Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Wednesday, March 4, 2009

Willem Buiter: Economicus Ignoramus

Oh my, this is rich. Here we have Willem Buiter, self-proclaimed genius and mediocre economist extraodinaire, suddenly discovers that there is a problem with the development of "Anglo-American" macroeconomic theory. See his little diatribe here.

We all have our own pet peeves with the way macroeconomic theorizing has progressed over the last few decades. My own is with the the so-called "New-Keynesian" paradigm (Woodford); which is clearly the "mainstream" view adopted by most policymakers (until recently, that is).

My beef with the NK paradigm is this in a nutshell. It is a model that ignores money and typically, financial markets too. It embeds unexplained "frictions," like sticky prices. It embeds conceptually vacuous "shocks" like "mark-up shocks" or "inflation shocks." It focusses on the policy problem of "stabilizing" the economy in the face of these little itty-bitty shocks. It is not a model designed to understand financial crisis. It is a model designed to legitimize what central bankers always believed they should be doing in the first place: adjust the short-term interest rate to stablize the economy around a predetermined long-run trend. This is why the NK model is the dominant paradigm; and this is why those that promote this view land all the cushy consulting jobs. Among those that promote this view include our very own Herr Buiter. Here are some links to the courses he teaches on the subjects: see here. Good job, Willem. One can easily see how your students (and yourself) were well-prepared to deal with the current financial market crisis with your "very useful ad hoc models" of the economy.

Of course, most economists who have worked to develop the NK paradigm are honest researchers with a sincere desire to understand how the economy works and how policy might be designed to meet worthy social objectives. Evidently, Herr Buiter has a different view:
Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck.
I presume that he is talking about himself here; he should not attribute his own objectives to others in this manner.

Let's see what else he has to say...

The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’.

This is clearly evidence that he has no idea of what he is talking about. The complete markets paradigm is the Arrow-Debreu model; and this is patently not what "New Classical" and "New Keynesian" theories assume.

In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity - both funding illiquidity and market illiquidity - are also impossible, unless the guilt-ridden economic theorist imposes some unnatural (given the structure of the models he is working with), arbitrary friction(s), that made something called ‘money’ more liquid than everything else, but for no good reason. The irony of modeling liquidity by imposing money as a constraint on trade was lost on the profession.

No, Mr. Buiter, the irony of modeling liquidity by imposing money as a constraint was not lost on the profession (see the work of Neil Wallace and Randall Wright, for example); it was lost on a subset of the profession of which you belonged.

It is clear that, when searching for an appropriate simplification to address the intractable mess of modern market economies, the starting point of ‘no markets’, that is, autarky or no trade, is a much better one than that of ‘complete markets’.

The conclusion, boys and girls, should be that trade - voluntary exchange - is the exception rather than the rule and that markets are inherently and hopelessly incomplete. Live with it and start from that fact. The benchmark is no trade - pre Friday Robinson Crusoe autarky. For every good, service or financial instrument that plays a role in your ‘model of the world’, you should explain why a market for it exists - why it is traded at all. Perhaps we shall get somewhere this time.
Oh thank you Professor Buiter; thank you for this. Let us begin by modeling exchange by assuming an economy populated by a single Robinson Crusoe. Yes, this should help. And let us model the exchange process as "involuntary" exchange instead of voluntary exchange. Perhaps we will get somewhere this time indeed. Good luck. I'm sure that you will lead the way.

Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many keBlockquotey asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. eduction.
And so where is Herr Buiter's theory that would replace the EMH? I am very much looking forward to my de-programming from such an enlightened and worldly individual.
The EMH is surely the most notable empirical fatality of the financial crisis. By implication, the complete markets macroeconomics of Lucas, Woodford et. al. is the most prominent theoretical fatality. The future surely belongs to behavioural approaches relying on empirical studies on how market participants learn, form views about the future and change these views in response to changes in their environment, peer group effects etc.

Clearly, he does not understand the EMH. We probably do have some things to learn from behavioral approaches; but I would not want this ignoramus to lead the charge.

I believe that the Bank has by now shed the conventional wisdom of the typical macroeconomics training of the past few decades. In its place is an intellectual potpourri of factoids, partial theories, empirical regulaties without firm theoretical foundations, hunches, intuitions and half-developed insights. It is not much, but knowing that you know nothing is the beginning of wisdom.

I too hope that central banks are now led to place less weight on the "conventional wisdom" expoused by Buiter and others. It is indeed a good thing to be humbled by the realization of the limits of our theorizing. But to expouse a program of ignorance "without firm theoretical foundations" is going too far. Too far that is, unless you are Willem Buiter, economicus-ignoramus ready for hire.

15 comments:

  1. Now, now, I'm sure that Mr. Buiter means well.

    EMH = efficient markets hypothesis.

    Hmm, I'd be interested in an analysis of the current downturn in light of the EMH. Where does it inform? Where does it fall short?

    I suspect that different interpretations stem from whether folks see markets as a process or as a static equilibrium.

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  2. Westslope:

    I'm sure that Buiter means well...for himself. Like any science, economics deserves its share of criticism. The criticism should be constructive though. Questioning the motives of a whole class of researchers is not constructive. And to heap hypocrisy on top of this is, well, it is unacceptable. He is an idiot.

    Among other things, the EMH predicts that asset prices should follow a martingale process. If asset prices are not a martingale, then there are potentially huge arbitrage opportunities available. The task, if you believe this to be true, is to explain why these aribitrage opportunities go unexploited by supposedlly greedy capitalists. The EMH does not, as many are apt to do, imply that there is no role for government policy.

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  3. David: is it the New Keynesian approach, or the Neo-Wicksellian subset of that approach, which ignores money and financial markets? Or do you see them as much the same thing? I had my own (little) beef with the latter a couple of days ago.

    By the way, I would like to see your thoughts on unorthodox monetary policy sometime. What (if anything) can and should the BoC do next? How would it work?

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  4. Hi Nick:

    Of course, it is the Neo-Wicksellian (Woodford) approach that ingores money. Other NK models simply force money in via a CIA constraint. Most DSGE models use the same short-cut. Very few people take the time to model intermediation and money seriously. There are exceptions of course; for example, Ed Green has done some serious work on the payments system. Champ and Freeman, in their undergraduate money text also take some time to explain the role of clearinghouses to ensure the smooth functioning of the payment system. All of this literature has been ignored by the mainstream. This is not necessarily a complaint on my part; it is just a statement of fact. My problem with Buiter is with his stupid generalizations about "Anglo-American" economists and their training. As if he ever did anything to contribute to a literature that takes money, intermediation, and financial stability seriously.

    My own view has remained unchanged from even before this crisis broke. The bank should stop focussing on the day-to-day tinkering of the short-term interest rate to smooth what they perceive to be "output gaps" in the process of economic development. Instead, the BoC should focus on its role as a centralized clearinghouse. This implies standing ready to make short-term collateralized loans (expanding the collateral base to include high-grade commercial debt instruments).

    What are your thoughts on this matter?

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  5. Can you further elaborate on what you think the BoC should do with short term interest rates? Are you suggesting this function should be handled by some other mechanism?

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  6. Thanks David. I'm leaning towards more aggressive action by the BoC myself. But I really wish I understood it better. The collateralised loans don't seem to be aggressive enough for me. I would prefer outright asset purchases. More illiquid assets. Not 100% sure though. I have a few recent posts on the Worthwhile Canadian Initiative blog, trying to stumble through this stuff.

    I used to be much more knowledgeable about "micro-theory of money", as we used to call it.
    Feeling a bit like an old, out-of-touch ex university administrator though.

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  7. Can someone explain to me why fiscal stimulus spending is required? It appears that the supposed benefits of stimulus would be years out. But how can we be so certain that any economic recovery was caused by the stimulus, rather than despite it? Shouldn't there be other grounds for determination of whether fiscal stimulus spending is necessary? Like for example spending a "mad money" amount?!

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  8. The only thing I actually agree on with Buiter is that in most practical situations markets are incomplete. However, that doesn't mean we should erase all our knowledge of economics and start from scratch as he suggests. On the contrary, we have some well-thought theories of endogenously incomplete markets developed in the past 20 years or so (but perhaps that was after Dr. Buiter stopped following economics and started consulting). These theories originate from the basic Arrow-Debreu framework but show how some markets may not operate in the presence of asymmetric information, limited commitment, or imperfect enforcement. Too bad these models are not often applied to 'macro'-policy issues and topics (with few exceptions). One typical lesson from these models is that the outcomes they predict, while often starkly different from those under complete markets, are constrained-efficient, i.e. the fact that the market fails does not imply that the government or anyone should necessarily intervene if they are subject to the same reasons for market incompleteness as all other agents.(realistically governments are probably subject to more such constraints). The only interventions that may improve efficiency would be those addressing the causes (as opposed to the symptoms) of the inefficiency, i.e. the asymmetric information, enforcement, etc. problems. This may be very hard to do in practice as it involves identifying the exact reason for the imperfection - there is a unique first best outcome but the possible departures from it are infinitely many.

    Of course, in reality most policy proposals focus on the (much more visible and politically 'interesting') symptoms of incomplete markets rather than their causes and hence the 'great' track record these policies have.

    On a personal note in the end, I am amazed how many long-forgotten macroeconomic 'experts' have crept out of their holes and are having a field day canoodling with eager 'let's-spend-other-people's-money' politicians these days. We need a counter-revolution.

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  9. Alexander: "One typical lesson from these models is that the outcomes they predict, while often starkly different from those under complete markets, are constrained-efficient,..."
    Is that correct? I thought it was typically the opposite result that came out? General application of the theory of second-best.

    Nick Rowe

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  10. Pointbite: I am fine with the way the BoC manages the overnight rate. This is because they in effect manage the rate in accord with what the market desires. And they have a well-defined inflation target in place, which is all that I think they can reasonably be expected to control.

    Nick: In principle, I am not against the more aggressive action you suggest. My concern here would be that it is potentially dangerous to allow a government institution to decide whose private assets deserve to be "monetized." Short-term lending at least imposes some discipline on this; although, there is always room for political shenanigans in such matters.

    Pani Pani: I think that an even better question is: Can anyone show me how fiscal stimulus has worked in the past? Where is the evidence? Japan?

    Alexander: An excellent essay; I think you hit the nail on the head.

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  11. Alexander,

    Information asymmetry seems promising given how many smart people were caught with their proverbial pants down by this contraction.

    Akerloff's market for lemons explains why you might want to drive your excellent condition older vehicle into the ground than sell it. But I don't see anything that explains why volumes of used car sales are generally large and growing and then suddenly contract.

    Even common pool resource overexploitation and destruction is not inevitably a one-way street, nor are exogenous institutional changes necessary to mitigate rent dissipation. Though I think I see some parallels between common pool resource crash and recovery cycles with financial sector crashes and booms.

    As to the eagerness for fiscal stimulation, isn't political rent-seeking a common feature of resolving crises? Witness the special interests that eagerly exploited the hyper-vigilant mass hysterical reaction that followed the 9/11 box-cutter terrorist attacks.

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  12. Nick: thanks for your comment. the so-called 'theory of second best' (Lancaster, 1956) was developed much earlier than the models I was talking about. In any case, this theory and what you say does not contradict anything I said - it discusses the theoretical possibility for mitigating/neutralizing one market imperfection with another one - that is, changing the economic environment in a way that addresses the initial cause of imperfections. Constrained-efficient is usually defined to mean that the economic environment (e.g. the information asymmetry) is kept the same for the 'planner' or policy-maker as for the market agents.

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  13. Alexander: Agreed. But I thought the usual result was that a tax or subsidy (for example) on something observable (by the government, and by everyone), would usually improve the allocation. Wouldn't a small employment subsidy, financed by lump-sum taxes, make evryone better off in an efficiency wage model, for example? (I think I used to know the answer to that question, but have forgotten.)

    David: Agreed. We don't want the BoC to be picking and choosing. But it could buy the index (stock and/or bond). Or buy x% of all new issues, or something.

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