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October 31, 2006

Fisking Philip Ball

A few days ago Mark Thoma posted an article by Philip Ball, "consultant editor of Nature", taking economists to task for, well, being economists.  Although Mark handled the rebuttal quite nicely, and there was lots and lots of fine commentary on Mark's site (a good chunk of which is summarized by Dave Iverson), I found the article so wrong-headed that I just can't help myself from commenting.  So, a-commenting I go:

Baroque fantasies of a most peculiar science, by Philip Ball, Commentary, Financial Times (free): It is easy to mock economic theory. Any fool can see that the world of neoclassical economics, which dominates the academic field today, is a gross caricature in which every trader or company acts in the same self-interested way – rational, cool, omniscient. The theory has not foreseen a single stock market crash and has evidently failed to make the world any fairer or more pleasant.

It is true that neoclassical economists tend to be the methodological children of Milton Friedman, heirs to a positivist tradition that directly connects explanation and predictability.  But predictability in this sense is conditional:  If X occurs then, all else equal, Y will follow.  As a matter of logic, large forecast errors may only prove that the arrival of X is especially uncertain, and that economists are not clairvoyant (a trait that I think is shared with physicists and other human beings).

To be fair, if Y equals a stock market crash, I cannot really tell you what X equals.  I am unaware of any serious economist who claims they can.  Even those economists who express knowledge of a "bubble" in some asset market or another shy from taking definitive stands on when and how the bubble will burst.  I do know this, however:  Economists have devoted a lot of energy to thinking about the lessons delivered by the Great Depression.  At least part of the conventional wisdom formed from that thinking is that it is a very bad idea to restrain liquidity when liquidity is most desired.  For an example of that wisdom in practice, I refer to you to the actions of the Federal Reserve in the aftermath of the 1987 market crash in the United States.  I'll stick my neck out and claim that the world was more pleasant as a result of putting that lesson into action. 

The usual defence is that you have to start somewhere. But mainstream economists no longer consider their core theory to be a “start”. The tenets are so firmly embedded that ... it is ... rigid dogma. To challenge these ideas is to invite blank stares of incomprehension – you might as well be telling a physicist that gravity does not exist.

That is disturbing because these things matter. Neoclassical idiocies persuaded many economists that market forces would create a robust post-Soviet economy in Russia (corrupt gangster economies do not exist in neoclassical theory)...

Economists accept -- insist, actually -- that institutions matter, and nobody would argue that market forces alone can create a "robust" economy absent well-defined property rights, functioning legal systems, and the like.  If you doubt that, check out the latest John Bates Clark award.

Neoclassical economics asserts two things. First, in a free market, competition establishes a price equilibrium that is perfectly efficient: demand equals supply and no resources are squandered. Second, in equilibrium no one can be made better off without making someone else worse off.

Wrong.  Mr. Ball is thinking of the concept of Pareto efficiency, which does indeed describe a situation in which "no one can be made better off without making someone else worse off."  But there is no presumption among economists that free markets and competition will deliver such an outcome. Any time an economist speaks of asymmetric information (conditions in which one person knows something another does not), externalities (things like pollution that is not paid for by the polluters), inflexible prices or wages, or taxes on any sort of economic activity, he or she is starting from the presumption that the free-market outcome is not efficient.  In fact, any time an economist speaks it is quite likely they are contemplating a world in which free-market outcomes are not efficient.  To not recognize this is demonstrate a startling ignorance of what economics is actually about.

The conclusions are a snug fit with rightwing convictions. So it is tempting to infer that the dominance of neoclassical theory has political origins. 

What?  Ever read Brad Delong?  Or Angry Bear?  Or Dean Baker?  Or Max Sawicky?  Good economists?  Yes.  Right wing?  Only by a standard so skewed as to be meaningless.

... the foundations of neoclassical theory were laid when scientists were exploring the notion of thermodynamic equilibrium. Economics borrowed wrong ideas from physics, and is now reluctant to give them up.

This error does not make neoclassical economic theory simple. Far from it. It is one of the most mathematically complicated subjects among the “sciences”, as difficult as quantum physics. That is part of the problem: it is such an elaborate contrivance that there is too much at stake to abandon it.

Well, OK, economics has become pretty mathematical, which does sometimes make it hard for non-economists to join the conversation. Shoot -- there are some papers that I can't figure out. But that does not equal an "error."  (And I still think quantum physics is a lot harder -- and every bit as abstract.)

It is almost impossible to talk about economics today without endorsing its myths. Take the business cycle: there is no business cycle in any meaningful sense. In every other scientific discipline, a cycle is something that repeats periodically. Yet there is no absolute evidence for periodicity in economic fluctuations. Prices sometimes rise and sometimes fall. That is not a cycle; it is noise. Yet talk of cycles has led economists to hallucinate all kinds of fictitious oscillations in economic markets.

It's true -- economists do not define business cycles as things that repeat periodically in a deterministic way, like sine and cosine waves.  Business cycles are instead defined somewhat loosely in terms of the co-movements of various aggregate variables (like GDP, employment, prices, etc., etc, etc.)  If we want to get a bit more statistically formal, we might define a business cycle in terms of co-movements of aggregate variables within particular windows of time (say two to eight years, meaning that we are ignoring very short-run and very long-run fluctuations in the economy).  And if want to define particular episodes of contraction (or recession) and expansion, we ask a committee to decide.

However we do it, the point is to identify a set of particular facts that can then be subjected to analysis, both theoretical and empirical.  Don't like calling it a cycle?  Fine.  Call it Aggregate Fluctuations.  Call it Co-Movement In Business Statistics.  Call it a Kumquat.  Just don't pretend a picky semantic point is serious criticism.

Meanwhile, the Nobel-winning neoclassical theory of the so-called business cycle “explains” it by blaming events outside the market. This salvages the precious idea of equilibrium, and thus of market efficiency. Analysts talk of market “corrections”, as though there is some ideal state that it is trying to attain. But in reality the market is intrinsically prone to leap and lurch.

I presume that Ball is referring to Real Business Cycle Theory.  Let me try a very simple description of real business cycle theory:  The business cycle -- those co-movements in macroeconomic variables that occur over certain frequencies (i.e windows of time) in the data -- result from random shocks that hit the economy combining with the intrinsic structure of the economy in such a way that those shocks are translated into ups and downs in GDP, employment, prices, etc., etc., etc.   

What is Ball's criticism of this view of the world? 

One can go through economic theory systematically demolishing all the cherished principles that students learn... [I]t is abundantly clear that herding – irrational, copycat buying and selling – provokes market fluctuations.

There are ways of dealing with the variety and irrationality of real agents in economic theory. But not in mainstream economics journals, because the models defy neoclassical assumptions.

Oh, I see.  Maybe he missed this paper. And this paper.  Or is unaware that conversations like this one, among economists who would otherwise describe their basic orientation as "neoclassical", are a part of any good macoeconomist's basic training.

Ball concludes:

There is no other “science” in such a peculiar state. A demonstrably false conceptual core is sustained by inertia alone. This core, “the Citadel”, remains impregnable while its adherents fashion an increasingly baroque fantasy. As Alan Kirman, a progressive economist, said: “No amount of attention to the walls will prevent the Citadel from being empty.”


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The best part about the conclusion is how completely worthless it is. I will take his route of comparing economics to physics and point out that, at several points throughout the history of science, have people realized that everyone was just fundamentally wrong. Even if this were the case with neoclassical economics, it takes time for ideas that make up the core of our beliefs to change. It took the Church 300 years to apologize for excommunicating Galileo and submitting to house arrest for heretically suggesting that the earth revolves around the sun. More recently, people like Magueijo who suggest an alternate cosmological model, previously touched on by Dirac and even Feynmen, are generally just brushed off and scoffed at. It's completely ridiculous to suggest that because he perceives certain beliefs held by economists as wrong that it is a failing of the science as a whole.

Posted by: Alex Mohr | November 01, 2006 at 04:26 AM

But, but, but - we Angrybears are free traders. Doesn't that get us qualified as rightwingers?

Posted by: pgl | November 01, 2006 at 09:19 AM

Ball's rhetoric and argument structure reminds me of creationist rants about evolutionary biology. A similar mixture of mischaracterization and 'can you believe?' ad-hoc argument, and lack of interest in actual work by actual researchers.

Posted by: stefan | November 01, 2006 at 01:02 PM

Nice post.

Yes, but ... look what a great discussion Ball's reactionary commentary has produced in various blogs. Ball's article is, I believe, a reaction to what the press, some politicos, and sometimes we as underinformed or ideologically blinded economists spin up as economic theory/practice--not adequately owning up to limits, nuances, etc. of our methods.

Hence we economists are not guiltless as to some general criticism well-aired on Mark Thoma's blog. Sometimes too, we are not well-enough covered by the press as to contrasting views/theories, etc. (then again who is).

Still, as Dave A. aptly points out we economists (taken collectively) are not shy about criticising each other and learning from our criticism, our practice, etc.

Posted by: Dave Iverson | November 01, 2006 at 05:51 PM

"At least part of the conventional wisdom formed from that thinking is that it is a very bad idea to restrain liquidity when liquidity is most desired."

Wow. That sounds like a rule-of-thumb, like the common-sense kitchen-table economics of the Average Joe. You offer this as a vindication for economic "science"? Ball will surely like that.

To Ball's undeniably correct observation "The conclusions are a snug fit with rightwing convictions. So it is tempting to infer that the dominance of neoclassical theory has political origins.", you answer by pointing out that there are also one or two economists who are not right-wingers. I suggest you take a basic course on scientific reasoning to learn why this "argument" cannot succeed.

Posted by: piglet | November 02, 2006 at 04:16 PM

"I will take his route of comparing economics to physics and point out that, at several points throughout the history of science, have people realized that everyone was just fundamentally wrong. Even if this were the case with neoclassical economics, it takes time for ideas that make up the core of our beliefs to change."

Well. There are several important things to point out. While it is true that physics has been revolutionized in the 20th century to the extent that Newtonian classical mechanics has been recognized as incorrect, it is worth remembering that Newtonian mechanics, far from being "fundamentally wrong", was and is still approximately correct. It correctly accounts for a wide range of observations. Does this apply to neoclassical economics? Secondly, it is worth noting that physicists of the 1900s were quick to understand that their traditional models were not sufficient any more to account for a new range of observations. Their reaction was not to massage the data, to discuss away unwelcome evidence or to ridicule those asking hard questions. A few papers written by an unknown physics teacher by the name of Einstein revolutionized the science and within a few decades, physical science received a whole new foundation. Why could that happen? because Einstein was right, that's why. This is why physics is a science.

What do we see in economics? Theories are not confirmed by empirical observation but nobody cares. I have been over at Mark Thoma's, and now on this discussion, and I haven't seen anything that seriously refutes Ball. Most troublesome is that many economists participating in the discussion don't even grasp what this is about. You simply don't get it, that's the really sad thing.

Posted by: piglet | November 02, 2006 at 04:30 PM

Piglet …

Maybe the real problem is with Economic Fundamentalism, Fred Argy covers the main bases for effective criticism of "economic fundamentalism here: http://www.australianreview.net/digest/2003/03/argy.html

Two questions: 1. How does one distinguish between "economic fundamentalists" and other practicing economists? 2. How does one practice economics w/o being libeled as a fundamentalist?

Posted by: Dave Iverson | November 02, 2006 at 04:41 PM

piglet --

We're all about constructive criticism here, but honestly you're not giving me much to work with. You assert that you haven't seen anything to refute Ball's criticisms. Perhaps you should go back and read Mark and my posts -- both of us point out that several of Ball's claims about economics are just simply wrong. You criticize my grasp of logic by pointing out that I cannot refute the rightwing nature of the discipline by pointing out a few economists who do not fit into that category. I may have been unclear on the point: "Rightwing" is a term that has absolutely no meaning or value in an informed discussion of issues. It is a cheap polemical trick, suited only to the discourse of coffee house pseudo-intellectuals. Define rightwing and maybe the conversation can progress, although I suspect that it will reveal only that your definition of rightwing is hopelessly out of the mainstream.

I'm quite glad that you think the lessons we have learned about the problems with moneatary policy in the Great Depression are so obvious. I was not giving a particularly deep rendering of that discussion in my post, but I do suggest that you read the relevant chapters in Friedman and Sschwartz's monetary history to gain some understanding of how existing orthodoxy of the time helped to turn a problem into a disaster. And you also might recall that there were views of the world -- still are, I suppose -- holding that the overaccumulation of capital followed by deep and prolonged slumps was the inevitable state of free market capitalism. I think the neoclassical economists carried the day on that one.

You suggest what we see in economics is theories not confirmed by enpirical evidence. I'm not sure what you mean by this. That our theories are untestable because they are not subject to controlled experimentation? Neither you nor Ball have offered anything that helps in understanding what are your real objections. Instead you set up straw men, knock them down, and dance gleefully around a vanquished pile of nothing.

I am guessing that Ball's objections -- maybe yours as well -- is that economists have the temerity to call their discipline "science". If that is what you object to, I say fine. On that there is precisely zero at stake. If you want, call economics an attempt to construct coherent stories about social phenomenon. I'm proud enough of that.

Posted by: Dave Altig | November 03, 2006 at 09:05 AM

As far as I can see, David Altig's claim is that since David doesn't know what Philip Ball is talking about (e.g., the contrast between the response of linear systems to random shocks and nonlinear dynamics, Alan Kirman's work), Philip Ball has not made his case.

Posted by: Robert | November 04, 2006 at 06:16 AM

FYI, Eric Beinhocker addresses all this and more in his book "The Origins of Wealth." Here's an entry I posted at my blog:

If you only have time for two chapters, make it chapters 3 and 4.

Posted by: Optimist123 | November 06, 2006 at 05:02 PM

Uh, Robert, where does Ball mention Kirman in this particular context? And honestly I don't know what Ball is talking about either. Maybe because he's making sh*t up.
(And I gotta say this again. Alan Kirman has made many important contributions to economics some of which have since been seized on by ideological hacks completely out of context and totally misunderstood)

Posted by: radek | November 06, 2006 at 06:07 PM

Robert -- I an aware, although I admit only in passing with evolutionary models. (I will make an effort to take a look at the Beinhocker book that Steve Conover notes.) But I'm with radek -- if Ball wants to make the case that these sorts of models are useful in ways that neoclassical models are not, then he should make that case. What he should not do is say a bunch of things about the conventional framework that simply aren't true. And maybe you can point me to the part of Kirman's work that suggests his complex dynamical systems are superior to models relying on individual maximization because they are not rightwing.

Posted by: Dave Altig | November 06, 2006 at 08:18 PM

The key criticism here – and in most other critiques of my article – is that economists seem to be reading “neoclassical economics” as “all of economics”. Interesting, that, and perhaps revealing, but come on guys, read the print. Once you do that, the remark about institutions collapses. So does the remark about market efficiency.

So let me say this clearly. Lots of economics goes beyond assumptions about perfectly rational agents, fixed preferences, perfectly efficient markets and so forth. That’s great. But lots doesn’t, and there are journals where you won’t get a look in if you challenge that dogma. My point is that it is time to ditch those notions altogether. Stop teaching them to undergraduates. Not only do they not work, but they are (mostly) demonstrably wrong in behavioural terms, and even if you accept them, the models derived from those assumptions are internally inconsistent. Won’t you at least admit that?

“It is tempting to infer that…” This is a rhetorical structure. It implies that “Yes, it’s tempting, but we should resist that simplistic idea.” I didn’t think this was so hard so understand, but sorry if I was wrong to assume that. In any event, clearly I shouldn’t have mentioned the dread words ‘right-wing’, because you’ve really got hung up on that. I’m interested in why it provoked such a response.

“This error” – is not that economics is highly mathematical, but that economics got stuck on ideas of equilibrium and a balancing of forces. Again, that’s what my article says quite clearly.

“Business cycle” – words matter. Cyclicity has been a persistent myth in economics, whence Kitchin cycles, Juglar cycles, Kuznets cycles, Kondratieff cycles, ad nauseam. Ditch the word – it is not helping. In fact, if this really is ‘fine’ with you, then do call them ‘aggregate fluctuations’. ‘Cycle’ sounds like something well behaved and well understood. ‘Fluctuations’ sounds a bit more disconcerting, but why not face up to that?

“RBC theory” – yes, that’s what I’m referring to. And as I clearly said, what I object to is the way it places the cause of fluctuations outside the system, in the form of random, external shocks. Why not entertain the idea that the fluctuations may be intrinsic to the dynamics of this complex system?

“Conversations like this one” – that ‘conversation’ begins “The rational expectations hypothesis swept through macroeconomics during the 1970s and permanently altered the landscape. It remains the prevailing paradigm in macroeconomics, and rational expectations is routinely used as the standard solution concept in both theoretical and applied macroeconomic modelling.” Look, I’m glad that hypothesis is now being debated, but are you seriously saying that this disproves my point?

“Whatever” – i.e. shut up. Well, OK, it’s your blog. But I thought these comments were meant to be pointing out my errors.

‘Mohr’ – seems to be saying ‘well, you could be right, but if so, change could take 300 years.’ Well, you said it. I’m more optimistic.

‘Robert’ – couldn’t have put it better myself.

‘radek: I don’t know what he’s talking about either’ – what did I say in the article about blank stares?

I’ve no objection to economics calling itself a science. I believe that is just what it should be. And it’s a really, really hard science, which other scientists don’t sufficiently appreciate. What puzzles me is why it is finding it so hard to discard wrong ideas. All sciences struggle with that, but this one seems to have more problems than most. At least one economist agrees: see the FT on 6 November, http://www.ft.com/cms/s/d0cd9ee2-6d3b-11db-9a4d-0000779e2340.html.

But look, I’m sure all of this sounds more aggressive than I want it to, because I get irritated when I think my words haven’t been read properly. I’m not interested, however, in saying that I’m right and you’re wrong. There’s a lot I can learn from this exchange. And I recognize that I could have done more to indicate that there are many branches of economics, by no means all of which suffer from the defects I mentioned. If I’ve provoked discussion, the article has served its purpose. Let’s try to keep it as discussion, and not turn it into a battle.

Posted by: philcball | November 07, 2006 at 03:54 AM

""The key criticism here – and in most other critiques of my article – is that economists seem to be reading “neoclassical economics” as “all of economics”""

Unless you're confusing "neoclassical economics" (which is a fuzzy way of just saying "most economics") with "new classical economics" then this critique is correct.

""there are journals where you won’t get a look in if you challenge that dogma.""

And which would these be? Have you looked through the articles in AER, JPE, QJE, JEP or JEL in the past ten years? Like I said, you're making sh*t up.

""Not only do they not work, but they are (mostly) demonstrably wrong in behavioural terms""

Actually as a first pass at looking at a particular phenomenon they often work surprisingly well. The extent to which they are "demonstratrably wrong" is smaller then you think - consider for example Vernon Smith's work. Or, like Kahnemann himself said "the standard economic paradigm of rationality is applicable 90% of the time. I'm just focusing on the 10% when it isn't".

""and even if you accept them, the models derived from those assumptions are internally inconsistent. Won’t you at least admit that?""

No, I won't admit it because it's false. If nothing else, economic models ARE logically consistent - anything that isn't, like say the concept of 'conjectural variation' that Keen is so enamored with, gets picked apart by the profession very quickly. In the same vain, rational expectations, for all its strong assumptions, largely came out of an effort to model expectations about the future consistently. You might think the assumptions are crazy, the parameters not estimatable, some concepts too abstract to have real world relevance. Fine. But logical consistency is one thing we do well.
Looking at your various responses it seems like you've just brought your ideological prejudices to the table (and like Paul Krugman says, it's not the job of economic theory to agree with folks' pet theories), combined it with a superficial view of economics as gleaned from hacks like Keen who have no understanding of what they're talking about and proceeded to make some arrogant pronouncments and generally insulted people.
This is why you're getting flak. Which you deserve.

Posted by: radek | November 07, 2006 at 11:53 AM

"If you want, call economics an attempt to construct coherent stories about social phenomenon. I'm proud enough of that."

I like that.

Posted by: bailey | November 07, 2006 at 12:09 PM

Well, I'd hoped to turn mudslinging into debate (and actually there has been some interesting debate both here and on Mark Thomas site). But it seems that economics (or at least, the economics blogosphere) has a different and far more aggressive mentality from the one I'm used to in the natural sciences. If the attitude is like Radek's, to say I'm right, youre an idiot, and the folks who disagree with me are by definition ideological hacks [I'm not thinking just or even primarily of Keen] and are talking out of their backsides, then frankly I'm not interested. It doesnt strike me as an attitude born of intellectual security (or a great deal of maturity, for that matter). Still, thanks to some of you for the considered comments, pro and con.

Posted by: philcball | November 08, 2006 at 06:51 AM

Dr. Ball --

Thank you for the measured and thoughtful response. And let me start my own by apologizing for the "whatever" that ended my post. I really didn't mean it say "just shut up", although I admit its hard to interpret it any other way. You are correct in surmising I was trying to make considered comments and that offhand remark had no place. My bad.

I'm not quite so sure why you react quite so negatively to radek's latest comments. I think he (or she)is articulating what many of us think is problematic with your critique -- your examples of things that we economists are presumably doing wrong just doesn't jibe with what we know to be going on in the profession. If the dominant paradigm remains rational expectations, for example, it is not because we are unaware of the many behavioral puzzles that exist or have no interest in phenomena like learning dynamics. Nor is it the case that there is no research into these issues or that researcher can't publish in the major journals if someone has something constructive to say about these issues. The problem is that we have not yet figured out how these types of expectational elements can be used to sufficiently discipline model predictions. That search for that sort of discipline was exactly what motivated rational expectations in the first place, and I think most of us would gladly throw it overboard if we thought it would help us better answer questions we are interested in.

To your comment: "what I object to is the way it places the cause of fluctuations outside the system, in the form of random, external shocks. Why not entertain the idea that the fluctuations may be intrinsic to the dynamics of this complex system?" I confess I still don't quite understand. Almost all of modern macroeconomics is about discovering the internal mechanisms that generate economic fluctuations. It is true that the impulses are stochastic shocks -- we try to interpret them, but they do largely arrive out of black boxes. But am I mistaken in thinking that physics, for example, still relies on models that are essentially systems of stochastic differential equations? Economics did have its moment of interest in chaos, or purely deterministic but highly nonlinear dynamic systems. Not much progress was made that I know of -- maybe we gave up too soon. But has the paradigm of chaotic systems carried the day in other sciences? Or am I (again?) simply not understanding the point.

As for the right-winger designation, I think I do not protest too much (as your comment suggests). I simply have no idea what it means, and as a critique it is unhelpful. I gather you agree, so we can leave it at that.

Here's the rub: As I read through your response, it occurs to me that what you really object to is the assumptions that economists make, something that economists generally argue cannot form the foundation of a considered critique. Maybe I am wrong about that, but I have yet to hear examples of what predictions and explanations our standard models get wrong that other models (not already embraced by economists) get right. If you have a battery of such examples, I would love to see them.

To close, though I disagree with you, I really am sincere in saying thanks for the prodding.

Posted by: Dave Altig | November 08, 2006 at 09:17 AM

Phil, your original article didn't shy away from mudslinging, whether you understood the subject matter or not. In fact, it was one big mud loogie. So I'm surprised (well, no not really, since this is a standard rhetorical trick) that you're surprised by my "attitude". I made specific references to what you said, and made specific counter arguments to yours. But YOU chose the tone of the discussion, so please drop the false innocence and hypocrisy.

In truth I have a lot of respect for many people who make criticisms of economics, even from an outsiders perspective, as long as these people actually bother to familiarize themselves with the field. At the same time there is a lot of "hacks" out there who contriute nothing but noise to the discussion. And yes, it gets old trying over and over to explain to people who don't know and who don't want to know how economics actually works. And this tiredness and frustration does sometimes show up as terse and curt replies.

Posted by: radek | November 08, 2006 at 04:15 PM

To wit:

"It is easy to mock economic theory. Any fool can see that... "

and that's just the start.

Posted by: radek | November 08, 2006 at 04:30 PM

I’m very grateful for your thoughtful and gracious comments. They make me realise that in fact I need to climb down from my high horse too and make sure that I am listening rather than just defending.

‘Right-wing”: First, let me reiterate that this could all be something of a red herring, since, as I said, I wasn’t saying that the conventional economic theory stems from right-wing beliefs, but almost entirely the opposite: that it would be tempting to suspect that, but that we should resist that temptation, because the current shortcomings, as I see them, have a quite different source.

But I fully accept that terms like ‘right-wing’ are not helpful, or even meaningful, in an academic discussion about economics. Indeed, I think we have had a recent illustration of that here in the UK, where the appearance of Adam Smith on the new £20 bank note has sparked a dispute in which both the political left and right have been trying to claim Smith for themselves. This, of course, misses the point that Smith was merely calling things as he saw them, regardless of the congruence with any particular political persuasion. In that regard I fully agree with the quote from Krugman, and I am perfectly happy to believe that economists take the same objective, politically neutral approach to trying to understand the economy. One of the things I said in my book Critical Mass is that, once we adopt such an approach to understand society, we need to be prepared to have our political preconceptions challenged.

Yet I do think that the term has some currency in a newspaper article, which is necessarily discoursing in a more colloquial vein. I think, for example, that few (certainly in the UK) would have any difficulty in understanding why a theoretical stance that argues for unfettered free markets fits with what the political right has been attempting to do (and often succeeding in doing) for the past several decades. I’m somewhat agnostic on that – I am sure that market competition has improved efficiencies in some areas, but it is very clear that it has been disastrous in others. I realise also that economists don’t generally argue for such a simplistic interpretation of neoclassical economics, and that the idea of market inefficiencies is completely mainstream. But the problem is that mentioned by a professor at LSE in one of the follow-up letters to my FT article (see http://www.ft.com/cms/s/8ddd349e-6d3b-11db-9a4d-0000779e2340.html): in the real world, the subtleties of economic theory are often stripped away to produce a dangerously simplistic message. That’s a problem for all of us (and for which real economists are usually not to blame – I think Krugman gave a nice account of how that process happened, in the US at least, in ‘Peddling Prosperity’).

What are the ‘better’ ideas? I accept that there isn’t a ‘better’ economics applicable to all situations, but that different tools will work for different circumstances. But it has been said to me just too often to attribute it to a few lone grudges that there is a strong opposition in some quarters to new ideas that deviate from the notion of an equilibrium market created by rational, or boundedly rational, and generally homogeneous agents. For example, I understand from one of the editors of the new Journal of Economic Interaction and Coordination that it was started because it was almost impossible to get work on interacting-agent models into most of the standard economics journals. The fact that these models don’t have an explicit equilibrium built into them, for example, was considered to be one strike against them from the outset.

I was criticized for alluding to the notion of Pareto optimality. Yet Kirman has said “The fact that the market equilibrium with its associated allocation of resources is Pareto optimal, is what is given as the principal justification for the market economy… the situation in which we find ourselves today [is as] victims in a certain sense of a very peculiar vision of equilibrium which has little empirical content.” In fact, Morishima pointed out in 1964 that “If economists successfully devise a correct general equilibrium model, even if it can be proved to possess an equilibrium solution, should it lack the institutional backing to realise an equilibrium solution, then the equilibrium solution will amount to no more than a utopian state of affairs which bear no relation whatsoever to the real economy.”

My contention is that interacting-agents models, which demand no a priori assumptions about agent behaviour, nor about its homogeneity, nor its capacity to evolve, and which do not impose an equilibrium perspective but models the system as a dynamic one, seem much more likely to do a good job of capturing many aspects of the economy. I don’t advocate them as a panacea. But the shame is that these approaches, while to some extent tolerated, seem to be marginalized, seemingly because of entrenched beliefs about how the economy works. I have heard that complaint too often, and from too many sources, to think it is just the whining of a lunatic fringe.

Criticisms of RBC theory: you’re quite right that many models of physical phenomena incorporate a stochastic noise. But – and I’m open to correction if I have this wrong – my understanding is that in RCB theory, if there are no exogenous shocks, then there is no ‘business cycle’. In other words, the imposed fluctuations might be modified by the behaviour of the economic system but are not intrinsic to it. A non-equilibrium theory, meanwhile, would allow the possibility that the system is intrinsically unstable and nonlinear (rather than just being a bit noisy).

Radek – you’ve misunderstood my meaning at the start of my FT article. ‘Any fool can see’ is not saying ‘So economists are worse than fools’, it is saying ‘Of course economists realise that this is a gross simplification of human behaviour’. My complaint was not that those models are stupid, but that alternative ideas get a hard time. But maybe I did not choose my words carefully enough.

Anyhow, I very much appreciate that, even if we don’t agree, it seems we can disagree calmly.

Posted by: philcball | November 09, 2006 at 06:44 AM

Fair enough Phil.

Posted by: radek | November 09, 2006 at 01:30 PM

Philip --

Boy, I think we are almost in agreement. As the conversation has progressed, it does strike me that there may be a bit of a semantic difficulty. I gather that when you use the term "equilibrium" you mean are using for the shorthand "unique and stable equilibrium"? The formal mathematics in our models do generally allow for solutions that are unstable and underidentified. In fact, several important narratives of the "great inflation" of the 1970s and its conquest rely on indeterminancies that allow "sunspot" fluctuations, escape dynamics in which a large enough shock can push the economy off of a locally stable equilibrium onto an unstable path, and so on.

That said, it is true that the dominant strategy is still to find ways around indeterminancies, instabilities, and nonlinearities. This is changing as our formal techniques improve, but we are not immune to the "looking under the lamp post" charge. On the other hand, there is an argument that such things as sunspots are more due to the necessarily incomplete nature of models, and that getting carried away with the wierd places the math might take you risks missing the point. I consider the case open on that one.

I also concede that adopting a modeling strategy that deviates from the conventional approach makes it harder to publish in mainstream journals, and hence to be taken seriously. That is an old problem in intellectual discourse -- and, of course, not unambiguously bad, as such conservatism promotes a common language upon which informed discussion can proceed. It does, on the other hand, certainly risk reactionary attitudes. I guess what I was arguing is that I think we economists are trying to be pretty good about keeping an open mind. I will, however, repeat one of my earlier comments: We are a positivist bunch, so it is unlikely that an approach relying on the notion that bounded (at least) rationality is a bad place to start is unlikely to gain much traction absent clear cut examples where assuming otherwise takes to a better understanding of the questions that economics has carved out for itself. I hope that falls more in the category of good scientific conservatism than reactionary conservatism.

As for the Pareto optimality issue: I think you are right that this is an idea that contributes to neoclassical economists' affection for "the market." It is certainly true in my case. However, we should be clear that the Pareto concept only says that a market can replicate the choices that would be made by a benevolent social planner -- where benevolence is defined only by the Pareto criterion of making nobody worse off whle improving the lot of another. In that sense, Pareto efficiency has nothing to say about the dominance of free market economic arrangements per se. In fact, I gather that those who would put themselves in the tradition of, say, Von Mises would object that neoclassical reliance on the Pareto idea misses the point about the virutes of the market entirely. Furthermore, Pareto efficiency is silent on issues related to the distribution of income. I think most economists would not concede that such issues are unimportant (though I am one of those who think economists should more readily admit how little we have to say about the normative aspects of that issue.)

Thanks again for all your input. you put up with some grief here -- and even more at Mark's blog -- but it really has been a good thing. I hope it continues.

Posted by: Dave Altig | November 09, 2006 at 03:43 PM

I have a sense that you may be as surprised as I am, given how this started out, that we can now see this degree of convergence. But I'm very glad that you feel that way. I'm deeply appreciative of your thoughtful comments, which I can see have been based on constructive and valuable criticism. I feel that I've learned a lot from the exchange. There's much in your last set of remarks that I should and will ponder carefully. Thanks again.

Posted by: philcball | November 12, 2006 at 02:41 PM

I read the Ball article and found it very naive. For instance, one does not have to believe that every actor is rational to get an efficient market's assumptions price. Just as individual animals do not need to change in response to changed environment...rather selection among them will drive evolution. I really don't think the guy is that bright. Not a surprise...lots of scientists...and science magazine editorial writers are not.

Posted by: TCO | November 18, 2006 at 05:22 PM

I make some comments in my blog regarding wikipedia article on Edward R. Dewey and purported criticism of this by Philip Ball. So I found your discussion here and in the preceding article interesting. You and your readers might also find this material of interest.
regards, Ray Tomes

Posted by: Ray Tomes | February 02, 2007 at 06:33 PM

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October 30, 2006

Bottoming Out? Part 4

From today's Wall Street Journal (page A2 in the print edition):

The maximum impact of falling home construction may have hit the U.S. economy in the third quarter, some economists say. But that doesn't mean the housing market is on the verge of a miracle recovery. Construction is expected to fall further as builders struggle to shed a glut of unsold homes. And many economists expect house and condominium prices to continue falling for at least an additional six months to a year in parts of the nation where speculators went wild.

For now, the consensus among economists is that the housing downturn will remain a drag on the economy but probably won't sink the U.S. into a recession next year.


Offsetting the housing damage are several positives. Gasoline prices and mortgage interest rates have fallen in recent months. The stock-market rally has made some people feel richer, even as those who trust only in real estate feel poorer. And job growth, though unspectacular, continues at a "solid" pace, says Scott Anderson, an economist at Wells Fargo in Minneapolis.

With home prices flat to lower in much of the country, Americans already have less ability to tap their home equity to finance spending. But it is unclear how much effect that will have on consumer spending.


Some of the optimists' arguments are dubious. To bolster its position that the housing market is stabilizing, the National Association of Realtors last week trumpeted a 2.4% decline during September in the number of previously occupied homes offered for sale through multiple-listing services. But the Realtors' news release didn't mention that listings almost always decline in September, when the back-to-school season means fewer people are moving. Over the past 20 years, listings have declined an average of 3.4% in September, says Ivy Zelman, a Cleveland-based housing analyst for Credit Suisse.

In addition, and with a hat tip to University of Chicago XP-77er Ken Sutton, there is this to think about, from Bloomberg:

An unexpected increase in auto production last quarter was a statistical fluke that will be reversed, making current U.S. economic growth even weaker, according to a former Commerce Department economist.

Last quarter's annualized 26 percent increase in motor vehicle production shocked Joe Carson, now director of economic research at AllianceBernstein LP in New York. Without the gain, the economy would have grown at an annual rate of 0.9 percent, not the 1.6 percent the Commerce Department reported today.

The reported increase in output came despite cutbacks announced by General Motors Corp., Ford Motor Co. and others. A drop in the wholesale price of SUVs and light trucks as the automakers cleared leftover 2006 models made production look stronger than it actually was, said Carson. The economic fallout from the auto-industry cutbacks will instead come this quarter, he said.

"Last quarter was weak even with the benefit of this mismatch and the fourth quarter will now also be weak because it's going the other way,'' Carson said.

Even an optimist would have to admit that the fourth quarter begins with a few pretty big challenges.

October 30, 2006 in Data Releases, Housing | Permalink


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I agree, the FED has HUGE challenges ahead. I'll add, NONE are greater than those caused by continued loose mtg. lending practices. I wonder what last month's home sales would have looked like without the no-doc, no down, option arm "funny" loans?
It's interesting the markets don't seemed concerned, they should be.

Posted by: bailey | October 30, 2006 at 10:35 AM

"An unexpected increase in auto production last quarter was a statistical fluke that will be reversed,"
But how could it have been unexpected looking at 2005 q3?
Elementary my dear Watson, the statistician was flukey and Carlos should have chosen his source with more care, more luck, somehing -anything less flukey.

Posted by: calmo | October 30, 2006 at 03:29 PM

What happend in the 3rd Q was auto sales were up and auto production was down. This showed up in the gdp numbers as a sharp drop in nonfarm inventories --
$ 27.4 billion in real terms.

I have not looked at the latest auto I/s sales number but this implies that auto output could rebound next quarter so even is sales are flat this big drop in nonfarm inventories could vanish, generating a significant jump in 4th Q real gdp.

Posted by: spencer | October 30, 2006 at 06:23 PM

Ok spencer, $27.4B down from end of 2005 yes? The drop since 2006 III -$2.7B and for 2006 II +$15.4B
Can I get my noodle around this broken english (seriously, these headings are mislabelled, yes?) The change in non farm inventories since last quarter is a depletion of ~$3B, but since 2 quarters ago when the shelves were really empty, up more than $15B...and over the stock at the end of 2005, 3 quarters ago, some $27.4B emptier.
This is the best my noodle can do, (and I blame the headings in the graph for not being really considerate to not-so-el dente noodles) although let me peak at the rest of the numbers in the line.
The magnitude of previous entries showing quarterly changes in this line have been as high as $60B, so a depletion of even $27B does not look like big potatoes.
But it does look like the data are telling me something different: Inventories down $2.7B from last quarter, up $15B from 2 quarters ago and down $27B from 3 quarters ago.
I needed to graph this out and my take is that it is a bit of a jig saw but does point out that inventories were seriously raided (ok only $33B --half some of the q/q entries) in the first quarter and that at the end of q2 we had replenished about half of that.

After all that I need to say that the auto/inventory detail is not the story for me but that 2nd quarter of deteriorating residential investment. It's not very huffy and puffy, not glamorous and just won't make the headlines...yet.

Posted by: calmo | October 31, 2006 at 11:00 PM


Excellent observations in this bottoming out "series",

The confluence of a falling housing and automotive sector are just starting to be felt.

I backtracked to you on this, hit the link for more.

Posted by: The Nattering Naybob | November 06, 2006 at 11:52 AM

Should You Invest In Foreclosures?

Periodically I hear from readers who want to make $1 million in real estate -- quickly and with no money down. Usually they want to know more about real estate foreclosures -- how to buy them and how to profit from such homes. I've participated in a couple of these deals, and I'm now working on my second million -- I gave up on the first.

Foreclosure properties can be a good place to invest for exponential growth (or loss). There are some deals out there for little or no money down, but potential investors should take precautions because foreclosed properties can involve significant risks. There are various ways to invest in foreclosure properties.

The first and probably most popular is to purchase a property, fix it up and then rent it out, hopefully creating a positive monthly cash flow. The investor then becomes a landlord, with all the responsibility of an investment property owner.
Another way to invest is to seek out foreclosures or "handyman" specials, buy them, invest more money to fix them up and then sell them, taking -- hopefully -- a profit once the house is sold.

Posted by: Wally Smith | December 12, 2006 at 01:03 PM

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October 29, 2006

Oops! (Yuan Edition)

Trading expert, economic commentator, and soon-to-be newly-minted Chicago Exec-MBA grad Jeff Carter sent me a heads-up on this story, from Bloomberg:

China's State Administration of Foreign Exchange banned banks operating in the country from trading yuan derivatives in the offshore markets, according to a document issued to lenders.

"Without SAFE's approval, no institutions or individuals on the mainland can participate in outbound renminbi foreign- currency derivatives trading,'' the regulator said in the document dated Oct. 25 obtained by Bloomberg News. "Banks should provide to clients products and services to hedge renminbi currency risks within the business scope allowed by the regulator.'' A SAFE spokesman said he was unaware of the document.

Foreign banks use the offshore forwards market to make bets on the yuan and avoid restrictions placed on onshore trades by the central bank. Domestic banks have been using the offshore market to hedge positions...

The SAFE document referred to "the need to prevent China's economy from exchange-rate risks and facilitate designated banks for foreign-exchange businesses in providing currency-risk- hedging products and services.'' It gave no specific reason for the ban.

Without that "specific reason", interpretations of the ban are necessarily speculative. But the following seems like a reasonable set of possibilities:  (a) The yuan peg is under some pressure;  (b) The Chinese banking system remains in a precarious state; (c) The Chinese government is as determined as ever to slow the pace of yuan appreciation; (d) All of the above. 

October 29, 2006 in Asia, Exchange Rates and the Dollar | Permalink


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The likely rationale for the ban is to keep Chinese banks from profiting from the arbitrage between onshore(which reflect interest rate differentials) and offshore(which reflect foreigners' speculative demand for CNY) rates, and thus make speculation on CNY appreciation even mroe difficult for foreigners (as local banks won't be there to bid the USD that they sold onshore.) Click on my name for a bit more on the subject.

Posted by: Macro Man | October 29, 2006 at 11:45 AM

"China's State Administration of Foreign Exchange banned banks operating in the country from trading yuan derivatives in the offshore markets, according to a document issued to lenders."
"Without that "specific reason", interpretations of the ban are necessarily speculative. ..."

4 speculations are provided.

But to me the one that makes the most sense is not and that is the Chinese Central Bankers are preparing the way to allow the Yuan to float, i.e., removing speculators in their midst of the home currency.

Posted by: im1dc | October 29, 2006 at 06:52 PM

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October 28, 2006

Was It Really That Bad?

From the Wall Street Journal (subscription required):

U.S. gross domestic product growth slowed to an annual rate of 1.6% -- the slowest pace in three years -- during the third quarter as the slump in the housing market took its toll on the overall economy. Economists had expected a much larger 2.2% growth rate.

Actually that 2.2% guess was higher than a lot of people were guessing -- Larry Meyer's Macroeconomic Advisers, for example, had been projecting 1.8% and, frankly, 1.6% was better than I was expecting.  One reaction to the report, from the WSJ opinion round up:

[T]his report actually was not as bad as the headline number would have you believe. The major reason for the sharp deceleration in growth was that the housing sector took over one percentage point out of growth. … Basically, you really don't have a weak economy if consumers are consuming, businesses are investing, exports are growing and imports are strong. -- Joel Naroff, Naroff Economic Advisors

That seems about right to me:




There are doubters, of course:

Expect today the usual spin with the soft-landing optimists … This fourth-quarter rebound has, so far, no base or data behind it: residential investment will be falling at a faster rate in the fourth quarter … nonresidential investment that was, until now, growing very fast will sharply decelerate … residential and nonresidential construction will directly affect retail activity where employment has already started to fall. … I thus keep my forecast that fourth-quarter growth will be between 0% and 1% and that the economy will enter into an outright recession by the first quarter of 2007 or, at the latest, second quarter. -- Nuriel Roubini, Roubini Global Economics

Well, OK. But facts are facts, and forecasts are forecasts.  And thus far the facts, so far as we know them, are not showing substantial weakness outside of residential housing.

October 28, 2006 in Data Releases | Permalink


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What is amusing is that this so-called 'horrible' Q3 number still represents faster quarterly growth than Europe has averaged since the gloabl recvoery started in 2002....

As for Robuini, does he seriuously expect a negative contribution from, say, net exports, given that oil has come down $15-$20? And he seems to have overlooked the fact that nonresidential construction added 0.4% to annualized growth last quarter. No doubt when the recession finally comes (2008? 2010?), he'll be the first to say 'I told you so.'

Posted by: Macro Man | October 28, 2006 at 08:50 AM

Is a soft landing really the optimistic scenario.

Recessions are generally self correcting mechanisms that contain the seeds of their own recovery.

But if we see a soft landing what would get growth reaccelerating?
We have had two soft landings, 1967 and 1995. In 1967 guns & butter lead to stronger growth and in 1995 it was the high tech boom.
But what would cause it to happen this time?

Is a soft landing scenario just slipping into a long term stagnation scenario?

Posted by: spencer | October 28, 2006 at 09:27 AM

Great economy if we omit the residential investment sector? Why not eliminate investment in structures and redo the calculation?

Posted by: pgl | October 28, 2006 at 04:42 PM

Less optimistically, you may note this article. GDP data-statistical fluke.


Posted by: Jeremy | October 28, 2006 at 10:02 PM

Well, I don't know. If "Structures" input about 1/8 what "residential investment" does to GDP, if Governnment spending varies widely month-to-month, if consumption makes up about 70% of GDP & housing's bottomed, I don't think I'd be concerned at all.
BUT, I haven't seen ANY evidence that housing's bottomed or that business is investing enough to offset the housing price correction I'm expecting to see.
Unlike BB & J. Lacker, I don't believe the housing price escalation 40% of our population has seen in the last 4+ years(Krugman's r.e. zones) was driven by "FUNDAMENTALS". (I sure wish you'd address this.)
I expect, if the FED stays out of the game, we'll see housing prices revert to their long-term mean growth rate & this will lead to a real drop in "consumption" in Krugman's "zones", & because of their significance to our economy, a recession.
I'm not nearly so apprehensive about a recession as I am of our long-term prospects if the FED intervenes to protect us from what I see as a MUCH-NEEDED price correction.

Posted by: bailey | October 29, 2006 at 06:59 AM

Roubini's response when asked on 10/02/06 by NY Magazine what he sees happening to the housing market:
"since 1997, real home prices have increased by about 90 percent. There is no economic fundamental—real income, migration, interest rates, demographics—that can explain this."

Posted by: bailey | October 29, 2006 at 03:48 PM

Recall that last year at this time we had a rosy 4.9% GDP growth spurred on by a 22.7 increase for autos (contributing 1.3 of that 4.9 figure). We were helped by an even larger auto component this time (25.8) (otherwise GDP would have been only 0.9). The 2005q4 GDP number slipped to 1.8 (in part from a dismal showing, -19, in those autos that were brought forward). So the declining oil prices will counteract the lousy auto numbers due next quarter, but GDP growth could be in negative territory nonetheless.

Posted by: calmo | October 30, 2006 at 01:16 AM

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October 27, 2006

Good News, Bad News, Take Your Pick

You might guess that there would be little good to say about a large drop in the median price of new homes sales in September.  But then maybe you're not trying hard enough.  From the Wall Street Journal (subscription required):

The newspaper headlines will blare that new-home prices fell by 9.7% year over year, the largest drop since 1970. Admittedly, this is a shocking headline, but do not make too much of it.


First, as we have noted many times, the mix changes every month so that these price numbers do not pertain to a comparable mix of homes over time. If people are scaling back their desires, if the regional mix changes, etc., then the numbers get skewed...

"The median new home price fell by 1.7% [in the third quarter] across the nation. However, the median sales price rose in each of the major geographic regions (Northeast +19.3%, Midwest +4.0%, South +0.7%, West +1.6%), which suggests that some of the home price decline is due to a shift in the regional pattern of sales toward lower-priced regions." --Bear Stearns Economics

On the opposite side of the not-quite-what-meets-the-eye spectrum stands the September durable goods report. From Reuters, via CNNMoney:

Orders for durable goods -items meant to last three or more years - leaped a much greater-than-expected 7.8 percent in September on a rush of civilian aircraft orders, a Commerce Department report showed.

But orders rose a smaller-than-forecast 0.1 percent when volatile transportation orders were stripped from the total...

And, despite the caveats in the housing report, nobody is suggesting that all is well.  Again from the Wall Street Journal:

The price decline] exaggerates the extent of the weakening price picture. Because sales in the more expensive Northeast fell sharply while sales in the South rose, the mix of homes sold shifted toward those priced at under $200,000, while sales of pricier homes fell as did the relatively small subset of homes prices at under $150,000. Nonetheless, the stronger sales helped builders pare inventories by about 1.9% but the stock of unsold homes remains at an uncomfortably high level that would still require 6.4 months to liquidate at the current selling rate. Summing Up: New home sales rose a "surprising" 5.3% in September BECAUSE builders were more aggressive in cutting prices. --Nomura Economics Research

Still, the sense of the day was relatively upbeat.  From Reuters:

"It is hard to say but it looks like we are in for the soft (economic) landing," said Stephen Gallagher, chief U.S. economist at Societe Generale in New York. "It is telling me that the worst is over for housing"...

Former Federal Reserve Chairman Alan Greenspan said on Thursday the U.S. economy was pulling away from a sharp housing-sector downturn and that the outlook for growth was "reasonably good." But, he noted in a speech delivered before the government released the home sales figures, that the sector's woes were "not over."

"Most of the negatives in housing are probably behind us," Greenspan said at a Washington conference. "The fourth quarter should be reasonably good, certainly better than the third quarter"...

"Outside of the volatile aircraft orders, manufacturing is still subdued and that's consistent with an economy that's growing moderately," said Gary Thayer, chief economist at A.G. Edwards and Sons in St. Louis.

You will, of course, have no trouble finding skeptics.

October 27, 2006 in Data Releases, Housing | Permalink


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Your comments on the housing data are very good.

But historically there has been a significant problem with new home price comparisons over the cycle.
Typically, when the housing market turns south builders drop out of the bottom end of the market first. Historically this has distorted the average price data and causes the averge sales prices to be inflated during housing downturns. The reverse happens during upturns.

So making the type of comparisons of new home prices around cyclical turning points
is usually a pretty meaningless excercise.

Posted by: spencer | October 27, 2006 at 11:33 AM

You can slice and dice data any way you want. For bears, it may be helpful to look at price data from the most overheated sectors of housing-and they will. A bear will immediately cite Naples, FL. There is still a lot of housing stock on the market in south Florida, and no one is aggressivley cutting price yet.

In the pockets of the US that didn't have a huge run up in housing costs, the supply demand equation is probably more neutral.

The only question in my mind about housing is when do the sellers in Florida begin to ratchet down listing prices aggressively? Or do they have enough money to wait it out. Eventually, over time, someone will lift their offer as supply wanes and demand creeps up.

I think expectations has a lot to do with the soft landing. The fed has remained transparent in their feeling on interest rates, and the market has adjusted. Once rates began to stabilize, buyers came back in.

Posted by: jeff | October 27, 2006 at 03:46 PM

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October 25, 2006

Bottoming Out? Part 3

With an assist from Bizzy Blog comes this take on the future of the housing market, from J. Benson Durham at the Federal Reserve Board of Governors:

... this paper addresses the first three moments of investors' expectations for home prices in particular and the broader housing sector in general. In other words, first, what is the mean expectation for the path of home prices? Second, how uncertain are investors about that mean projection? And, third, do investors see the risks to the outlook for housing as considerably skewed to the downside as opposed to the upside, which might be consistent with the perception of a bubble?

The answers?

CME housing futures currently suggest that market participants expect home prices to decelerate sharply or actually decline a little within the next year, although the anticipated drop is mild compared to some estimates of the purported overvaluation of the housing market. In addition, market participants seem more uncertain about the trajectory of home prices, as implied volatilities on the few CME options that have traded thus far are generally greater than the realized historical volatilities on the underlying indexes. Finally, probability density functions (PDFs) implied by options on select homebuilders' shares are only marginally negatively skewed at the present time. Moreover, the current skew of these densities is broadly comparable to that of the equity market as a whole, and skewness has not noticeably increased over time for these firms. Caveats about this proxy notwithstanding, this suggests that market participants do not in fact view the risks to home prices or, perhaps more accurately, to the broader housing sector as especially tilted to the downside.

So, the housing market has probably not reached its trough yet, people are not sure what the trough will look like, but the consensus is not rushing to the view that a free fall is in the offing.

All of which seems perfectly consistent with today's report on September existing home salesFrom MarketWatch:

Sales of U.S. existing homes dropped for the sixth month in a row in September while median sales prices fell for the second straight month, the National Association of Realtors said Wednesday.
Inventories of unsold homes fell for the second straight month, a sign that the market is correcting, said Laurence Yun, a senior economist for the realtors group.

That last bit of news sounds like a positive ...

But economists said the decline in inventories was normal this time of year. The inventory figures are not adjusted for seasonal factors, as the sales figures are. "When adjusting for the seasonal factors, inventories actually continue to climb," said Celia Chen, an economist for Moody's Economy.com.

On the other hand:

"This is likely the trough in sales," said David Lereah, chief economist for the realtors group...

"Some indicators, such as pending home sales and mortgage applications, have suggested that sales may be starting to stabilize, but the latest figures continue to show a decline in activity," said Michael Moran, chief economist for Daiwa Securities America.

In other words, that uncertainty noted in the Durham analysis seems well justified, but the data is not yet sending clear enough signals to make either pessimists or optimists repent.

Calculated Risk has suggested that this focus on whether the housing market is balancing itself or not is misguided:

... the significant impact of the housing bust will come from housing related job losses, the loss of mortgage equity extraction (used fro consumption), and any financial stress associated with falling housing prices and tighter lending standards.

There is a significant lag between when a housing boom ends, to when housing related employment starts to decline precipitously.

Maybe, but the dominant view today -- here, here, and here, example -- seems to be that the dominant view at the Federal Reserve is that the answer to "Bottoming Out?" is "yes."

October 25, 2006 in Data Releases, Federal Reserve and Monetary Policy, Housing | Permalink


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If we are already bottoming out on the housing boom or bust, then what was the big deal all about?

Come on, the sky was supposed to be falling. Right?

I looked at the sky tonight. A bit cloudy, but it was way the hell up there.

Housing bust? That was it? Nothing more drastic?

If this is the bottom or near the bottom, then what happens to the pricing situation going forward? We just eat the massive runup in housing prices?

Yeah, I know. You guys have better answers.

So, answer away. While I hold up the sky.

Posted by: Movie Guy | October 26, 2006 at 12:49 AM

I believe at the money options volatility is slightly higher than volatility of the underlying futures most of the time. But in this case higher option volatility may also reflect the illiquidity of the underlying futures, i.e. the difficulty options traders encounter buying and selling illiquid futures to adjust their options portfollios to manage the risk they assume.

Posted by: trader walt | October 26, 2006 at 10:09 AM

A nominal decline in home prices is of 2 percent (say) is a big deal. At a 3 percent inflation rate, it implies a 5 percent real decline. Two or three years of a 2 percent nominal decline sums to approximately a 15 percent real correction (and even more if one takes into account that in steady state house prices should increase at approximately 2-3 percent per year in real terms).

Posted by: Morris Davis | October 26, 2006 at 10:53 AM

Instead of "misguided", I think focusing on a bottom now is probably "premature".

We should see significant housing related job losses over the the next few quarters .... so the next 2 to 3 quarters should show the impact, if any, of the housing slowdown on the general economy.

Best Wishes.

Posted by: CalculatedRisk | October 26, 2006 at 11:39 AM

Dave, Whether home prices are bottoming is of secondary importance to how the FED is likely to react IF further price declines lead us into a recession. Instead of massaging incomplete data for I don't know what purpose, the FED would do well to satisfactorily explain BB's stated position that housing escalation was "driven by fundamentals".
IF housing price increases were NOT driven by fundamentals, the worst thing the FED could do would be to fight a much-needed price reversion to long-term mean growth rates.
It's not the FED's job to see we never again endure the horrors of living through two successive quarters of negative growth. It is the FED's job to protect our long-term economic viability. This begins with being an honest broker.

Posted by: bailey | October 26, 2006 at 12:22 PM

Dave, Whether home prices are bottoming is of secondary importance to how the FED is likely to react IF further price declines lead us into a recession. Instead of massaging incomplete data for I don't know what purpose, the FED would do well to satisfactorily explain BB's stated position that housing escalation was "driven by fundamentals".
IF housing price increases were NOT driven by fundamentals, the worst thing the FED could do would be to fight a much-needed price reversion to long-term mean growth rates.
It's not the FED's job to see we never again endure the horrors of living through two successive quarters of negative growth. It is the FED's job to protect our long-term economic viability. This begins with being an honest broker.

Posted by: bailey | October 26, 2006 at 12:23 PM

I believe my post above is incorrect. Prof. Altig is correct: the higher implied options volatility indicates that options traders expect volatility of the underlying futures to increase. That's why he is a professor and I am 1 bid, two offered in the pit. Sorry for the error.

Posted by: trader walt | October 26, 2006 at 01:56 PM

If you are looking at to how the FED is likely to react-check credit spreads in the eurodollars at the CME. All are negative through the next few years. This is an indicator that the expectation is the next move is down in interest rates. Many bank prop shops are forecasting a .5 cut in rates by this time next year.

Posted by: jeff | October 26, 2006 at 02:40 PM

No one answered my question about eating the runup in housing prices.

Come on, the sky is getting heavy...

Posted by: Movie Guy | October 27, 2006 at 12:21 AM

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October 23, 2006

Laffer's Defense?

A fair amount of (gleeful?) keystroking was instigated last week by a Washington Post article that included this "confession":

Robert Carroll, deputy assistant Treasury secretary for tax analysis, said neither the president nor anyone else in the administration is claiming that tax cuts alone produced the unexpected surge in revenue. "As a matter of principle, we do not think tax cuts pay for themselves," Carroll said.

In fact, one of the reasons to have some confidence that the most recent round of tax cuts in the United States did not pay for themselves is that the hard work of incorporating those incentive effects upon which the Laffer curve hinges has been done.  Kash had the story, at The Street Light

The tax cuts may indeed have stimulated some economic growth. In 2003 the Republican Congress convened a panel of economists (under the authority of the Joint Committee on Taxation, or JCT) to estimate exactly how much of a positive impact on tax revenues this feedback effect would provide, using a technique called "dynamic scoring" to measure the overall cost of the tax cuts.

This JCT study concluded that there would indeed be positive revenue effects from the economic growth that the tax cuts would stimulate, to the tune of some $30 or $40bn per year. But it turns out that the negative revenue effects of the tax cuts are a bit larger than that.

The "bit larger" there is facetious.  And, I think, the presumption that tax cuts won't pay for themselves is a good general principle.  But it is does have its limits.  Alex Harrowell, for example, unearths this interesting tidbit at A Fistful of Euros:   

... the Socialist government of Ferenc Gyurcsyany came up with a simple plan to cut the deficit from 10.1 per cent of GDP to something more reasonable.

Essentially, he decided to tax the rich until the pips squeaked. More accurately, he decided to tax industry until the pips squeaked, introducing a new 4 per cent “solidarity tax” on company profits...

The first results don’t look good. In fact they look disastrous. Volkswagen-Audi has reacted to this by cancelling €1 billion worth of investment at its plant in Gyor, which produces 20,000 Audi TT sports cars a year. The Gyor plant is Hungary’s biggest exporter, all on its own. VW had been planning to double its output. It is fair to say that essentially all the extra cars would be exported.

This particular anecdote does not, of course, indicate that Hungarian revenues will fall as a result of this tax hike.  But in this specific case, it doesn't seem implausible. 

Invoking a different example, both Mark Thoma and The New Economist reference a recent IMF paper that studies the aftermath of reforms in various countries that have implemented "flat taxes."  The conclusion:

... there is no sign of Laffer-type behavioral responses generating revenue increases from the tax cut elements of these reforms..."

I take no issue with that conclusion, but this, from the paper, bears emphasis:

But this paper—like the practical developments it addresses—is not about the HR flat tax.

Particularly in the United States, the term “flat tax” is associated with Hall and Rabushka (1983 and 1985; HR)... In effect, the HR flat tax is a consumption-type, origin-based value-added tax (VAT) collected by the subtraction method, supplemented by a (nonrefundable) tax credit against labor income.

And that really, really matters.  Several years back, I was part of a team that simulated the effects of the HR flat tax, and similar forms of fundamental tax reform.  We found that in the most straightforward version of this type of tax reform, the shift from something like our present income-based tax system to an HR-like consumption-based system would require a tax rate on labor-income of 21.4 percent in order to keep revenues from falling.  Over time, as the growth effects of removing capital taxation took hold in our experiments, the tax rate required to maintain revenue neutrality fell by 2 percentage points.  (The payroll tax rate required to finance social security benefits fell slightly as well).  In these experiments, then, really fundamental reforms did indeed generate "Laffer-type" effects, at least in the long run.

What's the moral to the story?  I guess it's that, even though the conventional wisdom is usually right, we probably shouldn't take for granted that it is always so.  There's a good reason to keep playing the game.      

UPDATE: Kash notes that the flat tax experiments I describe are about the efficiency gains of revenue-neutral fundamental tax reform and not that general cuts in tax rates raise revenues.  And right he is.  We are both agreed that the answer to what happens to revenues after any particular tax change depends on the both the nature and context of the change.  And I'll agree that once that point is recognized, the Laffer curve is not an idea that conveys much additional insight.

October 23, 2006 in Taxes | Permalink


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October 20, 2006

Bottoming Out? Part 2

The latest newsletter from Goldman Sachs US Economic Research just arrived in my inbox, with this to say:

The point of maximum deterioration in housing activity has probably passed.  The sharp downturn of the past year seems to have brought total housing starts single-family starts, multi-family starts, and mobile home shipments close to the level justified by the underlying demographics (as best we can measure them).

This is not to say that residential investment will stop falling anytime soon...

Still, the fact that the US economy has bent but not broken during the fiercest onslaught of the housing downturn is encouraging.  It suggests that real GDP growth probably bottomed for the cycle at the 1% (annualized) pace that we now estimate for the third quarter of 2006.  While the headwinds from the direct and indirect effects of the housing bust will remain substantial, a sequential pickup in real GDP growth is now likely.

Yeah, that's what I was thinking

October 20, 2006 in Housing, This, That, and the Other | Permalink


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If that's the case, I'd hope Staff is ready to recommend it's time for the FED to resume its tightening efforts to ensure our economic viability.
So, what will it be, what are the real priorities of the FED - to encourage saving over spending & managed risk-taking over unchecked speculation, or to see we never again suffer the horror of living through two successive quarters of negative growth?

Posted by: bailey | October 21, 2006 at 11:35 AM

Price stability is a hallmark of healthy, long term economic growth. Incipient inflation always feels good at first but, by the nature of inflation, indicates a sick economy. BB can forestall a quarter or two, but the underlying foundation is rotten.

The underlying source of the worldwide expansion is debt induced consumption by America created by printing press liquidity, depression level Keynsian spending by the republicans, and mercantilist production in third world coutries by the trans-national corporations. Nothing has changed. The drop in gasoline to more reasonable levels feels good but it is just waiting to increase.

I would like nothing more than to be optimistic. However, the continuation of the bubble economy is harvesting the future. The time to act was three years ago.

Posted by: zink | October 22, 2006 at 10:18 AM

Such galvanizing posts by bailey and zinc --more or less against the consensus-seeking host who has this cheery (possibly Polyanna, but annoying nonetheless) disposition that needs further weight on the Roubini side of the ledger.
So let's expand zinc's
"...but the underlying foundation is rotten.

The underlying source of the worldwide expansion is debt induced consumption by America created by printing press liquidity, depression level Keynsian spending by the republicans, and mercantilist production in third world coutries by the trans-national corporations. Nothing has changed."

Here is what's changed: in the 90s expansion tons were spent on up-grading communications and we have tons of better performance to show for it. In the recent expansion we have spent tons largely in housing and unlike communications, there is little improvement. Don't let the RE agents tell you different, the boxes are pretty much the same. No order of magnitude performance advances in housing and more particularly, no cross-the-board improvements (the products/services hit only 2 of 3 customers).
If zinc is not right about the underlying fundamentals being rotten, it is because there are no rotting fundamentals left underlying this expansion, a miscreant born out of 9/11.
Ok, not very cherry, but the time has passed for looking for the roses on this thorny bush.
It has.

Posted by: calmo | October 22, 2006 at 02:07 PM

Dave, Here's a FED decision I hope you'll address when you respond to the housing arguments of Roubini, Baker, & a great many others who are resolved we'll suffer significant economy-wide impact from our housing bubble.
On 10/18/06 the OCC released results from its latest survey of Bank Credit Underwriting. (Link to press release, with embedded link to survey results, follows.)
Banks cited their main reason for easing underwriting standards this last year was to "remain competitive". If that's not enough, these same Banks expect to ease further this coming year.
OCC is a branch of the Treasury Dept. which is under Bush, not the FED. But, these survey results raise serious questions why the FED took a kid-gloves approach with its Banks in its just released Nontraditional Mortgage "Guidance".
It looks to me like the OCC is looking for cover, strongly asserting the FED abdicated its supervisory responsibility to its Banks.
I agree. Just because Fed Banks' competitors challenge each other to to jump off a very high bridge, it does not follow that the FED should set policy to help its Banks compete to be first.
My read is that BB just missed his first opportunity to distinguish his FED policy from those of AG. And, he shouldn't be talking about the importance of saving while encouraging irresponsible speculation. I pin the miss completely on Staff.
SOMEONE at the FED needs to catch up & get in front of its housing delemma NOW.

Posted by: bailey | October 22, 2006 at 05:43 PM

Posted by: bailey | October 22, 2006 at 05:45 PM

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Bottoming Out?

The view under The Street Light is that things may be headed south for the U.S. economy, and at Econbrowser Jim Hamilton is spot on regarding the equivocal picture being drawn by the incoming data. Still, I'm feeling oddly optimistic.  I guess I'm not alone.  From The Wall Street Journal (page A10 in the print edition):

Leading economic indicators pointed to slower U.S. economic growth in September.

Separate reports showed that factory activity in the Philadelphia region was flat in a mid-October reading even as manufacturers remain optimistic, and that weekly U.S. jobless claims hit a four-month low.

The Conference Board reported Thursday its index of leading indicators edged up just 0.1% to 137.7 in September, but noted that consumer expectations have improved. The index fell by a revised 0.2% in August. Economists had expected a more robust 0.3% advance last month.

"The economy has slowed but the evidence to date doesn't suggest it will stall or go into a recession," said Ken Goldstein, an economist with the private research group. "To the contrary, the economy retains considerable strength," given the rise in stock prices and drop in energy prices, he said. Mr. Goldstein also noted that employment remains robust and inflation relatively low.

It's not that we are lacking negatives, of course:

The group noted that the leading index has fallen in five of the last eight months, and from March to September, the index is down by 0.9%, a 1.7% annual rate decline.

The Federal Reserve Bank of Philadelphia reported that a gauge of manufacturing activity in its region slipped to -0.7 in a mid-October reading from -0.4% in September... Negative readings indicate a contraction in activity.

But we know that the third quarter was bad, and this is relevant too:

The findings of [September Philadelphia report], however, weren't borne out in other regional manufacturing surveys, or in the Institute for Supply Management's national report...

Expectations for future manufacturing growth improved after last month's sharp decline. Indicators for future orders, shipments and employment were all higher.

And that's the thing that keeps sticking in mind.  In my line of business I have the opportunity to hear from a lot of people who are, as they say, close to the ground -- folks actually making stuff, hiring people, extending loans, putting together deals.  My thoroughly unscientific sense is that the distribution of beliefs out there suggests things are more likely to get better than get worse.

That does not apply to the housing market, of course.  But, for reasons I'll detail in a later post, I'm beginning to wonder about the reach of developments in that sector. I'm not quite ready to take the anti-Roubini bet with the degree of confidence that Nouriel himself puts on his recession call.  But I'm getting there.

October 20, 2006 in Data Releases, This, That, and the Other | Permalink


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I agree, "things are more likely to get better than get worse". Our economy is ALL about MONEY SUPPLY, its FLOW, and the AVAILABILITY OF CREDIT, including that to hedge funds. The FED's approach to the double digit growth money supply we've seen for years was to stop counting it. It's response to the astronomical credit growth we've seen is to reaffirm its asymetric policy. (If it's wrong & the bubble pops, there's no need for us to worry - the FED will drop money from helicopters to provide needed liquidity. The message is loud & clear: forget our grandkids, let the good times roll.
So, let's get back to the important stuff: What are FF futures suggesting the Fed will do in '07Q1? If the odds are right, I'd love to releverage my bet & borrow the down for that TRANSPAC boat I NEED. (I'd wait for year-end financial sector bonuses (remember, last year's totaled $22 billion), but the filing deadline's in June & that's not much time to get ready.) On second thought, I've already releveraged 4 times, I think I'll wait for more early xmas sales - Responsibilities, you know. I'll just use the two new credit card offers I got in the mail yesterday (0% into '08) to cover the down. Man, is this economy great, or what?

Posted by: bailey | October 20, 2006 at 12:20 PM

I'm with bailey and Roubini. I've been bearish since the mid-ninties.I believe we've (Madison Avenue, Wall Street, and the US gov) dealt our economy and our middle class a near lethal blow with offers of ever-entending credit.

I could not believe it when Greenspan decided to cheerlead the blowing up of the housing bubble and ARMs in the wake of the Nasdaq bubble crash. I await your "anti-Roubini bet" post.

I'm particularly interested in better understanding how we are going to avoid liquidity traps if we try to inflate our way forward beyond what may have been the untimate bubble play (i.e. the housing bubble).

Finally, what is your take on hedge funds and risk concentration, and "perfect storm" possibilities. Somebody, somewhere, has to help be understand why we (particularly some big NY banking/finance enterprises -- deemed by many to be "too big to fail" (or be allowed ot fail) hence "we") are not way over extended in that realm. See, e.g. Robert Reich's recent post, here: http://robertreich.blogspot.com/2006/10/of-dems-hedge-funds-and-cheneys-plans.html

Posted by: Dave Iverson | October 20, 2006 at 12:49 PM

Professor, I think housing will get worse, but the hard part is estimating the impact of the housing slowdown on the general economy.

It seems there are multiple transmission mechanisms: lost housing related jobs (something that has barely started), loss of mortgage equity extraction (also just started) and the impact of tightening lending standards (after a period of excessively loose underwriting standards).

We're already seeing some impact on overall job growth and retail (Q3 retail sales were sluggish according to the Census Bureau advanced data).

Right now I'd expect Q4 growth to be worse than Q3 as housing related job losses pick up and equity extraction declines. I look forward to your post.

Best Regards!

Posted by: CalculatedRisk | October 20, 2006 at 01:34 PM

Usually there is a part of the economy to lead us forward in the expansion. What do you see as that part? Healthcare and finance (Wall Street) are doing well, but is that sufficient? Do you see the rest of the world growing sufficiently to become interested in American products or just assets?

Posted by: Lord | October 20, 2006 at 02:08 PM

What is in the American product pipline, now that housing has given us the impression that it, like the Norwegian Blue, needs a rest?
Nanotubes? Picotubes? Femtotubes?
Yes, of course, but will they be made here by American workers earning wages (such Cromagnons!) to buy those products/services representing those financial (not-so-Cromagnonian) items "just assets"?
Consider the new (somewhat fickle) asset class FABS, people -- assets that are increasingly foreign manufactured/originated, foreign distributed/marketed and (asset holders especially are hoping), soon to be foreign consumed products and services.
Just because the American consumer is going to take a breather doesn't mean your assets are. There are billions and billions of others just dying to get their mits on your leave blower and other assets.

Posted by: calmo | October 21, 2006 at 10:31 AM

Dear Calmo & others:

This is it, there is nothing in the "Pipelines". We are going to have a severe economic downward re-adjustment -sort of of England/France in the 50s & 60's with its accompanying social ills.

What greenspan & Co have been trying to do is to extend the good times to see if something came down the "pipelines" & avoided the consequences.

Something could come down the "pipeline" - but it will have to be politically driven & likely have a statis feel to it. And unfortunately, we are overdose with free-market ideology & deepply entreched interests at this time, that will ensure a stasis until the toilet needs to be flushed.

2 Techs that could save the day -> Energy (but you'll have to kill the Oil industry); Transportation (just like the UK -The Railroad tracks are owned & maintaned by an Authority -the trains themselves are private & different networks for Passensger & Freight -with their different track needs & add to this Maglev Tech.; etc..

Posted by: wysiwyg | October 21, 2006 at 05:26 PM

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October 19, 2006

Fiscal Transparency

Hat tip to Mirra at BudgetBlog for bringing to our attention the brand new Open Budget Index, designed to "rate countries on how open their budget books are to their citizens."  The initial publication includes ratings for 59 countries, chosen to be a broadly representative global sample.  The index is based on questionnaires, the answers to which are made available for each country, along with very useful links to each country's key budget documents.   

Here's how the ratings stack up (click on the picture for a better look):




Among us types who harbor interests in fiscal affairs, it is not uncommon to engage in extended discussions about what should and shouldn't be included when calculating a measure like "the deficit".  (For example, should contributions to Social Security trust funds be excluded or not?)   I've always had a suspicion that, in this conversation, economists and p-wonks often make much ado about not a whole lot.  In the United States, all the information is there in its full glory: On-budget deficits, off-budget deficits, projections of entitlement expenditures and receipts; basically more than enough information to knock yourself out answering whatever question you think budgetary concepts really ought to answer.  The information may not be absolutely perfect, but the Open Budget Index suggests its pretty darn good. 

October 19, 2006 in Federal Debt and Deficits | Permalink


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