Yellen (and Akerlof)

Jon Hilsenrath has written a biography

Jon Hilsenrath’s Yellen profiles Janet Yellen and George Akerlof, a married couple of economists. Tyler Cowen reviewed it months ago, but I just read it.

For Hilsenrath, a financial journalist, Yellen is the more prominent figure, because she has held positions of power at the Fed and Treasury. But undergraduate majors are more likely to recognize Akerlof’s name, because his “market for lemons” idea is popularly taught in econ courses.

For me, reading Yellen felt like listening to a wedding toast in which a friend of the couple gushes endlessly about how the bride and groom are AMAZING and how much they are in love. The friend seems to need to tell every story he can remember about the couple, and the toast goes on and on.

Hilsenrath lauds Akerlof’s and Yellen’s personal charm and professional brilliance. The personal charm I don’t doubt.

Akerlof did his graduate work in economics at MIT, and most of the names dropped by Hilsenrath are from that department. The MIT economics department has always excelled at patting itself on the back. In those days, it was at its peak as a screening-and-placement machine. They had their pick of incoming graduate students. But more important, they were able to dominate academic job placement.

In any given year, there might be, say, 12 job openings for new Ph.Ds at top-tier economics departments. Of these, MIT students probably would fill 6 of them, with no other graduate school placing more than 1 or 2. As that went on year after year, MIT came to dominate the top departments, leading through sheer numbers to domination of the major journals, the National Bureau of Economic Research, and the prestigious awards (the Clark Medal and the Nobel Prize).

None of this required the faculty at MIT to have high value added in terms of teaching. Nor did it require the department to steer its talent pool in directions that might really advance the discipline of economics.

MIT economists were known for their faith in mathematics. Hilsenrath tells the story of Akerlof encountering Robert Solow, one of MIT’s iconic professors.

Meeting in the common room for the first time, Solow asked Akerlof what he wanted to study. The new economics student told his MIT elder that he wanted to learn topology. . .Economists didn’t typically study topology, but Akerlof thought the class would help him to look at problems differently… p. 21

Akerlof was ahead of his time. My generation of students had to study topology, because by then it was essential to graduate courses in general equilibrium theory. And we had to study stochastic differential equations, because that was essential to graduate courses in monetary theory or macroeconomics.

MIT economists acted as if using ever more difficult and abstract mathematics was the only margin on which economic knowledge could be improved. There was nothing to be learned by studying history, psychology, or business practices.

I believe that the infatuation with math has faded somewhat. Akerlof himself, although he used equations to express his ideas, went down a different path, incorporating psychology and sociology. That combination has become known as behavioral economics. Hilsenrath puts Akerlof closer to the center of the behavioral economics school than I would, but he was certainly part of it.

I actually think that one of the worst things Akerlof ever did was collaborate with behavioral economist Robert Shiller, in a book called Phishing for Pfools. I reviewed that book harshly when it appeared.

Akerlof’s most notable contribution, for which he shared a Nobel Prize, is his “lemons model.” I would explain it this way:

Consider used cars. Imagine that for a given year, make, and model of car, half of the cars have a true value of $12,000 and the other half are “lemons” with a true value of $8000. What will be the average value of a used car traded in the market?

If you answer $10,000, then you know how to calculate an average, but you have not thought through the problem the way that Akerlof did. The correct answer is $8000.

The people who own the good cars know that they are worth $12,000, and they will not want to sell them for less. Only the people who own lemons will want to sell them for less than $12,000. Buyers will figure this out. So the only cars that will trade will be the lemons. The average value of cars traded will be $8000, the value of a lemon.

Whether or not you believe this is worthy of a Nobel Prize, I think it is an insightful idea that helps teach the use of economic reasoning. It is what most professors do next that is disturbing.

What could come next is an analysis of possible solutions to improve the used car market. One solution might be for each buyer to pay a mechanic to examine a car before buying, so that the buyer can tell a good car from a lemon. Another solution is for the sellers who know that they have good cars to offer a warranty.

Instead, what most often comes next is that the professor teaching the lemons model says “This is what happens when people don’t have perfect information. The market breaks down. That is why we need government.”

The presumption that markets are flawed and government intervention is the solution pervades the thinking of much of the economics profession in general and Akerlof and Yellen in particular. As you know, I have a different point of view.

Are markets imperfect? Certainly. But solutions that come from the market itself can sometimes work. And solutions that come from government intervention can often fail. In short: markets fail; use markets.