much like it does away with companies that are not able to adjust to changing market realities.  But, creative destruction does not just imply the end of what no longer works.  It also ushers in the beginning of whatever make more sense in light of the new market environment. 

A whole slew of new ideas is now sweeping the field of economics.  The idealized, perfectly rational models of economics that dominated Brooks’ first act were highly theoretical and abstract.  Elegance and mutual consistency was highly prized.  These economists were essentially mathematicians, somewhat removed from the messiness of the real world. 

The new breed of economists are creating a field that has much more in common with empirical sciences than with pure math.  Following in the best tradition of physics, chemistry, biology and the social sciences, they are grounding economics on observation and experiments.  Theories arise out of empirical analysis, and must reflect the realities, and therefore the inconsistencies and messiness of the real world they aim to explain.

Behavioral economics, for example, is trying to take into account the social, cognitive and emotional factors that go into the economic decisions that people make.  At the core of behavioral economics is the conviction that: “Economics, like behavioral psychology, is a science of behavior, albeit highly organized human behavior”

It is fascinating that in its attempt to better factor in the real behavior of people, behavioral economics is actually bringing the field back to its origins and the works of Adam Smith, the 18th century Scottish philosopher who is considered the father of economics, as well as of free-market, free-trade capitalism. 

Smith had a balanced view of economics.  On the one hand, you had the forces of the marketplace, where individual strive to create wealth in a competitive, commercial economy dominated by the market’s invisible hand.  But, he strongly believed that in healthy markets, our actions were also guided by sympathy, the very human ability to have feelings of concern for individuals and communities, which leads to the mutual trust and confidence that an economy requires in order to work efficiently.           

Another very interesting new idea is the adaptive market hypothesis, proposed by MIT professor Andrew Lo.  One of the most prominent economic theories of the past several decades is the efficient market hypothesis.  It basically asserts that financial markets are informationally efficient, that is, market prices reflect all past available information, and will (more or less) instantaneously reflect any new information.  While mathematically elegant, the efficient market hypothesis assumes ideal-world conditions that many experts no longer consider valid based on empirical evidence.

In the adaptive market hypothesis Professor Lo looks at market efficiency from an evolutionary perspective.  He applies the principles of evolution - competition, adaptation and natural selection, - to reconcile efficient markets with behavioral economics:  

“Based on evolutionary principles, the Adaptive Markets Hypothesis implies that the degree of market efficiency is related to environmental factors characterizing market ecology such as the number of competitors in the market, the magnitude of profit opportunities available, and the adapt- ability of the market participants.  Many of the examples that behavioralists cite as violations of rationality that are inconsistent with market efficiency - loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases -are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment via simple heuristics.”

As often happens, disruptive events like our ongoing financial crisis leave in their wake a number of unanticipated consequences.  It seems that one of the most interesting such consequences will be that the field of economics is finally becoming a true empirical science. 

Comments

[Chris Ward]

Is this as cataclysmic as the events of 1776, whereby the colonists of North America decided that the 'status quo' ... rule by the English King ... wasn't sustainable any more ? That was a 'Black Swan' event, as viewed from Europe, and resulted in the founding of the United States of America, and the differences which survive to the present day as to whether your commercial disputes get resolved by the King and his men, or by the President and his men.

You use dollars, I use pounds. We welcome each other as tourists in our respective lands. Business and citizenship rights ? That's harder.

Many decisions will be called the same way in the UK and the USA. Some will be called differently.

[Henry Engler]

Irving,

Your reference to the Adaptive Markets Hypothesis reminds me of work that is being done to understand financial markets and contagion within the context of a complex adaptive system, borrowing tools and methodologies from other sciences.

Please see some of the excellent work done by Andrew Haldane of the Bank of England, as well as the Santa Fe Institute's Doyne Farmer.

http://www.finextra.com/Finextra-downloads/featuredocs/speech386.pdf

http://tuvalu.santafe.edu/~jdf/SFI%20Template/About%20Me.html

Best regards,

Henry Engler