"Economics" & rationality

One of the great irritations of our age is the tendency for non-economists to tell us what's wrong with economics. We've seen two egregious examples of this recently, with a common theme. Suzanne says:

[Economics] assumes behaviour is rational. It cannot calculate for contradiction, culture, altruism, fear, greed, love or humanity at all.

And Geoff says:

It is assumed we are coldly “rational” calculators, yet we are obviously strongly motivated by love, envy, fashion and insecurity.

Now, economists have conventionally assumed rational behaviour. There's a reason for this.Such an assumption generates testable predictions, whereas if we assume people are mad then anything goes. What's remarkable is that these predictions are quite often correct; demand curves usually do slope downwards and stock markets are sufficiently efficient that very few investors out-perform them.

But this assumption is only a starting point. And testing it against the evidence has allowed economists to discover its limits. There is a humungous and fast-growing body of good research on the role of cognitive biases. Behavioural economics is mainstream - sufficiently so that one of its founders got a Nobel prize.

Suzanne and Geoff are also wrong to claim that "economics" cannot cope with altruism or love. A quick search for "altruism" or "prosocial" in the usual places will return hundreds of results.

And of course it is the purest gibber to pretend that economics has no place for greed and fear; economists from Ken Arrow through James Tobin and Harry Markowitz to Daniel Kahneman (to name only the Nobels) have made big studies of risk aversion and its implications.

It's almost as false to say that economics cannot calculate for culture. Some of the most interesting research in recent years has been precisely about how history, culture and identity shape our behaviour. And this is mainstream stuff: George Akerlof has a Nobel prize, and Nathan Nunn and Daron Acemoglu are at top economics departments.

Of course, regular readers of this blog and of my alter ego know all this, and more. So why do I labour the point?

It's because Suzanne and Geoff (and of course the many others) fundamentally misrepresent economics in two ways.

First, they misunderstand what the mainstream of economics is. Mainstream thinking is fully aware of the limits of the "max U, markets work" view that Geoff and Suzanne are attacking. I suspect Paul Krugman is closer to most economists' thinking than, say, Casey Mulligan.

Secondly, they give the impression that economics is a fossilized body of ideology. It's not. It's a dynamic and diverse field of study. Of course, there's bad economics and bad economists, just as there's bad science and bad scientists. But these mustn't be mistaken for the entire subject.

And herein lies my real gripe with pieces like Suzanne's. They help to give non-economists the wholly false impression that economics is dull, ideological and useless. It's not.

Comments

[Mil]

Things beyond our ken frighten us, Chris. You know economics inside out; we only know the consequences of when politicians get economics wrong. When the Met gets the weather forecast wrong, we can brush off the inexactitude with good humour. When those who cloak themselves with the apparent inevitabilities of modern economic theory get it wrong, however, there is no way we can disengage from the results. All that's left to us is throw rubber bricks at the TV. And lose our livelihoods.

[chris]

@ Mil - this poses the question of how strongly influenced politicians are by economic thinking. I don't think the coalition or Angela Merkel are - though I suspect Gordon Brown was to a greater degree. This is another can of worms.

[Nymnchen]

Firstly, there is no such thing as a Nobel prize in economics; it is an invetion for economists, by economists, and can be concidered to be regarded more as an ideological/philosophical beauty-contest than a proof for excellence. No matter how small advancements economics performed as a "science", the prize would be give to some half-wit. (The prize given for the science has got some absolute criteria for undisputed scientific usefulness, which do not apply for the prize rewarded by Svenska Riksbanken, which you have misstaken for a Nobel prize)

Second; the criticism from non-economists is just a mirror of legitimate criticism from economists. Focus on that instead. http://www.georgesoros.com/interviews-speeches/entry/remarks_at_the_festival_of_economics_trento_italy/

[Luis Enrique]

I find two popular complaints amusing

1. economists don't pay enough attention to the real world

a claim invariable made by people who pay no attention to what real world economists really pay attention to

2. economists ignore messy reality, preferring beautiful and simple theories that purport to explain everything

being a pleasing and simple theory that purports to explain everything

[chris]

@ Nymnchen - sorry, but Soros is setting up a straw man. Yes, some economists thought bubbles impossible and that markets were often in or near equilibrium, but that is not and was never the universal view.
Many of Soros's other claims (eg reflexivity) are Taleb's trick - stating the bleedin' obvious and expecting acclaim.

[Luis Enrique]

yep, people who make claims about what economists think about financial markets typically ignore what economists who study financial markets think *

http://sims.princeton.edu/yftp/Bubbles2007/

http://www2.lse.ac.uk/researchAndExpertise/Experts/[email protected]

* as opposed to macroeconomists who mostly ignored them, for a mixture of reasons but mostly because they didn't think they were in the business of predicting crises but studying how to respond to "shocks" when they happen

[Mil]

@chris I can imagine so - but what about economists who deliberately get involved in political process? Wasn't Friedman and his school of that sort? Frighteningly messianic - and hands-on as far as ideological implications were concerned. The problem is not just the politicians who don't understand economics; it's the economists who refuse to contemplate the necessary breadth of vision good politics offers society, especially when they decide to push their envelope of responsibilities.

[Stephane Genilloud]

There was a comment on this blog the other day saying that in economics "the more you learn, the less you know". There is some truth in that statement. In its most basic form, economics is very simple and it delivers an excellent understanding of counter-intuitive phenomena.

The first problem comes when economists (or non-economists) extrapolate the conclusions of their basic models. Economics is simple, but the economy is complex. You should not expect to explain everything with basic models.
But you should not try to sophisticate those models too much either. That's the second problem. The law of diminishing returns is nowhere as harsh as in economic models. Every added element brings less and less global understanding.

If you build macro-models on micro-foundations, you encounter both problems: you overstate the meaning of the micro-models and you blur their mechanism in useless complexity.

[Neil]

Hey, us non-economists will stop annoying you with these accusations just as soon as you stop saying 'Hur hur hur ECON-101' whenever we say something you don't fancy answering. ]

Deal?

[Luis Enrique]

on the topic of rationality in economics, this new free book by Rubenstein (well free to read online, £2 on Kindle) looks fascinating

http://books.google.co.il/books/p/pub-8194589960919624?hl=en_GB&ie=UTF-8&oe=UTF-8&vid=9781906924775&q=OBPXX&redir_esc=y#v=onepage&q=OBPXX&f=false

I know a few economists who take the line that nothing they do is really intended to be useful or predictive

[Walter]

I think you are missing a point. I am sure you can find economist who hold all different kinds of ideas, but there is a main stream ideology that does exactly what the criticism implies, at lest here in the U.S. Paul Krugman himself often complains how universities go out of their way not to teach alternative models. I can tell you from personal experience, Keynesianism is demonized and Milton Friedman is still a demigod. If there is a bubble it is always the government’s faul because a true market would never have one, at least that is the dogma. Just watch the PBS documentary Mind over Money. You can see how impervious traditional economists are to new ideas; they deride the very notion of behavioral economics.

[Luke]

Why do we non-economists think we know so much about economics? It's not just that we think we know better than economists what the answers are (which could be justified either because there is some disagreement between economists or because they are not some infallible priestly caste). No, we also think we know better than them what they are actually studying.

I'm as bad as anyone - I'm sure I will confidently discuss the solution to the depression and the euro zone crisis on the basis of reading a few blogs and Krugman's latest book.

[Lee]

I generally agree, but worry that what they are attacking might be what a first year undergraduate textbook does look like....

[Main Street Muse]

"Now, economists have conventionally assumed rational behavior. There's a reason for this. Such an assumption generates testable predictions, whereas if we assume people are mad then anything goes. What's remarkable is that these predictions are quite often correct; demand curves usually do slope downwards and stock markets are sufficiently efficient that very few investors out-perform them."

1) If rationality is so prized by economists, explain how the theory that "housing prices will never fall" continued in popularity until housing prices crashed?

Way back in 2001 or so, in my little neighborhood in Chicago, we noticed that prices had skyrocketed well beyond what average salaries could afford - an alarming trend that happened in far too many other parts of the country too. There is irrationality in clinging to a belief in the face of information that should change one's mind. And there is irrationality in building models and deciding that there is no reason - ever - to change them.

2) If "stock markets are sufficiently efficient that very few investors out-perform them..." then why is there a market for non-index funds? Explain the rationality in thinking there is any fund that can beat the market. Yet there is a rather large business that supports such an irrational belief.

And in all seriousness, the recent history of the stock market makes it look like a middle-school lunchroom - swayed and transformed and rocked by rumors, innuendo and hunches. How can an investor really trust any information these days? (Remember repo 105? Rational, yes. Ethical, no. And the kind of deception that made it impossible for an investor to really know the shape of Lehman in advance of its collapse.)

3) Please explain how the majority of economists failed to predict the crash of 2008. Please explain the rationality of such a crash. I would be very curious to know how you rationalize such a crash with models that take into account the absolute greed and immorality that got the economy in such a disturbed state.

4) Explain the rationality of a financial sector that cannibalizes customers so as to gain on both sides of the deal. I suppose one could consider it "rational" but it is not generally a sustainable business practice. Why/how did AIG's economic models fail to prevent the collapse of its business model?

5) Please explain the economics of a synthetic CDS. It seems that many of those who are not economists find them inexplicable.

6) Explain the rationality of a financial sector where the best and brightest company (JP Morgan Chase) can lose $2billion or so on a "bet." (And is that even the real dollar amount of the loss?)

7) If economics is a bright and vital study, why the continued level of passion and discord over Keynes v Friedman? Who are the great new thinkers of economics? Seriously!

Please - take a look at recent economic history and try to understand why those of us outside the dismal science are no longer believers in your voodoo.

[Carter Jefferson]

You write:

". . . if we assume people are mad then anything goes."

Exactly. They are, and it does.

[Student]

Most of the haters think a macroeconomist is the hollow suit who comes on CNBC or Bloomberg and says the Dollar is up and the NASDAQ is down.

The Up and Down men.

These people really ought to actually read a damned macro paper before they start scapegoating.

[Marginally Thoughtful]

I think we economists need to to a better job educating our angry detractors about what we mean by 'rationality.' The 'rationality' we use as the basis for economic modeling is far removed from the popular definition of rationality.

By 'rational', economists mean that people make choices with some limited consistency.

Economists do NOT mean:

-People make choices with perfect foresight.

-People always act in their best interest (and often we define 'their best interest' as 'whatever I think they should be doing').

-People form beliefs according to the best available evidence, rather than prejudice and heuristics.

-etc.

In fact, behavioral economics has been so influential to the field (at least for us young folks) because most biases, most 'irrational' behaviors are in fact rational. We can model them.

Economic theory doesn't make insane predictions because behavior is not amenable to modeling. Economic theory makes insane predictions when economists make lazy assumptions about what people actually value.

[???]

@ Walter - You're exactly the kind of person that this post is about. Academic economists exist on a wide range of the political spectrum. Not sure what you're referring to about Krugman complaining about universities avoiding teaching alternative viewpoints (source?), because he's quite mainstream.

"I can tell you from personal experience, Keynesianism is demonized and Milton Friedman is still a demigod."
By whom? Your undergrad econ 101 prof? I'm quite sure you're not in econ academe, so I can't imagine you've interacted with that many economists.

"If there is a bubble it is always the government’s faul because a true market would never have one, at least that is the dogma."
Says who? You're citing this as if this is a commonly held belief by economists when of course it isn't.

"You can see how impervious traditional economists are to new ideas; they deride the very notion of behavioral economics."
Are you kidding? The pioneers of behavioral econ won the Nobel Prize years ago.

Did you even read the whole post?

[???]

@ Main Street Muse - I'm sure you have no intent on hearing any argument, but economists aren't the ones making CDOs and running AIG--quants are a completely different beast.

"If economics is a bright and vital study, why the continued level of passion and discord over Keynes v Friedman? Who are the great new thinkers of economics? Seriously!"

There is no passion or discord, that 'debate' is manufactured only in the writings of the kind of non-economists Dillow is discussing. Economists don't put past thinkers on the kinds of elevated pedestals they're put on by laymen. As for the great new thinkers, there's a ton of them listed in that article! Try reading it.

[Nymnchen]

@chris ok, ok but if the non-economists are also "stating the bleedin' obvious", maybe one shouldnt really blame them for that

[Walter]

???

I think we may actually agree. I apologize if I did not make myself a little clearer. Perhaps I was venting and raving a little bit. Most of my contact with economics was through business school. Where do you think I learnt of Ayn Rand? I know, the two fields are not the same. But it is called school of business and economics. Most business professors were incredibly dogmatic, they hated Keynes, and believed market value is the same as moral value. They claimed that economics as a field validated their ideology; right wing libertarianism. They not so much believed their models represented an accurate view of the world but rather believed their models had to be force in the world. Like the Chicago school of economies did with Latin America through the Chicago Boys.
But you are right, I recognize that. I cannot disparage an entire field just because it has a few bad practitioners.

[???]

@ Walter - My apologies for my own venting. Often these sorts of blog comment threads get extremely frustrating.

I'm not sure when you were in school, nor where, but I don't think you'd find that at the average economics department. Since you were at a business school, my immediate reaction is that you may have encountered professors who weren't economists (i.e., they had J.D.s or were executives-in-residence or something of the sort, of which there were quite a few in the business school at my undergraduate university), although it's also possible that you just happened to go to a business school that had a critical mass of intellectually dishonest economists. I'm sorry for your experience, I too find Objectivists frustrating.

I'm happy to say that modern economists (save a few) don't subscribe to Rand's viewpoints. Unfortunately, economics as an academic discipline is still tainted in the public eye by the group you talk about (as well as financiers and pundits who tout themselves as 'economists'), so our undergrad enrollment ends up filling up with teenage Objectivists and scaring off more liberally-minded students, so the reputation persists.

[Keith]

"I'm sure you have no intent on hearing any argument, but economists aren't the ones making CDOs and running AIG--quants are a completely different beast."

Really? Is this not the no true Scotsman fallacy?

No real economist could break the world financial system; its those nerdie quants fault. Whose theories were ( are? ) the Quants applying? Are the theories not part of economics? If economic theory cannot explain and prevent failures by strategically important economic institutions like large banks what use is it? How can it be a science? Physics can anticipate what happens if you jump off a cliff very exactly. For three hundred years. But economists cannot prevent repetition of the south sea bubble or tulip mania! Maybe more humility is called for from the universal experts on society economists claim to be.

[Antidismal.blogspot.com]

One of the great irritations of our age is the tendency for non-economists to tell us what's wrong with economics

Chris. I can't think that you will get too many economists disagreeing with you on this. But to be fair to non-economists a number of them have made great contributions to economics: Smith (phil), Marshall (maths), Keynes (stats), von Neumann (maths), Coase (commerce) and Tullock (law) to name just 6!

[Antidismal.blogspot.com]

@ Nymnchen. For the record the Nobel in Economcis is given according to the same principles and rules as the five original Nobel prizes - Physics, Chemistry, Physiology or Medicine, Literature and Peace and the econ prize is awarded by the same body as the physics and chemistry prizes, that is, the Royal Swedish Academy of Sciences.

[Main Street Muse]

From ??? "I'm happy to say that modern economists (save a few) don't subscribe to Rand's viewpoints."

Alas, poor, America! Unfortunately the man who was the top economist in America for several decades - Alan Greenspan - did indeed subscribe to the Randian world view. And the economy fared as one would imagine it would fare, should one have read the highly imaginative novel "Atlas Shrugged."

Here's Greenspan quoted in a 2008 Bloomberg article:

"Greenspan said he was ``partially'' wrong in opposing regulation of derivatives and acknowledged that financial institutions didn't protect shareholders and investments as well as he expected.

``We cannot expect perfection in any area where forecasting is required,'' he said. ``We have to do our best but not expect infallibility or omniscience.''

Part of the problem was that the Fed's ability to forecast the economy's trajectory is an inexact science, he said."

``If we are right 60 percent of the time in forecasting, we are doing exceptionally well; that means we are wrong 40 percent of the time,'' Greenspan said. ``Forecasting never gets to the point where it is 100 percent accurate.''

A shame, really, when being wrong just that 40% of the time means the US economy crashes precipitously and the bankers who steered the nation into crisis require trillions in federal support.

You can find the entire article here: http://bloom.bg/L6q3Pr It's a lovely read, one that casts a gentle light onto the issues non-economists find wrong with the dismal science....

[Marius]

"I'm frustrated because I wish I were criticizing greater things."

This pretty much sums up how I feel about Suzanne and Geoff. I'm reading this book called When Genius Failed and it's shaping up to be the friend of all who appreciate a more complicated picture. It only focuses on a handful of prominent financial economists, but it provides interesting insights into the relationship between professional economists and the legitimation of a certain worldview and a certain impulse to impose order where reality otherwise resists.

I think a similar critique might be explored in regards to the most recent financial crisis -- think The Inside Job, but much more focused and dispassionate. I'm convinced this inquiry is also applicable to other professions--accounting and law come to mind, but there are surely others.

[???]

@ Keith - No, I mean literally that most of the quants are math or physics PhDs who learned some finance methods, they're not trained as economists. They don't do economic research (or anything with the intent of benefiting the world); they just crunch numbers.

You act like predicting simple mechanical action is the same as predicting economic phenomena. Physicists can predict what happens when you jump off a cliff because it's deterministic--an economy is filled with millions of random components, so it's not possible to precisely predict events. Why can't physicists solve the three-body problem?

As for humility, most economists accept that prediction at the macro level is hard to impossible. You act as if there were hundreds of economists who were making bad predictions, but can you cite any? Do you have any examples beyond that common straw man?

[???]

@ Main Street Muse - No disagreement there, Greenspan was a Randian, but he doesn't reflect economic thought. Remember that he came to power at a point where the Reagan administration was justifying its economic policy via willfully misinterpreted theory--supply-side economics and the Laffer curve. Would you expect Reagan to have put someone on that post who wouldn't justify all of his policies? (Also, Greenspan wasn't exactly an academic economist--he went into Wall Street immediately after graduating from NYU and never looked back at the academy)

Also, it's true that being wrong 40% of the time is bad, but it's better than not thinking at all and being wrong 100% of the time. I don't want to defend Greenspan, but that statement isn't the place to hammer him.

[RedShift]

I've a recent economics graduate and I've got to say that Suzanne Moore's article is spot on. Economics is not a science, not even a social science but an ideological construct developed and funded by the 1% to justify the ever increasing proportion of national income and wealth accruing to them. It's a total sham, a pseudoscience, with as much value as astrology and yet 100 times more dangerous.

You say economists only use the assumption of rationality so that they get testable predictions, and don't truly believe in them. That's not the impression I got at university, where the assumption of rationality was never discarded in any of the models. Moreover, our lecturers specifically linked rationally to SELF INTEREST, so economists do believe that human beings always act selfishly, and care only about themselves.

This wouldn't matter if no one cared about economics, but unfortunately the subject is extremely influential, and I would argue is responsible for the increasing neoliberalisation and corporatisation of the global economy. Thatcher was influenced by Hayek, and her belief that "there is no such thing as society" is clearly validated by mainstream economic models, where individuals are atomised and the aggregation of their preferences is taken to reflect social preferences.

The public are actually becoming a lot more educated, and realising that they shouldn't simply accept what economists are telling them. Otherwise, we'd all sit by meekly while economists push through policies like mass privatisation, the destruction of the welfare state, free healthcare and comprehensive education, all the while these snake oil salesmen justify cutting taxes for the 1%.

Your defence of economics is spirited, but as a recent graduate I think you're overly optimistic about the subject. I was planning on doing a masters in my first year but quickly realised how economics has been responsible for some catastrophic social failures like poverty, global warming, mass inequality, starvation etc etc. I couldn't continue studying a subject that has such a large crime sheet.

The sooner this pseudoscience is consigned to the dustbin of history the better. We no longer teach astrology in universities, why do we continue to teach economics?

[Left&rational]

@redshift,

well you can't have been to many macro lectures then. almost the entirety of the programme was (and still is) based on Keynes/Hicks IS-LM, which doesn't assume rationality.

[RedShift]

The IS/LM framework was only used in the first year, and again it is based on the neoclassical-Keynesian synthesis promoted by Hicks and Samuelson. Okay, it's not based on microeconomic principles but the metholodogy is still neoliberal.

Moreover, the higher level macroeconomics modules are based on the new "microfounded" rational expectations based New Classical Macroeconomics, promoted by Sargent, Prescott, Kyndland, Lucas, etc. The policy conclusions of these models were almost exclusively ultra right wing, and none of our lecturers ever bothered to question the validity of these models, behaving as if they're as irrefutable as Newton's Laws of motion.

Another major issue with economics is how the discipline tends to indoctrinate students in neoliberal theology, promoting selfishness and greed and "profits before people" ideas. Look at the academic papers by people like Robert Frank, Rubinstein, Yoram Bauman and others. I don't think there exists another subject that has such a damaging effect on students than economics. If parents knew what was happening I'm sure they'd want universities to stop teaching it.

[Left&rational]

So Keynes is neoliberal. That's a new one on me.

I agree with you on Lucas, Prescott et al. Though these guys did their indeed influential work no later than the 1980s. You must admit your list is highly selective. (although Sargent is currently doing some interesting work on learning - in a departure from rationality.)

But since then there's a whole load of new Keynesian economics, underpinning proactive government. E.g. I would say that Krugman, Stiglitz, Mortensen and Pissarides (recent Nobel winners) and i would hazard a guess the majority of the mainstream as opposing the policies you caricature us of all recommending. (privatisation, welfare state destruction etc.)

And as for economics degrees perverting our children, I guess you survived? Maybe you're more rational than the rest.

[RedShift]

It's true that New Keynesians may advocate a more "balanced" approach to reducing government deficits, and some may even call for stimulus spending, but when it comes to the "core" mainstream beliefs that unions are bad, welfare states create disincentives to work, employment protection and other labour market "distortions" inhibit economic growth, the new Keynesians are firmly in the neoliberal camp. Hell, even Mankiw considers himself a new Keynesian and yet his ideas about "structural" unemployment reflect the views of most economic "scientists".

[Luis Enrique]

Redshift with your lecturers were appalling or you weren't paying attention. The goddamn textbook pours cold water on RBC models, go re-read Romer Advanced Macro, and no half decent economist reaches policy conclusions on the basis of three equation models

[tim]

"beliefs that unions are bad, welfare states create disincentives to work, employment protection and other labour market "distortions" inhibit economic growth". Redshift, are you saying they don't? Or are you saying that they may do up to a point in certain circumstances, but they have other justifications that economists typically don't take into account?

[Left&rational]

@luisenrique,

No the textbook reads as follows:

"you're feeling sleepy. counting down, 10, 9, 8,....

Markets are good. There is no market failure. We must liberalise and privatise. Government bad.

There are no frictions in markets, agents know everything, markets are good.

Altruism bad, self-interest good, markets are good. Government bad.

...8, 9, 10, you're back in the room"

[Keith]

Strangely people who are not economists are bemused by a subject that claims to be rational and scientific but which cannot prevent a repetition of tulip mania and south sea type bubbles. Which in fact seems to assume they are impossible. Rational processes are usually judged by results.

While it is true that Physics or chemistry or pure Mathematics has problems that cannot yet be solved or which involve uncertainty giving rise to only approximate solutions that seems to me to be true of only a limited domain of problems. The vast bulk of the physical sciences have a degree of truth and certainty which economics has never approached. When unable to get exact results Scientists can at least give degrees of reliability or orders of magnitude and make qualified statements. Doubt in modern Physics only applies at the advanced limit where experimental results have not yet made it possible to choose between theories. There is no doubt or controversy between Physical scientists about the fundamental aspects of their study. Or inability to draw useful real world conclusions. Or unwillingness to test the model against real world criteria.

Economics seems to be stuck in the Philosophical state criticised by Voltaire in Candide; the Dr. Pangloss world where every thing is for the best, earth quakes, plague and Inquisition not withstanding, is the world of economics. The modern Pangloss is not a doctor of Theology but a doctor of Economics.

[Luis Enrique]

Tim, but economists do take other benefits into account. My experience of what economists say to students about the welfare state is as follows: yes it affects labour supply decisions, let's study how, note not always in a bad way (give unemployed time to find a better match) but it also provides insurance against unemployment and is welfare enchancing and nobody but a lunatic would do away with it. And that's what the text books roughly say too.

[Luis Enrique]

Keith, where do you think you have acquired your knowledge of ecomonics? I could cite dozens of papers about bubbles, text book treatments and undergraduate courses on the topic at prominent universities.