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

By George Washington of Washington’s Blog.

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 Fed.

As Upton Sinclair said:

It is difficult to get a man to understand something, when his salary depends upon his not understanding it.

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  1. MyLessThanPrimeBeef

    Going with the current is probably a safe thing to do, especially if you are in the Amazon river.

    Warning: The following is not suitable for children or those easily frightend.

    I was watching the BBC series called Earth and at the end, there was a segment about this tiny fish in the Amazon river called Candiru. According to the local people, you do not under any circumstance urinate upstream, as the tiny, parasitic fish cound then enter your body and stay there happily ever after. It would take a very painful surgery to remove it.

    And so, it’s probably wise to go with the current.

  2. Graphite

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

    They’re still pretending this. CDS on U.S. government debt is the one market that Paul Krugman thinks we should listen to as if the participants were omniscient demigods.

  3. cougar_w

    [go with the flow, and with so many rewards for doing so, there is a strong unconscious bias towards believing the prevailing myths]

    Economics is not a science — as was discussed — but a religion. The pressure to “go with the flow” is touched off by the same fear of persecution that a heretic would experience.

    Economics as a practice has no more place in government policy making than does Haitian Vodou practice. And Vodou has nearly as much predictive power. They are equally good at making people feel better about themselves in a seeming random world, and as such provide a temporary benefit to mental health.

    Though obviously if you want to get personally rich you probably ought to study economics and not vodou. That, though the latter have the best parties evar.


  4. Eli Baker

    Upton Sinclair theorem:

    It is difficult to get a man to understand something, when his salary depends upon his not understanding it.

  5. bobh

    The shameful state of academic economics is guaranteed by the process that selects and advances academic economists. This article mentions the mechanisms that keeps ambitious economists from criticizing the Fed, but the larger, overall biases favoring corporations, financial elites, and “free markets” are enforced at every step of a potential economist’s path to the happy comfort of a teaching job at a major university. Graduate students or tenure candidates are screened and weeded out by their betters if they don’t embrace the ideas that are pleasing to the corporate and private donors who endow chairs and build new, named business schools. The result is a privileged class of mandarins who are happy to keep their eyes carefully lowered and focused on their desks, studying equations and models, while economic crimes are going on outside the gates of academe.

  6. craazyman

    What’s the old joke? “Economists exist to make astrologers look respectable” or something like that.

    What is fascinating to me, from the standpoint of analytical group psychology, is how these morons and all the crap they spout evolved into a system of thought that rose to such a height of influence.

    Of course it was powered by money and self-interest, but at a more abstract level I am not sure it’s all that much different in kind — although admittedly it is in degree — to the Cartheginians throwing babies into the pit of fire to appease their gods and turn back the Roman navies. Or the Aztecs eating the hearts of prisoners to fortify the life of their tribes, and stacking their skulls in sculptures of piety. This utter abandonment of Gnosis and embrace of a thoroughly diseased collective consciousness is one of them most frightening things about the human race. In the words of the rapper Tupak Shakur, riddled dead with bullets in a drive by at 25 years old, “the only thing I fear about death is reincarnation.” Oedipus Rex, know thyself and thy sins, they are legion.

  7. i on the ball patriot

    It is easy to get an economist to put shit in his head,
    When his salary depends upon not criticizing the Fed.

    The Wall Street Urinal is a propaganda tool of the man. Reflecting off of it gives it its voice and power. It needs to be on the shun and shame list.

    Deception is the strongest political force on the planet

  8. psychohistorian

    While I agree that the economics profession has a lot of our current situation to be blamed for I think the bigger culprit is the marketing and sales professionals that have taken the lies and deceit and convinced the ignorant among us to act against their best interests. These are the ultimate whores or pimps of society but on a much larger scale covering all aspects of life. They pimp worthless crap for the corporatists that have created the ultimate product/service that they convince the rubes to be valuable but is so cheaply made that it will be lucky to perform its original intent only a few times.

    Time and effort needs to be spent focusing on those that create propaganda for the oligarchs and marginalize and expose their trash talk for the sick vacuous spiel it is.

    Words matter.

  9. jake chase

    Excellent post. Economics contains very little honest analytical work. Henry George explained rent. Veblen explained business. Hayek exploded collectivism. Each of them was immediately discredited by academic charlatans who supported models built on fraudulent assumptions. Keynes’ general theory was really a special theory addressed to a liquidity trap. It took no account of the dynamic relationship between debt and collateral and thus has been helpless to prevent bubbles.

    Science proves nothing, since a hypothesis can only be falsified. As you say, mainstream economics is religious bunk surrounded by light mathematics. This explains Larry Summers, as if anyone who has ever listened to him needs an explanation.

  10. Artemus Ward

    Economics has some serious deficiencies, but stripping out all the assumptions and hypotheses is going to get you nowhere. In science we assume motion is caused by forces that obey certain laws, then see if the phenomena support this idea. The trick is to only strip out the demonstrably false assumptions.

    I’m an engineer who is continually amazed at the things economists say to each other. One guy says “The stock market is booming!” and the other guy says “No it’s not! It only looks that way because the dollar is falling!” That is the equivalent of two engineers arguing over how much something weighs when one is using English units and the other is using SI units.

  11. sth

    How exactly to apply the scientific method to field that is 95% psychology, has a potentially unlimited number of variables, and has very few constants or consistent results. The economy of a particular country, city, region, or person varies not only with that entity, but also with the particular time. It’s influenced by personality, culture, politics, cognitive biases, logical fallacies, ideology, desire, and fear.

    Making truly consistent predictions seems impossible. When we make “economic models” we’re really making “place, person, culture, political, and zeitgeist” models. This does not seem to lend itself well to a predictive science..

    1. craazyman

      That’s a good point, and it can’t be. The scientific method is a bit peculiar in the extreme. One could theorize that the height of hospital ceilings impacts the healing prospects of patients, and do a double blind study on that. The variables are always infinite.

      With economics the only certainties are history, institutional structures and incentives, and human nature. And there are some relatively straightforward observations there that should be instructive.

      I have a minor personal connection to our current mess. My dad was an economist at a federal banking regulatory agency in the early 1990s at the start of the derivatives boom. He and a few other colleagues objected to many of the premises underlying these instruments and urged that the dangers of them be taken much more seriously, but they were smacked down hard by the power structure, who alledged that neither they nor anyone in government really understood these things, that Wall Street and its mathematicians did, and that their agency didn’t have any legitimate role or right to try and reign them in.

      This of course is Washington and politics, and the agency heads (political appointees) were only parroting the zeitgeist at the time. No scientific method could have intervened in this case, but a common sense look at history and human nature, emboldened by integrity, could have.

    2. Chris

      The scientific method works reasonably well for psychology despite all the problems you mentioned:

      I think the bigger problem with economics as a science is that it operates on such a large scale that it’s difficult to obtain viable experimental data for hypothesis testing. You have to rely on historical data, which (while available in abundance) tends to bias you towards thinking that assumptions that have proved valid in the past will continue to apply in the future. As we’ve seen lately, that’s not always true.

      Theorizing in the abstract without testing the results in real world situations is the province of pure mathematics, not science. There’s nothing wrong with it on its own – the fault lies in claiming that your results actually mean something in a practical context. You can formulate a hypothesis from them, but it still needs to be tested.

  12. nik Kondratieff

    Economics, the dismal science, begets dismal policy.

    It’s high time policy makers and business leaders turn a deaf ear to the tripe that economists offer–especially neo-classical, free market, and behavioral economists.

  13. Hugh

    Economics is not about the scientific method or a search for testable principles. It is about the maintenance of orthodoxies. And for most of us, it is about how, by whom, and for whose benefit those orthodoxies are exploited. You see in this schema it doesn’t matter how often or massively economists are wrong. The question is are their ideas convenient for those who wish to use them to justify their market manipulations. Those who espouse such ideas get tenure at universities, they are hired into government, industry, and think tanks. If you made a fact based assessment of today’s economists, 95% of them would qualify as buffoons. But as I said, it doesn’t matter. They are buffoons with connections. That is why a week from now the WSJ or NYT will write some seriously toned article about what these “economists” think as if their insights meant anything.

  14. carping demon

    Well, the market (or whatever it is) goes on, and somebody has to make decisions about it tonight, and tomorrow and the next day, etc. Who’s it gonna be?

  15. timbo

    Lets not be too hard on economists. Plenty of other soft sciences out there, with enormous subjectivity involved. Hell, even the “hard sciences” leave enormous room for dissent and debate.

    Just remember that policy was not set because of the economists’ views, but vice versa – the economists were set because of the policy.

    In English – “They brought in yes men”

    So i wouldn’t throw an entire field of study out the window because some politicians bent statistics to lever up an asset bubble.

    1. Hugh

      It wasn’t just any asset bubble. It was the mother of all asset bubbles, and it was only one part of a house of cards validated by a generation of economists. I have seen this “few good apples” argument used to mitigate all kinds of stupidity, incompetence, arrogance, and evil. There are a few good politicians. So we should not talk about the pervasive corruption in our government. There are a few good journalists so describing the MSM as made up of clowns, shills, and stenographers goes too far. And yes, there have been a few good economists, like Keynes, Minsky, and Fisher, so we should not dismiss the whole field. In fact, I’m not, only 95% of it.

  16. Trainwreck

    Congress and Obama would do well to listen to Barry Ritholtz. We need to rebel against Wall Street, K street and our congress and hold them to task. Prosecutors out there? Start enforcing laws against fraud.

  17. selise

    i like these bits from the intro to steve keen’s book, “debunking economics” (typos mine):

    There are plenty of economists who have been well trained in conventional economics, and who are even more critical of economics than those who have not had such training. These critical economists are well-informed objectors to the delusion that economics consists of incontrovertible truths.

    … since mainstream economics is profoundly wrong, the existence of alternatives to it is highly important. The rejection of the dominant approach to economics does not leave us in an intellectual vacuum.

    i’m beginning, sadly, to have a better understanding of what “cognitive capture” means with regards to neoliberalism and economic policy prescriptions in usa politics, even progressive politics.

    a few days ago, rob parenteau and marshall auerback posted here as part of the debate on deficits. for the most part, they and their posts were rejected out of hand, prior even to much if any attempt to understand their posts or their alternative (heterodox) economics. it was, i thought, an astonishing response for blog readers who by and large grasp how badly mainstream economics has failed us.

    i really hope that readers of NC will reconsider their initial response to those posts and with an open mind make a serious attempt to understand before judging. especially for those who give lip service to minsky, rejecting the economists who are working to develop an economics in his intellectual tradition, people like rob, marshall, steve keen, randy wray and many others is, well, inexplicable. especially as they are making the effort to reach out to the public (having failed utterly to get a hearing within mainstream macro economics), and let’s face it, reading minsky himself is mostly pretty hard going and i seriously doubt many people here, even those who refer to him, have done so.

  18. fresno dan

    Crazyman said “I have a minor personal connection to our current mess. My dad was an economist at a federal banking regulatory agency in the early 1990s at the start of the derivatives boom. He and a few other colleagues objected to many of the premises underlying these instruments and urged that the dangers of them be taken much more seriously, but they were smacked down hard by the power structure, who alledged that neither they nor anyone in government really understood these things, that Wall Street and its mathematicians did, and that their agency didn’t have any legitimate role or right to try and reign them in”
    I like your points – I note that at the beginning of the crisis how many CEO’s were saying how NOBODY knew how these financial instruments worked (?Maybe someone with fiduciary responsibility to shareholders shouldn’t buy them???) – I guess between saying one knew and being at risk of prosecution, its easier just to say, “whoculdaknowd”

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