"The Need for a Clear and Credible Exit Strategy"

Peter Boettke

That is the title of John Taylor's contribution to The Road Ahead for the Fed.

I have been reading Taylor's various arguments very closely since last fall.  I also read a lot about the failure of modern economics, and how modern macroeconomists in particular have been proven completely worthless.  But reading Taylor has made me really think twice about those statements.

I find it hard to read anyone more persuasive in identifying the causes of our problems than John Taylor.  As he says in this essay, "In my view, the financial crisis was caused, prolonged, and worsened by the Fed's departure from traditional monetary policy."  He does end that sentence with the clause "even if some of the recent actions have been useful as a means of cleaning up the damage."  So I don't agree with 100% of what he says, but 90% or better --- my question to him would be, if there is not credible exit strategy then how has the Fed actions cleaned up the damage?  But lets leave that aside for now.  Just consider the first part of his sentence and the data that he has provided (e.g., in Getting Off Track). 

Where has Taylor been refuted in the literature by an economist?

What ideas from critics of modern economics would in fact make our policy world better?

What ideas among modern economists actually should be rejected for a more sensible policy regime to be ushered in?

In many of these discussions we run from a critique of mathematical economics to models of hyper-rationality and efficient markets to laissez-faire policies as if these represent coherent progression of argument.  This argument really doesn't quite work. A Keynes-Minsky type argument could in fact be presented in a highly formal model, and a Smith-Hayek type argument could in fact be presented in prose.  Modern economics has, in fact, seen models of rational actors producing sub-optimal results, and less than rational actors producing optimal results.  Style and substance are not as tightly linked.  I have in fact described the world of modern economics as "formalistic historicism".  An economics profession where both Bob Lucas and Joseph Stiglitz can prove their respective points about the efficiency or lack of efficiency of the market economy with the techniques of general competitive equilibrium modeling has successfully separated style of presentation from the substance of the presentation.  Nobody has to my knowledge shown either Lucas or Stiglitz to be logically flawed in their derivations.  Rather, it is a question about starting points in the analysis and the perspective of the theorist in question.  Modern economists can prove pretty much anything a theorist desires with a variety of formal techniques.  And, unfortunately, this situation cannot be resolved via sophisticated statistical testing.  In short, statisitcal testing cannot by itself ajudicate between competiting hypothesis derived from the different formalistic models.

This is the real plight of the contemporary Austrian or market process economist for the older debate between historicism and economic theory they have plenty of arguments to marshall from Menger to Mises against the historicist claims; and in the mid-20th century debate between formalism and verbal logic they have plenty of arguments from Mises, Hayek, Rothbard, Lachmann and Kirzner to rely on; but in the contemporary discourse where the opposing mainstream is formalistic and historicists, how are they to reply?  The arguments provided by the earlier generations of Austrians while not wrong, miss the target at critical points in our contemporary discourse.  A new defense of Austrian or market process economics for the contemporary discourse must be developed.

The most vociforous critics of modern economics have in fact been heterodox economists who would transform the practice of economics and the training of economists in a direction away from hyper-formalism, but not necessarily completely away from it, and who believe that the proper role of the state is more activist than what we currently have.  Jamie Galbraith could be viewed as the ideal type here.  His angry rhetoric over the so-called laissez-faire era and its incoherence is matched only by Paul Krugman's in the contemporary literature.

Would the policy regime under heterodox economists be more stable than our current world?  Where would the biggest difference be seen?  How should the training of graduate students be accomplished?

Many of the critics using the current crisis to voice their concern with the state of economics highlight a lack of concern with the real-world.  But is that actually an accurate critique of modern economics?  Since I was in graduate school the hot topics in economics and political economy have been the collapse of communism and the transition, the failure of development planning in Africa and Latin America, the search for root cause of the plight of underdevelopment in legal origins and colonial heritage, etc.  And we also shouldn't forget in the least the great appeal of exercises in "freakonomics", which are very real-world driven.

How would the critics envision this work being different if the training of economists was more to their liking than what is the current state of the art?

My proposal for educational reform is slightly different.  I don't think it is a waste of time for students to learn price theory and learn it really well from 1950s Chicago style, or 1960s/70s UCLA style, or even 1990s Stanford style game theory.  To understand those approaches, you also need to understand Arrow-Hahn-Debreu (and Koopmans and McKenzie and Hurwicz and Radnar).  Price theory is the core of the discipline of economics.  And there is also a unique Austrian or market process strand in price theory that is vital --- a strand that has the logic of Arrow, the universality of Becker, and the sensibilities to evolutionary adjustment of Alchian.  The ideas of Menger, Bohm-Bawerk, Mises, Hayek and Kirzner would be a central part of price theory.

I would also then return young economists to the library and field.  History of thought and economic history should be part of the core training of economists not for any antiquarian reason, but for the practical reason of getting aspiring economists to understand the context of the development of economic ideas, to see the continuity and discontinuities in the interests of economists, and to see the empirical record of both the market economy (and its organizations and instituitons) and the relationship between economic ideas, economic policies and economic performance.

Beyond that, the rest is either preparation to be able to read and think critically about the material in price theory and economic history, or it is further development of the implications of price theory (e.g., macroeconomic questions of inflation, unemployment and growth).  To reiterate a basic Austrian or market process point --- while there may be macroeconomic questions there are only microeconomic answers.

How different would the world of economics look if these simple educational reforms were made?

Comments

[amv]

great post. may I add that state of the art monetary macro a la woodford studies optimal monetary policies for inessential sequence economies (hahn), that is, for time-series which are just pseudo-dynamic reformulations of arrow-debreu economies which of course fnd no place for money at all. insane isn't it? this also hints to the problems with the taylor-rule. even though I have little doubt that taylor is right, that economic peformance would have been better if central banks followed his rule, this rule is no theory and lacks proper foundations since it is build on aggregate reduced-form models with representative agents. computational macro drives me nuts! here, I prefer the "hyperformalism" of radner, etc.

amv

[Greg Ransom]

Note well that Friedman in a 1975 letter to Hayek insisted that statistical testing would be able to adjudicate these things (a letter which ultimately betrays Friedman's complete ignorance of Hayek's picture of economic science / explanatory strategy in economics).

Samuelson in the 1940s and 1950s thought the same thing -- then confessed in the 1980s that his expectations about that statistics would be able to do had been utterly falsified.

I don't remember Friedman every finally confession what Samuelson acknowledged.

Pete writes:

"unfortunately, this situation cannot be resolved via sophisticated statistical testing. In short, statisitcal testing cannot by itself ajudicate between competiting hypothesis derived from the different formalistic models."

[Rafael Guthmann]

"And there is also a unique Austrian or market process strand in price theory that is vital --- a strand that has the logic of Arrow, the universality of Becker, and the sensibilities to evolutionary adjustment of Alchian. The ideas of Menger, Bohm-Bawerk, Mises, Hayek and Kirzner would be a central part of price theory."

Boettke, I have the perception that these 5 great authors that you cite are truly the most rigorous thinkers of the Austrian school, but while they are razor sharp in logic I had more difficulty understanding them (particulary Mises) compared to the more graphic/formal authors. I started studying economics around early 2004, when a read Human Action, The Road to Serfdom, Competition as a Discovery Procedure, etc, I learned a loot in those days but I noticed that I only understood what Mises really meant in 2008, after some "maturing" period (for example, only in 2008 that I really understood the relation between uncertainty and human action). The problem is that much is implicit in Mises (Hayek is more explicit than Mises and Kirzner is more explicit than Hayek). For comparison, in mathematical economics everything looks like that the theory is "in the book", while for the logical economists like Mises, the book represents only a constellation of manifestations of a underlying/implicit logic. It is a very tough nut to crack, I think that that is one of the main reason that so few people are Austrians (around 100?).

[knapp]

Peter

Enjoyed the post and I agree that John Taylor has done some interesting work within the fledgling "what went wrong" literature.

But where was John Taylor in 2005 in the midst of the housing boom when his Taylor Rule was being ignored by the Greenspan Fed. I'll tell you where he was, he was in Jackson Hole Wyoming at the KC Fed's Monetary Conference giving a hagiographic comment on Alan Blinder's paper: "Understanding the Greenspan Standard". In this paper he concurred with Blinder that "when the score is toted up, we think he has legitimate claim to be the greatest central banker who ever lived". Taylor's paper ends with "That Alan Greenspan's leadership is grounded in substance has been a huge positive for policy". No criticism of the Fed until 2008 when it was obvious to the world that the Global Financial Crisis had commenced.

Meanwhile, other mainstream economists and fellow attendees at the Jackson Hole conferences such as Claudio Borio and William White, using a mix of Austrian and Minskian insights, were not afraid to trash the Fed even as Greenspan himself sat in the audience.

[amv]

@knapp: Greenspan even left the room as White started is lecture!

[Barkley Rosser]

I agree with knapp and amv. Things might have been better if the Taylor Rule had been adhered to, but I do not see it as having prevented fully what happened. The housing bubble began in the late 1990s, and a major element of it was the spread of flakey derivatives based on the bubble, this latter having nothing to do with following the Taylor Rule or not doing so. We had a huge bubble, and its crash was going to cause a big mess, which it has.

Regarding the matter of statistical testing, well, it should be done, but it should also be kept in its proper place, given the numerous problems. There are alternatives to that for some things, especiallly regarding fundamental assumptions.

So, we know from repeated economic experiments that assuming rational expectations as people like Lucas and Fama and Woodford do without batting any eyes, is simply empirically wrong. People do not have ratex in general. Nevertheless, there was Lucas a few weeks ago defending Fama and all sorts of nonsense in an Economic Focus column in The Economist where he was taking to task the earlier cover story on problems in economic theory, all with an argument that implicitly assumed ratex, which the recent events have highlighted as being utter nonsense.

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