Noah Smith Fumbles Argument, Endorses Post-Keynesian Endogenous Money Theory

fumble

Economists say the darnedest things sometimes. They often say things that are factually inaccurate. Noah Smith put his foot in it recently when he claimed in a Bloomberg article:

It seems like the only people who don’t instinctively believe in credit-fueled growth are academic economists.

Now, this seems odd to me. In the article he notes that Post-Keynesians and Austrians do in fact think that credit fuels economic growth. Given that many of these economists hold academic positions and publish in academic journals are we to assume that they are not among academic economists? We will give Smith the benefit of the doubt here and assume that rather than belittling his colleagues he is simply a fuzzy writer who would do well sharpening his sentences before professional publication.

But when I read that I thought it more than a bit curious. After all, don’t monetarists believe that in the short-run economic growth is dictated by the growth in the money supply? Hey, don’t take my word for it, here is Milton Friedman himself in his article famous ‘A Theoretical Framework for Monetary Analysis‘:

I regard the description of our position as ‘money is all that matters for changes in nominal income and for short-run changes in real income’ as an exaggeration but one gives the right flavor to our conclusions. (p217)

Or, if that isn’t clear enough for you try this quote from his paper co-authored with Anna Schwartz ‘Money and Business Cycles‘:

There seems to us, accordingly, to be an extraordinarily strong case for the propositions that (i) appreciable changes in the rate of growth of the “stock of money are a necessary and sufficient condition for appreciable changes in the rate of growth of money income; and that (2) this is true both for long secular changes and also for changes over periods roughly the length of business cycles. (p53)

Now, we must assume that Smith — being an academic economist — knows the formula for money supply growth. For those readers outside the citadel of academic economics here it is:

Growth in £M3 = Public sector borrowing – non-bank purchase of government debt + bank lending to the private sector + net external private sector inflow – increase in non deposit liabilities of banks.

You see those highlighted terms? Yeah… those would be credit growth. And since the monetarists thought that growth in M3 fueled — and, indeed, caused — real GDP growth in the short-run and nominal GDP growth in the long-run we can only conclude that credit does indeed fuel economic growth in monetaristland. Indeed, it even causes economic growth for the monetarists.

But here is where it gets even weirder: New Keynesians also believe that credit fuels economic growth! One of the defining features of New Keynesian economics is that it believes money is non-neutral in the short-run. You don’t have to be an ivory tower academic economist to figure this out either. You could just check the Wiki page for ‘New Keynesian economics’ which states in no uncertain terms:

New Keynesian economists fully agree with New Classical economists that in the long run, the classical dichotomy holds: changes in the money supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run. Furthermore, some New Keynesian models confirm the non-neutrality of money under several conditions.

This is what led leading New Keynesian economist Greg Mankiw to state that New Keynesian economics should more properly be called ‘New Monetarist’ economics. You see, if money is non-neutral in the short-run then money growth does fuel real GDP growth in the short-run. And if the key component of money supply growth is credit growth then it follows that credit growth fuels GDP growth in the short-run for New Keynesians! This is all basic stuff that is given on undergraduate macro exams. How on earth can an academic economist like Smith get it so shockingly wrong!?

Well, actually if we examine his article carefully we see that Smith is just not writing clearly and that is what is leading to his confusion. He writes:

Here’s an alternative idea: Maybe credit is a follower, not a driver, of the boom-bust cycle. Maybe credit grows when the economy is growing, because of the need to finance investment, and shrinks when the economy is shrinking, because of the lack of investment. In retrospect, looking at a chart of credit growth vs. GDP growth, it might look like credit caused the cycle, but in fact it was just a passive tag-along.

Um… what!? Smith said earlier that academic economists “don’t instinctively believe in credit-fueled growth” but what he is talking about here is clearly… credit-fueled growth. That is, the growth is caused by other factors and fueled by credit! A car is fueled by petrol but driven by a driver. I am fueled by carbohydrates absorbed through my digestive system but my actions have something to do with mad electrical stuff going on in my brain. Smith’s writing is deeply and chronically confused. He has completely fumbled his entire argument by confusing the terms ‘to fuel’ and ‘to cause’. ‘To fuel’ is not ‘to cause’.

Interestingly, the argument that credit fuels growth but that growth is determined by other factors  like, as Smith says, “productivity changes, or changes in monetary policy, or changes in people’s sentiment and animal spirits” is the Post-Keynesian endogenous money argument. Here is a crystal clear statement from Post-Keynesian endogenous money theorist Basil Moore’s classic paper ‘Unpacking the Post-Keynesian Black Box‘:

The evidence suggests that the quantity of bank intermediation is determined primarily by the demand for bank credit. (pp538-539)

There you have it: the roots of Post-Keynesian endogenous money theory where credit/money is an endogenous variable. This is in contrast to, say, the ISLM where money/credit is an exogenous variable.

Smith is confused because, like most mainstream economists, he doesn’t know what he believes any more. Many of these people, for example, believed that the QE programs would drive (not fuel!) economic growth. But they were sorely mistaken. Now you see them fumbling around in the dark. Fortunately, they are arriving at the conclusions that heterodox economists arrived at decades ago. Welcome to the club, Noah, and please try not to insinuate that those academics who came to your own conclusions 40 years ago are not to be included under the heading ‘academic economists’. You may just be being fuzzy in your use of the English language but if this discussion has taught us anything it is that such fuzzy use of language can lead to substantial conceptual confusion.

Posted in Economic Theory | 2 Comments

Keynes’ Theory of the Business Cycle as Measured Against the 2008 Recession

cyclediagram

In this post I will explore Keynes’ theory of the business cycle. He discusses his views in Chapter 22 of the General Theory and I think they hold up pretty well today. At the beginning of the chapter he notes that the business cycle — so-called, because it is not really a “cycle” at all despite what Keynes says in the chapter — is a highly complex phenomenon and that we can only really glean some very general features of it.

Keynes opens with a very clear quote on what he thinks to be the key determinate:

The Trade Cycle is best regarded, I think, as being occasioned by a cyclical change in the marginal efficiency of capital, though complicated. and often aggravated by associated changes in the other significant short-period variables of the economic system.

Recall that the marginal efficiency of capital (MEC) is basically the expected profitability that investors think they will receive on their investments measured against the present cost of these investments. The key component in the MEC is, of course, investor expectations. Keynes is clear on this and distinguishes himself from those who claim that a rise in the rate of interest is the cause of the crisis. He writes:

Now, we have been accustomed in explaining the “crisis” to lay stress on the rising tendency of the rate of interest under the influence of the increased demand for money both for trade and speculative purposes. At times this factor may certainly play an aggravating and, occasionally perhaps, an initiating part. But I suggest that a more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital.

This is extremely perceptive and, I think, entirely correct. A rise in the rate of interest will typically precipitate a recession. In the US, for example, it is well-known that when the short-term rate of interest rises above the long-term rate of interest (i.e. when the yield curve is inverted) there will likely be a recession. (This is probably not, however, the case in other countries).

But the actual cause of the crisis is, as Keynes says, a collapse in the MEC. Consider the case of the 2008 recession. This recession was initiated by a fall in house prices which led to a fall in housing construction. Below is the number of housing starts plotted against the interest rate.

housing starts interest rateNow Keynes would argue that the causal chain went as follows: interest rates began to rise => the MEC of investors began to fall => eventually the MEC reached a threshold point at which investors stopped building houses. A recession ensued.

This is extremely important because the alternative interpretation is that the interest rate reached a point that it choked off credit demand for new housing. But this is not empirically valid. Take a look at the following chart plotting the same variables in the 1990s.

housing starts interest rate 2

In this period we see interest rates rise continuously — and, what is more, from a higher base — and yet housing continues to rise in lockstep. Clearly there is no mechanical relationship between housing starts and the interest rate. So, Keynes’ interpretation bears out: for some reason — and we shall not get into it here because it is very complicated — but for some reason in 2006 the interest rate rises triggered a collapse of the MEC among home-builders.

What happens next? Keynes says that liquidity preference shoots up quickly after the MEC collapses, the economy enters recession and the capital markets get nervous. He writes:

The fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the rate of interest may seriously aggravate the decline in investment. But the essence of the situation is to be found, nevertheless, in the collapse in the marginal efficiency of capital, particularly in the case of those types of capital which have been contributing most to the previous phase of heavy new investment. Liquidity-preference, except those manifestations of it which are associated with increasing trade and speculation, does not increase until after the collapse in the marginal efficiency of capital.

The effects of this are actually more difficult to perceive today than they were in Keynes’ time. Today central banks will step in and quickly flood the capital markets with liquidity when liquidity preference rises. Nevertheless, in extreme cases — such as a liquidity trap proper when the central bank loses control of interest rates — we will indeed see liquidity preference rise and interest rates on risky assets shoot up. This is precisely the case in 2008. Here is a graph showing interest rates on interbank loans shoot up vis-a-vis highly liquid treasury bills (which are money substitutes).

TED Spread 2008Keynes is quick to emphasise that monetary policy alone will ease interest rates and this may help recovery, but it will not actually provoke the recovery. He writes:

It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and, probably, a necessary condition of it. But, for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough. If a reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority. But, in fact, this is not usually the case; and it is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world. It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a “purely monetary” remedy have underestimated.

Again, if we turn to the data from the 2008 slump this will prove the case beyond a shadow of a doubt. The following graph maps gross private investment, the unemployment rate and the central bank interest rate.

impotent monetary policy

Meanwhile in the background the government deficit opened up massively and Congress passed a massive stimulus plan. After this investment picked up — very slowly — and unemployment started to fall — again, slowly. Because the stimulus spending did not plug the investment gap after six years we are still not back where we were in 2008 in terms of employment and investment has just about clawed back its losses.

Some will point to previous recessions where the interest rate was lowered and investment shot up as proof that monetary alone might be sufficient to steer the economy. I would say to them: take a look at the government budget balance. In all the post-war recessions the budget balance opened up — usually through the automatic stabilisers — and it was this that propped up demand. In absence of this some of these recessions would likely have become depressions.

Keynes is aware that the Austrians might pick up on his theory and then add their own ideologically motivated analyses of what constitutes ‘good’ and ‘bad’ investments. He makes clear something that I have tried to emphasise in a paper that I will be publishing shortly: we cannot say that the private sector will allocate resources effectively if left alone because they are subject to irrational swings of mood and do not engage in rational calculations as the marginalists (and Austrians) assume.

It may, of course, be the case — indeed it is likely to be — that the illusions of the boom cause particular types of capital-assets to be produced in such excessive abundance that some part of the output is, on any criterion, a waste of resources; — which sometimes happens, we may add, even when there is no boom. It leads, that is to say, to misdirected investment. But over and above this it is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent. in conditions of full employment are made in the expectation of a yield of, say, 6 per cent., and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary “error of pessimism”, with the result that the investments, which would in fact yield 2 per cent. in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent. in conditions of full employment, in fact yield less than nothing. We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are.

The final point we should bring out is the policy implications of this. Keynes favours that the central bank holds down the rate of interest and the government maintains full employment throughout the cycle. He writes:

Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.

I think that this is overly simplistic but certainly on the right track. We can hold down the general rate of interest so that money is cheap but then have the central bank exercise control particular rates of interest in markets prone to speculative bubbles by using Tom Palley’s ABRR proposal. In this scheme the central bank controls overactive investment markets but does not really hold responsibility for ensuring that economic growth be maintained continuously. That is the role of fiscal policy.

Personally I think that democracies are seriously flawed and politicians generally stupid and short-sighted. For this reason I would recommend building institutions that automatically open up the fiscal deficit in times of unemployment. Many welfare state institutions do exactly that — and we have these institutions, not politicians, to thank for ensuring that we have not entered a serious depression between 1980 and today. My favourite of such institutions is the Job Guarantee program developed and supported by Abba Lerner, Hyman Minsky and the Modern Monetary Theorists. But I recognise that this should be an open debate.

Posted in Economic Theory | 16 Comments

On the Two Departments of Monetary Macroeconomics

monetary macro

At the moment I am doing some research for a project that I might be working on soon. The project will be to provide a useable introduction to Post-Keynesian theory for those working in financial markets. Actually, I hope to write a book on this in the future, so this project is something that I have been interested in for a long time.

The more I studied Keynes’ own work and the work of some of his better interpreters the more I came to the same conclusion: Keynes was first and foremost a financial or monetary economist. I knew that others had also come to this conclusion — Hyman Minsky famously comes to mind — but I was not aware that a great deal of work had been done in this direction.

In actual fact, it has. HM Treasury economist Geoff Tily released a fabulous book in 2010 on just this topic entitled Keynes Betrayed. It is well worth a look. You can trace Tily’s work back to Minsky directly. Tily had his PhD supervised by Victoria Chick who was, of course, a student of Minsky himself.

My interpretation of Keynesian economics proper is very much so in line with these economists. I have always thought of myself as primarily a monetary/financial economist. Many find this ironic because — like Keynes and Minsky — I am very skeptical about using monetary policy as a tool to stimulate the economy. I believe that central banks should mainly be concerned with regulating financial markets and ensuring that they do their job while government must steer the economy on a continuous and ongoing basis. And yet, I would say that one of my main preoccupations is the interaction between central banks and financial markets; between the money creation process and interest rate formation. Why is this?

I think of proper monetary macroeconomics as having two departments, as it were. The first department we might call the ‘foundations’. The foundations are, broadly speaking, what are dealt with in the Keynesian framework that is (used to?) be taught in macro textbooks. That is: the savings/investment/national accounts identities; the multiplier relationship; the marginal propensity to consume; the marginal propensity to import; the accelerator effect and so on. In proper Post-Keynesian theory we also add to this a few things, namely: the distribution of income and thus differing marginal propensities to consume for different income groups; the production structure of real life firms that builds in excess capacity and so on.

I rarely deal with these issues on my blog. There is simply so much literature on these that they are not a focus of my attention. Also, I think these problems are basically solved in economics. The mainstream may have gone off into DSGE lalaland but the work is already done. If you want to study it you can find most of it laid out for you. Serious economists who are not fooled by the charlatanism that rules in economics departments can always track this work down and, indeed, you often find applied economists falling back on some of it in the real world.

The nonsense that has permeated academic economics may be pernicious but it is not due to the fact that there is nothing superior; rather it is a combination of social ideology and the desire on the part of certain people inclined toward insulated puzzle-solving to try to make their second-rate understanding of mathematics say something important about the real world. Basically, people who would never usually be given any modicum of responsibility in society being allowed to sit at the King’s banquet table; the King then uses them as a justification for whatever policy he is deciding to pursue on any given day. Because they tend to have no idea what they’re saying and thus no real confidence in any actual statements about the real world they make they are extremely labile and easy to manipulate.

When I did some straight economic journalism I prided myself on being able to get quotes from economists that said precisely what I wanted them to say by simply playing a few quotes from authority figures off these economists until I got the quote that I wanted. All the other journalists knew similar tricks but they tended to have a list of economists that they knew would give different cookie cutter responses; the journalist would then select the economist that best fitted the ‘mood’ of the news story being written. I tended to find that you could get better quotes by simply playing statements off a single economist until they said what you wanted them to say; often this was exactly the opposite of what they had said when you first engaged them! Perfect pawns on the chessboard of ideological persuasion. Anyway, enough digression…

A more peripheral, but important, aspect of the foundations are theories of the price-level. In standard neo-Keynesian theory this is represented by a Phillips Curve. Taken in its original form — that is, the notion that there is a trade-off between wages and inflation rather than unemployment and inflation — is a useful starting point. But then we have to loop this back in with Post-Keynesian distribution theory. After that, theories of the price-level must be considered part and parcel of the second department of proper monetary macroeconomics.

The second department of proper monetary macroeconomics is, as it were, the building. The building is the superstructure of the whole device. The foundations simply establish certain relationships. We might almost say that these relationships — like the multiplier — are almost simple identities. Once we plug in a variable the outcome is known. The building or superstructure seeks to explain how these variables are determined. Why is, for example, income distributed in this way? What is the relationship between the interest rate and investment? And so on.

Much of this is solved by simply examining the empirics. Is there a relationship between the interest rate and investment? Well, look it up. You’ll find that there is not a strong relationship at all. But when it comes to the determination of interest rates we cannot simply ‘look it up’. Nor can we simply ‘look up’ the effect that changes in central bank interest rates have on the financial markets. That requires theory and that is what I am most interested in. It is also what Keynes and Minsky were most interested in. This, to me, is where economics is both most challenging and most interesting. It is also, I think, where you can most embarrass the mainstream of the profession whose theories in this regard are simply ideology proper. If you ever want to see an academic economist properly melt down in conversation just start discussing the guts of the financial markets with them.

What is so interesting about the second department of monetary macroeconomics is that in order to understand it you have to appreciate both certain logical relationships and a certain amount of institutional psychology. The latter causes the former to constantly shift. So, you often find yourself chasing an ever-changing chameleon. But although the chameleon changes its colours it is still the same underlying animal at all times. Something similar can be said about the financial markets. Once you understand certain logical relationships — often quite difficult ones — you have the keys on hand. But you have to be able to apply these keys, as it were, to a door that moves and shifts around. It is not the easiest practice but then who ever gave up on a challenge?

The two key concepts in the second department of monetary macroeconomics are ‘animal spirits’ and ‘liquidity preference’ of which I think the latter is most important. I will stop here because in the next week or two I have a paper being published that shows exactly how an understanding of these two key concepts completely undermines the mainstream macroeconomic theory that is prevalent today.

Posted in Economic Theory | 3 Comments

Scotland: After the Election and Moving Into the Future

scotland future

I have some writing to do today, so I’m not doing a post. Yesterday, however, I published a piece on Al Jazeera America about the future of Scotland after the election. It might be worth a read.

Scotland’s future is still in doubt

If you are interested in this issue — and I think that it is an extremely interesting issue as Scotland still has the potential to be a country ripe for economic experiment — I highly recommend the following piece by Frances Coppola. In it she plugs my dual currency plan but that is not the only reason I link to it. It is also a fantastic piece on the new trajectory that the Scottish government needs to take once Westminster devolves more economic power to them.

What Scotland Should Have Done (And Still Should Do)

Posted in Economic Policy | 2 Comments

On ‘Coherence’ in Asset Markets: Everything is Going According to Plan

futurama

The author of the Philosophical Economics blog has a post up that caught my attention on the supply and demand dynamics of asset markets. It caught my attention because it looked, at first, very similar to my own dissertation that was published in working paper form last year by the Levy Institute. At first glance the author’s approach looks very similar to my own: what he/she appears to be doing is trying to put together what I referred to in the paper as a ‘stock-flow’ approach to asset pricing. But as I read on I realised that the author was not doing this and what they were instead doing was reintroducing the old textbook supply and demand fables.

The key point at which this begins to happen is about halfway through the post. You can see it crystal clearly when he/she writes:

For buyers, let’s suppose that this price range begins at $0 and ends at $500,000.  At $0, the average probability that a generic potential buyer–any individual living in an apartment–will submit a buy order in a given one year time frame is 100%, meaning that every individual in an apartment will submit one buy order, on average, per year, if that price is being offered (to change the number from per year to per second, just divide by the number of seconds in a year).  As the price rises from $0 to $500,000, the average probability falls to 0%, meaning that no one in the population will submit a buy order at that price, ever.

I am unsure why the author uses the language of probability here. The same result can be derived by simply saying, for example, “as the price rises from $0 to $500,000 no one will buy a house”. This is the standard textbook exposition and it makes far more sense than using the language of probability. In reality there is no need to use the language of probability here. All the author needs to discuss is the number of people willing to buy at a given price; he/she does not need to discuss the probability that someone will buy at that price. That is a level of abstraction that is simply unnecessary and only obscures the underlying argument.

Anyway, whether deploying the language of probability or simply saying that at a higher price less people will buy an asset the author comes to the same conclusion. Namely, the downward sloping demand curve that we see in textbooks. The author then supplements this with the upward sloping supply curve by assuming that at higher prices sellers will offload more of the asset. The author then goes on to explain why they make this assumption:

Over time, buyers and sellers become anchored to the price ranges that they are used to seeing.  As the price move out of these ranges, they become more averse, more likely to interpret the price as an unusually good deal that should be immediately taken advantage of or as an unfair rip-off that should be refused and avoided.

Um, I don’t think so. In fact, as I discuss at length in my dissertation, prices in asset markets can very often call forth more demand. This is known as ‘speculation’ and is a key feature in financial markets. During the housing bubble in the mid to late-2000s, for example, people bought houses precisely because the prices were rising. They did this because they thought that they might be able to lock in capital gains as prices rise. Similar phenomenon can often be seen in the stock market and in many other asset markets. As I discuss in my dissertation (pp13-17) this completely overturns the market equilibrium framework that attempts to use as its base model the familiar Supply-Demand (S-D) cross diagram.

The author begins to realise this when he/she writes:

Anchoring is often seen as something bad, a “mental error” of sorts, but it is actually a crucially important feature of human psychology.  Without it, price stability in markets would be virtually impossible.  Imagine if every individual entering a market had to use “theory” to determine what an “appropriate” price for a good or service was.  Every individual would then end up with a totally different conception of “appropriateness”, a conception that would shift wildly with each new tenuous calculation.  Prices would end up all over the place.

Yes, in such a situation prices would end up “all over the place”… which is precisely what we see in financial markets! But what the author seems to imply is that this would be completely chaotic and any semblance of orderliness would break down. So, prices would go from $0.01 to $100 and back again in moments. Why is this not the case? Well, there are other somewhat stabilising forces in the market. They are stabilising forces that we see across society and they were well articulated by Keynes in his famous 1937 article ‘The General Theory of Employment‘. There he wrote:

(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.

(2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture.

(3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average. The psychology of a society of individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgment.

It is the third of these that is key — indeed, the other two are really just derived from the third. And it is this that ties back into the famous ‘beauty contest’ theory of asset prices that Keynes put forth in the General Theory when he wrote:

Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.

Such behavior is known as imitation in anthropology, psychology and sociology. In psychoanalytical psychology it is known as identification. Whatever one chooses to call it basically everyone is in agreement that it is a key part of the socialisation process. Whenever we, as human beings, find ourselves in a new social environment we begin to imitate the behaviors of those around us by assuming — somewhat unconsciously — that they are somehow more ‘proper’ than ones that we might either create ourselves or arrive at by using our critical faculties.

This is what gives asset prices the modicum of stability that they display. It also accounts for the fact that bubbles can occur; after all, if the herd moves in a certain direction most people are simply going to imitate. It is this view of financial markets that I tried to get a grip on in my dissertation and I think it is a far better representation of actual asset markets than anything that incorporates the old S-D cross diagram. Indeed, using the latter leads to bizarre conclusions. The author of the post, for example, writes:

Housing markets represent an instance where these two phenomena–anchoring and disposition effect–are particularly powerful, especially for sellers.  The phenomena is part of what makes housing such a stable asset class relative to other asset classes.

He/she then produces a graph of nominal home prices that he/she claims shows stability in this market. Stability? In the market for homes? Really? The only reason that the author’s graph displays anything remotely resembling stability is because it is measured in nominal dollars and is thus pretty much constantly rising (as will be most graphs produced in nominal dollars). Here is a more realistic portrayal of the supposed stability of house prices (it is a largely stationary time-series which is the type that we typically use in statistics; the author’s own is non-stationary which is well-known to have misleading statistical properties):

house prices

That sure doesn’t look like a ‘stable asset class’ to me. It looks like prices bounce all over the place. They sometimes boom, rising up to almost 20% year-on-year, and they sometimes crash, falling nearly 10% year-on-year. Do we even need a chart to show this? Is this not intuitively obvious in a post-2008 world wracked by the consequences of property bubbles in multiple countries?

In order to get away from the type of thinking that is ingrained in us by learning the old S-D cross diagram by rote we need a different way of thinking about asset prices. While the approach I put forward in my dissertation was by no means perfect it at least pointed in the right direction. Thinking about prices in this way will ensure that we are not blindsided by bubbles in the markets. Because what the old S-D cross diagram and its derivatives really sell to the public is the vague notion that Markets ‘work’ and that whatever is going on in them at any given moment in time is sustainable (see Keynes’ points (1) and (2)). This, as I never tire of pointing out, is pretty much akin to a theological argument about a benign God that ensures coherence and justice in the world. Since what we are ultimately dealing with in both cases is belief there is no real logical cleavage between both types of ideas.

Rather than realising that prices rely on the beliefs that people hold about prices and, beyond this, that one’s own understanding of prices relies on the beliefs that one holds about the beliefs that others hold — scary thoughts that inject elements of arbitrariness into the way we organise our economies and our markets — people tend to fall back on some ‘fundamentalist’ vision that relies on the old Market metaphor. The Market provides coherence in a world the true structure of which is one of intertwined and interdependent beliefs. It is an easy way out and it stops reflection in its tracks by providing us with vague metaphors. But pretty as it is, it ain’t true.

Recent work by David Tuckett, a psychologist studying financial markets at UCL, and his team of economists and computer scientists has provided evidence that what people in the financial markets actually do when they think about problems is provide themselves with ‘conviction narratives’. These allow them to be confident about what they believe. Tuckett writes:

Our argument is that financial actors act by constantly and actively managing to modify in their mind s the threat uncertainty poses to their operations and ontological security. They do this by creating, proclaiming and maintaining what we call conviction narratives. Such narratives relate past and present to the future in an emotionally believable way and so manage day-to-day the cognitive and emotional elements necessarily and irreducibly created by decision-making under uncertainty. Constantly, but always tenuously, such actors have to create a sense of conviction as to their expertise, capacity to act and skill. They do it through developing stories told to themselves and others which combine (a) to exploit the opportunity element in uncertainty while (b), at the same time, to hold any doubts at bay. (p4)

If Tuckett is correct, and I think that he is, then the hoary old S-D cross diagram metaphor is what might be called the ‘master conviction narrative’. It is a key that turns any lock. Unfortunately, it does not open any door worth entering. Because what it really does it sell us the most simplistic of myths; precisely the ones that Keynes outlined in his 1937 paper. Everything is okay, everything will be alright, all will go according to plan. Or, as a Russian dissident poet once put it:

And the Perestroika is still going and going according to plan.
And the mud has turned into bare ice.

And everything is going according to plan.
And everything is going according to plan.

Posted in Economic Theory, Media/Journalism, Psychology, Toward a General Theory of Pricing | 14 Comments

Is Economics a Science? Dogmatic Economics Vs. Reflective Economics

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The question asked in the title of this post is actually somewhat of a trick. It is a trick because it all depends upon how you define ‘science’. Often when people say that economics is a science what they are doing is defining ‘science’ in such a way that economics fits the bill. They can do this because there is no real, firm definition of ‘science’ that is widely held among philosophers of science, scientists or, most certainly, among economists (who are the most anti-intellectual of the three groups by far).

If we look at Wikipedia, for example, it gives a definition of science that is Popperian — despite the fact that Popper’s falsifiability criteria have been called into question since the 1960s.

Science (from Latin scientia, meaning “knowledge”) is a systematic enterprise that builds and organizes knowledge in the form of testable explanations and predictions about the universe.

By this criteria economics is probably not a science because it cannot undertake repeatable experiments. Even in a weaker form most marginalist proclamations can be tested and falsified in the sense that they can be shown to not hold given the data we hold yet they remain powerful arguments within the discipline and are taught to students.

Let me then give a different definition of science. I am not saying that this is the correct one but it appears to me to be the one that modern economics as a discipline tried to follow when it was being born in the 19th and 20th century. My definition is as such: science is the search for timeless laws.

Here the obvious reference is Newton and his physics. Now, while we know that Newton’s system was imperfect and was completely overturned in the early 20th century the spirit of what he was doing was, I think, what gave rise to the scientific impulse during the Enlightenment out of which economics was born. When you look at a supply and demand graph you are looking at a representation that is trying to copy Newton by giving us timeless laws. This is also how such constructions are taught to students (any concerns are whisked away using the mysterious ‘ceteris paribus‘ clause).

By this criteria I do not believe that economics is science either. Before undertaking such a discussion I will first lay out my underlying criticism which will be long familiar to readers of this blog: economics deals with historical time which is non-homogenous and thus cannot generate timeless laws. Anything that remotely resembles a functional timeless law in economics is in fact an identity and is true only by its tautological construction.

Let us turn to the precursor to classical economics to give a sense of what I am saying. I am speaking, of course, of mercantilism. In this regard it is worth noting a now somewhat obscure work by the Soviet Marxist economist I.I. Rubin entitled A History of Economic Thought. It has been recently made available online and it is well worth a read.

What is so interesting about the work is that it places the older economic theories in their historical contexts. Rubin discusses each theory with respect to the specific circumstances of the historical situation out of which it emerged. What Rubin tried to show was that mercantilist theory and policy was not a simple ‘mistake’ as the later classical economists tried to portray them. Rather the mercantilist period was a phase of development of the young capitalist states that would go on to conquer the world. He writes:

The basic feature of mercantilist policy is that the state actively uses its powers to help implant and develop a young capitalist trade and industry and, through the use of protectionist measures, diligently defends it from foreign competition. (p26)

When economies had finished with this stage of development and had developed sufficient industrial capacity they were then ready to open up to the world and dominate its markets. It was at this stage that the classical economists arrived on the scene with their doctrines of free trade. This accounts for why the free trade dogma was accepted at different times in different countries. The Americans and the Germans rejected it until the late-19th and early-20th century simply because if they had adhered to it in the early and mid-19th century they would have been dominated by British industry.

Seen in this light it becomes clear that it is fruitless to ask whether an economic doctrine is ‘true’ in some timeless sense. That would be like asking whether, say, feudal law is ‘true’. Feudal law is neither true nor false. Rather it is the formalisation of a code by which a certain type of society organised itself. For that particular type of social organisation it was functional. If we tried to transplant it into a modern capitalist democracy it would probably prove dysfunctional.

Thus economics, and with it economists, fall into two categories. On the one hand we have what I opt to call ‘dogmatic economics’. Dogmatic economists are basically ideologues. They think that they have access to timeless truths and are scientists in the Newtonian mold. These economists are probably apt to get most things wrong most of the time. They also likely change their basic discourse over and over again. In the face of an ever-changing history they roll with the times, all the while maintaining the pretense that they have access to timeless truths. Basically the interpret and reinterpret their dogmas in light of new facts. The purpose of the dogmas is not illumination, rather it is to lend what they say authority. Dogmatic economists make up the majority of academic economists and also some very high up policy economists in government and economic institutions.

The other category of economics is what I opt to call ‘reflective economics’. Reflective economists understand that what they do is provide interpretations of a given historical constellation. They understand that there are better and worse interpretations — just like a judge can recognise a better or a worse interpretation of a law — but they do not hold to the idea that there are timeless, Newtonian laws in economics. Much of the sort of theory that they promote might be said to be very loose-fitting in that the tools needed for such interpretation tend to be less precise than those exacting constructions put together by the dogmatists. Reflective economists make up the minority of economists in academia. But the vast majority of serious working economists are in practice reflective economists.

What is the relationship between dogmatic and reflective economists in our society? Here there is no firm answer. The dogmatic economists react to the reflective economists in two ways: condescension and deep suspicion/fear. Working economists who do not partake in theoretical debate can be safely condescended to by the dogmatic economists. But the reflective economist who actually tries to engage in theoretical debate will provoke confusion and frustration in the dogmatic economist who is not used to having his or her authority challenged. The main device utilised here is to simply ignore these reflective economists and try to push them out of the debate through social isolation.

The reflective economists also react in two ways to the dogmatic economists. Some build a relationship of what psychotherapists call ‘transference‘ to the dogmatic economists. They assume that the dogmatic economists do in fact have access to timeless truths and that they, the poor working economist, did not make the cut to gain access to these truths. This reinforces the dogmatic economists’ power and social prestige. The other reaction is one of overt hostility. These reflective economists know that the dogmatic economists are Emperors that do not wear any clothes and they make no bones about saying it in public. This makes them quite unpopular with the dogmatic economists who then try to avoid such awkward discussions by isolating the critical reflective economists.

Posted in Economic Theory, Philosophy, Psychology | 38 Comments

GLS Shackle and the Link Between Theology and Marginalist Economics

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Yesterday I came across an interesting and unusual paper by Bruce Littleboy entitled ‘Religious Undercurrents in the Writings of GLS Shackle‘. As readers of this blog will probably be aware Shackle is one of my favourite economists. I had never, however, associated anything that he wrote with religion and I was unaware until reading this essay that he was a devout Christian.

Frankly, I think that Littleboy is wrong to attribute any religiosity to Shackle’s writing. But, in being wrong, Littleboy has raised an interesting question — albeit not the one that he thinks he has raised; namely: what is the connection between theological and economic discourses. I will argue that it is actually the form of economics that Shackle attacks that aspires to the theological.

In the essay he quotes Shackle as writing:

Decision is not, in its ultimate nature, calculation, but origination. (p3)

In response to this Littleboy writes:

Origination is an attribute of the Divine, and Christian creed regards humans as holding as a gift some fragments of God’s nature. (p3)

This is the theme of the whole essay. In Shackle’s exploration of decision-making he found many themes which might also be found in religious texts. But Littleboy never really makes what seems to me the obvious point: economics and theology deal with very similar questions. They deal, ultimately, with how we should structure social relationships and moral norms.

When we use terms like ‘utility’ what we mean is the same as what the theologians meant when they discussed human beings pursuing ‘grace’. When we say that human beings maximise their utility we are basically saying that human beings seek grace in their everyday lives.

The words are different but the semantic meanings are basically the same. Both utility and grace mean something like “what is good”. These spectral and rather mysterious entities are never observed but they are assumed to exist. They are also discussed in very similar frames. Grace is discussed in a world where an omnipotent and benevolent God reigns supreme; while utility is discussed in a world where an omnipotent and benevolent Market reigns supreme. Both of these entities — again, spectral, mysterious and unseen — effectively do the same thing: they guarantee coherence and promote the ‘best’ outcomes. Literally they are different; substantially they are the same.

Indeed, need it even be said that Adam Smith — the person who introduced the Market — had in mind the Protestant idea of God when he invoked the Hidden Hand? He quite literally borrowed the metaphor from theological discourse. That borrowing has since been buried but it is never buried too deep. The Market allows for perfection because It is benevolent.

So, what was it that Shackle was doing? The following passage from Littleboy’s essay points in the right direction:

Shackle’s framing of the human predicament is as much a contrast to God’s complete knowledge as it is to the similar claim of perfect knowledge in the hubristic (if not impious, even blasphemous) economic models of the orthodox kind. (p5)

Shackle, I think, saw the essentially religious underpinnings of marginalist economic discourse. He could see that this was, in fact, a form of pseudo-secular religion (how can it be truly secular when it so firmly believes?) and that struck him, as it strikes others, as absurd. He saw no place in rational discourse about the world for religious vagueness and so he tried to construct a theory of human decision-making that did not rely on a benevolent entity that reconciled all of our problems automatically.

Marginalist economics is modern religion. If you look closely you can see it when you listen to its adherents. They derive authority from doctrines that are effectively mystical. As the discourse becomes more mathematical it becomes increasingly difficult to tell what the underlying assumptions are. This leads to giving them even more mystical authority. Shackle’s work was an attempt to explore these underlying assumptions and remove from them any mysticism. He wanted a theory that was truly secular. He kept his religion, as it were, in another room.

Perhaps this is what gave Shackle the ability to see behind the mask. Perhaps he knew what belief was all about and he saw that many of the marginalist assumptions were in fact grounded in belief proper. Marginalists, for example, believe that the future can be known through objective probability estimates. Press them on why they hold this belief and they cannot answer. This is the same structure that dogmatic religious person’s hold; they do not even know that they believe because they have not even questioned what it means to believe.

Shackle was against dogmatism. He did not like it. If you think that the Market produces perfect outcomes you have to explain why and through what mechanism. That does not mean constructing a little piece of mathematics that builds in the assumption of what you are trying to prove. That is tautological. It means explaining how such conditions might be achieved given what we know about human psychology and lived experience. Likewise if you think that the future can be known with objective probabilities you have to either prove this by demonstration or you have to make a very convincing argument why we should assume this. Marginalists cannot do either. They never even consider these questions because, frankly, they are beyond them. All they have is their belief and they will cling to it like a dying man clings to life.

Posted in Economic Theory, Philosophy | 2 Comments