13 September 2009

Krugman on Economics

Several people have asked what I think of Krugman's piece (How Did Economists Get It So Wrong?) in the NY Times. In it, he says:
As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.
I have two comments:
  1. There were plenty of economists (the so-called "heterodox") who did NOT believe in this mathematical fantasy. I am one of them [read this, this and this], but others often identify themselves as Austrians (as in Ludwig von Mises), experimentalists, etc. Krugman is overstating the "autism" of the profession.
  2. Many economists work at universities, under an incentive system that rewards mathematical elegance over realism. My favorite example of how this doesn't matter in reality come from an interview with Nassim Taleb. He was asked if he was bothered that money managers (and economists) rejected his warnings of risk in the markets. "No, I just bet against them..." and made a killing, I'm sure!
If you agree that the profession has strayed too far from reality, please sign Geoff Hodgson's petition in support of Krugman's call for a re-appraisal.

Bottom Line: Math is fun, but it's not very good at describing how people behave. Real mathematicians economists strive for accuracy over elegance.

14 comments:

Eric said...

Experimentalists (physicists, chemists, biologists, engineerists, etc.)consider mathematics to be helpful, in support of experiments. These experimentalists do not pretend that math is better than experiments or that it replaces experiments. Experimentalists get paid for getting the answer right not for having nice mathematics.

For example, http://www.nytimes.com/2009/09/13/business/13unboxed.html?hpw, leaving out human interaction variables does not work so well. Quantum mechanics, the most mathematically successful approach to reality, arose in response to unexplainable experimental results. It did not arise on its own, from the heads of theorists like the birth of Pallas Athena. String theory did arise full blown, but, according to John Wheeler at Princeton, is philosophy not science because string theory is untestable. Predictive toxicology arose from the need to cut costs and is strongly coupled to experimental results.

So, in contrast to David's apparent bias, I, as an experimentalist, do not think that mathematics is useless. I think that mathematics is very useful as long as you don't 'drive past your own headlights.'

Today, I am using matrix analysis and decision support to try to understand a value chain network. Later, I have to put systemic risk and decision support into this analysis.

The analysis should tell me what direction to go and why. I expect the analysis to be changed within weeks to fit changing facts. While I can do elegant mathematical analyses, I don't do them so much any more. Why? Ugly, complex analyses get the answers right. I need the answers to be right.

For the quants in the audience, my default analytic mode is essentially agent based, because the world is agent based.

How about this approach--for academic economists, have their salary or grants be like a stock quote. Calculate earnings/profits from what they propose, multiply by an appropriate price to earnings ratio, award them money on the result of their earnings averaged over the last fifteen years (so that good predictions help and bad predictions last more than a quarter). {To steal from David's thoughts on water, this approach would create a functioning national market in academic economists and eliminate Krugman's distinct salt water and fresh water economists markets.}

Would such an approach work?

Eric said...

A bumper sticker vers

Physics and economics consider the first few terms of reality, the elegant part. People, flora, and fauna succeed by using the 150th term--the inelegant part, the messy part.

VV said...

You say: "Real (mathematicians) economists strive for accuracy over elegance." Well, yes, but then they get caught by statistics and reality flies away winged by medians and averages. Clever ones (what you have been, at least when we talked) look through the window. Usually they see something going on out there.

Eric said...

http://www.nytimes.com/2009/09/13/business/economy/13view.html?hpw

Flaw in the free market: Humans

JC said...

It is very true that this fight has to also acknowledge very good economics being done over these decades that had good math, good relevance and lots of "accuracy over elegance" as David brings our attention to. That kind of economics did not get that much attention or space in the top journals. But it was there working silently and is now being ... Read Morerecognized.

The other problem is that these debates do not go very far when they take it so personal. The recent response by Cochrane to Krugman does not help for sure:
http://faculty.chicagobooth.edu/john.cochrane/research/Papers/krugman_response.doc

RP said...

We, as a society, are very good at seeking out opinions that we want to hear. In good economic times, it is only natural that the economists who were wrapped up in slick new models and optimistic projections would get the press.

I am amused by Krugman's observation that "the economics profession went astray...". Economists are notoriously ... Read Moreportrayed as a collection of folks with wildly differing opinions. Suddenly we're all on the same "wrong" page. Please pardon the chuckle.

It has long been my opinion that economics is a balance of science and art. The line between the two is all too often blurred. That is why it is so important to take a step back every now and again to evaluate whether what we're seeing makes fundamental sense. If anything, the purveyors of new models in recent years may have been remiss in their due dilligence responsibilities.

JWT said...

David, your Krugman note reminded me of something else. For the last two years, I have been reading economists widely to see if anything had improved in the twenty-five plus years since those tedious classes at USC.

What I find is that none of them want to admit the existence of Business Cycles in spite of 500 years of evidence that they exist. Also, none of them want to admit that there is no equilibrium point in spite of the fact no one has ever found one.

I think Krugman's piece brings it all into focus, e.g., my crappy theory is better than your crappy mathematics. To which the reply comes, Oh no, our crappy mathematics are way better than your crappy theory.

I have come to the conclusion that if economists ever admitted there were such things as Business Cycles driven by human behavior, they would all be out of work. Therefore, it ain't gonna happen. As a result of too much economic theory and too many economists, we can look forward to increasingly severe contractions and an increasing deficit in every country (that matters) in the future. And that is a truly depressing future to look forward to.

Eric said...

Naive questions.

1. Skin in the game--If an economist or a set of economists make wrong predictions, can they lose their position or their funding? Do they have any skin in the game?
2. The dealer--How do academic economists get funded? Are the same economic world views funded for decades or can a new world view, for instance one that includes business cycles, get funding to the exclusion of old world views?

David Zetland said...

@JWT -- there are some economists who look at business cycles (and believe in them), e.g., the Austrians and experimentalists...

JWT said...

I am a little confused here. Is the problem nomenclature, or something else. First of all, the evidence of history everywhere is that economies are either expanding or shrinking. Sometimes the trough or peak can drag on for awhile, but that doesn't change anything. There is no theory here.

Just facts. I chose to label this process The Business Cycle because it seems more contemporary and easier for the most people to understand. But, in fact, in much older times there weren't functioning businesses as we know
them today and Business Cycle would not be an accurate description, but the phenomena is the same.

If nomenclature is the problem, I don't mind calling the phenomena anything you like, i.e., Economic Cycles, Snow White and the Seven Dwarfs. As old Bill said, "A rose by any name would smell as sweet".

If nomenclature is not the problem, then I am confused about what you are saying. It is because there is a continuing cycle that there is no equilibrium point. How can you have one and not the other?

Krugman, et al, refuse to recognize the nature of these recurring cycles and invent some crappy theories to take the place of the facts. We agree completely on the mathematical phonies so that is beyond comment. (By the way, the same way that mathematical economists took over the profession, mathematical marketing professors took over the journals with their utterly arcane, untestable, uncomprehendable formulas. The Journal of Marketing Research became completely unreadable within five years of its founding.)

About the Austrian economists, What's to work on?

My proposal would be to do away with the profession of economics, pick up the good pieces, price elasticity, measuring Gross National Product, etc. and start all over again by recognizing that human behavior drives the cycles (whatever they are called) which Adam Smith recognized clearly, and not some ivy tower theorizing, or arcane mathematics.

I heard a BBC interview with Alan yesterday and he said, "Gee, I didn't realize that people would act that way" (rough translation). Then he went
on to draw the wrong conclusion because he said he would change human behavior. Geezzzz......here we go again.

The fundamental thing to get right is that the "greed" that drives
expansions is not a bad thing overall. It encourages and rewards risking taking, whch is absolutely essential to a growing economy. And fear is not a bad thing in contractions since it reins in excessive risk taking and exposes frauds, etc. What we need are policies that are build on facts, not theories.

Eric said...

@jwt

One of the more satisfying accomplishments of an experimentalist is to blow up a theory by showing that the facts invalidate the prevailing theory. Most Nobel prizes in science are won by finding facts that blow up a theory. The rest seem to be won by finding a new theory that predicts the observed facts.

stickman said...

David,

I'm curious: Do you consider yourself an Austrian* economist?

You've established your libertarian leanings, cited Hayek often enough, and also spent a lot of time on government failure. However, I also get the feeling that you don't favour unfettered laissez-faire and would support regulation in a number of instances. Is this correct? (For what it's worth, I subscribe to this latter view...)

* I'll limit your Austrianess to general issues of the market and environmental goods. So, leaving aside some of the more "fringe" elements, such as a monetary policy reverting back to the gold standard. Although, if you'd like to comment on these...

David Zetland said...

@stickman -- I like a lot of Austrian ideas, esp wrt information and business cycles (let 'em cycle!). I am also a fan of sound money (a la Friedman) but not gold in particular (steady $ growth is useful).

I *do* agree that markets can fail and enviro goods need some centralized coordination, but I worry just as much about govt failure.

Does that help?

stickman said...

Gotcha.

As I said, more curious than anything else, but I appreciate you fleshing it out a little bit :)