BLF – in denial

I was reading an interesting study the other day that helps us understand why the macroeconomic policy debate is so awry at present. The paper – Cognitive dissonance, the Global Financial Crisis and the discipline of economics – by Adam Kessler an economist at a Florida university demonstrates that the mainstream economists who are highly influential in the current policy debate suffer from “cognitive dissonance” which leaves them in denial of the facts. CD leads to dysfunctional opinions and if these opinions carry weight in the public debate the policies implemented are also likely to be dysfunctional. It is a sad testimony that the mainstream of my profession is largely operating in a parallel universe but bringing their crazy ideas to our universe and pressuring governments to follow policies that damage a vast majority of people. One thing that is clear – the majority of these economists never have to carry the costs of their denial and retire on nice pensions. The same cannot be said for the victims of their arrogance and denial.

Adam Kessler started:

The global economic and financial crisis of 2007-2009 (?) provides a rare natural experiment for the study of the social psychology of the economics profession. The “sub-prime” crisis of 2007, the banking crisis and credit crunch of 2007-2008 and the deep global recession which started in the United States in December 2007 constitute a powerful shock to the worldview of … economists consisting of new classical economists, real business cycle (RBC) theorists, some new Keynesians, so-called “Austrians,” the monetarist remnant, many (most?) financial economists and assorted other believers in laissez-faire. I call them the BLF for short.

The paper was written in 2010 (and hence the ? concerning the date). We might realistically time reference the crisis as 2007- given the world economy is still struggling to get free of the aggregate demand failure.

The paper aims to “apply the concept cognitive dissonance (CD) to illuminate the BLF’s responses to the crisis”.

The motivation of his study is clear: “the BLF … they have wide influence on (and often dominate) public policy discussions, especially those involving macro policy and financial regulation. They seem to be in a position to shape the “conventional wisdom” disseminated by elements of the media, institutions such as the O.E.C.D. and G-20, a number of developed-country governments and some circles within the central banking universe”.

On that point we agree – it is indisputable that the deficit and public debt hysteria has been elevated beyond all proportions as the problem when in fact it is a non-problem and merely a barometer.

This Al Jazeera article (August 24, 2011) – The economy is a ‘machine’, not a ‘body’ – by journalist Paul Rosenberg is also very interesting.

He talks about “multitude of cognitive confusions” which contributed to the crisis and the entrenched nature of it. Among them he lists the “reverse causality” fallacy such as “the widespread assumption that the federal deficit is responsible for our prolonged recession”.

Rosenberg says that:

In fact, the recession both reduces tax revenues, due to all the people out of work, and increases government spending on food stamps, unemployment insurance, etc. In both these ways, recessions cause larger deficits – and big recessions cause much larger deficits, like the one the US is running today.

All those who understand economics know that a budget outcome is made up of discretionary policy choice outcomes and the cyclical impacts (the so-called automatic stabilisers). One cannot conclude that a rising budget deficit indicates that the government is moving into a more expansionary policy stance (even though in aggregate a larger deficit (as a per cent of GDP) is more expansionary.

Kessler considers the BLF to be:

… adherents of an ideology rather than upholders of a “paradigm” or participants in a “research program”[i.e., the well-known concepts introduced respectively in Kuhn (1962) and Lakatos (1970)].

I will leave it to you to work through that argument.

Essentially, he shows that the factions that comprise mainstream economics “may share many (important) “beliefs, values…and so on,” but not techniques (or methodologies)”. So in Kuhnian sense they are not a “scientific community” but more united by an ideological hatred of government and public intervention.

Many mainstream economists still eshew the conceptual basis of macroeconomics – which is founded on the existence (and importance) of compositional fallacies that bedevil orthodox microeconomic attempts to generalise from the specific. Please read my blog – Fiscal austerity – the newest fallacy of composition – for more discussion on this point.

For example the factions (New Keynesians etc) who build DSGE models construct them based on “utility-maximizing representative agents” which ignores the aggregation problems that render this type of analysis meaningless.

But what unites the different factions is that they fiercely defend virtues and primacy of the self-regulating “market”.

So the BLF:

… strongly believe in the virtues of markets because of their efficiency properties but also for moral-ethical reasons; they believe in the self-adjusting or self-correcting economy and therefore abhor government interventions of all sorts. Along with this core set of beliefs there goes a penumbra of vaguer attitudes with respect to private property rights, the legal system, the overarching value of (particularly) economic freedom, etc. It is this ideology which the BLF defend with great vehemence.

The financial and then real economic crisis has clearly undermined the central propositions of this ideology. Kessler wants to know why “a group of trained professionals, practitioners of a scientific or scholarly discipline (or any educated person for that matter)” would “adhere to an ideology and refuse to abandon it in the face of evidence undermining its tenets?”.

His answer lies in the power of “cognitive dissonance” – a concept stemming from the work of social psychology where empirical anomalies (such as completely missing the fact that a crisis was approaching and not knowing what would solve it) “cause psychological discomfort in individuals which they strive to reduce or eliminate”.

The literature also suggests that when CD is present, individuals “will actively avoid situations and information which would likely increase the dissonance”.

That is, BLF are in denial.

Paul Rosenberg says that responses driven by CD are “dysfunctional” but:

… rampant among free market economists, who simply could not deal with the fact that their beloved free market had gone so badly awry.

He also notes that the US government (to which we add most governments in the advanced world) “also suffer from this” and notes that no “matter how many times Republicans responded to gestures of compromise by moving to even more extreme positions, Obama continued compromising, rewarding and furthering their intransigence, and he was widely supported by Democratic politicians and voters for doing so”.

Kessler provides many examples during the current crisis when the growing weight of evidence that the BLF approach was unsound was just denied to be fact – that is met by “irrational, ill-considered or clearly erroneous responses”.

I have reported in the past that during my student days a well-known professor responded to student criticism (student will go unnamed but is known to you) that “the facts” do not support “the theory” – well then the “facts are wrong”.

One example Kessler gives is the claim by prominent Chicago school economist – Casey Mulligan – that the rising unemployment in the US during the crisis was due to “a decline in labor supply, not labor demand”.

This is consistent with the mainstream claim that unemployment is voluntary and fluctuates as a result of changing supply conditions. They deny that aggregate demand can fail.

Kessler (almost in shock) says “(t)his view does not require elaborate analysis” and that a “brief look at a relatively new data set can clarify the issue”.

Kessler refers to the following ratio – unemployed workers in the United States to the number of job vacancies obtained from the Bureau of Labor Statistics’ JOLTS survey. The JOLTs data can be downloaded from the BLS as can the unemployed numbers.

I updated the series to encompass the time period January 2001 to June 2011.

I recall reading a mainstream account (I have lost the reference unfortunately) of the Great Depression that claimed the dramatic rise in unemployment was during to workers acquiring a stronger taste for leisure which led them to quit their jobs (that is, a supply response).

There have been many articles written by key mainstream economists (such as Milton Friedman) that argue that business cycles are driven by labour supply shifts. Thus all shifts in unemployment should be consistent with the behaviour of quits in the economy (that is, quits are constructed as being countercyclical).

All the available evidence is to the contrary. Lester Thurow in his marvellous book from 1983 – Dangerous Currents said:

… why do quits rise in booms and fall in recessions? If recessions are due to informational mistakes, quits should rise in recessions and fall in booms, just the reverse of what happens in the real world.

In other words, the facts completely deny the fundamental predictions of a vast amount of mainstream literature in this area.

If you examine any data on quit rate behaviour from any country you will see that the quit rate behaves in a cyclical fashion as we would expect – that is, it rises when times are good and falls when times are bad. Many studies have demonstrated this phenomenon for several countries where decent data is available. Rates of layoff and discharges, which reflects the demand-side of the labour market are always firmly counter-cyclical as we would expect. Firms layoff workers when there is deficient aggregate demand and hire again when sales pick-up. Again this is contrary to the orthodox logic.

The clear significance of this behaviour is that the orthodox explanation of unemployment is not supported by empirical reality. Given that quits are not countercyclical then the orthodox labour market model that constructs unemployment as being a supply-side phenomenon is plain wrong.

To continue to assert such a model is an example of CD or denial.

Kessler provides further examples of denial by analysing recent offerings from Robert Barro (the Ricardian Equivalence originator) and Eugene Fama the Chicago economist that is associated with the “efficient markets” hypothesis.

Kessler considers the same Fama article that I analysed in this blog – We can conquer unemployment.

Fama’s article was written in early 2009 and he introduced a version of the sectoral balances framework as a vehicle for denying that the fiscal intervention could be ffective. He provided the following macroeconomics identity:

PI = PS + CS + GS

So private investment (PI) equals the suum of private savings (PS), corporate savings (retained earnings) (CS), and government savings (GS) (the surplus).

He then recognises that “(i)n a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole”.

He then says that:

Government bailouts and stimulus plans seem attractive when there are idle resources – unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.

He also noted that “government investments are prone to inefficiency” whereas “private entities must invest in projects that generate more wealth than they cost” (his belief in efficient markets!).

So according to Fama the “stimulus spending must be financed, which means it displaces other current uses of the same funds, and so does not help the economy today.”

That is exactly the logic that underpinned the British Treasury view in 1929. There are many ways you can refute the arguments.

If you think about the Treasury view as espoused by Fama you will note that the fiscal stimulus is assumed to change (GS – downwards) – that is undermine the fiscal surplus.

He also assumes a finite pool of savings so PS and CS are unchanged. In other words, the only other thing that can change is private investment (PI) which must fall by construction.

The flaw in Fama’s argument is of-course that saving is fixed.

Think about how the impact of a fall in private consumption spending might work in this model. So PS rises. The normal inventory-cycle view of what happens next goes like this. Output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly.

They are uncertain about the actual demand that will be realised as the output emerges from the production process.

The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.

Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms layoff workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.

As national income falls, so does overall saving (as some proportion of the loss of income).

The attempts by households overall to increase their saving ratio may be thwarted because income losses cause loss of saving in aggregate (the Paradox of Thrift). So while one household can easily increase its saving ratio through discipline, if all households try to do that then they will fail. This is an important statement about why macroeconomics is a separate field of study.

Typically, the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur – in the form of an expanding public deficit or a boost to net export.

So total saving always adjusts to changes in income and if a budget deficit can initially increase income then it will not compromise the capacity of firms to invest in productive capacity.

That was the way I dealt with the Fama article.

Kessler says of Fama:

… what seems to be involved is an old error of the 1920s and 1930s, i.e., the so-called “Treasury view.”

Are these examples of which “exhibit “irrational, ill-considered, and clearly erroneous responses” to the crisis by prominent BLFs” amount to CD? Kessler notes other factors might be at work including “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”. Thus the public nature of commentary might influence how a person responds.

So to establish CD, Kessler aims to establish that there is a “widely-held false belief about the causes of the crisis” that shows up in “an anonymous survey which would eliminate the problem created by public statements”.

He uses the contention that government intervention is to blame for the crisis rather than a failure of the market to show that the vast majority of surveyed economists lean to the former view. He says that the claim that “the government did it” is an “indicator of cognitive dissonance among this large group of economists”.

Kessler uses the example of the Community Reinvestment Act (CRA) of 1977, as amended in the 1990s which he says is “a law which was designed to encourage depository institutions in the United States to supply credit to low- and moderate-income communities from which they accept deposits”.

Mainstream economists claim it was this law that led to the crisis and so government was to blame – it tried to “fix the market”.

The CRA, allegedly, forced banks to “weaken their lending standards and to extend mortgage credit to unqualified borrowers” which then “led to the collapse of the sub-prime mortgage market, and everything else follows”.

He cites many mainstream economic articles that work through that sort of causal allegation. But he also demonstrates that the CRA could not have caused the crisis because while:

… the CRA encourages banks to make safe and sound loans in the communities they serve … nowhere does it tell them to make unaffordable, unsustainable loans that set people up for failure. Most of the subprime and high risk nontraditional mortgages were made by non-CRA lenders.

He provides a raft of factual evidence that refutes the CRA did it causality. It is categorical if you consider evidence to be important.

Kessler then reports on the results on an April 2010 e-mail survey he conducted but in the interests of (my) time, I will spare you the statistical details of the research.

The overwhelming insight is that “it is not reasonable to persist in the belief that the CRA wholly or partially caused the crisis and that persistence in such a belief can be viewed as a symptom of cognitive dissonance”.


There are a number of papers now coming out studying the language that economists use – which is an interest of mine and which I will write about in due course.

But the evidence is clear on whether mainstream economists are largely in denial. Their continued assertion that:

1. Budget deficits cause interest rates to rise – when conceptually they don’t and factually they haven’t.

2. Sharp rises in bank reserves are inflationary – when conceptually they make no difference and factually they haven’t.

3. That fiscal policy is ineffective – when conceptually net public spending adds to demand and factually saved the world from a Depression.

etc, all point to them being unable to come to terms with the evidence before them and juxtapose it with their pet theories. Without doubt the body of work that we call mainstream macroeconomics fails at every level.

The question is why do the proponents of it continue to interpret events as if it was a valid core of theory – and make such idiots of themselves.?

Friday’s musical feature

This is definitely not an example of cognitive dissonance.

This song – Need your love so bad – features Peter Green who is my favourite guitarist of all time (by some distance). He is fronting the original Fleetwood Mac before they became a pop band.

This version reached number 31 in the UK Singles Chart in August 1968. By then I was a teenager and hooked on the sounds Peter Green was making. For guitar players – note the Fender stratocaster and this video was shot before he gave away his Les Paul to Gary Moore.

Nice end to this week (if you have the same taste as me anyway).

Saturday Quiz

The Saturday Quiz will be back sometime tomorrow. I noted the bluster all week – people claiming 5/5 from last week’s quiz and how they “had arrived”. We will see.

This Post Has 18 Comments

  1. Thanks for the interesting article again. Hopefully there will be a growing attention to behavioral study to understand the (flawed) current economic models. In one of the (Dutch) papers there was a big article this morning about the work of Dan Ariely about predictable irrationality and how it explains the flawed thinking of economists we have had the last decades and why it is therefore needed for governments to step in.

  2. Matthijs,

    But Dan Ariely is actually a social psychologist and he hasn’t crossed the line. He should probably be approached by some MMT scholars as his understanding of macroeconomics might be limited. His mind is not tainted and he is clever but he clearly needs some guidance otherwise he will keep promoting increasing saving propensity as a solution to the crisis.

    Someone should debunk the marginal utility theory (including the more modern von Neumann-Morgenstern variant) based on the results of the experiments performed by social psychologists. Consumer preferences depend on the context and significantly change over time. One cannot introduce a preference relation on the “consumption set”. This implies that the model where utility functions exists does not apply to humans.

    Microeconomics has very shaky empirical foundations. One may question whether neoclassical macroeconomics has been correctly derived from the microeconomic principles. I think that we don’t even need to do that. The models invented in the 18th and 19th centuries based on speculative “pre-psychology” slightly patched in 1940-1950ies do not describe the reality and some social scientists know perfectly well about that – but there is an impenetrable barrier between the world of social psychology where the infamous Stanford Experiment shows the boundaries of the influence of the group on individuals and the world of economics inhabited by rational agents maximising their convex utility functions.

  3. Unfortunately, ideas mostly spread by emotional selection rather than logical or factual selection. Few people are properly trained in logic, philosophy and the empirical method so clear thinking is rare. On the other hand, all humans are naturally born as emotional and prejudicial thinkers. The vast bulk of extant enculteration further encourges emotion, prejudice and supernatural beliefs.

    So far as cognitive dissonance goes, it is clear that people who have invested heavily in a false belief will go to any length to deny disconfirming evidence. In fact, the stronger the empirical evidence against them, the more firmly they entrench their false beliefs. What will happen is that physical reality will destroy the false belief systems (the ideational superstructure) by destroying the material basis of the system. In other words, only massive material collapse will destroy the false beliefs of late stage capitalism.

  4. “The question is why do the proponents of it continue to interpret events as if it was a valid core of theory […] ?”

    Because humans usually reason – put forward arguments – to support a conclusion, chosen in advance according to one’s set of values (or interests). This paper of Mercier and Sperber makes it clear:

    The Roman Church threatened Galileo because the “ideological system” to support the social structure of the time – why the nobles should be nobles and the not-nobles should be not-nobles – had as a key step of argumentation Earth being at the center of the world.

    Since Galileo’s time to ours, the “ideological system” to support social structure changed to become mainstream economics, more precisely BLF…

  5. Max Planck:
    “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”

  6. More relevant than Festinger’s Theory of Cognitive Dissonance is Festinger, Riecken, and Schachter, When Prophecy Fails (1956). It is especially good on what takes place among group members when reality conflicts with belief. The consequences of such conflict are neither straight-forward nor easily predictable.

  7. The first application of Lakatos’s theory and methodology to the field of economics is Latsis (ed), Method and Appraisal in Economics (1974). The basic conclusion was that the neoclassical research program was one that was degenerate.

  8. So according to Fama the “stimulus spending must be financed, which means it displaces other current uses of the same funds, and so does not help the economy today.”

    That is exactly the logic that underpinned the British Treasury view in 1929. There are many ways you can refute the arguments.

    Isn’t the simplest refutation to this argument a statement of the fact that the money the government “borrows” to fund its deficit spending wouldn’t exist in the first place if the government weren’t spending it? In other words, no one would be able to put that money to any other use if the government weren’t spending it because it wouldn’t be there to spend on anything at all.

    Maybe I’m missing something, but it strikes me as being very odd that something that seems so obvious to me (at least since I’ve been reading this blog) wouldn’t be even more obvious to trained economists. The government is borrowing money that wouldn’t otherwise exist, so how can it displace anything? It’s one thing to say that there is competition for real resources, which may or may not be true depending on economic conditions, but to say there is competition for the funds themselves is plainly stupid. Am I crazy?

  9. WHQ,

    There seems to be a split between people who can see straight away the logic of the ‘fiat spending must come first’ and those that doggedly stick to the ‘government must be funded’ model – usually with increasing anger.

    You get the same effect when you write the Quantity Theory equation the other way around PY = MV.

  10. I suspect that part of the problem is that 18th and 19th century models may have been more accurate descriptions of behavior at that time. With vastly smaller selections of goods, and more “needs” for new developments, the reality of that time was very different from the reality of today. With less choice and more needs, consumer behavior was much more predictable (ie rational) then, than it is now. Life in the wartime 1940s to early postwar 1950s was more like the late 19th century than now in terms of choices, needs and availability. I would guess that formal economics got itself stuck in a once fairly valid rut, and simply hasn’t caught up with the changing behavior enabled by the material and communications explosion of the last few decades, and of course, not with going off the gold standard and the development of investment vehicles either.

  11. Ikonoclast:
    “So far as cognitive dissonance goes, it is clear that people who have invested heavily in a false belief will go to any length to deny disconfirming evidence.”
    Cognitive dissonance is quite commonly caused by simple ignorance of all of the facts, without any issue of investment in a belief. I think what you are describing is more an issue of “paradigm paralysis” or paradigm blindness, of which cognitive dissonance may sometimes be a subset. There are well documented cases of intelligent scientists who, when confronted with evidence that invalidates a cherished belief, can’t remember the evidence only a few hours later. Their paradigm acts as a filter between reception and storage in memory.

  12. Another book people might find interesting is “The Cunning of Unreason” by Ernst Gellner. This book is a critique of the Psychoanalytic Movement and “argues that although psychoanalysis (appears to)offer(s) an incisive picture of human nature, it provides untestable operational definitions and makes unsubstantiated claims concerning its therapeutic efficacy”.

    So whilst not being about economics, the book does address obliquely the issue of theories which use “untestable operational definitions and makes unsubstantiated claims concerning… efficacy.” Sound familiar? Sound like the BLFs in economic theory?

    Gellner’s discussion of “swichen realities” in this book is very interesting too. It’s a long time since I read his book and I can’t find any references now to refresh my memory. But “swichen realities” basically refers to two or more ways of viewing a holistic, complex yet arguably objective reality. An example is that two people can look at the world in total; one can see evidence of a divine creator and the other can see no evidence of any creation or intentional plan but only evidence of consistent physical laws drawn from experience.

    Swichen realities also talks about how views can change or “flip-flop” in sudden conversion experiences and disusses the role of foregrounding and backgrounding confirming and disconfirming evidence, much as certain optical illusions function to give different pictures depending on swapping perception of foreground and background.

  13. It must be easy to sack some of these economists, as after all, you would just have to thank them for choosing to dramatically increase their leisure time….

  14. Its all starting to look like a discworld novel. My favorite was Going Postal. Economists should also read The Color of Money, another great learning experience.
    Cheers Punchy.

  15. It should be noted that the CRA, when enacted, was more commonly known as the Anti-Redlining Act, and simply forbade the use of a neighborhood’s racial profile as a factor in granting mortgages. Not surprizingly, the first (veiled) reference to the CRA as the singular cause of the subprime crisis was made in February, 2008, by ex-Senator and UBS VP Phil Gramm, a simply God-awful economist (see Galbraith’s review of Phil’s doctoral dissertation) and noted dog-whistle racist. I understand that it is not considered good form to accuse all CRA conspiracy theorists as therefore being racist simply because of Phil, but as my family elders were so careful to impress upon this growing child, “you are know by the company you keep.”

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