Are prediction markets going to make it this time around?

That is the topic of my latest Bloomberg column, here is one excerpt: A skeptic might say that demand is limited because there are already so many good and highly informative markets in other assets. In 2009, for instance, was a market necessary to predict how well the iPhone was going to do? The share […]

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Can economists be trusted?

For the most part, economists don’t give people advice on how to run their lives. Rather we tend to focus on explaining the behavior of consumers and businesses, usually assuming they are at least somewhat rational. One exception is when there is a “principal-agent problem”, the case where the people you hire (the agents) have interests that differ from you own interest.

Thus economists might advise someone to be a bit skeptical if one’s dentist recommends that you get a new crown. Is it actually needed, or is the dentist merely trying to pad his income?

There is one area where economists are especially likely to give advice–personal investments. The Efficient Market Hypothesis (EMH) suggests that it’s extremely hard for financial advisors to consistently beat the market. Because these professionals must be paid for their services, managed mutual funds tend to do worse, on average, than index funds. Thus almost all economists that I know recommend that average people invest in index funds.

Because of the EMH, the field of economics has its own distinct epistemology. We believe in the wisdom of markets. We believe that the optimal forecast of many economic variables is embedded in the consensus market forecast. AFAIK, other sciences don’t use this approach to ascertain what is true. Thus meteorologists don’t typically assume that a prediction market forecast of global temperatures in the year 2050 represents the optimal forecast, even were such a market to exist.

On the other hand, I do wonder if economists are being consistent in the way they apply concepts such as the principal-agent problem and the EMH. Doesn’t our criticism of managed mutual funds apply equally well to our own profession? Consider the following two approaches to policy:

1. Most economists seem to believe that it makes sense for our profession to do a lot of research on the macroeconomy, and then base our monetary policy on forecasts derived from computer models of the economy.

2. I believe that much of this research is wasteful, and that monetary policy should be guided by market forecasts of the relevant economic variables.

In order to see who’s right, let’s take the same analytical framework that makes economists so critical of the managed mutual fund industry and direct it toward our own field. We immediately see two problems. Just as with the financial industry, it is in the best interest of economists if society spends a lot of money financing research on predicting future macroeconomic outcomes. These are good jobs!

Second, the EMH suggests that the output of these investigations will be inferior to the consensus market forecast, and yet we usually argue that policymakers should rely on our computer models, not the consensus market forecast. Thus we seem to be dismissing the value of the EMH when it comes to our own profession, after using the EMH as a bludgeon to bash the financial services industry.

Of course one could argue that research by individual economists is a valuable input into the market forecast of inflation and GDP, but one could equally well argue that research by individual financial experts is a valuable input into the market pricing of assets.

And even if economic research should be subsidized because information has external benefits, that does not justify using a particular Fed model to set policy, rather than the market forecast.

Economists are also “agents”, and our self-interest is not the same as society’s self-interest. On the other hand, I’m also an economist, so why should you believe me? My self-interest might be to carve out a career as a contrarian.

I would respond as follows. I’m not trying to brainwash you; I’m merely pointing to some implications of ideas that many of you already know, especially those with some background in economics.  Back in 1996 (when he was defending free trade), Paul Krugman gave four suggestions to people trying to become public intellectuals.  This one struck home:

Adopt the stance of rebel: There is nothing that plays worse in our culture than seeming to be the stodgy defender of old ideas, no matter how true those ideas may be. Luckily, at this point the orthodoxy of the academic economists is very much a minority position among intellectuals in general; one can seem to be a courageous maverick, boldly challenging the powers that be, by reciting the contents of a standard textbook. It has worked for me!

That’s what I did in my new book, which comes out this summer.  And that’s what I’m doing here.  The principal-agent problem and the EMH are well-established ideas.  And it is well known that economists are highly skeptical of managed mutual funds, and often recommend indexed funds.  In this post, I’m merely pointing to the implication of applying this sort of analysis to my own profession.  Don’t automatically believe what I say—think about whether it makes sense.

After all, my best interest doesn’t coincide with your best interest.

PS.  You might argue that asset markets don’t exist for some key macro variables.  But that’s no excuse; the Fed can create them.

PPS.  Part 2 of my MMT critique is now out.  Now there’s a theory that categorically rejects the EMH!!

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Postscript: Orwell for Socialism

[Scroll to the end for a couple final reactions to comments .]

In a reflective moment, George Orwell wrote, “Every line of serious work that I have written since 1936 has been written, directly or indirectly, against totalitarianism and for democratic socialism, as I understand it.”  Yet if you actually read his oeuvre, you’ll find a striking disparity: Orwell’s anti-totalitarian writing is massive, but his pro-socialist writing is wafer thin.  As far as I know, the closest thing Orwell produces to an argument for democratic socialism appears in his review of Hayek’s Road to Serfdom:

[Hayek] does not see, or will not admit, that a return to ‘free’ competition means for the great mass of people a tyranny probably worse, because more irresponsible, than that of the State. The trouble with competitions is that somebody wins them. Professor Hayek denies that free capitalism necessarily leads to monopoly, but in practice that is where it has led, and since the vast majority of people would far rather have State regimentation than slumps and unemployment, the drift towards collectivism is bound to continue if popular opinion has any say in the matter.

And:

Capitalism leads to dole queues, the scramble for markets, and war. Collectivism leads to concentration camps, leader worship, and war. There is no way out of this unless a planned economy can somehow be combined with the freedom of the intellect, which can only happen if the concept of right and wrong is restored to politics.

In Orwell’s day, many readers would have responded, “Orwell wrote little, but the few pro-socialist words he wrote suffice.”  Even today, many would sympathize.  Yet despite my love for Orwell, he he’s thoroughly mistaken.  Point-by-point:

[Hayek] does not see, or will not admit, that a return to ‘free’ competition means for the great mass of people a tyranny probably worse, because more irresponsible, than that of the State.

Hardly.  As of 1940, quality of life for “the great mass of people” was near its all-time global high in the world’s most capitalist countries: the United States, United Kingdom, and Switzerland.  These countries were the richest and the freest – and not “just for the rich.”  Seriously, where on Earth would you rather be living in 1940?  You could say that the United States, United Kingdom, and Switzerland were even better for the great mass of people immediately prior to the Great Depression.  But that’s praising with faint damnation.

The trouble with competitions is that somebody wins them.

This is misleading even for athletics.  Yes, someone wins the game.  To continue winning, however, even the best teams have to keep practicing and improving.  Every day is another chance for losing teams to turn things around.

The same goes for business.  On any given day, some firms are doing great.  That doesn’t mean, however, that they’ve permanently “won.”  Even if all of their direct competitors go out of business, successful firms have to worry about future competitors.  Amazon is by far the best store in history, but they tirelessly strive to improve because they want to stay number one.

Professor Hayek denies that free capitalism necessarily leads to monopoly, but in practice that is where it has led…

“Monopoly”?!  What is Orwell even talking about?  I suppose he could be focusing on a few industries with large economies of scale, but even in his time that would have been a modest share of total output.  Or he might be thinking about industries like agriculture with state-sponsored cartels, but you can hardly blame “free capitalism” for that.

and since the vast majority of people would far rather have State regimentation than slumps and unemployment, the drift towards collectivism is bound to continue if popular opinion has any say in the matter.

Mass unemployment is a grave evil, and the evil was probably never graver than during the Great Depression.  But even in Orwell’s day, economists had a compelling diagnosis and effective cures.

The diagnosis: Unemployment is caused by excessive wages.  The effective cures: Either (a) let wages fall, or (b) print more money to reduce wages surreptitiously.  Despite its popularity, “state regimentation” is a red herring that fails to address the actual problem.

Capitalism leads to dole queues, the scramble for markets, and war.

The dole was indeed a popular response to high unemployment.  But once you grasp the wage-unemployment connection, you start to worry that the dole prolongs unemployment by reducing the pressure to bring wages down to the full employment level.

The “scramble for markets” story is Leninist dogma.  As the gravity model predicts, rich countries mostly trade with nearby rich countries, not their nation’s colonies.  The post-war loss of colonies was a big blow to nationalist pride, but economically trivial because the colonies were never economically important in the first place.

And war?  Blame nationalism and totalitarianism, not “capitalism.”  If capitalist greed ran Europe in 1914, all of the major powers would have realized that preserving good economic relations with European neighbors was vastly more profitable than grabbing some remote, impoverished colonies.

Collectivism leads to concentration camps, leader worship, and war.

Yes, yes, and yes.

There is no way out of this unless a planned economy can somehow be combined with the freedom of the intellect, which can only happen if the concept of right and wrong is restored to politics.

On the contrary, the “way out” is to combine freedom of the intellect with a free market economy.  Fortunately, that’s easy because these two freedoms are not only compatible, but mutually supportive.  And if we restore the concept of right and wrong to politics, combining these two freedoms is precisely what we’ll do, because there is a strong moral presumption in favor of freedom.

Final Reactions

A few final reactions:

Miguel Madeira:

“Strictly hereditary dictatorship, per Pascal, has the lowest selection pressure for bloodthirsty power-hunger. ”

Unless we follow the KevinDC model – if we assume that bloodthirsty power-hunger dictators will purge all other potential bloodthirsty power-hunger dictators (meaning that his successor will probably be a risk-averse yes-man)…

I’d say that a truly risk-averse yes-man would steer clear of politics.  The most bloodthirsty dictators might select for underlings who are risk-averse by the standards of ruthless politics, but their absolute level of risk-aversion would still be low.

BK:

Thoroughly enjoyed this book club. I’ve been curious throughout whether you would ever touch on the meta-theory that Oceania is actually a lie and the totalitarian state is actually limited to a small autarkical geography. That the reasons that some of the balance of power arguments between the major powers seem shaky are attributable to the power of the government itself being a lie. The reference above to believing absurdities plays nicely into this, and reminds me somewhat of my travels in Cambodia and some of the reflections on the Khmer Rouge’s reign.

I never heard this story, but it doesn’t seem plausible.  Winston Smith clearly lives in England.  They still have a train system, airplanes, and rockets.  And he remembers nuclear war.  So it doesn’t sound like he’s living in a small isolated country.

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