Long-time readers know that Economic Principals loves a good "Upstairs Downstairs" story.  That classic television drama was "The Sopranos" of its day -- the 1970s. Available on DVD, it depicts the parallel (and intertwined) lives of an ensemble of domestic servants and the genteel Edwardian family that employs them, in the house that they all share, during the first quarter of the twentieth century, in London's Eaton Place.  The series (68 episodes!) appeared on British television and then was exported to the rest of the world with great success, thereby introducing a new generation to the watershed that was World War I. 

The basis for a high-tech version of something of the sort has been unfolding recently in economics, where a world of inventive and highly-paid practitioners constitute a boisterous "downstairs" to the relatively serene precincts of aristocratic university departments.

Nassim Nicholas Taleb burst upon the scene with a 2001 best-seller, Fooled by Randomness:  The Hidden Role of Chance in Life and in the Markets. Born in Lebanon, educated at the Wharton School of the University of Pennsylvania, he had traded various derivatives for twenty years for UBS, CS-First Boston and Bankers Trust, and currencies for Banque Indosuez.  The book was a highly-engaging guide to common mistakes that the statistically unsophisticated make in persuading themselves that patterns exist where there are none, especially in financial markets. After a few years seeking to turn his insights into cash with a hedge fund, Empirica Capital, without pronounced effect (though in 2000, when the dot.com bubble burst, he earned 60 percent), Taleb is back with The Black Swan:  The Impact of the Highly Improbable. The new book is an even greater success.

The title derives from a line of the eighteenth-century philosopher David Hume: "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion."  When, a few decades later, black swans were discovered in Australia not only to exist but to be relatively abundant, Hume's observation took on additional significance. Taleb classifies as "black swans" all highly unlikely, unexpected and very disruptive events that afterwards are quickly rationalized so as to have seemed predictable all along: market crashes, technological surprises, acts of God, acts of terrorism and the like. We spend our lives assuring each other that each day will be pretty much like the last, he says, but in fact "the world is dominated by the extreme, the unknown and the very improbable."

Although Taleb has a PhD in mathematics from the University of Paris, he is no economist. He is a "quant," or, rather, a scribe of quants, those who invent and build financial markets, as opposed to those who seek to understand them. (John Seo, another influential member of the tribe, Harvard biophysics PhD, founder of Fermat Capital Management and promoter of "catastrophe bonds," was profiled to good effect by the peerless Michael Lewis -- Liar's Poker, Moneyball] -- in the New York Times Magazine last month.) Taleb has a cult following on Wall Street, and a fan in former Secretary of Defense Donald Rumsfeld (remember his much-mocked distinction between "known unknowns" in Iraq and the completely unforeseen surprises he called "unknown unknowns"?). Taleb is "suspicious of theories (particularly those concocted by economists)" and contemptuous of forecasters. He is very big on the lecture circuit.   

Meanwhile, however, a pair of papers that make roughly the same case -- a disturbing one in the closely-reasoned world of technical economics -- will appear this month in leading economic journals.  In "Subjective Expectations and the Asset-Return Puzzles" in the September issue of the American Economic Review, Martin Weitzman, professor of economics at Harvard University, contends that the standard treatment of rational expectations equilibrium conceals a hidden assumption, which, if unwarranted, means that economists confront a future permanently more uncertain than previously believed -- a "thick tail" of probabilities, in the language of the bell curve, instead of the comforting thin tail of  a normal distribution of probabilities, which describes possibilities that are evermore small.  

And in an essay in the Journal of Economic Literature, Weitzman locates his "nonergodic, Bayesian learning perspective" -- meaning an evolutionary view of both the economy itself and of the possibilities of learning about it -- in the context of the biggest problem of the age, the debate over greenhouse gases. Reviewing the 700-page Stern Review of the Economics of Climate Change, he notes that the report, commissioned by the British Treasury and organized by Sir Nicholas Stern, has been criticized by several leading economists for its alarmist tone. He, too, indicts it for the very low discount rate the study employs to justify immediate and very expensive measures to cut greenhouse gas emissions. 

But Stern may have been right for the wrong reasons, says Weitzman. It wouldn't be right to ignore "the enormously unsettling uncertainty of a very small, but essentially unknown (and perhaps unknowable) probability of a planet Earth that in hindsight we allowed to get wrecked on our watch." A responsible policy approach, then, "neither dismisses the horror stories just because they are two standard deviations away from what is likely not gets stampeded into overemphasizing false dichotomies as if we must make costly all-or-nothing decision right now to avoid theoretically possible horrible outcomes in the distant future."  Follow a middle course, he urges: gradually increase emission controls, and commission serious research into the worst possibilities, while conducting plenty of public discussion. "The overarching problem is that we lack a commonly-accepted usable economic framework for dealing withÉ thick-tailed disasters," he writes.

(Both papers may be found on Weitzman's Harvard website, along with a third, "Structural Uncertainty and the Value of Statistical Life in the Economics of Catastrophic Climate Change," which is presumably headed Economica.)

To be sure, a clear distinction between anticipated fluctuations and pure surprise has been around in literary economics at least since Frank Knight delineated the difference between "risk" and "uncertainty" in his 1916 thesis, in hopes of  illuminating the centrality of the entrepreneur in economic affairs.  It doesn't help that, as Weitzman explains, "what economists call 'risk' and associate narrowly with known probabilities, scientists and most others name 'uncertainty' -- while what economists call 'uncertainty' and associate narrowly with unknown probabilities, scientists and most others label 'deep uncertainty'  or 'structural uncertainty.'" But Weitzman writes Greek-letter economics, with theorems and proofs. There is little room for ambiguity in his pages of equations.

When it comes to thinking about the way that people think about the future, macroeconomics economics has been dominated for thirty years or so by a convention known as "rational expectations, a mathematical version of the future-perfect tense. Robert Lucas explained it this way many years ago (to Michel Parkin), "[Rational expectations] doesn't describe the actual process people use trying to figure out the future. Our behavior is adaptive. We try some mode of behavior.  If it's successful, we do it again. If not, we try something else.  Rational expectations describes the situation when you've got it right."

Rational expectations replaced a raft of informal and ad hoc stories about how people formed their expectations of the future -- Keynes' famous parable of "beauty contests," the corn-hog cycle, and the like. The new convention quickly turned into a workhorse model of an interdependent modern economy, one in which the next hundred years are expected to be pretty much like the last. Harvard professor Jerry Green explains, "We're not physics, we don't gave the universal gravitational constant, there are no objective probabilities. But we have got a hundred years of data, so we replay those frequencies to capture our intuition of what constitutes normal behavior. We believe in these models, and act as though they are really the truth. Sometimes we overlook their limitations." The more realistic approach to human psychology resulted in big gains, at least in some areas: it permitted economists to think seriously about issues of credibility and commitment and produced an especially big payoff in new central bank policies that reduced inflation.

The assumption that the future would be pretty much like the past was useful to theorists, but it produced some troubling puzzles, too, about why markets behave the way they do. The biggest of them was posed forcefully in 1985 by a high priest of rational expectations model, Edward Prescott, writing with Rajnish Mehra. If everybody knew what to expect, they asked, how come stocks did so much better than bonds, returning an average of six percent more over time?  How come the "risk-free" rate of interest on the best government bonds was so much more than the model indicated it should be? Why were stocks so volatile, when the underlying fundamentals driving them changed so little?  

Three years later Thomas Rietz of the University of Iowa postulated that this equity premium was no puzzle at all if you figured that investors might be worried that a low-probability event, another Great Depression, might occur some time in the future.  The generic possibility of a "hidden" event, one that hasn't occurred but which might be a source of legitimate worry, was quickly dubbed "the peso problem" in the early 1990s, after the "puzzle" of high yields on Mexican bonds (at a time the peso was pegged to the US dollar) was suddenly solved -- when the value of the peso collapsed. Investors, it dawned on theorists, had foreseen the possibility of devaluation all along.  

Enter Weitzman, 65, a senior figure in the profession, possessed of a lifelong interest in capital theory and a reputation for unusual depth. In the 22 years he taught at Massachusetts Institute of Technology, before moving to Harvard in 1989, Weitzman became an expert on the economics of planning in the Soviet Union, and of the place of natural resources in the national income accounting of the industrial economies of the West.  It was in the course of publishing, in 2003, the lectures he had prepared for an advanced undergraduate course on green accounting, as Income, Wealth, and the Maximum Principle,  that he became curious about in the implications of unknown hidden randomness that might not be evident in the data. A couple of years later, he had concluded that: "the strong force of evolutionary-structural uncertainty is empirically a far more powerful determinant of asset prices and returns than the weak forces of known-fixed-structure [rational expectations equilibrium]-type pure risk."  (Gernot Wagner, late of the Financial Times, boils down the issues here in a lucid explanation of Bayesian asset pricing.) Humankind simply hadn't had enough experience to be confident about its expectations of the future, and Weitzman could prove it. He was pregnant with celestial fire!

True, Weitzman had grown excited before -- in the 1980s, about the possibilities for organizing an entire economy around the concept of profit-sharing, a brainstorm that eventuated in a well-regarded but little-heeded a book, The Share Economy; in the 1990s, about the possibilities of combinatorial algebra for growth theory. And the appearance of "Subjective Expectations" was complicated by the presence of his Harvard colleague Robert Barro, who seemed to hop in front of Weitzman with an extension of the Rietz paper, "Rare Disasters and Asset Markets in the Twentieth Century," published last year in the Quarterly Journal of Economics (which Barro co-edits with two other Harvard professors).

But the authority of Weitzman's insights was reinforced by the recognition that John Geweke, of the University of Iowa, had made a similar argument in a five-page communication to Economics Letters in 2001. Weitzman himself made the rounds of seminars at the top universities with his paper last year, accelerating the assessment process. He burnished the section in which he lays out a parable of  "as-if" rational expectations equilibrium.("[It] is only human nature to yearn deeply to be able to capture the essential spirit of a bewildering real-world actuality  by reformulating it in the more reassuring language of some familiar -- but necessarily oversimplified -- paradigm.") And a tough-minded and accelerated refereeing process brought acceptance earlier this year of the key paper at the AER.

The controversy has yet to be joined by the progenitors of the standard model -- Prescott, Lucas, Thomas Sargent and their seconds.  Presumably, they will weigh in before long. Behavioral economists will have their say, as well. Geweke says, "I think Marty is doing what senior people ought to do, bringing it all back together, showing why it matters. If he can get a [new] line of thought going on global warming, attract students, so much the better." For Weitzman, that means beginning with a deep discussion of the characteristics of the standard rational expectations equilibrium model. 

Of course, one of the reasons that Donald Rumsfeld admires Nassim Taleb is their shared contempt for the conventional wisdom, whatever it happens to be. Those black swan events come out of nowhere.  Take global warming. A small but significant segment of the expert community locates the cause of the problem not in the buildup of greenhouse gases, but in heightened energy output by the sun -- a tick up in a cycle that they think could subside unexpectedly in a decade or two. Experiment widely, says Weitzman.  For all the clarity and precision, his argument about "the inherently-thickened  left tail of the reduced-form posterior-predictive probability" of our rates of growth and consumption of the natural world boils down to the injunction to continue to "Expect the unexpected," and to send out probes.

* * *

Management of one of the most successful publishing ventures in economics quietly changed hand last week. Brookings Papers on Economic Activity (BPEA) was founded 38 years ago by Arthur Okun and George Perry of the Brookings Institution in Washington. Okun died in 1980 and William Brainard of Yale University replaced him. Almost overnight, the twice-a-year journal (three times in the beginning) changed the landscape of economic policy analysis.

"[P]olicy analysis was a wasteland in the 1960s," Robert Gordon of Northwestern University recalled in an after-dinner speech. "There were only two choices, refereed journals that often rejected policy-oriented papers as ephemeral, and the alternative of conference volumes that took three years to appear in print and were often instantly obsolete." Robert Hall, of Stanford University, added, "One went to the AEA meetings and the Econometric Society meetings and to department seminars, but nothing else. How did we survive?"

BPEA changed all that.  Instead of three years, the lag between presentation and publication for policy-oriented papers was reduced to three months.  Young authors were encouraged to contribute. High standards were a must.  Always the emphasis was on real-world problems and current events

Success spawned imitation. The Carnegie Rochester Conference Series on Public Policy opened for business in 1973, the National Bureau of Economic Research's International Seminar on Macroeconomics and its Summer Institute in 1978, the Centre for Economic Policy Research's Economic Policy in 1985, the NBER's Macroeconomic Annual in 1986, the Minnesota Workshop in Macroeconomic Theory in 1990.

The BPEA, however, has remained at the top of the heap, having scored a substantial number of famous papers over the years. Speakers Thursday at a gala dinner to honor the retirement of Brainard and Perry were Alan Greenspan and Robert Solow. 

Replacing the founding editors are some familiar faces -- N. Gregory Mankiw and Lawrence Summers, both of Harvard University, and Brookings Scholar Douglas Elmendorf, late of the Federal Reserve Board.