In a recent New Yorker, John Cassidy spends time with a number of influential economists at the University of Chicago, home to the Chicago School and its emphasis on the productive efficiency of free markets. Obviously, the financial maelstrom of the last few years has led many to question this premise, at least in its strongest form. How have these economists reacted? If you read my recent article in Wired on the psychology of failure, you probably aren't too surprised to learn that Cassidy finds several eminent Chicago economists who insist that the market failure wasn't actually a failure, or that even if there was a failure then it didn't involve the markets. In other words, their assumption remains intact - it's the evidence that's so flawed.
Here, for instance, is Cassidy interviewing Eugene Fama:
I asked him how this theory [the efficient-markets hypothesis, which "underpinned the deregulation of financial markets] had fared in the recent crisis, which many, myself included, have described as an example of gross inefficiency. Fama was unruffled. "I think it did quite well in this episode," he said..."Stock prices typically decline prior to a recession and in a state of recession. This was a particularly severe recession. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline. That was exactly what you would expect if markets were efficient."
The emphasis that Fama placed on the stock market surprised me. Surely, I said, we had experienced a giant credit bubble, which eventually had burst. "I don't know what a credit bubble means," Fama replied, his eyes twinkling. "I don't even know what a bubble means. These words have become popular. I don't think they have any meaning...People have jumped on the bandwagon of blaming financial markets. I can tell a story very easily in which the financial markets were a casualty of the recession, not a cause of it."
The interview continues in a similar vein. The point is that nothing in the last few years, at least in Cassidy's telling, has led Fama to reconsider his theoretical assumptions. The financial markets are efficient; government regulation is to blame. In my Wired article, I discuss some of the neuroscience behind such intellectual stubbornness, and the way the brain cleverly dismisses dissonant information.
But Cassidy's excellent article also made me think about the role of colleagues in triggering new ideas, and the potential dangers of working in a department filled with people who share the same ideology. Here I describe the research of Kevin Dunbar, who spent several years watching scientists work:
While the scientific process is typically seen as a lonely pursuit -- researchers solve problems by themselves -- Dunbar found that most new scientific ideas emerged from lab meetings, those weekly sessions in which people publicly present their data. Interestingly, the most important element of the lab meeting wasn't the presentation -- it was the debate that followed. Dunbar observed that the skeptical (and sometimes heated) questions asked during a group session frequently triggered breakthroughs, as the scientists were forced to reconsider data they'd previously ignored. The new theory was a product of spontaneous conversation, not solitude; a single bracing query was enough to turn scientists into temporary outsiders, able to look anew at their own work.
But not every lab meeting was equally effective. Dunbar tells the story of two labs that both ran into the same experimental problem: The proteins they were trying to measure were sticking to a filter, making it impossible to analyze the data. "One of the labs was full of people from different backgrounds," Dunbar says. "They had biochemists and molecular biologists and geneticists and students in medical school." The other lab, in contrast, was made up of E. coli experts. "They knew more about E. coli than anyone else, but that was what they knew," he says. Dunbar watched how each of these labs dealt with their protein problem. The E. coli group took a brute-force approach, spending several weeks methodically testing various fixes. "It was extremely inefficient," Dunbar says. "They eventually solved it, but they wasted a lot of valuable time."
The diverse lab, in contrast, mulled the problem at a group meeting. None of the scientists were protein experts, so they began a wide-ranging discussion of possible solutions. At first, the conversation seemed rather useless. But then, as the chemists traded ideas with the biologists and the biologists bounced ideas off the med students, potential answers began to emerge. "After another 10 minutes of talking, the protein problem was solved," Dunbar says. "They made it look easy."
When Dunbar reviewed the transcripts of the meeting, he found that the intellectual mix generated a distinct type of interaction in which the scientists were forced to rely on metaphors and analogies to express themselves. (That's because, unlike the E. coli group, the second lab lacked a specialized language that everyone could understand.) These abstractions proved essential for problem-solving, as they encouraged the scientists to reconsider their assumptions. Having to explain the problem to someone else forced them to think, if only for a moment, like an intellectual on the margins, filled with self-skepticism.
The lesson is that the process of discovery benefits from our differences, from the disagreements and contradictions that arise when people with different assumptions discuss the same data. When everyone agrees, or has the same academic background,
then the stubbornness is reinforced. The theory doesn't change. The School of X - and it doesn't matter what X is - remains tethered to its dusty preconceptions. The failure never leads to a better answer.
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... or the "Ishmael effect" in action! when you think your opinion is right and others blatanly wrong.
I agree with the lesson you suggest.
The problem in the UK is that we've had rampant socialism and state control. Brown has taken over several large banks, bailed out others, forced some into liquidation.
ie. It's socialist state control.
Capitalism does involve companies going bust. It's part of the process.
What makes you think otherwise or are you the economic equivalent of a creationist?
This does seem like it might be a useful episode to clear up misunderstandings of EMH, but it doesn't seem to have been terribly usefully leveraged for that purpose. "When Genius Failed" was perhaps the most egregious, supposing that EMH forbids fat tails (when in fact it would seem to me to require them), and "Irrational Exuberance" similarly seemed to layer onto EMH the idea that returns should be constant over time. (I honestly couldn't follow where Shiller got that idea.) EMH, especially in its strongest form, is clearly false, and it's annoying to see so many smart would-be opponents of it charging at comical straw men instead -- at the idea that markets are perfectly clairvoyant, for another example. So taking a crash as an opportunity to illustrate how it is consistent with EMH might be useful for getting people at least on topic.
(Not that EMH was really the subject of this post. Bias-confirmation is an interesting and important topic, as you note, and is ubiquitous.)
What you're talking about seems similar on a small scale to what Kuhn's paradigm-shift notions described on a grander scale.
We live in a day of such hyper(and unavoidable)-specialization that scientists walk around with blinders on most of the time but rarely realize it. (I'd say that's especially true in medicine... but, hey I won't go there ;-)
Fama also thinks he may win a Nobel at some point. Admitting error would make that even less likely.
You assume that Fama is wrong. If he isn't, then your example illustrates the importance of maintaining one's views in the face of criticism. If he thinks that recent events confirm his theory, why should he reconsider his basic premises? If everybody did this, nobody would understand anything.
Jonah, youâre assuming itâs basically a cognitive issue. It could be primarily affective. There may be an emotional need to be right. In Mindset, Carol Dweck gives a plausible explanation for this kind of stubbornness. People of the fixed mindset believe that human qualities, such as intelligence, are fixed. You got it or you donât, and there is nothing you can do about it. You can learn new things, but you canât really change your basic intelligence. This results in feeling that everything is a test; youâre always being judged. Failure shows you donât have it, and you never will. It is a final judgment. So you never admit failure; you donât make mistakes; it is never your fault. (Thatâs another characteristic of the fixed mindset, blame.)
If I had read the paragraph I just wrote before I read Mindset, I would have thought that it is too simple and implausible an explanation. But Dweckâs research is pretty convincing. Then again, another feature of the fixed mindset is they need validation, and may surround themselves with people who confirm their views. They cut off dissent. Paul Krugman has said that about the Chicago School many times, including here:
âChicago just turned inward on itself circa 1982, and stopped paying attention either to the world or to anyone not of its tribe.â
That makes just two different backgroundsâ¦ :-) Still better than nothing, though, of course.
"Problem"? That was damage limitation. Successful damage limitation, I must add. The problem had existed much earlier!
Good comment, SJA.
A cleaner case for this kind of thing is Samuelson's rejection to the Kelly Formula for sizing bets. The results have a huge variance that is unattractive for portfolio management by an investment adviser, but how much variance to tolerate is a subjective judgment. Rather than point this out, Samuelson attacks the math. It's gibberish.
I consider myself way left of center and I've always been suspicious of stock markets, and markets in general for that matter. But your argument here seems thin in the extreme. An apparent counterexample to a theory, arising from a superficial examination of the facts, can on closer inspection turn out to be no such thing.
It seems to me that we have here something more insidious than stubbornness, and that is the practice of performing a psycho-analysis on someone you don't agree with, in order to avoid actually having to argue for your own position.
I might also add that, now that you've made a name for yourself with these books, you have a vested interest in finding examples of the phenomena you describe all over the place, particularly in people who hold views very different from your own.
Rick - You may be right, but take for instance this quote from the article
"Are you saying that bubbles canât exist?
They have to be predictable phenomena. I donât think any of this was particularly predictable."
And then look at this graph
I think anyone who looked at this data in 2006 or so (or who watched the prices rise from 2000-2006) would have asserted there was a bubble more than "half the time." The guy has to be either ignoring these shots at his theory or avoiding them.
The Chicago Schoolâs defense of efficient markets just doesnât hold up against all the known facts. Their error is not simply that they are holding on to their position, but that they do not seriously consider facts and explanations that contradict their theory. Continuing from my first comment, this is consistent with what Dweck found regarding people of the fixed mindset. Studies using fmri show that they attend primarily to feedback about whether they were right or wrong on the experimental task, while not attending to feedback that would help them improve their performance, like people of the growth mindset did. Those of the fixed mindset are concerned about being right and confirming their positive self-image, not on improving their understanding.
This also shows up when there is undeniable failure. Those of the fixed mindset fall apart. Those of the growth mindset learn from their mistakes and move on.
Hayek explained the boom-bust cycle decades ago and received the Nobel Prize for his work. The latest meltdown doesn't prove him wrong, it proves him right.
In a true market economy, we can't all be borrowing at the same time. I should only be able to borrow what you save or vice versa. If everyone wants to borrow 1) rates will go up and 2) banks will choose the borrowers most likely to pay back the money. Both prevent low-interest loans to people with lousy credit scores.
But insert a central bank into the equation and allow it to expand the money supply and force rates down to far below their market level, then you can get a boom followed by a bust. It's happened several times, in this country and others. That's not a failure of markets. It's a failure of central banks.
Tom, your argument is self-contradictory. If markets are efficient, then participants should take the Central Bank into account. If risks are high because of Central Bank action, they should back off, not create a bubble. What you are doing is redefining efficient markets. You are finding something to blame for the failure of emh. Whatever you blame, if it affects the market, then a truly efficient market would consider it and make it a non-factor.
Soros had it right. Markets are efficient much of the time, but it is inevitable that a self-reinforcing feedback loop will develop, and booms and busts will far overshoot rational valuation. Booms and busts occurred before central banks existed.
"If markets are efficient, then participants should take the Central Bank into account."
This is like saying if the heart is an efficient organ, then the parts of the heart should adapt and remain efficient even if you plunge a knife into it (but they didn't! Ha!). The heart should take that into account. I mean, all kinds of weird stuff can happen. Therefore, NOTHING can be truly efficient, since you can always think of some external part that could come along and disturb it. How fast is your computer if I smash it with a hammer? Not very fast, I'd guess. Therefore it was never really and truly fast!
WOW! Deep stuff!
Jonah's point about the differences between the two groups is made persuasively by Scott E. Page in The difference: how the power of diversity creates better groups, firms ...
Add'ly, the idea that Fama should just pay attention to what supports his theory is the point: his duty (a al Popper) is to disconfirm his hypotheses -- to seek out what does not fit
Is it possible this one also comes under the question of what causes the stubbornness of partisan allegiance? Economics is a highly partisan profession, and the Chicago School is further to one side politically than the other prominent schools of thought. Maybe Fama is defending whatever it is that political ideologues always defend in political debates (I have an opinion of what that is, but I'll leave that for my own blog).