Monthly Archives: December 2014

Unknown knowns about financial markets

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Robert Shiller’s point, in the new edition of Irrational Exuberance, about the lack of attention paid to the warning signals of bubbles, has been preoccupying me. The attention problem was the theme of a conference at the Toulouse School of Economics a couple of years ago, as well as books like [amazon_link id=”000731731X” target=”_blank” ]The Invisible Gorilla[/amazon_link] by Chris Chabris and Dan Simons.

[amazon_image id=”0691166269″ link=”true” target=”_blank” size=”medium” ]Irrational Exuberance[/amazon_image]   [amazon_image id=”000731731X” link=”true” target=”_blank” size=”medium” ]The Invisible Gorilla[/amazon_image]

Of course, this isn’t just an issue in financial markets. One of the interesting essays in Rebecca Solnit’s [amazon_link id=”1595341986″ target=”_blank” ]Encyclopedia of Trouble and Spaciousness[/amazon_link], which I read recently, riffs on [amazon_link id=”074325239X” target=”_blank” ]Donald Rumsfeld’s[/amazon_link] famous known knowns, known unknowns, and unknown unknowns, adding a fourth category (which she attributes to Slavoj Zizek) of unknown knowns. In her essay, the context is the scale of the US economy and policy devoted to military resources. In the financial markets, it is the existence of bubbles or stresses that exist in the data – in the world – but are not seen.

[amazon_image id=”1595341986″ link=”true” target=”_blank” size=”medium” ]The Encyclopedia of Trouble and Spaciousness[/amazon_image]

Or seen, but not allowed to rise to conscious thought and action. In the year or two before the 2008 crisis, the signals were (with hindsight) very clear – an inverted yield curve, and super-high PE ratios and house price-earnings ratios. Few people paid attention, however. But it’s extraordinarily hard to be just about the only person paying attention to unknown knowns. The Office of Financial Research was intended to be a post-crisis solution to this problem, gathering data and developing visualisations or effective methods of monitoring the markets. I don’t think it has the hoped-for impact.

Next year’s reading

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At the end of the year I’ll do my usual round-up of forthcoming economics and business books, but I can’t resist mentioning a few tantalising titles my own publisher, Princeton University Press, is bringing out next spring. As the author of [amazon_link id=”0691156794″ target=”_blank” ]GDP: A Brief But Affectionate History[/amazon_link], I will have to read Dirk Philipsen’s [amazon_link id=”0691166528″ target=”_blank” ]The Little Big Number: How GDP Came to Rule the World and What to Do About It[/amazon_link]. Francois Bourguignon has [amazon_link id=”069116052X” target=”_blank” ]The Globalization of Inequality[/amazon_link] out in June. Ian Morris – author of the fabulous Why the West Rules – For Now – has a new book, [amazon_link id=”0691160392″ target=”_blank” ]Foragers, Farmers and Fossil Fuels: How human values evolve[/amazon_link].

[amazon_image id=”0691166528″ link=”true” target=”_blank” size=”medium” ]The Little Big Number: How GDP Came to Rule the World and What to Do about It[/amazon_image]   [amazon_image id=”0691156794″ link=”true” target=”_blank” size=”medium” ]GDP: A Brief but Affectionate History[/amazon_image]

[amazon_image id=”0691160392″ link=”true” target=”_blank” size=”medium” ]Foragers, Farmers, and Fossil Fuels: How Human Values Evolve (The University Center for Human Values Series)[/amazon_image][amazon_image id=”069116052X” link=”true” target=”_blank” size=”medium” ]The Globalization of Inequality[/amazon_image]

There are many more, in a terrific list, but I also can’t resist mentioning two new books on Benford’s Law, [amazon_link id=”0691163065″ target=”_blank” ]An Introduction to Benford’s Law[/amazon_link] by Arno Berger and Theodore Hill, and Benford’s Law: Theory and Applications edited by Steven Miller. Benford’s Law says the first digits of data sets (such as economic statistics) are not uniformly distributed from one to nine – it helped reveal the fact that Greek economic statistics prior to the crisis were not accurate.

Exuberance, animal spirits and identity

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The arrival this week of Robert Shiller’s revised edition of his wonderful book [amazon_link id=”0691166269″ target=”_blank” ]Irrational Exuberance[/amazon_link] was timely, because it came in the wake of Aditya Chakrabortty’s radio programme about the teaching of economics. One of the the bizarre claims made in the programme is that mainstream economics is fixated on rational choice models. Shiller’s work on finance, for which he received the Nobel Prize of course, serves as Exhibit One in showing this claim to be incorrect. (Tony Yates blogged about this and other issues with the programme.)

[amazon_image id=”0691166269″ link=”true” target=”_blank” size=”medium” ]Irrational Exuberance[/amazon_image]

The new preface to [amazon_link id=”0691166269″ target=”_blank” ]Irrational Exuberance[/amazon_link] begins: “One might think that years after the bursting of the speculative bubbles that led to the 2007-9 world financial crisis, we should be living in a distinctly different post-bubble world. One might think that people had learned their lesson, and would not again pile into expanding markets.” But no. Although the situation isn’t as fragile now as in 2000 (ahead of the 1st edition) or 2005 (2nd edition), Prof Shiller clearly thinks there is renewed potential for a crash somewhere. The bond market is clearly a leading candidate. One substantial addition to the book is a chapter on the bond market, which he believes has a high probability of currently being in a bubble, vulnerable to bursting. But it isn’t just bond markets that could be bubbly, but also equities: the ratio of real share prices divided by the ten-year average of real earnings in the US is higher than it has been at any time except 1929, 2000 and 2007.

Interestingly, the book suggests that the psychology of bubbles is not one of firm belief that a crash cannot happen, but rather one of inattention to evidence that it might or will do. This is in line with work Paul Seabright at the Toulouse School of Economics has beein doing on attention – or its lack. A second kind of addition to this 3rd edition is the integration of Shiller’s thinking on psychology since his book [amazon_link id=”069114592X” target=”_blank” ]Animal Spirits[/amazon_link] co-authored with George Akerlof. Akerlof has continued to work on this too, including his very interesting work with Rachel Kranton on the role of identity in economic choices, in [amazon_link id=”0691146489″ target=”_blank” ]Identity Economics[/amazon_link].

[amazon_image id=”069114592X” link=”true” target=”_blank” size=”medium” ]Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism[/amazon_image]   [amazon_image id=”0691146489″ link=”true” target=”_blank” size=”medium” ]Identity Economics: How Our Identities Shape Our Work, Wages, and Well-Being[/amazon_image]

[amazon_link id=”0691166269″ target=”_blank” ]Irrational Exuberance[/amazon_link] is a classic and it is essential reading on economics and financial markets; for anyone who hasn’t yet read it, this 3rd edition brings the contextual information up to date and expands on the psychological insight of the original. I should add, Robert Shiller is the most prominent exemplar of economists using decision assumptions and frameworks other than ‘rational choice’ but he has plenty of company in the profession – in fact, it’s pretty mainstream nowadays.

Adam Smith for our times

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Adam Smith’s [amazon_link id=”0143105922″ target=”_blank” ]The Theory of Moral Sentiments[/amazon_link] has had something of a revival in recent times. Emma Rothschild’s Economic Sentiments focused on it, and Nicholas Phillipson’s recent biography of Smith, Adam Smith: An Enlightened Life underlined its importance in Smith’s thinking. My own dear publisher Peter Dougherty also gave it due credit in his [amazon_link id=”0471720909″ target=”_blank” ]Who’s Afraid of Adam Smith: How the Market got its Soul[/amazon_link]. So, while still far less well-known and less widely read than [amazon_link id=”0140432086″ target=”_blank” ]The Wealth of Nations[/amazon_link], [amazon_link id=”0143105922″ target=”_blank” ]Moral Sentiments[/amazon_link] is creeping onto the intellectual radar of our times – we are rediscovering the Adam Smith we need now.

[amazon_image id=”0143105922″ link=”true” target=”_blank” size=”medium” ]The Theory of Moral Sentiments (Penguin Classics)[/amazon_image]

It gets a deserved boost from Russ Roberts’ new book, [amazon_link id=”1591846846″ target=”_blank” ]How Adam Smith Can Change Your Life[/amazon_link] (which I read in manuscript and provided a little comment for). This is a delightful book translating Smith’s 18th century prose into a 21st century guide to individual and collective living well. I choose that phrase because it isn’t just a guide to leading the Aristotelian good life, nor a book about how to run the economy better, but combines the two into insights about how wise choices can help the individual and society.

[amazon_image id=”1591846846″ link=”true” target=”_blank” size=”medium” ]How Adam Smith Can Change Your Life: An Unexpected Guide to Human Nature and Happiness[/amazon_image]

For example, in the chapter ‘How to Make the World a Better Place,’ Roberts says: “In The Theory of Moral Sentiments, Smith describes how individual choices can lead to important social outcomes. He’s talking about something more important than the price of apples. He’s describing the role each of us plays in creating a moral society.” And he goes on to explain how emergent social norms create the standards or proper, moral behaviour. “Smith argues that norms and culture are the result of the tiny and infinitely numerous and subtle ways we interact.” I particularly like this chapter. It combines Hayek and Ostrom in a rather unexpected way.

The chapters have titles such as ‘How to be Happy, ‘How Not to Fool Yourself’, ‘How to be Loved’, ‘How to Live in the Modern World.’ The last of these links The Theory of Moral Sentiments and The Wealth of Nations, explaining that they share the same world view, the same view of human nature, but apply it to different domains, the personal and the commercial.  “A modern person has to inhabit two worlds at the same time, a world that is intimate and a world that is distant, a world that is held together by love, and a world that is held together by prices and monetary incentives.”

Russ Roberts will be known to many readers of this blog for his Econtalk podcasts, a huge public service. He’s an excellent writer – I am a fan of his novels, [amazon_link id=”0262681358″ target=”_blank” ]The Invisible Heart [/amazon_link]and [amazon_link id=”0691143358″ target=”_blank” ]The Price of Everything.  If[/amazon_link] you haven’t read [amazon_link id=”0143105922″ target=”_blank” ]A Theory of Moral Sentiments[/amazon_link], or if you have and would like an enjoyable reminder, [amazon_link id=”0241003199″ target=”_blank” ]How Adam Smith Can Change Your Life[/amazon_link] is a pleasure to read.

What do economists know?

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Emran Mian, who runs the Social Market Foundation (and has written a brilliant novel, [amazon_link id=”1846556260″ target=”_blank” ]The Banker’s Daughter[/amazon_link]), has a terrific essay – Prediction and the Flagpole –  in 3am Magazine about the problem of knowledge in economics – what do we actually know about how the economy works, about causality? As he points out, either the mechanisms are highly contested among economists, or ignored by them. We don’t know very much at all.

There should be no shame in this, because we don’t know much about anything. This is why epistemology is so hard. However, as the article also says, “We live in a peculiarly economics-friendly public sphere.” Yet many economists over-claim their knowledge, especially when it comes to making predictions. Personally, I think economic forecasting is largely a hopeless task except for the limited task of using time series methods to predict a short period ahead. (I was a forecaster for several years, a long time ago, so I know whereof I speak.) Chris Dillow has recently blogged about the nonsense often associated with forecasts – unicorn farming is his term for it. Nate Silver’s [amazon_link id=”0141975652″ target=”_blank” ]The Signal and the Noise[/amazon_link] has a terrific chapter effectively demolishing most macroeconomic forecasts.

After the onset of the financial crisis, there were lots of calls for economists to be humbler. I don’t see a lot of humility, alas. Most f my colleagues have little interest in the philosophical questions, although of course my great hero David Hume was keen on epistemology. One terrific book about what economists can know is John Sutton’s [amazon_link id=”0262692791″ target=”_blank” ]Marshall’s Tendencies: What Can Economists Know?[/amazon_link]. I must read Mary Morgan’s [amazon_link id=”0521176190″ target=”_blank” ]The World in the Model: How Economists Work and Think[/amazon_link], and Nancy Cartwright’s recent [amazon_link id=”0199841624″ target=”_blank” ]Evidence-Based Policy[/amazon_link] – she has also written a lot about the causality question.

[amazon_image id=”0262692791″ link=”true” target=”_blank” size=”medium” ]Marshall’s Tendencies: What Can Economists Know? (Eyskens Lecture) (Gaston Eyskens Lectures)[/amazon_image]  [amazon_image id=”0521176190″ link=”true” target=”_blank” size=”medium” ]The World in the Model: How Economists Work and Think[/amazon_image]  [amazon_image id=”0199841624″ link=”true” target=”_blank” size=”medium” ]Evidence-Based Policy: A Practical Guide to Doing It Better[/amazon_image]