A Self-Examined Academic Life

Macroeconomists seemingly have adopted monastic practices of self-flagellation to explain why the tribe completely misjudged the housing bubble .  Their collective crystal balls didn’t predict an ensuing financial crisis either.  A blog entry by Finance Professor Raghu Rajan at University of Chicago has further stimulated the conversation today.  He’s written a book called Fault Lines and made remarks from the book at its official blog site. I found it at Memeorandum along with a few choice links.

I’ve written about  fresh water and salt water economics before.  Some of today’s discussion clearly involves philosophical fault lines.  Rajan is from the panultimate fresh water university and all finance academics eventually drown in the Efficient Markets Hypothesis (EMH) literature. I’ve been pretty outspoken about how much damage I think the EMH has done to economics and especially my field, financial economics.  However, it’s hard to get published in finance journals taking a contrarian view.  This is one explanation he examines, then dismisses which is why I’ve taken a good look at his argument.

I have not read his book, but judging from the video and this blog entry, Rajan spends some time on the role of EMH and EMH true believers in the crisis.   I can provide you with my own anecdotes on this.  I can also tell you I tried to avoid some seminars because I don’t want to read any more Eugene Fama who is Rajan’s colleague.  I frankly think EMH blinders or misunderstanding were a good deal–but not all–of the problem.

I was researching the subprime markets directly after Katrina and was told by my finance professors that I was following an unpublishable and boring line of research. (They used the term ‘unsexy’.)  I saw hints of problems in subprime markets as early as late 2005 in the work I did with the sensitivity of stock prices of finance companies heavily invested in subprime loans to some key macroeconomic variables. I was told that line of research was unlikely to help my marketability and ability to get tenure upon graduation.  They yawned when I presented the paper.  I turned it in for my third econometrics seminar and switched to something else.

Finance journals editors do love them some EMH so anything on market anomalies is likely to get a jaundiced set of editor eyes.   But, Rajan brings up some important points and the resulting discussion is worth viewing here.   Here’s Rajan talking directly to the EMH and why he thinks it may not be a big deal.

Perhaps the reason was ideology: we were too wedded to the idea that markets are efficient, market participants are rational, and high prices are justified by economic fundamentals. But some of this criticism of “market fundamentalism” reflects a misunderstanding. The dominant “efficient markets theory” says only that markets reflect what is publicly known, and that it is hard to make money off markets consistently – something verified by the hit that most investor portfolios took in the crisis. The theory does not say that markets cannot plummet if the news is bad, or if investors become risk-averse.

Critics argue that the fundamentals were deteriorating in plain sight, and that the market (and economists) simply ignored it. But hindsight distorts analysis. We cannot point to a lonely Cassandra like Robert Shiller of Yale University, who regularly argued that house prices were unsustainable, as proof that the truth was ignored. There are always naysayers, and they are often wrong. There were many more economists who believed that house prices, though high, were unlikely to fall across the board.

Rajan points out that this probably isn’t the sole or primary explanation even though it is one that gets a lot of ink these days.  I too think some of the problem is a misunderstanding of the various forms of EMH . So, the major philosophical debate happening in finance circles isn’t central to Rajan’s explanation. There is no conspiracy of EMH apologists to force misunderstanding of market rationality, so alright, I’ll give him that one.

Economist Tyler Cowen at Marginal Revolution likes the alternative succinct explanation Rajan provides.  (You should read the comments to that thread.)

Raghu Rajan nails it:

I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.

Rajan also dismisses  another  circle of conspirators by stating this.  It’s also probably why one of those so-called progressives jumped on the dismissal earlier today.  This conspiracy meme crosses circles of folks that are more into political economy than economics itself.  This group argues the hypothesis that the “system” bribed economists to stay quiet.  I’ve gotten into it more than a few people of the Matt Stoller mindset and various Rand hanger-ons about  this improbable case.  One of the biggest memes is that the FED actively influences economists not to publish things against their interests. (Usually, this comes from Austrian School folks who can’t get published any where mainstream because they want to completely operate outside of the scientific method and ignore data.)  Matt Yglesias is one of these people making a living off this canard and he jumped to the bait immediately. His reasoning  speaks more about him than about economists.

Rajan glosses a leading alternative hypothesis thusly:

Finally, an answer that is gaining ground is that the system bribed economists to stay silent.

Obviously bribe-based theories of human behavior are crude and rarely capture reality. But how about translating this into economics? How about incentives? Rajan says it’s not individual corruption that led to a lack of insight, it’s structure features of the way the profession is organized. That makes a lot of sense to me. But what explains that structural organization? Is it really unrelated to the financial basis of the economics profession? Or are economists supposed to be immune from the factors that influence human behavior in other instances?

I always find  that Yglesias, Stoller, et al come to this conclusion more by self-projection than nearly anything else.  You do not become a primary researcher to sell your soul to Wall Street.  You can go directly to the source and just sell your soul to Wall Street at any time. It’s easier and much more lucrative. I’ve done my share of consulting.  I’ve worked at the FED.   My degrees and experience have value to Goldman Sachs and they do place some pretty enticing want ads out there.  However, none of this interferes with my desire to find some truth and contribute to basic knowledge or theory. I say this as one who has switched to primary research from digging through numbers in the ‘real world’.  I do not think I’m alone in that.

Now, my career is quite unorthodox by academic standards because I came late to a doctoral program.  I know that a lot of people get finance PhD.s these days because it’s worth a lot of money.  But, those people make THOSE choices.  They can go to Wall Street.  Others head off to academia. There are rare plum positions in top schools these days and those don’t even get on the market.  The majority of academics do not have Paul Krugman careers. The rest of us wind up in public universities where we still have to publish to get tenure and we have to publish to get meager raises.  You struggle a lot more to get ink if you don’t have the ‘proper breeding’.  You have to come up with dynamic ideas to get attention.  Believe it or not, there is a market for dynamic ideas in academia. If you can breach the wall of a top journal, your life is much easier.  I’m about ready to start that assault myself; gray hairs and all.

But, it’s not all about easy pubs or kiss up pubs.  Perhaps I should bring up that ENRON may not have been uncovered with out the dabbles of a finance professor.  The gaming of NAVS on funds traded in the US with underlying assets in Asia may not have been uncovered either.  A finance professor’s research uncovered backdated executive pay schemes just recently when what he  found that a significantly huge number of  executives  ‘coincidentally’ achieved  stock incentives on the most favorable day of the year for values.  There are more than a few times when academics have tripped across things that the SEC has missed.  These are just three of the ones I can name off the top of may head having done research into these things during my doctoral-level finance seminars.  That’s the kind of thing I live for.

But, not according to Matt.  Here’s an example of Ygelisa’s self projections onto people like me.

If so, I’d like to meet these people! In journalism, I think most people want to do a good job and produce good articles. But people also want to get raises, get better jobs, get invited to cool events with important people, get on TV and be famous, etc.

Ygelisa can call me or frankly, bite me.  He can call any academic that doesn’t have an Ivy League pedigree and an easy route to those rare, excellent jobs.   I’d rather uncover one bit of truth that contributes theory and earns a huge number of  peer cites than “get invited to cool events”.   It would actually do my career some good as well as my soul.

I am motivated to pay my bills.  There’s not a huge cushy job market out there for academics.  Not even ones with the pricey degrees get terrific jobs.  Most academics don’t job hop either.  Tenure is a motivator to stay in place as is your pension plan.  None of the finance professors that contributed to those findings above wound up in glamorous jobs and beltway circles.  They just keep teaching students and publishing articles because if they don’t, their school loses its accreditation and they don’t get in on whatever meager pay raises could be available.

So, there is probably some credence to all of these reasons that Rajan dismisses but his main argument–as pointed out by Cowen–remains sound in my little corner of experience.  I’ll borrow from Ygelsias’ journalism example.  Rajan and Cowen speak from prime time.  I speak from the morning news desk in Peoria. I taught macroeconomics at the time–having a monetary economics background–while taking doctorate finance seminars.  My research is getting more specific all the time.

Like medicine, economics has become highly compartmentalized – macroeconomists typically do not pay attention to what financial economists or real-estate economists study, and vice versa. Yet, in order to see the crisis coming, you had to know something about each of these areas, just like it takes a good general practitioner to recognize an exotic disease. Because the profession rewards only careful, well-supported, but necessarily narrow analysis, few economists try to span sub-fields.

I do think that the majority of academics that still publish and do research are somewhat disengaged from reality. I know that because I entered academic being very tired of that reality.  The academic life encourages and rewards disengaged behavior. My own experience suggests that you try to make your life easy by going after research that will get you the publications that you need.  But, a lot of the research that you can do–especially in finance–has to do with the size of your university’s budget for data.  Because of Governor Bobby Jindal and the flooding of New Orleans after Hurricane Katrina, I struggle continually to get to databases containing foreign direct investment. I’ve even recently called the World Bank begging that New Orleans be considered a third world country so I can get their numbers free. Legacy schools get better data sources which get better publication.  Of course, legacy schools have closer ties to Wall Street too.

Maybe it’s because I live in an academic backwater that I did get some sense that something was terribly wrong some where between 2005 and 2006.  I got anecdotal stories from friends that were social workers and that turned me on to researching the subprime markets. They had a lot of clients that had entered into contracts they didn’t understand that were beginning to eat them alive.  I thought it might be an underlying trend with bad results.  I already told you how far that got. But,  I personally pulled a lot of money out of various investments at the time because I just didn’t ‘feel’ the markets were in touch with fundamentals.   I also carefully avoided the real estate game at the time.  I don’t trust any market where there are information brokers because, theoretically, these are FAILED markets.   Any sign of insurance agents and sales brokers means price distortion and bad asset valuation.  You don’t need an ivy league degree to find that out since its in every basic microeconomics textbook.  Clearly, a lot of people could’ve seen the warning signs if I did as a meager grad student.

So, my bottom line is that I think that academics, like any one else, just go along the path of least resistance.  They take the easiest routes to publication which in finance means bowing to the gods of EMH or sticking it out in more obscure journals or going above and beyond the norm to prove a nonstandard thesis.  Academics take consulting jobs because it helps pay their bills.  It doesn’t blind them when they research.  Every one wants that one perfect paper.  Some, after tenure, just don’t pursue that as intensely as they did when they were younger.  In finance and economics, if you’re after the money, you go to Wall Street immediately.  If you want to do policy stuff, you head to NGOs, think tanks, or the agency of your choice.  It’s really not a mystery why the majority of  us aren’t sitting around looking for omens for the perfect storm.  We’re not in positions to do so.  There’s plenty of intervening factors to deter us.  That seems to be Rajan’s thesis.