Friday, October 31, 2008

David Brooks

It's far to much work to write about everything David Brooks says, but one of his last columns was fairly irritating, as it continues the "behaviorist" trend he's been talking about a lot.

First, there is notion that somehow economics "doesn't explain" what's going on. Well, the decision of millions of Americans to stop saving and withdraw equity from this homes is a fairly rational response to the Greenspan put of record low interest rates and booming house prices. Actions by banks to leverage up and take advantage of these trends are also fairly predictable. The Austrians actually have a good story of the liquidity boom and collapse as well. If you actually care to understand financial collapse, there are a wealth of sources, from blogs to Krugman and Brunnermeir, that manage to describe ongoing events well enough. Many of these people were pessimistic several months ago. The models I use at work to describe trends in mortgage default rates work rather well especially if you stress them with house price decreases. The problem wasn't "modelling," but rather models that failed to take into account the underlying changes in the types of people getting mortgages.

Much of the behaviorist stuff, however, doesn't seem to me particularly well targeted at explaining ongoing events. Even if you buy Mandelbrot and Taleb that the tail ends of stock returns are fat, why should volatility increase now? The problem with a philosophy that people are just "stupid" is that it really lacks the ability to explain changes over time, or to explain ongoing events, or to predict future events. It works great for blaming people ex post, however, and makes for a good column. Even many of the Nudge policy prescriptions--improve information, set defaults correctly--seem exactly the neoclassical prescription as well.

For the behaviorists to get better at modeling actual economic problems of interest, they're probably going to have to move from a system that goes "people in general are stupid, as judged from undergraduates in labs" to "in certain conditions, more psychologically realistic assumptions yield better explanatory and predictive power."  That is, behavioral work would be really good at explaining heterogeneities in the population.  There is some good work heading in this area--that poor people have high time discount rates, for instance, but even there it's tough to separate a behaviorist from an economic approach.

Friedman's approach of using whatever assumptions are needed to explain the data probably isn't ideal either. Clearly the quality of the assumptions and the sanity of the model do matter, and most people do care about economic intuition. So there's nothing wrong with behavioral assumptions.

The big problem I have with this whole train of thought, however, is this implicit assumption that psychology is "better" than that abstract economics. Really? Every theory is wrong, so the power of the behaviorist critique ought to be judged by the quality of their insights and the strength of their competing model. And it's not like psychology doesn't have a host of problems of its own. First of all, it's entirely descriptive, rather than explanatory; an uncomfortable mix of "facts" that barely pass the p = .05 criteria of truth. When was the last time you saw an experimental study support the null hypothesis? Either these people have a fantastic record of picking hypotheses and running tests, or else experimental error is strife, or else they are suppressing all sorts of things. Their "biases" often extend in both directions, and often feel like things that good Bayesians should do anyway. It's not clear the extent to which biases  persist in outside of the lab, where social interactions are complex, or even to what degree they effect a given individual, after all of the potential moves in a direction are netted out.  For instance, the "Gambler's fallacy" says that people expect a coin to come out heads after many tails.  But the "hot hand" fallacy suggests that people should expect a run of tails to be followed by another tail.  Which result dominates?  It's not clear to me that the existence of human failings is an alternative, and better, explanation of ongoing events.

Brooks is, however, right about two things. For one, much of macroeconomics is rather bad at figuring out what's going on. What macroeconomic theory says the government should buy equity states in banks, or buy failing assets? Economists may support either position, but don't generally rely on macro to do so. The representative agent models don't capture the connections and risk that are driving a lot of systemic problems. One problem here seems to be, well, that the rational expectations movement has bound macro to microeconomic assumptions. Of course, the Sonnenschein-Mantel-Debreu theorem shows that microeconomic assumptions need not entail any macroeconomic consequences. People don't talk about this a lot. A reasonable conclusion seems to that people should do macro using whatever assumptions they please.

It's also true that the notion ownership hasn't worked out great. No one had a bigger incentive to make sure Iraq went well than the neoconservatives, yet it took a while for people to start caring.  Of course, as political actors, they had relatively lighter incentives to change their (fairly wrong) priors on the possibility of the spread of democracy.  Similarly, the bank executives had plenty of their own money at stake, yet continued to make outsize risks anyway. Many people did respond to ownership well, such as those hedge funds that correctly bet against the housing bubble or Goldman Sachs, but plenty did not. It's not clear what happened here.  It's much easier to justify taking the risks everyone else is taking, since you'll all fail at the same time.  But since your money it at stake too, shouldn't you care about the absolute return as well?  The loans that banks kept on their books failed as well as the loans they securitized and sold off to others.  What system of incentives, if any, could encourage people to actually do risk analysis?  This is not just a "suprime" problem; Emerging Market Debt was badly priced in Europe, while the rating agencies in general gave private firms too high marks relative to municipal governments.  Maybe people are just bad at analyzing risk, even with lots of their own money at stake.  

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