Facts, frictions & "mainstream" economics

John Rapley’s claim that economics has become a religion has kicked off another debate about the state of economics.

For me, there seems to be a presumption here which both sides seem to share but which I don’t – or at least that I don’t care about. It’s that economics is a canon of work which is taught to students and the outside world. However, I think of economics differently – as a box of theories, evidence and mechanisms which help me make sense of the world. What I care about is: what are the facts? And: how do we explain them? I don't much care what's orthodox or heterodox. 

I’ll take an example from financial economics. We have a theory here – the capital asset pricing model – which predicts that riskier shares will on average out-perform safer ones, where risk is defined by a share’s covariance with the market (or beta). I used to believe this.

But there’s a problem with it. It’s false. We know this not because of methodological diversity but because of the facts. We have a body of evidence which shows (pdf) that less risky stocks out-perform riskier ones – in flat contradiction to the CAPM*. I stress here that it’s the body of evidence that matters. Single studies are prone to not being replicated, but the defensive anomaly has been found in different data and with different measures**. And the CAPM’s failure is now accepted even by mainstream economists: Eugene Fama and Ken French have written that it “has never been an empirical success”.

Now, maybe the CAPM is still taught uncritically in some business schools and universities. To the extent that it is, Rapley is right. But I don’t really care. The purpose of university is to acquire credentials and a grounding for later learning rather than to get a complete education.

What I do care about is why the CAPM is wrong. A big part of the story lies in market imperfections.

Researchers at AQR Capital Management point out (pdf) that many investors cannot borrow and lend freely as the CAPM assumes. They express their bullishness not by borrowing to buy the market portfolio but by buying high-beta stocks – those which are in effect a geared play on the market. This causes such stocks to be over-priced on average, because most investors are usually bullish; they know about the equity premium. The counterpart to this is that defensives are under-priced.

A second imperfection is that short-selling is a damned sight harder in practice than in theory. Even if you’re right in the long-term (a few weeks) that a stock is over-priced, margin calls can wipe you out in the near-term. This is especially true for volatile stocks.

Such frictions mean that mispricings persist. Again, we know this not because of abstract theorizing but because economists have done the hard yards of seeking the facts. David McLean and Jeffrey Pontiff show that only around half (pdf) of mispricings in the US are eliminated after they’ve been discovered. The proportion is even smaller in Europe.

What does all this tell us? In part, it leads me to side with some “heterodox” economists***. Market frictions such as borrowing and short-sales constraints (pdf) are not minor quirks that can be ignored until later in one’s studies. They are instead part of the essential nature of the beast which generate the most important thing in economics – facts.

But I also sympathize with the “orthodoxy”. Flaws with “mainstream” theory are to be found – in the first instance - not by armchair theorizing but by gathering facts.

Now, you might object that financial economics is a minor tributary of economics that nobody much cares about. For me, this is its appeal. Macroeconomics is, for many people, so tied up with their political passions that progress is more difficult.

* This isn’t the only evidence against the CAPM: there’s also momentum, among other things.

** In the day job, I’ve ran my own real-time test. I’ve simply taken an equal-weighted basket of the 20 lowest-beta stocks in the FTSE 350 and measured their performance. My chart shows that they have hugely beaten the FTSE 350.  

*** The scare quotes are because I don’t care about the distinction between heterodox and orthodox. What matters is what explains the facts.

Comments

[Luis e]

I presume there's a huge amount of mainstream economists digging into why CAPM wrong, taking frictions seriously. I know you don't care about it, but it irks me that criticising economics is cast as a heterodox thing whereas imho the best criticisms of the mainstream often come from within.

[TheBirmingham6]

I remember myself and another hedge fund manager bod who specialised in buying and selling equities day in day out having horrendous long-winded debates with a friend in Investment Banking/Corporate Finance about how CAPM was b.s.

It's surprisingly quite hard getting through to people who want to believe a theory despite your practical observed experience being totally counter to their preconceptions. Cognitive Dissonance is strong when you can 'sell' a M&A transaction to the Board of a FTSE100 and make your bonus for the year in one transaction!

[chris]

@ Luis e - this is exactly my problem with these sort of debates. They go like this:
Critic of economics: "Economics assumes perfect markets/rationality/whatever"
Economist: "No they don't. Look at papers A, B, C etc"
Critic: "But those papers aren't mainstream"
Economist: "Yes they are"
Critic: "No they're not"
Etc

[Tate]

I think you should care. Its because its amazing that a theory that is so empirically wrong/doesnt agree with facts can even make it out of academia to gain legitimacy for itself and its academics. Its an insight into how terrible a shape the orthodoxy is in to even allow for this. This is not as great a problem with other fields.
Imagine if this was the case for vaccines. You wouldn't care how it got out into the real world in the first place?

[chris]

@ Tate - I see your point. Maybe I was being solipsistic. I was driving at the point that I can construct something meaningful out of economic research.
The problem here though is that word "orthodox". Is the CAPM orthodox? The question leads to for me tiresome issues of definition. I suspect you might well be right that academia (at least in some parts) perhaps still prizes theoretical elegance over facts.

[Tate]

Is the CAPM orthodox? Well depends how you define orthodoxy. It certainly smells similar to orthodox econ.

[rjw]

I am with you on the main point .... being overly fussy about what camp one sits in is inimical to progress. I very much share the view that a healthy approach to economics is to see it as a collection of theories, arguments, mechanisms and so on that help us analyze and understand the world, and what matters is telling a good story backed up by sensible empirical evidence. And bugger the school of thought you come from. But I dont think everyone else out there is quite so open minded. I spent a couple of days on a professional course on "the theory of economic growth". After endless variations on the solow growth model, I asked the professor when we might discuss trade, geography, the division of labour, Smith, and all that. I got a very blank look. Open any undergraduate textbook at the chapter on growth and you will be lucky to see a mention of anybody before Solow. I think, indeed, you are being solipsistic.

[Pepe]

The problem is facts definition/evaluation are not theory independant, this is the classic exemple of ptolemean epicycles.

[sam]

the capm is still useful if wrong because the frictions can only be understood as departures from the baseline frictionless model. if we didn't have capm and you said "high beta stocks are over priced", I would have to ask, relative to what? if you said, this is the case because investors can't borrow and loan easily enough, I'd ask well how easily should they borrow and what would we expect if they could? it's precisely be cause we are able to conceptualise an ideal market, that we can identify departures from the ideal and understand their effects. heterodox don't like that we teach students about the fantasy of ideal markets, but where else to start? we could start with a model with all the frictions, without telling them that they are frictions, or what would happen if they were removed, but this seems like a cruel trick! and how would we decide which frictions to include in this new baseline?

and every field of economics is organized this way; start with the baseline perfect competitive market. compare its predictions to stylized facts. investigate frictions that could reconcile the differences. in labor this lead us to search models, in macro to price rigidities, in health to asymmetric information, in public finance behaviouralism.

[Chris Auld]

Chris, I think you're giving far too much credit to the pop-econ-critic echo chamber.

They're not evaluating theories such as CAPM and arguing that the evidence is inconsistent with the theory, and they're in particular not interested in the fact that mainstream economics is largely empirical.

They aren't even talking economics at all. They are talking politics.

And in this political discussion economists are assigned the role of political villains: usually right-wing villains, and always right-wing villains in the case of the Guardian. The discourse of pop critics is completely divorced from that "box of theories, evidence and mechanisms" you highlight.

And it is time research economists started pushing back. Biologists, climatologists, and medical researchers suffer from much the same problems with pop critics, but they have a long history of firmly responding to such criticism in the public sphere. Economists have largely let this dangerous nonsense go unchecked, and the result of our failure can be seen perhaps most clearly in the dizzying levels of anti-intellectualism at the Guardian.

[Luis Enrique]

chris,

yes I agree that's tiresome, so why choose to write that by emphasising frictions and mispricing you are siding with the heterodox?

tate, CAPM might be an orthodox theory, but that does not mean orthodox economists think it is a satisfactory description of reality. It does not show orthodoxy is in a 'terrible shape', it shows that the study of economics inevitably starts from simple theoretical scaffolding that only gets you so far, and that's fine so long as you understand that's all it is, which imho most economists understand perfectly well, and it's the critics who think economists take these theories to be complete descriptions of reality.

[Tynnie Todgers]

Perhaps the problem isn't so much mainstream economics as its representation in mainstream media. All too often, people with right wing agendas present anti-union, anti-minimum wage etc "Econ 101" rationales as if they were complete, uncontested descriptions of reality. And with barely a murmur of dissent from mainstream economists.

[Chris Pepin]

I was energized by the comment in your last paragraph about the appeal of financial economics. Also, the more I learn about economics the more diffuse the boundary between "orthodox" and "heterodox" becomes...