New Issue of Critical Review on Financial Crisis

The current issue of Critical Review is devoted to an examination of the causes and consequences of the financial crisis.  The collection of contributors is truly impressive and includes Vernon Smith, John Taylor, Daron Acemoglu, and Joe Stiglitz among others.  Financial regulations, monetary policy, rating agencies, capital requirements, accounting rules, etc. are all touched upon.  Also the culpability of modern economics is addressed in a piece by David Colander et al (an overstated case imho).  Friedman's introduction (which is available for download) does a great job of setting the stage for the issue and framing the discussion of the crisis in general. As Friedman's title suggest, we are talking about a crisis of politics, not of economics.

Comments

[e weick]

Peter,

The high probability of a global credit collapse was known by 2004 to anyone who had eyes to see and ears to hear.

Studying Mises, Hayek, Buchanan, etal., plus some idea of how markets work and historical chronology were sufficient.

ED

[Mario Rizzo]

How "wise" of the editor to exclude Austrian contributions. After all, they might have been "out of the box." The box is the home of all Truth.

[S Andrews]

Very interesting thoughts. It all depends on what you are trying to achieve through your blog. If it is an extention of your classroom, as you say it is, and you only intend to engage the students from your classroom, then you can limit ability to post comments to only your students.

However, if your goal is to spread good economic thinking, then you shouldn't read too much into the nature of the comments or the commentors. you should sleep well @ night knowing that your message is reaching people @ various levels, not all of them need to become tomorrow's economists.

As for conspiracy, which socio-political group doesn't have their cliques of kooks, especially amongst libertarians, who by their very nature are suspicious of an all powerful state.

[S Andrews]

I posted my comment in the wrong thread. Sorry!

[Jeffrey Friedman]

WHAT COUNTS AS AN "AUSTRIAN" CONTRIBUTION TO SCHOLARSHIP?

My friend Mario’s comment is based on a serious misunderstanding, and raises a perennial question about the nature of "Austrian" scholarship.

The misunderstanding is that I somehow tried to "exclude" self-identified Austrian economists from contributing to Critical Review’s special issue on the crisis. In truth, I made every effort to include them.

However, long-time readers of this blog will discover in the May and June 2008 archives that when the crisis was unfolding and CR's special issue was in its planning stages, I got myself into quite a controversy here bemoaning the fact that The Austrian Economists were discussing the presidential campaign, foreign policy, Ron Paul, pirates—but not the economic crisis. This was immensely frustrating to me because I needed some Austrians to do research on the causes of the crisis that I could publish—and I couldn’t find them!

So instead, what I did is publish individual articles on all the things Austrians might have suspected were responsible for the crisis—using my own Austrian-influenced beliefs as my guide. Thus, our special issue makes widely accessible in print John Taylor's classic paper on the Fed as the cause of the crisis; and it includes new research on the same theme coauthored by Vernon Smith, plus a comprehensive summation of how the Community Reinvestment Act, Fannie, and Freddie contributed to the crisis, by Peter Wallison. The special issue also includes a paper on the legal protection of the rating agencies’ oligopoly, by Larry White of NYU.

Finally, the special issue includes a scathing indictment of the unrealistic assumptions of mainstream neoclassical economics, *especially the omniscience assumption*--the famous “Dahlem report,” by David Colander et al.

Not satisfied with all of that, I wrote a 60-page introduction to the issue—available at http://arnoldkling.com/econ/book/JFintro.pdf --that provides a synthetic *Austrian view of the political economy of the crisis.* In it, I argue that the *mistakes* of bankers in purchasing subprime mortgage-backed securities were caused by the *ignorance* of the financial regulators, whose rules encouraged those very purchases.

Now what more should I have done by way of “including Austrian contributions”? Or does Mario mean that, for a contribution to count as Austrian, it has to be written by someone with a Ph.D. in economics (mine is in political science) from NYU or GMU?

Or does someone have to talk about Austrian business cycle theory for his contribution to be "Austrian"? I am totally open to publishing ABCT research, as with Bill Butos's "The Recession and Austrian Business Cycle Theory: An Empirical Perspective" (1993), the last time there was a serious recession. But I haven't seen such research on the 2008 crisis yet. And in any case, I think that only a narrow, parochial view of “Austrian contributions” would reduce them to ABCT.

So Mario, exactly what "box containing all Truth" do the articles in CR all, supposedly, fit into? Where will you find a more intellectually diverse yet Austrian-oriented collection of scholarship on the crisis?

To me, what is distinctive about Austrian economics is its focus on mistakes caused by ignorance. That is also what I think makes Austrian economics supremely realistic, and applicable outside the realm of economics (especially in the realm of politics).

My introduction to the special issue, kindly highlighted by Pete Boettke, goes on the offensive on behalf of that Austrian idea--which is traceable not only to Hayek but to Don Lavoie and to Mario's *Economics of Time and Ignorance.* I argue that without the concept of ignorance-based error, we cannot properly understand the crisis. What more could I have done to include "Austrian contributions"?

Jeffrey Friedman
Editor, Critical Review
[email protected]

[Wladimir Kraus]

The only paper besides the introduction that I read, is the one by Stiglitz. My general impression is that the symposium was at least an excellent opportunity for Austrian economists to put forward their understanding of the crisis, especially given the quality of the forum and two participating Nobel Laureates. What more would one hoped for career-wise and otherwise!?

(It's a pity I missed it, otherwise I would have something to say from an Austro-Classical perspective as developed by George Reisman.)

Anyway, it is indeed puzzling why the leading Austrians did not participate in the debate.

Wladimir

P.S. Jablecki and Machaj are young Austrian economists, so there are two Austrians who contributed something. Machaj is outstanding and I know his paper with Jablecki is worth a look.

[Jeffrey Friedman]

Yes, the Juliusz Jablecki and Mateusz Machaj paper in our special issue, entitled "The Regulated Meltdown," is one of the most important in the whole volume, if not *the* most important. But I didn't know whether the authors would identify themselves as "Austrians." I don't apply that litmus test to papers in Critical Review--but I knew about these young authors because Matt Machaj already had a paper on Hayek forthcoming in CR, which will appear next year.

Jeffrey Friedman
Editor, Critical Review
[email protected]

[Lee Kelly]

Wow, that was some introduction. It's like a two-mile driveway with great scenery. Perhaps CR's introductions are always like this, perhaps I am just betraying my ignorance, but that was an interesting read.

I worked briefly for a mortgage broker about two years ago, and they actually specialised in subprime. This was in England, and so the regulatory and monetary environment was slightly different, but some of the people who were getting mortgages were ... well, I think everyone there just assumed that the companies buying these mortgages had figured it all out. Some people were getting mortgages without declaring their income, with little or no downpayment, and with bad or ambiguous credit ratings. Many had names like "Michael Ocemoglu", spoke with a thick Nigerian accent, and seemed utterly uninterested in the risks involved--they just wanted to know when they could have the money. Often, these were "interest only" loans, where the borrower claimed to have some kind of investment vehicle to pay the loan.

Crazy stuff.

I should get a t-shirt saying, "I WAS PART OF THE HOUSING BUBBLE 2002-7."

[Lee Kelly]

The place I worked was desperate to hire new mortgage brokers--a qualification was legally required. One woman working there had left a career in IT to start a new career in the financial industry; she had invested in earning the necessary qualifications, and thought she was entering into a emerging field. I don't know what she is doing now.

It's a great example of resource misallocation during a bubble.

[Lee Kelly]

I don't know how it works in the U.S., but checking someone's credit rating in the U.K was actually quite difficult.

The kind of person who is a high credit risk also tends to have two other traits, 1) multiple residences over a short period, and 2) multiple names (different spellings, contractions, concatenations, etc.), and between the two it makes checking their credit rating a nightmare, (especially when you're handed 50 or so to do in a couple of hours!)

I am sure that mistakes were frequently made, but there was so much demand for mortgages, and so much competition among mortgage brokers, that the cost of more cautious checking was too great. And, so far as I could tell, we were in complete compliance with existing regulations.

[Peter Boettke]

Folks,

I have read the CR issue, the papers are very good and dig deep into the issues.

As Friedman can tell you, I read his introduction and gave him my detailed reaction. His introduction is very good.

Jeff has an uncanny ability to get leading scholars to contribute to CR -- he has done this throughout the history of CR. Jeff also has an uncanny ability to synthesize arguments across traditions, and also to identify the core issues involved in debates --- with regard to intellectual history, and actually historical events.

Now I do think there are several people who have written very good things from an Austrian perspective that have been circulating since the time Jeff is talking about. I would list O'Driscoll, White, Selgin, Garrison, and Horwitz as early indentifiers of the fundamental causes.

And I should point out, and readers on the blog can double check, but we (especially Fred and I) talked about the possibility of a coming crash due to a global credit crisis for at least 5 years (with an acknowledgement to our friend Ed Weick, who is a very successful individual in the financial services). But of course, we didn't "predict" the crisis in any relevant financial sense.

Tom Wood in Meltdown lists Peter Schiff, James Grant, and Jim Rogers as also individuals who pointed out the potential problems on the horizon.

Woods book is very good reading and I highly recommend it.

But I would very much recommend CR issue --- as Jeff says, all the elements are there for a full understanding of the causes and consequences of the Great Recession of 2008-2009.

In addition to this volume, readers of the blog should know that the Mont Pelerin Society ran a special session on the crisis earlier this year --- I gave my paper "Whatever Happened to Efficient Markets?" there, and a version of that paper will appear in the Independent Review. I found the discussions at MPS by Anna Schwartz, John Taylor, Axel Leijonhufvud and especially Nail Fergusson to be outstanding and informative. Also see the recent working papers by Horwitz and myself (and the other papers collected at the Mercatus Center).

Work is coming out, and will continue to come out. Austrians didn't miss an opportunity with CR, just as Jeff didn't exclude the Austrians. The volume is full of "Austrian insights" and provides a multi-factor causation rather than a mono-causal theory. But as Jeff said, it is (as would be expected from Jeff) through the lens of ignorance that the story is told by Jeff.

Pete

[David Andersson]

For me, the piece by JF was a great learning experience. Discussions about financial crises and other macroeconomic phenomena have always confused me(too many variables, too messy), but the CR intro was unusually well-structured. Also, it offered a lot of historical background of which I -- and I suspect many others -- were ignorant. The biggest factual surprise (for me) was the protected position of the rating agencies, and their role in the build-up to the crisis.

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[Wladimir Kraus]

What is certainly very impressive about this volume is the extraordinary amount of scholarship devoted to the underlying very complex regulatory institutional mechanism. Like I said, I did not have the chance to read all the papers but a careful studying of Jeff's introduction makes plain the extraordinary level of quality to be expected from the papers.

However, the institutional factors are just one factor. The influence of ignorance -- Jeff understands it, if I interpret him correctly, as wrong theories that guided all parties involved -- is another. Bankers were just wrong about the underlying processes and so were all other participants, regulators included. Particularly, when we deal with a complex issue shaped by millions of actors the issue of ignorance, i.e. having "bad" theory, has momentous consequences. Under such constraints, regulators by the nature of what they do can only issue monolithic and universal decrees. They cannot be expected to do much more. Even if they had a correct understanding of the mechanics of the market, they still would have to impose rigid, monolithic, universalistic and necessarily quite simplistic decrees. But in a complex and dynamic setting this approach is simply disastrous, for the well-known Austrian reasons.

But then there is the third factor and, in my view, the most important of all. On p. 25 (in .pdf) he rightly dismisses wicked incentives or motives (greed) as completely irrelevant. It is by far not enough to know what one wants, or how desperately one wants it but, in Jeff's words, how do I get what I want. As I quoted Thomas Woods in my review of his Meltdown, the real, all-defining issue is:

"Why did banks have so much money available to lend in the mortgage market — so much indeed that they could throw it even at applicants who lacked jobs, income, down payment money, and good credit?"

In the absence of the means, of constantly growing new and additional checkbook money supplied by the Fed, all the motives for more and easy-to-earn money, the presence or absence of regulatory rules would have no real-world effect. If my child is not provided with a sheer unlimited supply of candy, he will find it difficult to construct elaborate schemes to gain by swapping, betting, risking his candy supply. Now, I would be the last to deny that to understand the mechanics of such a market for candy. It would be even more interesting to observe what happens when I step in, in an effort to avert the potential bad consequences from my child's excessive energy at trading and dealing, and impose some restrictions, but do not stop the supply. I'm sure a different dynamic would emerge, again very interesting to analyze and understand.

My point is that it seems that even the present collection of essays is short at analyzing, not condemning (!), the process of means provision. The problem of credit expansion, and how it affects the financial sector as well as the broad market, is such a hugely important element that I wish that more attention to be devoted to it.

[Current]

Lee Kelly has mentioned England above. I think that some more attention should be paid to this side of the pond. Where I live in Ireland there has been a huge housing boom and bust too over the same period.

However, there is no securitization in Ireland, there is little securitization in the UK too. Mortgages are generally held by the banks and building societies that originate them. There is no Fannie or Freddie.

I think that comparisons should be made between the UK and US to find out what factors are most important.

[Jeffrey Friedman]

Pete: Thank you for setting the record straight: I did not "exclude Austrian contributions"; I sought them out. And I found them. But they weren't written by people with economics Ph.D.s from NYU or GMU.

So I would still like to hear your opinion about why people with Ph.D.s in economics from Austrian programs are necessarily the go-to guys for "Austrian contributions" in a given case, as you seem to imply.

As a practical matter, in this particular case, I, too, tried to go to those go-to guys first (because at first I thought this was obviously an "economic" crisis). But the reaction from Mario prompts the thought that one way Austrians might expand the reach of their ideas is to seek them out, encourage them, or at least acknowledge them regardless of *who* produces them. For instance, in political science, I and two tenure-track Yale political scientists, one at Georgetown, and one at the University of London are pursuing them, with more such people in the pipeline--but none of us are identifiably "Austrian" using traditional metrics.

And in your own discipline, Amar Bhide, for example, another contributor to our special issue, seems to be influenced by Austrian economics; but he didn't get a Ph.D. from NYU or GMU, so apparently he's not a "go-to guy," and my publication of him is viewed by some Austrians as part of my "exclusion" of Austrian economics. Similarly with Michael Goldberg of Dartmouth, a contributor to the "Dahlem report" published in the special issue, whose work with Roman Frydman (of NYU, but not of Austrian "lineage") should be a hot topic among Austrians, I would think.

These political scientists and economists are all doing pioneering theoretical and empirical work on the role of ignorance (in politics and economics). So my question is whether someone has to be certifiably "Austrian" to make "Austrian" contributions.

Jeff

[Jeffrey Friedman]

Wladimir: Thank you for noticing the depth of the contributions to the special issue. They really do provide food for thought, and if it's not clear already, I'm as proud as a new father of this child, our special issue, which I helped deliver.

Regarding your question: I wonder what the appropriate dependent variable is. When I started doing research for the special issue, I assumed, like everyone else, that the question was why so many subprime mortgages had been issued. And it does seem that low interest rates were a necessary if not sufficient condition for that.

However, the great contribution that the Jablecki-Machaj paper (and also the one by Viral Acharya and Matthew Richardson) made to my understanding of the crisis is that (these authors claim) the real problem was not subprime mortgage issuance, but the fact that half of the resulting subprime mortgage *securities*, which could have been sold to investors around the world, instead stayed in the hands of the banks. Hence a financial crisis that froze lending, rather than merely a widespread loss to investors around the world.

If the retention of subprime securities by the banks is your dependent variable, I'm genuinely unsure whether the low interest rates were even a necessary precondition.

Jablecki-Machaj and Acharya-Richardson suggest that the reason the banks held onto half of these securities was that *regardless* of whether they were prime or subprime, they received "capital relief" under the Basel rules--in Europe, when they were placed in off-balance-sheet entities like SIVs; and in America, even when they were held on-balance-sheet, as long as they were rated AAA or AA by the ratings oligopoly.

If capital relief was the reason for holding mortgage-backed securities, then presumably the demand for such securities from the banks would have remained strong even as the quality of the underlying mortgages themselves declined, because (here's the amazing part) the quality of the mortgages didn't affect the AA and AAA ratings.

In other words, the way the Basel rules were implemented in the United States, banks seeking capital relief might (in principle) have bought cotton-candy-backed securities--as long as they were rated AA or AAA--and gotten the same benefit. So as the pool of prime mortgage borrowers got used up, banks threw mortgages at subprime borrowers--in this view, just to satisfy the demand for the resulting AA or AAA backed securities.

(Lee: this would apply in Europe too, through SIVs, but the difference between the European and the U.S. versions of the Basel rules is a very pressing area for further research.)

In tentative support for this theory, Michael Lewis's article on AIG in the August Vanity Fair (I'll take empirical research wherever I can find it!) points out that subprime mortgage issuance actually began to skyrocket just when interest rates started to *rise* (in the second half of 2004).

To be sure, this leaves an important role for low interest rates, but the counterfactual is whether the Basel rules, in conjunction with the rating agencies, could have nonetheless caused the crisis without the low interest rates. I honestly don't know what to think about that--but, again, it's surely a great research topic.

In fact, the financial crisis would be a great dissertation topic, and given the current academic hiring situation in all disciplines, it might be a great career move.

Jeff

[Wladimir Kraus]

Jeff,

thank you for your reply! I think your focus on capital is central to the problem, and not only in connection with Basel II accord and the fact that those mortgage securities stayed with banks. There are several additional dimensions to the capital question.

1. I'm not familiar with the exact mechanics of Jablecki-Machaj paper (I don't have access to it) but there appears to be a strong relationship between Basel II capital requirements and the problem of credit contraction despite the mighty efforts of the Fed to jump-start lending again.

What constrains banks to lend are not their reserves, they have more than plenty of them, but the lack of capital. The dramatic decline in securities prices in the face of killer leverage with which banks were operating wiped out their capitals almost completely. This one element in the puzzle might explain the unprecedented built-up of bank reserves.

But this is by no means the end of the story. The financial crisis has engulfed other parts of the economic fabric of society. We are in need of a much detailed description of underlying processes and explanation of the mechanism of driving forces behind them.

2. Thus the wider macroeconomic problem of credit expansion, overconsumption and malinvestment.

There is no doubt that the enormous volume of fiduciary media pumped into the economic system in the span of the last 15 years, and not some global savings glut, has contributed to two major bubbles during that period. That too is unprecedented. Now, both the ability to lend as well as the ability to repay loans have been undercut dramatically because of the enormous loss of capital caused by the credit expansion. The economy must get rid off the debt burden and start accumulate capital again. There is no substitute for capital accumulation out of savings. The lure of the idea that credit expansion (increase of the money supply in form of fiduciary media) may provide capital without the need to abstain from consumption contains at the same its own undoing.

So, a more comprehensive account of the crisis should pay attention to all its phases. Certainly the most important phase right now is the consequences for the so-called "real" sector, employment, inflation, budget deficits, growth prospects etc.

If one begins to think about the enormity of the problems, an idea for another few installments of the present CR issue might be important to consider.

Incidentally, Prof. Reisman, over at the Mises Institute website (http://mises.org/articles.aspx?AuthorId=143), over the years has published several lengthy articles with a detailed description/explanation of the relationship between credit expansion, overconsumption, malinvestment. I hasten to add that his writings, recent and in his book Capitalism, the problem contain several original points, sometimes at odds with the usual ABCT malinvestment story. I would even claim that among all mises.org writings on the subject his are the most scholarly and comprehensive.

Wladimir

[Jeffrey Friedman]

Wladimir--Just to clarify, yet another area for future research is the effect of Basel II vs. Basel I.

Basel I is what I was talking about. It was agreed upon in 1988 and implemented in the United States in 1991. Each country's regulators get to add their own fillips, and in the United States, the whole regulatory apparatus, from the Fed on down, decided to grant capital relief to asset-backed securities with an AA or AAA rating. This wasn't true in Europe, posing a potential problem for the Jablecki-Machaj/Acharya-Richardson thesis.

However, in Europe as in the United States, a bank could almost entirely (I erred in my introduction by saying "entirely") escape capital minima using off-balance-sheet entitites, and Jablecki-Machaj point out that the great majority of these were indeed in Europe.

Later--I think in 2005?--Basel II was agreed to. If I'm not mistaken, it was supposed to be implemented by all developed countries by 1/1/07. It took the American approach under Basel I to a ridiculous extreme, with many fine gradations of capital regulation depending on the regulators' assessment of the risk of the asset--according to the rating agencies.

My understanding is that some European countries began implementing Basel II in 2006, which would give it time to have contributed to the crisis. But I don't think it was implemented in the United States until 2007, so it wouldn't have had much chance to contribute to the crisis there (here).

Again, research needed! (BTW, I think you could probably do this research in political science or law--if you don't want to deal with the manifest career problems facing all economists, but esp. Austrians--since the topic is the effect of regulations. Contact me if this route interests you.)

The Jablecki-Machaj and Acharya-Richardson papers confine themselves to Basel I. I'm sorry that they aren't available online. For financial reasons, we had to make Routledge our publisher, meaning that they get most of our sales revenue in return for assuming the production costs of the physical journal. Part of the deal is that only one paper per issue can be posted on our website. That's why my PDF alone is there.

Jeff
[email protected]

[K. Jager]

As Austrian friendly student who participated in a Critical Review seminar, I think the claim that Jeff Friedman excludes Austrian contributions is unjustified. On the contrary, I think his scholarship is Austrian-inspired by emphasizing how knowledge acquisition differs in politics and/or government agencies compared to the free market which is not grasped by mainstream economics with its unrealistic assumption of perfect knowledge. It's a pity that many Austrians embraces just the economic mainstream approach in political science by reiterating public choice theory which is constantly refuted by empirical studies. On the other hand, I think CR offers a more Austrian approach in political science by applying the knowledge problem to ignorant voters and ideological constraint politicians.

[Peter Boettke]

Jeff,

Why do you say that I think the "go to guys" are people with PhDs from GMU and NYU? I never said that --- ever! I think you should go to whoever is interested and capable and I actually don't care as much about it being "Austrian" as I do about it being true.

See on the other thread related to Jeff Miron, I mention John Cochrane, Luigi Zingales, and Casey Mulligan --- all 3 at U of Chicago -- as voices that I would have liked to see.

Amar Bhide is indeed influenced by the Austrians, and in turn influencing them with his own work. He is excellent.

I understand why you were interested in the Colander, et. al., indictment of economics --- a similar sort of argument was made by Jon Elster as well. But I don't think these criticisms are correct, though they do reflect the standard perception of those outside of the discipline and those within the discipline that thought modern macroeconomics implied something.

The intellectual and policy dust is still swirling and has not settled yet. When it does, it is going to be a fascinating battle for the future of research in economics (just as it was after WWII). The battle over the meaning and nature of capitalism will be one, but the disciplinary battle will be another. You have staked out a claim that economics as a discipline is irrelevant due to its style of reasoning. I think this is shaped by your exposure to a certain brand of Austrianism, and to the methodenstreit in political science over rational choice. But your work is grounded in the economic way of thinking for the most part, even when you sometimes want to deny it --- you have those glasses. The problem is that you want to draw critical distinctions when in fact the distinction is not there in the way you want to say it is.

So, let me be clear --- your introduction is great; the issue of CR is highly recommended; you don't need to have a PhD from GMU or NYU or even call yourself an Austrian economist to make great contributions to economic theory and policy; but there are individuals doing a lot of work on this and other issues advancing the ball that are not represented in this issue and who are working within the economic way of thinking.

Congratulations on a great issue of CR, and hopefully this will be a catalyst for lots of work in this area.

[Jeffrey Friedman]

Pete--Scoll up the page. On July 9 you said:

"Now I do think there are several people who have written very good things from an Austrian perspective that have been circulating since the time Jeff is talking about. I would list O'Driscoll, White, Selgin, Garrison, and Horwitz as early indentifiers of the fundamental causes."

All of them have Ph.D.s from NYU or GMU, as far as I know. On July 10, I responded with my question about why we should be thinking about "Austrian people" as being the only ones capable of generating "Austrian contributions." Only on July 11, on a different thread, did you add the Chicago boys--which depresses me, because I remember the days when there was antagonism between the Chicago and Austrian schools, for good reason.

Allow me to clarify one last thing. You are much too sweeping when you say that I think "economics as a discipline is irrelevant due to its style of reasoning." No--I constantly learn from economists when they bother to do research, as for instance most of the contributors to our special issue did. In those cases, the worst I would say is that the obsession with incentives sometimes distorts the conclusions that economists draw from their own research.

But more importantly, I'm glad you used the phrase "economics as a discipline." It's economics as a discipline that tends to be obsessed with incentives, to the exclusion of such crucial factors as market participants' heterogeneous perceptions of risk and profit opportunities; and to the exclusion of the fact that some market participants may not perceive a certain "incentive structure" as providing incentives at all, because they are ignorant of it. E.g., you may think the bailout of LTCM created the incentive for reckless risk-taking by financial institutions that were too big to fail, but that was not the way, say, Jamie Dimon at JPMorganChase saw it. Apparently he was ignorant of what you perceive in retrospect (correctly) to have been the truth that he needn't have been so cautious--he'd have been bailed out no matter what.

However, the obsession with incentives *to the exclusion of* cognitive factors is not a problem with economics per se. It's certainly not a problem with Austrian economics per se. And it's not a problem that has to afflict anyone who seeks a career investigating such matters as the effects of economic regulation in a discipline other than economics (such as law, political science, or possibly sociology).

Jeff

[Peter Boettke]

Jeff,

Wrong.

O'Driscoll --- PhD UCLA

White --- PhD UCLA

Garrison -- PhD U Virginia

Selgin --- PhD NYU (yes)

Horwitz --- PhD GMU (yes)

Now to matters of substance --- Zingales is just great independent of school affiliation.

On the issue of incentives and ignorance, the case you raise about Jamie Dimon just illustrates that you are not taking seriously the point about the Lester-Machlup debate. There is a difference between the knowledge of the agents and knowledge of the scientist studying the agents.

Also, your claim that economists "bother to do research" is a rather silly claim, since economics as a discipline has a proven track record of research, research tools, and research results --- far superior in track record to any other social science in fact.

Economists deal with the problem of heterogeneous agents all the time ... in fact, Pete Leeson's main contribution to economics to date in his papers in J of Legal Studies, and JPE is in fact deal with social cooperation among heterogenous agents. Anthony Evans is leading a project right now on heterogeneous entrepreneurship and price distortions.

And finally Jeff, I think it rather strange that you would talk to me about cognitive factors, when I am the editor of a series at Cambridge that is entitled "Cognition, Economy and Society" --- you are preaching to the choir here.

Look, you have a certain view of economics and in particular rational choice theory that enables you to contrast your work with. Jon Elster does this as well (see his various essays on the excessive ambitions of rational choice). And as you know, Mises and Hayek both rejected the sort of hyper-rational model of man that is evident in much textbook economics. As William Jaffe onces said of Menger in contrast to the other marginalists --- to Menger man is not the lightening calculator of pleasure and pain, but is forever caught between alluring hopes and haunting fears. But man -- even in such a state --- is at the center of the analysis.

Responding to incentives does not require omniscience, but instead constraints and filters that steer in directions. As Steve pointed to, look at the Alchian 1950 article, or Vernon Smith's Nobel Prize address on what we have learned from experimental economics.

Incentives does not imply an ignoring of cognitive factors, in fact, they go hand in hand (this is what you are refusing to see) is say the work of A. Smith, D. Hume, L. Mises, F. Hayek, J. Buchanan, D. North, V. Smith, etc.

I just don't know why you insist on making the case the way that you do, rather than recognizing the different slices in the explanation.

BTW, so that we might make some progress on where to go rather than running in circles, what is your assessment of Russ Hardin's two recent books --- Indeterminacy and Society (Princeton 2003) and How Do You Know (Princeton 2009)? I am using both books in my PhD seminar this fall to get at issues related to the logic of choice, the institutional contingencies, and the idea of epistemic environments. I take Hayek's 1937 piece as the starting point of this entire research agenda.

It is an agenda which sees the inter-relationship between Cognition, Economy and Society (thus the name of the series!!!).

[Wladimir Kraus]

The problem with this "incentive structure"-abracadabra is that whatever its use otherwise at home or playing with the kids, in the scientific work on the workings of a developed division-of-labor economic system it is not only extremely limited but may lead to a dead end in research.

Take the work of a recent Nobel Laureate Leonid Hurwicz. He took the question of incentives very seriously, developed its implications and applied the basic framework in the study of such big problems as stability/desirability of capitalism vs. socialism.

The main accomplishment of Hurwicz, it's said, is the introduction and elaboration of the notion of incentive compatibility, i.e. compatibility of incentives to reveal private information. Starting from the general insight that what matters, what drives human action are incentives and incentive compatibility in the social context he hoped to formulate a new and more general theoretical framework to study problems of society -- economic, political, cultural etc.

In Hurwicz's incentive compatibility we allegedly have the more general theoretical framework with which help to understand more fully the "different economic institutions, like those of capitalism and socialism."

What is the nature and essence of this framework?

Quite simply it's all about incentives, any kind of incentives -- the incentive to escape punishment in form of imprisonment, social ostracism, layoff, the incentive to deceive and work less but continue to receive the same pay, the incentives to be a more productive worker or manager that a higher wage creates etc.

Now since incentives of different people are often in conflict with each other and with the notion of public good in general (measured in the optimal work effort in relation to a given pay scale), Hurwicz has developed a framework and specific analytical tools (game theory) that enable us to see whether particular institutional arrangements bring about a harmony of different interests and incentives. To the extent they do, then we can speak of great or lesser incentive compatibility.

Socialism and capitalism, as alternative institutional arrangements, are thus judged by their ability to reconcile different and sometimes conflicting incentives.

An example. In one paper by Myerson, discussing Hurwicz work, we read: "Mises and Hayek expressed great scepticism about the feasibility of such central planning without free competitive prices, but their argument on this point remained informal, focusing largely on the intractable complexity of the resource allocation problem. It's hard to be persuasive with such arguments of intractability. After all, if the economy is too complex for our analysis, then how can we be sure that a competitive market will find an efficient solution, or that a socialist planner will not find one? For a convincing argument, they needed a simple economic model in which socialism (suitably defined) could be proven to be less efficient than capitalism."

Hurwicz's & Co. "more convincing argument" is to analyze incentives in socialism and capitalism. In order to do so they pick two concepts which are very prominent in neoclassical economics: moral-hazard problem and the problem of adverse selection.

Some quotes may be helpful to understand the actually very simple idea behind this abracadabra.

"...Samuelson (1954) argued that no feasible mechanism can guarantee an efficient allocation of public goods, because asking a person to pay for public goods according to his benefit creates an incentive for him to misrepresent his benefit. This remark seemed consistent with the general view that efficiency is found only in competitive private-good markets. But in trying to formalize this argument, Hurwicz (1972) found that the same incentive problems arise in the allocation of private goods, once we drop the assumptions required for perfect competition. He showed that, with finitely many individuals, no incentive-compatible mechanism can guarantee a Pareto-efficient allocation that is at least as good as autarky for all combination of individual preferences in a broad class.Thus, the concept of incentive-compatibility was introduced."

In other words, there're circumstance where private markets fail to bring about the largest possible incentive compatibility. Then the failures of the free-market are compared with possible failures of socialism.

Here's why the criteria of moral-hazard and adverse selection are central to the "new general" framework:

"We have come to understand that there are really two kinds of incentive constrtaints in the general social coordination problem: informational incentive constraints that formalize adverse-selection problems of getting decentralized information, and strategic incentive constraints that formalize moral-hazard problems of controlling decentralized activity. As Hayek (1945) emphasized, economic plans must make use of decentralized information that different individuals have about their resources and desires. An individual could not be expected to honestly reveal private information that would be used against his interests, and such adverse-selection problems are formalized in economic models of informational incentive constraints. But economic plans must be implemented by decentralized actions of many different individuals, and there is a problem of getting individuals to accept appropriate guidance and direction when they have conflicting strategic incentives. An individual could not be expected to obediently refrain from opportunistic behavior that would be more rewarding to him, and such moral-hazard problems are formalized in economic models by strategic incentive constraints."

Now, when it comes to adverse-selection, Myerson claims, socialism has an advantage over capitalism because "socialism may actually have an advantage here, because socialism can flatten the manager's incentives to eliminate his temptation to lie about his chances of success." The particular context here is that in their model they assume two types of managers. The first, a "high" type who knows that he'll be able to succesfully realize the investment project using not his own capital but someone else's, i.e. society's. In contrast, the "low" type knows that he's not competent and the investment project will fail. The important consideration here is that the low type has the incentive not to reveal his private information about his abilities and shortcommings. And so, Myerson writes: "Under socialism, there's no problem getting the manager to reveal type honestly, because he's willing to report his type honestly when we just pay him a flat wage no matter what he reports." It is precisely on the basis of such analysis of "incentives" that these Nobel laureates conclude that socialism may work better.

Essentially the same line of reasoning is pursued in regards to the problem of moral-hazard.

In the basic model Myerson introduces punishment of managers as additional variable that stands for a paticular category of "cost". He writes: "Now let us add the possibility that managers can be punished, and let x denote the punishment cost inflicted on manager if the project fails."

Here comes a particular gem which must be read very carefully to let its meaning sink in.

"So there are two obvious ways for socialist reformers to achieve full efficiency here. First, they could allow some individuals to hold more wealth... Perhaps such favored people could be heroes of the socialist revolution (or of the Norman conquest). Second, they could drop the participation constraint and force people to become managers without compensation for punishment risks. Perhaps such disfavored people might be prisoners or enemies of the state. But either way, socialism looks rather less appealing from the perspective of this moral-hazard model, as it forces us to admit either inequality or coercion of productive inefficiency into our imagined socialist paradise."

And so it goes. It's remarkable how utterly naive and totally unrealistic such a "general theoretical framework" is. This framework totally neglects the defining characteristics of the division of labor society and build its case entirely on the analysis of incentives.

But what is missing here? Exactly, the most important objective factors in a capitalist society, private ownership of the means of production and the price system. Yes, incentives do exist there but they are embedded in that system, are informed and constrained by the given structure of prices. It is spreads between prices that determine whether it is more profitable to invest in this or that line of production. To that extent one may speak of "incentives", yes. But then "incentives" becomes a completely dependent variable, determined by the interaction of billions of market participants. Here the profit motive, a form of "incentive", is connected with and entirely depended on the given structure of prices. But the extent of incentives of businessmen and capitalists are entirely dictated and determined by economic competition that finds its outward expression in these prices.

But this is not how Hurwicz, Myerson et al apply the notion of incentives in their analysis. In their quest for a "general framework" they completely disregard the objective constraints of a market economy. Instead, in the true "subjectivist" tradition they take a much broader of incentives and end up with absolutely nothing.

At least on this point, Marxists were absolutely correct in criticizing Austrians for their "unhistorical" approach to economics.

[Jeffrey Friedman]

Wladimir--That was breathtaking!

I think we should all take a break from writing here, and write for publication instead.

At a certain point, inevitably, the participants in these threads lose track of what each other has said (for instance, at the very start, I invoked Lavoie and Alchian as my inspirations, and now am being lectured to read Alchian--but who knows which thread I said that on?), and misunderstandings grow into antipathy. Moreover, complex arguments are poorly stated, so mutual incomprehension occurs. True, this is the human condition, but it's worse on blogs.

This started out with Pete complimenting and recommending the special issue of Critical Review on the financial crisis. That's where it should have stopped! ;-)

However, Mario made a snide remark suggesting that I had "excluded Austrian contributions" from the issue, which I now think was simply because Mario hadn't had a chance to read the issue yet and just saw the list of authors.

I then thought it was necessary to correct the misimpression that there is something anti-Austrian about Critical Review, when in fact I have spent 21 years--that's almost half my life, people!--using Critical Review to try, however imperfectly, to develop what I consider to be the central Austrian insight, straight from the socialist calculation debate: that people are ignorant.

I thought I could correct this misimpression constructively by asking a question that unfortunately has not been pursued at all (on this thread): What exactly *is* "Austrian" economics? Is it just economics that has been produced by professional economists who call themselves "Austrian"? (Forgive me for thinking that the list Pete provided all had NYU or GMU degrees! But my question has not been answered.)

In asking that question, I was in no way attacking economics--from which I have learned much, as I said. In my own work (other than on the financial crisis), what is it that, at bottom, "the public" is "ignorant" of? Economic theory!! So I'm sure not against economic theory.

All I'm saying is that theory is not enough. Theories are ideal types (hypotheses) that need to be tested against reality if they are to explain that reality.

I have read every paper on the crisis that Tyler's blog has pointed to since the crisis began, and if I'm not mistaken, only the one by Gary Gorton, a law professor, and the one that was a precursor to the Acharya and Richardson article in Critical Review did anything but speculate about--let alone investigate--about the causes of the crisis. Yet the speculation is usually couched as assertion. There are even contributors to the Critical Review symposium who do this, famous ones. (This is not at all a slap at Tyler or his blog--it's an attempt to explain what I find frustrating about economists. And I don't think this can be written off as the ramblings of a disciplinary interloper, unless you consider David Colander and Michael Goldberg, some of the coauthors of the Dahlem report in CR, less-than-"real" economists for making the same point.)

Consider also Richard Posner, another very good friend of Critical Review and a prince of a man who has just written an entire book on the crisis. Yes, he's a law professor too, but wait.

The heart of his argument for it being a "crisis of capitalism" is a story that treats knowledge as somehow created by incentives, or conveniently coexisting alongside them--just like the too-big-to-fail (TBTF) theory, except Posner means the incentives of bank executives and employees who supposedly *knew* they were taking big risks but took them anyway to get big bonuses.

That's possible, but where's the evidence? Well, he cites just two papers, both by economists, neither of which contains a shred of evidence, and one of which (by Rajan Raghuram) has become totemic among economists as "explaining" the crisis (in 2005, yet!)--because it presents a plausible incentives story. Meanwhile, Posner pretty clearly does not know about the existence of the Basel rules and if he knows about the SEC's creation of a ratings oligopoly, he doesn't mention it.

I asked on another thread how we would choose between Posner's incentives-produce-knowledge story on the one hand and, on the other, the too-big-to-fail incentives-produce-knowledge story. Nobody answered. The answer, I think, is: We can't just choose by assertion or logical analysis (game theory). We have to do empirical research.

So please don't misunderstand my occasional (or monotonously regular) criticism of the tendency of some economists to treat incentives as magically leading to knowledge as an attack on economics. It's no more such an attack than was Mises's bracketing of the central planners' incentives at the beginning of the socialist calculation debate.

Alchian's paper (I'm not going to address Machlup) tells us that market competition will tend to weed out firms that make mistakes (exactly the point I make at the end of my article on the crisis, citing Alchian). That gives us a general normative case for markets (as I wrote). But that is very different from an empirical "incentives" explanation of any specific historical example. Explaining facts requires knowing facts, so if we are interested in understanding something like the causes of the financial crisis, that's what we need to get--facts.

I am Alchian's biggest fan, but he never suggests that in explaining concrete historical firm behavior we can talk about incentives and knowledge "going hand in hand" unless we are saying, as he was, that neither incentives nor knowledge might actually be at work in a given case--so they may be hand in hand only as ideal types with no actual manifestation in reality. (Perhaps you aren't disagreeing, Pete, in which case we have reached consensus.)

What does the work in Alchian's model is the implied evolutionary selection mechanism--consumer choice--which mimics both knowledge and incentives on the part of firms' managers. For all we know it could simply be good luck that accounts for any firm's success--that was the point of the paper I gave at NYU and GMU 8 or 10 years ago, "Death to Homo Economicus." So if we want to know whether bad luck, perverse incentives, ignorance, all of the above, or some specific variant of the above *actually* caused a huge series of mistakes like the crisis in a given case, we have to go find out what the participants were actually thinking. Alchian is not a license for saying "incentives must have done it." (Again, Pete, perhaps I'm misunderstanding you.)

Jamie Dimon of JPMorgan and the CFO (I forget his name) at Goldman Sachs acted *contrary* to the incentive structure allegedly created by the TBTF doctrine and emerged with by far the strongest banks in America. Citigroup, Bear Stearns, and Lehman Brothers acted *consistently* with those alleged incentives and are dead or as good as dead. Moreover, many mid-size and small banks that were *not* TBTF did the same thing.

In order to sort out whether a given incentives theory--or any other theory--explains a given case, we have to actually test the theory against the facts. That's all I'm saying.

All of the social sciences are in a sad state--surely, Pete, your pride in the allegedly superior empirical track record of economics doesn't mean that you think economics just needs to keep on keeping on? The point (I thought) is to constructively engage each other so as to make the social sciences *better* from an "Austrian" perspective. That is why I asked my question--What constitutes an "Austrian" contribution? If you scroll up, it's right there in caps near the top.

Meanwhile, if anyone has any suggestions about how to improve political science, please share them. And I will now go back to trying to do precisely that (improving political science, not sharing suggestions--I'm done with that. The costs outweigh the benefits.).

I hope to buy you all a drink at the SDAE meetings in San Antonio, near where I live. Unless I would be risking my life to show up.

Jeff

[Peter Boettke]

Jeff,

First, let me say that you are more than welcomed at the SDAE and if you want to buy me a beer, I will gladly accept. Perhaps I can talk you into 2.

Second, a contribution to Austrian ECONOMICS should never be limited to those who call themselves Austrian. Instead, we should just care about truth tracking theoretically and empirically. There are lots of fascinating things going on in ECONOMICS right now --- not related to behavioral economics. Many of it, if one cared to, could find roots in the work of Hayek. And that work does come under the rubric of the epistemic turn and/or New Institutional economics.

Third, I think the reason Jeff gets the reaction he does is that sweeping criticisms are often leveled, not pointed criticisms. And since Jeff is very smart, this requires a response. Economics has problems, but it is not as bad as he suggests. The indictment of modern economics should really be focused on MACROECONOMICs, not economics. And even there, if you look at the general policy advice of modern macroeconomics, and then look at the deviations from those rules (e.g., Taylor's identification of how we "got off track"), you can reasonably argue that our current problems resulted not from the failure of modern macroeconomics, but instead deviations from those teachings. I wouldn't got this far, but I could see someone reasonably argue this. Morever, I disagree with your assessment of the work of O'Driscoll (who has a deep knowledge of the industry) and White (who has a deep knowledge of monetary policy) and Horwitz (who actually looked into both). I am not faulting you for not including them in your volume, but I am suggesting that your dismissal of the work as "speculative" is unfair. The Mercatus Center has a financial market study group established, and so are many other groups. Many people are trying to get a handle on all of this, dissertations are being written, papers are being writtten, and monographs and books are in preparation. You don't have to dismiss others to be proud of what you have accomplished with this issue of CR. It is a great issue, but just an invitation to inquiry.

Fourth, Wlad -- you should look at Mirowski's Machine Dreams for a discussion of how taking up Hayek's challenge led to the mechanism design work. However, see Lavoie (and Kirzner and Thomsen) on why mechanism design theory doesn't address Hayek's challenge. If you look at my reaction to the Nobel (including my WSJ piece), I make this argument as well. I will be participating in a great seminar in CA on mechanism design theory this coming fall. In my 9 volume reference set on socialism and the market, I have 1 volume devoted to mechanism design work. Lavoie's Comparative Economic Studies paper on Knowledge conveyance is an outstanding critique of Hurwicz et al.

Incentive compatibility is not necessarily a bad idea, but what all that entails in terms of knowledge is often overlooked. BTW, Jeff look at the work by Sunder and Gode on zero-intelligence traders and allocative efficiency. Again, think in terms of Nozick --- filters and equilibrium tendencies.

Ultimately, I continue to think there is just a fundamental sematic issue at root which we are not getting a chance to resolve.

But let me be clear about your question --- What constitutes an "Austrian" contribution? To me it has nothing to do with fidelity to individuals (such as Mises or Hayek) or to place of education (Vienna, LSE, NYU, or GMU), but instead to a set of ideas that are incorporated into your analysis. And yes Jeff one of those core ideas is our ignorance, but also the institutional mechanism that either serve to permit us to cope with that ignorance, or compound that ignorance.

Pete

[Steve Horwitz]

I'll just add that my invocation of V. Smith and Alchian was not to say Jeff had overlooked them, but to say that they were part of the tradition that Pete was emphasizing - a tradition that understand both the cognitive and incentive issues involved in complex market economies, and the ways they are intertwined. They also both understand that rationality is context-dependent and evolutionary and that, yes Jeff, incentives are not objective givens but perceived realities, but that institutional structures matter for determining what incentives might be more or less powerful.

There is no Austrian telling a story of this recession that is an "incentives only" story.

And as I believe I said in an email after reading an earlier draft of your intro, it's great stuff. I haven't got to the rest of the issue yet, so don't take my silence as anything but silence. I also think you are exaggerating the differences between where you are and where Pete and I are.

You might also understand how I get a little peeved when you say Austrians of our type weren't writing on the crisis. That's bullshit. My "Open Letter" (like it or not) got tens of thousands of hits and has been translated into at least 5 languages and has been reprinted in magazines at least twice. I've given several public talks, including one at FEE this coming Saturday that is already the best attended Evening at FEE in several years. I've got several working papers too. You don't like 'em? Fine. But to say that we weren't out there writing is just wrong.

This is a lot of wasted breath over not very much in the way of differences.

[Jeffrey Friedman]

Pete--What in God's name are you talking about?

I have offered no "assessment" of the work of O'Driscoll, White, or Horwitz, all of whom I have enthusiastically published and will again, I hope.

I simply said that in the spring of 2008, when I was putting the special issue together, I was unaware that any Austrians were doing any work on the crisis, and I was frustrated by that because I wanted to publish such work. You then offered up those names, but their work came later. That's all.

End of controversy and end of my blogging here. People cannot be expected to pay close enough attention to make it a real dialogue.

Jeff