Sunday, January 24, 2010

Cycles of Explanation in Economics

In areas of science such as physics and biology our successive theories developed over time are better and better explanations of the observed facts. Think heliocentrism versus geocentrism, or natural selection versus Lamarckism. But in economics I suspect this is not always the case. Traumatic events like the Great Depression, or (hopefully) the current crisis can force a brief period of clarity. But over time economic forces will result in the mainstream replacement of the theory which most closely matches the observed facts of the previous crisis with a theory which maximizes short term profits for powerful actors. The time-frame over which this shift occurs is probably a generation, in which those with first-hand memories of the previous crisis leave power.

Here are two exhibits for my point. The first is a quote I have been re-sending for years:

"When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve's attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain's gold loss and avoid the political embarrassment of having to raise interest rates.

The "Fed" succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market -- triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930's."

Gold and Economic Freedom, Alan Greenspan, 1967.

Here the Greenspan of 1967 believed holding Fed rates too low caused a bubble that could not be cleaned up afterwards. But the Greenspan of the late 1990s and again early 2000s no longer believed low rates caused bubbles, or that a bubble could be too large for the Fed to clean up afterwards. Why the shift? I think the earlier theory fits the facts of the 1920-30s (and our current situation now) better. But note his successor Ben Bernanke still denies low rates cause bubbles.

A second exhibit is the presentation I wrote in 2006 and posted as Black Swans in the Market in 2008. I showed that any Statistics 101 student could easily demonstrate that daily stock prices changes are not normally distributed. This makes people like the CFO of Goldman Sachs, who claimed in 2007 "We were seeing things that were 25-standard-deviation events, several days in a row" look extra-silly. Why were they using such bad models? Is finance in general so ignorant of basic statistics[*]? No, they are simply choosing models which maximize their short-term profits -- and bonuses.

[*] OTOH, a Google Books search on "which shows a histogram of the daily returns on Microsoft stock" shows that as of 2005 Brealey et. al. were still peddling this nonsense to unsuspecting MBA students in their Principles of Corporate Finance and related texts. A 2005 edition apparently shifted the MSFT date range from 1986-97 to 1990-2001 (omitting the crash of 1987!). Later editions don't hit on the search terms; no idea if they have cleaned up their act.


Gemfinder said...

As we've discussed, I think the vast majority of the population is short-term profit seeking all the time, not just when memories of crisis have faded.

So models with short-term explanatory power will tend to dominate most of the time, even if wrong.

In 1964, thanks to Sharpe's CAPM paper, the fictional assumptions of normally distributed prices and efficient pricing swept like Beatlemania through academic finance.

Why was CAPM so successful? Because most of the time it predicted short-term moves more accurately than anything that came before. The first option traders to infer something like Black-Scholes (CAPM-derived option pricing) made absolute killings in the market in the late 60s, because their model, though wrong at the edges, was usually better than that of the investment banks writing the options.

Because of this, a reasonable argument can be made that CAPM, though wrong and dangerous, was still a modest advance in the explanatory power of academic finance.

I don't know about macroeconomics, but I wouldn't be surprised to learn that monetary policy works the same way, i.e. the Taylor Rule works experimentally with short-run, small changes, under stable conditions, and then flamboyantly fails under exactly the extreme conditions under which you really need it.

It's easy to see how short-term profit seeking would evolve. In the wild human experience, whatever is observably true in the short run is almost always also true in the long run. It's a heuristic that works, until the chimps invent financial markets.

Eric Rollins said...

All reasonable.

Everybody cares about economics, since it affects everyone. Most people don't care about astrophysics (since there is no money to be made), and the few who do have no problems working with models over a 14 billion year timeframe.

Here's John Taylor on the recent crisis:

"The classic explanation of financial crises, going back hundreds of years, is that they are caused
by excesses—frequently monetary excesses—which lead to a boom and an inevitable bust. In the
recent crisis we had a housing boom and bust which in turn led to financial turmoil in the United
States and other countries. I begin by showing that monetary excesses were the main cause of
that boom and the resulting bust.
Figure 1 shows that the actual interest rate decisions fell well below what historical experience
would suggest policy should be. It thus provides an empirical measure that monetary policy was
too easy during this period, or too “loose fitting” as The Economist puts it. This was an
unusually big deviation from the Taylor rule. There was no greater or more persistent deviation
of actual Fed policy since the turbulent days of the 1970s. So there is clearly evidence that there
were monetary excesses during the period leading up to the housing boom. "

John B Taylor, The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, November 2008