Can Schiff’s Argument be Salvaged by Introducing Nonsense Assumptions?

In my previous post on Peter Schiff and the Austrians a commenter pointed out that I might be misrepresenting Schiff’s position and that it could be salvaged if we allowed for some of Schiff’s own nonsense assumptions. The conversation got a little weedy and veered off course somewhat. Here I would like to take the commenter’s argument at face value, not debate the accounting and see if Schiff’s position remains consistent with very basic macroeconomics.

Okay, so let’s start with our sectoral balances framework,

(S – I) = (G – T) + (X – M)

Now, let’s substitute in some numbers that are fairly consistent with the current US numbers (all numbers are expressed as a percentage of GDP),

(8% – 4%) = (14% – 6%) + (4% – 8%)

These are approximations, of course. I did not look up the real numbers. But they are not far off and using them will not harm our argument in any way.

Now, recall that Peter Schiff argued that the US should do three things: first, it should increase savings; second, it should decrease the government deficit; third, it should increase the interest rate and strengthen the dollar.

In order to examine the first of these the commenter suggested that we reorganise the equation as such,

(S) = (I) + (G – T) + (X – M)

Again, we can give those expressions numerical values,

(8%) = (4%) + (8%) + (4% – 8%)

I’m not altogether comfortable with this approach for reasons I laid out in the comments section. But let us proceed to examine Schiff’s argument in this light anyway to see if it is possible.

Now, the interest rate should rise according to Schiff. This has the effect, according to him, of increasing private savings — which it would. But it would also have the effect of increasing the trade deficit as imports, M, became cheaper and exports, X, more expensive. Let’s plug some numbers into those parts of the equation then,

(10%) = (?%) + (?%) + (2% – 10%)

In order for this to balance, as I pointed out in the piece (while providing empirical evidence of just this) the government deficit, (G – T), would have to increase. The commenter said that this was not the case. Instead, private investment could increase.

There are two assumptions that need to be examined here. (1) That private investment would increase in a high interest rate environment and (2) That an increase in private investment in the face of a rise in the value of the dollar would not increase imports, M, and further worsen the trade balance.

Both assumptions are false. Private investment tends to fall, not rise, in the face of high interest rates — that is basic macroeconomics. Also, with a high value dollar imports would obviously rise if investment increased.

Let’s suppress the first assumption though. Let’s imagine that investment, for some bizarre reason, did rise in the face of increased interest rates. But let’s be realistic and assume that this also led to an increase in imports because of the increased investment together with the higher valued dollar. So,

(10%) = (8%) + (?%) + (2% – 11%)

Well, now we have to balance the equation by adding in a value for the government balance, (G – T), right? So, let’s do that,

(10%) = (8%) + (11%) + (2% – 11%)

What has happened? Even assuming that private investment increases in the face of high interest rates — a highly unlikely, if not impossible assumption — if we allow that such investment would further deteriorate the trade balance in the face of a high valued dollar, the government deficit still increases from 8% of GDP in our first equation to 11% of GDP when we try to implement Schiff-o-nomics.

This is, of course, perfectly consistent with the empirical example I laid out in the original post.

We could, of course, tell some different stories. We could have wages fall and this might offset the fall in exports from the higher valued dollar. Let’s try that then. Let’s say that the wage decreases totally offset the fall in exports,

(10%) = (8%) + (9%) + (4% – 11%)

Well, the government deficit still rises from 8% of GDP to 9% of GDP.

The lesson should be clear: Schiff’s story is totally inconsistent. It makes no sense. When examined in any detail it simply does not add up. Even if we give him the benefit of the doubt on certain issues — like the fact that investment will increase in the face of high interest rates — the argument doesn’t add up. Schiff and the Austrians are talking swill that is totally at odds with very basic macroeconomics. And that is the end of the story.

Global Sectoral Balances

I recently came across a very confused post on the sectoral balances approach here. I’m not going to argue with it because that would be boring. But check out the graphic that the author has put together. Good stuff!

Peter Schiff, the Austrians and Their Mission to Increase US Debt Held by Foreigners Together With the Budget Deficit

Today I’m going to do something that I usually refrain from doing; that is, I’m going to engage with some of the crank arguments that come from the so-called ‘Austrian economists’. (Actually I have done this once before, but shhh… I’m secretly ashamed…).

I’m going to take up three lines of argument that certain Austrian pundits make that are logically connected but which do not seem logically connected in the minds of these pundits. Let us take as our sample pundit Peter Schiff, as he is certainly the most vocal and visible of the Austrians. The first line of argument is that the dollar is going to collapse because foreigners are going to dump it as their reserve currency. Schiff has been making this argument since 2003.

Tied to this is the fact that the US economy has been running persistent trade deficits for years. In the populist language of the Austrians this is registered as the US’s “lost ability to produce” which can be seen being spouted by Schiff here. According to Schiff the trade deficit will eventually lead to a run on the dollar which will then generate massive amounts of inflation in the US presumably as foreign goods and services become more expensive in dollar terms. What he is referring to, of course, is a classic currency crisis.

Now, let’s imagine for a moment that this argument holds up. Let’s imagine that Schiff is correct on the impending dollar collapse (even though he’s been wrong for 10 years running for reasons that are obvious to anyone who follows global macroeconomic events). But let’s give him the benefit of the doubt and pretend that he’s right. What is his prescription? Well, this is where Schiff’s argument goes from being somewhat grounded, if extremely misleading, to being launched right into the stratosphere and leaving reality behind: he thinks that US interest rates need to be higher and the dollar stronger.

I know… need I say anything else? Anyone with any economics training at all must be completely baffled by this argument. Indeed, I think the only reason that Schiff hasn’t been called out on it up until now is because his whole narrative has never been laid out in any consistent manner. I feel that by pointing to the obvious error here I will be patronising my readers somewhat, but I will do so nevertheless for posterity’s sake: a rise in interest rates and an accompanying rise in the dollar would severely damage US competitiveness, cause imports to rise as they become cheaper in dollar terms and cause exports to fall as they become more expensive in foreign currency terms. In a few words: the trade deficit would get much, much bigger.

In fact, as those with a more sophisticated knowledge of macroeconomics will know, this will have effects on the relative positions of the private and governments sectors too. We know this because the sectoral balances accounting identity must hold at all times. That accounting identity is as follows,

If the trade balance component in that identity deteriorates — that is if ExP fall and InP rise — then one of four things will have to happen: (1) private savings will have to fall/private debt will have to rise; (2) private investment will have to rise; (3) government tax revenues will have to fall; (4) government spending will have to increase. In reality, the result will be some combination of the above, although (2) is clearly the least likely. The end result will be an increase in the government and private sector deficits.

But then, perhaps we’re getting overly complicated here. Perhaps we should just stick to what is a simple point: if interest rates rise and the dollar’s value rise this will lead to a much larger trade deficit. This is not high theory either. We can simply examine the historical record in this regard. All we need to do is go back to the late-1970s and early-1980s when Fed chairman Paul Volcker raised interest rates to historic highs to fight inflation. Here is what happened.

First of all, as Schiff says, the dollar’s value increased enormously. The high interest rates in the period 1978 to 1985 led the dollar to increase in value by about 40% (all data is from FRED),

And what happened to the trade balance? Well, obviously it went massively into deficit as imports became cheaper in real terms and exports became more expensive,

Of course, this dynamic is obvious to ANYONE who knows basic macroeconomics. I’m not even talking about ‘mainstream’ versus ‘Austrian’ or ‘Austrian’ versus ‘Keynesian’. All schools of thought would recognise that an increase in the value of a currency would, ceteris paribus, lead to a deterioration in the trade balance. This is so obvious it seems embarrassing to assume that someone who paints themselves an economics expert would not realise it…

And what about our accounting identity? Did it hold in this period? Did the government deficit increase as the trade balance deteriorated? Of course it did. Accounting identities must hold!

It should thus be obvious that what the likes of Peter Schiff are selling is snake oil of the highest order. They complain about the trade balance and warn that it will lead to a dollar collapse and inflation when foreigners stop “lending the US money”. But then they prescribe something that would obviously worsen the trade balance (and the government deficit).

Frankly, it’s shocking that they get away with airing their views in public without being subject to ridicule. But then, these people usually exist outside of the realm of academic economics and are not subject to basic checks and balances. Their audience are also likely not rational people so such rational arguments will not sway them. God help us all if the likes of Ron Paul get into power… although watching the confusion of the Austrian pundits as Armageddon reigned down would be rather amusing.

Update: A more thorough investigation of the logic underlying Schiff’s argument can be found here.

Historians, Avoid the Mistakes We Economists Made!

A friend of mine recently drew my attention to something he thought would be of interest to this blog.  Apparently something of a controversy has arisen regarding a recent study in the Proceedings of the National Academy of the Sciences that was discussed on Andrew Brown’s blog at The Guardian. Brown interpreted the study to suggest that war has been the key driving force behind human society. Some on the political left have disputed this as it has rather dire implications for any left-wing political project.

First it should be said that this is not a new idea. Nietzsche, for example, saw war as a constructive force. In his On the Genealogy of Morals he writes,

The beginnings of everything great on earth [are] soaked in blood thoroughly and for a long time.

While elsewhere he openly calls for war to wipe out weaker and less productive humans. This idea has been with us for a rather long time and it is unlikely to ever disappear.

The study though makes a somewhat novel case. It claims that war leads to greater social cohesion — or, what the authors call ‘ultrasocial norms’. The authors of the paper give an example,

As an example of an ultrasocial norm, consider generalized trust. Propensity to trust and help individuals outside of one’s ethnic group has a clear benefit for multiethnic societies, but ethnic groups among whom this ultrasocial norm is wide-spread are vulnerable to free-riding by ethnic groups that restrict cooperation to coethnics (e.g., ethnic mafias). An example of an ultrasocial institution, much discussed by historians and political scientists, is government by professional bureaucracies. Other examples include systems of formal education, with the Mandarin educational system in China as the most famous example, and universalizing religions. (p1)

The idea lying behind the paper is then that war breeds higher degrees of social cohesion which leads to the formation of states which in turn generates greater civilisation. The authors lay out the causal chain as such,

The conceptual core of the model invokes the following causal chain: spread of military technologies→intensification of warfare→evolution of ultrasocial traits→ rise of large-scale societies. (p2)

The authors then use modelling that will be familiar to readers of this blog; that is, they effectively use a variety of regression techniques that are familiar to economists. As readers of this blog know, I am extremely skeptical of these techniques. The above mentioned study indicates that such techniques are now being applied to history under the guise of something called ‘cliodynamics’ and which is often associated with ecology (which I think is a somewhat dubious ‘science’…). The author of a Wired article discussing the study describes cliodynamics as such,

Cliodynamics is a field of study created by Peter Turchin in the early 2000s. The idea is to use data as a means of predicting the future, but also as a way of testing theories about what happened in the past. You build a model that seeks to explain history, and then you test this model using real historical data.

I assume that this will sound more than a little familiar to economists in general and those that read this blog in particular.

There are so many problems with applying these techniques to historical data — which, in my opinion is identical to economic data — that it would take me far too long to enumerate them. But the core problem is that of causality. As can be seen from the causal chain laid out by the authors above the study definitely assumes a rather fixed causality. Yet mathematicians that developed these techniques have long pointed out that they cannot really identify causality.

David Freedman, for example, notes that without being able to do real experiments — which we cannot generally do with historical or economic data — any causal inferences drawn from such models are useless. He writes,

The usual point of running regressions is to make causal inferences without doing real experiments. On the other hand, without experiments, the assumptions behind the models are going to be iffy. Inferences get made by ignoring the iffiness of the assumptions. That is the paradox of causal inference… Path models do not infer causation from association. Instead, path models assume causation through response schedules, and – using additional statistical assumptions – estimate causal effects from observational data … The problems are built into the assumptions behind the statistical models … If the assumptions don’t hold, the conclusions don’t follow from the statistics.

The complex nature of historical data, like that of economic data, means that we cannot draw causal inferences from the examination of the statistics alone. In order to do so we need a theory. And if this theory is flawed in any way — which it likely will be given the heterogeneous nature of historical data — then any results we get from applying it are also meaningless.

Take the recent examples of war in the 20th century. I’m no historian but I think we can make some pretty general claims about three major wars in this century with regards to their leading to greater or lesser social cohesion and progress. First, World War I. Did this war lead to greater social cohesion and development? Absolutely not. In fact, it precipitated two decades marked by economic and political strife across the Western world which eventually led to another war. This was in part due to the war but it was in part due to instabilities arising in the economies of Western nations which were only partly due to the war.

World War II, on the other hand, undoubtedly ushered in an age of economic progress and large-scale social cohesion in Western nations. Why was this? Again, the reasons are complex, but a good deal of it probably had to do with the new economic system that emerged during the wartime planning which increased social equality and ensured adequate state-supported infrastructure for stable economic and social development. What about Vietnam? Well, after Vietnam economic and social cohesion began once more to break down. This was not due to the Vietnam war, although the latter certainly contributed in that it was the final nail in the coffin of the Bretton Woods economic system; rather it was due to the falling apart of the post-war socio-economic model.

Why all these differences? Because history is not homogenous. It is irreducibly heterogeneous. In history there are no perfect causal processes that explain events.

History, properly conceptualised, is a series of constellations. These constellations change through time and are not subject to any overarching meta-narrative. They are contingent and particular and in their contingency and particularity cannot be reduced to a set of ‘laws’. The study of history is never final. It is rather a meditation. Techniques like cliodynamics are the phrenology of our day. They have a veneer of scientificity about them. But they are pseudo-science of the highest order.

Nevertheless, they tend to draw attention — even if this attention is fleeting — and so they tend to draw funding. I would council historians, however, that to go down this path is extremely dangerous. If they would care to look at the contemporary state of economics — a subject now held in public ridicule — they can see the end result of applying pseudo-scientific principles to what is ultimately the study of historical processes.

Updating the Technostructure: A Sketch of Galbraith’s Institutionalism with a Financial Sector

I’m currently rereading The New Industrial State by John Kenneth Galbriath. It is a very rewarding book and, despite what some have said, I do not see it as being at all outdated. I think it translates perfectly well to our contemporary world with the key difference that where Galbraith laid out what he called the ‘planning system’ — that is, corporate monopolies/oligopolies — and the ‘market system’ — that is, some primary producers — we now need to add a third sector: the ‘financial system’.

Anyway, the book is also, at points, very amusing. Galbraith is a very funny writer. In fact, one of the funniest parts of the book is also one of the most insightful. Galbraith is discussing the idea that the economy is, as it is in the marginalist models, made up of profit-maximising agents. He points out, however, that a good deal of the population who actually engage in production are working in various parts of the corporate bureaucracy — what Galbraith calls the ‘technostructure’.

The scientists and engineers, for example, are no longer like Edison or the Wright brothers, rather they are working together in a massive bureaucracy. They are devising formulas for new types of paint or rubber or metal alloy for the latest model of car. They cannot try to maximise their profits by, say, taking a breakthrough discovery to a rival corporation. Their credibility and trustworthiness would be in tatters. These people have given up the drive to maximise profits for the greater good of the company.

All that is left then for economic theory to do is to assume that corporations are maximising profits to satiate their stockholders. This, Galbraith writes, is not a very credible idea,

If the traditional commitment to profit maximization is to be upheld, [the members of the technostructure] must be willing to do for others, specifically the stockholders, what they are forbidden to do for themselves. It is on such grounds that the doctrine of maximization in the mature corporation now rests. It holds that the will to make profits is, like that of sexual intercourse, a fundamental urge. But it holds that this urge operates not in the first person but in the third. It is detached from self and manifested on behalf of unknown, anonymous and powerless persons who do not have the slightest notion of whether their profits are, in fact, being maximized. In further sexist analogy, one must imagine a man of vigorous, lusty and reassuringly heterosexual inclination who eschews the lovely and available women by whom he is intimately surrounded in order to maximize the opportunities of other men whose existence he knows of only by hearsay. Such are the foundations of the maximization doctrine when they are fully separated of power from reward. (pp148-149)

Some now claim that since Galbraith had published these lines in 1967 the revolution in finance has pushed shareholder value to the fore and that this can be used as a proxy in order to theorise the corporation as a profit maximising entity. But this is simply not true. It is all a smokescreen. Corporations do not try to maximize shareholder value at all. They continue, as they did when Galbraith wrote, to pursue whatever other ends are seen fit (growth, expansion, corporate looting etc.). They simply hide behind a veneer of stockholder sovereignty.

When these corporations do pursue higher share values they need not do so with long-term production goals in mind either. Take a look at this chart together with commentary from Byron Wien, Vice Chairman of Blackstone Group from Business Insider,

What this shows is that, as the sequestration cuts kick in, corporate earnings have actually fallen. But because the companies want to keep their stock prices afloat they just use cheap money to buy back shares and decrease the overall pool, thus increasing earnings-per-share. Such activity is certainly a far cry from shareholder value as a means for economists to theorise normal, economic profit maximisation in corporations. What we see in such examples is that share prices becoming completely detached from any notion of production or output and thus being unable to serve as a proxy for the profit maximisation theories of the marginalists.

In fact, this can be understood rather well from the framework for asset prices that I’m currently trying to get published. There I lay out a framework that allows us to understand asset prices as being, to some degree, fixed by those who issue the asset. In this, assets themselves become but another fixed or quasi-fixed price market just as they are when firms engage in buybacks to fix price and by doing so Institutional analysis of Galbraith’s type once again comes into its own.

Consider the following equation which is a stripped down version of my asset pricing framework,

Okay, so Pft is the final price of an asset at time t. While pft-1 is the price of the asset in the previous period. The lower case delta term, which looks like a small d, represents the price elasticity of demand. The term Peft stands for the average expected future price of the asset (upper-case delta [triangle] indicates, of course, change). The uppercase chi, which kind of looks like an X, stands for the relative confidence of investors in their expected future price Peft. The term q stands for the tendency on the part of the issuer of an asset to increase the quantity of that asset while the term Zt stands for the issuer’s ability to increase the asset’s issuance. When dealing with purely financial assets like shares which can be increased in unlimited quantities it is best to set q equal to one and alter the Zt term as needed. Or,

Now, imagine the situation where a company engages in share buybacks. Let us say that private investors do not wish to purchase any of the share in this period, so Peft is equal to zero. Thus, the price will ultimately be equal to the price in the previous period minus the amount of shares the issuer issues. In the case of a share buyback we might say that they destroy shares. So we place a negative number in the place of Zt which would thus raise the price of the share to the tune of the quantity bought back times the price elasticity of demand term.

Is this profit maximisation? Not really. When the Zt term is decreased a separate balance-sheet operation** occurs where cash deposits are lost and overall equity decreases — so, it is not clear that the actual value of the company has increased in any meaningful way. The effect is that the Return on Assets (ROA) and the Return on Equity (ROE) increase which give the markets a nod as this is registered as an improved financial ratio and the price of the shares consequently increases***.

Certainly, this has absolutely nothing to do with profit maximisation in the marginalist sense. It is just an accounting trick that increases the value of shares in the eyes of the market — or, at least, that’s what it’s supposed to do if investors swallow the signal created by the company. It does not increase investment or output and thus has nothing to do with producers increasing output up to the point where profit is maximised as in the marginalist story. Indeed, what the issuer of the share is actually doing is engaging in financial asset destruction to temporarily boost financial profits.

When we begin to integrate these aspects of corporate life through an understanding of asset-pricing and corporate balance sheets we can start adding on the financial sector to Galbraith’s two-tier analytical framework. After doing so I think we’ll find more and more that his criticisms of the marginalist profit maximisation framework are just as relevant today as they were in 1967 and that his framework, properly updated, will be just as valuable as it was all those years ago in understanding how our advanced capitalist economies work.

———————————————————————

** Ideally, if we were engaged in an extensive analysis of this process we would include a Godley-style accounting matrix to supplement the algebra and bring out clearly the balance-sheet effects. The balance-sheet would, however, be slightly different to Godley’s in that it would integrate corporate accounting norms.

*** We can, however, imagine a rare case in which a share buyback does not result in increased share prices. If the company undertakes, for example, a share buyback purely to cover up extremely poor financial ratios and investors and analysts understand this the price of the shares may not rise (there are other examples which can be read about here). In the context of our algebraic framework this must be taken as a negative signal which decreases investor expectations. Thus, in the special case of a share buyback being used to cover up poor financial ratios that is recognised instantly by investors the destruction of shares is inversely related to the expectations of investors. Or, alternatively (and somewhat perversely), the confidence of investors is positively correlated with increased issuance,

Bad Criticisms of Economics: A Response to Chris Auld

A quick bit of fun regarding criticisms of economics. It is a post by a blogger listing 18 “bad criticisms of economics”. I think this might be worth engaging with because (a) some of the criticisms are highly subjective and would require further argument and (b) some of the criticisms should be listened to by critics of economics. I will list all 18 and provide responses below.

1. Treats macroeconomic forecasting as the major or only goal of economic analysis.

It is unclear what the author means. Surely most macro-based criticisms would also imply that policy formulations are important. The author needs to think this one through more as it strikes me as a strawman.

2. Frames critique in terms of politics, most commonly the claim that economists are market fundamentalists.

This is true. Poor criticism does do this. If the critics articulated themselves properly they would point out that marginalist economics is based on a core assumption of a market and then various inefficiencies etc. are added. If this latter is a poor criticism then the author has an issue with much contemporary philosophy of science (Lakatos etc.).

3. Uses “neoclassical” as if it refers to a political philosophy, set of policy prescriptions, or actual economies. Bonus: spells it “neo-classical” or “Neo-classical.

Agreed. As I laid out here, “neoclassical” refers to a very specific type of economic reasoning. When properly applied, however, the term is perfectly clear and functional. It is not a critical term per se (one could support the methodology) but it can be used to denote a field that can then be criticised.

4. Refers to “the” neoclassical model or otherwise suggests all of economic thought is contained in Walras (1874).

This can be fruitful in some circumstances (and provided the moniker “neoclassical” is not used). Walras’ model is the kernel of any model based on general equilibrium assumptions. General equilibrium modelling — including DSGE modelling — can and probably should be criticised and starting from Walras’ model is often not a bad idea because if the fundamental assumptions of this model are not worthy of consideration more advanced models likely are not either.

5. Uses “neoclassical economics” and “mainstream economics” interchangeably. Bonus: uses “neoliberal economics” interchangeably with either.

Agreed. Again because of the point made under point 3 above. Also, there is no such thing as “neoliberal economics”. Neoliberalism is a political ideology, not an economic doctrine.

6. Uses the word “neoliberal” for any reason.

“Neoliberalism” is well-defined in the literature and can be used in analysis. Using it to make critical comments about economic theory rather than policy does seem misguided though. But given that economic policy is also a part of “economics” and the author purports to be dealing with “criticisms of economics” then it is hard to see why this term should be censored. Perhaps the author would care to rewrite 6 as: “Uses the term “neoliberal” to criticise pure economic theory”.

7. Refers to “corporate masters” or otherwise implies economists are shills for the wealthy or corporations.

If they imply that all mainstream economists are such shills then yes, this is nonsense. If they imply that certain economists who are actively shilling for corporations are shills I see no such problems. If the critic is wrong a libel suit will sort that out rather quickly.

8. Claims economists think people are always rational.

Agreed. This is a poor criticism. Rather critics should note that marginalist economics generally assume rationality as a core component of their models and deviations from rationality to be anomalies. Criticism can then follow from there.

9. Claims financial crisis disproved mainstream economics.

I assume that the author means “the crisis of 2008”. Does this disprove mainstream theory per se? No. But it certainly calls into question many very important aspects of mainstream theory. I shall not list them here.

10. Explicitly claims that economics is not empirical, or does so implicitly by ignoring empirical economics.

This is tricky because some assume that econometric modelling is empirical while there are good reasons — highlighted by leading statistical mathematicians — to claim that it is not. If one disagrees that econometric modelling is empirical then much of mainstream economics is indeed non-empirical and true empiricism is rare. There is also the issue, which I think many critics are getting at, that some economics models are actually contradicted by available empirical evidence. This is self-evidently true.

11. Treats all of economics as if it’s battling schools of macroeconomics.

Certainly if you are trying to lay out debates in macroeconomics then the major schools have to be noted. Does this constitute economics as a whole? Of course not. I’m not sure who claims that it does.

12. Misconstrues jargon: “rational.”

Certainly. But defenders often also misconstrue this jargon. And there is a case to be made that this jargon is semantically meaningless.

13. Misconstrues jargon: “efficient” (financial sense) or “efficient” (Pareto sense).

As above.

14. Misconstrues jargon: “externality“.

I’m not clear on this one. I know what the term means but I do not see it regularly pop up in criticism.

15. Claims economists only care about money.

Most critics claim that mainstream economics neutralises money, so this is an odd point. But if some critics do this they should indeed be taken to task.

16. Claims economists ignore the environment. Variant: claims economics falters on point that “infinite growth on a finite planet is impossible.”

This is actually a pet peev of mine, so I have to pretty much resoundingly agree.

17. Goes out of its way to point out that the Economics Nobel is not a real Nobel.

Actually this is a very important thing to point out. The history of this is currently being written and from what I have seen this was a very important move to give economics a scientific mantle it likely does not deserve and suppress political criticism of central bank independence.

18. Cites Debunking Economics.

If a specific argument is not cited and fully understood then, yes, I agree. But there is much in Keen’s book that is interesting.

All in all, some good points, some bad. But I agree that criticism needs to be sharper. Some of the points, however, fall into the category of “signs that you’re not dealing with a first rate defender of mainstream economics”.

Is Peer Review Forcing Academics to Become Prostitutes?

Recently I came across a fantastic blog entitled Rejection Letters of the Philosophers. It is a satirical blog in which famous philosophers are imagined to have submitted their manuscripts to their peers via the contemporary academic peer-review system. The humour lies in writing the rejection letter from a completely clueless and bigoted referee who merely want to defend already-existing ideas. (Sorry to be so analytical, I know that to explain the joke is to kill it, but I cannot assume that all my readers will go and read the blog).

After I read the posts, I sent in one of my own. In it I imagine a rejection of George Berkeley’s path-breaking, though largely ignored, essay De Motu by a Newtonian living around the same time that Berkeley published the essay. It can be read here.

I discussed the actual issue underlying the blog with the owner at some length via email. He directed me to this fascinating paper entitled Publishing as Prostitution? — Choosing Between One’s Own Ideas and Academic Success. It is written by an economist called Bruno Frey and, although it employs a utility-based analysis that I find reductionist, it nevertheless raises some very interesting points that I believe are worthy of further consideration.

Although it might seem strange to readers of this blog that a utility-based analysis might yield anything of interest I should say clearly that I do not think this is actually the case; rather I think that the author has cleverly bent utility-analysis to suit his own purpose, which is to criticise the Groupthink dynamic generated by the contemporary peer-review process. All the salient points that the author makes can be made just as clearly — and perhaps more forcefully — outside of a utility framework. That said, let us now turn to the substance of the paper.

The author identifies the fact that the peer-review process can often give rise to what he calls “intellectual prostitution”. The idea lying behind this is that the author trying to publish in a journal sells themselves by bending and altering their ideas to fit those that are considered to be “good” by their peers who are refereeing their paper. In an ideal world it would be expected that referees and editors, provided they see that the paper conforms to basic academic standards (clear argument, good format, references etc.), would then engage in “light touch” editing; that is, they would suggest possible improvements; where clarity might be enhanced; or suggest slight changes in layout. This, for example, is how the sub-editing process in a newspaper works.

Frey notes, however, that this is rarely the case. Rather the referee process is used to try to push group opinion on the author. Frey writes:

All authors would like to receive referee reports helping them to improve their paper. Alas, this is rarely the case. Normally, the referees want to see substantial changes basically altering the paper. Often, an almost completely new paper is demanded. At the very least, the author is asked to write things he or she would not otherwise have written. The more fundamental and numerous the changes demanded by the referees are, the less it pays to submit a paper and to engage in an academic career. (p208)

Frey is quick to note that this should not be considered a bad thing per se. As he notes with regards his analogy, it is possible to take the view that prostitution is a voluntary market act taken in line with a given monetary incentive that does no harm to anyone else and so has no externalities (whether one agrees with this evaluation matters little to the argument). So why then can we not view intellectual prostitution in the same manner? Frey writes,

Scholars are seen as performing a similar activity to artists, in particular painters who, since the Renaissance, are expected to express their own beliefs and convictions – which led to an explosion of creativity in the arts. The almost dictatorial demands advanced by the referees are difficult, or even impossible, to reconcile with authors wanting to publish their own ideas in economics journals. (pp206-207)

Frankly I think that in this passage Frey is bending his utility analysis until it breaks. He is clearly here making a moral or aesthetic judgment as to what “good” academic work should be. He cannot justify this on the basis of cold utility analysis. I could point out the flaws here in more depth but that is not my goal as I think that, while the form that the paper adopts is disingenuous, the substantive issues it raises are very important and the author’s contribution extremely interesting.

Frey goes on to identify what he believes to be the key reason that peer-review may lead to intellectual prostitution. He writes,

A useful starting point for a rational choice theory of referees’ and editors’ behavior is to acknowledge the difference between the two groups of actors on property rights to journals. Anonymous referees have no property rights to the journal they advise. They are not concerned with the effect their advice has on the journal. The absence of property rights must be expected to lead to shirking. The interests of the journal and the referees are not aligned… Many referees will be tempted to judge papers according to whether their own contributions are sufficiently appreciated and their own publications quoted. They carry, for instance, no costs when they advise rejection of a paper they dislike (e.g., because it criticizes their own work), even if they expect that it would be beneficial for economics as a discipline. (pp208-209)

I think that Frey is absolutely correct here. Hidden under the cloak of anonymity referees need not be neutral at all. Indeed, they can be as factional, subjective, authoritarian and nasty as they want and it will not do any damage to their reputation. This is, of course, precisely what often happens. If one is handed a paper to referee and one doesn’t like the ideas contained because they conflict with your own, you have no disincentive not to act like a child and demand that the author of the paper conform to your own narcissistic view of the world.

I say that this is true because, having trained as a sub-editor, I know that this habit has to beaten out of people. When you start sub-editing newspaper copy the temptation to insert into it your own views is enormous. You have been imbued with power over another person — over their thoughts, one might say — and while all power corrupts, absolute power corrupts absolutely. This tendency persists even when you have recognised that this impulse is authoritarian, immature and tasteless. To take a truly neutral view of the material is extremely difficult. I believe that this is almost impossible for the average anonymous referee who has not gone through any such training process.

So, what does Frey recommend? Well, he says that we should recognise basic property rights. The owner of a journal is the editor and that editor’s reputation — unlike that of his/her referees’ — hangs on his/her journal. If the editor is forced to make the decision alone his/her reputation will be damaged if he/she is seen to be persistently engaged in bias. Personally I think that there is a lot of wisdom in this proposal. It is certainly better than the system we have now which is, as the author says, driving creative young academics out of academia and amassing power to an older generation unwilling or unable to change their minds on certain issues.

Finally I should say, given that this is an economics blog, that this does not just apply to the mainstream economic journals. I have not had a great deal of experience with the heterodox journals, but it should be noted that the two heterodox economists whose work is currently in vogue — that is, Hyman Minsky and Wynne Godley — largely did not publish in these journals. It should also be noted that the force that has popularised heterodox economics more than any other — I think of Modern Monetary Theory (MMT) — has done so outside of established journals. This suggests, to me at least, that there may be something rotten in the state of Denmark, as it were. The market for ideas is quite manifestly in disagreement with the contemporary journals.

Addendum: I should note that while I believe I have brought out the salient points of the paper above, it is nevertheless worth reading as there is much else of worth in there. At some points the paper almost seems like a well-written satire; especially when the author discusses “born intellectual prostitutes” and “learned intellectual prostitutes” on page 211.

Why the Fall in Gold Prices Will Not Let Up

Here we take a quick break from our scheduled program so that I can brag a little and buttress the points I’ve been making about the gold market. Back in July of this year I pointed out that gold had stopped reacting to the QE programs at least since the inception of QE3. I also noted there that this was the primary signal I picked up on which told me that gold was probably in terminal decline.

Well, Business Insider have run a nice little collection of charts wherein they have allowed their top-rated analysts to pick what they think to be the most important chart in their particular field of research. I might run through some more of these charts in the coming days, but right now it might be worth seeing what Michael Widmer, Head of Metals Market Research at BoA Merrill Lynch has to say about the shiny metal,

Not bad for an amateur observer who casually watches this market from the back pages of the Financial Times…

Back tomorrow with regular programming when I will deflate my chest and return to being my humble self.

The CAPM and the Non-Ergodic Axiom

While doing my dissertation on constructing a new theory of asset-pricing I became exposed to some contemporary theories. To be frank, I didn’t really know how to integrate them because they seemed to be ether (a) intuitively incorrect or (b) useless for what I consider to be the real underlying dynamics of asset-pricing, or some combination of both. The CAPM was a combination of both.

It seems to me that the CAPM begs more questions than it answers. Or, at the very least, it restricts the field of inquiry to an extent which I do not think can be properly justified.

The model seeks to estimate a sort of “fair return” on a stock in the stock market. This is represented by what is called the Security Market Line (SML). Any really existing stock that falls above the SML is said to be undervalued (and should thus be bought), while any stock that falls below the SML is said to be overvalued (and should thus not be bought). Here is a graphical representation of the SML.

The point at which that line begins (the intercept), Rf, is the risk-free rate of return. We may think of this, perhaps, as the yield on treasuries or something similar. The Y-axis (vertical) represents the expected return on a given asset, E(Ri), while the X-axis (horizontal) represents the systemic risk or Beta. We will return to this latter component in a moment.

The SML then is the expected return on a well-diversified market portfolio. Thus any assets that are correctly priced will fall along the SML, while any that fall away from it are either over or undervalued.

The questions as regards the non-ergodic axiom begin when we ask what exactly we mean by expected returns, whether these be conceived of as expected returns for the market as a whole, E(Rm), which is represented by the SML, or as expected returns for an individual asset, E(Ri). From what I can tell, most people that use the CAPM derive these values from some sort of fundamental analysis. But the moment we take expectations and other interesting anomalies into account this becomes rather questionable. Although in theory these could be integrated by the analyst into the expected returns but at this point the estimation process becomes a subject of guesswork.

This is where we must come back to our Beta term. The Beta term is the covariance of the return on an individual asset and the market return, divided by the variance of the market return. Or,

To dejargonise that, what it measures is the sensitivity of the individual asset to moves in the market. What is of interest here is that if, say, the entire market moves by X amount what effect will this have on the individual asset.

This, I think, is where the non-ergodic axiom comes into full force. The assumption is that the relationship between moves in the market and in the individual asset are in some way fixed. But one would expect entirely the opposite to be the case.

Take a simple example. Let’s say that we learn that the government of a given country seeks to undertake a stimulus. Now, we know that this will likely boost the stock market of that country because the increased spending will accrue to companies as profits. Added to this, as GDP growth picks up we can be sure that this will boost confidence and so the animal spirits will have their effect too.

Now, let’s say that we want to try to maximise our returns by buying individual stocks in that market rather than just buying into an index fund. We learn from some rather vague announcements that the stimulus will include large outlays for health and infrastructure investment, specifically in the case of the latter, a light rail project. Well, we would then do well by buying up stocks that will be affected by those expenditures most immediately.

I don’t think what I have just said is in any way controversial. Indeed, it seems to me to be simply common sense. But it will mean that the Beta on such stocks will change drastically. Because the relationship between the market and these particular stocks will be differently affected by the coming stimulus we cannot assume that the past values of Beta will hold in the future. So, what will instead? We simply cannot say. But we can make a very intuitive guess and it will be in such a guess that a good deal of profit will be forthcoming.

Such above market profit is usually referred to in the CAPM jargon as “Alpha” and is thought to derive from the stock falling above the SML. But as we have just seen, such “Alpha” may be generated by a change in the underlying Beta due to non-quantifiable but nevertheless comprehensible shifts in the investment flows underlying the market.

Beta, as we have said, seeks to measure systemic risk, but I’m not fully convinced that it does. It also picks up, in a very real way, any changing relation between the overall market and the individual asset. The irony being, of course, that this is precisely what good investors should be interested in. In that very real sense the CAPM hides what is most interesting.

The model gives us a nice story. “Assuming that the relationship between how the market and the individual asset moves is held constant, here is a representation that will show us whether the individual asset is over or undervalued.” But it seems to me that often the most interesting and relevant information when picking a stock is to try to figure out where and when this relationship — the Beta — is about to shift and make a bet based on this.

I assume that others, especially those working in markets, will now chastise me. “Oh, you don’t get it at all. We don’t actually believe that the Beta is fixed or ergodic. We just use this as a rule-of-thumb.” Such may be the case. But I’m suspicious. I’ve seen too many times before how people using such devices become hypnotised and entranced by them. A clever clogs financier may think that they’re not being fooled by the assumptions of a model but, in my experience, the vast majority of the time the model has the last laugh.

The Economics of Counterfeit Money

Endogenous money theory, which is usually associated with the Post-Keynesian school of economics, has long told us that central banks do not control the supply of money in the economy. Instead the amount of money is determined by the demand for money which, in turn, is determined by the demand for credit. This idea, however, leaves out what is actually a rather important component: counterfeiting.

Of course, endogenous money theory is not at odds with the counterfeiting of money — after all, why would anyone counterfeit if it were not for their demand for money — but it is rarely discussed. I assume that the reason for this is that endogenous money theorists think that it is a small-scale phenomenon. But this is simply not the case; when one looks into it, it is actually extremely widespread. In Britain, for example, some 1% of banknotes are counterfeit, while one in thirty-three pound coins are fakes.

That is an enormous number, so why aren’t economists more aware of this? Well, it would seem that the central banks don’t want to be too vocal about this because, frankly, it undermines some of their perceived powers. The Independent says,

The Bank of England plays down the gravity of the situation. “It’s not serious,” said a spokesman. “Less than l per cent of the pounds 18bn of genuine money in circulation is fake.”

But those who run businesses disagree,

John Hall, head of security at the 1,700-strong Co-Operative Wholesale Society chain, reckons it is getting worse: “Over the last year, counterfeit money through our stores has jumped 20 per cent,” he said. “The quality of the forgeries has improved enormously and the counterfeiters have switched from photo-copying to computer-generated graphics, which give a cleaner image and are more difficult to detect.”

Clearly the Bank of England are trying to play down the problem. I would argue that this is not just because it undermines their perceived autonomy in controlling the money supply but also because, if examined carefully, money counterfeiting is actually in agreement with the Bank’s present policy goals.

One of the aims of the Quantitative Easing programs was to fill private banks with reserves so that they would loan them out and increase the quantity of money in circulation. This did not occur, but where the QE program fails, counterfeit money succeeds. There is no doubt that every time a £20 note is counterfeited it circulates in an identical manner to a real one, generating incomes and profits, until it is discovered and removed from circulation. In a time where even the central banks recognise that there is a major output-gap money counterfeiting actually goes some way to filling this.

So, what is the magnitude of this hidden stimulus? Well, in 2009 it is estimated that cash transactions totaled £266bn. In the same year, nominal GDP — that is GDP in nominal money terms — was estimated to be £1.417trn by the OECD. That means that about 19% of nominal GDP in 2009 was made up of cash payments. If we assume that 1% of these cash payments are counterfeit then about 0.19% of total nominal GDP is being driven by counterfeit payments in the UK.

In a world where every tenth of a percent of GDP growth matters, this is a not insignificant number. No wonder then, that economists at the Bank of England are so reticent to discuss the phenomenon of money counterfeiting in any detail.

Of course, I am not endorsing the counterfeiting of money. It obviously redistributes incomes to criminals. Nevertheless, one simply cannot deny that in an economy that is not operating at full capacity money counterfeiting adds to incomes.