Another View of Chicago

Tyler Cowen links to this article.

Alexander Rosenberg (Duke), as most readers will know, is a leading philosopher of science, especially of biology and economics, and author of a devastating critique of economics, Economics: Mathematical Politics or Science of Diminshing Returns? (University of Chicago Press), which won the 1993 Lakatos Prize in Philosophy of Science from the London School of Economics. I asked Professor Rosenberg for his reaction to John Cochrane's reply to Krugman, and he kindly gave me permission to post his thoughts:

Samples of Rosenberg:

Cochrane thinks that neither Krugman nor the last years of the Bush stock market can impugn the “efficient markets hypothesis” and so everything in conventional economic theory is untouched.

The efficient markets thesis is that the market makes complete use of all relevant information, and the “proof” is roughly that in a perfectly competitive market among perfectly rational agents prices invariably and instantaneously reflects all agents’ real beliefs and real desires. Any one who knows anything that can make him or her money acts on it—buys or sells—and that signal is picked up by every one else, who also acts on it, thus preventing any one from making excess profits—rents--long-term.

The first thing a philosopher notes about this notion is that since most people have false beliefs, especially about the future, an efficient market doesn’t internalize knowledge, but only beliefs. If they are mostly false, then the market isn’t efficient at internalizing (correct) information, it’s efficient at internalizing mostly false beliefs. If false beliefs are normally distributed around the truth, then they’ll cancel out and the proof of a probabilistic version of the efficient markets theorem will go through—market prices reflect the truth most of the time. Too bad false beliefs don’t always take on this tractable distribution. Even worse, when enough people notice the skewed distribution of false beliefs, they can make rents, as the markets crash. This is what Cochrane seems to think can't happen. How many times will it have to happen for the Chicago School to give up the efficient markets hypothesis?

There are so many way the assumptions of the efficient markets theorem can go wrong—different ones at different times, often even cancelling one another out, that it's easy for a complacent economist to see in the long term trend a vindication of the efficient markets theorem. And all Chicago economists have been taught to be complacent with their mother’s milk—Milton Friedman’s famous insistence that the falsity of assumptions doesn’t matter.

But Friedman’s children, like Milton himself, forgot his caveat that false assumptions are harmless so long as predictive power is improved, or at least preserved. Now the real point of Krugman’s essay is the obvious one. The economic theory the Chicago School prizes lacks the predictive resources even to have retrodicted the last two years of the world’s economic trajectory. The catastrophe of international finance is only the head-line grabbing symptom of this failure. And Chicago economists don’t have the slightest idea of where to start to explain (to retrodict) it. They don’t know which of their assumptions to give up, and how much of each of those to give up. Add in their ideological attachment to the nonsensical ideas that the marginal productivity of labor or capital measures its causal role, and therefore its moral right to a proportional slice of the profits, and you easily slip from Laissez-faire “science” to “trickle down” political philosophy.
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All the reasons the failure of financial markets gives us to question the scientific status of Chicago-school economic theory are mutates mutandis reasons to ignore their “rational expectations” claims (the wish being the father of the thought) that the stimulus wont work—or at least that the non-tax-cut portions of it wont.

So is Chicago (with all those almost Nobels) really just an ideology posing as a an economic theory?