One of the reasons I’m still a bear on the economy is because the economists in the optimist camp are relying upon very bad economic theory. If that theory is telling them good times are ahead, that’s one of the best predictors of bad times you could have.
This isn’t because the optimists are bad economists, bad people, or any other permutation: most economists I know are good at what they do, and are very well intentioned too.
It’s just that they were taught a crock of nonsense at university, and they now build models based on a crock of nonsense that they erroneously believe to be accurate descriptions of the real world.
There are so many bits of nonsense in economic theory that it would take a book to detail them all, but common to many of them is the following dilemma:
Almost everything economists believe is possibly true at the level of an isolated individual, but almost certainly false at the level of an economy.
The most egregious example of this is one theory that even most economists are now willing to admit is false: the Capital Assets Pricing Model (CAPM), which preached that stock market price shares accurately, that the amount of debt finance a company has doesn’t affect its value, and many other notions that have gone up in smoke during the GFC.
The CAPM is actually derived from a model of the behaviour of an isolated stock market investor. The investor has expectations about how all the shares in the market are going to perform in the future, and the ability to lend or borrow money at a “risk free” rate. She then combines a portfolio of shares that gives her the best risk-return tradeoff with this risk-free asset—borrowing money to lever her investment in the market if she’s a “risk-seeker”, and lending money if she’s conservative.
William Sharpe, the developer of the model, was then stuck with a dilemma: how to go from a model of a single, isolated investor, to one of the entire stock market? He did what so many neoclassical economists before him had done: he “assumed a miracle”. To quote Sharpe:
“In order to derive conditions for equilibrium in the capital market we invoke two assumptions:
“First, we assume a common pure rate of interest, with all investors able to borrow or lend funds on equal terms.
“Second, we assume homogeneity of investor expectations: investors are assumed to agree on the prospects of various investments—the expected values, standard deviations and correlation coefficients.
“Needless to say, these are highly restrictive and undoubtedly unrealistic assumptions…” (Sharpe 1964, pp. 433-434)
Sharpe thus went from a feasible theory of a single investor to a ludicrous theory of the entire market, by assuming (a) that all investors are identical (except for their attitudes toward risk), and (b) that all investors can accurately predict the future.
Though he didn’t admit point (b) in this paper, it was made explicit by one-time believers, Eugene Fama and Ken French, in a later examination of the model’s empirical failure. They noted that the mad assumptions could be why it had failed:
“The first assumption is ... investors agree on the joint distribution of asset returns ... And this distribution is the true one — that is, it is the distribution from which the returns we use to test the model are drawn.” (Fama & French 2004, p. 26)
So for four decades, economists applied a theory of the stock market that was based on the absurd assumption that every last stock market investor is a Nostradamus: all investors agree about the future and their expectations about the future are correct.
If only this were an isolated piece of nonsense. Unfortunately, it’s indicative of a failing that is endemic to conventional “neoclassical” economic theory. They develop a model which starts from an isolated Robinson Crusoe individual; then when they bring in “Man Friday”, they pretend that relations between individuals don’t alter the story in any significant way.
Unfortunately, they do. So the individual parables with which economists regale us, and which make sense on an individual scale, don’t apply at the aggregate level.
The education of economists at most universities (not, I am pleased to say, my own university) is the farce that turns this into tragedy. These fatal flaws in the theory are evident in the original research papers of the discipline. But economic textbooks—and the standard subjects based on them—gloss over these weaknesses completely.
So in place of Sharpe’s clear statement of the absurd assumptions behind the CAPM model, we get textbook discussions that outline the “weak” and “strong” forms of the model — that the market price reflects all available information, or everything including “insider” information.
Therefore, most practicing economists who read the textbooks but not the original literature, are completely unaware of the pitiful foundations on which their carefully crafted models are built. Their assurances about the future are therefore utterly unreliable.
I’ll happily remain a bear while theories like neoclassical economics predict the imminent arrival of spring.
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