I recently read a number of books during the past couple of years about Wall Street and the events leading up to the 2008 financial crash. The latest is ECONned: How Unenlighted Self-Interest Undermined Democracy and Corrupted Capitalism. It was published two years ago, but unfortunately is still as relevant as it was then.
What this book offers that the previous ones didn’t is an analysis of how bad policies were based on unproved but widely accepted economic theories, and how these theories continued to be accepted even though evidence had proved them wrong.
One example is the Arrow-Debreu Theorem, a mathematical proof that for any commodity at any given time, there will be a price that will clear the market—that is, leave no sellers with unsold goods or buyers with unsold orders.
The Arrow-Debreu Theorem assumes perfectly competitive markets, buyers and sellers with equal information, no buyer or seller big enough to influence the market, separate markets for different locations and a futures market with no limits on time or place.
In other words, it assumes conditions that never were and never will be. It is like the joke about the physicists who came up with a formula for predicting the outcome of horse races, based on the assumption of spherical horses racing in a vacuum.
Nevertheless many economists decided that the Arrow-Debreu Theorem proved that you should work for unconstrained markets, especially unconstrained futures markets, with the idea that this would bring you closer the ideal of the market-clearing equilibrium price. They persisted in advocating this even after the Lipsey-Lancaster Theorem, which showed that unless every single one of the Arrow-Debreu conditions were met, partial fulfillment would be useless or even harmful.
Some of Smith’s other examples are:
- The Capital Asset Pricing Model, which says that risky investments can be made relatively safe through diversification. The fact is that in a market crash, the prices of all securities fall, because investors sell their better investments to cover their losses. I found this was true in 2007 when my diversified mutual funds all collapsed in price at the same time.
- The Black-Scholes pricing model, which says that you can figure out what’s a good price on an option to buy a stock or bond based on the stock or bond’s “beta” (the history of its variability). But this ignores all the outside factors that could affect the price of a security—the effect of a bad tomato harvest on the stock of a ketchup company, for example.
Even more fundamental economic concepts aren’t always true, Smith pointed out. Economics is the study of how people respond to material incentives, but that is a narrow and inadequate way of looking at human behavior. The typical human being is not trying to maximize utility in isolation from everything and everyone else. Sometimes raising the price of something means you get less of it, rather than more, because somebody may have a target amount of money they’re trying to make, and quit when they reach it.
The economics profession has sought to distinguish itself from the other social sciences by greater reliance on mathematical rigor. The equations don’t necessarily reflect reality, but they enhance the intellectual authority of economists in the eyes of those who are mathematically unsophisticated.
Yves Smith does not say that fundamental economic concepts or mathematical economics are completely wrong or completely useless, only that they are not the whole truth and should be subject to a reality check.
Yves Smith
About half the book is devoted to the claims of financial economists to understand and hedge against risk. The financial crash of 2007 was partly due to financiers who didn’t understand risk. They didn’t understand that if a larger enough number of people are hedging against the same risk, there is nobody left to bail them out. That is why Long-Term Capital Management Company, a hedge fund headed by two Nobel economists, collapsed in 1998 and would have brought down a large part of the U.S. banking and finance industry along with it, if it hadn’t been bailed out by the Federal Reserve System.
There also were many financiers who understood the risk very well, but were nimble enough to push it off onto those who didn’t. They were given free rein because of a more fundamental fallacy—the belief that individual pursuit of material self-interest always works for the general good.
I think Smith is too harsh in her judgment of the economics profession. As she noted, many economists saw that an economic crash was coming, and issued warnings, but they were disregarded. Economists are developing new tools, such a behavioral economics, which overcome some of the limitations of past theory, but they do not influence policy. But it is the economists who were wrong, not the ones who were right, who guide the U.S. government’s policy.
Yves Smith is the pen name and Internet handle of Susan Webber, a graduate of Harvard Business School, who formerly worked in corporate finance for Goldman Sachs and headed the mergers and acquisitions division of Sumitomo Bank, and now has a consulting firm called Aurora Advisers Inc. She knows whereof she speaks.
Click on naked capitalism for her web log. She and her contributors produce outstanding investigative financial journalism and commentary on conventional economic thinking.
Click on the following three links for a good summary of her book
ECONned Part I: The Theory Behind the Great Recession,
ECONned Part II: Shadows of a Crash and
ECONned Part III: Insuring Financial Stability.
Tags: ECONned, Economic Delusions, Economic Fallacies, Economic Reasoning, Economics, Financial Economics, Free Markets, Wall Street, Yves Smith
November 2, 2012 at 5:34 pm |
An economist friend sent me the following e-mail
Your review of Econned refers to “Lipsey-Lancaster Theorem, which showed that unless every single one of the Arrow-Debreu conditions were met, partial fulfillment would be useless or even harmful.” This is a slight over-statement. A more balanced statement would begin with “one can construct examples such that…” More pertinent to financial markets is a related result that, when markets are incomplete, opening an extra market (e.g., introducing a new financial instrument) but failing to open all possible markets (thereby completing the markets) may lead to a reduction in welfare. (See, e.g., http://www.princeton.edu/~erp/ERParchives/archivepdfs/M281.pdf)
These all are theories—i.e., hypothesis—though. Unfortunately, I cannot think of empirical research that tests these theories in the context of financial innovation. It would be a fascinating research question. I know people who contemplate this question, but it is very hard.
Coming back to your review, I think journalists and commentators are to blame more than economists. Journalists often treat economic research as physics research or engineering. Economics is not engineering (except, perhaps, Al Roth’s work, for which he was awarded Nobel prize this year), the models are stylised (even when estimated empirically), and the results have a myriad of qualifications. Academic economists realise that, but commentators tend to interpret economic models literally. Of course, one can blame academic economists who focus perhaps excessively on academic research instead of popularising existing ideas. But often, as soon as one starts popularising ideas, one somehow loses touch with the economic profession. One can construct examples of this.
I agree with your review in that all models in economics are false. This does not make them useless, of course. What is surprising is that the Wall Street types, who are highly intelligent, choose to make costly mistakes while relying on these models. My sense is that they choose to err rationally, as their liability is limited.