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”.

Conclusion

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.