Barry’s Misplaced in His Criticism of Mankiw

Barry Ritholz dissected Harvard econ professor Greg Mankiw’s piece from the Sunday NY Times.  I think Barry is pretty far in left field, both metaphorically and politically.

Mankiw says after studying 25 years of economics, there is still much he doesn’t know.  No surprise there, if we knew everything, we wouldn’t keep studying and using the scientific method to try and prove or disprove theories.

It’s pretty safe to say we know communism doesn’t work as an economic system, so there really isn’t any reason to study it anymore.  However, the crux of the debate worldwide is with Keynesianism vs Classical; intellectually at American universities you might say, saltwater vs freshwater.

Mankiw wonders if we can look beyond strict economics to better predict what is going to happen.  Economics is a blended science of math, psychology, and sociology.  Often called the dismal science because many economists are just geeks that crunch numbers.  In addition, it’s easy to poke holes in many economic projections with regard to macroeconomics because they are almost always wrong.

Macro has much more randomization and variability to it than microeconomics.  Hence the wider variance of predictive power, and the room for lots of debate between the two sides.

Unfortunately, Mr. Ritholz offers up nothing to advance the debate.  Instead, he uses his blog to attack Milton Friedman without offering up evidence, and goes after former President Bush.

Barry writes, “Let’s put aside the fundamental error of classical economics — that Humans are rational, self-interested, profit maximizing creatures. They are clearly not; Humans are actually irrational social animals with flawed cognitive apparatus.”

Actually, let’s not put that one aside.  Aren’t humans simply trying to maximize their self interests?  Whether they collaborate to help someone out or jealously guard every resource they have isn’t germane to the debate of maximizing self interest.  It may be in the self interest of the human to collaborate, engage in charity work, take less of a gain this time on something because the opportunity costs and risk calculated by that individual human direct them to behave in a certain way.   No one said all humans engaged in the same optimal decision making.  Hopefully we learn from our mistakes.

Gary Becker in his seminal 1962 paper, Irrational Behavior and Economic Theory, showed how irrational behavior is consistent with the classical economic theorems that used rational investors.  It really is a genius piece and you ought to read the whole thing.

Becker says, “How can these extensive criticisms be reconciled with the fact that the main implication of utility theory-that market demand curves would be negatively inclined-has been consistently verified empirically, and found extremely useful in practical problems?”  In simple words, demand curves slope down.  They never slope up.  At the margin, people will consume more of something if it’s price goes down.

The rational investor exists.  The rational household exists.  The rational business exists.  The rational charitable foundation exists.  They each face downward sloping demand curves and make trade offs based on changing variables.  Does the irrational investor exist?  Sure, but they don’t last for long because eventually they face the same demand curves everyone else does.  If they choose not to face them, they are out of business.

Ritholz criticizes Mankiw and economists for looking at post WW2 cycles to predict what will happen to this one.  Of course, then he cites an economic text, rather than looking outside economics to find the answers.

In his second criticism he says, “Friedman’s belief that people were engaging in immediate behavior based upon their momentary consideration of long term inflation reveal he hadn’t a clue as to how actual human beings operated in the real world. No wonder he foolishly believed we could get rid of the FDA — who needed Food inspections anyway? And the marketplace will help determine what Drugs will and should sell.”

How is going after the FDA idea an answer to economic problems?  In addition, the hoarding that is going on worldwide with several commodities proves Friedman’s expectation thesis.   People expect higher prices.  Here is a photo of a rational investor.

Then Ritholz comments about Mankiw, “He writes: “A remarkable feature of current financial markets is their willingness to lend to the federal government on favorable terms.” This must be a change of heart for the professor, given his role as Chairman of the Council of Economic Advisors from 2003-05. He never said much — at least publicly — about this “unsustainable fiscal trajectory” when his boss was busy turning a surplus into a “huge budget deficit.”

From the CBO to the GAO, every honest broker who has analyzed the situation has observed that the Bush tax cuts, the war of choice in Iraq, the prescription drug entitlement were the biggest factors pre-2008 in the runaway budget. Add to that the collapse of revenues brought about by the financial crisis, and you have the makings of a awful balance sheet.”

Why is he going after the war, an entitlement and tax cuts as a proxy argument for bond market trust?

First, whether you agree with the war in Iraq or not is indifferent to the cost. It just isn’t that expensive. Here is a graph of deficits with and without the Iraq War
The war was costly in deficit terms one year out of eight. Combine that with the fact that the budget is strictly accounting numbers and not real economic numbers and who knows where we are really at?

I am not here to defend the spending policies of the Bush administration or the Republican controlled Congress from 2000-2006. They were appallingly bad. But there are more things affecting the bond market than simply the US deficit. Where do you think people think their money is safest today? That’s why US bond yields aren’t higher.

Contrary to Mankiw’s question(which might be rhetorical), and Ritholz opinion, I think the answer to our troubles are found in economics. The solution is to create incentives for people, and businesses to behave rationally. That would mean ending subsidies, tax breaks stripping out a lot of government regulation and spending, and lowering tax rates. In short, it means less government not more. It also means setting broad policy and having individuals take entrepreneurial risks to grow the economy. Trust the individual to make the best choice, not some overarching body.

  • barry ritholtz

    Hey Jeff,

    My next response is to tell you to look at the second half of my quote you cited — you left out the best parts !

    You cited:

    “Let’s put aside the fundamental error of classical economics — that
    Humans are rational, self-interested, profit maximizing creatures. They
    are clearly not; Humans are actually irrational social animals with
    flawed cognitive apparatus”

    But why ignore the second half of the paragraph? That is the money shot!

    “Frequently emotional, occasionally self-destructive, often times erratic, humans only rarely exhibit the traits that economics ascribe to them. If the study of economics begins
    with such a shaky foundation, is it any wonder they get so much wrong?”

    The critique is not of any branch of economics, but of the entire discipline! It is based upon a flawed premise, and that helps to explain why the field gets it so wrong so often . . .

    • pointsnfigures

      Fair enough. I didn’t mean to misquote you. I would agree that macroeconomics is very inexact. Micro is not. However, that being said, I put my faith in the individual rather than large government entities to solve problems and grow the economy.

      We disagree on the rational investor concept. I believe in it. There are certainly instances of individuals behaving irrationally, but over the entire course of the demand curve if you sum everything in, the average investor behaves rationally.

  • barry ritholtz

    The war in Iraq isn’t that expensive?

    I know you find spreadsheets boring, but a $ trillion dollars is an enormous sum of money. And some estimates of the total, all in cost of the IraqWar of choice — caring for injured veterans, replacing military hardware, etc. — are north of $3 trillion dollars.

    You cannot be a serious critic of deficits and defend the massive costs of invading the wrong country.

    • pointsnfigures

      I only supported the Iraq War once Colin Powell made the case to the UN. Before that I was against invading. Ever mindful of the “you break it you fix it” dictum, it was going to be expensive. As a percent of GDP, it wasn’t expensive. It wasn’t nearly as expensive as all the spending that has happened since 2007. But, your point is well taken. Avoidance of war is the correct strategy for as long as you possibly can.

      • 666momus

        And Colin Powell resigned once he realized he’d been asked to present lies.

        • pointsnfigures

          Okay, you say lies, they say bad intelligence that virtually every other allied country thought was true as well. Anyway, once the tanks roll it’s pretty hard to turn them around.

          As I said, no matter what you think of the war, it simply wasn’t that expensive in relation to GDP. The war is not the cause of our deficit-it’s the spending that has taken place-mostly on entitlements. The Republicans spent money like drunken sailors from 2000-06, and were tossed out on their ass. The Dems from 2007-2010 were significantly worse, and tossed on their ass.