Archive for the 'Economics' Category Page 2 of 6



Shackle on Rational Expectations

The Rational Expectations model in economics assumes that each economic agent (whether an individual or a company) can predict the future as perfectly as the modelers themselves.   To anyone living outside the rarified bubble of mathematical economics, this is simply ridiculous.   It is clear that no one associated with that theory has ever made any real business decisions, or suffered their consequences.

Here is non-mainstream economist George Shackle, writing to Bryan Hopkins on 1980-08-20:

‘Rational expectations’ remains for me a sort of monster living in a cave. I have never ventured into the cave to see what he is like, but I am always uneasily aware that he may come out and eat me. If you will allow me to stir the cauldron of mixed metaphors with a real flourish, I shall suggest that ‘rational expectations’ is neo-classical theory clutching at the last straw.

Observable circumstances offer us suggestions as to what may be the sequel of this act or that one. How can we know what invisible circumstances may take effect in time-to come, of which no hint can now be gained? I take it that ‘rational expectations’ assumes that we can work out what will happen as a consequence of this or that course of action. I should rather say that at most we can hope to set bounds to what can happen, at best and at worst, within a stated length of time from ‘the present’, and can invent an endless diversity of possibilities lying between them. [Italics in original]

Of course, unlike John Muth or Robert Lucas, Shackle had actual real-world experience of investment decision-making from his experience during WW II on national infrastructure planning.

Reference:

George L. S. Shackle [1980]:  Letter to Bryan Hopkins.  Quoted in:  Stephen L. Littlechild [2003]: Reflections on George Shackle:  Three Excerpts from the Shackle Collection.  The Review of Austrian Economics, 16 (1): 113-117.




De mortuis nil nisi bonum

In a posthumous tribute to one of my late university lecturers, I read:

His [name of university] years were characterised by his love and enthusiasm for teaching.  His dedication to his students was reciprocated in their affection for him.  The large Economics I classes that he taught (numbering in some cases up to 400 students) were legendary.”

Although I would prefer not to speak ill of the dead, these words are a distortion of the historical truth, or at the least, very incomplete.   The lecturer concerned was certainly legendary, but mostly for his vituperative disdain for anyone who did not share his extreme monetarist and so-called “economic rationalist” views.   It is true that I did not know ALL of my fellow economics students, but of the score or so I did know, no one I knew felt they received any affection from him, nor did they reciprocate any.   Indeed, those of us also studying pure mathematics thought him innumerate.   He once told us, in a thorough misunderstanding of mathematical induction, that any claim involving an unspecified natural number n which was true for n=1, n=2, and n=3 was usually true, more generally, for all n.  What about the claim that “n is a natural number less than 4“, I wondered.

As I recall, his lectures mostly consisted of declamations of monetarist mumbo-jumbo, straight from some University of Chicago seminar, given along with scorn for any alternative views, particularly Keynesianism.  But he was also rudely disdainful of  any viewpoint, such as many religious views, that saw value in social equity and fairness.   Anyone who questioned his repeated assertions that all human actions were always and everywhere motivated by self-interest was rebuked as naive or ignorant.

In addition to the declamatory utterance of such tendentious statements,  his lectures and lecture slides included very general statements marked, “Theorem“,  followed by words and diagrams marked, “Proof“.  A classic example of a “Theorem” was “Any government intervention in an economy leads to a fall in national income.”   His proof of this very large claim began with the words, “Consider a two-person economy into which a government enters . . . ”  The mathematicians in the class objected strongly that, at best, this was an example, not a proof, of his general claim.  But he shouted us down.  Either he was ignorant of the simplest forms of mathematical reasoning, or an ideologue seeking to impose his ideology on the class (or perhaps both).

I remained sufficiently angry about this perversion of my ideal of an academic discipline that I later wrote an article for the student newspaper about the intellectual and political compromises that intelligent, numerate, rational, or politically-engaged students would need to make in order to pass his course.   That such a lecturer should be remembered as an admirable teacher is a great shame.




Krugman speaking truth to power

When the economic history of the Great Global Recession of 2007- ? comes eventually to be written, let it be recorded that many of us were profoundly opposed from the outset to the economic austerity policies pursued by Governments and central banks in Europe and elsewhere. Not only are these policies selfish, class-based, and unfair, they are also ineffective. Those of us who had heard of Keynes knew they would be ineffective before they were tried. In the case of the “rescue” of southern and peripheral Europe by northern European troikas, they are also being imposed undemocratically and unfairly, rewarding northern European private investors and bank shareholders at the expense of ordinary southern European citizens. (The effective interest rates on troika loans to Greece, which are much higher than current market rates, are truly rapacious.)

Only a handful of economists in this period are speaking truth to power. The most prominent of these is Paul Krugman. He has nailed the bastards again, in this oped article last week. Some excerpts:

The bad metaphor — which you’ve surely heard many times — equates the debt problems of a national economy with the debt problems of an individual family. A family that has run up too much debt, the story goes, must tighten its belt. So if Britain, as a whole, has run up too much debt — which it has, although it’s mostly private rather than public debt — shouldn’t it do the same? What’s wrong with this comparison?

The answer is that an economy is not like an indebted family. Our debt is mostly money we owe to each other; even more important, our income mostly comes from selling things to each other. Your spending is my income, and my spending is your income.”

Krugman could also have added that most families, unlike Governments, cannot increase their income by increasing their spending.

So what happens if everyone simultaneously slashes spending in an attempt to pay down debt? The answer is that everyone’s income falls — my income falls because you’re spending less, and your income falls because I’m spending less. And, as our incomes plunge, our debt problem gets worse, not better.

This isn’t a new insight. The great American economist Irving Fisher explained it all the way back in 1933, summarizing what he called “debt deflation” with the pithy slogan “the more the debtors pay, the more they owe.” Recent events, above all the austerity death spiral in Europe, have dramatically illustrated the truth of Fisher’s insight.

And there’s a clear moral to this story: When the private sector is frantically trying to pay down debt, the public sector should do the opposite, spending when the private sector can’t or won’t. By all means, let’s balance our budget once the economy has recovered — but not now. The boom, not the slump, is the right time for austerity.

As I said, this isn’t a new insight. So why have so many politicians insisted on pursuing austerity in slump? And why won’t they change course even as experience confirms the lessons of theory and history?

Well, that’s where it gets interesting. For when you push “austerians” on the badness of their metaphor, they almost always retreat to assertions along the lines of: “But it’s essential that we shrink the size of the state.”

Now, these assertions often go along with claims that the economic crisis itself demonstrates the need to shrink government. But that’s manifestly not true. Look at the countries in Europe that have weathered the storm best, and near the top of the list you’ll find big-government nations like Sweden and Austria.

And if you look, on the other hand, at the nations conservatives admired before the crisis, you’ll find George Osborne, Britain’s chancellor of the Exchequer and the architect of the country’s current economic policy, describing Ireland as “a shining example of the art of the possible.” Meanwhile, the Cato Institute was praising Iceland’s low taxes and hoping that other industrial nations “will learn from Iceland’s success.”

So the austerity drive in Britain isn’t really about debt and deficits at all; it’s about using deficit panic as an excuse to dismantle social programs. And this is, of course, exactly the same thing that has been happening in America.

In fairness to Britain’s conservatives, they aren’t quite as crude as their American counterparts. They don’t rail against the evils of deficits in one breath, then demand huge tax cuts for the wealthy in the next (although the Cameron government has, in fact, significantly cut the top tax rate). And, in general, they seem less determined than America’s right to aid the rich and punish the poor. Still, the direction of policy is the same — and so is the fundamental insincerity of the calls for austerity.

The big question here is whether the evident failure of austerity to produce an economic recovery will lead to a “Plan B.” Maybe. But my guess is that even if such a plan is announced, it won’t amount to much. For economic recovery was never the point; the drive for austerity was about using the crisis, not solving it. And it still is.”




Alan Greenspan in 2004

Alan Greenspan, then Chairman of the US Federal Reserve Bank System, speaking in January 2004, discussed the failure of traditional methods in econometrics to provide adequate guidance to monetary policy decision-makers.   His words included:

Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy.”

The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario.”




Digital aspen forests

Brian Arthur has an article about automated and intelligent machine-to-machine communications creating a second digital economy underlying the first physical one, in the latest issue of The McKinsey Quarterly here.

I want to argue that something deep is going on with information technology, something that goes well beyond the use of computers, social media, and commerce on the Internet. Business processes that once took place among human beings are now being executed electronically. They are taking place in an unseen domain that is strictly digital. On the surface, this shift doesn’t seem particularly consequential—it’s almost something we take for granted. But I believe it is causing a revolution no less important and dramatic than that of the railroads. It is quietly creating a second economy, a digital one.

. . . .

We do have sophisticated machines, but in the place of personal automation (robots) we have a collective automation. Underneath the physical economy, with its physical people and physical tasks, lies a second economy that is automatic and neurally intelligent, with no upper limit to its buildout. The prosperity we enjoy and the difficulties with jobs would not have surprised Keynes, but the means of achieving that prosperity would have.

This second economy that is silently forming—vast, interconnected, and extraordinarily productive—is creating for us a new economic world. How we will fare in this world, how we will adapt to it, how we will profit from it and share its benefits, is very much up to us.”

Reference:

W. Brian Arthur [2011]:  The Second EconomyThe McKinsey Quarterly, October 2011.




O ignorance! O mores!

In the last few weeks, it was reported that mathematician Edward Nelson of Princeton had claimed to show that Peano Arithmetic, one of many possible axiomatic systems for the numbers, was internally inconsistent.   Within a short period, his claim and proof were subject to examination by other pure mathematicians, not least Terence Tao of UCLA, who thought Nelson’s argument had potential flaws.   Nelson initially defended himself and then, accepting the criticisms, retracted his claim.  More details can be found in a post by John Baez on the n-category blog, which initiated a dialog in which both Tao and Nelson participated, and where Nelson announced his retraction.   A subsequent discussion of what happened in this dialog and the lessons for the philosophy of mathematics can be found on the blog of Catarina Dutilh Novaes, a discussion to which Tao again contributed, this time on his methods.

This example of fast proposal-criticism-retraction contrasts sharply with mainstream Economics, where an error in deductive reasoning may be pointed out, with neither retraction nor revision nor apparent learning from its adherents 70 years on.  Keynes’ criticisms of conventional austerity economics were first uttered in the 1930s, and yet they still have to be repeatedRelcalcitrant ignorance indeed.

One of the key insights of Keynesian economics is that a government is not like a household:  Governments can increase their income by increasing their spending, something most households cannot do.   Another key insight is that the effect of one person doing something may be very different if many people also do it.  To see better at a baseball stadium, for instance, you can stand up, but this only works if the people in front of you stay seated; if everyone stands, you will see no better than if everyone stayed seated.    Likewise, the economy-wide effects of individuals saving may be deleterious even when the effects are beneficial for an individual.   Keynes called this the savings trap.  Instead of learning from such insights, we get a British Prime Minister telling us all in 2011 to save hard and reduce our personal debt, and treating the national budget as if he were running a a household in Grantham.




Recalcitrant ignorance in economics

British business economist John Kay has written an essay for the Institute for New Economic Thinking on the failures of mainstream macro-economics.   Among many insightful comments, there is this:

What Lucas means when he asserts that deviations are ‘too small to matter’ is that attempts to construct general models of deviations from the efficient market hypothesis – by specifying mechanical trading rules or by writing equations to identify bubbles in asset prices – have not met with much success.  But this is to miss the point: the expert billiard player plays a nearly perfect game, but it is the imperfections of play between experts that determine the result.  There is a – trivial – sense in which the deviations from efficient markets are too small to matter – and a more important sense in which these deviations are the principal thing that matters.”

Mostly agreeing with Kay, Paul Krugman repeats a point he has made before about the freshwater economists — their failure to understand the deductive implications of their own models:

Here’s what we agree on: if consumers have perfect foresight, live forever, have perfect access to capital markets, etc., then they will take into account the expected future burden of taxes to pay for government spending. If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

But suppose that the increase in government spending is temporary, not permanent — that it will increase spending by $100 billion per year for only 1 or 2 years, not forever. This clearly implies a lower future tax burden than $100 billion a year forever, and therefore implies a fall in consumer spending of less than $100 billion per year. So the spending program IS expansionary in this case, EVEN IF you have full Ricardian equivalence.”

As Krugman says:

The fact that these guys don’t even get the implications of their own models right tells us that the problem runs deeper than believing too much in abstract math. At some level it has to be political: they want to declare government policy ineffectual so badly that for all their vaunted modeling mojo they can’t be bothered to think it through, or listen to other people who point out their error.”




The macroeconomic dark ages

Paul Krugman, writing about the failings of macro-economists before and after the Great Recession, notes the wide social consequences of the pro-abstraction, anti-history turn in the study of economics this last half-century.   Sadly, this turn has been another instance of the dominance of Descartian autism in western intellectual culture.

Early in 2009, when the Obama stimulus was under discussion, I was stunned to read statements from a number of well-regarded economists asserting not merely that the plan was a bad idea in practice — a defensible idea — but that debt-financed government spending could not, in principle, raise overall spending. Here’s John Cochrane:

Continue reading ‘The macroeconomic dark ages’




Networks of Banks

The first plenary speaker at the 13th International Conference on E-Commerce (ICEC 2011) in Liverpool last week was Robert, Lord May, Professor of Ecology at Oxford University, former Chief UK Government Scientific Advisor, and former President of the Royal Society.  His talk was part of the special session on Robustness and Reliability of Electronic Marketplaces (RREM 2011), and it was insightful, provocative and amusing.

May began life as an applied mathematician and theoretical physicist (in the Sydney University Physics department of Harry Messel), then applied his models to food webs in ecology, and now finds the same types of network and lattice models useful for understanding inter-dependencies in networks of banks.  Although, as he said in his talk, these models are very simplified, to the point of being toy models, they still have the power to demonstrate unexpected outcomes:  For example, that actions which are individually rational may not be desirable from the perspective of a system containing those individuals.  (It is one of the profound differences between Computer Science and Economics, that such an outcome would be unlikely to be surprising to most computer scientists, yet seems to be so to mainstream Economists, imbued with a belief in metaphysical carpal entities.)

From the final section of Haldane and May (2011):

The analytic model outlined earlier demonstrates that the topology of the financial sector’s balance sheet has fundamental implications for the state and dynamics of systemic risk. From a public policy perspective, two topological features are key.

First, diversity across the financial system. In the run-up to the crisis, and in the pursuit of diversification, banks’ balance sheets and risk management systems became increasingly homogenous. For example, banks became increasingly reliant on wholesale funding on the liabilities side of the balance sheet; in structured credit on the assets side of their balance sheet; andmanaged the resulting risks using the same value-at-risk models. This desire for diversificationwas individually rational from a risk perspective. But it came at the expense of lower diversity across the system as whole, thereby increasing systemic risk.Homogeneity bred fragility (N. Beale and colleagues, manuscript in preparation).

In regulating the financial system, little effort has as yet been put into assessing the system-wide characteristics of the network, such as the diversity of its aggregate balance sheet and risk management models. Even less effort has been put into providing regulatory incentives to promote diversity of balance sheet structures, business models and risk management systems. In rebuilding and maintaining the financial system, this systemic diversity objective should probably be given much greater prominence by the regulatory community.

Second, modularity within the financial system. The structure of many non-financial networks is explicitly and intentionally modular.  This includes the design of personal computers and the world wide web and the management of forests and utility grids. Modular configurations prevent contagion infecting the whole network in the event of nodal failure. By limiting the potential for cascades, modularity protects the systemic resilience of both natural and constructed networks.

The same principles apply in banking. That is why there is an ongoing debate on the merits of splitting banks, either to limit their size (to curtail the strength of cascades following failure) or to limit their activities (to curtail the potential for cross-contamination within firms). The recently proposed Volcker rule in the United States, quarantining risky hedge fund, private equity and proprietary trading activity from other areas of banking business, is one example of modularity in practice. In the United Kingdom, the new government have recently set up a Royal Commission to investigate the case for encouraging modularity and diversity in banking ecosystems, as a means of buttressing systemic resilience.

It took a generation for ecological models to adapt. The same is likely to be true of banking and finance.”

It would be interesting to consider network models which are more realistic than these toy versions, for instance, with nodes representing banks with goals, preferences and beliefs.

 

References:

F. Caccioli, M. Marsili and P. Vivo [2009]: Eroding market stability by proliferation of financial instruments. The European Physical Journal B, 71: 467–479.

Andrew Haldane and Robert May [2011]: Systemic risk in banking ecosystems. Nature, 469:  351-355.

Robert May, Simon Levin and George Sugihara [2008]: Complex systems: ecology for bankers. Nature, 451, 893–895.

Also, the UK Government’s 2011 Foresight Programme on the Future of Computer Trading in Financial Markets has published its background and working papers, here.

 




Markets as feedback mechanisms

I just posted after hearing a talk by economic journalist Tim Harford at LSE.  At the end of that post, I linked to a critical review of Harford’s latest book,  Adapt – Why Success Always Starts with Failure, by Whimsley.  This review quotes Harford talking about markets as feedback mechanisms:

To identify successful strategies, Harford argues that “we should not try to design a better world. We should make better feedback loops” (140) so that failures can be identified and successes capitalized on. Harford just asserts that “a market provides a short, strong feedback loop” (141), because “If one cafe is ordering a better combination of service, range of food, prices, decor, coffee blend, and so on, then more customers will congregate there than at the cafe next door“, but everyday small-scale examples like this have little to do with markets for credit default swaps or with any other large-scale operation.

Yes, indeed.  The lead-time between undertaking initial business planning in order to raise early capital investments and the launching of services to the  public for  global satellite communications networks is in the order of 10 years (since satellites, satellite networks and user devices need to be designed, manufactured, approved by regulators, deployed, and connected before they can provide service).  The time between initial business planning and the final decommissioning of an international gas or oil pipeline is about 50 years.  The time between initial business planning and the final decommissioning of an international undersea telecommunications cable may be as long as 100 years.   As I remarked once previously, the design of Transmission Control Protocol (TCP) packets, the primary engine of communication in the 21st century Internet, is closely modeled on the design of telegrams first sent in the middle of the 19th century.  Some markets, if they work at all, only work over the long run, but as Keynes famously said, in the long run we are all dead.

I have experience of trying to design telecoms services for satellite networks (among others), knowing that any accurate feedback for design decisions may come late or not at all, and when it comes may be vague and ambiguous, or even misleading.   Moreover, the success or failure of the selected marketing strategy may not ever be clear, since its success may depend on the quality of execution of the strategy, so that it may be impossible to determine what precisely led to the outcome.   I have talked about this issue before, both regarding military strategies and regarding complex decisions in general.  If the quality of execution also influences success (as it does), then just who or what is the market giving feedback to?

In other words, these coffees are not always short and strong (in Harford’s words), but may be cold, weak, very very slow in arriving, and even their very nature contested.   I’ve not yet read Harford’s book, but if he thinks all business is as simple as providing fmc (fast-moving consumer) services, his book is not worth reading.

Once again, an economist argues by anecdote and example.  And once again, I wonder at the world:  That economists have a reputation for talking about reality, when most of them evidently know so little about it, or reduce its messy complexities to homilies based on the operation of suburban coffee shops.