realists, constructionists, and lemmings oh my! (part I)
Here is an exchange from Friday’s News Hour with Jim Lehrer :
David Brooks: People took out these loans. People assumed house prices were going up. It’s a contagion all across the world in highly regulated economies in Europe, less regulated economies here. And to me, it’s this social contagion that has sort of transcended all the other barriers.
Jim Lehrer: Well, as Alice Rivlin said on this program the other night, what nobody counted on was the possibility even that home prices wouldn’t always go up, they would eventually go down. Nobody considered that as a possibility.
Mark Shields: Twenty-six years we had — from 1982 forward, we had low unemployment, low inflation, and pretty good economic times. A lot of people were hurting, but, you know, so there was that reason, that expectation that things were going to get better.
Jim Lehrer: And home values were always going up.
Mark Shields: Yes.
And here is what former Fed governor Rivlin had said:
We were victims, the whole country, of a collective delusion that housing prices would keep on going up. And I think we lost control of our common sense.
Many people who bought mortgage-backed securities, who bought other securities that were related to them, didn’t ask one simple question, which was, what happens to the value of these securities when housing prices go down, as they eventually would?
I find this kind of talk to be fascinating. For at least two reasons. First, these are smart people, but they are saying silly things. Were you deluded into thinking that housing prices were always going to go up? Did you lose control of your common sense? Personally, I had long thought that it was moronic to believe that housing prices were always going to go up, and I was convinced that they had become insanely overvalued. And I’m positive that that is true for many of you. I’m even reasonably sure that this is true for the talking heads quoted above. At least, I’m sure they thought there was a significant possibility that we were in a housing bubble. And I’m certain that they participated in numerous discussions since 2000 and even before about such a possibility. Like many of us, I’m sure that they were aware of the work of Robert Shiller–and maybe even got sent this fun video [based on these data]) If you have any doubts that the idea that we were in a housing bubble of unprecedented proportions was widely discussed, here is the number of articles in U.S. publications mentioning the words “housing bubble” by year (courtesy of Factiva):
So, while there certainly were many dissenters with the view that we were in a housing bubble (please don’t all raise your hands at once!), it is clearly wrong to say that we are were all deluded, jumping lemming-like (metaphorically, not literally– turns out lemmings were given a bad rap by our friends at Disney) to our financial ruin. The possibility that we were in a bubble was widely discussed and believed by many.
The second reason I find this interesting is that it is a useful route in to a set of related questions concerning how we should think about market prices and how they relate to “fundamentals,” an issue I promised in my last post that I’d address, and this issue relates more broadly to the perennial divide between realism and constructionism, with implications far beyond financial markets and including, in particular, the truth-value of scientific theories. (Sorry for that awful sentence) In my next post, I’ll try and stake out an intermediate position that both incorporates the wisdom in each perspective and tries to deal with their problems. In this post, I’ll lay the groundwork, by showing how pure constructionism and pure realism ironically lead to roughly the same (uncomfortable) place.
To begin to see how these seemingly opposing perspectives lead to the same place, note that adherents of both a pure constructionist perspective and a pure realist perspective should start sweating at the idea that we were in a housing bubble. Why? Well, the answer is obvious when you take the realist point of view– the notion of a bubble implies that prices are not (always) constrained by fundamental values. But what about the pure constructionists? At first blush, you might think they would take a perverse pleasure in the bubble in that it shows that prices really are constructed and not anchored in fundamental values. However: (a) Acceptance of the claim that we were in a bubble implies acceptance of the claim that prices can be, and were, wrong [which is a four-letter word in constructionist land]; (b) Acceptance of the idea that the bubble popped implies acceptance of the idea that prices ultimately are constrained by fundamentals, even if such constraints are looser than realists typically suppose. So there is a sense in which it is more comfortable from a pure constructionist perspective to say that in fact there was no bubble and that, as always, prices are just social constructions with any price being possible.
Note that this implication can be seen in the politics of realism and constructionism. Greenspan’s Congressional testimony on Thursday is case in point for why it is idiotic to have a pure realist as a chief regulator. Why did he not do something about the mispricing of risk by banks? In short, he gave the same answer as James Cox, as quoted two posts ago:
Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.
In my previous post, I already discussed the basic flaw in this line of thinking. In short, while individuals act in their own self-interest, this very pursuit of self-interest can lead them away from fundamental values when they are; (a) acting as agents rather than principals: and (b) speculators rather than income or enterprise investors. For the moment though, what is crucial is to recognize is how idiotic it is to have a regulator who thinks that the self-interest of the targets of regulation is enough to ensure the desired behavior– in this case, that they will price loans (and secondarily, home values, upon which the value of those loans depended) correctly. Essentially, the prices must be right because market participants have such a strong incentive to get them right. And then the job of the regulator is…?
But just as it is silly to have a Chicago-type economist as your chief regulator, it would be just as silly to replace him with a constructionist. To paraphrase Abbott in The Chaos of Disciplines (sorry– I don’t have the book in front of me and so don’t have the exact quote or page number), “the problem with constructionism is that it has no politics.” Constructionism can never tell you what should be; it can only tell you that there is little basis for what is. In particular, if there is no such thing as a right price or a wrong price, would Greenspan’s constructionist doppelganger have any more basis for questioning banks’ lending practices than did the Greenspan-the-realist? No.
As I said, parallel issues come up in the science wars, especially as they pertain to the “performative” properties of economic theory. Consider in particular how orgtheory’s own Teppo Felin and his coauthor Nicolai Foss respond, in their forthcoming article, to a paper by a 2005 AMR paper by Ferraro, Pfeffer, and Sutton. FPS argue that the self-fulfilling nature of social scientific theories (and especially high-status ones coming from economics) imply that even a false theory can become true if practitioners adopt that theory and enact its principles. F&F argue that a focus on such positive feedback-loops ignores various negative feedback loops that prevent the acceptance of economic theories that are unconstrained by objective reality and human nature.
As with the debate concerning the basis for financial market prices, this debate is between a constructionist position (FPS) that says that the success of a theory is a function of what people are ready and willing to believe, and a realist position (F&F) that insists that the theory must be valid for people to believe it. And note again that while these positions oppose one another, they lead to the same place– neither them of them can account for the widespread acceptance of a wrong theory! For FPS (and the performativity movement with which it is allied), this would be problematic because it means that the self-fulfilling properties of economics are not so powerful after all. And for F&F (and the realist position that it develops), the widespread acceptance of a wrong theory is problematic because it implies that the truth does not constrain (economic) theories very much. In sum, while the performativity folks suggest that “economists make markets” and the realists think that economists just provide insight into markets, neither of them can account for when wrong economic theories prevail for long periods of time. Perhaps this doesn’t matter because there are no, widely-adopted, but wrong economic theories. But then what about the efficient markets theory espoused by Greenspan, and his Chicago-type allies?! This was certainly not a case of economists being right about markets, as F&F would lead us to expect. And it was not a case of economists making markets, as FPS and their performativity cousins would lead us to expect. In fact, this was a case of economists breaking markets!
In sum, we need an intermediate position– one that reconciles:
(a) The idea that prices (or the relative success of different theories) reflect subjective valuations and these valuations are governed, in the first instance, by (the anticipation of) others’ subjective valuations; with
(b) The idea that such valuations are constrained by fundamental and objective values.
Moreover, such a position should hopefully be able to explain why those constraints operate so loosely for periods and then tighten up. And this question is particularly vexing since we clearly have a case where there was a massive bubble but there was not, contrary to the talking heads quoted above, a mass delusion. What did people believe then, and what changed?
I’ll try to develop such an intermediate position (basically, just a summary of views that I’ve already expressed in my articles on stock market valuation) in my next post.