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!!