Wall Street Journal Admits Economists Were Wrong, But Fails to Discuss their INCENTIVE for Being Wrong → Washingtons Blog
Wall Street Journal Admits Economists Were Wrong, But Fails to Discuss their INCENTIVE for Being Wrong - Washingtons Blog

Wednesday, November 4, 2009

Wall Street Journal Admits Economists Were Wrong, But Fails to Discuss their INCENTIVE for Being Wrong

The Wall Street Journal admits this week that economists blew it:

The pain of the financial crisis has economists striving to understand precisely why it happened and how to prevent a repeat...

The crisis exposed the inadequacy of economists' traditional tool kit, forcing them to revisit questions many had long thought answered, such as how to tame disruptive boom-and-bust cycles...

"We could be looking at a paradigm shift," says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.

That shift could change the way central bankers do their job, possibly leading them to wade more deeply into markets. They could, for example, place greater emphasis on the amount of borrowing in the economy, rather than just the interest rates at which borrowing is done. In boom times, that could lead them to restrict how much money various players, ranging from hedge funds to home buyers, can borrow
I have repeatedly pointed out the flaws in mainstream economics. See this, this, this, this and this.

But the Journal makes it sound like the policy-makers and economists who deployed faulty models were innocently ignorant of any larger truths:
The models "were not able to draw up the red flags," says Tim Besley, a professor at the London School of Economics who served on the Bank of England's policy-making committee until recently.
Barry Ritholtz has an excellent criticism of the article, pointing out:

There are many areas I would have liked to see the [journal's] article explore: The lack of Scientific Method, the mostly awful performance of economists, its misunderstanding of the value of modeling, the bias inherent in Wall Street variant of economics, and lastly, the corruption of economics by politics...

Let’s start with the basics. Hard “science” — Physics, Biology, Chemistry, and all variants thereto — begins humbly. They try to describe the universe around us by creating theories, and then testing them. These theorems are always preliminary. Even when testing validates them, Science is always prepared — even eager — to replace them with newer theories that are proven to be even more valid.

The humility of science begins with an admission: We know nothing. We seek to learn through experiment and logic, and constantly evolve more and more accurate explanations. Scientific belief evolves gradually over time. Nothing is assumed, presumed, or hypothesized as true. Indeed, research is a presumption that current theories are inadequate or incomplete. The practice of science is a an ongoing search for better explanations, more proof, further verification — for Truth.

Science is the ultimate “show me” state.

Economics has a somewhat, shall we call it, less rigorous approach. Indeed, the arrogance of economics is that it is the polar opposite of Science. It begins with a few basic assumptions, many of which are obviously untrue; some are demonstrably false.

No, Mankind is not a rational, profit maximizing actor. No, markets are not perfectly, or even nearly, efficient. No, prices do not reflect the sum total of all that is known about a given market, sector or stock. Those of you who pretend otherwise are fools who deserve to have your 401ks cut in half. That is called just desserts. The problem is that your foolishness helped cut nearly everyone else’s 401ks in half. That is called criminal incompetence.

Where was I? Ahhh, our sad tale of the practitioners of the dismal arts.

Starting from a false premise that fails to understand the most basic behaviors of the Human animal, economics proceeds to build an edifice of cards on a foundation of sand. (How could that possibly go astray?) Like a moonshot off by a few inches at launch, by the time the we reach further into time and space, the trajectory is off by millions of miles . . .

Economics ... creates an illusion of precision where none exists. The belief in their models led to all manner of mischief, from subprime to derivatives to risk management...

The Behaviorists have been fighting the mainstream for decades now, trying to correct the errors of the basic building blocks of the dismal science.

But I would go further in my criticism of the economic profession by arguing that the decisions to use faulty models was an economic and political choice, because it benefited the economists and those who hired them.

For example, the elites get wealthy during booms and they get wealthy during busts. Therefore, the boom-and-bust cycle benefits them enormously, as they can trade both ways.

Specifically, as Simon Johnson, William K. Black and others point out, the big boys make bucketloads of money during the booms using fraudulent schemes and knowing that many borrowers will default. Then, during the bust, they know the government will bail them out, and they will be able to buy up competitors for cheap and consolidate power. They may also bet against the same products they are selling during the boom (more here), knowing that they'll make a killing when it busts.

But economists have pretended there is no such thing as a bubble. Indeed, BIS slammed the Fed and other central banks for blowing bubbles and then using "gimmicks and palliatives" afterwards.

It is not like economists weren't warning about booms and busts. Nobel prize winner Hayek and others were, but were ignored because it was "inconvenient" to discuss this "impolite" issue.

Likewise, the entire Federal Reserve model is faulty, benefiting the banks themselves but not the public.

However, as Huffington Post notes:

The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.

This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed's thrall, the economists missed it, too.

"The Fed has a lock on the economics world," says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. "There is no room for other views, which I guess is why economists got it so wrong."

The problems of a massive debt overhang were also thoroughly documented by Minsky, but mainstream economists pretended that debt doesn't matter.

And - even now - mainstream economists are STILL willfully ignoring things like massive leverage, hoping that the economy can be pumped back up to super-leveraged house-of-cards levels.

As the Wall Street Journal article notes:
As they did in the two revolutions in economic thought of the past century, economists are rediscovering relevant work.
It is only "rediscovered" because it was out of favor, and it was only out of favor because it was seen as unnecessarily crimping profits by, for example, arguing for more moderation during boom times.

The powers-that-be do not like economists who say "Boys, if you don't slow down, that bubble is going to get too big and pop right in your face". They don't want to hear that they can't make endless money using crazy levels of leverage and 30-to-1 levels of fractional reserve banking, and credit derivatives. And of course, they don't want to hear that the Federal Reserve is a big part of the problem.

Indeed, the Journal and the economists it quotes seem to be in no hurry whatsoever to change things:
The quest is bringing financial economists -- long viewed by some as a curiosity mostly relevant to Wall Street -- together with macroeconomists. Some believe a viable solution will emerge within a couple of years; others say it could take decades.
Note: I am not necessarily saying that mainstream economists were intentionally wrong, or that they lied because it led to promotions or pleased their Wall Street, Fed or academic bosses.

But it is harder to fight the current and swim upstream then to go with the flow, and with so many rewards for doing so, there is a strong unconscious bias towards believing the prevailing myths. Just like regulators who are too close to their wards often come to adopt their views, many economists suffered "intellectual capture" by being too closely allied with Wall Street and the

As Upton Sinclair said:
It is difficult to get a man to understand something, when his salary depends upon his not understanding it.


  1. 1. "It's the models and their assumptions, stupid." Oh, and ignoring history, like Irving Fisher, John Maynard Keynes, Abba Lerner, and Hyman Minski.

    2. This wasn't an economic or financial problem as much as a forensic one. It was a giant crime (Ponzi) scheme and still is. Economists aren't responsible for foreseeing this. Regulators were and are.

    3. Moral hazard incentives pillaging the safety net. These incentives distort markets and vitiate normal economic models.

  2. Brilliant, George! We're being played as fools and slaves by a collusion of oligarchs in finance, government and media. What a pitiful and loveless game of control they are playing. I hope the oligarchs and their minions begin splitting: those who would choose love can act for a Truth and Reconciliation option that you and I advocate.

  3. The economists are only a small piece of the puzzle. They don't deserve a break, but acknowledging the systemic risks in toto really lets them off the hook.

    The enlightened economists of the now STILL miss the big picture. We have efficiently strip- mined the capital upon which our entire productive enterprise absolutely depends!

    How does an economist 'sell' something like this? Better to pretend and ignore and hope/pray for technology.

    Who is paying attention? I recall reading this line of thinking from Wendell Berry about 30 years ago ... This isn't economics, but something far more existential.

    Industry received both a free lunch and the benefit of the doubt until the time of William Jennings Bryan and William McAdoo. Industry was (and still is) equated with 'progress'. With a near 150 year head start and endlessly drilled indoctrination over the decades, it is hardly a wonder that anyone can perceive the curtain, much less the conniving wizards hiding behind.

    Repeat after me, kiddies; 'Industry equals progress! More industry equals more progress.'

    Andy Xie and James Hamilton mention oil and finance in the same articles, Herman Daly, Robert Costanza; a name or two on Jim Puplava's website and little else ... certainly not anywhere within the establishment. That system is in complete denial.

    Gregor McDonald is paying attention, but he is a journalist, not an economist; Chris Martinsen is also not an economist but does indeed 'get it'. So do Stoneleigh - not an economist - and Ilargi; Your's Truly - also not an economist - Barry Ritholtz, (occasionally) Karl Denninger ... who is also not an economist, but a smart trader ... a short list of those who 'get it'.

    I am a simple dumbass, how did I get here???

    Right now ... the instantly 'Niewe Petro' dollar is congealing into concrete right before our eyes, harder than specie, driving in its van the next, awful leg of deleveraging. It's happening without a word being spoken in any blog I can find easily or newspaper; the dollar carry trade is at the edge of the abyss along with its child, the vaunted 'economic recovery'. The massive finance 'balance sheet' of tens/hundreds of trillions in lent dollars is about to become unhinged and swing around its axle and smash down upon the citizenry without pity like the hammer of Thor.

    The astounding price level for crude oil has and is washing away the world's economies from the bottom up and hardly anyone is paying attention.

    It's not what the economists missed, it's what the econs are missing right this second. Hello!

    The background noise never ends; "Credit, credit and more credit; too much, too crooked, too little too late."

    Credit and credit bubbles were - and are - nothing more or less than a hedge against increasing real fuel costs ripping through the economy. High costs propelled America from a manufacturing nation to one of middlemen and 'fixers'.

    The economists rationalize the outcome as well as any, the process of transformation has been lost in the mists. We chose to live by over- consumption and will now die by it. The bias toward waste is baked into the cake of modernity.

    The Luddites were right ...

  4. To a certain extent all the critics of fed policy are sycophants, seeking to measure their own scant conceptual shadow against the giant of shadows cast by these colossal incubators of economic policy. The personage of A. Greenspan or B. Bernanke are little more than figureheads of gigantic think-tanks manned by experts with far more on their minds than economics or economic theory.

    Leading the world is like climbing on board a bucking-bronco.

    Policies are less steerage than they are a
    defensive grasping at some modestly safer harbor. Most often policies chosen are the least-worse of many different more-worse possible directions that are exhaustively explored and projected.

    Yes, someone calls the shots, -but dozens upon dozens of well-connected people get the chance to say, "See, I told you so."

    There is also a gigantic chess game being played behind the scenes.

    It's not a fair game by any stretch of the imagination, but, there is a continual necessity to make the better defensive move to prevent seepage of the lopsidedness of the current game-board and its often unforgiving rules.

    From the quite childish perspective of these critics, some interesting avenues are explored -for the common mind. But no one should be deceived into thinking there is any real impact going on here other than upon the delusions of a small segment of an ill-informed public.

    It was pointed out long ago, how the human mind will watch an athlete, and find what that athlete is doing -is not only easy to loosely comprehend, but similarly easy to imagine oneself doing too, -too easy as it turns out.

    Our minds are after all, finite, if complex.

    Reality is infinitely complex by comparison.

    Our minds have a sometimes movable but limited range in every expression, observation, or experience.

    That limited range is best observed as we consider our fallible memories. It is seemingly easy for us to fill in the blanks.
    The inherently limited range of expression, observation and experience is why our memories fail to conjure an exact reality for our reflective perception.

    This same inherently limited range of expression, observation and experience is also why our dreams do have every appearance of reality.

    It is as if we had a deck of fifty-two playing cards fulfilling the entire range of all our expression, observation and experience. The seemingly infinite variety we experience in life is due to however many hands we are dealt with just such a limited number of these same cards.

    Most of us have a full deck. However, very few of us will ever be in the position to do what Tiger Woods does, or Ben Bernanke.

    And in that position, only a fool believes it would not be all too easy to blow the chance.

  5. Progress in economics will occur one funeral at a time...

  6. Profound thoughts, Anonymous.

    As a critic of the Fed (and the whole debt-based money system it presides over), I guess I am one of your sycophants. To me, it seems pretty obvious that the design of the money system is wrong. It creates more debt every year than it creates ability to service that debt and even a dumb guy like me can see that at some point that has to crash.

    From this intellectual netherworld, I support the kinds of monetary reforms that George discusses in the post: Take the Power to Create Credit Away from the Giant Banks and Give It Back to the People (11.3.09)

    US treasury Issue debt free money. Capital G Greenbacks. Banking system remains private, but it loses the ability to create money (fractional reserve banking). Money creation becomes a public utility, spent into existence by the government, ideally on things like bridges, education, and health care.

    Look at it this way: with Greenback dollars, you only pay for the bridge once, when you build it. Not two or three times over, the way we do now letting the banks create the money and borrowing it from them.

    If we had done this in 1960, there would be no National Debt right now, and if such a system were well managed we could have an economy that would require very few taxes.

    Imagine how well capitalism could work if you just removed the drag of the national debt.



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