Alexander Rosenberg (Duke), as most readers will know, is a leading philosopher of science, especially of biology and economics, and author of a devastating critique of economics, Economics: Mathematical Politics or Science of Diminshing Returns? (University of Chicago Press), which won the 1993 Lakatos Prize in Philosophy of Science from the London School of Economics. I asked Professor Rosenberg for his reaction to John Cochrane's reply to Krugman, and he kindly gave me permission to post his thoughts:
I can imagine how a Chicago-school free-market economist like John Cochrane feels when he reads an article in the New York Times Magazine like Paul Krugman’s “How did Economists get it so Wrong?” How would analytical philosophers have felt if Quine had published an accessible version of “Two dogmas of empiricism” in the Times, along with cartoons making fun of Kant and Carnap?
The fact that Cochrane can't do any better than the response on his blog is about as significant for economics as the fact that the best opponents could do to Quine was Grice and Strawson’s question-begging article, “In defense of a dogma.”
Cochrane thinks that neither Krugman nor the last years of the Bush stock market can impugn the “efficient markets hypothesis” and so everything in conventional economic theory is untouched.
The efficient markets thesis is that the market makes complete use of all relevant information, and the “proof” is roughly that in a perfectly competitive market among perfectly rational agents prices invariably and instantaneously reflects all agents’ real beliefs and real desires. Any one who knows anything that can make him or her money acts on it—buys or sells—and that signal is picked up by every one else, who also acts on it, thus preventing any one from making excess profits—rents--long-term.
The first thing a philosopher notes about this notion is that since most people have false beliefs, especially about the future, an efficient market doesn’t internalize knowledge, but only beliefs. If they are mostly false, then the market isn’t efficient at internalizing (correct) information, it’s efficient at internalizing mostly false beliefs. If false beliefs are normally distributed around the truth, then they’ll cancel out and the proof of a probabilistic version of the efficient markets theorem will go through—market prices reflect the truth most of the time. Too bad false beliefs don’t always take on this tractable distribution. Even worse, when enough people notice the skewed distribution of false beliefs, they can make rents, as the markets crash. This is what Cochrane seems to think can't happen. How many times will it have to happen for the Chicago School to give up the efficient markets hypothesis?
There are so many way the assumptions of the efficient markets theorem can go wrong—different ones at different times, often even cancelling one another out, that it's easy for a complacent economist to see in the long term trend a vindication of the efficient markets theorem. And all Chicago economists have been taught to be complacent with their mother’s milk—Milton Friedman’s famous insistence that the falsity of assumptions doesn’t matter.
But Friedman’s children, like Milton himself, forgot his caveat that false assumptions are harmless so long as predictive power is improved, or at least preserved. Now the real point of Krugman’s essay is the obvious one. The economic theory the Chicago School prizes lacks the predictive resources even to have retrodicted the last two years of the world’s economic trajectory. The catastrophe of international finance is only the head-line grabbing symptom of this failure. And Chicago economists don’t have the slightest idea of where to start to explain (to retrodict) it. They don’t know which of their assumptions to give up, and how much of each of those to give up. Add in their ideological attachment to the nonsensical ideas that the marginal productivity of labor or capital measures its causal role, and therefore its moral right to a proportional slice of the profits, and you easily slip from Laissez-faire “science” to “trickle down” political philosophy.
Cochrane talks earnestly about how the Chicago School’s scientific economists are forever comparing their theories to quantitative data. Since most of what they will accept as data is unreliable, and mostly it shows no short-term trends, the Chicago School satisfies itself that its theory is consistent with the long run (the logarithmic long run at that). Here the expected quote from Keynes can’t be resisted. In the long run, we are all dead. What we want from economics—if it purports to be a science—is at least medium term predictions. What Krugman seeks, and Keynes before him sought, is a theory that has some medium term consequences, something that would make it relevant to governmental policy that will ameliorate peoples’ lives while they wait for the hidden hand’s benevolent long run outcome. The Chicago school has scientifically self-protective and normative objections to the very possibility of medium-term prediction. It will put a theory that can make none out of business, and it will put a theory that does at the disposal of a government that might use it to redistribute if that is what it takes to increase the total size of the pie.
Keynes, not Kahnemann, was of course the first of the behavioral economists—think about propensities to consume, liquidity traps, and most of all “animal spirits.” It was easy for Chicago School proselytes to explain away ‘70’s stagflation by showing that perfectly rational economic agents couldn’t be fooled into spending their way out of a recession by inflationary government policies Keynes inspired. But the fact is that people are not like that. They are satsificers exploiting fast and frugal heuristics with kinky indifference curves.
Keynes’ repudiation of rational choice theory’s description of the economic agent was the first straw, and the last for the Chicago school. Without even allowing for the work of the last 40 years, it was enough to put paid to Keynesianism among the free market elect. For the same reason—their retrospective rationalization of the stagflation they hadn’t predicted—they felt themselves able to ignore work that won many of the subsequent ersatz Nobel Prizes in their subject—especially those awarded for work in behavioral and other branches of economics that don’t take general equilibrium solutions seriously. The same after-the-fact account of why Keynesian pump priming stopped working in the ‘70s also licensed their repudiation of the Obama administration’s stimulus spending this year. We wont hear of its successes from them. Too much of an embarrassment.
All the reasons the failure of financial markets gives us to question the scientific status of Chicago-school economic theory are mutates mutandis reasons to ignore their “rational expectations” claims (the wish being the father of the thought) that the stimulus wont work—or at least that the non-tax-cut portions of it wont.
Since I am not an insider, I’ll refrain from commenting on Cochrane’s hurt feelings about the insults. But if this is the best a Freshwater economist can do by way of reply to Krugman, there is not much chance he will have to take anything back.
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Alex Tabarrok has a great post today clarifying the complaint that "economists failed to predict this crisis." Some big guns have come out and said that not only should they be excused for failing to predict the crisis, but they should be congratulated for predicting that they would fail to predict this and all future crises. (If you think I'm exaggerating to make a joke, read it yourself.) So Tabarrok calls this move for the obvious foul that it is. (Incidentally, Tabarrok is responding to this defense of macro by David Levine. But when I get more time, I have to write a full-blown article on it, it's so bad.)