Category Archives: Economic education and methods

Finance: Practitioners vs. Economists

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Pablo Fernandez writes,

If all investors had identical expectations,
A) Trading volume in financial markets would be very small. However, the trading volumes of many markets are
huge.
B) All valuations of the shares of a company should coincide. However, there are huge differences in stock
valuations (analysts, investment banks, consultants, financial companies …)
C) The return required for the shares of a company should be identical in all valuations.
D) The expected cash flows of the shares of a company should be identical every year in all valuations.

Since our world is not characterized by any of the four above characteristics, how can one even insinuate the
hypothesis of homogeneous expectations?

My thoughts:

1. I think that the models developed by financial economists have some value, unlike those of Keynesian macroeconomists.

2. However, the fiction of the “representative investor” is problematic for some of the reasons that the fiction of the “representative agent” is problematic in mainstream macro.

3. Economists tend to assume that the conflict between financial practitioners and financial economists should be resolved in favor of economists. To some extent, this has happened, as index funds and Black-Scholes option pricing became important in practice. But as Fernandez points out, financial practice still differs sharply from what models say that it ought to be, and the economists seem to be unwilling to explore why this is the case.

Economics and Medicine

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Concerning fields comparable to economics, a commenter wrote,

How about an analogy to medicine? We didn’t design the human body. It is a painfully complex system that emerged from evolution and some human intervention (cultural preferences for mates, for example). But we know how to fix it when it breaks under a large variety of circumstances and are getting better at it every day.

I think this is one of the more interesting analogies. I think it is helpful in understanding the preference for economists with “answers.” People would rather see a Shaman who promises to cure them than consult someone who admits that they have no cure.

Until around the late 19th century, a doctor was probably more likely to make you worse than make you better. Even now, we have Hansonian medicine, so progress in some areas has been somewhat offset by flawed thinking in others.

In economics, we face the additional challenge that the economy evolves not (typo corrected) at the speed of cultural evolution, which is faster than biological evolution. Thus, our theories have to hit targets that are moving much faster.

I think of economics as being about where medicine was around, say, 1900. But the pace of progress in economics is slower.

Robert Skidelsky on Economic Methods

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A month ago, he wrote,

If you believe that economies are like machines, you are likely to view economic problems as essentially mathematical problems. The efficient state of the economy, general equilibrium, is a solution to a system of simultaneous equations. Deviations from equilibrium are “frictions,” mere “bumps in the road”; barring them, outcomes are pre-determined and optimal. Unfortunately, the frictions that disrupt the machine’s smooth operation are human beings. One can understand why economists trained in this way were seduced by financial models that implied that banks had virtually eliminated risk.

Good economists have always understood that this method has severe limitations. They use their discipline as a kind of mental hygiene to protect against the grossest errors in thinking. John Maynard Keynes warned his students against trying to “precise everything away.” There is no formal model in his great book The General Theory of Employment, Interest, and Money. He chose to leave the mathematical formalization to others, because he wanted his readers (fellow economists, not the general public) to catch the “intuition” of what he was saying.

Those paragraphs would have fit into Specialization and Trade, particularly the first sentence of the first paragraph.

My view of Keynes’ “intuition” is that it is very appealing but ultimately misleading. I am thinking in particular of the “spending causes jobs” and “jobs cause spending” intuition that is what passes for Keynesian economics in the press. In real economics, you cannot just posit quantity-quantity interactions without any prices involved.

By the way, Skidelsky’s three-volume biography of Keynes (not the abridged version) really is the best thing you can read on “what Keynes really meant.” He really gets at Keynes’ views on the psychology of saving (or hoarding) and investing. I do not think that “animal spirits” means what Akerlof, Shiller, and nearly everyone else thinks it means– bouts of optimism or pessimism. I think it probably is closer to the drive for reproduction, or for immortality. Mr. Trump built his towers to try to give his name a lasting presence, not because he had a burst of optimism about real estate investment.

Taking Macroeconomics Backward Through Regression

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Olivier Blanchard recently wrote that there ought to be two classes of macroeconomic models.

Theory models, aimed at clarifying theoretical issues within a general equilibrium setting. Models in this class should build on a core analytical frame and have a tight theoretical structure. They should be used to think, for example, about the effects of higher required capital ratios for banks, or the effects of public debt management, or the effects of particular forms of unconventional monetary policy. The core frame should be one that is widely accepted as a starting point and that can accommodate additional distortions. In short, it should facilitate the debate among macro theorists.

Policy models, aimed at analyzing actual macroeconomic policy issues. Models in this class should fit the main characteristics of the data, including dynamics, and allow for policy analysis and counterfactuals. They should be used to think, for example, about the quantitative effects of a slowdown in China on the United States, or the effects of a US fiscal expansion on emerging markets.

In response, Simon Wren-Lewis rejoiced,

Ever since I started blogging I have written posts … to try and convince fellow macroeconomists that Structural Econometric Models (SEMs), with their ad hoc blend of theory and data fitting, were not some old fashioned dinosaur, but a perfectly viable way to do macroeconomics and macroeconomic policy.

Pointers from Mark Thoma.

For why Blanchard and Wren-Lewis are wrong, see my essay Macroeconometrics: the Science of Hubris. If the profession follows their advice, macroeconomics will be regressing in every sense of the word.

Duncan Watts on Methods

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He wrote,

the problem with social science is not so much that it has one theory for one thing and another theory for another thing6, but rather that it has many theories for the very same thing. Even worse, these theories — although often interesting and plausible when considered individually — are fundamentally incoherent when viewed collectively. I then argue that this incoherency problem arises not only because of a lack of appropriate data for evaluating social scientific theories, but also because of the institutional and cultural orientation of social-science disciplines, which have historically emphasized the advancement of particular theories over the solution of practical problems. Finally, I argue that one possible solution to the incoherency problem is to reject the traditional distinction between basic and applied science, and instead seek to advance theory specifically in the service of solving real-world problems.

I recommend the entire essay (thanks to Michael Gibson for bringing it to my attention).

My perspective on Watts’ proposal for “solution-oriented social science” is that it addresses the question of how to test theories. Consider three options.

a) undertake a statistical analysis

b) try it out as a public policy, but be prepared to modify it should it fail to work as expected.

c) try it out by starting a business based on it

I think that a lot of us have lost confidence in (a). There are too many important causal variables that cannot be controlled for in the real world. Esther Duflo seems to argue for (b). I think that economists ought to be more aware of (c) and less eager to try (b). Of course, problems in sociology or political science may be less amenable to private entrepreneurial solutions. Watts’ point is that (b) and (c) are viable approaches for arriving at reliable knowledge.

at no point does the existing system for producing social scientific knowledge either facilitate or reward the activity of reconciling disparate frameworks. As a result, facts and theories pile up in an incoherent heap

In economics, I think that we also have the opposite problem. We fail to consider other frameworks that might work as well as our preferred framework.

Another excerpt:

theories in social science tend to rise and fall in popularity more like works of fiction than of science, gaining support for reasons other than their ability to account for empirical observations.

The Economist as Entrepreneur

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Beatrice Cherrier comments on Esther Duflo’s AEA lecture, “The economist as plumber.”

She wanted economists to reconceive economic agents, policy-makers and bureaucrats as bounded “humans” embedded in wider power structures and cultures, and to realize that thinking goods ideas is not enough to improve the latter’s welfare. “Incentive architecture” is thus needed, and economics expertise is especially relevant because it deals with behavioral, incentive and market equilibrium issues. The recent success of (some) “nudge” has given some salience to benefits of crafting incentives carefully, for instance by fixing regulations to prevent firms from exploiting loopholes. Plumbing was also beneficial for economics as science, she continued, as it helped generate counterfactuals by randomizing on entire markets. Plumbing also shines the spotlight on issues theorists had previously ignored, like how important the default scenario is. Economics as plumbing requires a more pragmatic and experimental mindset, she concluded, as it requires them to make decision without having a full knowledge of the system to be tinkered (“tinkering” was one of the keywords of the speech).

I recommend the whole post. Pointer from Mark Thoma.

When I think of trial-and-error tinkering to try to solve a problem, I think of an entrepreneur.

In fact, we might be better off thinking of policy-oriented economists as state-backed entrepreneurs. That is, while ordinary entrepreneurs have to convince investors to back their ideas and convince customers to pay for their offerings, state-backed entrepreneurs have to convince politicians to back their ideas.

I am not very enthusiastic about state-backed entrepreneurship. I believe that the market does a more rigorous job of experimentation, evaluation, and evolution.

I am glad to see alternatives to the image of the economist as a white-coated scientist. However, I do not think it should be replaced by an image of droopy-pantsed plumber. I am afraid that a more accurate image is of an entrepreneur who is trying to short-cut the market by pitching business ideas to a political audience. And we should be cognizant that politics is an inferior arena for trying out entrepreneurial schemes.

Daniel Little on the Evolution of Disciplines

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He writes,

academic disciplines are in fact highly contingent in their development, and that there is no reason to expect convergence around a single “best” version of the discipline. The history of disciplines should better be understood in analogy to the brachiation and differentiation associated with the evolution of species and sub-species over time — lots of contingency, with a consequent specialization of the intermediate results to the demands of a particular point in time. This implies that a discipline like sociology or political science could have developed very differently, with substantially different ideas about research questions and methods.

I take the view that economics evolved in the wrong direction in the United States, particularly following the second World War, as it followed down the path laid out by Paul Samuelson. Some of my thoughts on this are expressed in Specialization and Trade. More thoughts are on the way in a long essay.

Economists and Mr. Trump

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Justin Wolfers writes (not Justin Fox, as I mis-typed earlier) that at the recent American Economics Association meetings,

Over three days of intense discussions, I didn’t encounter a single economist who expressed optimism that Mr. Trump’s administration would be good for the economy. The optimists were those who thought Mr. Trump would not have the energy to actually implement his agenda; the pessimists’ thoughts veered toward disaster.

Pointer from Mark Thoma.

It is possible that they are correct. However, I doubt it. While I disagree with Mr. Trump on immigration and trade, and I condemn his interventions with individual business decisions, I think that these will cause relatively little harm. This harm could be more than offset by reining in regulations, replacing Obamacare, and/or tax reform.

What is true is that Mr. Trump and the professoriate have an adversarial relationship. Mr. Obama takes his world view from the faculty lounge of the sociology department, and he very much respected academic credentials. Mr. Trump is the opposite.

I think that credentialed economists deserve a bit more respect than what we receive from Mr. Trump, but much less than what many American Economics Association members seem to think we are entitled to. I think that Justin Wolfers’ colleagues are fantasizing about a scenario in which Mr. Trump causes an economic disaster so that the status of academic economists shoots up. But I do not think see this as a very likely scenario.

On the generic topic of academic expertise in government, Tyler Cowen writes,

when it comes to the nuts and bolts of governance, typically I would prefer to be ruled by the Harvard faculty, even recognizing the biases of experts. They understand the importance of applying expertise to complex problems, and they realize many issues do not respond well to common-sense fixes. The citizenry usually cannot make good decisions, or for that matter expert appointments, when technocracy is required.

I tend to focus on what I call the knowledge-power discrepancy. Joe Citizen may have less knowledge than Professor Jones, but Professor Jones could be more dangerous. That is because Professor Jones may over-estimate his suitability for telling other people what to do.

Compared with academics, business executives and military leaders have more experience with the challenge of implementing ideas. A good business executive would not take it for granted that a web site is going to work. A good general would emphasize all of the difficulties and risks of trying to shape the Middle East.

Timothy Taylor on Homo Narrativus

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He writes,

Homo sapiens likes to protest that all conclusions come from a dispassionate consideration of the evidence. But again and again, you will observe that when a certain homo sapiens agrees with the main thrust of a certain narrative, the supposedly dispassionate consideration of evidence involves compiling every factoid and theory in support, as well as denigrating those who believe otherwise as liars and fools; conversely, when a different homo sapiens disagrees with the main thrust of certain narrative, the supposedly dispassionate consideration of the evidence involves compiling every factoid and theory in opposition, and again denigrating those who believe otherwise as liars and fools. Homo sapiens often brandishes facts and theories as a nearly transparent cover for the homo narrativus within.

That is his gloss on Robert Shiller’s recent address to the American Economic Association.

Notes from the 2017 Edge Question

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Folks were asked to name a scientific concept that deserves to be better known.

Lisa Randall nominates “effective theory.”

an effective theory tells us precisely its limitations—the conditions and values of parameters for which the theory breaks down. The laws of the effective theory succeed until we reach its limitations when these assumptions are no longer true or our measurements or requirements become increasingly precise.

Matthew D. Lieberman nominates naive realism.

If I am seeing reality for what it is and you see it differently, then one of us has a broken reality detector and I know mine isn’t broken. If you can’t see reality as it is, or worse yet, can see it but refuse to acknowledge it, then you must be crazy, stupid, biased, lazy or deceitful.

In the absence of a thorough appreciation for how our brain ensures that we will end up as naïve realists, we can’t help but see complex social events differently from one another, with each of us denigrating the other for failing to see what is so obviously true.

Matthew O. Jackson nominates homophily.

New parents learn from talking with other new parents, and help take care of each other’s children. People of the same religion share beliefs, customs, holidays, and norms of behavior. By the very nature of any workplace, you will spend most of your day interacting with people in the same profession and often in the same sub-field.

…Homophily lies at the root of many social and economic problems, and understanding it can help us better address the many issues that societies around the globe face, from inequality and immobility, to political polarization.

Dylan Evans nominates need for closure.

However great our desire for an answer may be, we must make sure that our desire for truth is even greater, with the result that we prefer to remain in a state of uncertainty rather than filling in the gaps in our knowledge with something we have made up.

Gary Klein nominates decentering.

Decentering is not about empathy—intuiting how others might be feeling. Rather, it is about intuiting what others are thinking. It is about imagining what is going through another person’s mind. It is about getting inside someone else’s head.

…Being able to take someone else’s perspective lets people disagree without escalating into conflicts.

Adam Waytz nominates the illusion of explanatory depth.

If you asked one hundred people on the street if they understand how a refrigerator works, most would respond, yes, they do. But ask them to then produce a detailed, step-by-step explanation of how exactly a refrigerator works and you would likely hear silence or stammering. This powerful but inaccurate feeling of knowing is what Leonid Rozenblit and Frank Keil in 2002 termed, the illusion of explanatory depth (IOED), stating, “Most people feel they understand the world with far greater detail, coherence, and depth than they really do.”

Cristine H. Legare nominates Cumulative Culture.

Cumulative culture requires the high fidelity transmission of two qualitatively different abilities—instrumental skills (e.g., how to keep warm during winter) and social conventions (e.g., how to perform a ceremonial dance). Children acquire these skills through high fidelity imitation and behavioral conformity. These abilities afford the rapid acquisition of behavior more complex than could ever otherwise be learned exclusively through individual discovery or trial-and-error learning.

If someone had asked me, I would have proposed something similar: cultural intelligence.

Eric R. Weinstein gives us Russell Conjugation.

the human mind is constantly looking ahead well beyond what is true or false to ask “What is the social consequence of accepting the facts as they are?” While this line of thinking is obviously self-serving, we are descended from social creatures who could not safely form opinions around pure facts so much as around how those facts are presented to us by those we ape, trust or fear. Thus, as listeners and readers our minds generally mirror the emotional state of the source, while in our roles as authoritative narrators presenting the facts, we maintain an arsenal of language to subliminally instruct our listeners and readers on how we expect them to color their perceptions.

Sarah Demers nominates blind analysis.

The idea is to fully establish procedures for a measurement before we look at the data so we can’t be swayed by intermediate results. They require rigorous tests along the way to convince ourselves that the procedures we develop are robust and that we understand our equipment and techniques. We can’t “unsee” the data once we’ve taken a look.

John Tooby nominates coalitional instincts.

These programs enable us and induce us to form, maintain, join, support, recognize, defend, defect from, factionalize, exploit, resist, subordinate, distrust, dislike, oppose, and attack coalitions. Coalitions are sets of individuals interpreted by their members and/or by others as sharing a common abstract identity

…to earn membership in a group you must send signals that clearly indicate that you differentially support it compared to rival groups. Hence, optimal weighting of beliefs and communications in the individual mind will make it feel good to think and express content conforming to and flattering to one’s group’s shared beliefs, and feel good attacking and misrepresenting rival groups.