February 16, 2007

The paradox of majoring in economics

Getting a BA in economics is widely considered the appropriate major for ambitious young people who want to become corporate executives, Wall Streeters, or consultants. It's thought much classier than majoring in business administration, but much more germane to business success than majoring in, say, history or philosophy.

Econ is, like, scientific, but it's also about, like, money! (That was essentially my chain of thought many decades ago as I majored in econ, among other things, then got an MBA.)

This logic has made the econ major one of the most popular on Ivy League campuses, especially among male students.

The funny thing, however, is that if you took your economics courses seriously, they would cripple your drive to make a bundle in the business. The Efficient Markets Hypothesis, for example, really does inspire the old joke about the two University of Chicago professors walking down the street who see a $20 bill lying on the sidewalk. They think about picking it up, but keeping walking because it's much more likely that they are both suffering mutual simultaneous hallucinations than that the free market would be so inefficient as to leave a $20 bill lying around.

In contrast, a successful businessman's essential prejudice has to be that his competitors in the market are inefficient knuckleheads who leave money lying around everywhere for him to snatch up.

Fortunately, the vast majority of econ majors pay little attention to the implications of their courses, so America's economy continues to hum along.

My published articles are archived at iSteve.com -- Steve Sailer

47 comments:

Anonymous said...

Economics also benefits from the fact that it's perceived as more marketable than the liberal arts but easier than science or engineering.

Peter
Iron Rails & Iron Weights

Anonymous said...

"In contrast, a successful businessman's essential prejudice has to be that his competitors in the market are inefficient knuckleheads who leave money lying around everywhere for him to snatch up."

This is the central conceit of George Soro's book "The Alchemy of Finance" where he replaces a general equilibrium model with a general disequilibrium model. The practical difference between the two models is never made clear, however.

Anonymous said...

Wall Street firms are well-aware of the paradox. That's why they tend to prefer new hires with undergrad degrees in math, engineering or quantitative sciences over econ majors.

Dave

Anonymous said...

In all the courses that I took as an Econ/Math double major, at no time did I think the models presented were supposed to fully represent the way the world actually worked. I didn't go to Wall Street, but I'm in corporate finance now.

I think you're overstating the case quite a bit. Also the simple Supply/Demand curve has a consumer and producer surplus, nothing says you can't make money in business.

Anonymous said...

Marcus,

The opposite of the Efficient Market theory would seem to be the view of the old school value investor Benjamin Graham and the investors he influenced. Graham's view was that the stock market was inefficient in the short term, but efficient in the long term. Graham believed (and pretty much everyone who isn't an indexer believes) that this short term inefficiency gives investors opportunities to buy currently-undervalued stocks which the market will eventually value fairly.

The Efficient Market Theory, by driving so many investors to indexes (especially market cap-weighted indexes like the S&P 500) is rivaled only by Modern Portfolio Theory in helping investors get crappy returns. A lot of investors could get better returns with less risk with 10-20 well-chosen stocks than they could with an index fund or a combination of index funds.

Modern Portfolio theory's negative contribution to investing is the link it posits between risk and return (i.e., risk equals volatility and is generally inversely correlated with return). In reality, some of the best long-term market-beating stocks had lower volatility than the broader market.

Dave

Steve Sailer said...

Majoring in econ at Rice U., which is a quite difficult science and engineering school, was pretty easy. The one tough course was Econ 101, which everybody took, so majoring in Econ was seen as more challenging than, say, sociology or poly sci by outsiders who hadn't gotten to the easy upper level courses.

Of course, if you go to grad school in econ, the math demands jump enormously.

Anonymous said...

I had the same experience at Harvard; actually upper-level was easier than midlevel which was easier than intro... Ec 10 was the killer, 700 students or something, but after that ... I remember taking an upper-level class pass/fail and realizing I had an easy A going into the final. Never realized why this is so.

Do they even have Business majors at the good schools?

Anonymous said...

"Do they even have Business majors at the good schools?"

Well, yes, to a certain degree. They don't call them "business degrees". Usually they combine Econ with an applied business practice, such as econ w/ accounting concentration, econ w/ finance concentration, econ w/ marketing concentration, etc.

These are essentially business econ degrees. In fact, some schools actually call them business economics degrees (like the UC system calls them).

I personally think bus econ degrees are good. They combine economic theory and real-world business applications. Thus, students who get bus econ degrees actually have marketable skills.

Anonymous said...

"The one tough course was Econ 101, which everybody took, so majoring in Econ was seen as more challenging than, say, sociology or poly sci by outsiders who hadn't gotten to the easy upper level courses."

Does Rice require you pass an econometrics series of courses in order to graduate with a BA in econ?

Econometrics courses are not easy. They are probably the most mathematically rigorous requirement of getting an econ degree. Depending on the school, econometrics courses contain calculus, probablility and statistics.

However, I will agree that they other upper-level courses are not too hard.

Steve Sailer said...

I don't know about today, but in 1976-1980 at Rice there was no econometrics requirement to get a BA in econ. The econ professors said that the gap in mathematical skills required between undergrad and grad studies in econ was the largest of any field.

Rice had a "managerial studies" major (i.e., business admin) that had more math in it (e.g., linear programming) than the undergrad econ major.

Until about 1975, Rice had a "commerce" major open only to football players. Rice was the smallest Division I football-playing college in the country at the time (2500 undergrads), and had an honor code against cheating, so the solution had been to have a separate major just for football players.

We still got killed playing in the old Southwest Conference, which eventually broke up due to endemic cheating.

I recall a game against Texas in 1976, where the Longhorns had the ball 4th and 1 at midfield. Both the 15,000 Rice fans and the 50,000 Texas fans in our Rice Stadium knew Texas would hand the ball off to the great Earl Campbell (who would win the Heisman the next season). Instead, the faked it to Campbell and pitched out to Johnny Lam Jones, who two months before in Montreal, had finished sixth in the Olympic 100m dash final. Only five men in the world were faster than Johnny Lam Jones, and, I can assure, none of them played defense for Rice, so no defender came within 15 yards of touching him on his way to the end zone.

Anonymous said...

I have an econ degree, but one of the first things I learned after I graduated is that most businesses are run by people who haven't a clue as to what they're doing. Now that I work in audit it's even worse.

As a side note, my intro to micro and macro classes were really easy but the intermediate micro/macro classes were quite tough. I blame this on the intro courses being required for a business major. Had I known then what I know now I would have rejected the school out of hand simply for offering a straight business degree. Oh well.

Steve Sailer said...

The Harvard endowment has enjoyed a 15.2% annual rate of return over the last ten years. Isn't that a lot higher than what you or I got following the Efficient Markets Hypothesis by investing in index funds? Do they let Harvard economists anywhere near the Harvard endowment (which is now up to $29 billion)?

http://www.news.harvard.edu/gazette/2006/09.21/99-endowment.html

Anonymous said...

Steve,

Re the Harvard Endowment: Like you said, it was the U. of Chicago (Eugene Fama) that came up with the Efficient Market Theory. So maybe that makes it easier for Harvard to ignore it.

It's amazing how different successful money management is from the dog food most investment companies peddle. I used to work for one of the largest mutual fund companies in America as a wholesaler (sort of the financial services equivalent of a drug rep). The first couple of years I worked at this firm, I didn't have access to their 401(k). So I put $2k one of those years into an IRA with that company's Large Cap Growth fund and $2k the next year in its Tech fund. This was maybe '97 and '98, respectively. A year and a half ago, I finally got smart and threw $2k into the stock of the mutual fund company itself. Today, that $2k is worth $4k, and the combined $4k I put into those two funds 9 years ago is worth $2800.

Whenever I dealt with brokers who had a client who inherited a couple million dollars, invariably that money didn't grow that big from index funds. Usually, it was a few concentrated positions in great long term stocks -- e.g., someone who bought Exxon or Philip Morris decades ago and reinvested the dividends.

Dave

Anonymous said...

"I don't know about today, but in 1976-1980 at Rice there was no econometrics requirement to get a BA in econ."

This is pasted from the current Rice econ website:

2. The following courses are required for all Economic majors*:
ECON 211, ECON 370, ECON 375, STAT 280 (or STAT 310/ECON 382), and ECON 446 (or ECON 400).


Steve, ECON 446 (or 400) at Rice is Econometrics, and as you can see above, it is required for the degree. Economics has gotten a lot more mathematical in the past couple of decades, so it is not a surprise that econometrics is now a required course at most universities.

Steve Sailer said...

From Greg Mankiw's blog:

"The Secret to Investment Success"

"Harvard's endowment has earned a remarkable return in recent years. Now the Economist tells us why:

"According to one former Harvard official, its endowment fund has done so well because it has avoided taking advice from the economics faculty."

"Of course, this is merely comparative advantage in action. You also shouldn't trust your investment managers to teach economics."

http://gregmankiw.blogspot.com/2007/01/secret-to-investment-success_21.html

Anonymous said...

Here is something else I have pasted from the current Rice econ website:

Enrollments in economics are high nationwide, and our campus is no exception. Economics is one of the largest majors at Rice, in part because our graduates have had excellent employment opportunities. According to a recent Career Services survey, the average starting salaries for our economics graduates have been among the highest of all Rice University graduates.



As you can see above, a lot of people enroll in economics because of the high salarys, not because it is necessarily an easy major. The math requirements for getting an econ degree have gone up in recent years, and today most econ departments require econometrics, calculus, probablity and statistics courses in order to graduate.

dobeln said...

Re: Efficient market hypothesis:

The efficient market hypothesis and the assumption of perfect competition (infinite number of small firms, no market power, no economies of scale, etc.) is a purely academical construct. It's useful for predicting the competitive performance of actual markets. It is not meant to prove that actual, existing markets are perfectly competitive.

Complaining about the efficient market hypothesis being "unrealistic, because people really make profits out there" just misses the point entirely. It's akin to the people dismissing evolution because "there are still monkeys".

Anonymous said...

How do you quantify "the mathematics is hard" What is hard for someone with a SAT of 1000 is easy for one with 1200 and so on throughout the scale..

-MensaRefugee

Anonymous said...

Is the EMH a product of the Rational Expectations school?

It must be a bit outdated now, but one book I enjoyed reading once is Eonomists in Conversation:
http://www.davidrhenderson.com/articles/0784_economists.html

Jeff Burton said...

Reminds me of a similar paradox regarding Calvinists.

Anonymous said...

Yeah, I think one of the things most people don't get in their economics classes, at least for awhile, is that these are mathematical models of very complicated systems and events. They're approximations at best, and if you want to use them, you have to figure out when the approximation makes sense.

Similar things happen with statistics and evolution, right? First you learn the simple models, then you start running into all kinds of weird stuff--arms races, frequency-depenedent selection, multilevel selection--that is not nearly so straightforward.

Grumpy Old Man said...

A logical citizen wouldn't vote, either. What are the chances that your one vote is going to make any kind of a difference?

Anonymous said...

Many years ago, an older Jewish guy caught me reading a thick tome about economics, and said to me, "You want to learn about how the world really works? Sell something, anything. Sell lemonade. Then you will learn something that all the charts, graphs and equations in that book can never tell you."

Anonymous said...

So how's the lemonade business?

Anonymous said...

"You want to learn about how the world really works? Sell something, anything. Sell lemonade. Then you will learn something that all the charts, graphs and equations in that book can never tell you."

A wise old man (no sarcasm). However, whether you realize it or not, you are selling something - your knowledge of economics. Granted, its not what he meant - and he has a strong point... if you dont get your hands dirty - your knowledge will always be incomplete.

-MensaRefugee

Anonymous said...

I was an econ major, and one thing that attracted me to it was that it seemed respectable for possible employers (and, consequently, my parents didn't mind subsidizing my education), but it wasn't entirely removed from the humanities the way the business majors were. I got to complete one of my undergraduate philosophy requirements with a course in the history of economic thought. One semester I registered for one of those "subject to be announced" courses just because I liked the professor, and it turned out to be on the economics of the atlantic slave trade, on which the professor had recently done some research. It was as interesting as any course I took, and easily better than most of the offerings from the history department.

But yes, the economics professors were very clear that they'd really prefer to have math majors applying to the graduate program. The reasoning was "If you can do the math, we can teach you the theory. But probably not the other way around." ...And, today, I'm a lawyer with a BA.

Anonymous said...

"But yes, the economics professors were very clear that they'd really prefer to have math majors applying to the graduate program."

Economics has become more mathematical in recent years. In the future, economics might get classifed as applied math instead of social science.

Anonymous said...

Coincidentally enough, minutes before reading this post I watched the classic scene from Glengarry Glen Ross where Alec Baldwin's character makes just that assertion. (That money is lying around for the taking.)

agnostic said...

"According to one former Harvard official, its endowment fund has done so well because it has avoided taking advice from the economics faculty."

Now, imagine that the official said that Harvard's design and construction of new buildings has worked so well because they've avoided taking advice from the physics faculty -- you'd know for sure that you were in pre-Copernican times. Ditto for success in animal breeding by ignoring the theories of the biology faculty: pre-Mendelian / Darwinian.

Pre-modern civilizations managed some impressive engineering feats, but without a grand, pretty theory to motivate them. They just tinkered a lot, and some things worked. Seeing the larger patterns in these piecemeal advances had to wait until the Scientific Revolution.

That's what econ is like now (and that's being charitable). By "econ," I'm referring to the science of how abstract things called economies work -- not the Behavioral Econ stuff, which is a sub-division of psychology. This should be borne in mind whenever an economist confidently asserts that "economic theory predicts that..."

dobeln said...

"That's what econ is like now (and that's being charitable). By "econ," I'm referring to the science of how abstract things called economies work -- not the Behavioral Econ stuff, which is a sub-division of psychology."

I'll take Economics over Psychology or almost all other social studies areas any day.

As for Behavioral Econ, etc. the whole field of Economics is really a sub-division of psychology, writ really large. Problem is, many economists don't understand that themselves.

Finally, about the actual state of knowledge in the field, you have to keep some perspective. Given the tremendously shitty ideas that used to hold major sway in economics, the strides made from the weeding out of bad economic ideas have been really huge. There is something of a slump right now in the field though, I agree.

"This should be borne in mind whenever an economist confidently asserts that "economic theory predicts that..."

Most economists are smarter than that - hence the demand for those proverbial one-armed economists...

AJK said...
This comment has been removed by a blog administrator.
Anonymous said...

Burton G. Malkiel's response to that $20 bill joke was something to the effect of (not an exact quote): "you had better hurry up and snatch that $20 bill up, because the markets are pretty darn efficient".

TabooTruth said...

Economics tries to simplify the world through models. All field do it-it's just that the models used in the physical sciences are based upon verifiable data and experimentation, and physical laws. Economics and other social sciences try to create models based on human behavior, which is much more unpredictable.
I wouldn't say that econ necessarily teaches raw information that can be used in the workplace, but it indicates that the person is capable of analyzing numbers and data and applying it to real world issues.

I am a master's student in econ, and most of my courses have had significant calculus, especially micro theory and econometrics.

I would say that one of the biggest failures of economics is the inability to create a sustainable solution to world poverty. However, this is purely because of the theoretical fantasies of most economists, that all human beings have equal intellectual endowments. Behavioral economics and evolutionary psychology, divorced from political correctness, can make economics much more potent.

Also, its economics' obsession with math that has actually hurt its predictive abilities, most likely because models that are mathematically solvable always get more attention than the ones that aren't (but that are equally possible).

http://pitruth.blogspot.com

What is ironic is that the president of Harvard, who is an economist, said something rational based on his analysis, about gender differences, and was promptly vilified. This shows how constrained economics is.

Steve Sailer said...

"Reminds me of a similar paradox regarding Calvinists."

My favorite econ professor at Rice had recently converted to Calvinism. I told him that Catholicism handled incentives much better than Calvinism -- if, according to Calvinism, you are either saved or not saved, what's your incentive to behave well in this life? But he had thought about these things much harder than I had, and that didn't faze him.

And then he got turned down for tenure and had to leave Rice. That also happened to another econ prof who had just won the award issued annually by recent alumni as the best teacher at Rice. The gap between what was required in econ for success in publishing papers -- mathematical logic -- and what was required for teaching econ to undergrads -- verbal logic -- caused a lot of these problems.

Steve Sailer said...

It's like how Thomas Sowell has done an enormous to educate the reading public in how to think like an economist, but he hasn't won the Nobel Prize for his seminal book "Knowledge and Decisions" because he thinks in words, not equations.

Anonymous said...

...if, according to Calvinism, you are either saved or not saved, what's your incentive to behave well in this life?

That's a good question, and the answer is that if a Calvinist ever finds himself behaving like a sinner, then that is a sign that he is damned for sure, whereas if he represses every single thought and urge, then he can at least hope he still has a chance. Thus Calvinists become the most puritanical believers. And what better way to prevent bad thoughts than to spend all your time at work.

A Catholic knows he can always repent on Sunday.

Anonymous said...

The Church of Rome . . . thoroughly understands, what no other Church has ever understood, how to deal with enthusiasts.

http://www.victorianweb.org/authors/macaulay/ranke2.html

Anonymous said...

I would say that one of the biggest failures of economics is the inability to create a sustainable solution to world poverty. However, this is purely because of the theoretical fantasies of most economists, that all human beings have equal intellectual endowments.

Yes, we are still awaiting the birth of an evolutionary economics that will serve as an antidote to the models of economics espoused on EconLog and Marginal Revolution.

Anonymous said...

Dave said: The Efficient Market Theory, by driving so many investors to indexes (especially market cap-weighted indexes like the S&P 500) is rivaled only by Modern Portfolio Theory in helping investors get crappy returns. A lot of investors could get better returns with less risk with 10-20 well-chosen stocks than they could with an index fund or a combination of index funds.

Isn't that what all those "actively managed" funds attempt to do? Beating the index seems easy enough; doing so is another matter entirely.

Bashing economics/economists is easy (and fun!), but the knowledge obtained by the field does help us to avoid the more wildly fanciful policy directions that I'm pretty sure we can all imagine some groups would seek to pursue. For all of economics' shortcomings we're still better off for studying, especially when you consider that the only other alternative is ignoring it.

The main problem I see with economics is that plausibility substitutes for proof; a luxury the hard sciences don't have. I wish this would encourage more economists to be more tentative about their predictions and to be more flexible with their theoretical stances, the latter which seem to be driven as much by politics as economics.

Anonymous said...

Re: Thomas Sowell

- It's unfortunate that Sowell will never get the recognition and acknowledgment he deserves because he articulates his message through words. He's one of the most cogent and logical thinkers in the US and it's a shame more people don't read his works. I have an undergrad degree in econ. and never had any super rigorous mathematics; I don't know what goes on at the graduate level, but I've always thought that economic principles are more easily conveyed in words and not graphs. While I was usually able to make sense of the graphs, it was easy to lose your mental focus when trying to answer a graph-related question on a cluttered graph. Because it often took several minutes for your brain to digest what you were looking at, the slightest distraction put you back at square one...

Anyway, I've always thought it especially unfortunate that Sowell is not really known by African-Americans. He's a national treasure who still writes columns and books, but gets little or no love from other prominent members of the African-American community

Anonymous said...

This is the central conceit of George Soro's book "The Alchemy of Finance" where he replaces a general equilibrium model with a general disequilibrium model. The practical difference between the two models is never made clear, however.

The general equilibrium model implies efficent markets. A general disequilibrium model does not. To Soros and his ilk, that implies there are always price imbalances that one can profitably arbitrage, such as currency exchange rates.

General equilibrium economics -- similar to outdated uniform, gradualist models of biological evolution, some might say.

Disequilibrium models -- more similar to punctuated equilibrium concepts of evolution. (?)

--david.davenport.1@netzero.com

Anonymous said...

Daniel,

You might have noticed that I didn't write that the average investor would be better off investing in actively managed mutual funds; I wrote that he would be better off with a small, well-chosen portfolio of individual stocks. There is a world of difference between the two.

Dave

dobeln said...

"You might have noticed that I didn't write that the average investor would be better off investing in actively managed mutual funds; I wrote that he would be better off with a small, well-chosen portfolio of individual stocks. There is a world of difference between the two."

Using a qualifier like "well-chosen" renders that piece of advice nearly useless. Unless you can give us a hint of how to achieve that "well-chosen" portfolio.

Economics has one major piece of advice in this area - diversify. Apart from that, you need pretty extraordinary skills to beat the market consistently.

Anonymous said...

Buying an index fund is not an implicit acceptance of the EMH. There are skilled investors and lucky investors. Separating the two requires more information than the average person has time to assemble. Market reversal can remove skilled investors just as easily as booms can benefit imbeciles. The problem with an average index fund is it actually leaves the individual over-exposed to that market. Mandelbrot and Taleb argue modern portfolio theory underestimates the amount of diversification the average investor should seek.

The problem for average people is that they will hear more from those who successfully invested in 8-20 stocks, and try to follow them, than those who lost money on the same strategy. Today, most are of course overweight property, for the same reason, with little insight into how the world of structured finance, rather than their own wit, has delivered them their recent gains.

Anonymous said...

Excessive diversification ensures under-performance; it's also not much of a hedge against risk when there is high correlation between one's investments.

Building a small, "well-chosen" portfolio of stocks isn't rocket science; neither is it the same as active management. Buy stocks like MO, XOM and AB and reinvest the dividends for decades.

If you don't think you're smart enough to pick your own stocks, buy BRK. In the years I worked in the financial services industry wholesaling products like mutual funds, managed accounts, unit investment trusts, ETFs, etc., the clients I came across who had built real money did it by buying and holding stocks like those above.

Dave

Anonymous said...

... let me simply say that most math used in econ is quite bogus.

Example, please?

--david.davenport.1@netzero.com

Anonymous said...

I don't know if anyone has pursued this further, but David Friedman has written a fair bit about the overlap between evolutionary psychology and economics. Google for his weblog....