Economics must be harder than it looks
By Scott Sumner
Mark Sadowski sent me this paper from Paul Davidson, which he thought was hilarious:
There are two different major economic theories that attempt to explain the operation of the money using, entrepreneurial economy that we call capitalism and its financial markets. The first and most widely recognized one, and the one that I believe most members of this audience accept as correct is the classical economic theory which is sometimes referred to as the theory of efficient markets, or “mainstream economic theory”. Efficient market theorists claim that if economics is to be a science it requires rigor, consistency, and mathematics. Nobel Laureate Paul Samuelson has explicitly added one additional characteristic– an axiom that most efficient market theorists implicitly assume- namely, economists must accept the ergodic axiom in their models if economics is to be a rocket science on par with physics, astronomy, and chemistry. I will explain in a moment what this ergodic axiom ( a term Samuelson borrowed from statistical mechanics) presumes regarding knowledge about the future. But first I raise the question that if
efficient market theory possesses the characteristics attributed to it by its advocates, then how is it possible that efficient market theorists did not foresee the financial crisis that started in 2007-8? Moreover how many risk managers in the audience who had to put their employers’ money where there computer model mouths were, saw the financial collapse of 2007-2008 coming? The mantra of this efficient market theory is that enlightened decision makers in free financial markets will always know the future outcome for any decision made today. These decision makers, therefore, always pick those choices that provide the highest possible future returns. Consequently, free markets are efficient in the sense of allocating capital to its best (most profitable) use. Any government interference in these efficient markets will, therefore, always produce a less than optimal outcome. In other words, interventionist government economic policy is the problem, while the free market is the solution.
Whether they declare themselves Monetarists, Rational Expectation theorists, Neoclassical Synthesis [Old] Keynesians or New Keynesians, the backbone of all mainstream theories is the efficient market analysis model where it is presumed that correct information about the future exists today and this information can be obtained by decision makers.
Surely he can’t be serious? This reminded me of those Paul Krugman posts where he accuses people like Fama, Barro and Cochrane of making inane comments about the multiplier and/or AD. On the other hand I did a post showing that at least some of these comments were probably much less inane than they appeared to be. Multiple interpretations are possible. Are there alternative interpretations for the Davidson comment? I toyed with the idea that he wasn’t implying they ought to be able to predict the timing of the crisis (which the EMH says is impossible) but just the fact that the system was susceptible to such crises, and needs to be fixed. Now even that interpretation would have been wrong (Neil Wallace did warn us) but slightly more defensible. But each time I reread the quotation I see a much bolder and more indefensible argument being made. What do you think?
I’m also reminded of a famous multiple choice question on opportunity cost that was asked of 200 economists at an economics conference. I thought the answer was obvious, and so did Alex Tabarrok, but the actual responses were equally distributed among the 4 choices. Then Tyler Cowen did a post arguing another answer was plausible. Then someone wrote a paper arguing that all four possible answers were defensible.
I’m still not convinced, but which of the following two options seems more plausible?
1. About 80% of the profession, including Tyler Cowen, doesn’t understand EC101.
2. Economics is trickier and more susceptible to multiple interpretations than it appears at first glance to me, and to Paul Krugman.
PS. In case Noah Smith is reading this post; that was a rhetorical question. I am not actually claiming Tyler Cowen doesn’t understand EC101. He literally wrote the (text) book. Last time I posed this sort of rhetorical question Noah insisted I WAS calling Izabella Kaminska a phony. Lots of other very smart people agreed. On the other hand lots of other equally smart people thought my actual meaning was obvious. Which sort of proves my point, doesn’t it.
PPS. I’m also puzzled by Davidson’s claim that rational expectations is equivalent to perfect foresight. Or did I misunderstand that passage as well?