The Mistakes Economists Make

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What has been is what will be, and what has been done is what will be
done; there is nothing new under the sun
—Ecclesiastes 1:9

It’s almost worth a Great Depression to learn how little our big men know
—Will Rodgers

Paul Krugman’s remarkable article How Did Economists Get It So Wrong? reminds us that the high priests of modern societies often have a muddled understanding of the economy they preside over. Their poor track record of late has not deterred many economists from making their usual prediction—despite the small bump in the road we’ve encountered lately, prosperity is just around the corner.

Before I am accused of making sweeping generalizations, let me be clear that I am referring to the kinds of economists Krugman discusses in his article. Winston Churchill allegedly said that “if you put two economists in a room, you get two opinions, unless one of them is Lord Keynes, in which case you get three opinions.” Unfortunately, all the economists Krugman talks about had the same opinion.

Let’s talk about the mistakes economists make. This is an awfully big subject, so it’s hard to know where to begin. There are the Big Misconceptions, and the smaller ones that follow from them. Here are the overriding fundamental errors as I see it.

1. People are rational
2. Endless growth is possible.

Right away we run into trouble, for it is not reasonable to assume that endless growth on a finite planet is possible. The math alone tells us that sooner or later, humanity will get its comeuppance. These large mistakes are founded on another error.

• Markets, driven by the power of price & technological innovation, always overcome apparent limits on growth or obstacles arising from human imperfection.

I call this the Assumption of Human Progress. Economists rarely make this assumption explicit, but this is what they have in mind. The progress assumption implies that markets, a human invention, are like God—omnipotent (all-powerful), omnipresent (always present) and omniscient (all-knowing). Whereas a rational individual suffers from limitations such as imperfect knowledge, a market does not.

It follows that markets assure ongoing and orderly human progress whereby human populations increase while economies grow concomitantly to provide greater and greater comfort to more and more people. I found a pure statement of this position at the blog The Futurist.

Needless to say, this degree of acceleration in economic growth [over human history] affects nearly every possible facet of the world in the 21st century. From a continually rising stock market to the proliferation of millionaires to the rapid uplifting of all metrics of human development, massive abundance is a certainty. The inevitable derivatives of wealth, such as the spread of democracy, the uplift in the sophistication of human psychology, and thus a corresponding drop in warfare, will soon follow. Resolving current problems, such as reducing poverty in developing regions, to funding sophisticated health care technologies, to increasing literacy, to funding ambitious space exploration, are merely just a matter of time.

Because markets ensure economic growth, limitations on resources such as conventional crude oil, fresh water, and fish are apparent, not real. The power of price and technological innovation will provide more of the resource should its supply run low, or substitutes for the resource as needed.

When an economist speaks of people as rational actors—this is the definition of Homo economicus—he means they are predictably self-interested in making financial decisions. If people are viewed as automatons—accurate accounting machines—who can be counted on to increase their personal advantage in all transactions at all times, their collective actions can be more easily plugged into mathematical models of economic behavior. As Richard Thaler puts it, “this is similar to doing physics without bothering with the messy bits caused by friction.” Krugman agrees—

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly
perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Imputing rationality to human beings itself convincingly demonstrates that people—economists in this particular case—are not rational. If you doubt that people harbor an almost endless capacity for self-delusion, I suggest you review today’s news. A recent example from the oil industry illustrates the delusional quality of every day life—

BP has reopened the debate on when the “peak oil” supply will be reached by announcing a big new discovery in the Gulf of Mexico which some believe could be as large as the Forties, the biggest field ever found in the North Sea.

BP, already the largest producer of hydrocarbons in the US, said its “giant” Tiber discovery in 4,100ft (1,250m) of water was particularly exciting because it promised to open up a whole new area.

Shares in BP were up 4% to 539p in afternoon trading, making it the biggest riser in the FTSE 100 despite the company saying much more drilling appraisal work was needed before Tiber’s commerciality could be guaranteed.

Does it make sense to buy BP stock now based an oil find 1) whose commerciality has not been guaranteed and 2) whose oil will not be produced until God Knows When, but will only be produced if the discovery is indeed deemed commercial? Of course not. From the Houston Chronicle’s BP’s oil find Is big, but miles out and down—

But experts said it could be a decade or more before BP begins pumping oil from the field, given the technical hurdles and huge costs involved with operating in the harsh environment.

“I would say 2020 would be a good target [for producing Tiber],” said Matt Pickard, analyst with Quest Offshore Resources, a Sugar Land company that studies deep-water oil discoveries.

The same may be true for other high-profile Lower Tertiary discoveries [in the Gulf of Mexico] in recent years, including Chevron Corp.’s Jack field. Three years ago at Jack, an industry-first well test confirmed that the trend contains a vast quantity of oil and that it can be brought to the surface.

The Jack discovery made by Chevron, Devon and Statoil in 2006 also “reopened” the peak oil debate. Now we are told that we might expect to see some oil from Jack in 2020, a mere fourteen years after their successful test well. Chevron has put plans in motion to produce 120 to 150,000 barrels-per-day at some unspecified time in the future. They now have a five-year lease on an ultra-deepwater drillship, Transocean’s Discover Clear Leader. Does this mean we may see this some oil—150,000 barrels per day is not a lot of oil—a mere 10 years (including a typical 2-year delay) after the successful Jack test? Stay tuned, but don’t hold your breath.

And what happened to Chevron, Devon and Statoil stock values after the Jack announcement almost exactly three years ago on September 5, 2006?

Devon shares climbed $7.99, or 12 percent, to $72.14 in New York Stock Exchange composite trading, the biggest daily gain since May 1992. The stock is up 15 percent this year.

Chevron stock rose $1.51, or 2.3 percent, to $66.34. Statoil shares rose 1.5 Norwegian kroner to 176.5 kroner in Oslo.

BP’s Tiber is out in the boondocks. Producing this oil means overcoming a very challenging high pressure/high temperature (HT/HP) physical environment several miles under the seabed. The oil will probably not be produced until 2020 in the best case.

As with Jack, the notion that Tiber—this is not an easily accessible Ghawar—reopens the peak oil debate is absurd. No one concerned about peak oil ever said there was no more oil to find. What I and others have said is that most of the easy oil has already been discovered and new finds will be much harder and more expensive to put into production. Tiber is a case in point. So was Jack three years ago.

There is nothing extraordinary about the unwarranted hype surrounding the Tiber discovery. Irrational is normal for most people most of the time. We humans are designed by nature to overvalue recent information, especially if it is perceived as good news. In behavioral finance, this is called overreaction and availability bias. That explains why oil company stock prices went up.

There are many other biases, including confirmation bias, which is “a tendency to search for or interpret information in a way that confirms one’s preconceptions.” Thus the Tiber discovery confirms Daniel Yergin’s faith that markets and technological innovation solve all problems.

From Foreign Policy — “Again and again, in researching oil’s history, I was struck by how seemingly insurmountable barriers and obstacles were overcome by technological progress, often unanticipated.”

From the Washington Post — Daniel Yergin, chairman of Cambridge Energy Research Associates, said that the [Tiber] discovery “demonstrates how technology continues to expand the horizon of the Gulf of Mexico.”

Given the difficulties in producing Tiber stated above, PFC’s Bob MacKnight, a neutral observer, took a more rational view of the discovery—

Bob MacKnight, a senior consultant with the Washington consulting firm PFC Energy, cautioned that while the big new discoveries [like Tiber] were welcome news, they might not boost overall U.S. oil output because other Gulf of Mexico fields are expected to decline. “We really need this,” he said. “After 2012, given current developments, we will see production start to decline. Without continued discoveries . . . that decline could be steep.”

Economists did not stop with the delusional premise that people are rational. They took the next logical step by assuming that markets were rational too. This is a natural move to make if you believe that markets price & allocate resources efficiently to solve any economic problems that might crop up. This astonishing theory, called the Efficient Market Hypothesis, follows from the Assumption of Human Progress stated above. From Richard Thaler—

From the starting point of rational investors came the idea of the efficient market hypothesis, a theory first elucidated by my colleague and golfing buddy Gene Fama.
The EMH has two components that I call “The Price is Right” and “No Free Lunch”. The price is right principle says asset prices will, to use Mr Fama’s words “fully reflect” available information, and thus “provide accurate signals for resource allocation”. The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account…

On the price is right, if we include the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and, in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be “right”, then these bubbles would not occur. But they have, so what are we to do?

[My note: Thaler is referring to the NASDAQ equities bubble in the late 1990s and the Housing Bubble. See Figure 1 below.]

The economic consensus thought bubbles were a thing of the past. Krugman divides that consensus into two groups, the “Freshwater” (Midwest) and “Saltwater” (East Coast) economists, but takes pains to show that there was no significant difference between them regarding their firm belief in rational individuals and markets. The “Freshwater” group, whose views depart from reality in a most alarming way, is dominated by those who came after Milton Friedman at The University of Chicago, my alma mater. Here’s Krugman again—

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.

[My note: The economic “theory of everything” is not “a long way off.” There will never be such a theory (see below). Human Nature, properly perceived and understood, precludes it.]

Krugman compares the assumption of efficient markets to the naivete of Voltaire’s Dr. Pangloss, who teaches that “all is for the best in the best of all possible worlds.” And, really, Krugman’s not kidding—that was the mainstream view. Ben Bernanke, no less, called the tranquil period 1985-2004 of mostly unperturbed economic growth The Great Moderation.

The shared delusion among economists was far worse than Krugman lets on anywhere in his text. During the so-called Great Moderation, the consensus forgot to make graphs like Figure 1 and ponder their deeper meaning.

Figure 3 — This graph is explained at length in my article Don’t Buy Stuff You Can Not Afford. During the Great Moderation, income & debt decouple in 1983 (Event I). Later, housing wealth decouples from real income during the Housing Bubble (Event II). The bubble tops are circled (light gray). Apparently, it didn’t occur to either the Freshwater or the Saltwater economists that endless growth can not be based on endless debt. Even worse, the rich were getting richer but the Middle Class was saddled with most of the debt.

The Great Moderation turns out to be counterfeit. For example, “the private sector ended up with a net loss of 223,000 jobs since August 1999, according to the latest figures from the Bureau of Labor Statistics. Meanwhile, the nation’s population has grown by 33.5 million people.” It is not rational to believe that economic growth is sustainable if that growth depends on an ever-growing mountain of debt. Such growth can not be real if it depends on moving future demand forward. Once again, economists placing their faith in efficient markets populated by rational actors failed to acknowledge their own unreasonable assumptions.

It was irresponsible Big Finance that caused much of our current troubles. But this is nothing new. Krugman quotes John Maynard Keynes—

And Keynes considered it a very bad idea to let such [financial] markets, in which speculators spent their time chasing one another’s tails, dictate important business decisions: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

Keynes was passé or treated with disdain during the Great Moderation, as was John Kenneth Galbraith, who wrote A Short History of Financial Euphoria in 1990. The story of our downfall is simple: “rational” economists ignored the entire centuries-long history of finance. This quote is taken from a review of Galbraith’s small book—

Galbraith describes the characteristics of the mass psychosis that typifies the period of financial euphoria that precedes the inevitable crash. In the first instance, the general paper profit-making becomes (temporarily) a self-fulfilling prophecy, that leads to self-sustaining and self-congratulatory behavior, what Galbraith terms “a vested interest in error” on the part of the participants, who, as members of a crowd are willing to suspend disbelief: Galbraith quotes Walter Bagehot – “all people are most credulous when they are most happy“. To this, the author adds an elegant statement of the power of the vested interests who condemn and criticize doubting voices in an almost tribal manner.

Galbraith does not spare sarcasm in his characterization of the attitudinal follies that lead to and sustain these episodes. He is brutally succinct in describing the extreme shortness of financial memory and the ignorance of history which leads to the same mistakes being repeated under similar circumstances within a few short years…

The real world is populated by Homo ovinus—ovinus is the Latin word for sheep. Bubbles could not occur if investors, like sheep, did not move together in the same direction during these exuberant episodes. Homo economicus is a convenient fictional construct. Economists forgot that markets, which were thought to be efficient but are full of irrational human beings acting in concert, must be properly regulated to inhibit fraud & theft, prevent natural risk-takers from getting carried away, and prevent bad money from driving out good money.

Beyond groupthink, how could economists have made such Big Mistakes? I believe the answer lies in the underlying assumption of continuous human progress I spelled out above. In the real world, however, things do not always get better. Sometimes, like now, they get worse. It has always been that way.

[Irving Fisher] used the Panic of 1837 as an example. It was caused by heavy demand for loans to buy land, build businesses, and invest in the country’s development. Prices began rising, economic strains built up, and a speculative bubble developed that burst in New York on May 10 when every bank stopped payment in specie (gold or silver coinage). A five year depression followed. Many banks failed, and unemployment soared to record levels…

The Panic of 1857 ended the boom years following the 1846 – 1848 Mexican
War. It gave America undisputed control of Texas, established the US – Mexican border at the Rio Grande River, seized the present-day states of California, Nevada, Utah, and parts of Colorado, Arizona, New Mexico, and Wyoming, and opened this vast new area to speculation and development. Much of it was to expand railroads. It proved unsustainable and led to crisis. The failure of the New York branch of the Ohio Life Insurance and Trust Co. was the proximate cause. It ignited panic as a result of massive embezzlement and heavy losses on depreciated railroad investments. Eroded public confidence took over, setting off a chain of events…

The Panic of 1873 (near the onset of the Gilded Age) was called “the real Great Depression” by some. It began eight years after war ended and started a six-year depression until 1879. It was triggered by the Vienna Stock Exchange crash in May (the so-called Grunderkrach or “founders’ crash”), then spread to America in the fall… [and so on]

[My note: Based on Irving Fisher’s Debt-Deflation Theory of Great Depressions (1933).]

Bernanke’s Great Moderation, which turns out to have been a sham, represents an insignificant blip in time even when time is measured in mere centuries.

Most economists, including the behaviorists, accept the Assumption of Human Progress (or they used to). You may have run across the term technocracy, whose short definition is “a government or social system controlled by technicians, especially scientists and technical experts.” Economists are our technocrats, and their belief is that enlightened monetary policy, along with sophisticated mathematical models, will always provide the “best of all possible worlds” lampooned in Voltaire’s Candide. This is best explained by example. This passage, which I have quoted at length intentionally, is Ben Bernanke analysis of the causes of the Great Moderation (link cited above).

My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation… Let us begin by asking what economic theory has to say about the relationship of output volatility and inflation volatility… This apparent trade-off between output variability and inflation variability faced by policymakers gives rise to what has been dubbed the Taylor curve [figure below] reflecting early work by the Stanford economist and current Undersecretary of the Treasury John B. Taylor…

As I will shortly discuss further, an insufficiently strong response to inflation let inflation and inflation expectations get out of control and thus added volatility to the economy. At the same time, strong responses to what we understand in retrospect to have been over-optimistic estimates of the output gap created additional instability. As output optimism and inflation pessimism both waned under the force of the data, policy responses became more appropriate and the economy more stable. In this sense, improvements in policymakers’ understanding of the economy and the role of monetary policy allowed the economy to move closer to the Taylor curve (or, in terms of Figure 1, to move from point A to point B)… [much more technical discussion ensues]

The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.

Figure 2 — The Taylor Curve. Pay no attention to the man behind the curtain…

Don’t worry about the actual meaning of “the relationship of output volatility and inflation volatility” as shown in the Taylor Curve. I am not trying to explain that relationship, even if I could. Bernanke wants to demonstrate how improvements in monetary policy allowed the economy to move closer to the ideal described by Taylor’s curve (A –> B) in which both inflation and output volatility are muted. In other words, output (GDP) growth was steadier and more reliable. Recessions were shorter and less severe when they occur. This was Bernanke’s Great Moderation.

Bernanke was optimistic about the future because he was confident policymakers would not forget the lessons of the 1970s, which was a time of great volatility in the American economy. Unfortunately, no one remembered, or took seriously, the lessons of the 1830s, the 1850s, the 1870s, the 1920s, and the rest.

Bernanke had faith that technocratic cleverness always improves economic conditions over time. All-powerful markets were allowed to function on their own even when they were clearly deranged. The Fed did not need to enforce its regulatory powers. All that was required of the Fed was a little fine-tuning in monetary policy to curb destructive volatility. Bernanke’s policy approach, just like that of Alan Greenspan before him, reflected his faith in human progress.

Moreover, there were many technological “innovations” in Finance. All of those fancy derivatives (e.g. collateralized debt obligations) were said to reduce risk, not increase it. The derivatives Casino was based upon other “innovations” like credit cards or interest-only mortgages. Galbraith knew better than to trust such alleged improvements—

The second important insight of [A Short History of Financial Euphoria] is the summary of common denominators in all such episodes, many of which are visible in the period we are currently experiencing [in 1998]. Among these (and probably inevitable given the shortness of financial memory) is the appearance of specious financial innovation. This is treated at length in the discussions of the South Sea Bubble, John Law, and [junk-bond king Michael] Milken… Galbraith argues that most of these seeming innovations were essentially variations on the theme of [increasing] leverage [debt-based speculation]

[My note: In the Housing bubble, increasing speculative leverage involved the use of fancy new derivatives to increase short-term profits during a Ponzi Scheme in residential real estate.]

We now know that the Great Moderation ended very badly, an outcome Galbraith surely predicted but did not live to see. And we’re nowhere near the end of the Great Recession’s harmful effects; these will last for many years to come. The technocrats were wrong, and always will be.

True progress—I’m not talking about washing machines or iPhones here—is an illusion. The economy is entirely a human affair and as such, flawed. Ecclesiastes was right—there is nothing new under the sun. These things only work out in science fiction. Do you remember Isaac Asimov’s Foundation series? His character Hari Seldon invented Psychohistory, a social science based on statistical models that allowed him to predict the general flow of human events thousands of years into the future. That was the ultimate technocratic dream.

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