I read an article some time ago by the Nobel Prize-winning economist Paul Krugman in which he described the renewed battle between so-called freshwater economists (so named because they are largely based at the University of Chicago and other Midwestern universities) and saltwater economists (based primarily at Princeton, MIT, Berkeley and other coastal universities). The freshwater economists are disciples of Adam Smith and espouse the free-market and rational actor models. The saltwater economists align with John Maynard Keynes and his belief in the need for regulation in financial markets and that people aren't rational actors.
The past 50 years have been dominated by freshwater economists who had a reverential faith in the power of free markets (Smith's "invisible hand," which only had three mentions in his writings, yet is treated like gospel) and the rationality of people in their financial decisions. Given what has happened to our economy in the last decade, noted for its "irrational exuberance" and multiple bubbles (e.g., Internet, housing, mortgage), it's hard to believe that any of these "efficient market" adherents still have jobs, much less credibility in how the economy actually works.
I would love to put these economists on the couch and explore what is going on in their heads that enables them to observe the objective reality of the recent economic devastation, yet still hold as sacred their most basic, yet obviously flawed, beliefs about a free-market-driven financial system.
As I have read more about the Smith followers, what seemed like pretty obvious questions kept popping into my head:
• What universe do these people live in?
• Do these economists live in complete isolation without interaction with actual human beings?
• Have they never been in love, been gambling, or had sex?
• Have they never seen people get angry, frustrated, depressed, excited, or joyful and then observed their subsequent behavior?
If we ever had answers to these questions, we would understand the how of their devotion to an economic mindset that is clearly not supported by economic reality. These questions then led me to ponder the why of their delusional dedication:
• Are these economists such number-crunching automatons that they never even consider actual human behavior in the real world of finance?
• Are they so doctrinaire as to miss the obvious?
• Are they so enamored of the sheer elegance of their mathematical theorems that they reject outright and without consideration what is obvious even to laypeople?
What I find ironic is that, by rejecting the irrationality of human behavior, they are in fact affirming its irrationality. To see ourselves as rational beings is the epitome of irrationality.
Of course we aren't rational, and you don't need a Ph.D. in Economics or Psychology to realize that (though an advanced degree in economics from the University of Chicago seems to have the opposite effect). Human beings, for all their cerebral development, still act most of the time the way animals and humans have for millions of years, namely, as irrational, unpredictable, and not particularly intelligent creatures.
What I find so remarkable is that there is any debate at all. As a former psychology professor of mine once noted, "All psychology does is label things that we already know to be true." In the Bizarro world of freshwater economics, that adage would be modified to, "All economics does is reject things that we already know to be true."
Thankfully, the emerging field of behavioral economics, which is the melding of psychological and economic thinking, has generated a growing body of research demonstrating that we are, in fact, incredibly irrational beings who act in ways that are not only poorly conceived, but that are often counterproductive and sometimes even self-destructive. Examples of such irrational behavior can be found in a variety of well-researched cognitive biases:
• Bandwagon effect: we believe or do things because others believe or do them.
• Confirmation bias: seeking out information that supports our beliefs.
• Illusion of control: our belief that we have more control over outcomes than we actually do.
• Déformation professionnelle: looking at things through the lens of one's profession while ignoring broader perspectives.
The last cognitive bias seems particularly fitting for freshwater economists who seem to have been so busy developing their fancy theories in their laboratories that they forgot to look out their windows and see what was actually happening in the real world. The list of cognitive biases that we succumb to goes on and on with most having direct implications for understanding our financial behavior.
Finally, it is instructive – and scary – to consider the degree of hubris or denial on the part of the freshwater economists, whom I would assume are very intelligent men and women. They continue to cling to now-discredited theories, even when confronted with overwhelming experimental and real-world evidence that demonstrates what just about everyone else in the world can see with their own two eyes: humans, including economists, are not rational!
"They continue to cling to now-discredited theories" - describes Keynesians perfectly.
The correct answer to regulation vs. free market is probably "some mixture of both that annoys both sides."
So, gonna have to point out that this is clearly a straw-man argument. The saltwater / freshwater debate has very little to do with what extent individuals are rational. If that were the case, I could write an entire article talking about Keynes belief that investors were all acting at the behest of 'animal spirits' and call it a refutation of saltwater economics.
To better capture the spirit of the debate, you would need to try to analyze whether regulating market interactions to 'correct' for market failures is more efficient than allowing a free market to arrive at a value for goods. There is a whole spectrum between 100% regulated and 100% free market, but none of them require accepting that humans are completely rational/irrational.
To see the freshwater response to the article (because, ya know, I prefer to present an equitable debate), please see the following link.
http://faculty.chicagobooth.edu/john.cochrane/research/Papers/krugman_r…
And how much hubris do you have for believing that people who spent 4-8 years of their lives studying a subject hadn't thought of these issues? Bounded rationality? DSGE models? RBC theory? The point of economic assumption is to see where the analysis falls.
I suggest you actually look at what economists are actually doing currently in the field before making these sweeping judgments. People have to actually make provable conclusions in research papers. We can't all just throw a wave of hand argument and get published sorry.
They may not be rational but they sure are predictable; while the individual man is an insoluble puzzle, in the aggregate he becomes a mathematical certainty. You can, for example, never foretell what any one man will do, but you can say with precision what an average number will be up to. Individuals vary, but percentages remain constant. So says the statistician.
For the record, crashes and crises have been going on like clockwork since before there were economists, let alone freshwater or saltwater ones.
Maybe a better way of putting this is that in the median case, the median investor is rational. But a lot of damage gets done to others when irrational people really take over in the market. And these irrational behaviors of the market cost our economy a lot of money.
Look, if you're a trader, or if you work at a hedge fund, you can't believe in the Efficient Market Hypothesis and all of the other rigmarole assumptions that Chicago School/Classical Economics makes. If all assets are priced fairly, everyone who works in this industry is out of a job.
I'm saying that a social science, in this case economic theory, can apply to an aggregate. My view is rational in the case of economics is a "median case", rational in financial markets is a point of view. Understanding the drivers of that point of view is how you make money in financial markets. A lot of "irrationality" in economics can be traced to rational market dynamics that distort the "median case", the housing bubble was a perfect example. If you want to extrapolate my commentary on economics to an extreme dislocation in market pricing in order to "debunk" it... go ahead but that's making a lot of assumptions and leaps in logic from my original comment.... :-)
I think the claim of efficient markets is that the prices reflect all available information, not necessarily fair value. One could have all of the available information, analyze it correctly, and still be forced to sell at prices you know to be low. Of course if the markets were truly efficient firms wouldn't be placed into such situations in the first place, but still.
I can tell you like Paul Krugman because you immediately resort to vitriolic personal attacks on people with whom you have an honest intellectual disagreement.
I believe that many of the arguments that the OP makes can be generally applied to much of academia, where these folks write papers that no one reads and prove stuff that is unproveable or changes all the time or relies on their specific definitions (ie. defining irrational as... therefore my theory states that...) even though definitions of irrational may and will differ a lot and therefore make their "conclusion" or "theory" invalid! (and that's ok, its just a part of life)
Honest (or frustrated) academics will admit this (I know some of my college professors have, as have my friends who are not PHDs/post docs/professors). You also see that a number of academics are just like top people in finance, top athletes or superstars in a sense (not moneywise...) but in that they have always been seen as "very smart" or "brilliant" and told that by everyone. A lot of it is ego and how it has been built up. If they are smart, they must usually be right about stuff, or so the thinking goes or what people tell them, so in turn what they tell themselves (I still see it in markets all the time. You don't have to be a genius academically to be a great investor though people put a lot of faith in people with Ivy League backgrounds). So it will give them a complex. Many of them WILL NOT hang out with laypeople, since their job does not require it (ditto for finance and many other professions) and their friends won't be laypeople. This is just reality.
@"HilbertSpaces" - I'm not sure the OP has too much hubris to say that people who have studied for 4-8 years haven't thought such of things. He/she I think, has a point. They have been too busy in their own little world to take a step back and give such issues a proper look (and this is not limited to academia, think about bankers working 90 hours a week for like 4-8 plus years or so many others). There are only 24 hours a day, in which to work, eat, sleep, drop a deuce, try to date, do hobbies, run errands etc. I see the same thing in finance and many other professions all the time. I think his/her frustration is just more along the lines of "shouldn't academics be more grounded and realistic since they are trying to figure out how to solve problems in society?" (this is an extremely broad statement, I know).
So, you really think that Fama is 'so busy in his little world' that he has NEVER considered the existence of irrational behavior? While I appreciate the position that academics can get focused on highly impractical issues, the OP's basis for commenting that 'it's surprising these people still have jobs" is entirely tied to a gross oversimplification. He's ignoring, much like Krugman did in the original article, that simplifying assumptions in economic models (like assuming rational behavior) are critical to achieving intelligible results and may not always absolutely reflect all facets of the real world or even the beliefs of the author.
Source: http://www.openculture.com/2014/08/george-orwell-reviews-mein-kampf-194…
You completely fail to understand both freshwater and saltwater schools of thought. It not just a little bit, it looks like you went out of your way not to try to understand any of the issues. If I had time I would pick your rambling apart piece by piece, however, since that involves pretty much every single sentence you wrote that would take some time. It's funny how non-economists comment on things they have absolutely no clue about - similar to having a bus driver comment on biochemistry.
Just have to point out that you do not understand what is meant by rational within the context of economics. Rational is bounded by the availability and cost of information for example. Gambling can be accounted for by the fact that people derive pleasure from playing the game, even though the odds are against them. I really hope idiots like you do not actually get a job on Wall-Street.
No. Far less introspective and 1 dimensional people get jobs on the street... I think you lot are making a mountain out of a molehill. Economics is a social science and the data used in most studies is seldom ideal and that is at the best of times. This makes it, well, not exact or even close to it, regardless of the school of thought. Let's move on or agree to disagree with the op rather than disparaging each other.
It actually is a very important debate as it is something carry with them throughout their lives (e.g. voting, debating policy issues, etc.).
Saying that economists are full of crap is the argument that could have kept us in depression (whether 1929 or 2008)
These guys came the closest they have to winning this argument back in 2010 when Rand Paul was arguing it seriously. Incidentally the gold market peaked shortly thereafter. All of this money printing in 2008, 2009, and 2010 that was supposed to make the 1970s' 18% inflation look like a picnic hasn't occurred yet.
If the money printing for the Vietnam War happened in the late 1960s, it's now the mid 1970s. Oil prices are half-decade lows, gold prices are at their lowest levels since 2008, TIPS vs Treasuries are implying 1-2% inflation. When the Fed ended QE3, rates went DOWN.
Look, the government is procyclical and the Tea Party Economics people are one gigantic source of the cyclicality. They were pushing their hardest, politically, for the gold standard when gold prices peaked. And the PhDs at the Federal Reserve were right all along.
Let's leave monetary policy to the experts. Actually, I'd be a fan of making Fannie and Freddie organizations that were run by similar PhDs and had a similar level of independence from the politicians. (I am not sure Obama's move to lower borrowing standards at the FHA and Fannie/Freddie was a smart move.)
Lots of thoughtful commentary, just want to add: a major part of the problem is that economists have to agree with one school of thought or another in order to progress through the ranks. It's a patronage issue, and they're generally not intellectually independent because they have to agree for many years with the person/institution signing their paycheck/PHD/etc before they are positioned to wield real influence...and by that time they're just a product of the system. The better way would be to compare data to theories, instead of defending theories, and see what theory was right in what situations, and then synthesize the larger truth.
It's easier to be interested in the truth when you don't have an agenda, you're freed from convention to look for underlying principles and form new/upgraded theories. Most economists have their social reality to contend with. Ultimately, a new overarching economic theory is needed given the pros/cons of BOTH schools of thought.
Keynesian and Austrian economics are two sides of the same coin. Whoever can "coin" that label and enunciate the overarching pattern will be deemed a genius, even though it's something a lot of people are aware of on some intuitive level. We live in a mixed economy, that's the reality of it, so maybe just call it "mixed economics".
Deserunt aut velit porro in. Est ab voluptas aut nemo molestiae rerum quo.
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