Readers gave high marks to Andrew Dittmer’s summary of a dense but very important paper by Claudio Borio and Piti Disyatat of the BIS and asked if he could produce more of the same.
While Andrew, a recent PhD in mathematics, has assigned himself some truly unpleasant tasks, like reading every bank lobbying document he could get his hands on to see what their defenses of their privileged role amounted to, he has yet to produce any output from these endeavors that are ready for public consumption.
However, I thought readers might enjoy one of Andrew’s older works. He e-mailed me right after I started working on ECONNED. Our conversation went something like this:
Andrew: I am a Ph.D. student in mathematics at Harvard. I have found your blog to be terribly interesting while trying to make sense of the way in which the global economic architecture is evolving, or devolving as the case may be.
I should finish my doctorate in a month, assuming nothing goes terribly wrong. I would be very happy to help you with your book in whatever ways are useful for you. In particular, I would definitely be able to review and comment in a fairly minute and exacting way on chapters of your book.
Me: That is a very kind offer, thanks! What is your dissertation on, BTW? And are you doing theoretical or applied math?
Andrew: Theoretical math
Me: [inwardly] Holy shit, this is one of the smartest people in the country!
It turns out that Andrew did indeed provide detailed commentary on the logic of all the chapters, as well as the thread of the argument across the book after it was drafted (something few editors do). Chapter 2 was the most daunting chapter, in that it is a fundamental critique of economics from a methodological standpoint. Every time I though I had a draft nailed, I’d get extensive feedback from Steve Waldman and Andrew, with the net result that I’d go back and start from close to scratch. This happened eight times and I was clearly losing patience.
Andrew, recognizing that I was starting to get frayed (writing an ambitious book in six months was rather deranged, and all the revisions were adding a lot of pressure) suggested how to restructure the chapter in the form of a lesson guide for sixth graders (as mentioned earlier, Andrew taught six and seventh graders math in the Cambridge public schools on the side). It was useful and also provided some badly needed comic relief.
Those of you who have read ECONNED may recognize the parallels (I adopted his outline in large measure). I am confident readers who have not read the book will still enjoy his rendition.
* * * * * (HISTORY)
Once upon a time, about a hundred years ago, economics was different from how it is today. Many famous people had thought about economics, including Adam Smith, Ricardo, Marx, and others. Economics was not a perfect science, and lots of people who thought about economics disagreed. But in the last century, economists started to agree about two things: economics should become as mathematical as it possibly could, and politicians should listen to economists.
Economics at the time was not a very mathematical science, at least compared to the way it is today. Economists used to write articles with very few equations, or even without any equations at all. When did economists start to use math more? The beginnings might have been toward the end of the 1800’s, with some economists named Jevons, Menger, and Walras. But a person who was particularly important was Paul Samuelson. He comes into the story later.
In the 1920’s and 1930’s, there lived a great economist named John Maynard Keynes who came up with new ideas about economics. Many people thought that they made a lot of sense because they seemed to explain how governments had managed to get their countries out of the Great Depression. Politicians began to listen to economists more and more.
Someone named Lorie Tarshis went to Keynes’ classes, took notes, and made a book out of it. The name of the book was “Elements of Economics.” It was published in 1947. Back then, there were people who thought that communist spies were everywhere. Some of these people, including William F. Buckley, decided that Tarshis’ book was also part of a communist plot, and started saying so very loudly to as many people as they could find. Many colleges became afraid to use “Elements of Economics” as a textbook.
Meanwhile, Paul Samuelson was writing his dissertation, and he saw how angry the people had gotten with Tarshis. He decided to make it so his dissertation could not be attacked in the same way. So he did three things, writing very “carefully and lawyer like.” First, he changed Keynes’ ideas a little bit so that in Samuelson’s version of them, they said that corporations in the capitalist system would always give everybody a job as long as the government and labor unions didn’t bother the corporations. That made corporations happy with him, so that they didn’t think people should call him a communist. Second, he called his ideas “neoclassical synthesis Keynesianism.” That made other economists think that he wasn’t changing their ideas very much, so they were more happy to support him. Third, he wrote all of his arguments up in mathematical form. Now why would he want to write up his ideas as mathematical arguments?
Well, for one thing, a lot of people don’t understand complicated math, so he could automatically win arguments with someone who didn’t understand math. Even the people who went around calling people communists couldn’t call him a communist if they didn’t understand the math he was doing. There was another reason, too. Samuelson could turn problems that economists used to argue about into equations. Then he would solve the equations and the argument would be over. [Lucas quote]
Samuelson’s book was called “Foundations of Economic Analysis.” It was published in 1947, and it became a big success. Nobody told Samuelson that he was a communist. Other economists started to use mathematical models more.
Later on, in the 1950’s, two economists named Arrow and Debreu made a simplified mathematical model of the economy, and proved that in their model, there would never be a time when people wanted to buy something and nobody would sell it to them. Economists thought that this was very exciting. Now they used math even more.
Nowadays, most papers on economics have equations in them. All economists have to be able to talk about their ideas using mathematical models and statistics, or other economists won’t respect them. This is part of what is called being able to “think like an economist.” It is a special ability that you can only learn by going to graduate school in economics. A professor named David Colander surveyed economics graduate students to find out which of seven factors were most important in order for them to succeed in graduate school. The top three factors all had to do with being good at math. The least important factor was having “a thorough knowledge of the economy.”
So learning how to “think like an economist” is very important, because if you don’t do it, then no matter how well you understand the actual economy, economists still won’t take your arguments seriously.
Have these changes made economics a better science, or a worse science?
* * * * * (CRITICISM OF AXIOMATIC MODELS)
Samuelson, by using mathematics, was able to win arguments and make sure people liked him, especially the more important people. Other economists followed his example. How did Samuelson use mathematics to become successful? The first thing he did, if you remember, was that he made sure that his economics would say that corporations would make sure people had jobs, and so corporations were good. So his first technique was to make sure that his economics said things that people would like. But that doesn’t seem to make sense. Isn’t the point of mathematics that in math, things are either right or wrong?
Actually, the way that things work in math is that first, you make ASSUMPTIONS, and then you figure out from the assumptions whether things are right or wrong. So the way that you use a mathematical argument to say things that people will like is that you change the assumptions until they make it so the answers are answers that people like.
[At this point the kids become angry. “That’s stupid, ” they say. “It sounds like they’re going in circles.” The responsible teacher at this point tries to avoid being too political with his or her young audience, and tries to make vague excuses for the economists. However, the teacher can’t help recognizing that the students sort of have a point.]
Even though economists were supposed to be using mathematics so that they wouldn’t have to argue any more, it doesn’t seem to help much if they can still get any answer they want by just changing their assumptions around. For example, [insert McCloskey quote about the A’/C’-theorem].
That means one way to figure out whether mainstream economics makes sense is to see what the assumptions are, and to try to decide whether those assumptions make sense. For example, what were Samuelson’s assumptions? What were Arrow and Debreu’s assumptions?
Samuelson had one big assumption, that economists call ergodicity.
[Teacher pauses to give kids time to stumble over the word.]
When they say ergodicity, they mean that no matter what happens in the world, in the end, everything will reach a point whether things stop changing. That point is called the “equilibrium.” At the equilibrium, everyone will end up with a certain amount of money. The amount of money that everybody gets at the equilibrium depends on how talented they are, and not on anything that happened before. So if you rob a bank, it won’t matter because when you get to the equilibrium, if you’re stupid, you will still have the same amount of money you would have had if you didn’t rob the bank.
[A kid with disciplinary issues mutters, “This is bullshit. Why do we have to learn this?” Other kids ignore him and try to take notes.]
What’s more, at the equilibrium point, everyone will have a job, everyone will have lots of stuff, and no one will feel like there is any way that America could be a better country.
[Eyes glaze over.]
Actually, what’s kind of funny is that in physics, if there are three stars or planets and gravity pulls them around, what do you think happens? They end up going into orbits around each other. But their orbits will be different if they start out in different places. So it would be kind of weird if an economy with millions of people doing all sorts of complicated things always ended up in the same way, if three planets can end up in all sorts of different ways depending on where they start moving from. But who knows? Maybe the economists are right about ergodicity.
It’s actually even weirder than that. Because in physics, Poincaré figured out one hundred years ago that even if you know where the planets start out, if you’re wrong about how far apart two planets are by even an inch, then as time goes on, the orbits that you think the planets will go on will start to get more and more wrong, until there comes a point when the orbits you thought the planets were going to settle on are totally different from the way that the planets are actually traveling. So it’s really hard to predict what will happen even to three planets, if you try to look far enough into the future. But who knows? Maybe economists are right about ergodicity, and in an economy if you measure things carefully enough and are clever enough, you can figure out exactly what will happen to the economy for the next one hundred years.
Then there were Arrow and Debreu, who proved that in their model people who wanted to buy something would always be able to find someone who would sell it to them. They had assumptions, too. They assumed ergodicity, like Samuelson, but they also assumed other things. They assumed that everybody in the world knows everything about everything that is being sold all over the world. Also that you know the odds of whether it will rain on a Tuesday in a thousand years. This is called “perfect information.”
Some people who don’t think like economists have made fun of economists for making unrealistic assumptions like these. Those people seem to think that if economics is based on assumptions like these, that maybe aren’t true, then economics must not be a useful science. But these people don’t know that in 1953, Milton Friedman destroyed all of their arguments with a magical “get-out-of-reality-free card.” When you play this card, it makes it so you’re not allowed to make fun of economists for basing their theories on assumptions that aren’t true.
Friedman said that if you could use a theory to describe the world correctly, it didn’t matter if your assumptions weren’t true. Actually, it was even better if they weren’t true, because that would mean that your theory was very, very clever!
That means to decide if standard economics makes sense, we need to see whether it says things that are true, and we shouldn’t pay attention to whether or not the assumptions are true. For example, economists say it’s bad to pay the people with the worst jobs more money
[Kids snap out of their stupor. “What?” a kid asks, dazed.]
because if you do, then the people who give the poor people jobs will fire some of them. A couple of economists named Card and Krueger tried to test the theory and they announced that the theory was wrong, and you could pay poor people more money and have it be a good thing. Other economists saw that if Card and Krueger were right, then standard economics had to be wrong, and they went into shock. They were sure that Card and Krueger had to be wrong somehow.
[One kid asks, “But wait. I thought that Friedman said that the assumptions of the theory weren’t important, just whether it was true in real life. If it wasn’t true in real life, then it was a bad theory, right?” Teacher tells the kid to wait, there isn’t much time left in class and there are a lot of other things left to discuss.]
Some of them tested what happened when you gave poor people more money and said that no, the theory was right after all. Other ones tested it too and said that Card and Krueger were right and the other economists were wrong. So even though Friedman’s magic get-out-of-reality-free card sounds like a cool thing, it’s actually really hard for economists to use it in real life.
But even though the card might not really work, mostly people don’t argue with economists and so they still use their theories and “think like economists.” “Thinking like economists” is kind of like looking at the world with 3-D glasses. When you’re watching a 3-D movie, it makes it so that you see really neat things. When you’re not watching a 3-D movie, then everything looks red and blue and kind of weird. But economists still like wearing their 3-D glasses.
When economists look at the world through their 3-D glasses, they see it as having “ergodicity.” Remember what that means? It means that if you just leave corporations alone and help them to do what they want faster, the world will, all by itself, become a happy place. You don’t need to stop them from doing anything they want to do, or try to make them wear seatbelts. Just help them to drive as fast as possible. It also means that economists can figure out what the economy is going to do, and you can trust them.
For example, economists have invented computer programs called “DSGE models” that they use to predict the future. Because of ergodicity, the DSGE models say that nothing bad will happen to the economy unless something crazy happens, like the people in the Middle East not wanting to sell us any more oil or Martians attacking the earth.
Another example is that some of the big banks invented really complicated things that were sort of like money, but sort of not like money. Those things are called “derivatives.” The big banks liked the derivatives because they were sure they could make a lot of real money from them. Some other people who weren’t economists thought that derivatives might be dangerous. Those people thought that if things in the economy went faster, they might also break more easily. But because of ergodicity, economists were sure that since derivatives helped corporations do things that they want to do faster, the derivatives would be good. So the economists made it so nobody paid attention to the people who said derivatives were dangerous, and the big banks got to make all of the derivatives they wanted to.
Later, the derivatives helped to make trouble in the economy. That’s why some of your parents lost their jobs. The big banks who made all the money from the derivatives had trouble too and were almost destroyed, but the government gave them more money so that nothing bad would happen to them. Meanwhile, the government won’t let people find out what it did with the money it gave to the banks. It says that the details need to be kept secret by a group of bankers and economists called the Federal Reserve. The people on the Federal Reserve think like economists and so it’s okay for them to know the secret.
* * * * * (OTHER APPROACHES TO ECONOMICS)
There have been some people who don’t like the economics that starts with assumptions and then tries to do math with the assumptions. [you could cite Blaug here] Some of these people have tried to make other kinds of economics.
Some people tried to make a kind of economics that is called “systems dynamics.” In this economics, you pretend like the economy is a really big machine, and sometimes parts of it can go crazy or break. Some people liked this kind of economics, including some of the people who said that derivatives were dangerous. But economists mostly don’t like this kind of economics, so they don’t use it.
One day, some economists noticed that if you’re playing cards, if you peek at someone else’s hand, then you’ll probably win more than someone who doesn’t peek. That’s because you know your cards and their cards and they only know their own cards. The economists who noticed this called it “asymmetric information.” Since economists before that assumed “perfect information,” so everybody playing cards knows everybody else’s cards, they were amazed at how smart these economists were and gave them Nobel Prizes.
Another day, some economists noticed that sometimes people are stupid and do things that waste money. They made a theory about this called “behavioral economics.” Since economists before that assumed “perfect information,” [and rational expectations] or in other words, people know everything that is happening everywhere in the world and always do whatever makes the most money, they were amazed at how smart these economists were and gave them Nobel Prizes.
There were also some economists who noticed that if you give another kid your lunch and tell him to hold it for you until lunch, he might eat your chocolate bar and then tell you that someone stole it. Their theory is called the “principal/agent dilemma.” This theory also seemed very new and exciting to other economists.
When people started making fun of economics because economists hadn’t realized that there was going to be an economic crisis, some economists like Eichengreen and Rodrik told those people that they were wrong and economists could have been able to know that there was going to be a crisis. Eichengreen and Rodrik said that the only problem was that economists hadn’t used the new theories like asymmetric information, behavioral economics, and principal/agent theory, but economists would remember and use them next time.
But since all of the new theories are different from the old economics, what usually happens is that economists use only one of them at a time. If they got rid of the old economics completely, then other economists who like the old economics would be angry at them or not pay attention to them. So they use the old economics and then add on a little bit of the new economics and hope that it works. An economist named Peter Dorman said that if the old economics is like a big giant, then each thing that is wrong about the old economics is like a wound that blood is pouring out of. Each new kind of economics is like a band-aid that economists try to put on one of the wounds, but they can’t put band-aids on all of the wounds at the same time. So the giant lumbers forward, blood spurts out of him all over the place, and nothing changes. Gruesome, huh?
Some economists have tried to use a lot less theories and mostly just figure out what is actually going on in the world. This kind of economics is called “empirical research.” For example, when Card and Krueger tried to figure out what would happen if you paid more money to people with crappy jobs, that was empirical research.
But when they did it, a whole lot of people got angry with them and disagreed. So it can end up being pretty hard to tell what is going on in the world.
There are a few reasons why this is true. For one thing, the way economists usually try to find out what is going on is by looking at some numbers or graphs and trying to find a pattern. But the numbers might not be right. And what happens if someone wants to study something and they can’t find any numbers to study it with? For example, some economics students decided they wanted to find out if the trouble with the economy had to do with making it so companies that try to get people to buy houses didn’t have to follow as many rules. But those companies wouldn’t give them any of the numbers they needed to find out if their idea was right. So the economics students gave up. They didn’t have to give up – they could have talked to people who bought houses and interviewed them and things like that. But it would have been more work and other economists might have thought that they were weird to use interviews instead of numbers. So instead they gave up.
This is kind of like the story about a drunk guy who loses his keys and walks over to the street light and looks under it. Somebody asks him why he’s looking under the light when he probably lost them some other place. He says that it’s dark in the other places so it’s hard to look there. Do you see the connection with the economics students who wanted to study houses? They couldn’t find the numbers that made it easy to look at their problem, so they stopped looking.
[In fact, the connection between the joke and the problems with the mortgage lender deregulation research is the one idea here that is abstract enough that it would be tricky to explain to sixth graders.]
Another problem is that if you look at enough graphs, you’ll eventually find one with a pattern just by chance. This is bad, because it might not be a real pattern. It might just be an accident. If you take a fake pattern and make people think that it’s a real pattern, that’s called “overfitting the data.” It’s kind of like cheating.
If you don’t want to cheat and overfit, there are some ways to make it more likely that you’re finding a real pattern and not a fake pattern. If you find a pattern one year, you can look at another year, or another place, and see if there is the same pattern. This is called “cross-validation.”
Even though it’s a good idea to do cross-validation, a lot of economists don’t do it. A couple of people named Gerber and Malhotra did detective work on economics papers, and they found out that lots of economists were probably overfitting. They couldn’t tell who was doing it, just that a lot of people were doing it. If you’re an economist, you want to have a good job, and to get a good job, it helps to find patterns and write papers describing the patterns to other people. So some economists maybe wanted to get a better job and so they overfitted so they could find more patterns.
* * * * * (STATUS AND FUTURE OF ECONOMICS)
Economics seems to be in a lot of trouble right now. The old economics has problems, and the new kinds of economics have problems too. Some economists have even given up studying the economy and now study things like speed-dating and violence in movies.
A guy named Thomas Kuhn said that when people make a science, they keep using it as long as they can. Sometimes they can tell the science isn’t working very well. This is called the “late-paradigm” stage. It sort of means that the old science has become sick. Even then, people will only stop using the old science when someone invents a new better science AND when all of the professors who liked the old science get old and die.
It looks like economics is in a “late-paradigm” stage. But people don’t have a new better economics, so people still keep using the old economics. What are some things that should happen?
(1) Economists should be honest about when they don’t know what will happen in the future so that people don’t rely on them in ways that they shouldn’t.
(2) Economists should admit that in economies some people want some things to happen and other people want other things to happen. They should be honest about what kind of world they want to live in, and not pretend like they know how to find a world in which everybody will be overjoyed.
(3) Economists should work less at trying to find reasons not to listen to people, and try harder to learn about the economy, even from theories that they don’t like, methods like interviews that don’t involve numbers, and from the ideas of people who are not economists.