Physics Envy and the Abandonment of Common Sense

It has been said that economists suffer from 'physics envy', and we get confirmation of this truism nearly every day (see e.g. our brief critique of the approach taken by Alan Blinder to justify Big Government). Modern macro-economics has been invaded by mathematical modeling and subjected to the very 'scientist approach' that Friedrich Hayek warned about in his famous Nobel lecture on the 'Pretence of Knowledge'. One would think that if economics could really be improved by attempting to press the complex gestalt of millions, even billions, of individual human economic actors into a system of mathematical equations, there would soon be agreement on what it all means.

 

Alas, modern day econometricians squabble even more over economic policy prescriptions than  theoretical physicists do over how to best arrive at the GUT (the 'grand unified theory'). We find it notable that one of the greatest books on economics ever written, Ludwig von Mises' 'Human Action', appears to be able to make do without a single mathematical equation (if you want to be picky, there are a few passages where von Mises elucidates concepts by using place-holders, as for example in the chapter on capital goods, where he writes: 'We may call p the total supply of capital goods available on the eve of the credit expansion, and g the total amount of consumers' goods which these p could, over a definite period of time, make available for consumption without prejudice to further production.'…and so forth. Alas, that is how far as it goes). The point we want to make is merely that in their urge to make the social science of economics more 'scientific', to bring it closer to the natural sciences and their 'hard truths'  by adopting mathematical modeling, many economists have ceased to see the forest for the trees.

Consider for instance the fact that a large percentage of today's preeminent economists failed to predict an economic crisis that anyone with a smattering of common sense could detect well in advance. Surely this serves as proof for how useless all their 'modeling' really is when it comes to real life. In this context, note the comments made by Wharton professors Franklin Allen and Sidney Winter on this topic after the crisis had arrived:

 

It's not just that they missed it, they positively denied that it would happen," says Wharton finance professor Franklin Allen, arguing that many economists used mathematical models that failed to account for the critical roles that banks and other financial institutions play in the economy. "Even a lot of the central banks in the world use these models," Allen says. "That's a large part of the issue. They simply didn't believe the banks were important." Over the past 30 years or so, economics has been dominated by an "academic orthodoxy" that says economic cycles are driven by players in the "real economy" – producers and consumers of goods and services – while banks and other financial institutions have been assigned little importance, Allen says. "In many of the major economics departments, graduate students wouldn't learn anything about banking in any of the courses." But it was the financial institutions that fomented the current crisis, by creating risky products, encouraging excessive borrowing among consumers and engaging in high-risk behavior themselves, like amassing huge positions in mortgage-backed securities, Allen says. As computers have grown more powerful, academics have come to rely on mathematical models to figure how various economic forces will interact. But many of those models simply dispense with certain variables that stand in the way of clear conclusions, says Wharton management professor Sidney G. Winter. Commonly missing are hard-to-measure factors like human psychology and people's expectations about the future. Among the most damning examples of the blind spot this created, Winter says, was the failure by many economists and business people to acknowledge the common-sense fact that home prices could not continue rising faster than household incomes. Says Winter: "The most remarkable fact is that serious people were willing to commit, both intellectually and financially, to the idea that housing prices would rise indefinitely, a really bizarre idea.”

 

Allegedly there has been a lot of 'soul-searching' since then, although we frankly don't think anything has really changed.  After all, many of these 'couldn't see the crisis coming' economists are now busily devoting their time and modeling skills to helping us find a way out of it, or, as is the case with Alan Blinder or Richard Koo, are constructing models that attempt to prove that things would have been even worse had government not intervened by spending money it doesn't have. The basic approach to economic theorizing has not come into question at all – and yet, if you consider the above comments by the good Wharton professors, that is what appears to be the most pressing issue.

 

Monetary 'Science'

What prompted this introduction is that we recently came across Eric Leeper's (he is a professor of economics at Indiana University) presentation at Jackson Hole, entitled 'Monetary Science and Fiscal Alchemy'(pdf). The paper is mainly a critique of fiscal policy, contrasting it with the allegedly 'scientific' approach to monetary policy that has emerged over recent decades. We actually don't want to go into the paper's main topic here, the main reason why we mention it is precisely this particular assertion about the 'science' of monetary policy.

Leeper writes:

 

“Monetary policy decisions tend to be based on systematic analysis of alternative policy choices and their associated macroeconomic impacts: this is science. Fiscal policy choices, in contrast, spring from unsystematic speculation, grounded more in politics than economics: this is alchemy.”

 

We wouldn't quibble with the notion that fiscal policy springs from 'unsystematic speculation grounded more in politics than economics', but we do have a problem with the characterization of monetary policy as 'science', as that makes it sound as though this particular problem of central economic planning were 'solved'.

Leeper details this view as follows:

 

“Ten years ago Clarida et al. (1999) proclaimed the arrival of “The Science of Monetary Policy.” Although the past few years’ experiences may have raised some questions about the robustness of the science, the paper’s general theme continues to resonate: modern monetary analysis has progressed markedly from the days of monetary metaphors like “removing the punch bowl” and “pushing on a string.” Key elements in the progress include modeling dynamic behavior and expectations, understanding some of the critical economic frictions in the economy, explicitly discussing central bank objectives, developing operational rules that characterize good monetary policy, and deriving general principles about optimal monetary policy. In a surprising twist of fate, the practice of monetary policy marched along side the theory. Central banks around the world have adopted clearly understood objectives — such as inflation targeting and output stabilization —and central bankers espouse and articulate the science in public discussions about managing expectations, the transmission mechanism of monetary policy, and the role of uncertainty in policymaking. Modern monetary research and practical policymaking are united in aiming to make monetary policy scientific.”

 

This, as they say, is quite a mouthful. We highlighted above the 'slight doubts' that have apparently crept in about the 'robustness of the science', which evidently do not keep Leeper from hailing modern day central banking as a genuine triumph of central economic planning. The 'clearly understood objectives' of the central economic planners at the monetary authority, such as 'inflation targeting and output stabilization' – all of which they are apparently able to 'control' by tweaking a short term interest rate and adjusting the growth momentum of monetary pumping! –  did absolutely nothing to avert the formation of the biggest credit bubble of all time. In fact, we would strongly argue that the 'scientist' approach of modern day central bankers blinded them just as much to the consequences of their policies as most modern day macro-economists were blinded by their countless mathematical models when it came to arriving at simple common sense conclusions about the sustainability of the credit bubble and its eventual outcome. It is perfectly true that central bankers 'espouse and articulate the science in public discussions about managing expectations, the transmission mechanism of monetary policy, and the role of uncertainty in policymaking' as Leeper writes. Ever since the experience of run-away rising prices in the 1970's, when the lagged effect of decades of monetary pumping on prices forced the Federal Reserve to adopt forceful medicine under Paul Volcker to save the fiat dollar-based monetary system from imminent implosion, central banks have been very explicit with regards to 'expectations management'. This is to say, they have become quite adept at inflating the supply of money and credit while 'boiling the frog slowly' via the 'anchoring of inflation expectations'. In the main though they simply got lucky (alas, it appears that their luck has now run out).

The period 1980-2000 was in many respects a close cousin to the 'Roaring 20's', chiefly insofar as economic productivity made enormous strides. The emergence of the computer industry specifically left no nook or cranny of business activity untouched – the productivity of literally every single production process was vastly improved by computerization. We can in fact not think of any economic activity off the cuff  that did not profit in some shape or form by the computer industry's achievements. So what happens when the productivity of production processes improves? In a free market economy, what happens is that prices fall. After all, an increase in productivity means that more goods and services will be produced with the same inputs. If the supply of money concurrently remains stable, the prices of goods and services will accordingly decline. However, the central banks had adopted a policy of 'price stability', which originally was intended to be a bulwark against run-away price increases for goods and services like those experienced in the 1970's decade.

Given that large productivity increases as well as the opening up of the global economy after the fall of the communist system put relentless downward pressure on prices, this policy however meant that the supply of money and credit could be vastly increased without triggering a marked rise in the 'general price level'. The result was the giant credit bubble that has now burst, bringing forth the biggest economic bust since the Great Depression.

This 'success' of modern 'scientific' monetary policy-making is one we could certainly have done without. Leeper's assertion that 'modern monetary research and practical policymaking are united in aiming to make monetary policy scientific' sounds more like a threat to us than anything else.

 

Central Planners Recognizing their Limitations

There are quite a few thoughtful and smart people at the Federal Reserve. The current internal debate over whether or not additional monetary pumping would be effective in arresting the economic slump has brought forth a number of interesting contributions from various Fed presidents. In this context we would for instance highlight a recent speech by Minneapolis Fed president Narayana Kocherlakota on the unemployment problem.

He stresses what the Fed can definitely not do, by noting:

 

“The job openings rate has risen by about 20 percent between July 2009 and June 2010. Under this scenario, we would expect unemployment to fall because people find it easier to get jobs. However, the unemployment rate actually went up slightly over this period. What does this change in the relationship between job openings and unemployment connote? In a word, mismatch. Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch — geography, skills, demography — and they are probably all at work. Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.”

 

In other words, it takes time for workers to adapt to the changes the economy's production structure is currently undergoing. The production structure is in the process of being rearranged to conform to economic reality rather than the economic illusion that pertained during the boom. It is precisely as Kocherlakota says – the Fed can not transform construction workers into manufacturing workers. There is always work to do in the economy – contrary to what Keynesians assert, demand can never really be a problem, unless all human wants and needs were satisfied already (in that case we should have arrived in Utopia, with economic scarcity abolished). It follows that there is always work to do for which the services of labor are demanded. However, after the production structure has been distorted by a credit boom, the process of transformation that is required to make it conform to the post boom reality is not an easily or quickly accomplished transition, as different skills are now in demand than previously. In addition, workers are slow in adjusting their wage demands, having gotten used to overly high wages in those sectors of the economy that were most distorted by the boom.

It is definitely not a problem that can be ameliorated by monetary pumping and Kocherlakota deserves recognition for saying so. As we can see here , the Fed can not possibly fulfill one part of its dual mandate – namely to keep the economy at 'full employment'. Other interesting contributions to the current debate have emerged from the sole dissenter at this year's FOMC meetings, Thomas Hoenig, from well-known hawk Richard Fisher – who points quite rightly to the 'regime uncertainty' problem bedeviling the economy – and even James Bullard's recent ruminations on the 'zero bound' problem contain some interesting ideas on how the Fed's ZIRP could have a negative influence on economic activity by its influence on expectations of economic actors (we will discuss the so-called 'zero bound problem' in a separate post). It is notable though that the most thought provoking contributions to this policy debate come from those Fed members that are pointing out the limitations of the Fed's ability to 'steer the economy'.

 

Conclusion

In spite of the allegedly 'scientific foundation' of modern day monetary policy-making, the monetary authority today finds itself at a loss as to what to do in the face of the secular bust. Apparently no tried and true recipe exists that tells the planners how to best proceed. Macro-economists are meanwhile as divided over the issue as the Fed itself seems to be. All sorts of proposals are pouring forth – and most of them mainly have in common that they continue the 'pretence of knowledge' –  the conceit that central economic planning is actually viable and will lead to economic outcomes that are superior to free market based outcomes.

The basic problem of central economic planning – namely the so-called calculation problem – can not possibly be solved by economic science. The central bank's interventions, which consist mainly in moving interest rates away from the natural rate indicated by time preferences, will always result in sub-optimal outcomes, no matter how well intended or well planned the policy is. The problem is that distorting the interest rate imparts falsified information about the state of the pool of real savings to entrepreneurs – this can not result in anything but malinvestment and capital consumption. We conclude that economists trying to improve on central planning by making it 'more scientific' are essentially wasting their time. The recognition – widely accepted in economics today – that the free market is superior to a command economy, should not be arbitrarily suspended when it comes to the subject of money. Price fixing is a bad idea, no matter who does it.

 


 

 

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6 Responses to “The Myth of the ‘Scientific Monetary Policy’”

  • It is curious how our economists are continually behind the curve. I remember back in 2002 when Greenspan was helping Bush create The Housing Bubble. He forced interest rates 235% below the ten year treasury bill for a year. At the time economists called him the maestro.

    8 years later economists have just come to the realization of Greenspan’s mistake and have acknowledged that he was complicit in the creation of the bubble.

    Presently Bernanke has placed the fed funds rate 2300% below the ten year treasury and he is planning on keeping rates there “for and extended period” or forever.

    So economists are presently vilifying Greenspan’s 235% faux pas.

    But they are cheering Bernanke’s 2300% insanity as saving our economy from economic ruin.

    Mathematically it appears that Bernake’s 2300% insanity is 8 times as large and will be many times longer than the Greenspan 235% faux pas.

    I would like to know the monetary mathematical formula that allows Bernake to pump 10 times or perhaps 20 times more liquidity into the system than Greenspan.

    How can Greenspan be a villian and Bernanke be a hero?

    • In my opinion Bernanke is quite possibly one of the worst choices for Fed chairman ever. He is likeable, intelligent, well educated – and has the wrong job. Of course he was purposely chosen precisely because of his famous ‘helicopter speech’ in 2002, that identified him as someone who would not shy away from printing copious amounts of money once the credit bubble collapsed. It will ultimately create an even worse problem, unless the policy is reversed (and it sure doesn’t look like it will be).

  • Ovid, Pater is merely presenting books which contain ideas he disputes. Yesterday, his topic was Krugman, whose books were presented and had prices well in excess of $100 each. His writing was clearly anti-Krugman. None of these guys seem to recognize the effect of misallocated capital, excessive debt (Bernanke and Greenspan were totally clueless or if not clueless, dishonest) and the fallacy of government directed business. What we have had was a series of serial bubbles, starting with the Japan mess, followed by Asia, the stock market and housing. The result is too many houses and too much debt and now deflating prices. The policy is to stop the deflation and what we are going to get is a world where middle class retirement will be impossible and an eventual financial collapse of the United States. This is one of the best sites I have found in awhile.

  • rootwad:

    I love it …Physics Envy

    I see it all the time ….

  • ovid:

    Interesting to me that at the same time that you ridicule the progress that has been made in monetary policy analysis, you happily advertise books written by Mishkin and Gali, two of the major proponents of “monetary science.”

    Ain’t capitalism a wonderfully consistent paradigm?

    • Please note that the ads for books are picked by Amazon automatically – apparently it looks at keywords in the articles and then chooses from those which books to display. It does not mean I agree with the content of the books diplayed. As you can probably imagine I am very critical of the theories espoused by Mishkin et al.

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