When economic theory fails the maths exam

Eight years ago, in December 2005, I began warning of an impending economic crisis that would commence when the rate of growth of private debt started to fall. My warnings hit a popular chord: journalists throughout the world picked it up and publicised my views – as well as similar arguments from Nouriel Roubini, Dean Baker, Ann Pettifor, Michael Hudson, Wynne Godley, and a few others.

But our arguments were ignored by the economics profession because, according to mainstream economic theory, private debt should have no impact on aggregate demand. As Bernanke put it, lending simply transfers spending power from lender to borrower, and “pure redistributions should have no significant macro-economic effects” (Bernanke, Essays on the Great Depression, p. 24).

Yet the empirical evidence that change in debt does have “significant macro-economic effects” is compelling: the correlations of change in debt to the level of employment (Figure 1), and of acceleration in debt to changes in employment (Figure 2), are overwhelming.

Figure 1: Compelling visual evidence? Not to a mainstream economis
Graph for When economic theory fails the maths exam

Figure 2:Something else to ignore because it doesn't pass the a priori test


Graph for When economic theory fails the maths exam

This visually compelling numerical evidence of what caused the crisis was and still is ignored by mainstream economists, while less numerate journalists latched onto it. Why? You would expect that the more numerate a person is, the more he would take evidence like this seriously.

But that isn’t the case it seems – and a fascinating new study of numeracy and reasoning has indicated why this might be so. It seems that when an issue is politically neutral, a higher level of numeracy does correlate with a higher capacity to interpret numerical data correctly. But when an issue is politically charged – or the numerical data challenges a numerate person’s sense of self – numeracy actually works against understanding the issue. The reason appears to be that numerate people employed their numeracy skills to evade the evidence, rather than to consider it.

The research paper, Motivated Numeracy and Enlightened Self-Government, tested people’s ability to interpret numerically challenging data against their ratings on a numeracy test, and their political allegiances. Precisely the same data was presented as the results of two quite different studies: whether a new skin care product did or did not reduce skin rashes, and whether gun control laws did or did not reduce crime. The hypothetical data was set up so that half of the survey group saw objectively positive results – the skin care product worked, or gun control reduced homicide rates – and the other saw objectively negative results in each case (see Figure 3).

Figure 3: The hypothetical data presented as real data to different segments of the survey group


Graph for When economic theory fails the maths exam

The “data” was designed to be confusing to those with low numeracy skills: a simple comparison of numbers in the first column would lead to reaching the wrong conclusion – that the skin cream increased rashes when it reduced them, or that gun control laws decreased crime when it increased it. Getting the correct answer involved a comparison of the ratios of the two columns.

The experimenters expected that more numerate people would trump less numerate people in both instances – so that effectively, a higher level of numeracy would lead to a lower level of ideological bias, whether the issue was politically charged or not, and whether the subject was conservative (Republican) or progressive (Democrat). The argument, effectively, was that a higher level of intellectual skill would mean higher cognition in general and a lower level of political bias. As a psychological hypothesis, they termed this the “Science Comprehension Thesis” (SCT).

Mentally, the reason for the expected bias of the less numerate people was that they would use what Kahneman called System 1 or “fast” thinking, which is more instinctive and emotional – the sort of reasoning that stops you becoming a meal for a lion on the Serengeti. More numerate people were expected to also employ System 2 or “slow”, logical reasoning – the sort that enables you to turn the lions into prey rather than predators.

But there was an alternative hypothesis as well, which proposed that more numerate people would use their greater numerical skills to hang on to pre-existing beliefs, in order to preserve their membership of a group that was socially important to them. The researchers termed this hypothesis the “Identity-protective Cognition Thesis” (ICT):

Individuals, on this account, have a large stake – psychically as well as materially – in maintaining the status of, and their personal standing in, affinity groups whose members are bound by their commitment to shared moral understandings. If opposing positions on a policy-relevant fact – e.g., whether human activity is generating dangerous global warming – came to be seen as symbols of membership in and loyalty to competing groups of this kind, individuals can be expected to display a strong tendency to conform their understanding of whatever evidence they encounter to the position that prevails in theirs.

The results are summarised in Figure 4 – and interpreting it might itself be challenging if you’re not American, because red signifies conservative while blue signifies progressive!

The simplest observation is that higher numeracy led to a higher ability to interpret the data in the politically-neutral skin rash data, and that there was no significant difference in ability due to political allegiance.

Figure 4: Correct results by topic versus numeracy level and political allegiance


Graph for When economic theory fails the maths exam

The more complex result is that higher levels of numeracy led to higher, rather than lower, polarisation on the politically charged issue of gun control. There was no gap between Republicans and Democrats of low numerical skill when interpreting data that found that gun control increased crime: both groups were equally bad at getting the right answer. But there was a very big gap for numerate Republicans and Democrats when the “results” contradicted their pre-existing beliefs. Highly numerate Democrats were little better than innumerate Democrats in correctly interpreting data that showed that gun control increased crime; and equally, highly numerate Republicans were little better than innumerate ones in interpreting data that showed that gun control reduced crime.

The polarisation between Republicans and Democrats also increased as numeracy rose – the opposite of what you would expect if you thought political differences over objective data arose from an inability to interpret that data. There was no difference between innumerate Republicans and Democrats when presented with data that implied that gun control failed, but a very large gap between their numerate brethren. The substantial gap between innumerate Republicans and Democrats when presented with data that implied that gun control worked (we’re talking America, after all) became a chasm between the numerates.

The authors found the implications of their study for democracy rather depressing, since it implies that both evidence and intelligence make precious little difference to how people will vote on contentious issues – which are after all the only ones we do vote on. The need to preserve a sense of identity matters more than the evidence and this can’t be treated as “irrational” behavior either, because it’s quite rational to want to retain membership of a group that is immediately important to you.

Numeracy can make you blind. Who’d a thought?

Someone who did belatedly reach the same conclusion was one of history’s great numerates, Max Planck – the father of quantum mechanics. He found it near impossible to convince his fellow physicists to accept his new – and empirically far more accurate – characterisation of the nature of energy, and he ultimately concluded that:

A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it. (Max Planck).

Planck’s pessimism might well turn out to be optimism when compared to how economics “evolves”. As John Quiggin put it in his book Zombie Economics (which hands down has the best cover of an economics book that I’ve ever seen), ideas that manifestly conflict with empirical data continue to exist long after reality killed them. The data on private debt and employment should long ago have killed the “Loanable Funds” model of lending that led Bernanke and his tribe to ignore private debt before the crisis hit, but I expect they’ll hang on to their pet theory and find a way to make it appear compatible with the data instead—and Larry Summers may well have given them the means to remain part of The Great Undead with his “secular stagnation” hypothesis.

Kahan and colleagues’ research also has implications for people in the global warming debate – and many other areas of social conflict over empirical issues. Each side tends to deride the other as lacking the ability to interpret the data – thus thinking they are more numerate than their opponents. Those who believe that global warming is happening (guilty as charged Your Honour) tend to think that their opponents are scientifically dumber than they are, and simply can’t process the overwhelming numerical evidence in favour of the hypothesis; those who reject global warming believe their opponents are politically motivated dumbos who are deliberately hoodwinking themselves.

But this research implies that leading lights on both sides of the argument could be just as numerate as each other, and numerical evidence alone will never cause one side to concede defeat. Only reality itself will ultimately end that debate.

Steve Keen is Associate Professor of Economics & Finance at the University of Western Sydney and author of Debunking Economics and the blog Debtwatch.

More from Business Spectator

Comments

Please login or register to post comments

Comments Policy »

Congratulations. Your theory explains politics as well, it doesn't matter what the numbers say each political party interprets them according to their political agenda.

Someone want to get me a right wing economist to get some data that supports supply side? There will be plenty of economists but no data

Yes indeed, and that's why we have outcomes like 5% unemployment even though 20% of the population are looking for a job.

Which - of course is why I keep suugesting to Callam that he puts his colored pencils away. Graphs provide nothing but excuses - often hindsight based - and graph based conclusions are less believed in than they used to be. Many have abandoned that faith as mumbo-jumbo

There are no patterns except those we ourselves impose. The Economic game seems based on the idea that you get people to believe in a pile of garbage and then predict how they will behave by following the same book. When events, or a person tear up the rule book, statistics based economics has no real answer and has to invent a new myth

It has been suggested that Patton employed against Rommel what he had learnt from reading Rommel's own book on military tactics. The trick is to invent the rules, get other people to believe in them (possibly by creating an entire University faculty) - Then you break those same rules, thereby catching them with their pants down.

Good article, Steve. Amazingly, I understood pretty much all of it, but I also found your comment on the global warming debate a little condescending to the opponents of the theory. Speaking of being affected by the position one takes, both physically and financially, could it well be that you're also in this one-eyed category that will be proven wrong? Somehow, I suspect that you won't, but feel that the event your anticipating is being artificially delayed by those with vested interests: a la bankers and politicians. Meanwhile, the great globalisation robbery of the western world continues to keep the show nicely oiled for the elite, whilst everyday people are looking at retiring into their 70s with the debt noose stubbornly embedded around their necks!

Chris E

I think it was German philosopher, Nietzsche who said something along the lines that "conviction is a greater hindrance to truth than lies". One only needs to engage in the briefest exchange with someone of strong political convictions to realise that it is a waste of time. They cherry pick "facts" (frequently bumper-sticker type slogans) to "support" their position and indicate no disposition to consider the merit of alternative propositions.

Absolutely Doctor, we are all part of the group think mentality. However sometimes, history will throw up someone, that does not require the affirmation of the group. People such as Issac Newton, the founder of economics, who lost most of his money making bad investments. Or Albert Einstein, who explained that all matter was a product of energy. Or Stephen Hawking, who explained, that the big bang was a random event, that occurred because of potential difference. Or George Soros, who made a fortune in the FOREX market, which is the trade of potential difference.

Economics is not mathematics, Newton proved the 3 Laws of Motion, using mathematics yet be displayed his fallibility, while using economics.

So, spending money, creates jobs, the way the debt is spent determines mathematical aptitude.

Correlation is not causation.
There is no clear indication of one quantity leading the other.
Why do you think that private debt influences employment ?
What if it's the other way round ? This is actually more plausible - if job security is lower people will be reluctant to take on new debt !
The third possibility is that both quantities are driven by a third factor.

Stefan, that is a good point.

That is a good point, although the debt change does trend downward before the employment change tending to indicate that the credit level is the driver, unless as you say there is a third driver of both indicators. I'm interested though in the correlation departure from late 1995 to late 1997 in which the debt level is decreasing but employment level is increasing. If the debt level and employment levels are intrisically linked then I would conclude that there have been no actual productivity drivers in the overall US economy and "productivity gains" are actually a function of continually bringing future consumption into the present via increasing debt levels at lower and lower interest rates and the departure period was possibly the once in a lifetime productivity increase created from increasing usage of computers in business allowing actual cost savings to pass through the economy and increase prosperity/profit margins without pulling consumption forward.

Steve, if you will humour me for a moment... "It's not just the debt, stupid!" I think you will find that the price of oil, the rise of China, superannuation and the savings glut all had a role to play in the current situation. You can't blame everything on the banksters. They just do what they do. They do not create the circumstances under which they become a bloated sector of the economy all by themselves.

So if 'numerate' people will have a position that can't be changed by mere facts and maybe not by propositions not based on numeracy (assuming that they put more store in numerate data), then political parties might need to target the less numerate with the most effective non-numerate statements they can muster. Probably works best when it appears to be based on numerate data too. Is that the lesson? Maybe not necessarily dumbing down, but not smarting up either.

Though as we've seen from the Abbot government it would help to do the smart behind the scenes work to effectively support your policies and bolster them when there is effective opposition to them.

Thank you Steve, it's great to read a piece like this in a business publication, but I'm not sure your graphs make the case in a way that's convincing for me. I'm more convinced by what happened in Ireland and Spain, for example, where private housing debt turned a difficult situation into a calamity. The way my brain works makes it easier for me to believe an historical context than a set of numbers. That's partly because I find there is such a storm of data in economics and the investment world that I can only find a path through it by selecting what I think matters more than some other piece of data. The moment I do that, cultural factors come into play. I think it's too crude to regard those factors as 'bias' as Kannemann seems to do in his fantastic little book. That implies that numbers are 'truth', which borders on the mystical to me, especially when you know that a thousand economists could pop up now and present hundreds of graphs to demonstrate why private debt isn't that important. Numerical data is very, very important of course, but in a field as dominated by culture as economics, it isn't enough.

I think the reason numerate people are steadfastly holding on to their opinions even when presented with conflicting data is a almost total loss of faith in "reports" by think tanks etc. Everything seems to be politicised. So here where a numerate Republican was presented with data showing gun control lowered crime they would be thinking this data has been politicized because they have seen that happen so often before on a range of issues and likewise the numerate Democrat would be saying the same thing when it showed it did not lower crime. The more informed you are the more you would be aware of the policitization of everything.
For instance as a conservative if I see a report come out from the Grattan Institute that conflicts with what I believe I am immediately suspicious. No doubt a left winger seeing a report from CIS or IPA feels the same way.
So I am not so sure people are so pig headed as they have just lost faith in supposed independent sources and studies etc.

As the French would say... "viva Le differencia", or something like that. At least we still have just enough democracy left to talk. Enjoy it while it lasts.....

Effectively - we're all stupid.

Once there are more than three interactive variables at play it is incomprehensible to the majority of people to work out the possible states. Me included. That is why relatively simple models like Minsky are so powerful. The models put the numbers in context.

Pure banking theory is simple and works in a simple context, Steve Keen you theory sits in this context perfectly. Unfortunately the environment we live in is so complex and has so many interested parties with differing levels of influencial power that the basic principles of banking are twisted, bent, warped, interpreted differently and manipulated to accomodate self interest, greed, insecurity, arrogance and idealism. Considering this together with the logic of main stream economists and Ben Bernake there doesnt seem to be much point in thinking logic will ever prevail.

"Eight years ago, in December 2005, I began warning of an impending economic crisis that would commence when the rate of growth of private debt started to fall. "

Can you link us to this?

Google is your friend.

In http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf it says that Professor Keen

"first publicly predicted Australia’s financial troubles in December 2005 in an interview on Perth radio and ABC Radio. In December 2006, Keen (2006) wrote that the debt-to-GDP ratio in Australia (then 147 per cent) “will exceed 160 per cent of GDP by the end of 2007. We simply can’t keep borrowing at that rate. We have to not merely stop the rise in debt, but reverse it."

The radio interview doesn't appear to be online but the article from 2006 is.

You can find it at http://evatt.org.au/news/lily-pond.html

While Keen is better than the economists winning so-called “Nobel” prizes (no such thing in economics; the money actually comes from banks), he’s still not as penetrating and scientific as the topic requires. For instance, it’s not just private debt in general that triggers recessions but private mortgage debt or, more precisely, our spending for land (under houses). When that gets out of hand, it sucks up our spending that no longer can go to purchasing the goods and services produced by our neighbors, so they cut back, a vicious spiral ensues, and recession is under way. Not grasping the deeper phenomena at work, economists (even the nice ones) can’t see the deep policy shift that’s needed to correct economies — which would be geonomics at progress.org.