Libertarian Paternalism is Clearly an Oxymoron

Blackwhite…this word has two mutually contradictory meanings. Applied to an opponent, it means the habit of impudently claiming that black is white, in contradiction of the plain facts. Applied to a Party member, it means a loyal willingness to say that black is white when Party discipline demands this. But it means also the ability to believe that black is white, and more, to know that black is white, and to forget that one has ever believed the contrary. This demands a continuous alteration of the past, made possible by the system of thought which really embraces all the rest, and which is known in Newspeak as doublethink.

— George Orwell, 1984

“Hey, look, I’m not racist but…”. You just know that this statement is likely to be followed by a racist comment of some sort, right? Well, what about the statement — issued in the title of a paper — that libertarian paternalism is not an oxymoron. Yeah, you’re probably going to think that what is likely to follow is going to be oxymoronic and poorly argued.

Well, you’d be right. But even the term itself — “libertarian paternalism” — is so obviously a perversion of language that it should be immediately confined to the dustbin of duoblethink words along with “blackwhite” and “goodbad”. What the coiners of the term have done is fuse together two words that are mutually contradictory. In doing so they seek to obfuscate thinking and confuse people.

Don’t get me wrong. Politically and economically I’m very sympathetic to the argument put forward by the so-called “libertarian paternalists”. I certainly think that state intervention is a necessity in a modern economy; I certainly think that people do not always act in their own self-interest; and I fully agree that the less encroachment upon personal freedom that the state has to engage in to achieve the best results the better. But this does not excuse nonsense. We do not need to pervert language and reason to make this case.

Here is the basic argument as laid out in Sunstein and Thaler’s paper Libertarian Paternalism is Not an Oxymoron,

We elaborate a form of paternalism, libertarian in spirit, that should be acceptable to those who are firmly committed to freedom of choice on grounds of either autonomy or welfare. Indeed, we urge that libertarian paternalism provides a basis for both understanding and rethinking a number of areas of contemporary law, including those aspects that deal with worker welfare, consumer protection, and the family. In the process of defending these claims, we intend to make some objections to widely held beliefs about both freedom of choice and paternalism. Our emphasis is on the fact that in many domains, people lack clear, stable, or well-ordered preferences. What they choose is a product of framing effects, starting points, and default rules, leaving the very meaning of the term “preferences” unclear.

The substance of the above quote is actually true. When scrutinised in any meaningful way so-called ‘preferences’ in marginalist economics are fairly meaningless. Human beings are not robots and their decisions are usually made under the substantial weight of ‘framing’ and subject to all sorts of biases and blindnesses. Put more simply: sometimes people don’t make very good decisions.

The idea of the self-proclaimed libertarian paternalists then becomes to ‘nudge’ people to make good decisions but give them an opt-out clause so that the choice is not forced upon them. Basically, the idea is to use the superior intelligence of the policymakers to trick people into doing what the policymaker thinks will best ensure the welfare of both the few and the many. Advertisers have been doing this for years, as have many other in the public relations industry.

You see, the problem with this argument is that it basically doesn’t want to recognise that while such ‘soft paternalism’ — let’s not delude ourselves with terms like ‘libertarian paternalism’ — is undoubtedly preferable to ‘hard paternalism’ it is only sometimes adequate. Economic policymakers often have to confront decisions that they must make that will have very ‘hard paternalistic’ outcomes.

For example, if your country was facing down a massive speculative attack on the currency it would be likely a good idea to counteract this with capital controls. These would limit the freedom of people to move money in and out of the country and this would likely be very unpopular. The inflation that would result without these controls, however, would provoke far more damage and would ultimately be much more unpopular.

The same case can be made with respect to almost all economic policies: from interest rates, to the taxation and spending system, to the minimum wage. Even policies with a substantial component of free choice — like the MMT Job Guarantee which offers anyone willing and able to work a job at a set rate — has a ‘hard paternalistic’ element to it in that we know that this will likely increase worker bargaining power and put upward pressure on wages. Many of us may like this outcome but we should recognise that it is coercive on certain groups.

Look, the libertarian paradigm is ridiculous. It rests on the idea that people exist as atoms in a world where each atom has no effects on other atoms except through completely free contractual arrangements. As a starting premise for a political philosophy this should be ridiculous to anyone who is not completely mentally insulated from the world around them. What such fantasies then generate is the obverse nonsense that any form of paternalism by the state is basically as bad as a forced labour camp or something similar.

This rubbish is propaganda, of course. It persuades people by framing issues in a certain way and appealing to primitive emotions. Ironically, it is a manifestation of precisely the sort of ‘nudging’ or ‘soft paternalism’ that Sunstein and Thaler advocate — and that the libertarians claim to hate. In short, anyone who buys such primitive arguments is the very rube that the soft paternalistic professions like advertisers, political strategists and public relations people target.

Just dump the libertarian stuff. Sensible people will recognise that we should try to maximise individual freedom unless this is not possible given a certain set of circumstances. The libertarian rubes — numbed as they are through the propaganda they are spoon-fed — will always paint these people as tyrants. But no matter. It’s better to keep our language and our reason intact than to try to appeal to people who are clearly brainwashed by using doublethink-oriented brainwashing techniques.

Shadow-boxing with DSGE Models

Lars Syll has recently linked to a post by Noah Smith criticising DSGE models. Criticising DSGE models is the latest fad in mainstream macroeconomics — hey, it’s easy to use the model that was in fashion just before the crisis as a scapegoat to distract the profession from the fact that they still have no idea how to begin to explain the crisis or its aftermath.

I’m somewhat miffed that Syll gave Smith a pass on this one, to be honest. These criticisms of the DSGE models are so transparently self-serving that they really need to be called out. I can show this quite clearly by breaking down Smith’s argument and reconstructing it in a somewhat different way. Once this is done such criticisms of DSGE models can be seen as what they are: a rearguard defence mounted to prop up a rapidly decaying intellectual program.

Okay, so Smith’s post focuses on the fact that a key component of DSGE models called the Euler Equation is empirically wrong. Basically the Euler Equation states that when interest rates rise consumption will fall. The idea here is that the interest rate is a reward for forgoing consumption — i.e. saving — and so when it rises saving increases and consumption falls.

As Smith notes this simply doesn’t square with the data. In actual fact we see that in reality when interest rates rise consumption also rises. Smith makes no attempt to explain why this is the case — mainstream economists these days, obsessed as they are with their little models, don’t care much about causality and explanation — but it might be worth noting that this is probably, as Nicholas Kaldor noted in his study of the monetarist interest rate hikes in the late-70s and early-80s, due to the fact that higher interest rates add to savings which then produces a sort of wealth effect where the interest income stimulates consumption.

Now, let’s break down the steps implicit in Smith’s argument to see what, for him, constitutes a viable argument.

1. Step one is that a hypothesis is created. In this case it is the idea that consumption should fall when interest rates rise.

2. Step two is that this hypothesis should be tested against the data.

3. Step three is that when we find that the data contradicts the hypothesis then the hypothesis is dropped.

Okay, this all seems pretty obvious, right? Well, why don’t we apply the same criteria to one of the marginalist sacred cows?

You see, in his post Smith notes that the argument he lays out also relies on the idea of a utility-maximising agent whose preferences can be fixed. But of course we all know that this idea does not stand up to empirical scrutiny. After all, Daniel Kahneman won a Nobel Prize in economics showing just that. So, not only do we have data on this hypothesis but we also know that this data is accepted by the mainstream economics community.

Well, by Smith’s own criteria shouldn’t that make the idea of a utility-maximising agent just as dodgy as that of the Euler Equation? Of course it should but Smith marches on regardless without criticising the utility-maximising agent even though it would be falsified using the same criteria as he uses to falsify a theory that he doesn’t like — that is, DSGE models.

This is what mainstream economics has turned into. Economists bicker amongst themselves over models that are obvious nonsense. They will use criteria to prove or to falsify such models that when turned around on beliefs they all hold in common would demolish these too. It is a bizarre show.

Basically this is a group of people vying for the Throne of Macro all the while secretly terrified that anyone will push the scientific criteria they claim to uphold too far and expose the fact that the Emperor is naked. How long can this carnival last? Well, if we look back on the last time such a discourse was firmly entrenched — that is, during the Scholastic era in the Middle Ages — we can be confident that it will last as long as those in power put up with it. With regards to mainstream economics that day might well be coming to an end.

Berkeley’s ‘Master Argument’ Doesn’t Exist

In 1974 the philosopher Andre Gallois published an article in The Philosophical Review entitled Berkeley’s Master Argument. In the article Gallois picks one quote from Berkeley’s Three Dialogues that he then goes on to say constitutes Berkeley’s supposed ‘Master Argument’. This term has since gained much currency in philosophical circles when Berkeley’s philosophy of subjective idealism or immaterialism is discussed. Here is the passage from the Three Dialogues that Gallois quotes (note: ‘Phil’ is ‘Berkeley’ and ‘Hyl’ is his interlocutor):

Phil. If you can conceive it possible for any mixture or combination of qualities, or any sensible object whatever, to exist without the mind, then I will grant it actually to be so.

Hyl. If it comes to that the point will soon be decided. What more easy than to conceive a tree or house existing by itself, independent of, and unperceived by, any mind whatsoever? I do at this present time conceive them existing after that manner.

Phil. How say you, Hylas, can you see a thing which is at the same time unseen?

Hyl. No, that were a contradiction.

Phil. Is it not as great a contradiction to talk of conceiving a thing which is unconceived?

Hyl. It is.

Phil. The, tree or house therefore which you think of is conceived by you?

Hyl. How should it be otherwise?

Phil. And what is conceived is surely in the mind?

Hyl. Without question, that which is conceived is in the mind.

Phil. How then came you to say, you conceived a house or tree existing independent and out of all minds whatsoever?

Hyl. That was I own an oversight.

That is the Master Argument: you cannot conceive of something in your mind that is unseen. If I try to conceive of the tree outside of my house, I will always conceive of it as being seen from some point-of-view by someone with similar sensory capacities to myself. That is rather straightforward, right?

Well, no, not really. Many philosophers have then gone on to say that this means that Berkeley was saying that if I cannot form an image of something in my mind then it does not exist. Now, that is a very problematic statement. Try for a moment to form an image in your mind of the number one, for example. By that I do not mean the numeral ‘1’ — rather I mean the concept behind it. Of course, I can imagine one apple, one car and so on but I cannot imagine the concept of one — or, at least, I cannot visualise it.

Does this mean that Berkeley was denying that the number one, or any other number for that matter, exists? No, of course not. I think the reason that this confusion has arisen is because Berkeley in the above passage uses the word ‘object’. That could be taken in the colloquial sense of ‘an object of immediate experience’ or it might be taken in the philosophical sense of ‘an object of thought’. In the case of the latter we might indeed be talking about a concept. But in the sense of the former — which is in keeping with the tone of the Three Dialogues — we are clearly talking about an object of immediate experience.

In the Three Dialogues Berkeley was attacking a very particular concept: that of matter. He was giving the example of a tree because this is an object that some claim exists as a substance called ‘matter’. Berkeley would not claim that his argument would apply to the number one or any other concept. What he is getting at in the Three Dialogues is that the concept of matter is a useless abstraction  that is often confused for being an object of immediate experience and that we can get by without it.

Why is the idea of matter a useless abstraction? Because it passes itself off as an object of immediate experience when it is, in fact, an abstract concept that serves no real purpose. This is what Berkeley is at pains to show.

Yes, matter could be said to exist as an abstract concept if we so wished but then the question becomes: why would we use such an abstract concept? It seems obvious to me why we would use the abstract concept of the number one in daily discourse, but it does not seem obvious to me why we should use the abstract concept of, say, a mystical force that heals my body from serious illness without me having to go to the hospital. Both of these have the same philosophical status — that is, they are both concepts that I never experience in an immediate sense — but it is clear that one is useful while the other will likely end up killing me someday.

Again, to stress, this is the key point: Berkeley wants to show that matter is a useless abstract concept because it explains nothing that we cannot explain without it. It is a useless abstract concept that passes itself off as something we experience immediately on a daily basis. This is what his writings on immateralism are all about.

This is also what Berkeley’s well-known criticisms of abstraction are all about. His famous mathematical work The Analyst, for example, is not concerned with saying that differential calculus is useless. Rather he is raising two points: first of all, that the calculus deals with topics that are far more abstract and mysterious than those dealt with in theology; and secondly, that there is a logical contradiction within the calculus itself.

It is the second point that is usually focused on today but it is the first point that was more important to Berkeley because it served as a dual warning: first, that those who dabble in high mathematics and believe that it has bearing on the real world should be very cautious about what they dismiss as nonsense; and second, that people should be very careful when applying highly abstract concepts to the real world as they can easily end up talking nonsense.

This is all extraordinarily obvious if we examine the title page of The Analyst which reads,

THE ANALYST; OR, A DISCOURSE

Addressed to an

Infidel Mathematician.

WHEREIN

It is examined whether the Object, Principles, and Inferences of the modern

Analysis are more distinctly conceived, or more evidently deduced, than

Religious Mysteries and Points of Faith.

Which is then followed by the following quote,

“First cast out the beam out of thine own Eye; and then shalt thou see clearly

to cast out the mote out of thy brother’s eye.”

S. Matt. c. vii. v. 5.

The message is clear: “So, you scientist and mathematical types think that you are well above us theologians who only speak in abstractions. Well, let’s see if your abstractions are really any more grounded than ours, shall we?”

To conclude we should return to the Three Dialogues for a moment. Again, Berkeley was trying to purge philosophical discourse of what he regarded a useless and dishonest abstract concept: matter. In order to do this he had to show that it was an abstract concept with no real world existence that passed itself off as an object of immediate experience.

But this is not an argument against abstract concepts as the Master Argument seems to suggest. Rather it is an argument against poor uses of abstraction and useless abstract concepts that cloak themselves as objects of immediate experience. That is what all Berkeley’s work is about and it is as fresh today as it has ever been.

A Short Note on a Connection Between Marginalist Economics and Folk Medicine

One peculiar aspect of modern marginalist economics is its obsession with equilibrium. I was recently re-listening to an excellent lecture given by Joan Robinson in Stanford in 1974 entitled ‘What is Wrong With Neoclassical Economics?‘. The entire lecture is about the inability of marginalist economics, which is obsessed with equilibrium positions, to deal with historical time. I would add to this that even a dynamical economics that used differential equations would also be unable to incorporate historical time — the simple fact is that mathematics cannot be used to do history and economics done correctly and with any relevance to the real world is basically an applied historical methodology.

Now, what really struck me was the Q&A section at the end of the lecture. The sheer amount of hostility — outrage even — directed at what Robinson had just said was astonishing. Her complaints seemed to strike a chord with a lot of the economists in the room. “But you can’t fault the logical consistency of the models!” said one, with an obvious tone of distress in his voice (around the 21 minute mark of the second half of the lecture).

It was the question of another that really hit home for me though. “How is it possible,” he asks around 22.30 minute mark in the second half of the lecture, “that a decentralised system in which individual decision-makers communicate only through the market and only through price signals, how might it be possible for such a system to produce a coherent result?”

What a strange question, I thought to myself. Robinson just spent over an hour telling them that such an approach — an approach that sought an equilibrium result in material that was historical by nature — was completely inadequate to the material that economics deals with. Also from what Robinson had just said surely the person asking this question would understand that she was saying that such a framework — where “individual decision-makers communicate only through the market and only through price signals” — is a completely inadequate way to understand an historical process like the actual formation of exchange relationships at any given moment in time.

No one in the audience could really refute what Robinson was saying either — or at least no one tried. (This is something I often encounter when criticising marginalist methodology, by the way; supporters don’t really engage; they either accept what you’re saying and then pretend you never said it or they babble incoherently about how there is no alternative framework). So, what thought process could lead someone to simply ignore what she had said and continue to pose the naive question of equilibrium? And then it struck me: the question that the interlocutor was asking was not logically based, rather it was emotionally based.

You see, the notion of equilibrium — of a “coherent result”, of an answer, a solution, a True State of the Universe — is a well-recognised mythic construct among anthropologists and social historians. They have noted how, in many different contexts, human beings try to form narratives about the universe with which to guide their lives which give them such results. To take one of the most interesting examples consider the following quote from Roy Porter’s fantastic history of medicine The Greatest Benefit to Mankind: A Medical History of Humanity from Antiquity to Present,

In traditional medicine, as I have said, health is a state of precarious balance — being threatened, toppled and restored — between the body, the universe and society. More important than curing is the aim of preventing imbalance from occurring in the first place. Equilibrium is to be achieved by avoiding excess and pursuing moderation. Prevention lies in living in accord with nature, in harmony with the seasons and elements and the supernatural powers that haunt the landscape: purge the body in spring to clean it of its corrupt humors, in summer avoid activities or foods that are too heating. (p39)

One also finds slightly more advanced articulations of such concepts in early Hippocratic medicine as well as in elite medieval medicine. But, as Porter notes, the same concepts could be found in extremely primitive folk medicine — among tribes-people and in early villages. Thus we can only conclude that such ideas arise from some deep, unconscious strata of the human mind.

What significance does this idea of equilibrium have? Why is it a concept which we so readily wish to apply to those things that we identify with — whether the human body or society at large? It seems to me that it provides a sort of emotional comfort. Robinson’s interlocutor wanted a “solution”. He was clearly disorientated by the chaos of the economic world as he saw it and wanted a solution on a blackboard that would bring order to this chaos. Nothing could be more of an affront to how he conceived the world than to be told that his methodology could not even begin grasp the material he was trying to digest.

Equilibrium in economics, as in folk medicine, is a fantasy construction — and a rather primitive one at that. It is the mark of a mind that cannot process anything complex and relatively disordered. But if the Q&A section of Robinson’s lecture shows anything it is that the vast majority of the time people with the temperament needed to become mathematical marginalist economists actually do not have the capacity to do real economic work. That is a very sad state of affairs. But it also puts us in that strange position where we must recognise that the very form that economics took after World War II is leading the discipline to interminable ruin.

2013 in review

The WordPress.com stats helper monkeys prepared a 2013 annual report for this blog.

Here’s an excerpt:

The concert hall at the Sydney Opera House holds 2,700 people. This blog was viewed about 60,000 times in 2013. If it were a concert at Sydney Opera House, it would take about 22 sold-out performances for that many people to see it.

Click here to see the complete report.

Comments on Feyerabend’s ‘Against Method’ III: Intellectual Support for Mainstream Economics

If you read Feyerabend’s Against Method closely and you take the argument seriously a rather unnerving fact comes to light: namely, that the argument contained therein lends full intellectual support to mainstream marginalist economics. While the theories of philosophers like, say, Popper or Lakatos can easily be applied to refute marginalist economics by showing either that is inconsistent with the facts or is a ‘degenerating research program’, Feyerabend’s approach actually lends it weight.

Feyerabend’s argument is that a theory cannot be judged simply based on the facts that supposedly refute it or on the ad hoc propositions that are often needed to support it. Rather new theories must be seen as advancing new paradigms that may appear strange and counter-factual at first but which nevertheless require time to gain momentum and for other existing theories to catch up. Consider the following passage which nicely sums up this view,

Observations become relevant only after the processes described by these new subjects have been inserted between the world and the eye. The language in which we express our observations may have to be revised as well so that the new cosmology receives a fair chance and is not endangered by an unnoticed collaboration of sensations and older ideas. In sum : what is needed for a test of Copernicus is an entirely new world-view containing a new view of man and of his capacities of knowing. (pp111-112)

Or again,

Thus the new view is arbitrarily separated from data that supported its predecessor and is made more ‘metaphysical’: a new period in the history of science commences with a backward movement that returns us to an earlier stage where theories were more vague and had smaller empirical content. This backward movement is not just an accident; it has a definite function; it is essential if we want to overtake the status quo, for it gives us the time and the freedom that are needed for developing the main view in detail, and for finding the necessary auxiliary sciences. (pp113-114)

If we take this argument seriously — and I think we must because Feyerabend makes a very strong case that this is how science progresses — then much about contemporary economics can be forgiven. When people complain about the absurd simplifying hypotheses that economic models are based on, when they raise objections that the models just cannot be squared with the facts, and when they say that various parts of mainstream economic thought are in complete disharmony with one another, all these gripes can be overcome by looking at the history of the development of science and saying “But it was always so…”.

What philosophers of science are really complaining about when they discuss mainstream economics is that the discipline does not fall in line with what they understand good reasoning to consist of. That is, they are complaining that judged by the standards of modern science — both hard science and social science — mainstream economics is a hopeless farce. But as Feyerabend shows so convincingly when judged in terms of then contemporary Aristotelianism, which was highly empirical, the theories of Galileo and Copernicus were hopelessly flawed.

One might say then that mainstream economics is so far ahead of contemporary social science that we cannot judge either its methodology or its results by the standards of other social sciences. Indeed, we could actually lend this considerable weight by pointing out how these sciences are now adopting techniques that were first deployed in economics and were developed specifically in line with its methodology — I have in mind, of course, econometrics. This could then be seen as proof that these disciplines are gradually moving in the same methodological direction as economics and thus that economics as a paradigm is taking over the social sciences.

Actually, I have long thought all of the above. I have no doubt in my mind that the economic paradigm is spreading rapidly through the social sciences. But here’s a thought: what if the process that Feyerabend spots in the development of science also works in reverse. What I mean is, what if the very same process that moves Man in the direction of progress and Enlightenment can also work to move Man in the direction of regress and intellectual darkness? What if that which sheds light on matters is the very same thing that submerges them in darkness?

I see no reason to assume that this cannot happen. Indeed, what Feyerabend’s arguments tell us is that there is no Scientific Method with a capital ‘S’ and a capital ‘M’. Rather Man is just groping in the dark trying to find his way in the world. That this process of groping may lead him in the direction of absurdity and dogma just as it may lead him in the direction of clarity and truth should be no surprise.

And what does this say about criticisms of mainstream economics from philosophers of science? Well, they are largely meaningless and can easily be ignored. They might be nice from a rhetorical point-of-view — although these days saying in academia that something is not ‘scientific’ often comes across about as sophisticated as comparing someone on the internet to Hitler — but they have no real meaning.

Rather it needs to be recognised that economics is not and never can really be a science. It is instead a tool of governance and very little else. In this sense mainstream economics works perfectly as it should in that it supports a certain mode of governance. Of course, mainstream economics cannot produce the results that it seeks — it does not lead to stability, full employment and growth — but that raises entirely different questions that are related to whether this economics is fit for purpose. It has nothing to do with how ‘scientific’ mainstream economics is.

A Quick Note on Michael Emmett Brady’s Paper on Keynes and Probability

“Ask and it will be given to you; seek and you will find; knock and the door will be opened to you.” — Matthew 7:7

Michael Emmett Brady’s paper Keynes, Mathematics and Probability: A Reappraisal is a bizarre piece of work. In it he reads things into Keynes work on economics in a manner that is not dissimilar to someone reading another person’s fortune into tea leaves.

In the paper Brady claims that in Keynes’ Treatise on Probability the author stopped trying to make ‘point estimates’ of probabilities — that is, estimates that crunch out a single number — and instead moved toward trying to make ‘interval estimates’ — that is, estimates that place the probability of an event in a position among a series of other events. In this part of the essay Brady’s scholarship is up to scratch and his conclusions convincing.

But then Brady starts to read this into Keynes’ later work as if the original author were leaving secret clues for Brady to pick up. At this point Brady goes in off the deep end. Here is an example of one of the passages of the General Theory that Brady quotes,

The object of our analyses is… to provide ourselves with an organized… method of thinking our particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then… allow for the probable interactions… This is the nature of economic thinking. Any other way of applying our formal principles of thought… will lead us to error. It is great fault of symbolic pseudo-mathematical methods of formalizing a system of economic analysis… that they expressly assume strict independence between the factors involved and lose all their cogency and authority if this hypothesis is disallowed.

Now most people would take this quote as proof that Keynes — as those who worked with him on economic issues like Joan Robinson insisted — was largely against the overuse of mathematics in economics. Brady, however, underlines the word ‘pseudo’ and claims that Keynes was actually hinting that a whole new system of ‘real’ mathematics should be used for economic thinking. Brady writes,

These two quotations, along with a similar quotation from p. 275 of the GT, have been widely quoted and horribly misinterpreted. Keynes’ objection, on both p. 275 and pp.297-98 of the GT, is to pseudo-mathematical methods, which ignore feedback and interactive effects and assume strict independence among the variables. Obviously, such assumptions would lead to simple, unrealistic linear models. Keynes, on the other hand, was simply more advanced in his understanding of the need to model such economic phenomenon non-linearly. (p18)

Ask yourself a question: is a linear model that ignores feedback and interactive effects really a pseudo-mathematical model? Is the mathematics involved ‘fake’ in some way? Of course it is not. It may be a poor representation of the system it is trying to model but that doesn’t make the mathematics ‘fake’. Keynes knew this, of course. He was, however, engaged in rhetoric. Calling such applications ‘pseudo-mathematical’ was not an accusation that the mathematics was ‘false’ and that all that needed be done is to apply ‘real’ mathematics, rather it was a rhetorical flourish to point out the pretentiousness of the technique.

So, why doesn’t Keynes keep his ‘real’ mathematics a secret from his reader? Well, Brady has an answer and it is as follows,

Unfortunately, Keynes does not point out that he is not opposed to the use of numbers, only their misuse as point estimates, in this essay. However, since he had discussed his inexact approach or applied it in ten chapters in the TP (chapters 5, 10, 14, 15-17, 20, 25, 29-30), his omission is understandable. (p19)

Well, I don’t think its at all understandable. What Brady is telling us is that Keynes was keeping his true feelings about mathematics a secret. Why would he have done this? Why not just say “If the reader would like to know how to interpret what I have just said mathematically please see the following chapters of my Treatise on Probability…”? Brady never tells us. He assumes that its normal for authors to bury clues in various texts for him to find and interpret.

Now, here’s where Brady’s paper turns from tragedy to farce… In the very next sentence he writes,

In conclusion, I find absolutely no textual evidence to support the claim, made in the following two sections, that Keynes was either opposed to the use of mathematical methods or that he himself was ignorant and error prone in the use of such methods. (ibid — My Emphasis)

Brady says that he finds no textual evidence to support Keynes’ opposition to the use of mathematics in economics. But he also finds no textual evidence  to support Keynes’ championing of his own interval approach. And then he concludes that the latter exists anyway! Bizarre stuff.

What Brady is really doing is picking at words in the text like a Talmudic scholar, ignoring the fact that there is no evidence whatsoever that Keynes ever applied his interval approach to probability to any economic problems and then finding a trail of breadcrumbs that any non-biased reader would see he is himself dropping as he makes his way through Keynes’ oeuvre.

Did Keynes’ early work on probability influence his thoughts on economics? Yes, of course. Anyone who reads his famous essay on econometrics — Professor Tinbergen’s Method — can see that clearly. But his work on probability did no more than allow him to appreciate the limits of using mathematics to understand complex systems where humans interact. Otherwise why didn’t he write a response to Tinbergen showing how you could use his own interval approach to do the econometrics properly? Well, Brady has a fairly wild imagination so I’m sure he can come up with some reason or other.

Interest Rates and Animal Spirits: A Response to JW Mason

JW Mason has an interesting post on the interest rate over at his Slackwire blog. In it he basically tries to resuscitate Keynes’ theory of liquidity preference as that which determines the interest rate on various assets. I think that he does rather a good job given that this is his goal but from the moment I looked into this debate over a year ago I was always bothered by what was going on.

First let us start with the conclusion that Mason comes to when considering the theory of the interest rate that Keynes lays out in the General Theory,

If we take a more realistic view of credit markets, we come to the same conclusion: the yield on a credit instrument (call this the “credit interest rate”) has no relationship to the intertemporal substitution rate of theory (call this the “intertemporal interest rate.”)

Mason gives the example of the mortgage market. He points out, quite rightly, that when a bank loan is made there is no intertemporal substitution on either the side of the bank or on the side of the borrower. What he means by that is that neither the bank nor the borrower must forgo consumption in the present for consumption in the future. So, he asks, what then explains the amount of loans outstanding? He answers as such,

Buying a house makes you less liquid — it means you have less flexibility if you decide you’d like to move elsewhere, or if you need to reduce your housing costs because of unexpected fall in income or rise in other expenses. You also have a higher debt-income ratio, which may make it harder for you to borrow in the future. The loan also makes the bank less liquid — since its asset-capital ratio is now higher, there are more states of the world in which a fall in income would require it to sell assets or issue new liabilities to meet its scheduled commitments, which might be costly or, in a crisis, impossible. So the volume of mortgages rises until the excess of housing service value over debt service costs make taking out a mortgage just worth the incremental illiquidity for the marginal household, and where the excess of mortgage yield over funding costs makes issuing a new mortgage just worth the incremental illiquidity for the marginal bank.

So, again we’re back to Keynes: the interest rate is based on liquidity preference. Now, this looks all neat and tidy doesn’t it? Well, I would argue it isn’t. Let’s wind this back a little bit, shall we?

Okay, so why do economic actors require liquidity? Well, according to Keynes’ theory it is a buffer against uncertainty. Economic actors do not have access to crystal balls — that is, they do not know what is going to happen in the future — so they keep cash on hand in case anything bad and unforeseen happens in the future.

The same is basically true of Mason’s reformulation of Keynes’ liquidity preference theory. The purchase of a house ties the buyer down in a market that is by no means perfectly liquid, while the extension of the loan also places the bank in a less liquid position.

Now, this all sounds good, right? Well, not really. You see the operative word here is ‘uncertainty’. In order for this theory to work we must fully recognise that economic actors operate in an environment of uncertainty. But earlier on in the piece Mason laid out what determines an interest rate as such,

The yield of the bond — the thing that in conventional usage we call the “interest rate” — depends on the risk of the bond, the expected price change of the bond, and the liquidity premium of money compared with the bond. (My Emphasis)

You see those three sections of the sentences I highlight? Well, are they not one and the same thing? After all, isn’t the risk of the bond and the expected future price of the bond inherently tied up with the liquidity premium of money compared with that of a bond?

I do not raise this issue simply to be pedantic. No, I believe it contains within it an important oversight: namely, that these is no such thing as “risk” on the bond in the sense of a given objective probability that people hold inside their heads. If there were then the notion of a liquidity premium on money would be meaningless. Why? Because, again, liquidity is something we desire only in the face of an uncertain future. If we assume that bonds have objective probabilities then there is no uncertain future and there is no need for liquidity preference. Whereas if we assume that the future is uncertain and that liquidity preference is real then there is no such thing as “risk on a bond”.

This makes the whole issue far simpler and also paints the dividing line between the mainstream and the heterodox theory much more clearly: either there is uncertainty, in which case “risk” cannot be measured and so interest rates are subject to “animal spirits”, or there is no uncertainty and interest rates merely reflect intertemporal substitution. There really is no point in talking about liquidity premium and the risk on a bond as the very existence of the former is predicated on the non-existence of the latter.

What’s more, as I’ve argued extensively before, most New Keynesian economists today think that financial markets — i.e. those in which interest rates are set — are subject to animal spirits. This, as I’ve pointed out in the above linked to post, means that any theory of a natural rate of interest is inconsistent with their belief in behavioral finance and economics because the natural rate of interest theory requires that interest rates across the economy are set to line up savings and investment perfectly and thus must incorporate all information about the future perfectly.

Understanding Why the US Stimulus Package Worked While the Spanish Package Did Not

A couple of days ago I wrote a quick post comparing Spain and the US after their recessions in 2007/2008 and the government responses. The post was based on the premise that the US government had engaged in active stimulus while the Spanish government had not. As Mark Sadowski pointed out in the comments section this was not correct; in fact, the Spanish government did engage in fiscal stimulus beginning in 2008.

So, what accounts for this discrepancy? Are we to assume that the US succeeded where Spain failed because of the QE program that the Fed undertook? I don’t think so. I think the explanation is far simpler and can be uncovered by looking in detail at the national accounts.

The first thing that we need to understand is the different structural make-up of each economy. We can do this by comparing how GDP is formed. The following graphs show to what extent GDP was weighted toward Final Consumption Expenditure and Gross Capital Formation — that is, toward consumption and investment. (All data is from the OECD and is expressed in constant prices).

The difference, as we can see, is rather striking. Throughout the period 2007-2008 the Spanish economy was far more reliant on investment than the US economy, which was substantially more consumption driven. Just prior to the recession in Spain consumption accounted for 76% of GDP while investment accounted for 29%. Meanwhile in the US just prior to the recession consumption accounted for 82% of GDP while investment accounted for 22%.

When we dig deeper into the data we find that key to this difference was the fact that housing construction (Dwellings) in Spain was a far more important component of GDP than was the case in the US. I have mapped their relative importance in the chart below. (Note that Spanish GDP peaked in 2008 while US GDP peaked in 2007 so I have taken each country at the pre-recession peak).

Again, the differences are striking. Just prior to the recession in Spain housing construction accounted for nearly 10.8% of GDP while in the US it only accounted for nearly 4.7%.

Now that we understand the relative structures of each economy it should be clear what happened during 2007-2008. As we can see from the chart below, housing construction fell from it’s pre-recession peak in both countries at fairly similar rate.

But as we have already shown the Spanish economy was far more reliant on this housing construction in the US. This, I think, is why the stimulus worked in the US while it did not work in Spain; simply put, the demand gap opened up by the bursting of the housing bubbles was far larger in Spain than in the US. Thus even if the Spanish government put a larger stimulus package in place it is not surprising that it failed where the US package succeeded.

How the US Fiscal Stimulus Worked and Why Spain is Still Stuck in a Rut

So, I’ve been debating an economist called Mark A. Sadowski over at Scott Sumner’s TheMoneyIllusion blog. The debate started on my blog when we were debating the effects of the QE programs on my post a few days back but it has since moved on to macro-theory and a brief discussion of how fiscal deficits work and it has finally fallen onto the topic of being something like an empirical discussion of the budget deficits in the US versus those in the Eurozone.

In one comment Sadowski wrote the following,

Raw general government deficits imply that fiscal policy in Spain Ireland and Greece was far more expansionary than in the US from 2003 to 2009 and has been substantially less contractionary in Spain and Ireland than in the US since 2009. This contradicts what you have said about their relative fiscal stance far more severely than the cyclically adjusted measures.

This is in response to a comment I made to the tune that whether the deficit spending comes from active fiscal policy or from automatic stabilisers matters little. I think I should probably clarify this: it is certainly correct that the source of the spending largely doesn’t matter, however when trying to conceptualise how large one budget deficit was relative to another it certainly does matter.

For example, Sadowski is largely correct that Spain’s absolute fiscal stance is laxer than the fiscal stance in the US but in Spain’s case it is driven purely by the automatic stabilisers. What we see in Spain is a very specific dynamic that runs something like this.

1)  In 2008 the Spanish budget deficit opened up as the automatic stabilisers kicked in. It reached its height in 2009 when the deficit was around €116429m.

2) The Spanish government then undertook austerity measures to shrink the deficit.

3) These austerity measures largely failed and today we do not see much change in the euro value of Spain’s budget deficit. At the end of 2012 the deficit was still €109572m.

In the US, however, the dynamics were entirely different and this was due to the fiscal stimulus undertaken in 2009 and the relatively lax fiscal stance that was taken after this. The US dynamic runs something like this,

1) In 2008 the US budget deficit opened up as the automatic stabilisers kicked in. But shortly after this, in 2009, the Obama administration launched an $831bn stimulus program.

2) This program added to the deficit in the coming years substantially over and above the effects that the automatic stabilisers had on the economy.  The CBO estimates that 90% of the impact of the program had been felt by the end of 2011.

3) If we take the US Treasury’s measures of the deficit in these years we will see roughly how much the stimulus supplemented the automatic stabilisers. The Treasury measures were as follows:

2008 – $455bn

2009 – $1,417bn

2010 – $1,294bn

2011 –  $1,299bn

2012 – $1,089bn

Now, if we follow the CBO and allow that 90% of the $831bn stimulus program had been spent by the end of 2011 this means that $748bn was spent in this period. Given that this was a three year period we can average out that the stimulus added around $249bn a year to the deficit. We can express how much the stimulus increased the deficit in each year in percentage terms as follows:

2008 – 0%

2009 – 17.6%

2010 – 19.2%

2011 –  19.2%

2012 – ?%

So, what does this tell us? Let’s think of it this way. The Spanish recession caused an endogenous increase in the deficit and then began to try to cut this same deficit. They failed. The endogenous deficit that was run in Spain was keeping the economy from falling into a protracted depression but it was not sufficient to return the economy to even modest growth.

In the US the endogenous deficit that opened up was supplemented by a stimulus program that added to this deficit by about 18% a year between 2009 and 2011. Thus on top of the endogenous deficit that we would have seen anyway — and which would have merely kept the economy from falling into a depression, as it did in Spain — the US added an extra 18% which gave the economy the momentum to return to modest growth. A good deal of this, as I said to Sadowski, was due to the impact this additional demand had on investment in those years which has almost recovered in the US to pre-2008 levels — see here.

Here is a nice way to think of this: automatic stabilisers will merely stabilise your economy. They will make up for the shortfall in demand to the extent that your economy will not fall into a total depression. But they need to be supplemented with stimulus to generate a cyclical upswing as we saw in the US. This explains why the US is experiencing modest growth right now while countries like Spain are stuck in a rut.

Update: It appears that the above post was incorrect in its assertion that there was no stimulus in Spain after the 2008 crisis. In fact, there was. I am currently addressing this in the comment section (see below) and will likely have some more posts on this in the coming days.

Update II: As promised here is the post exploring why the US stimulus worked where the Spanish stimulus did not.