The Great Financial Crisis and Why Economics is Largely Theology

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This post is to add another piece of corroberation to my contention that economics is largely theology — the business of making arbitrary and false articles of faith appear respectable, sound and truthful. That is not to say that economics is entirly mythical, inaccurate and incapable of providing orientation in reality. But such guidance and the requisite realism and competence are rare.

In diesem Post möchte ich einen weiteren Beitrag hinterlegen, mit dem ich meine These begründe, dass Ökonomie auch heutzutage noch größtenteils Theologie ist — der Versuch, unwahre Überzeugungen in das Gewand der Wahrhaftigkeit zu kleiden.

Above all, what I see in Fama's position is a tendency to insulate his theory from falsifiability.

Fama tendiert dazu, seine Theorie so darzustellen, dass sie nicht widerlegt werden kann, dies jedoch nicht weil keine sachlichen Gründe gegen sie sprechen, sondern, weil sie so formuliert ist, dass die Bedingungen ihrer Widerlegung nicht gerade augenfällig sind.

Remember the – Interview with Eugene Fama – that the New Yorker’s John Cassidy published on January 13, 2010.

Eugene Fama is an economist at the University of Chicago and is most known for his work promoting the so-called efficient markets hypothesis.

[...]

The efficient markets hypothesis has been a core of mainstream macroeconomics and asserts that financial markets are driven by individuals who on average are correct and so the market allocates resources in the most efficient pattern possible. There are various versions of the EMH (weak to strong) but all suggest that excess returns are impossible because information is efficiently imparted to all “investors”. Investors are assumed to be fully informed so that they can make the best possible decisions.

At closer inspection, Fama's theory is vulnerable: "individuals being on average correct" is a rephrasing of the neoclassical presumption of ergodicity (deducibility of future states from probabilistic data) and omniscience. Claims of allocative efficiency collapse with that presumption. 

Famas Worte spiegeln nur den neoklassischen Mythos der Ergodizität (Ableitbarkeit zukünftiger Zustände aus probabilistischen Daten) und des Allwissens der Marktteilnehmer wieder. Mit dem Nachweis, dass diese beiden Bedingungen nicht gegeben sind, kollabiert natürlich auch die Glaubwürdigkeit der Behauptung allokativer Effizienz.

Fama told John Cassidy that the financial crisis was not caused by a break down in financial markets and denied that asset price bubbles exist. He also claimed that the proliferation of sub-prime housing loans in the US “was government policy” – referring to Fannie Mae and Freddie Mac who he claims “were instructed to buy lower grade mortgages”.

While, I hold that Fannie Mae and Freddie Mac did play a significant role in the run up to the crisis, Fama is utterly mistaken in suggesting that it is possible to have "pure" markets, unaffected and unencumbered by a political framework. Markets will always be significantly affected by political decisions, and cannot even exist without such "extraneous" decisions being taken. He is less than convincing in praising markets as efficient most of the time (and, indeed during long stretches of time as long as 30 years), except when they are not — owing to a sudden emergence of distorting politics.

Damit Menschen einigermaßen frei wirtschaften können, bedarf es umfangreicher und tiefgreifender politischer Regelungen, sowohl bei der Gründung als auch bei der Aufrechterhaltung einer Marktordnung. Märkte sind politische Produkte; sie sind immer reguliert, mal besser, mal schlechter. Es ist ein großer Irrtum anzunehmen, dass es so etwas wie einen reinen Markt gibt. Fama begeht diesen Irrtum und bescheinigt den reinen, daher freien, daher effizienten Märkten dass sie nicht jenen Kräften zuzurechnen sind, die Krisenepisoden auslösen, sondern höchstens von diesen erfasst werden. 

Mitchell's below point strikes me as weak, the agencies (and government policies that undermined loan quality and gave crisis-prone incentives to banks and debtors) did have a massive distorting effect, but operators and beneficiaries of "efficient markets" were more than happy to see their business supported by bubble-enhancing policies.  The haggling over whether the origins of the crisis are "more private" or "more public" in nature is not helpful, at this point in the argument — both spheres will always be closely intertwined, for which reason referring to "pure markets" is referring to a figment. There simply are no pure, therefore free, therefore crisis-immunised, therefore efficient markets. A market is always a political construction, with countles issues cropping up all the time that can only be resolved by political action.

Fischer Black, one of the inventors of the Black-Scholes option pricing model  made lots of money by exploiting the idealisations in his model that the more naive market participants did not take cognizance of because they believed in pure and therefore efficient markets; Fischer, by contrast, was well aware of the real issues that his model did not take into consideration, deducing arbitrage opportunities from systematic mispricing by market particpants.

I am not aware that those exploiting the "greater fools" ever complained about the inefficiency of the market — they simply took advantage of it to grow rich.

Ein Tauziehen zwischen denen, die private Ursache für die Krise verantwortlich machen und jenen, die den Staat und die Politik als Verursacher anprangern, bringt nicht viel. Beide Sphären sind in Märkten stark verzahnt. Die Vorgeschichte der Krise ist auch eine Vorgeschichte regulatorischer Anreize und Verzerrungen, die auf den späteren Bust hinwirkten. Allerdings wurden sehr viele dieser Regeln und Gesetze von den Märkten gutgeheißen und ausgenutzt, wenn nicht sogar massiv beworben.

Fischer Black, der Mit-Erfinder des Black-Scholes Optionspreismodells, war sich sehr wohl bewusst, dass es keine effizienten Märkte gibt, obwohl sein Modell auf einer deratigen Idealisierung beruhte. Die naiveren Marktteilnehmer verstanden die Ineffizienz des realen Marktes nicht, glaubten an Black-Scholes und ließen sich von Fischer Black kräftig ausarbitrieren. Mir ist nicht bekannt, dass sich die profitablen Markt-Player über einen ineffizienten Markt aufgeregt hätten; lieber verdienten sie sich eine goldene Nase an den ineffizienten Preisen. 

When it was pointed out that these agencies were a small part of the market as a whole and that the “the subprime mortgage bond business overwhelmingly a private sector phenomenon”, Fama claimed that the collapse in housing prices was nothing to do with the escalation in sub-prime mortgages but rather:

What happened is we went through a big recession, people couldn’t make their mortgage payments, and, of course, the ones with the riskiest mortgages were the most likely not to be able to do it. As a consequence, we had a so-called credit crisis. It wasn’t really a credit crisis. It was an economic crisis.

At this point, things get rather confused. Having just complained about the impact of the credit agencies, Fama now denies a credit crisis, insinuating three distinct spheres in what is truely a close knit whole: a world of credit, another world harbouring the economy and a third world comprising efficient markets. The economy and the world of credits are capable of generating crisis, but not unencumbered efficient markets. This sounds suspiciously like the views of a specialist whose area of knowledge appears to him as immculate, whereas evil is compartmentalised away in the pigeonholes that happen to be the playgrounds of other specialists. Fama figures as a fervent promoter of capitalism, but admits that he does not understand the capitalist economy and its crisis mechanisms, only financial markets: "I'm not a macroeconomist. [Then don't talk like one]"

Fama beklagt sich gerade noch über die Kreditagenturen und im nächsten Moment bestreitet er eine Kredit-Krise. Für den Spezialisten Fama gibt es offenbar drei separate Sphären, das Kreditwesen, die Wirtschaft als Ganzes, von denen Krisen ausgehen können, von denen aber er nach eigenem Bekunden nichts versteht, und die Finanzmärkte, mit denen er sich auskennt, die aber nicht ursächlich sein können für Krisen. Fama macht gerne globale Aussagen über den Kapitalismus und Märkte, die jedoch nicht vereinbar sind mit seinem Bekenntniss, die Gesamtzusammenhänge (einschließlich der Wirkung von Kreditgeschäften und des Funktionierens der Gesamtwirtschaft) nicht zu verstehen: "I'm not a macroeconomist. [Then don't talk like one]"

John Cassidy checked if he had heard it right asking “surely the start of the credit crisis predated the recession?” to which Fama replied:

I don’t think so. How could it? People don’t walk away from their homes unless they can’t make the payments. That’s an indication that we are in a recession.

Once again he was prompted to think about that – “So you are saying the recession predated August 2007″, to which Fama replied:

Yeah. It had to, to be showing up among people who had mortgages.

He was then asked “what caused the recession if it wasn’t the financial crisis”?

(Laughs) That’s where economics has always broken down. We don’t know what causes recessions. Now, I’m not a macroeconomist so I don’t feel bad about that. (Laughs again.) …

Fama asserted that “the financial markets were a casualty of the recession, not a cause of it”.

Later, in defending the efficiency of financial markets, Fama wondered how many economists:

… would argue that the world wasn’t made a much better place by the financial development that occurred from 1980 onwards. The expansion of worldwide wealth—in developed countries, in emerging countries—all of that was facilitated, in my view, to a large extent, by the development of international markets and the way they allow saving to flow to investments, in its most productive uses. Even if you blame this episode on financial innovation, or whatever you want to blame, would that wipe out the previous thirty years of development?.

And despite him confessing that he is “not a macroeconomist” he wasn’t backward in using his position to write a stringent macroeconomic attack on the US government fiscal plans, which all the evidence now shows saved millions of jobs. Not enough jobs were saved but without the stimulus, the world would have still been wallowing in the depths of Great Depression 2.0.

The logic he used came straight out of the introductory mainstream macroeconomics textbooks and he didn’t have the guile to realise it was both operationally flawed (as a description of what actually happens) and empirically bereft (none of the major predictions of the model ever come to fruition).

The source.