Eight Unanswerable Questions

1. Is the EMH true?
2. Free will or determinism?
3. Poor countries; is it bad policies or bad culture?
4. Do we know the Truth about reality, or do we merely regard things as true?
5. Would economic problem X have been prevented by better regulation?
6. Are murder, rape and slavery objectively evil, or do we regard them as evil?
7. Can improved foreign aid significantly affect long run economic growth?
8. The universe’s deepest structure:  pure mathematics, or  . . .  turtles all the way down?

Here’s my theory.  These questions are not about the nature of our universe, they are about the nature of our minds, our temperaments.  They reflect that fact that different people think about things in different ways.  On one side are the sort of world-weary fatalists.  On the other are the optimistic Americans with the can-do spirit.  The guys that want their hands on the steering wheel, and don’t want to be in the passenger seat.  I’m happier in the passenger seat (unless my wife is driving.)

I recall a quotation by William Easterly to the effect that the economic crisis was a point in favor of modern economics.  After all, the EMH says we can’t predict financial crises, and we didn’t.  It didn’t go over well.

I wasn’t surprised that Easterly and I would share this view, although logically there is no relationship between his views on the EMH, and on the efficacy of foreign aid.  But I would be very surprised if an American with that can-do spirit (say Jeffrey Sachs) had the same attitude.  My hunch is that people with a “can-do”  frame of mind are more likely to all line up on the optimistic side of these 4 economics and 4 philosophical questions (actually 3, the last was a joke.)

Given my views on the EMH, can you guess my views on free will and determinism?  Hint:  I’ll present both sides:

Determinism:  All scientific theory suggests that at the macro level, events are caused by the laws of science interacting with the pre-existing states of the universe.  This allows no role for free will.  At the micro level some events seem to be random, but those also don’t seem to involve free will.

Free Will:  Come on!  If there is a salt and pepper shaker in front of me, obviously I can choose to pick up the salt shaker, or I can choose to pick up the pepper shaker.

Compare that with two views of the EMH:

Pro-EMH:  Economic theory suggests that if asset prices had obviously moved away from their equilibrium position, investors would take advantage of the situation by going long in undervalued markets and short in overvalued markets.  This would eliminate any obvious mis-pricing.

Anti-EMH:  Come on:  If house prices are far too high relative to income, or stock P/E s are way too high, then you obviously have a bubble.

Robin Hanson wants some sort of test to see if there is a magic formula that can beat the market.  But in my “alchemist” post I argued that such a formula would be worth billions of dollars if held privately, but the value of the formula would fall to zero if published in a scientific journal, just as would the formulas for turning lead into gold—and yes, alchemists do know how, but they are not so stupid as to publicize the formula. So we will never see Robin’s proposal enacted in a way that is acceptable to all sides.  If something seems to work initially, arbitragers will quickly eliminate any easy profits, and the EMH guys like me will say the initial success was just luck.  It’s not about tests, it’s about how you think about reality.  It is about whether you see yourself as a passive observer of reality, or an active agent of change that can “just do it.”

BTW, these views are not necessarily reflected in the way that people behave, but rather how they think about things.  Everyone behaves as if free will exists, regardless of their philosophical orientation.  And I like the term ‘orientation’ better than beliefs, as these varying outlooks are analogous to one’s sexual orientation.

Part 2:  Did government cause the crisis?

Vernon Smith says yes:

And we got into the business of, particularly at the federal level, the Community Reinvestment Act in the 1990s became a means by which the federal government enabled, wished to enable people of modest means to buy a home and so as a result that act created scoring system for private lenders whereby if they got good scores by aggressively, more aggressively making loans to people whose incomes were below 80% of the median those scores helped them, gave them, enabled them to more easily get approval for making expansions in regional banks and these scores were used in helping to decide whether to approve mergers, this sort of thing.  Various devices were used to encourage private lenders to more aggressively make loans on homes to be purchased by people of modest income and what we got from that was a particularly strong demand for homes at the low end of the pricing tier.

Whereas Tyler Cowen and Paul Krugman say no:

This is actually a very broad problem with all accounts of the crisis that try to exonerate the private sector and place the blame on the government and/or the Fed: none of the proposed evil deeds of policy makers were remotely large enough to cause problems of this magnitude unless markets vastly overreacted. That is, you have to start by assuming wildly dysfunctional financial markets before you can blame the government for the crisis; and if markets are that dysfunctional, who needs the government to create a mess?

BTW, this is a Krugman quotation, which Cowen calls “excellent.”

I am inclined to agree with both quotations, at least partially.  I should clarify that Vernon Smith did not explicitly blame the government, I just assumed most people would infer that from his remarks (very similar to my commenter Patrick.)

Here’s my take.  The government thought it a good idea to encourage banks and also F&F to make more loans to lower income people.  And the government thought this would not lead to a financial crisis that devastated banking. Private banks were partly encouraged by the government, but mostly simply decided that they could make money on lots of sub-prime lending.  And they also thought these actions would not devastate the financial system.  Indeed, you’d really have to have strong ideological blinders to argue against either of these assertions.

If I am right then society simply made a big mistake.  But most people aren’t satisfied with that answer.  We want villains, and we want policy implications.  I’m not much interested in looking for villains in either the public or private sector (excluding my Congressman of course) but I am interested in policy implications.  So if we roll back the clock, what do we do if both the government and the private sector are suffering from the sort of mass delusions that used to affect medieval villages that had a crop of bad mushrooms?  Obviously there is nothing we could do to directly address the bubble, unless you bring in a deus ex machina solution.  If Republicans and Democrats and bankers all missed it, and all wanted to shovel more money to borrowers with no income and no down-payment, then we are stuck.

But maybe there are alternative economic systems that could make those episodes of mass hysteria do less harm.  If you are a Democrat, perhaps the way to encourage more home ownership (a goal I don’t share, BTW) is to give tax credits to first time low income home buyers.  This doesn’t put our financial system at as much risk.  If you are a Republican you might want to abolish F&F, other countries get by fine without them.  If you are a libertarian you might want to abolish FDIC and TBTF.

Vernon Smith tends to favor free markets, but worries about the fragility of the banking system.  I think it is much less fragile than he thinks, because he wrongly attributes the problems of the 1930s to bad banking, whereas they were actually caused by the Fed letting NGDP fall in half.  Banks were actually far more conservatively run in the 1920s than the 2000s.  But he’s not a macro-historian, so his view is understandable.  Let’s say he is right that the system is inherently unstable, and also assume we are stuck with FDIC and TBTF. What then?  Smith gives what seems to me to be the only plausible answer:

And so what is important is really to avoid these kind of crisis situations in the first place and because they’re so difficult to deal with once we get into them because if nothing else the politics of these situations will drive policy and the politics is not necessarily good long term economic policy and of course the way to have avoided this kind of a problem in the first place was to have better collateralization of the kinds of loans that we’re being made in the housing market and generally in consumer credit markets.  It’s not only the housing market, but it’s also credit card debt, student loan debt, automobile loans, all of those credit markets, which ended up being the kinds of private credit instruments that the Federal Reserve found itself necessary to make loans on in 2008.

.   .   .

Born is seen now as something of a hero because she wanted to reexamine the question of the exempt status of those instruments and I think actually a fairly simple regulatory change for those derivatives is all that is called for and that is simply require them, derivatives to be listed on exchanges.  If you did that the exchanges then would require them to be collateralized and that is to me the main problem in the derivatives market, particularly that was true in the housing mortgage derivatives market because those are essentially markets where people are making bets on whether a certain class of mortgage backed securities are going to suffer default and the providers of that, the seller of those contracts. You see that’s a form of insurance in the sense the person who buys those contracts sees that as a way of hedging their risk of default, but it’s not insurance if the sellers of those contracts are not required to collateralize the contract and generally those contracts were not required to be collateralized.  This is basically how AIG go into trouble.

.   .   .

So to me it’s what is needed here is not some kind of heavy handed regulation, but simply an application of principles that we’ve already learned a lot about in other markets.

Collateral, collateral, and more collateral.  That’s the only practical answer.

Krugman seems to think it is realistic to expect regulators to spot bubbles in real time, and then do something about them.  Smith is more skeptical:

Question: What is the proper role of regulation in these markets?

Vernon Smith: I don’t think there is anything you can do to prevent bubbles.  I think we’ve had frequent stock market bubbles that have self corrected and the burden of those bubbles and the pain is basically borne by the investors in those markets and you do not have collateral damage to the economy from bubbles in stock markets like you have in bubbles with housing and generally with consumer durables and I think the solution in the housing and the consumer durables markets is the same as the solution that we’ve worked out institutionally in stock markets and that is require these purchases to be reserved, collateralized.

We can’t stop the winds from blowing.  Let’s build a financial system that can survive strong winds, not one that collapses in a light breeze.

Then let’s build a monetary policy that stabilizes NGDP growth.  Arnold Kling seems to think there is something inexplicable about the severity of this recession.  I don’t quite understand his puzzlement.  Standard macro theory (as illustrated in the AS/AD graph in the new Cowen/Tabarrok textbook) says that if NGDP suddenly grows 8% below trend then there will be a sharp drop in RGDP.  The severity of the drop is exactly what one would expect in a world of sticky wages (sticky relative to the fall in NGDP, not relative to the also sticky prices.)  The only interesting question is why did NGDP suddenly start growing 8% below trend.  That’s what this blog is mostly all about, but I’ve already gone on way too long.

PS.  Kling also makes this cryptic comment:

The Keynesian story at least has some microfoundations. Scott Sumner’s Y = expected MV/P story is just hand-waving.

I recall discussing expected NGDP, but never expected MV/Y.  And I use changes in expected future NGDP to explain changes in current NGDP, as do all the modern new Keynesians as far as I can tell.  So I am not quite sure how to respond to Kling.  I suppose my microfoundations are a bit more sticky-wage and a bit less sticky-price than those of the average Keynesian, but you can get a severe recession under either assumption if NGDP falls.

In fairness to Kling, while the severity of the recession is easily explicable, I expect the recovery to be slower than predicted by natural rate models due to a 40% jump in the minimum wage, 73 week extended unemployment benefits, and other supply-side problems created by Congress.