I have been working on a project that investigates the institutional constraints on expert advice in development economics. Specifically, I have been using PT Bauer’s work from the 1950s on Indian Economic Policy and West African Trade as an example to argue that the quality of expert advice is constrained by how experts relate to their subjects. The idea is that when experts and their subjects operate within the same network of reward and feedback mechanisms, experts will be more likely to internalize negative feedback and update. When experts operate in a network of rewards and feedback that is separate from the network of their subjects, on the other hand, they are further removed from potential negative feedback and therefore much less likely to learn and update their theories to comport with real world evidence (see aidwatchers.com from more recent evidence of this problem in development economics).
Ever since I started working on this project, I have been subject to confirmation bias, i.e. everywhere I look, I see my theory in action. The same thing happened as I was reading Barry Eichengreen’s most recent book, Exorbitant Privilege. Eichengreen argues in this book that the Fed bares at least partial responsibility for the 2008 financial crisis because its monetary policy was too loose. According to Eichengreen, the FED had followed the Taylor rule in setting interest rates throughout most of the nineties and early 2000s. The Taylor rule derives the target short-term interest rate from the divergence between actual inflation and the desired level of inflation, as well as between actual GDP and potential GDP. Eichengreen suggests that fears of deflation led the Fed to diverge from the rule in 2002 when instead of raising rates, as the rule would have prescribed, it chose to keep them at low levels to prevent a Japanese style deflationary crisis.
I am as far away as any academic economist could be from being an expert on monetary policy, but as I am reading Eichengreen’s description of Fed policy in 2002, I cannot help but being reminded of current FED policy. Fears of deflation have been cited for almost 2 years now as a reason for historically low rates. And, the FEDs most recent increase of the Fed Funds Rate by 25 basis points seems timid given the recent good news about a recovering US economy and what the Taylor rule would prescribe. I might be wrong about the connection between 2002 and today, but if there is any resemblance between economic conditions then and now I cannot help but wonder what it is that keeps the experts at the Fed from updating and learning?
Eichengreen also cites the ‘pseudoscientific nature’ of an increased mathematization of the financial industry as one of the reasons for the excessive risk taking that lead up to the crisis. Yet, everywhere I look, I see academic economists advocating the use of ‘quantitatively rigorous techniques’ without ever indicating what the limits of quantitative analysis might be (Nassim Taleb being the exception). Again, I cannot help but wonder why we do not update? What is it that keeps the economics discipline from learning? Why do we not change our strategy in the face of disconfirming evidence? Every fool will learn not to make the same mistake twice, but as academics (the same is true for economic policy makers) we seem to be blind to real world evidence.
Given the implications of my theory about why it is that economists are so bad at predicting policy, it is not hard to see why we keep making the same mistakes over and over again. Just like development economists, academic economists in general are removed from their subjects. Ben Bernanke will eventually return to his job at Princeton University where he already has tenure. Why should he be worried about the consequences of his bad theories in action? Similarly, most academic economists around the country, who continue to preach the need for quantitative rigor already have jobs with tenure and will keep those jobs whether or not their theories have any practical relevance. Maybe the recent proposal by the Utah legislature to get rid of tenure is not such a bad idea after all. However, I am doubtful whether that would suffice to bring the theory underlying policy prescriptions into closer alignment with reality. What are some good proposals for reform of academia that might make us as a discipline more realistic?
Interesting post. I think it's a fascinating question: how do policymakers update their beliefs? Looking at the environment that the policymakers operate within: the environment of ideas, but also, the day-to-day business of politics. Where do policymakers get drawn from, i.e., what is the FOMC representative of?
ReplyDeleteThe organization of the Fed Reserve System surely influences how tightly the policymaking mirrors the broader environment, or rather in what respects policymaking mirrors this or that other micro-environment. When the regional reserve banks had more power than today, as in the 1920s, New York fought to control the volume of credit and its allocation to markets through price rationing (interest rate targeting) against the Board in Washington, which preferred to attempt to selectively control the volume of credit in various markets (viz., credit for speculative purposes vs. for commercial purposes). Seems reasonable to suppose that this difference in beliefs is not independent of the difference in the environment in NY vs in DC.
or consider this snippet from a letter from Jacob Viner to the head of the NY Fed, written in the 1940s, suggesting that the policymaker's perspective is surely influenced by his proximity to the money market:
'You certainly have the advantage over me of being closer to the market, but it may not be an unmixed advantage. The ticker may loom too large in your perspective and what from the point of view of the national economy are molehills may... appear to you as mighty mountains .' (quoted in Meltzer's history of the Fed).
Anyway, interesting point. Your project sounds interesting. Hope you're well...