Baseline Scenario -- A Lot of Good Things to Follow Up Between the Football This Weekend

The Baseline Scenario
Krugman on Economics
Expert Panels and Bipartisan Consensus
Football, Statistics, and Agency Problems
Krugman on Economics
Posted: 04 Sep 2009 07:46 AM PDT
This weekend’s New York Times Magazine has the 7,000-word article about the state of macroeconomics that Paul Krugman has been hinting at for some time now. It’s a well-written, non-technical overview of the landscape and the position Krugman has been presenting on his blog, which for now I’ll just summarize for those who may not have the time to set aside just now.
Like many, Krugman faults the discipline for its infatuation with mathematical elegance:
“[T]he central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.
“Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.”
His history of post-Depression macroeconomics goes through roughly three phases: Keynesianism; Milton Friedman and monetarism, which, he argues, was relatively moderate compared to the positions of some of his self-styled followers; and the period from the 1980s until 2007, which he describes as the conflict between the Saltwater (coastal, pragmatic, New Keynesian) economists and the Freshwater (inland, efficient markets, neo-classicist) economists. According to Krugman, these two schools had differences on a theoretical level, but those differences were papered over by practical agreement on government policy: namely, monetary policy was superior to fiscal policy at managing the economy.
This false peace was exploded during the financial crisis by the zero bound, something Krugman has invoked often. The agreed-upon way to stimulate the economy in a recession is to lower interest rates. When interest rates hit zero, they can’t be lowered anymore (rather than lend you money and expect to get less back in the future, I should put it under my mattress), and then the policy question is what if anything else should be done. This provoked the fallout between people who favored the stimulus as a way of propping up demand and those who thought that for theoretical reasons a stimulus could not possibly have any positive impact.
In addition, Krugman argues, the two sides shared the same desire to represent the world using elegant mathematical models: “But the New Keynesian models that have come to dominate teaching and research assume that people are perfectly rational and financial markets are perfectly efficient.” Instead, we need to look to behavioral finance and behavioral economics, which has just gone from a hot fad in economics to the bandwagon to end all bandwagons. Krugman mentions Larry Summers’s “There Are IDIOTS” paper, which must now be the world’s most-cited-although-unpublished article, Robert Shiller, Andrei Schleifer, and Robert Vishny in particular.
This is from Krugman’s conclusion:
“So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.”
In other words, the world is messy and people are irrational, and as a result the world breaks down occasionally.
The field of economics has been going on a massive land-grab over the past few decades. It’s ironic that the area it seems to understand the least well is how an overall economy functions.
By James Kwak

Expert Panels and Bipartisan Consensus
Posted: 04 Sep 2009 06:52 AM PDT
Last week, Planet Money aired an interview by Adam Davidson with Barney Frank, the blunt and colorful chairman of the House Financial Services Committee. Davidson and Frank had a pitched disagreement over the question of whether it made sense to appoint a bipartisan, expert panel to take some time – figures between one and three years were thrown around – to study the causes of the financial crisis and, on that basis, recommend regulatory changes. Davidson thought it was a good idea; Frank thought it was nonsense.
I’m with Frank on this one, and the argument applies to the Financial Crisis Inquiry Commission, also known hopefully as the “New Pecora Commission,” appointed by Congress to study the causes of the crisis.
A parallel is commonly drawn to the 9/11 Commission, which I believe is widely considered to have been both genuinely bipartisan and worthwhile. However, I think the differences are more important here. On September 12, 2001, most people – certainly including most people in government and policy, and almost certainly including even the most highly-placed people in the country – had only the vaguest idea of how nineteen terrorists had infiltrated the country and managed to hijack four plans, using three of them successfully as bombs. The Commission’s mandate was to understand how that happened, and in particular how our intelligence and security agencies had failed to prevent this attack. That is, there was a shortage of information, and most of the information was classified anyway, so a thorough investigation was called for.
By September 16, 2008, most people in the business already knew the causes of the financial crisis: cheap money, new and predatory mortgage products, lax underwriting practices, the transfer of risk through securitization. dependence on ratings by overwhelmed rating agencies, failure of regulatory agencies to regulate, greediness on the part of banks and bankers who ate up their own AAA-rated dog food, unhealthy dependence on short-term funding, etc. There has been argument about the relative importance of these factors, but the basic story is so well known that it has spawned multiple cartoon caricatures. There is little fact-finding necessary to determine the causes of the crisis; we should already be at the phase of analyzing empirical data, and I can predict with confidence that seventy years from now there will be economic historians arguing both sides of this question; after all, that’s what happened with the Great Depression.
I expect, and hope, that the Financial Crisis Inquiry Commission will uncover some especially sordid details of bankers laughing about screwing their customers, or regulators on the take from the banking industry. And if that happened, then those people should be sued or put in jail. But we already know that bankers were screwing their customers, and we know that regulatory agencies were friendly toward the banking industry (whether because of corruption, simple ideological alignment, or orders by political appointees makes little difference in the broad story).
I am skeptical that months or years of study will bring us any closer to consensus on the major questions, because the crisis is so overdetermined; there is plenty of evidence to construct multiple plausible narratives about how it happened, each one of which points to a different regulatory solution (and whether you could get that solution through Congress is yet another question).
Thinking cynically, spending 1-3 years studying the problem could also be cover to let the issue fade away; the impetus for reform is already far weaker today than it was in, say, February when Citigroup was going through its third near-death experience. I know that’s not Davidson’s intent, but I’m sure there are others who would be only too happy to bet that the economy and the popular mood will return to normal. Remember Sarbanes-Oxley? It was weaker than originally imagined, and by 2007 there was a movement afoot to repeal it, since people had already forgotten Enron and Worldcom. Let’s hope that doesn’t happen again.
By James Kwak

Football, Statistics, and Agency Problems
Posted: 03 Sep 2009 07:48 PM PDT
The most interesting part of Monday’s post on TARP may have been this little football example:
In honor of the changing seasons, imagine it’s the first quarter of a football game and you have fourth-and-one at the other team’s 40-yard line. Anyone who studies football statistics will say you should go for it; it’s not even close. (Some people have run the numbers and said that a football team should never – that’s right, never – kick a punt.) If the offense fails to make it, the announcer, and the commentators the next day, will all say that it was a bad decision. That’s completely wrong. It was a good decision; it just didn’t work out.
One of my friends was particularly intrigued by the theory that a football team should never punt. I recall reading this somewhere, but I couldn’t find it actually demonstrated anywhere, although this high school football team implemented the strategy – and won the state championship. That article cites “Do Firms Maximize? Evidence from Professional Football” by David Romer, who analyzes the punting question in detail.
He calculates the point value of a first down at any point on the field, and from that the point value of the “kicking” and “going for it” options at any point on the field; the point value of the punt option is based on the opponent’s expected field position, while the point values of the field goal and go for it options are based on your expected points and the expected resulting field position.
The conclusion (PDF p. 14) is that over most of the field you should go for it if you have four or fewer yards to go; there is a big spike around the opponent’s 33-yard line where you should go for it even on fourth and nine, because the net field position benefit of punting is low and the expected point value of attempting a field goal is low.
The implication, of course, is that football teams don’t maximize. Romer concedes that making the right decision on fourth down would lead to about one more win every three years, and this is probably outweighed by the asymmetric returns: you are more likely to be penalized (as a coach) if you go against convention and are wrong than if you follow convention, since the fans (and the owners) are more likely to notice departures from convention. So the incentives of football coaches are not simply to maximize points, but also to maintain their reputations.
It probably wouldn’t be too hard to come up with a banking analogy at this point, but I won’t beat a dead horse.
Update: Commenter Ian M. helpfully links to this analysis of the “never punt” strategy. Taunter also says that Gregg Easterbrook (Tuesday Morning Quarterback at ESPN) has been advocating this strategy.
By James Kwak