FCIC: Hidden Assumptions and Policy Debates

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.’[6]

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.


3 thoughts on “FCIC: Hidden Assumptions and Policy Debates

  1. Thanks for the explanation of the FCIC inquiry/outcome; it was apparently designed to continue the charade – extend and pretend! It seems obvious that Wallison is a defender of the crooks who create the myths (assuming that he is not also the creator). I recall reading Dr Bill Mitchell’s autobiographical comment regarding his finding (during grad school), that certain of his teachers/classmates (U of Manchester, UK as I recall) not infrequently employed statistical tools inappropriately in efforts to deal with poorly designed economics projects. As you remind the reader in this report, the math and statistics procedures employed by certain economists are usually straight-forward; the assumptions as to appropriateness of applicability is all too frequently questionable.
    As a retired biochemist, I am not qualified to criticize economists’ behaviors. However, professional standards of most scientific and engineering organizations do not tolerate unethical (or pretend) authority figures. You may recall that when Alan Greenspan was awarded the post of head of the Fed Reserve, Russian refugee novelest Ayn Rand accompanied him to the award ceremony. A Greenspan’s economic philosophy was reported to change over time; reports of the Fed Reserve’s meetings were always introduced with conditions assumed – as if the media were unable to understand his language (apparently, his bosses/associates on Wall St and at the Dept of Treasury understood). In a fashion similar to that of L Blankfein (God’s emissary), A Greenspan (who recently mentioned that he may have made a mistake or two) must think that he too deserves special consideration (though not necessarily for decisions which harmed the economy of the USA). Obviously, in these types of situations involving finance and politics, concepts such as professional ethics appear not to exist.

    • Yes, Wallison is one of the creators of the problems. He works at the American Enterprise Institute (a right-wing, free-market fundamentalist think tank) where he heads up the Financial Deregulation program. He would no doubt be fired if he admitted that improved regulation could have prevented the crisis.
      It is ironic that what the economics profession has most desperately wanted in the past century is to become accepted as and viewed as “objective scientists”. Within the discipline it’s called “physics envy”. Yet as a whole, they (we) have refused to behave like other scientific disciplines. As you note, professional standards are common and largely enforced/monitored in most scientific and engineering organizations. Yet, the American Economic Association has only just this month gotten to a code of ethics. See NPR story here. One of the greatest, yet largely hidden, problems is the manner in which the consulting money and job opportunities that banks and The Federal Reserve offer tends to enforce a limited, orthodox view of macro and monetary theory. A view that, not surprisingly, is favorable to banks and The Fed. You mention Bill Mitchell, one of my favorites. It’s a blessing of the Internet and Web that Bill and Steve Keen (another dissenting Australian) can now reach my desktop and the desks of others. Maybe we can begin to breakup the orthodoxy and get back to real scientific investigation and learning.

  2. In today’s post at New Economic Perspectives, Wm K Black offers a more comprehensive presentation of the nature of hacks employed at AEI and elsewhere to provide cover/justification/alibis for the criminal financial engineers:

    Thursday, February 3, 2011
    Wallison Reinvents History – and His Own Positions on the Causes of the Crisis
    By William K. Black


    Following is the concluding summary which your readers might find interesting:

    ‘Wallison is channeling Gregory Mankiw’s (President Bush’s Chairman of the Council of Economic Advisors) infamous remark as discussant after hearing George Akerlof and Paul Romer present their paper “Looting: the Economic Underworld of Bankruptcy for Profit” (1993) (“it would be irrational for operators of the savings and loans not to loot”).

    Wallison is a lawyer, and he is read primarily by other lawyers and senior corporate officials. In criminology, we refer to what he and Mankiw did as “neutralization.” It’s designed to render the criminal and immoral acceptable. Neutralization increases crime. In a word: no. It is dishonest to report false loss reserves in order to make your bonus. It frequently constitutes looting. It typically requires the CEO to commit multiple felonies.

    Again, more importantly, if Wallison believes what he is saying then he should study philosophy and ethics and work every day to undue the corrupt culture his anti-regulatory policies have created. His dissent doubts the ethics of subprime borrowers. If he believes what he says about CEOs and CFOs he should place his ethical focus at the top of the food chain.

    The key point is that the Republican leadership knew exactly what it would get when it appointed Wallison to the Financial Crisis Inquiry Commission. He was there because he would have to repudiate his entire career before he could ever join in a bipartisan report. The tragic effect is that by trying to discredit the staff’s findings Wallison has most benefited the CEOs who have been able to commit fraud with impunity. His apologia for their “rational” “not dishonest” accounting manipulations marks a new low point in his anti-regulatory zeal. He now defends fraudulent CEOs, those he aptly calls the “genuinely wealthy,” and claims that they should be able to manipulate the accounting to maximize their bonuses. America needed a unanimous Commission willing to write that Wallison’s homo economicus concept of morality is depraved and is producing recurrent, intensifying crises. As authors of the book Moral Markets (a very pro-market volume) emphasize – homo economicus is a sociopath.’

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