This discussion between Edmund Conway and Andrew Lilico on the Today programme on the alleged crisis in economics seems to me to rest upon a misunderstanding of what economics is.
Conway says the crisis has been “an earthquake for economic thought” and Lilico says we need “new theories.“ This, though, seems to regard economics as a settled but inadequate body of knowledge and theory. It’s not. It is instead a vast number of diverse insights. What’s more, all of the insights that help explain the current economic crisis were, in truth, well known to economists before 2007, for example:
1. Risk cannot be simply described by a bell curve. But we learnt about tail risk on October 19 1987. And we learnt from the collapse of LTCM in 1998 that correlation risk, liquidity risk and counterparty risk are all significant.
2. Assets can be mispriced. But we’ve known about bubbles for centuries - since at least 1637. Their existence does not disprove the efficient market hypothesis; as I’ve said, the EMH is not the rational investor hypothesis. Nor, contrary to Conway’s implicit claim, is the EMH inconsistent with the possibility that behaviour can be swayed by emotions; the EMH allows for the possibility of time-varying risk premia*.
3. Long periods of economic stability can lead to greater risk-taking. We’ve known this since (at least) Hyman Minsky.
4. Banks can suffer catastrophic losses - which are correlated across banks. We learnt this - not for the first time - in the Latin American debt crisis of the early 80s and in the crises in Japan and the Nordic countries in the early 90s. Banking crises are a regular feature of even developed economies.
5. Institutions, such as banks, can be undermined by badly designed incentives. But there’s a huge literature on the principal-agent problem.
The current crisis, then, has not thrown up much that economists didn’t know.
Instead, our problem is a different one. It’s that what we have are lots of mechanisms, capable of explaining why things happen and the links between them. What we don’t have are laws which generate predictions. In his book, Nuts and Bolts for the Social Sciences, Jon Elster stressed this distinction. The social sciences, he said:
Conway says the crisis has been “an earthquake for economic thought” and Lilico says we need “new theories.“ This, though, seems to regard economics as a settled but inadequate body of knowledge and theory. It’s not. It is instead a vast number of diverse insights. What’s more, all of the insights that help explain the current economic crisis were, in truth, well known to economists before 2007, for example:
1. Risk cannot be simply described by a bell curve. But we learnt about tail risk on October 19 1987. And we learnt from the collapse of LTCM in 1998 that correlation risk, liquidity risk and counterparty risk are all significant.
2. Assets can be mispriced. But we’ve known about bubbles for centuries - since at least 1637. Their existence does not disprove the efficient market hypothesis; as I’ve said, the EMH is not the rational investor hypothesis. Nor, contrary to Conway’s implicit claim, is the EMH inconsistent with the possibility that behaviour can be swayed by emotions; the EMH allows for the possibility of time-varying risk premia*.
3. Long periods of economic stability can lead to greater risk-taking. We’ve known this since (at least) Hyman Minsky.
4. Banks can suffer catastrophic losses - which are correlated across banks. We learnt this - not for the first time - in the Latin American debt crisis of the early 80s and in the crises in Japan and the Nordic countries in the early 90s. Banking crises are a regular feature of even developed economies.
5. Institutions, such as banks, can be undermined by badly designed incentives. But there’s a huge literature on the principal-agent problem.
The current crisis, then, has not thrown up much that economists didn’t know.
Instead, our problem is a different one. It’s that what we have are lots of mechanisms, capable of explaining why things happen and the links between them. What we don’t have are laws which generate predictions. In his book, Nuts and Bolts for the Social Sciences, Jon Elster stressed this distinction. The social sciences, he said:
Can isolate tendencies, propensities and mechanisms and show that they have implications for behaviour that are often surprising and counter-intuitive. What they are more able to do is to state necessary and sufficient conditions under which the various mechanisms are switched on.
This is precisely the problem economists had in 2007. We knew that there were mechanisms capable of generating disaster. What we didn’t know is whether these were switched on. The upshot is that, although we didn’t predict the crisis, we can more or less explain it after the fact. As Elster wrote:
Sometimes we can explain without being able to predict, and sometimes predict without being able to explain. True, in many cases one and the same theory will enable us to do both, but I believe that in the social sciences this is the exception rather than rule.
The interesting question is: will it remain the exception? My hunch is that it will; economists will never be able to produce laws which yield systemically successful forecasts.
What’s more, I am utterly untroubled by this. The desire for such laws is as barmy as the medieval search for the philosopher’s stone. If you need to foresee the future, you are doing something badly wrong.
* The basic insight of efficient market theory is that you cannot out-perform the market except by taking extra risk. I am sick and tired of hearing people who still have to work for a living trying to deny this.
What’s more, I am utterly untroubled by this. The desire for such laws is as barmy as the medieval search for the philosopher’s stone. If you need to foresee the future, you are doing something badly wrong.
* The basic insight of efficient market theory is that you cannot out-perform the market except by taking extra risk. I am sick and tired of hearing people who still have to work for a living trying to deny this.
Even if there were laws for economics, it would be extremely difficult to isolate single hypotheses which you could disprove by scientific experimentation.
Analysis of economic mechanisms involves many different sources of information - some of them are factor inputs, some are outputs, some are proxies etc. There's lots of data, from different sources, of different levels of quality, to process.
Economic forecasts essentially bundle together hundreds of data sources and many mechanisms and disjointed models in order to cobble together future projections. And then further treatment work is applied to make the outputs internally consistent. They are not based on one simple law or equation which pops out an answer.
Sometimes its easier just to use the human brain to make an economic forecasts - very similar process....
I think the commentators you mention are just after writing a new cover on their reprinted textbook...
Posted by: Glenn | July 31, 2009 at 03:03 PM
If your theory explains things but makes no predictions it's no better than story-telling. You might as well say fairies did it.
Posted by: Mr Art | July 31, 2009 at 06:43 PM
Mr Art, this is a tired criticism, hardly worth addressing, but I will try, briefly. A theory starts with some assumptions and then generates conclusions. You can test, in principle, whether these conclusions occurred or not while the assumptions held. This allows falsification of the theory, in principle. But who says that these conclusions have to do with the future, thereby making them predictions in the sense that Wall Street wants to have predictions?
Posted by: Dimitrios Diamantaras | July 31, 2009 at 08:01 PM
Dialectic materialism needs to justify its claim to science otherwise its toast (which it is IMO)
I am happy with good guesses if you are?
Posted by: sean | July 31, 2009 at 08:58 PM
Personally I think economics *does* make predictions. It is especially good at telling us what won't work (see Zimbabwe for example).
But we (the general public) demand impossible accuracy of macroeconomic forecasts. Even a well-run economy has its ups and downs.
Posted by: Mr Art | July 31, 2009 at 09:46 PM
"If you need to foresee the future, you are doing something badly wrong."
I don't understand why you say this. Can you elaborate?
To me, making predictions of the future is one of the most important things humans do. What other species attempt to plan out so far and adjust the environment to accommodate their unknown future.
Posted by: David Crookes | August 02, 2009 at 04:38 PM
"If you need to foresee the future, you are doing something badly wrong."
Wait, Wha? Sounds like sour grapes. We can't do that so doing it is really unimportant, lol.
"...economists will never be able to produce laws which yield systemically successful forecasts."
Economics was created in the age of limited data and the need for overarching simplifying assumptions. As the world has developed the data handling to allow working with billions of rows of data, economists have stayed with their little data sets and big assumptions. Additionally, concepts like operating leverage and ROA, with its trade-off relationship between sales and profitability, is completely lost in the great Supply and Demand curve. Works great for commodities but not so good for laptops. Oh, and the life cycle of the household savings model is a joke, ignoring periods of capital outflow associated with purchase of move-up home and kids in college. Both businesses and households are poorly conceptualized black boxes to economists.
ps. there is a very strong relationship between the age of the head of household and the likelyhood of homeownership. It was very easy to take the demographics of the US and this historical relationship, adjust upward for the lift due to increased educational attainment and increased propensity for 2 income households, and predict a "housing boom" as well as a following "housing bust." The tricky part was adjusting for the timing impact of birth control/abortion.
You keep buying the emh, I say meh.
Posted by: Frank the sales forecaster | August 04, 2009 at 04:41 PM
Dear Sirs,
Mr. Art is precisely correct. Economies are mathematically of the form np-complete or, as your Mr. Roger Penrose would term them, "non-computable". It is not a question of hundreds of variables but rather millions of variables.
No conceivable computer can "solve" the problem in the foreseeable future. Sorry, guys - it's all SWAG, Scientifically Wild Ass Guesses.
Regards,
Roy
Posted by: Roy Lofquist | September 01, 2009 at 04:45 AM
Never frown, when you are sad, because you never know who is falling in love with your smile.
Posted by: Ugg london | January 12, 2010 at 12:33 AM
CHI flat iron by Farouk system. Direct from the manufacturer, this genuine Chi ceramic iron comes with valid, one year warranty!
Posted by: chi flat iron | January 18, 2010 at 09:32 AM