Never Let a Serious Crisis Go to Waste

by Philip Mirowski

  Patently, in the counterreformation, economists should never have been expected to predict the really bad stuff: that was the sole province of the market, the greatest information processor known to humanity. Furthermore, you in the bleachers don’t appreciate what it means when we offer you a “model”: it only “predicts” in limited situations that resemble the ones the model was built for. Caveat emptor.

  One index of the extent of disruption within the profession induced by the crisis was that economists no longer felt compelled to humbly defer to the Nobelist Robert Lucas as they had before 2008, but rushed to go on record to dispute this “defense” of the profession and distance themselves from the Curia. The Economist was happy to provide a special blog on which they could register their dissent.28 Some insisted that the heart of the problem was the efficient-markets hypothesis. Brad de Long suggested Lucas was changing his tune as the crisis evolved. Others, like Harvard’s Robert Barro, propounded the proposition that the proof of the pudding was not in the success of the prediction, but instead what the clientele would pay for: “Like Bob Lucas, I have a hard time taking seriously the view that the financial and macroeconomic crisis has diminished economics as a field. In fact, the crisis has clearly raised the demand for economic services and economists. There is no more counter-cyclical occupation than economist.” This only served to pour gasoline on the blogosphere.

  The line quickly hardened within the counterreformation that the orthodox efficient-markets hypothesis had been confirmed by the crisis, and that economists had never borne the onus of predicting much of anything at all. This comes out quite clearly in the New Yorker interviews with Chicago economists:

  I asked Fama how he thought the theory, which says prices of financial assets accurately reflect all of the available information about economic fundamentals, had fared.

  Eugene Fama: I think it did quite well in this episode. Stock prices typically decline prior to and in a state of recession. This was a particularly severe recession. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline. There was nothing unusual about that. That was exactly what you would expect if markets were efficient.

  Many people would argue that, in this case, the inefficiency was primarily in the credit markets, not the stock market—that there was a credit bubble that inflated and ultimately burst.

  I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning. . . .

  Back to the efficient markets hypothesis. You said earlier that it comes out of this episode pretty well. Others say the market may be good at pricing in a relative sense—one stock versus another—but it is very bad at setting absolute prices, the level of the market as a whole. What do you say to that?

  People say that. I don’t know what the basis of it is. If they know, they should be rich men. What better way to make money than to know exactly about the absolute level of prices.

  So you still think that the market is highly efficient at the overall level too?

  Yes. And if it isn’t, it’s going to be impossible to tell.29

  And then there is the Cassidy interview with the Cato neoliberal John Cochrane:

  The two biggest ideas associated with Chicago economics over the past thirty years are the efficient markets hypothesis and the rational expectations hypothesis. At this stage, what’s left of those two?

  John Cochrane: I think everything. Why not? Seriously, now, these are not ideas so superficial that you can reject them just by reading the newspaper. Rational expectations and efficient markets theories are both consistent with big price crashes. If you want to talk about this, we need to talk about specific evidence and how it does or doesn’t match up with specific theories.

  In the United States, we’ve had two massive speculative bubbles in ten years. How can that be consistent with the efficient markets hypothesis?

  Great, so now you know how to define “bubbles” for me. I’ve been looking for that for twenty years.30

  If one imagines the faint echoes of the Seekers after they were left stranded by the flying saucers, then perhaps you begin to comprehend how complaints that economists didn’t predict or foresee the crisis are not going to change anyone’s mind in economics.31

  Abortive Attempts to Close the Barn Door After the Horses Have Bolted

  As opposed to the out-and-out denial of a John Cochrane or a Eugene Fama or a John Taylor or a Robert Lucas, many neoclassical economists were sufficiently chastened or blindsided by events in the economic crisis to concede that “something” about orthodox theory needed to be changed.32 Of course, given the years that have elapsed, candidates for revision have tended to multiply. It would be a thankless task to track down and document each and every proposal, much less immerse oneself in the literature surrounding that option in order to assess its prospects and implications. Yet another reason to hesitate before this vast beehive of economist activity is the fact that a comprehensive history of the desire to “fix” macroeconomics would have to wait long after crisis events had transpired, if only because an appreciation of which specific amendments and ideas really mattered would tend to become apparent with the fullness of time. Nevertheless, five years on, there is no consensus School of Reformed Orthodoxy in sight. And then there is the prospect that, all things considered, most readers of this volume probably are not all that hopeful about the chances for a revived and fortified economic orthodoxy. Consequently, a survey of proposed amendments to the corpus of macroeconomics will be conducted with relatively limited purview, tethered to a more tendentious set of objectives.

  It is important to realize that, in the heat of the immediate crisis, a subset of economists was fully aware that a stance of implacable intransigence would play rather poorly in the public arena, so when journalists came around pleading to be enlightened on which aspects of economic orthodoxy would be revamped, these crafty economists saw an opportunity to promote lines of research that they had already been pursuing. Although many such options were potentially on offer, it can be reported that only a few were chosen, in the sense that only a small subset of revisions tended to get repeated and elaborated upon and promoted to the public. In fact, only three tended to get puffed up into full-blown paladins of deliverance: naming them in decreasing order of ambition, they were (1) behavioral economics; (2) repudiation of the efficient-markets hypothesis; and (3) fixing the DSGE macro model. All three were extensively discussed in the blogosphere and in generalist books, newspapers, and magazines; yet incongruously, all three were hopelessly ineffectual when it came to understanding the crisis. It is their power to mesmerize combined with their impotence that warrants their discussion in this chapter. Returning once more to our insistence on the importance of agnotology, it takes some diligence and not a little digging to come to understand why the populace was being led up the garden path; those seeking enlightenment were lured to waste their time in dalliance with ideas that did little more than divert attention from the deeper structural causes of the crisis. Daron Acemoglu’s curious notion that “the crisis has increased the vitality of economics” was premature, to say the least.33

  1) Getting a Little Irrational: Paradoxes of

  Ditching “Rationality” in Economics

  It has become fairly common in the annals of economic history to observe that in the wake of serious financial crises, observers tended to bewail a certain weakness in human cognition, attributing pecuniary disaster to an endemic “madness of crowds.”34 In the current neoliberal era entranced with proclaiming the “wisdom of crowds,” venturing to insist that the average man was a few sandwiches short of a picnic often appeared one easy way to register dissent from neoliberalism. Eventually, eschewing structural explanations, all serious problems would conv
entionally tend to be traced back through intermediate “bad choices” to moral or character flaws in particular individuals. Thus, it was no surprise that a pervasive and immediate response to 2008 was to blame the entire mess on a rabid outbreak of irrational exuberance.

  Unfortunately, madness often lodged in the eye of the beholder. When it came to orthodox economics, the term “rationality” bore a very narrow and curious interpretation as the maximization of a utility function subject to constraints by an otherwise cognitively thin and emotionally deprived “agent.” This unsatisfactory version of rationality had been the perennial subject of complaint and criticism from within and without economics since the 1870s; numerous defenses had been developed over the decades to supposedly neutralize those concerns.35 I am not concerned here to rehearse familiar complaints that economists misconstrue or otherwise misrepresent that notoriously protean concept. All that is needed for current purposes is to point out that in orthodox economics, repudiation of “rationality” meant in practice tinkering with the utility function and/or its maximization. The latest forays at accommodation dated from the 1990s, introducing some amendments from narrow subsets of psychology (mostly decision theory) while keeping the basic maximization of utility framework: this had come to be called “behavioral economics.” Some psychologists suggested these amendments were governed more by an imperative to save the previous neoclassical economics than to explore actual reasoning in the wild; but economists ignored them.36 This purported “enrichment” of simpler concepts of rationality had even established a beachhead in the study of financial economics prior to the crisis; its most prominent advocate in the prelapsarian era was Lawrence Summers, which might begin to signal that its revolutionary potential may not have been all that transformative. Mostly, in finance it fostered models predicated upon the posited existence of a two-class world consisting of (a) stupid people, sometimes more charitably known as “noise traders,” who performed certain functions in financial markets (liquidity, smoothing of reactions to shocks) so that the (b) neoclassically “rational” agents could more readily find the “true” or “fundamental” values dictated by the prior orthodox theory. Nothing here substantially impugned the basic orthodox model. As Jovanovic reports, “There exists as yet no unified theory of behavioral finance.”

  Once the crisis hit, journalists predictably turned to accusing Wall Street of behaving irrationally (in the looser vernacular meaning), and economists of investing too much credence in the rationality of their agents. Two best-selling books were especially effective in broadcasting this line: John Cassidy’s How Markets Fail and Justin Fox’s Myth of the Rational Market. Some economists who had been strong advocates of behavioral approaches prior to the crash, such as Robert Shiller and Robert Frank, leaped in with op-eds essentially blaming the entire crisis on native cognitive weaknesses of market participants.37 This line became entrenched with the appearance of George Akerlof and Robert Shiller’s Animal Spirits: displaying an utter contempt for the history of economic thought, they “reduced” the message of Keynes’s General Theory to the proposition that people get a little irrational from time to time, and thus push the system away from full neoclassical general equilibrium.38 They wrote:

  The idea that economic crises, like the current financial and housing crisis, are mainly caused by changing thought patterns goes against standard economic thinking. But current crisis bears witness to the role of such changes in thinking. It was caused precisely by our changing confidence, temptations, envy, resentment, and illusions . . . In Keynes’ view these animal spirits are the main cause for why the economy fluctuates the way it does. They are also the main cause of involuntary unemployment.39

  Nevertheless, in the few instances when journalists actually read the book, the first thing they noticed is that it said very little that was substantive about the current crisis, for much of it had been written well before 2008. Brought up short, they began to doubt its pertinence. The second thing they noticed was it was full of overweening claims, but contained very little in the way of causal mechanisms. “Animal spirits” boiled down to such timeworn neoclassical expedients as changing the utility function over time and calling it “confidence” (while Chicago called it “time-varying rates of discount”), appealing to sticky wages and prices while attributing them to “money illusion” and concerns over fairness (which the neoliberals modeled as “envy”), and suggestions that corruption would grow over the course of a long expansion (the Chicago theorist Gary Becker theorized this as the “rational choice approach to crime”). Far from some brave venturesome foray into the unexplored thickets of real psychology by open-minded economists unencumbered by entrenched dogmas, this was just more of the same old trick of tinkering with the “normal” utility function to get out the results you had wanted beforehand—something falling well short of the trumpeted dramatic divergence from standard economic theory.

  This portmanteau utility function raised an objection that had long been a subject of discussion in the methodology literature: Wasn’t “irrationality” in the neoclassical lexicon an oxymoron, since the moment one formalized it in the utility function, didn’t it effectively get subsumed under some perverse version of meta-rationality?40 Richard Posner, an especially perceptive critic from the right, pushed this point home in a review of Animal Spirits.41 The Akerlof-Shiller reply, deficient in philosophical sophistication, proved unable to confront this debility:

  When Posner asserts that it is not always easy to rule out that people are acting rationally—even if they seem not to be—he is of course right, for this is what most academic economists have thought. It is hard to disprove such a theory that people are completely economically rational because the theory is somewhat slippery: It doesn’t specify what objectives people have or what their information really is.42

  The problem with behavioral economists going gaga over “irrationality” was that they conflated that incredibly complex and tortured phenomenon with minor divergences from their own overly rigid construct of pure deterministic maximization of an independent invariant “well-behaved” utility function. Akerlof and Shiller could only condone an incongruously rationalist framing of their irrational exuberance. Two decades of such behavioral research certainly has not resulted in any consensus systematic revisions of microeconomics, much less macroeconomics. Perhaps even more damning, the conventional sadomasochistic excuse that individuals would learn under pain of loss to behave like neoliberal agents was also unavailing: “almost no empirical evidence exists documenting that individuals who deviate from economic axioms of internal consistency (e.g., transitive preferences, expected utility axioms, and Bayesian beliefs) actually suffer any economic losses.”43 Beyond wishful thinking, why should one even think that the appropriate way to approach a macroeconomic crisis was through some arbitrary set of folk psychological mental categories? Again, they had to admit that Posner had caught them stuffing the rabbit into the hat:

  Posner makes the interesting point that most behavioral economists—who study the application of psychology to economics—did not predict the economic crisis either. We would put this somewhat differently: There were very few behavioral economists who made forceful public statements that a crisis may be imminent. That is because there are very few behavioral economists who even specialized in macroeconomics, and so virtually none was willing to take the risk of making any definitive forecast.44

  The plea that in the eventuality behavioral economics had more adherents, it would have done more of the things Akerlof promised, is hardly a compelling reason to get enthused about that line of research. Akerlof and Shiller were loathe to admit that they had not proffered any good conceptual reasons to believe behavioral economics was even particularly relevant to the crisis. What this literature had to do with the genesis of credit default swaps, the rise of the shadow banking sector, and the collapse of the manufacturing sector was entirely opaque. And however much Akerlof and Shiller protested that their politics were diametrica
lly opposed to neoliberals like Reagan and Bush, what was their version of “animal spirits” but tantamount to simply blaming the victims for the macroeconomic contraction? (This was the option entertained by MIT’s Andrew Lo, described in the previous chapter.) Shiller’s previous books did indeed identify the housing bubble as a potential problem, but his “solutions” always involved even more baroque securitizations of the assets in question, as well as getting more people invested in Wall Street even deeper than ever.45 He finally revealed his true colors soon thereafter in his unabashed apologetics for financial-sector jiggery-pokery in his Finance and the Good Society. In this, he rivaled the most avid Reaganite in his belief in the superior power of the market to fix any problem.

  The unbearable lightness of Akerlof’s behavioral theory is nicely exemplified by the one paper that was repeatedly cited by bloggers and journalists during the crisis, his and Paul Romer’s “Looting: The Economic Underworld of Bankruptcy for Profit.” From reading the title, one would suspect it might deal with the phenomenon of running a financial institution into the ground given the temptations of short-term trading profits, like, say, Bear Stearns or Lehman Brothers. Few of its enthusiasts actually bothered to go so far as to peruse the model, however. In the MIT tradition, it was a purely deterministic little toy model of a single firm over three periods, where assets are not bought or sold after the first period, and a little maximization exercise which argues that if the owners of the firm could pay themselves more than the firm is worth and then declare bankruptcy in period three, then they will do so. Accounting manipulation and regulatory forbearance (which were not described in any level of detail) are asserted to make this outcome more likely. Deposit insurance permits owners to offload costs of autodestruction onto the government. This was then asserted to “explain” the savings-and-loan crisis of the 1980s.