Economics as Market Failure

August 11th, 2013 at 12:37 pm

Over at the WaPo, Barry Ritholtz has a resonant and interesting piece questioning economists’ value-added to investors.  He reports that while they’re “…intelligent, engaging and often charming folks, …their work is often of little use to investors.”

Though he makes many great points here (about which more in a second), he leaves out a few interesting wrinkles.  First, the ideological and economic incentives that play a role in ways in which economists often get it wrong, and second, there’s the market failure that Ritholtz seems to be documenting: if economists add so little value to markets, why do markets pay economists so much for their advice?

According to Barry, economists’ limited value to markets stems from:

the lag in their insights relative to markets: since markets are often “out of sync” with the economy, even if you knew the results of an economic report before others, your prediction of the market’s reaction might be wrong, and since economists are not very good at prediction–their forecasts are “mostly miserable”–they don’t even help in that regard.

the limits of economists’ theories: since our theories are an “imperfect lens” through which to view the world, when we cram what we see into them, what comes out is often wrong.  Many influential economists, including Greenspan, were driven by the theory of self-regulating markets, and thus missed a massive housing bubble that tanked both financial markets and economies across the globe.

–Quoting directly from the piece: “Narrative drives most of economics. Everything seems to be part of a story, and how that story is told often leads to critical error. Think about phrases like “stall speed,” “second half rebound,” “muddle through,” “Minsky moment,” “austerity,” “escape velocity,” etc. All of these lead to rich tales often filled with emotional resonance — but not a lot of insight.”

Actually, I disagree with this one, though he may have a point re investors.  Many of these narrative devices provide useful summaries regarding actual economic developments in ways that should inform policy makers (though I’m not sure how useful they are to investors).

We were, and to some extent still are, in a Minsky moment, when risk underpricing flips to risk overpricing.  To recognize that reality is crucial in, say, the current debate over the government’s role in housing policy.  As long as providers of credit remain too risk averse, there is still a role for larger-than-normal government support of the housing market.  As the Minsky moment passes, that role must diminish.

Austerity is an critically important description of the wrong-headed belief the cutting government spending at the wrong time worsens both output gaps and fiscal debt.  The fact that the economy has yet to achieve “escape velocity”–fast enough growth to generate the virtuous cycle of spending, investment, job-creation, income growth, spending, etc.–in part due to the presence of the Minsky moment and fiscal tightening by the austerions, is an important insight, one that would guide policy makers if we were not stuck at the intersection of dysfunction junction.

I’d actually argue that it’s here–in understanding and explaining the economic narrative–where the good economists, which in my world are those who understand not just the rules of classical econ and statistics but the role of political power, wealth distribution, class, gender, and more, actually can add considerable value to both our understanding of our society and the need for corrective public policy.  Though, to be fair to Ritholtz, I’m not sure how much any of that has to do with investors gaining a trading edge.

About the two wrinkles I thought were missing here: First, the role of economists’ ideology and its linkage to financial incentives should not be overlooked in such a critique.  Going back to G-span and the housing bubble, it is well-documented that he viewed home ownership as a wealth enhancer that not only links middle-class households to a potentially valuable asset, which it does, but also gives them buy-in to capitalism in some sort of Randian fashion.  This is a very dangerous viewpoint–or more accurately, set of blinders–for someone whose job is to oversee the nation’s banks and the quality of the debt they hold.

Going back further, to the latter 1970s (and admittedly pretty far afield from Barry’s piece), there was a toxic intersection between the arrival of “rational expectations” economics, which roughly argued that government oversight and taxation can only screw things up, and the doctrine of supply-side-trickle-down, which argued that if you let the wealthy keep more of their money, they invest more and the benefits will redound to all.

Those ideas led to lots of economists making lots of big money presenting lots of equations as to why taxes and regulation were as bad as Ronald Reagan (and later, Bill Clinton re financial market regulation) said they were.  The results, in terms of fiscal deficits, financial bubbles and busts, and now, dysfunctional government, are evident.

Which brings us to the last point.  If economists add so little value, at least to investors, why do they get paid so much, including by markets?  Part of the reason is, as Ritholtz points out, some actually do give worthy advice—Barry’s beef seems to be more with the class and the discipline than chosen individuals.

But one can’t help but wonder if there’s not a market failure here.  Barry’s absolutely right, for example, that economists nudge investors and the media to read much more than they should into monthly data releases, at least based on the amount of accurate economic information such reports actually contain.  Of course, Keynes’ beauty contest is also in play here: what matters is not how much information is in the report—what matters is how much my trading counterparties think is in there.

Anyway, I’ve gotta run to visit the “aged p” (as per Dickens), but here’s an assignment for extra credit.  It would be worth seeing if economists pay is at all responsive to their mistakes.  Was there any consequence for the discipline for missing the housing bubble (or, conversely, did Dean Baker get a big raise for spotting it early and screaming about it), or for the mistakes of austerity that literally led recovering economies back into recession?

Go ahead and look for the data (I’d start with the BLS Occupational Employment data), but I think we all pretty much know the answer in advance.

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5 comments in reply to "Economics as Market Failure"

  1. Yastreblyansky says:

    I do not see why economists should be of value to investors (except when investors are paying them for specific tasks). Would you say zoology should assist lions in keeping ahead of hyenas? Would you complain that linguistics isn’t helpful enough to propagandists?

  2. Dave says:

    Ah, investors don’t care much about reality.

  3. Dave says:

    I don’t know what economists add to investor sentiment, but I don’t care. I think the good economists look out for people. And that is all.

    And there are almost no good economists except for Jared. Most of them care nothing about anything but their careers.

    This is where democracy needs to focus. On this field.

  4. Andi says:

    Why do investors pay economists?

    Availability bias springs to mind. Investors are just humans so most want to believe there’s somebody out there that can tell them how things will turn out. It’s not far away from astrology and fortune telling, just with a veneer of science and maths applied. As an investor I would like to see advice from economists also come with a complete prediction hit-rate history – something you never see from analysts (or sports pundits!)

    Confirmation bias is clearly important too on both the investor and economist sides. Ideology drives most of us and unless you’re an academic who prizes scientific rigour (or is punished by lack of it) it’s hard not to cherry-pick or present the angle you’d prefer.

    Also the “nobody-got-fired-for-buying-IBM” effect.

    I’d love to see economist pay linked to predictive success. I have a feeling the discipline would suddenly find out a lot more about how things really work.