The Dismal Science

Sorry, I just have to follow up on my prevous post. Economists jumping on those in other fields in social sciences - it's just not very stylish. We are reminded, at this post by DeLong that standard economic theory fails to explain the observed levels of equity returns and interest rates. Economics is really "The Dismal Science". DeLong and others has found some hope that the problem is not due to lack of realism of the basic assumptions in Economics, but rather "in the specification of uncertainty ". (Had we really seen the development of quantum theory in physics if the shortcomings of classic theory, i.e the photovoltaic effect, the boltzmann radiation 'heat crisis', had not eventually been attributed to just the basic assumption, that of continuitiy of the energy spectrum?)

To my very far from expert understanding of it - the high (historic) equity premium is evidence that people are highly risk avert. Which they don't seem to when it does not come to equity investment. And the high indicated level of risk-aversion would mean that people find little use per dollar from hefty gains, but good use from small gains and much pain from small losses. Hence they would try to convert the hefty future gain from steady economic growth to a small gain today, they would have a great interest in borrowing money. Which would drive up interest rates to levels far above the observed. That's the puzzle, one of many in economics I guess.

Now, just take this risk-aversion thing - and look how yours change more or less in no time - as described by the Allais paradox. People just don't seem to have consistent risk-preferences (try your own and your friends' using Allais' experiment!), how could you really expect to explain advanced things like interest rates using such concepts? To me it seems that - among other things - a closer description of how people really handle risk is needed, rather than some change "in the specification of uncertainty".

Update: John Quiggin has what seems to me a much balanced and reasonable comment on Crooked Timber.

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