Monday, October 05, 2009

The Chicago School Circle Is Now Complete

In former University of Chicago professor Milton Friedman's influential 1953 essay "The Methodology of Positive Economics", he argued that we shouldn't care about whether theories are realistic or not, but whether or not they yield non-truistic predictions about phenomena’s not yet observed:

"The ultimate goal of a positive science is the development of theory” or “hypothesis” that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed. Such a theory is, in general, a complex intermixture of two elements. In part, it is a “language” designed to promote “systematic and organized methods of reasoning.” 5 In part, it is a body of substantive hypotheses designed to abstract essential features of complex reality.

Viewed as a language, theory has no substantive content; it of tautologies"

This has served as justification for using wildly unrealistic assumptions, such as continued arbitrage activity despite the absence of any gains for such activities. When questioned these assumptions have been justified as necessary to provide for mathematical models that can be used for precise forecasts.

The problem has always been that partly because these assumptions have been unrealistic, their predictions have usually been wrong, or at least no better than the predictions of someone picking scenarios randomly.

Now that some people like Paul Krugman (whose prediction track record is hardly better BTW) pointed this out, University of Chicago professor John Cochrane turns Milton Friedman's old doctrine on its head and declares:

"It’s fun to say we didn’t see the crisis coming, but the central prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going — neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences."

But if we can't make any predictions about not yet observed phenomena’s, then how could deliberate unrealism in theoretical reasoning in order to enable theories to be expressed in the forms of advanced mathematical models be justified? The circle is now complete and the neoclassical mathematical Chicago school is exposed as having both unrealistic assumptions and useless models.

It should be noted that while this inconsistency is most blatant in the Chicago school, it is also present in almost all non-Austrian school, including Krugman's Ne Keynesianism.

BTW: The alleged conflict between realism of theories and their usefulness in predictions is of course false. No one can predict the future perfectly even with correct theories, but by using the correct theories the predictions will be true more often than not.


Blogger Aragon said...

One William Easterly preached EMH when he wrote some months the following:

"[E]conomists did something even better than predict the crisis. We correctly predicted that we would not be able to predict it. The most important part of the much-maligned Efficient Markets Hypothesis (EMH) is that nobody can systematically beat the stock market. Which implies nobody can predict a market crash, because if you could, then you would obviously beat the market.

If this is the main attitude of these guys then why on earth give any predictions at all? :)

(I stole that quotation from Bob Murphy's article but it came immediately into my mind when I read this piece)

8:57 PM  
Blogger Jarda said...

"But if we can't make ANY predictions about not yet observed phenomena’s..."

How does this conclusion (with the particular stress on "any") follow from what you have said in the post?

Cochrane's statement may be bold and apologetic, but the conclusion you are making is a logical fallacy.

2:04 AM  
Blogger stefankarlsson said...

Jarda, that's what Cochrane thinks. I was discussing his argument.

9:20 PM  

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