Eric Schliesser has made some very interesting points in response to an article by Alex Rosenberg. Rosenberg’s article is itself a response to some of Paul Krugman’s ideas about the failure of economics to predict important events like the recent financial crisis.
Krugman’s latest thoughts on the matter are here. Here is an excerpt:
In what sense did economics go astray? Hardly anyone predicted the 2008 crisis, but that in itself is arguably excusable in a complicated world. More damning was the widespread conviction among economists that such a crisis couldn’t happen. Underlying this complacency was the dominance of an idealized vision of capitalism, in which individuals are always rational and markets always function perfectly.
Now I think there has been a lot of confusion about determining the precise failure of neoclassical economics with respect to the crisis. Is the problem really that neoclassical models convinced economists that such a crisis couldn’t happen? Certainly many models generated no system states representing such a possibility. But it is up to each economist interpreting each model to decide whether this entails that the possibility doesn’t exist or whether it simply falls outside the explanatory scope of the model.
The point that gets missed in most of these discussions is that there is a possibility that unambiguously was ruled out by most neoclassical economists, namely the possibility that such a crisis could happen and be accurately predicted by the right economic theory. Andrew Lilico’s article, ‘Good economists are almost always right about almost everything’ makes this case succinctly:
Orthodox economics tells us that it is impossible to predict significant financial crises in advance – or else everyone would predict them and trade off that and so they wouldn’t happen.
I trust him on what ‘orthodox economics tells us’. But then what it tells us depends on a solecism. The idea is, I think, that the lead-up to a financial crisis consists of a seller’s market for assets, in which prices are driven up by the expectation that they’ll rise further. This leads to a crash, but if the crash were predictable, the sellers would see it coming, start shorting the assets, and thus reverse the rise in prices that was leading towards the crash.
The flaw in this case was aptly highlighted by Joan Robinson long ago:
Each firm in a seller’s market aims to expand its own productive capacity up to the point that would be profitable if the seller’s market were to last, but the others are doing the same, and the seller’s market will not last. Even a general knowledge that this is likely to be so does not stop the overshoot, for each hopes to be among the lucky ones who will survive while the coming buyer’s market drives others out of existence. (Economic Philosophy, 128).
Thus it is perfectly possible for there to be ‘general knowledge’ that a crash is coming, without this leading sellers to modify their behaviour (‘trade off’ the coming crisis, as Lilico would put it). What the general knowledge of the coming crash does not yield to any individual seller is information about whether or not she is one of the lucky ones who will survive and ultimately benefit. This fits with the empirical fact, denied or ignored by most orthodox economists, that plenty of heterodox economists – Steve Keen, Nouriel Roubini, and Ann Pettifor for example – predicted not just the crash in asset prices but also the dynamics of private debt inflation and then deflation that transformed it into a recession. Krugman claims that neoclassical economists were wrong to hold that the crisis couldn’t happen; I’d rather say that they were wrong to hold that the prediction of the crisis couldn’t happen.
Rosenberg applies the label ‘reflexivity’ to the phenomenon that ‘expectations about the economic future tend to actually shift that future’. Schliesser argues that reflexivity does not prevent predictability, and I offer the above reasoning as further support for his conclusion.
This brings me back to Milton Friedman’s ‘positive economics’ article, which I mentioned in my last post. Friedman’s main claim in that essay is that the only way to judge a theory is by the accuracy of its predictions. But think about the case above. One thing that distinguishes Keen, Pettifor, et al from orthodox economists is how seriously they take the role of banks in the economy. Standard asset pricing models don’t include banks or lending at all. On Friedman’s view it ought to have been entirely surprising that Keen, etc. did better at predicting than the orthodoxy, since predictive success is the only measure by which we can judge the respective theories. But it wasn’t surprising. Anybody whose mind wasn’t destroyed by too much economics could have guessed that the theorists who acknowledged the existence of banks were probably getting it more right than the theorists who didn’t.
One last point I can’t resist making: Rosenberg claims that:
Keynesian models assumed that economic agents were irrational or ignorant or both. They were built on the idea that when the government incurs a deficit in order to stimulate the economy now, the tax payers will forget that to make good that deficit they’ll have to pay more taxes later.
This is all wrong. Tax payers don’t ‘forget’ that they’ll have to pay taxes later to ‘make good’ the government’s ‘deficit’. They know, instinctively, that what they are said here to ‘forget’ is a false statement clothed in misleading terminology. In fact government ‘deficits’ aren’t debt at all; government bonds are interest-bearing savings accounts. They no more need to be ‘made good’ than bank deposits created by loans need to be paid off, rather than being indefinitely shifted around. Issuing too many bonds might cause inflation. But solvency is simply not an issue, any more than it is for those central bank ‘liabilities’ that we call ‘cash’. What is ignorant is the neoclassical theory that denies all of this, not the agents in Keynesian models who act as though they are at least implicitly aware of it. So thbbbbbbbt.