Students are often curious and perplexed by the level of disagreement among economists, particularly macroeconomists. They hear the competing claims of politicians and others and get confused. While economics, and macro in particular, has always been rife with competing views, the Global Financial Crisis and Great Recession of recent years has exposed and highlighted these disagreements. Our “practical” leaders, the politicians, bankers, and businesspeople, being the “slaves of some defunct economist” as Keynes observed boil these macro disagreements down to simple one-line sound bites and slogans. Yet, students and lay-people naturally expect there should be some significant amount of agreement among the “experts” in any field and are confused by the disagreements. One of the latest of these disagreements just arrived yesterday in the form of the final report of the Finacial Crisis Inquiry Commission, the “bi-partisan” task force charged by Congress and the administration to investigate and determine the “causes” of the financial crisis of 2008. As befits our times, there was not a single final report, there was a report of the majority and not one, but two, dissenting minority reports. This post is less about the FCIC report and the crisis than it is about the flaws and unconscious thinking that leads to different conclusions in macro. If you are interested in the report, I urge you to go to Calculated Risk’s summary – it’s short and an easy read.
The source of much disagreement comes not from errors in calculations or math or logical inference from models. Most economists are competent in those areas. Instead, the disagreements and confusion comes from two sources, in my opinion. First, is that economists are prone to “sticky” ideas born of ego and the difficulty of accepting that empirical data or results may have actually disproved some elegant pet theory. This is source of Zombie Economics. Occasionally a prominent economist repents but such events are notable because of their rarity.
I want to talk about the second cause here: hidden assumptions. When models and theories are published, it is normal to state some “assumptions”. Usually the stated assumptions are technical. They’re the values used for certain variable or coefficients when interrogating the model. Often the stated assumptions are just simplifications to make the model usable: things like assuming there’s a “single representative household” instead of explicitly including the variety of households that exist in the real world. What doesn’t get stated are the hidden assumptions. For example, it’s been fashionable in macro research now for 20-30 years for macro models to all be based on what are called DSGE models. Indeed it’s been difficult to publish a model that wasn’t DSGE. Yet, the very choice of such a type of model makes some a priori assumptions that usually aren’t explicitly stated. These assumptions are hidden – they form the background. In the case of DSGE models, among the assumptions is that the economy is always at or very near equilibrium, that markets clear. This by itself pretty much eliminates the possibility of having extended, high involuntary unemployment exist in the model since the labor market itself must clear by definition. Not surprisingly, some economists that are married to the DSGE approach denied the existence of high unemployment throughout our crisis, preferring instead to claim that would-be workers were voluntarily refusing to work because they’re holding out for too-high of a wage. In the case of DSGE, Robert Solow noted in Congressional testimony:
‘I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way… The protagonists of this idea make a claim to respectability by asserting that it is founded on what we know about microeconomic behavior, but I think that this claim is generally phony. The advocates no doubt believe what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether.’
My point is that these hidden assumptions, and the logical implications of them, are too often ignored. Yet these hidden assumptions are often more powerful in determining the conclusions than any other factor. To make things worse, the hidden assumptions are often made because they are ideologically attractive. Because the assumptions remain unstated and hidden, they are in effect, unconscious. As my friends in psychology warn, what remains in the unconscious remains powerful. We learn and gain power when we bring to consciousness.
In the interest of bringing such hidden assumptions to consciousness, I want to return to the just released FCIC report. One of the authors of the dissenting opinion is a Peter Wallison. The media are breathlessly covering his comments and views, and indeed, giving both he and Douglas Holtz-Eakin, another dissenter, IMO, out-sized coverage relative to the main report. [shouldn’t the majority opinion get at least as much airtime and coverage as the minority dissent report reflecting the views of one person?]. Anyway, Wallison dissents from the idea that regulation could in any way have prevented the Financial Crisis, despite the evidence assembled by the majority. Instead, Wallsion adopts the curious view that the crisis was NOT the result of failed regulation but instead he maintains that it was the result of government housing policy. I am tempted to dwell on the inherent conflict in his position: government policy (banking regulation) cannot/did not cause the crisis through poor regulation of financial markets, yet government policy (an obscure mortgage market regulation that didn’t affect private banks) is powerful enough to crash the system. But I won’t dwell on that here. Instead, I want to examine why Wallison dissents. William Black at New Economic Perspectives, offers a much longer and more in-depth examination of Wallison’s views. I just want to quote a piece of Black’s outstanding criticism here. Black is pointing out that Wallison has thoughout his career taken the position that absolutely no regulation of banking is necessary. That is correct, he views any and all regulation of banking as being totally unneeded. He concludes, despite historical evidence, that banks would perfectly self-regulate, be stable, and never have a crisis if a government were to simply and completely ignore them. Why does he think this? It follows logically from the hidden assumptions he makes about how bankers and people would behave in such a world. He has no evidence of how they would behave, he simply assumes they would self-regulate. He “expects” it. Black writes:
He believes in complete deregulation – banks deposits should not be insured by the public and banks should not be regulated.
I have critiqued Wallison’s claims about the current crisis and explained why I think he errs. I will return to this task in future columns now that he has written a lengthy dissent. In this column I will discuss a portion of a shorter, even more revealing article that he wrote that exemplifies what I will argue are the consistent defects introduced by his anti-regulatory dogma in each of his apologies for a series of financial deregulatory disasters over the last 30 years.
Wallison wrote an article in Spring 2007 (“Banking Regulation’s Illusive Quest”) criticizing a conservative law and economics scholar, Jonathan Macey, who had written an article about financial regulation. Wallison was disappointed that Macey, who typically opposes regulation, concluded that banking regulation was necessary. Wallison wrote the article to rebut Macey. I’ll discuss only the portion of Wallison’s article that seeks to defend S&L deregulation.
Wallison begins his critique of Macey by asserting:
If the business of banking is inherently unstable, it would long ago have been supplanted by a stable structure that performs the same functions without instability.
Why? That assumes that there are banking systems that are inherently stable and that the market will inherently establish such systems. There is nothing in logic or economic history that requires either conclusion. Economic theory predicts the opposite. Indeed, the paradox of stability producing instability was Hyman Minsky’s central finding.
Wallison does not support his assertion. The accuracy of the assertion is critical to Wallison’s embrace of financial deregulation. If banks are inherently stable, then financial regulation is unnecessary. He assumes that which is essential to his conclusion. His closest approach to reasoning is circular and unsupported.
In the absence of regulation or deposit insurance, one would expect to see banks hold sufficient capital for this purpose, simply because instability would result without it and instability would make it difficult for banks to acquire deposits.
So, absent regulation and deposit insurance, bank instability cannot exist because instability would make banks unstable. Banks would want to be stable, so Wallison “expects” that they would hold “sufficient capital.” His “expectation” is his conclusion. One does not prove one’s conclusions by “expect[ing]” that they are true.
Wallison’s mind is closed. It was absurd to have him on the commission because he is unable and unwilling to examine his assumptions and open his mind to facts. This isn’t economics or research or debate. It’s ideology and evangelism. Rational investigation and learning isn’t possible unless we openly state all our assumptions and critically examine them. Examining the unconscious isn’t just for the shrink’s couch.
Unfortunately, the media will provide Wallison with ample opportunity to expound his fantasy-based ideas. The Republican party/ Fox news echo chamber will no doubt repeat his assertions until they gain legitimacy through loud repetition. But the TV news cycle won’t critically examine the thinking behind Wallison’s assertions. They can’t afford to spend 15 minutes of TV time thinking it through. They don’t have time – they have to hurry to repeat the same simple 30 second assertions 30 times. And students and lay-people will continue to be confused about why these “experts” in macroeconomics cannot agree on anything.