Defending Economics

Over the past month, there have been a spate of negative articles about economics, with some comparing it to a ‘fake science’ such as astrology, and or how the inability of economists to predict the 2008 crisis is evidence of the failure of economics:

The new astrology

How economics became a religion

Even though I’m not an economist, I find myself defending them.

Yet if history teaches anything, it’s that whenever economists feel certain that they have found the holy grail of endless peace and prosperity, the end of the present regime is nigh. On the eve of the 1929 Wall Street crash, the American economist Irving Fisher advised people to go out and buy shares; in the 1960s, Keynesian economists said there would never be another recession because they had perfected the tools of demand management.

 

2008 crash was no different. Five years earlier, on 4 January 2003, the Nobel laureate Robert Lucas had delivered a triumphal presidential address to the American Economics Association. Reminding his colleagues that macroeconomics had been born in the depression precisely to try to prevent another such disaster ever recurring, he declared that he and his colleagues had reached their own end of history: “Macroeconomics in this original sense has succeeded,” he instructed the conclave. “Its central problem of depression prevention has been solved.”

The media only focuses on failure, not where economic policy has succeeded. The media ignores all the times economic policy has worked: TARP (the ROI was high, unlike most govt. programs), the rescue of LTCM, the fed’s response to the 1987 stock market crash, the bailout of Mexico due to its Peso crisis, etc. Interventionist policy contains problems before they have a chance to become bigger. If spending $50 billion can avert a trillion dollars of potential losses, it’s a good deal. Of course, that does not answer the question of why such crisis occur in the first place, and there is the criticism that bailouts create an incentive for risky behavior.

The 2008 bank bailout, in retrospect , although maligned, was a success by infusing liquidity to the weakest parts of the economy (financial institutions, housing, etc.) so that the healthier parts (retail, tech, payment processing) would not be hurt by contagion. The post-2008 bull market and economic expansion is the longest ever, and programs such as TARP helped in that regard, but also the strength of the private sector, exports, technology, and consumer spending.

Due to low interest rates, TARP was effectively free, and the entire program returned a $15 billion profit, making it one of the few government programs to be profitable (compared to social security, which will probably become insolvent). In spite of all the spending and debt, taxes have not gone up out of necessity (but rather due to political pressure). Taxes went up, not because of inflation, but in order to resolve the fiscal cliff impasse.

But a common argument is, wasn’t it unfair to bailout the banks while homeowners lost their homes? These were homes that were purchased with 0-20% down, by people that were not qualified to own such homes in the first place. Bailing out these homeowners would have not only cost more, but would also been unfair, because why should someone get a free home? But also, policy is to blame, from the post Defending Finance: Why Bankers and Economists Are Not to Blame for the Crisis:

And then lastly, and probably most importantly, the government played a complicit role in inflating the housing market, forcing lenders to create risky loans to meet quotas.

 

“The National Homeownership Strategy: Partners in the American Dream”, was compiled in 1995 by Henry Cisneros, President Clinton’s HUD Secretary. This 100-page document represented the viewpoints of HUD, Fannie Mae, Freddie Mac, leaders of the housing industry, various banks, numerous activist organizations such as ACORN and La Raza, and representatives from several state and local governments.”

Contrary to the myth of bankers being bailed out, although the bailouts infused liquidity to the financial system, the shareholders still lost almost everything when shares of Bank Of America, Citigroup, and AIG went to zero. Yes, the banker jobs and bonuses did not go away, and that, admittedly, is a problem and a valid criticism. And incentive structures that promote risky behavior are still intact. [2]

Although economists are occasionally wrong, so too are other professions:

-doctors used to believe smoking was not bad for health, that everyone should drink 8 glasses of water a day, and that the food pyramid was correct. Such notions have all been upended.

-engineering failures include the Hindenburg and the Titanic, but also the Challenger space shuttle, and many others.

-physicists and astronomers used to believe in ‘Aether’

-regarding education, the ‘self esteem movement‘ movement/con, which duped thousands of teachers and students into believing that positive affirmations could boost achievement.

-or how about the ‘replication crisis‘ in psychology, in which more than 50% of peer review studies are unable to be replicated by independent researchers.

No sooner do we persuade ourselves that the economic priesthood has finally broken the old curse than it comes back to haunt us all: pride always goes before a fall. Since the crash of 2008, most of us have watched our living standards decline. Meanwhile, the priesthood seemed to withdraw to the cloisters, bickering over who got it wrong. Not surprisingly, our faith in the “experts” has dissipated.

The S&P 500 is 60% higher than it was in 2008. After factoring in dividends, it’s 80% higher. Profits & earnings have also grown considerably. Dwelling on the mistakes and crisis of the past means one overlooks how things have improved.

As for the well-worn criticism that economists cannot predict, a doctor cannot predict with 100% certainty when or if someone will get sick, but does that mean doctors are therefore useless. From the post Why Economists Don’t Need To Be Able To Predict:

Economists are better at solving and explaining economic problems than predicting or preventing them. A doctor cannot reliably predict if someone will get cancer or prevent someone from getting cancer, but he can offer treatment for it and an explanation for the biological processes that cause cancer. Does this mean doctors aren’t credible? Absolutely not.

A car mechanic cannot predict with 100% certainty when someone’s car will fail.

All professions involve making forecasts from data, yet wrong economic forecasts get so much more media coverage than wrong forecasts from other fields.

Economics models such as the Black Scholes equation do an adequate at describing reality. Are they perfect? No, but in most instances good enough. When such models fail, they can be modified, but that does mean having to do away with models altogether. There are extremely sophisticated option pricing models that encompass nearly all facets of market behavior, including jumps and stochastic volatility, much like how physics models have evolved. I agree that over-reliance on models can be problematic, but models are descriptive, not just prescriptive. Just saying “We don’t know” and ending it there means scientific progress stalls.

The efficient market hypothesis, despite its weaknesses, provides an account of market behavior that is mostly accurate: stock prices, by in large, tend to process the introduction of new information instantly. Studies have shown that ‘technical analysis’, which tries to predict future price action based on various chart ‘patterns’, yields statistically insignificant predictive results, in agreement with the efficient market hypothesis. 95% of day traders fail, and the vast majority of ‘active managers’ fail to consistently beat the S&P 500, both in agreement with a market that is efficient.

For decades, neoliberal evangelists replied to such objections by saying it was incumbent on us all to adapt to the model, which was held to be immutable – one recalls Bill Clinton’s depiction of neoliberal globalisation, for instance, as a “force of nature”. And yet, in the wake of the 2008 financial crisis and the consequent recession, there has been a turn against globalisation across much of the west. More broadly, there has been a wide repudiation of the “experts”, most notably in the 2016 US election and Brexit referendum.

The media’s constant focus on how economists are wrong may distort one’s perception of the accuracy of economics, versus reality. Look at zerohedge…for the past nine years they have been publishing articles about how QE and the debt would cause high inflation, or about the ‘lack of confidence in the fed’, or how the fed would be unable to wind down the balance sheet, etc., yet everything has gone smoothly. The M2 money supply growth is in-line with historical trends. The hyperinflation many in 2008-2010 predicted failed to happen. Look at it this way: someone who shorted the treasury bond market in 2000 anticipating debt-related inflation would have lost a lot of money despite the national debt rising considerably since then. That’s not an invitation for wasteful spending, but it means that concerns over the debt are almost always overblown, but also the disconnect between reality and perception. If one only reads zerohedge, they are inclined to believe that economists are are at best dart-throwing monkeys.

But that’s not to say economists aren’t wrong, sometimes habitually so: for example, Paul Krugman (who has been wrong about many things [1]), the Obama stimulus (which was according to many economists was ineffective), Cash for Clunkers (another ineffective program that had the adverse, unintended consequence of making used cars more expensive, hurting the very middle class people it was supposed to help). Many experts who predicted a bear market and recession as a consequences of Brexit and Trump (such as Justin Wolfers) were dead wrong, but that goes to show how hard predicting is (but I’m sure personal political biases also played a role). But economics is also descriptive: the US economy did not enter recession, simply because Brexit and Trump failed to have any negative impact on earnings.

[1] Krugman in 2012-2013 repeatedly warned that the GOP-controlled House ‘obstruction’ and budget cuts would push the US economy into recession (in his words ‘holding the economy hostage’)…the stock market is up 30% since then and GDP and other data remains strong, so he was hugely wrong there. In 2010 he also wrongly predicted the dissolution of the Euro and Eurozone. He incorrectly predicted deflation (although inflation is low, there was no deflation except for a brief period between 2008-2009). He underestimated Trump (although so did 99% of pundits). And after Trump won he wrote, “…we are very probably looking at a global recession, with no end in sight. I suppose we could get lucky somehow. But on economics, as on everything else, a terrible thing has just happened” LOL with the S&P up 10% for the year and GDP growth other metrics strong, the Krugster was wrong about that, too.

[2] Some risk taking is necessary to have a dynamic, innovative economy. Imagine being a banker in the 90′s, and an entrepreneur pitches the idea of an ‘online bookstore’. The default/conservative response would be, “…but Barnes and Nobles is good enough…why would anyone want to use this ‘internet’”. To deny such a loan would be to deprive the economy of potentially billions of dollars of economic value creation.