StanCollender'sCapitalGainsandGames Washington, Wall Street and Everything in Between



Disagreeing With Andrew, Pete, Bruce, and Krugman On The Failure Of Economists

11 Sep 2009
Posted by Stan Collender

I'm coming a little late to this party, but only fashionably so.

This all started last Sunday with Paul Krugman's thought-provoking/anger-inducing article in The New York Times Magazine, "How Did Economists Get It So Wrong."  The following day, Andrew challenged some of Krugman's basic assertions in a post that got Pete exercised the day after.  Yesterday, possibly just to embarass me for being late to class, Bruce expressed a few thoughts as well.  And earlier today, Andrew added some fuel to the fire with this.

Gentlemen...I admire and respect you all but thou doth protest too much me thinks.  Economists are not the problem.

The question shouldn't be whether, why, and how the economics profession has failed.  The better question is, given the absolute certainty that uncertainty and a lack of perfect information exists in macroeconomics, why do we keep taking what economists say as if it is a pronouncement from on high?

And this isn't even a new question.  Does no one else remember (or remember reading about) the debate that took place after the Kennedy administration when the economic team was convinced it could "fine tune" the economy?

And why in the world are we arguing about salt water vs. fresh water or Keynsian vs. monetarist economics as if any one of them could possibly be the answer to everything all of the time?

A few other comments in no particular order...

1.  As much as economists might like to believe (and might like others to believe), economics is anything but an exact science.  In fact, we should admit that economics is not really a science at all.  Nothing can be tested in a lab with controlled conditions so results are always tainted.

2.  The fact that some economic events happen that we don't expect and can't predict with any certainty is almost absolute proof that, given the current state of what we know, economics and economists can't, don't, and won't always get it right.  There's no shame.  Get over it.

3.  Krugman, Andrew, Pete, and Bruce are all being far too defensive.  Economists don't make policy choices by themselves or on their own and decisions are not made solely on the basis of economic theory or practice.  Unlike the situation in Isaac Asimov's Foundation trilogy, where psychologists ruled, decisions are made in a highly charged political environment that almost never allows for economic purity.  With very few exceptions, every economic polciy decision is a compromise that, if we were all honest with ourselves, doesn't really allow conclusions to be reached about them even when the policy succeeds.

4.  Besides, even if it looks similar, the next situation to which that same policy may seem appropriate will be at least somewhat different than the last time it was used.

5.  Economists are not today's equivalent of high priests or partisan eunuchs.  In much the same way that pollsters read numbers differently depending on their political affiliation, economists are often political animals whose views are frequently stated in partisan terms or for partisan reasons.

6. As much as we might like to believe otherwise, at least some markets clearly are not inherently stable and it's ridiculous to believe otherwise.  More importantly, these days many market participants thrive precisely because of that instability and do things that create it if it doesn't occur on its own.

7.  Andrew indicated that he was surprised by the fact that rating agencies were, in his words, "in on the con."  This is not that different from Alan Greenspan's much-quoted comment (I'm obviously paraphrasing) that he was shocked to learn that Wall Street firms' actions were not based on what was right for the markets.

Is it really that surprising that rating agencies and financial firms operated on what was best for them rather than for the market  as a whole?  Isn't "what's bad for the market" an externality that individual participants seldom, if ever, take into account?  Isn't that what government is supposed to do?

About the rating agencies...

Re observations such as:

"I had no idea that the major ratings agencies like Moody's and S&P were in on the con. I thought they made their money by preserving their reputations for honest assessments above all else.

"Many elements of financial innovation and regulation were dependent on a AAA rating ..."

and

"Is it really that surprising that rating agencies and financial firms operated on what was best for them rather than for the market as a whole?"

The rating agencies are a government-mandated, created and protected cartel.

Not anybody can be a "nationally recognized" rating agency, whose rating is indeed required by regulation or otherwise in countless cases. Thus the agencies have susbtantial market power, obtained from the government.

In the 1990s there were only three agencies. Since then about a half dozen more have been authorized, but mainly as small specialized niche players. Other firms with ratings skills cannot freely and competitively enter the market to provide "nationally recgonized" ratings as regulators require.

When your business is protected from competition, "preserving its reputation above all else" is not a competitive necessity because you are not competing.

By the same token, it is not at all surprising that you then operate on the basis of what is best for you, rather than for the market as a whole. Everybody always operates on the basis on the basis of what is best for themselves -- the only thing that coordinates this self-interest with society's interest is competititon. That's the point of Adam Smith's "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest".

In the rating agencies' case the situation has been compounded by the fact that the regulator that selects the agencies and governs their practices is the SEC -- which hasn't exactly covered itself with glory lately. (Maddoff escaped five SEC investigations and was recently quoted in the NY papers as saying he "couldn't believe" he got through the last couple.)

SEC rules also are in large part responsible for the fee mechanism used by the big rating agencies, of charging the firms that issue rated securities for rating them (instead of serving the buyers of the securities) -- with the self-evident conflict of interest that results.

"He who pays the piper calls the tune", here as everywhere else. If the rating agencies are paid by those they rate and protected from competition by regulators, nothing is more natural than for them to shift their attention to the tunes called by those who pay them and protect them. The interest of those who pay them is obvious -- and let's not forget that during the whole run-up the politicians who run the regulators were unanimously gung ho in pushing the home ownership made possible by these mortgage securities into the ranks of those with ever lower credit standings.

So if one wants to say the rating agencies were "in on the scam" -- while that's somewhat of a pejorative way of putting it, being that they didn't see a collapse in home prices coming any more than anyone else did, which is what "scam" implies (and even Shiller himself didn't see a collapse coming, contrary to all popular stories today, if you read what he actually wrote at the time) -- well, yeah, but what was more natural when operating under the incentives applied to them? Incentives matter, a lot.

Eric Falkenstein is a financial economist who's written some interesting analysis of the rating agencies, neither forgiving nor demonizing them. E.g:, he's pointed out that while Moody's predicted far too low default rates back in 2006 it now is forecasting implausibly high rates to come, as a CYA defense, in response to obvious incentives -- and its forecasting rates that are too high isn't good for the economy either.

He also examined an interesting counterfactual: What if Moody's had knocked down its ratings of mortgage securities in 2006? His conclusion -- it wouldn't have been good either for the economy or for Moody's (which would have gotten blamed for subverting an otherwise healthy economy) ... meaning that under the operational arrangements of the time, it would have been a very hard thing to make come true -- contrary to so many opinions today that it would have been easy if only people had done their jobs right. Again, institutional arrangements and incentives matter a lot.

So if we really want make the rating agencies accountable to those who rely on their ratings (including society as a whole) maybe we should do just that -- change the regulatory regime so they are paid by and answerable to those who use their ratings, and are open to new competition at all times from new entrants to the field who might do the job better.


These are good points, but

These are good points, but when have economists been taken seriously on financial regulation? The last time seems to be the deregulation under Clinton--and the figures reponsible for that have returned to office.

These are all also excellent reasons for being skeptical of the Dartmouth-Orszag position on heathcare; the only comparable situation I can think of where technocrats are driving policy.


Overconfidence in predictions

why do we keep taking what economists say as if it is a pronouncement from on high?

Many microeconomic predictions do deserve such deference. When economists say, for example, that price controls will lead to shortage, only fools ignore them. But fools are never in short supply, so we're accustomed to defending robust findings from them, and when we encounter questions like those of macroeconomics, where we don't have confident answers, it's easy to forget and treat tentative predictions the same way.




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