Liberty Matters

The Hard Challenge of Dumb-Dumb Economics


Humans have limited intelligence.  Basically, we're dumb.  That's obvious enough.  And yet most economists struggle with this simple fact.  The old-fashioned "hydraulic" Keynesian models assumed that the economic experts were smart. (Phillips 1950)   These were dumb-smart models.  Entrepreneurs are dumb; economists are smart. Dumb-smart economic theory was relatively easy because the economy was viewed as a simple machine.  The "Lucas critique" says this asymmetry in smartness gives you the illusion that you can fine tune the economy by twiddling a few dials.  It's not that easy, however, because private actors will react when policy changes. (Lucas  1976)  
Today's standard ("DSGE") macroeconomic models try to avoid the Lucas critique by assuming everyone is smart.  They are smart-smart models.  Both private and public actors are smart because they have "rational expectations."  They are so smart, in fact, that they can compute the uncomputable. (Spear 1989)  The hard thing with DSGE models is the math.  But the economics is still relatively easy.  If there are no frictions, the economy is efficient because smart people can always glide smoothly into the perfectly calculated optimal action.  Add in some friction, and policy may have some role at least in the short run.  The game for economists is to discover or, perhaps, invent frictions that will justify your prior policy preference.  Paul Romer (2010) calls that sort thing "mathiness," though in the context of growth theory.  As far as I know, there aren't many models in which private actors are smart and public actors are dumb.  I suppose that would be too much for the vanity of any economist with policymaking ambitions. 
Finally, there is dumb-dumb economics, in which everyone has "bounded rationality" in some sense.  I say "in some sense" to remind the reader of the important criticism Felin, Koenderink, and Krueger (2016) make of the standard model of bounded rationality.  The epistemic institutionalism of Hayek and the Austrians is dumb-dumb economics. Private actors are dumb, but so are public actors.  This dumbness symmetry is a part of the analytical egalitarianism Boettke mentioned.
Dumb-dumb economics is hard.  The dumbness symmetry between policymaker and public implies that clever policy wonks cannot consistently outsmart the public.   Health economist Jonathan Gruber, sometimes dubbed the "Obamacare architect," famously said that the "stupidity of the American voter" was essential to the passage of "Obamacare," i.e., the Affordable Care Act of 2010. (Roy 2014) That's dumb-smart thinking, and it won't fly.  The dumbness assumption makes it impossible to imagine that everybody will just automatically do the optimal thing.  People have to receive the appropriate signals and make the appropriate calculations.  Different institutions will produce different signals, making different calculations possible. 
This stuff matters.  Smart-smart macroeconomics seems to have led to some poor decision-making at the Fed.  Following the onset of the Great Recession, Alan Greenspan confessed to an error in his economic logic. In testimony before Congress in October 2008 Greenspan (2008, p. 2) said he had "found a flaw" in his model of capitalism:
[T]hose of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets' state of balance. If it fails, as occurred this year, market stability is undermined.
In Greenspan's logic, "self-interest" was sufficient to ensure foresight and stability.  This embarrassing error was a product of smart-smart macroeconomics.  Greenspan thought it was sufficient that counterparties had skin in the game.  In some way that we needn't understand, smart agents will figure out what is in their interest and act accordingly.  Greenspan did not think it was necessary to identify any mechanism for the production and distribution of the knowledge that counterparties required to protect themselves. 
If we reject the illusions of dumb-smart and smart-smart macroeconomics, if we take up the intellectual challenge of dumb-dumb macroeconomics, then we will be driven to seek out and identify the mechanisms of knowledge production and distribution in society.  And it is a challenge.  We need to immerse ourselves in the institutional structures shaping knowledge production and distribution.  To explain the Great Recession, for example, we need to understand how too-big-to-fail shapes the risk-taking behavior of large financial institutions.  Greenspan's obliviousness on this score is a striking example of the dangers of smart-smart economics.  If we want an even moderately complete dumb-dumb account of the Great Recession, we need to penetrate to a more fine-grained understanding of the institutions of knowledge production and distribution in society.  To cite just one salient example, we need to understand the institutional structure of the rating agencies that so flamboyantly failed.  In the United States, bond-rating agencies are creations of the government, and they had an incentive to produce unrealistically optimistic ratings. (Levy and Peart 2008, 2017) 
Epistemic institutionalism requires us to identify the mechanisms of knowledge production and distribution under the dumb-dumb assumption that no one has superhuman powers of cognition.  It is a challenging research program, but the only one likely to spare us from the sort of "shocked disbelief" Alan Greenspan experienced when things fell apart.
Greenspan, Alan. 2008. "Testimony of Dr. Alan Greenspan." Prepared for Committee of Government Oversight and Reform. October 23. <>.
Levy, D. and Peart, S. 2008. "An Expert-induced Bubble: The Nasty Role of Ratings Agencies in the Busted Housing Market". Reason. 30 September. <>.
Levy, David M. and Sandra J. Peart. 2017. Escape from Democracy: The Role of Experts and the Public in Economic Policy. Cambridge: University of Cambridge Press.
Lucas, Robert. 1976. "Econometric Policy Evaluation: A Critique." In K. Brunner and A. Meltzer, The Phillips Curve and Labor Markets. Carnegie-Rochester Conference Series on Public Policy. New York: American Elsevier. pp. 19–46.
Phillips, A. W. "Mechanical Models in Economic Dynamics." Economica.New Series, Vol. 17, No. 67 (Aug., 1950), pp. 283-305​.
Romer, Paul. 2015. "Mathiness in the Theory of Economic Growth." American Economic Review: Papers & Proceedings 105(5): 89–93.
Roy, Avik. 2014. "ACA Architect: 'The Stupidity of The American Voter' Led Us to Hide Obamacare's True Costs from the Public," Forbes, 10 November 2014.  <>.
Spear, S. E. 1989. "Learning Rational Expectations Under Computability Constraints." Econometrica. 57: 889–910.