Whoops

Novelist John Lanchester is giving a public lecture at the London School of Economics this coming Thursday linked to the launch of his new book, Whoops  – an anlysis of the financial crisis. The FT and the Sunday Times both carried extracts over the weekend. I was particularly struck by his comments on behavioural economics:

I have a confession to make about Kahneman and Tversky. I’d never heard of them until Kahneman won the Nobel, and when I first read about their work it seemed to me to consist of things that were surprising only to economists.

You can read the full extract here.

Author: Colin Scott

Colin Scott is Principal, UCD College of Social Sciences and Law and Professor of EU Regulation and Governance at UCD. He is a Co-Editor of Legal Studies (Wiley-Blackwell).

29 thoughts on “Whoops”

  1. I think this might deserve a little more discussion:

    “Kahneman and Tversky directly take on the central shibboleth of contemporary academic economics. The assumptions of rationality permeate modern economics, which is increasingly preoccupied with developing pseudomathematical formulas. These provide models of behaviour which never quite fit what actually happens, in a way that resembles the physical sciences gone wrong: instead of equations describing reality, economics produces equations describing ideal conditions and theoretical clarity of a type that never occurs in practice.”

    I presume by ‘pseudomathematical formulas’ the author is referring to econometrics. I have had a few gentle digs at this before on this site, but I am not sure I fully agree with the author here.

    He seems to be on the same page as optimistic John, looking for economics to give accurate predictions of the future. But economics, for all its pseudomaths is not physics.

  2. @LorcanRK

    I agree, this could also be a source of the mistrust many people have of economists.

    Furthermore, I would like to add, that given people are often irrational beings, current policy based on economic models which assume ideal conditions can very often work counterproductively. Let this perhaps be an argument for Ludwig von Mises approach on government intervention.

  3. As Upton Sinclair put it: ‘ It is difficult to get a man [or woman] to understand something when his[her] salary [or academic job] depends upon his not understanding it. ‘

    Nice folksey piece – but that is all. The issue raised is far more interesting. Veblen and the Americaan Pragmatists had this sussed over a hundred years ago …… and some of the mid-century Austrians [shorn of their ideology) has also been ignored …. some good stuff on a previous thread on this ……. at least we can give some credit to Greenspan (the Ayn Rand disciple: still a good few of them around here – they haven’t gone away you know – and have failed to decommission dat dangerous ideological cache which does find its way onto our TV, radio, newspapers, lecture theatres, and er…. this blog) and G. Becker for remainging open to new ideas and challenge …….. Fama appears to be sulking in the corner due to lack of the Nobel that he believes, rationally (of course), to be his right – his time is gone.

    Yet, we cannot totally dismiss their science – or indeed, econometrics – it is simply one sided – has a very impoverished conception of human agency and rationallity – and ‘on its own’ has now been proved to be as dangerous as quite a few have been claiming for years –

    Main lesson: Social Science + Ideology = Trouble for Joe and Joan Citizen

  4. Think I’ll write a book – can’t call it ‘whoops’ – think I’ll call it:

    THE ERA OF THE ERRORS OF JUDG(e)MENT

    (-;

  5. This was a surprize to many but not all. Many on the inside and some who joined them, ensured that they could make themselves money by assisting in making it especially bad, ie worse than it needed to be.

    Worse than it needed to be. Think about it and the lack of apparent awareness offered on the part of economists.

    That is a store of reasons why economists will be declining in popularity.

  6. Being flat-out wrong has never stopped the development of a profession before.

    Look at medical science. Those guys get it wrong all the time, and never bat an eyelid.

    And when was the last time you heard of a disgraced psychologist? “Oh, sorry, you didn’t want to murder your father and sleep with your mother after all … how wrong I was!”

    Or journalists: “The BBC has publicly apologised to President Putin for erroneously jumping to conclusions concerning Russia’s war with Georgia…” As if!

    Economists are just a soft target. It’s the pocket protectors stuffed with ball-point pens.

  7. I wonder what distinguishes “pseudomathematical” formulae and mathematical formulae? Economics applies mathematics like every other scientific discipline, more than some less than others.
    The reference was almost certainly to economic theory. And if you think mathematics is bad for economics try doing it without its use.

  8. Traditionally the field of pseudo-mathematics concerns itself situations in which pseudo-mathematicians use that wavy equals-sign to mean “approximately equals”

    However, recent advances in pseudo-mathematics include the wavy subtraction sign to mean “possibly minus”, while a just-published cutting edge pseudo-mathematics paper has posited the idea of a wavy plus sign, which may or may not be added to the discipline.

  9. I agree with @Kevin that in many cases you can’t do the analysis without the maths.

    I think the problem is that some take the results of mathematical models as fact (notwithstanding wavy signs).

    I like what Krugman has to say about mathermatical models:
    “The important point is that any kind of model of a complex system — a physical model, a computer simulation, or a pencil-and-paper mathematical representation — amounts to pretty much the same kind of procedure. You make a set of clearly untrue simplifications to get the system down to something you can handle; those simplifications are dictated partly by guesses about what is important, partly by the modeling techniques available. And the end result, if the model is a good one, is an improved insight into why the vastly more complex real system behaves the way it does.” That is why key assumptions and results of theoretical model should be tested using observed behaviour – in some cases the the models are useful approximations and in others they are not.

    Elsewhere on this blog some have suggested that all economists are forecasters – in fact the minority are. Just in case people get the idea that all economists are into banking and finance – not true either. Indeed there are lots of ‘quants’ in banks who never studied economics, nor do bankers exclusively use economic models/methods.

    Apart from behavioural economists (who I think are doing some very interesting work) there are also lots of us working on the actual behaviour of individuals (e.g. changes in demand due to price changes etc. etc.).

    With no more than a hazy understanding of economics it is very easy to bash economists.

  10. @ kevin denny

    Neal Koblitz and Serge Lang made very clear distinctions between “pseudomathematical” formulae and mathematical formulae.

    Extract from Wikipedia on Neal Koblitz:
    —————
    Koblitz’s 1981 article “Mathematics as Propaganda”[2] criticized the misuse of mathematics in the social sciences and helped motivate Serge Lang’s successful challenge to the nomination of political scientist Samuel P. Huntington to the National Academy of Sciences.[3] In The Mathematical Intelligencer, Koblitz[4][5][6], Steven Weintraub[7], and Saunders Mac Lane later criticized the arguments of Herbert Simon, who had attempted to defend Huntington’s work.
    —————-

    Extract from New York Times September 25, 2005 obituary of Serge Lang:
    —————-
    One focus of Dr. Lang’s ire was the Harvard political scientist Samuel P. Huntington. Dr. Lang mounted a one-man campaign against Dr. Huntington’s nomination to the National Academy of Sciences in 1986, dismissing Dr. Huntington’s use of mathematical equations to relate factors like economic development and political instability as “pseudoscience” and “nonsense” – “a type of language which gives the illusion of science without any of its substance.” Dr. Lang also challenged Dr. Huntington’s description of apartheid in South Africa in the 1960’s as a “satisfied society.” Dr. Huntington, who said the math was not meant to be rigorous but rather a “shorthand” of his arguments, twice failed to win election to the academy.
    ————

    Lang Obituary in Notices of the American Mathematical Society: http://www.ams.org/notices/200605/fea-lang.pdf

  11. “Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views.” Paul Krugman, NYT Sept 2, 2009.
    The fundamental core of economics has no epistemological validity. Indoctrinating another generation of students with this pseudo-science does not serve the public interest. As an academic game, albeit one supported by the public purse, orthodox neo-classic economics has little scope for damage. But let’s not inflict this obsolete mindset on government.

  12. @Graham Stull 🙂

    @Kevin, I certainly don’t disagree with you, economics without some maths is probably closer to philosophy. Theories need to be tested and economic relationships measured. The maths are important (whether pseudo or not).

    @Edgar: “With no more than a hazy understanding of economics it is very easy to bash economists.”
    Yes, of course. But the inverse is also true. With no more than a hazy understanding of economics, it is very easy to expect too much from economists.
    In the current economic climate (I hate that phrase, but it will work well here) the media spotlight is on economists, with people looking for very simple answers to very complex questions.
    When they ask when the recession will end, they expect an answer accurate to a few days.

    Which all is quite close to that other much maligned profession whose maths don’t seem to lead to 100% accurate predictions – meteorologists. (hence the climate reference) The only major difference is that meteorologists have been getting bashed for generations. Maybe they could give the economists lessons in turning the other cheek?

  13. Apparently John Lanchester has no problem with Kahnemann & Tversky even though their work has been mathematised as well (K&T themselves came up with functional forms). In fact, it took quite a while before prospect theory was given a formal axiomatic basis. It turns out that Prospect theory is a special case of what is called Choquet Expected Utility, which, in turn, is an extension of Expected Utility Theory.

    I’d agree with @Edgar.Morgenroth that most results from mathematical analyses in economics are taken as fact where they shouldn’t be. Actually, a lot of mathematics used in economics does not yield “numbers” at all. Decision theory is a great example. There the question is what sets of axioms on human behaviour can be represented by (expected) utility functions. Mathematics is used in DT to link (hopefully verifiable) axioms to functional representations which can then be used to build, e.g., models about economic growth.

    Unfortunately, much of economics education forgets about this step and starts by assuming agents come equipped with certain utility functions (CRRA, CRRA, and what have you not) because they happen to lead to nice results. Often without any reference to their axiomatic underpinning.

  14. “It’s a basic law of money that risk is correlated to reward — the amount of money you can make is determined by the amount of risk you are willing to take on.”

    The problem was the disconnect between risk and reward. Basically, if I am free to do any actions for which there is little if any down side, but for which, my bonus will go through the roof if I am correct. My attitude will be what the heck. If peoples jobs are on the line or they are likely to be sanctioned, they will suddenly grow a very keen understanding of risk which they hither to fore gleefully abandoned.

    This is what Obama is trying to restore with his new bank oversight agenda. Once they understand that there is no such thing as to big to fail then you can be assured that they will act in accordance with the norms of behavioral psychology. Moral hazard has to be restored.

  15. My general somewhat tired response to economics bashers (& there are enough of them & they are having a field day now) is: “if you can do better, go ahead make my day” [unfortunately I don’t have a Magnum].

  16. I view Lanchester’s writing as providing a serious engagement with economics, from an outsider’s perspective, and a generally positive view of how acting on the insights of behavioural economics about how people behave in market (and other) settings might enhance our understanding of the world and, possibly, stimulate better policy making. My own interest has been stimulated by a gradual shift in ideas about how consumer laws should be framed, and in particular a better sense of likely changes in behaviour which might be stimulated by transparency regulation of various kinds. The European Commission and the Australian government, amongst others, have been grappling with the implications of this body of work for consumer policy.

  17. He seems to be […] looking for economics to give accurate predictions of the future. But economics, for all its pseudomaths is not physics.

    I’m not an economist, but I suspect that economics should not be compared — for good or bad — with physics, but with the science of weather forecasting. It is (I simplify — and probably distort) not a science that can be brought under laboratory conditions to any useful extent (experiments with university students on whether game theory applies in reality notwithstanding), but has the wealth of observations for predictive models to be built and the explanatory underlying mechanisms to be theorised.

  18. @Colin Scott and his observations on the attempts to apply the insights of behavioural economics to consumer policy by the European Commission and the Australian government:

    I would love to see the behavioural elements of the discipline used to help with analysis of the mechanisms that lead to the distributions of wealth and income we observe in the world (and thence help with the normative task of formulating regulatory and policy approaches to reducing the inequalities that exist).

  19. @tombuktu: You are not the first to make the comparison with meteorology & probably not the last. It probably has some merit. We have the extra complication that the clouds,winds etc don’t have brains & hence can’t choose how to behave. Nor should we kowtow to physics: astronomy/astrophysics is an observational science too you know.
    I wouldn’t dismiss lab experiments either. Whether they are ecologically valid is an important question & a tough one. Sometimes they probably are. But remember the aircraft that you fly in were probably tested (in miniature) in wind tunnels so experiments have a role in many applications. The hard bit is knowing how far to take them.

  20. It is very like weather forecasting.

    Ever since the treaty on banning use of weather as a weapon.
    The trouble with such a treaty is that if artificial weahter cannot be detected then it can be used as often as required. I sure hope that no one cracks making earhtquakes on demand…… ;-)! Something similar happened in the USA with human involvement acheiving a colossal and conscious bubble of sub-prime debt.

    Whoops indeed.

  21. What might be lacking in the mathematical models that have been built and are being built in the private sector is peer review.

    The models that were built by intelligent people but having intelligence does not mean being infallible. It is unlikely that the brains in investment bank x let the brains in investment bank y have a look at their models to see if the models might be good or have serious deficiencies.

    Also, it might have been more economical to simply try to tailor the product towards the model. The bonds were sliced & packaged many times & the given reason seems to have been that by doing so the rating agencies could give good ratings. Good rating = good price.

    The rating agencies model might have been good but it was never and will never be perfect. As long as it is possible to “game” the system (the rating model) then smart people will do so as the risk/reward ratio has suddenly been altered in their favour.

    Rating agencies were targeted earlier in the crisis. Tailored products that exploited weaknesses in their models are more to blame than the agencies themselves. Only way to stop the tailored products is to stop the ratings.

  22. People should read the 1982 book “Judgment under uncertainty: heuristics and biases” before commenting too much on Kahneman and Tversky. A paper from 1974 in Science that is an ancestor of this book is available below. UCD students will be happy to know that this Friday’s lecture is on K+T so you can decide yourself what their contribution has been. To my mind, it is one of the strongest of the 20th century in any discipline, as far as my limited mind can grasp.

    http://psiexp.ss.uci.edu/research/teaching/Tversky_Kahneman_1974.pdf

  23. @ Liam Delaney: People who liked the classic T&K paper you provided the link for will also enjoy Leonard Mlodinow’s recent book The Drunkard’s Walk: How Randomness Rules Our Lives.

  24. It should be kept in mind that Ronald Reagan and Margaret Thatcher were influenced by their own experiences rather than economists and their opportunities came after a period of dislocation ushered in by oil embargos.

    The intellectual underpinning or religion of seeing the world in black and white terms, was provided by these various theories on rationality and efficient markets.

    Mrs Thatcher was an admirer of Friedrich August von Hayek, presumably because his view of the world, coincided with her own. Ditto for Milton Friedman.

    Last Dec at a Wall Street Journal event, Paul Volcker made a reference to possibly one of the authors of the Black–Scholes model: “A few years ago I happened to be at a conference of business people, not financial people, and I was making a presentation. The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.

    I was listening to this, and I found myself sitting next to one of the inventors of financial engineering. I didn’t know him, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity.

    Much to my surprise, he leaned over and whispered in my ear that it does nothing—and this was from a leader in the world of financial engineering. I asked him what it did do, and he said that it moves around the rents in the financial system—and besides, it’s a lot of intellectual fun.

    Now, I have no doubts that it moves around the rents in the financial system, but not only this, as it seems to have vastly increased them.”

  25. The other strange thing that is starting to emerge on this site and elsewhere is the idea that there is a distinction between mathematical economics/econometrics and behavioural economics. There simply isn’t. It is fair to say that much of the earlier behavioural economics was more accessible than the mainstream work but this has nothing to do with the actual ideas. Nowadays, people like Jean Tirole are writing papers in the behavioural domain using mathematics that would make your eyes water. In general, as behavioural economics has moved more to the center of the discipline it has become more formalised. Pretty rapidly, the phrase “behavioural economics” will become harder to maintain as it will apply to most of applied econometrics and a lot of economic theory in many domains.

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