The lesson of Cassandra -- sometimes it's no fun being right

Mark Thoma has taken Paul Krugman's one-day hiatus from his column as an opportunity to pull from the archives an extraordinary piece by Krugman from back in the late Nineties. I limited myself to one paragraph but the whole thing merits a careful reading when you get the chance. You'll find that in 1998, Krugman was saying most of the same things he'd be saying in 2011:

I don't know what provoked [Robert] Samuelson's outburst. But if one of our most well informed economic journalists has come to disdain macroeconomics, this may be because he has been listening to economists themselves. Over the past 30 years, macroeconomics--and especially that part of macroeconomics that concerns itself with recessions and depressions, in which the economy as a whole is less than the sum of its parts--has fallen steadily into disfavor within the economics profession. As late as the mid-1970s, many textbooks still followed the lead of Paul (no relation to Robert) Samuelson's classic 1948 Economics, beginning with the macroeconomics of booms and slumps and turning to microeconomics only in their second half. Nowadays, however, every textbook (yes, even the one I'm writing) relegates macro to the second half. Even within the macroeconomics half, more and more books (like the much-hyped new text by Harvard's N. Gregory Mankiw) dwell on "safe" issues like growth and inflation as long as possible, introducing the question of recessions and what to do about them almost as a footnote.

Paul Krugman has no shame

No honorable man would use this title, even if the topic is core inflation. Even Shakespeare would have said this one goes too far.

"The Instability of Moderation"

Some essential Krugman today. You may not agree that we've entered the Dark Age of macroeconomics but Krugman makes a good case for how and why things got so bad:

The brand of economics I use in my daily work – the brand that I still consider by far the most reasonable approach out there – was largely established by Paul Samuelson back in 1948, when he published the first edition of his classic textbook. It’s an approach that combines the grand tradition of microeconomics, with its emphasis on how the invisible hand leads to generally desirable outcomes, with Keynesian macroeconomics, which emphasizes the way the economy can develop magneto trouble, requiring policy intervention. In the Samuelsonian synthesis, one must count on the government to ensure more or less full employment; only once that can be taken as given do the usual virtues of free markets come to the fore.

It’s a deeply reasonable approach – but it’s also intellectually unstable. For it requires some strategic inconsistency in how you think about the economy. When you’re doing micro, you assume rational individuals and rapidly clearing markets; when you’re doing macro, frictions and ad hoc behavioral assumptions are essential.

So what? Inconsistency in the pursuit of useful guidance is no vice. The map is not the territory, and it’s OK to use different kinds of maps depending on what you’re trying to accomplish: if you’re driving, a road map suffices, if you’re going hiking, you really need a topo.

But economists were bound to push at the dividing line between micro and macro – which in practice has meant trying to make macro more like micro, basing more and more of it on optimization and market-clearing. And if the attempts to provide “microfoundations” fell short? Well, given human propensities, plus the law of diminishing disciples, it was probably inevitable that a substantial part of the economics profession would simply assume away the realities of the business cycle, because they didn’t fit the models.

The result was what I’ve called the Dark Age of macroeconomics, in which large numbers of economists literally knew nothing of the hard-won insights of the 30s and 40s – and, of course, went into spasms of rage when their ignorance was pointed out.

Political instability

It’s possible to be both a conservative and a Keynesian; after all, Keynes himself described his work as “moderately conservative in its implications.” But in practice, conservatives have always tended to view the assertion that government has any useful role in the economy as the thin edge of a socialist wedge. When William Buckley wrote God and Man at Yale, one of his key complaints was that the Yale faculty taught – horrors! – Keynesian economics.

I’ve always considered monetarism to be, in effect, an attempt to assuage conservative political prejudices without denying macroeconomic realities. What Friedman was saying was, in effect, yes, we need policy to stabilize the economy – but we can make that policy technical and largely mechanical, we can cordon it off from everything else. Just tell the central bank to stabilize M2, and aside from that, let freedom ring!

When monetarism failed – fighting words, but you know, it really did — it was replaced by the cult of the independent central bank. Put a bunch of bankerly men in charge of the monetary base, insulate them from political pressure, and let them deal with the business cycle; meanwhile, everything else can be conducted on free-market principles.

And this worked for a while – roughly speaking from 1985 to 2007, the era of the Great Moderation. It worked in part because the political insulation of central banks also gave them more than a bit of intellectual insulation, too. If we’re living in a Dark Age of macroeconomics, central banks have been its monasteries, hoarding and studying the ancient texts lost to the rest of the world. Even as the real business cycle people took over the professional journals, to the point where it became very hard to publish models in which monetary policy, let alone fiscal policy, matters, the research departments of the Fed system continued to study counter-cyclical policy in a relatively realistic way.

But this, too, was unstable. For one thing, there was bound to be a shock, sooner or later, too big for the central bankers to handle without help from broader fiscal policy. Also, sooner or later the barbarians were going to go after the monasteries too; and as the current furor over quantitative easing shows, the invading hordes have arrived.

Paul Krugman and the limitations of historical analysis

I really like this post from Paul Krugman both for the reasoning and, more importantly, his awareness of the limitations.

So, about the first point: economic history is a great source of evidence about how the economy works – in fact, pretty much our only source. And the RR project, drawing on evidence from much further back and farther afield than usual among economists, was a great idea.

But there are usually major problems with historical analysis, no matter how much data you have, because it’s very difficult to isolate the things you’re interested in. There’s an old line to the effect that everything in the economy affects everything else, in at least two ways; this gives enormous room for spurious correlation. Econometrics is supposed to provide ways to disentangle the effects of multiple factors, but it’s difficult, and my sense is that few big arguments in economics have ever been settled by multiple regression analyses, let alone by all the sophisticated techniques developed these past three generations.

But Reinhart-Rogoff is relatively robust to these problems. Why? Because it focuses on extreme events. Financial crises are very big things, sharply concentrated in time. As a result, it’s reasonably certain that the economic developments in the aftermath of a financial crisis were driven by that crisis, not by other stuff that may have been going on.

Of course, not all economists are so careful when it comes to drawing their conclusions.

Elegance and Economics -- a choice comment from Paul Krugman

From "How did Economists Get It So Wrong?" (September 2nd, 2009):

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

And in the wake of the crisis, the fault lines in the economics profession have yawned wider than ever. Lucas says the Obama administration’s stimulus plans are “schlock economics,” and his Chicago colleague John Cochrane says they’re based on discredited “fairy tales.” In response, Brad DeLong of the University of California, Berkeley, writes of the “intellectual collapse” of the Chicago School, and I myself have written that comments from Chicago economists are the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten.

What happened to the economics profession? And where does it go from here?

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.

What Auteur Theory and Freshwater Economics have in common

(the first draft is the dominant genre of the internet. Between the roughness of this essay and my extensive ignorance of criticism and economics, I'm sure there is plenty of room for improvement here. If any readers have suggestions for taking this to the next level please let me know.)

(you might want to read this New York Times piece by Paul Krugman before going on -- it's the best primer I know of for this debate.)

We'll define freshwater economics as the theory that economic behavior (and perhaps most non-economic behavior) can be explained using the concepts of rational actors and efficient markets and auteur theory as the idea that most films (particularly great films) represent the artistic vision of a single author (almost always the director) and the best way to approach one of those films is through the body of work of its author. Both of these definitions are oversimplified and a bit unfair but they will get the discussion started.

At first first glance, these theories don't seem to have much in common, but as we step back and look at them in general terms, fundamental similarities start to emerge in their styles, their ecological niches and in the way they've been received.

Compared to their nearest neighbors, film criticism and economics (particularly macroeconomics) are both difficult, messy fields. Films are collaborative efforts where individual contributions defy attribution and creative decisions often can't be distinguished from accidents of filming. Worse yet, most films are the product of large corporations which means that dozens of VPs and executives might have played a role (sometimes an appallingly large one) in determining what got to the screen.

Economists face a comparably daunting task. Unlike researchers in the hard sciences, they have to deal with messiness of human behavior. Unlike psychologists, microeconomists have few opportunities to perform randomized trials and macroeconomists have none whatsoever. Finally, unlike any other researchers in any other field, economists face a massive problem with deliberate feedback. It is true that subjects in psychological and sociological studies might be aware of and influenced by the results of previous studies but in economics, most of the major players are consciously modifying their behavior based on economic research. It is as if the white mice got together before every experiment and did a literature search. ("Well, there's our problem. We should have been pulling the black lever.")

Faced with all this confusion, film scholars and economists (at least, macroeconomists) both reached the same inevitable conclusion: they would have to rely on broader, stronger assumptions than those colleagues in adjacent fields were using. This does not apply simply to auteurists and freshwater economists. Anyone who does any work in these fields will have to start with some sweeping and unprovable statements about how the world works. Auteurists and freshwater economists just took this idea to its logical conclusion and built their work on the simplest and most elegant assumptions possible, like Euclid demonstrating every aspect of shape and measure using only five little postulates.

(Except, of course, Euclid didn't. His set of postulates didn't actually support his conclusions. The world would have to wait for Hilbert to come up with a set that did. The question of whether economists need a Hilbert will have to wait for another day.)

Given that we have two similar responses to two similar situations, it is not all that surprising to see that both schools of thought have followed similar paths and have come to dominate their respective fields. I don't think that anyone would argue that any institution has had more impact on economics than the Chicago school over the past fifty years and I doubt you could find a theory of film that comes close to the impact of auteurism over the same period.

This dominance was achieved despite serious criticisms and counter-examples. When the writer William Goldman (Butch Cassidy and the Sundance Kid, Princess Bride, many, many, many others) heard about auteur theory, his reaction was "What's the punchline?" The sentiment was echoed by many writers who pointed out that many of the elements that the critics discussed were determined, explicitly or implicitly in the script. On related grounds, others pointed out how many of the creative decisions were made in preproduction often before the director was hired (John Huston said that a film was mostly finished once you had the cast and the script). Others talked about films that were "saved in the editing room," a common Hollywood expression for films that are radically changed for the better in post-production, usually after having been taken away from the director. Many (including Goldman) argued that films were the sum of many individual contributions and that changing any of them would result in a different movie.

Critics of classical economics question the realism of the school's postulates. They suggest that the proposed 'homo economicus' would have to be a cross between a lightning calculator and a high-functioning psychic. They point to findings from behavioral economics that show individuals failing to act according to neoclassical principles and historical cases where neoclassical models failed to predict economic events.

Both schools of thought partially address these complaints by arguing that their critics are trying to apply their ideas in cases where the necessary conditions don't hold. For auteurists, conditions included technical competence, recognizable style and a sufficient body of work. For freshwater economists, conditions included symmetry of information, a sufficient pool of buyers and sellers, a lack of externalities and freedom from government influence. These conditions did not refute the criticisms but they did provide defensible positions.

There is nothing unusual, let alone improper about proponents of a theory laying out conditions that have to be met before their concepts can be applied. (I could have written essential the same paragraph about Keynesians or deconstructionists.) What makes this notable is the disconnect between this approach and the way lay people use these ideas.

The dominance of auteurism and the Chicago School is, if anything, greater when you venture outside of academia. Most financial journalists, pundits and politicians take the power of market forces as a given and the vast majority of movie reviewers routinely assume that the director is the author of the film they just saw, but in both these cases with very few exceptions, the lay people using these theories have no idea that the conditions of the previous paragraphs even exist.

The problem with auteurism is compounded by the fact that most reviewers have no idea what a director actually does. This was certainly not true of the original French critics who popularized the theory (who were, themselves, directors) or of its primary American proponent, Andrew Sarris, (who went to great pains to discuss exactly and also set out the definitive list of the conditions I referred to).

Today most reviews will use the possessive form of the director's name then proceed to discuss everything about the film but the direction. The strange result of all this is that directors are both the most overrated and under-appreciated of movie makers. They are given credit for the work of everyone else while their own contribution is generally ignored.*

Obviously, the stakes are higher for economics but the disconnect is just as big. Open up any op-ed page or tune in any news conference and you are likely to find someone using freshwater arguments in situations where any serious freshwater economist would tell you they don't apply. For example, it is easy to pundits and politicians who believe we should let the market forces handle global warming instead of having a carbon tax, despite the pro-tax position of economists like Laffer, Cowen and Mankiw. It isn't that these laymen are consciously disagreeing with these experts; they simply don't know that using taxes to address externalities is a fundamental part of the philosophy they think they are espousing.

Finally, both schools had clear winners and have been aggressively promoted by those winners. Directors were the big winners in auteur theory; they gained power and prestige which in an industry that knows how to reward those attributes. It may not have been entirely a coincidence that the original auteurist critics had their careers as directors enhanced by the rise of the theory.

In economics, there is no question that the rise of freshwater ideas and approaches have been advanced considerably by institutions like the American Enterprise Institute and the Heritage Foundation, nor is there any question that much of the funding for these institutions came from companies that directly benefited from the dominance of freshwater economics.

Do these schools deserve their positions of dominance? That's a question for people above my pay grade. I'm just pointing out that widely separated disciplines can be surprisingly similar when you take things to a high enough level.


* For a view of how little influence some directors have on actors' performances check out these comments by Robert Mitchum (cutter in this context means film editor).

note: The Paul Krugman link at the top was added 5/31/10.