A friend argues that I need to try harder to understand the how otherwise reasonable non-economists make sense out of fundamental economic concepts like capitalism, free markets, and business cycles. He recommended a recent book, Having and Being Had by Eula Biss.
I read the book. I was disappointed. The author’s admittedly humorous distain for economics makes it difficult to understand how much her book aligns with the thinking of reasonably informed non-economists. One passage, however, did catch my attention. It occurs while Biss is making fun of recipients of the 2013 economics Nobel Prize. While laughing at Eugene Fama and Robert Shiller for having theories that “directly contradict” each other, she draws attention to a number of interesting issues.
“Even after the [2008-09] housing crash, Fama denied that the housing market had been a bubble and was skeptical that bubbles existed. ‘I don’t even know what a bubble means,’ he said. Economics isn’t good at explaining certain things, Fama acknowledged, like what causes recessions, but he still believed that the markets were ‘rational’. Rational markets don’t make bubbles. Rational markets don’t need to be regulated. Shiller, who had been tracking irrational behavior in the markets, disagreed. The idea that stock prices were rational, he wrote was ‘one of the most remarkable errors in the history of economic thought’.” (p.53)
What causes recessions? I do not know Fama or what he knows about recessions. I do know that economists who matter at the Fed, CBO, the Treasury, and big financial firms are good at explaining what causes recessions. It’s their bread and butter. Periodic contractions of total employment and output result from the combination of significantly weakening aggregate nominal spending and price, largely wage, downward inflexibility. It is aa intuitive law of economics that, if prices cannot adjust to a shock, then real quantities must change. Effective stabilization policy always focuses on managing total demand. Recessions cause significant damage; unchecked recessions morph into depressions and cause terrifying damage. Biss, her readers, and other non-economists are fortunate that economists involved with stabilization policymaking understand what causes recessions and how to tame them.
What are asset-price bubbles? They are defined as the broad divergence of (financial and real) asset prices from those consistent with their market fundamentals. Mainstream theorists mistakenly believe that market fundamentals are the whole story, dominating the rational determination of asset prices.
Do rational macro bubbles exist? Economists’ market determinism raises questions about the coexistence of bubbles and rational behavior. Bubbles obviously exist. It is not unusual for asset prices to significantly diverge from market-centric fundamentals. Doesn’t that prove that bubbles are inherently irrational? That question is deeply problematic for mainstream economic theorists whose assert their models to be motivated by rational behavior. The quandary has been solved by the GEM Project. Its generalized-exchange modeling has expanded the scope of proper analysis to include workplaces restricted by costly, asymmetric employer-employee information. In the two-venue framework, asset prices do not significantly diverge from generalized-exchange equilibrium.
Is the idea that stock prices are rational “one of the most remarkable errors in the history of economic thought”? No, it is not. The idea is correct. The rational-behavior generalized-exchange theory easily accounts for the asset-price bubbles that led Shiller to that wrong, badly misleading assessment. I should make it clear that I like and admire Bob Shiller, who served with me on the New York Fed’s Academic Advisory Board. He is one of the many good economists who have been misled by restricting rational exchange to occur only in the marketplace.
What do macro asset bubbles tell us? The GEM Project’s extreme-instability model, rooted in rational behavior, identified divergence of equity prices from their market fundamentals in 2008-09 as indicating a severe deterioration of investor assessment of the credibility of stabilization authorities’ real-side objectives. That conclusion provides crucial guidance to the construction of effective remedial policies.
Do rational markets need to be regulated? Yes. That affirmative answer has long been understood by careful economists. The core idea is that rational market outcomes can generate negative externalities, e.g., the profit margins enhanced by dumping harmful waste into a near-by river. Economists have long known that it is a primary duty of public policy to identify and correct negative externalities. Market regulation is a necessity.
What Biss Does Not Know
Biss is funny and angry. She also, probably out of ignorance, badly misleads. What Biss does not know is that modern rational-behavior economics is exceptionally powerful, usefully explaining things big and small. In the big stuff, economists understand that capitalism is most usefully defined by market centricity in the pricing and allocation of scarce resources. It explains why market economies have produced rising living standards and economies in which government controls pricing and allocation stagnate. Market economies have pulled most of the globe out of subsistence; command economies have failed in that fundamental responsibility. That great fact of economics must not be ignored.
Rational-behavior macroeconomics additionally explains mild and severe instability in employment, production and asset prices and identifies policies that effectively ameliorate recessions, great recessions, and depressions. Economic knowledge accumulated since the 1930’s depression is why the U.S. has never experienced a repeat of that mass devastation. Figuring out how to do that, most recently on display in the 2008-09 financial crisis and the on-going pandemic, is no laughing matter.
Blog Type: Policy/Topical Saint Joseph, Michigan