By William K. Black
April 3, 2016 Minneapolis, Minnesota
I want to thank two prominent “freshwater” macroeconomists, Dr. Narayana Kocherlakota (until recently the President of the Minneapolis Fed and previously the Chair of the University of Minnesota’s economics department) and Dr. Kartik Athreya (Research Director of the Richmond Fed) for their article (2010) and book (2013) , respectively, designed to convey the current status of macroeconomics. Reading their descriptions, and reviewing the work of Oliver Williamson, Roger Myerson, and Leonid Hurwicz in light of the discussion of macroeconomics has made it clear to me that the central difficulties in micro and macroeconomics are with concepts that are the core of what we study as white-collar criminologists and what I dealt with as a financial regulator. There is, therefore, an opportunity for substantial advances should economics draw on the findings of the discipline (white-collar criminology) and the insights of the professionals (successful financial regulators) with the preeminent expertise in these problem areas. Athreya also stresses the key role of law and how the effort to contain fraud explains significant portions of the legal rules for commerce. I also have expertise in law.
Since I combine those three forms of expertise and teach various microeconomics courses, I thought I would write this open letter to orthodox macroeconomists and macroeconomists. For reasons that I will discuss, the perfect person to address is Athreya, with a “cc” to Kocherlakota.
Where economists have drawn on our insights, the results have proven successful. Indeed, I will show that one of the greatest opportunities for the advancement of “modern” macro (and micro) economics would be to cease ignoring George Akerlof and Paul Romer’s 1993 article “Looting: The Economic Underworld of Bankruptcy for Profit.” I can think of no other field in which a Nobel Laureate, writing in his area of greatest expertise (fraud is the most damaging form of “asymmetrical information”), who proved correct and explicitly warned his field about the need to focus on “looting” (via “accounting control fraud”) would be religiously ignored by scholars in his or her discipline.
Athreya’s Twin, Interactive “Central Impediment[s]”
In his book (2013: 221), Athreya identifies two related problems that he argues “interact” (emphasis in original) to form the twin scourges of real world economies and orthodox macro.
“[A]symmetric information and limited commitment” “are economists two ‘usual suspects’ in creating problems for decentralized trade.”
By “decentralized trade” he means markets. Athreya asserts that the interaction of these twin scourges is minimal in “spot” markets, but can prove immensely destructive in “IOU” markets. I will return to that assertion in a later installment of this open letter. By “limited commitment” he means the inability of a party to a transaction to give credible, effectively enforceable commitments that will protect the counterparty from loss in the event that the first party breaches. That inability, of course, leads to increased defaults and greater losses upon default and increases the incentive to defraud and abuse counterparties. The ultimate form of abuse of “asymmetric information” and “limited commitment” is control fraud, which is my greatest expertise.
The key takeaway is that our greatest areas of expertise as white-collar criminologists and effective financial regulators are precisely the greatest areas of weakness for the real world economy and the orthodox macro and micro. Fraud and other extreme forms of “opportunistic behavior” in markets (aka, predation) are the “central impediments” to the economy and orthodox macro and micro. Further, those problems are likely to be most severe in banking and finance, which is our wheelhouse. For bonus points, law and institutional design in finance are critical according to Athreya, which is once more in my wheelhouse. None of these subjects is one in which orthodox economists have material expertise or experience. There is, therefore, a superb opportunity to address these weaknesses through multi-disciplinary collaboration with orthodox macro practitioners if they are open to such a collaboration.
Kocherlakota’s List of the Key Problems for Orthodox Macro
Kocherlakota famously opened his 2010 article by admitting the central, crushing failure of orthodox macroeconomics in the run up to and the response to the most recent crisis. He cited three underlying conceptual difficulties as producing the failure of macro models.
I highlight three particular weaknesses of current macro models. First, few, if any, models treat financial, pricing, and labor market frictions jointly. Second, even in macro models that contain financial market frictions, the treatment of banks and other financial institutions is quite crude. Finally, and most troubling, macro models are driven by patently unrealistic shocks.
At first blush, it might seem that Kocherlakota’s list has no overlap with Athreya’s twin “central impediment[s].” But Kocherlakota is using the concept of “frictions” to include Athreya’s central impediments. Kocherlakota then stresses that these problems are likely to be most severe in finance and ends by saying the entire approach of orthodox macro to “shocks” and finance fails because it is not based on the real world (e.g., the shocks are “patently unrealistic” and the treatment of banks is “crude”).
White-collar criminologists can make unique contributions to macro’s weaknesses by addressing each of Kocherlakota’s three points, which are interrelated. As I will explain in a future installment, we can offer additional help with the first weakness by suggesting why the “friction” metaphor is so misleading and reinforces orthodox macro’s tendencies to make key errors when its practitioners attempt to model asymmetries and limited commitment (aka, “fraud” and other severe forms of “opportunistic behavior”). We can also explain an important subset of the real world shocks most likely to trigger crises.
Why I am Addressing Athreya
Athreya is an obvious recipient of this open letter given his book and his position as research director at the Richmond Fed, but I confess that a part of my choice is reading his infamous rant (2010) along with his book. His book appears to have been his constructive response to his rant, so I will be gentle. His rant had many ringing phrases that were received with howls of laughter, but for these purposes two phrases suffice to convey his pain.
[T]he patron saints of the “Macroeconomic Policy is Easy: Only Idiots Don’t Think So” movement: Paul Krugman and Brad Delong. Either of these men will assure their readers that it’s all really very simple (and may even be found in Keynes’ writings).
It is hard to imagine a chemist attacking a Nobel Laureate in his discipline in these deliberately insulting terms for comments the Laureate made about chemistry, but such attacks are common in economics. My colleagues and I profoundly disagree with what followed this quotation in Athreya’s rant, but because my mission is to reach out to orthodox economists I will forbear from that discussion in this installment of my open letter to him. Suffice it to say that Athreya’s understanding of “accounting,” as displayed in his rant, is a key area in which our expertise can add value to his analysis and prompt him to use superior models that “beat” the orthodox models. I discuss accounting below in some detail for it is the “weapon of choice” in financial fraud.
But the part of Athreya’s rant that is most infamous is this.
So far, I’ve claimed something a bit obnoxious-sounding: that writers who have not taken a year of PhD coursework in a decent economics department (and passed their PhD qualifying exams), cannot meaningfully advance the discussion on economic policy. Taken literally, I am almost certainly wrong. Some of them have great ideas, for sure. But this is irrelevant. The real issue is that there is extremely low likelihood that the speculations of the untrained, on a topic almost pathologically riddled by dynamic considerations and feedback effects, will offer anything new. Moreover, there is a substantial likelihood that it will instead offer something incoherent or misleading.
In the hopes that a gentle answer might turneth away wrath, I offer the observation that other fields (white-collar criminology) and professions (financial regulation and the law) are “trained” (rather than “untrained”) to master (not “speculat[e]” about) sophisticated frauds schemes and legal rules and institutions that are “almost pathologically riddled by dynamic considerations and feedback effects.” Athreya’s book and Kocherlakota’s article demonstrate that white-collar criminologists and effective financial regulators offer vital insights that are “new” to orthodox economists in precisely the areas that both have identified as their greatest problem areas. Precisely because of our superior expertise and experience with “pathological” “dynamic considerations and feedback effects” we offer unique insights. Orthodox economists are unaware of these dynamics and feedback effects because they have no experience with them and because they implicitly assume them out of existence in their Arrow Debreu McKenzie (ADM) and Dynamic Stochastic General Equilibrium (DSGE) models. As a result, white-collar criminologists, effective financial regulators, and legal scholars can aid micro and macro economists to recognize and address the “incoherent and misleading” aspects of their orthodox models and theories that cause their models to fail so routinely and comprehensively on the most important macroeconomic events, as Kocherlakota acknowledged in his 2010 article and Athreya did in his 2013 book.
In his book, which is designed for non-specialists, Athreya maintains his disdain for multi-disciplinary scholars.
“What is out there that is better?” “Should macroeconomists canvass broader audiences to better diagnose what ails them? [M]y view is that each of us, in the modern world, knows some small thing about what we specialize in, and next to nothing about anything that we do not.” “Specialized knowledge and generalized ignorance are joined at the hip” (p. 363).
I note that despite these sentiments, in his book, Athreya talks about how to respond to the problem of crime in multiple passages. Therefore, while I pretty much exemplify “multi-disciplinary,” I trust he will not be too upset if I return the favor and discuss a few of the most important implications of the findings of white-collar criminologists, effective financial regulators, and legal scholars for economic theory. I also note the logical problem of asking “what is out there that is better” while maintaining and valorizing a “generalized ignorance” for orthodox economists that makes it impossible for them to know “what is out there that is better.” Not to fear, however, a criminologist, effective financial regulator, and legal scholar is answering his call to know “what is out there that is better.”
Economists love paradoxes that advance their ideological priors (e.g., the seller’s greed reliably makes him act towards customers as if the seller were altruistic). So prepare for my paradox –the thing that is “better” “out there,” the core insights that we have drawn in my primary fields and my areas of greatest professional expertise that orthodox economists need to learn and incorporate are already mostly in the best economics literature – and orthodox economists are ignoring it. We know about it because we are multi-disciplinary and because we contributed to the development and refinement of that economics literature.
The fact that orthodox economists have ignored this superior economic literature, and have done so for decades, should drive introspection and a reevaluation of whether “modern macro” actually comports with the valorous description given it by its practitioners. I want to stress that my definition of superior economic research is not idiosyncratic. I am talking about economic theory that Athreya agrees is superior. He claims that Akerlof’s theories are increasingly incorporated into modern macro because they have proved superior in precisely the areas in which “modern macro” models have proved weakest. I will show how Akerlof’s theories have been bowdlerized by orthodox economists to exclude control fraud.
Akerlof and Romer agree with the extension and refinements of their theories made by white-collar criminologists that have repeatedly proven accurate in crises after 1993. Indeed, Akerlof and Romer now agree that effective financial regulators had developed by 1984 a theory of control fraud that was superior in several aspects to the theory that Akerlof and Romer would independently develop in 1992 about accounting control fraud. Akerlof and Romer called their model “looting” when they published it in 1993. Beginning in late 1992, the three groups – regulators, criminologists, and economists (Akerlof, Romer, and James Pierce) began to exchange ideas in a fruitful multi-disciplinary collaboration.
The irony is that because white-collar criminologists and effective financial regulators are multi-disciplinary we have drawn on and learned from the best economics. We then advance and refine those principles because we use reality and other scientific research methodologies that are better able to observe and understand “dynamic considerations and feedback effects” that are assumed out of existence (often implicitly) by DSGE and ADM models.
Our fields are “pathologically riddled” with complexity because that complexity was generated by “pathological” CEOs to aid their frauds. The sophisticated fraudsters we identify, counter, and prosecute would pervert any game theoretic solution generated by orthodox economists without working up a sweat. My article on the Japanese dango (bid rigging cartel) provides an example of that ability in the real world.
We do not suggest that the advances we can bring, and have brought, to economics will make macroeconomics “easy.” What we show is that orthodox modern macro (DSGE) is impossible. It cannot work because it assumes out of existence that which is essential to model the economy if one wishes to understand its crises and how to reduce and respond to them. It assumes out of existence precisely the two points that Athreya terms the central impediments to the economy and to macro models.
In one sense, our insights will make macro far “tougher,” because they will bring reality, in the form of indeterminacy and the denial of “equilibrium” to DSGE, sweep away the blithe “bliss” of ADM, reveal the depravity and non-optimality that would dominate “Pareto optimality” once the unacknowledged “ADM God” (Athreya 2013: 103) is acknowledged to be a myth (and worse, a hidden cheat). Our insights introduce enormous, realistic shocks into dynamic models, further demonstrate the circularity of many orthodox claims about “rational expectations,” demonstrate that “decentralized” actions by sophisticated control frauds could simultaneously shrink the “pie,” make its division exceptionally unequal, and enrich the most immoral and destructive economic actors, and falsify on logical and empirical grounds the “just so” stories that orthodox economists find so persuasive. Collectively, these micro-foundational flaws in the orthodox models make it impossible for them to model the economy properly. Fixing these flaws will not make macro “easy,” but doing so is essential to make macro “tough” rather than impossible.
My colleagues who are macroeconomists can then make orthodox macroeconomics far tougher by injecting a realistic understanding of money, accounting identities, budget, and real resource constraints in nations such as the United States that maintain sovereign currencies. Once more, my colleagues’ work demonstrates that “modern macro” (DSGE) is not “tough” – it is impossible. It incorporates fictions (in the guise of “discipline”) and excludes reality in a manner that makes it impossible to model economic crises and superior means of recovery. Incorporating these two sources of revolutionary analytical changes from real world micro and macro would create a real revolution in economic theory and allow a truly modern macroeconomics with predictive ability to arise, but neither source of change will make macroeconomics “easy.” It will, however, be a considerable advance to cease making macro impossible.