• Robert Marks [2010]:  A timeline of the Global Financial Crisis. (Initial version published in the Australian Journal of Management, and since updated.)
• Larissa MacFarquhar [2010]:  The deflationist:  How Paul Krugman found politics.  The New Yorker, 2010-03-01, pp. 38-49
• John Lanchester [2009]:  Outsmarted:  high finance vs. human nature.  The New Yorker, 2009-06-01, pp. 83-87.
• Anon [2009]: The other-wordly philosophers.  The Economist, 2009-07-18/24, pp. 70-72.
• Anon [2009]: Efficiency and beyond.  The Economist, 2009-07-18/24, pp. 73-74.
• John Cassidy [2010]:  After the Blow-Up:  Laissez-faire economists do some soul-searching – and finger-pointing.  The New Yorker, 2010-01-11, pp. 28-33.
• Paul Krugman [2009]: How did economists get it so wrong? The New York Times, 2009-09-06.
• J. Doyne Farmer and Duncan Foley [2009]: The economy needs agent-based modeling. Nature, 460, 685-686 (2009-08-06).
• Mark Buchanan [2009]: Economics: meltdown modeling. Nature, 460, 680-682 (2009-08-06).
• Jonathan Jarvis [2009]:  Crisis of Credit (Animation).

An excerpt from Kay’s column:

Both the efficient market hypothesis and DSGE [Dynamic Stochastic General Equilibrium models] are associated with the idea of rational expectations – which might be described as the idea that households and companies make economic decisions as if they had available to them all the information about the world that might be available. If you wonder why such an implausible notion has won wide acceptance, part of the explanation lies in its conservative implications. Under rational expectations, not only do firms and households know already as much as policymakers, but they also anticipate what the government itself will do, so the best thing government can do is to remain predictable. Most economic policy is futile.

So is most interference in free markets. There is no room for the notion that people bought subprime mortgages or securitised products based on them because they knew less than the people who sold them. When the men and women of Goldman Sachs perform “God’s work”, the profits they make come not from information advantages, but from the value of their services. The economic role of government is to keep markets working.

These theories have appeal beyond the ranks of the rich and conservative for a deeper reason. If there were a simple, single, universal theory of economic behaviour, then the suite of arguments comprising rational expectations, efficient markets and DSEG would be that theory. Any other way of describing the world would have to recognise that what people do depends on their fallible beliefs and perceptions, would have to acknowledge uncertainty, and would accommodate the dependence of actions on changing social and cultural norms. Models could not then be universal: they would have to be specific to contexts.

The standard approach has the appearance of science in its ability to generate clear predictions from a small number of axioms. But only the appearance, since these predictions are mostly false. The environment actually faced by investors and economic policymakers is one in which actions do depend on beliefs and perceptions, must deal with uncertainty and are the product of a social context. There is no universal economic theory, and new economic thinking must necessarily be eclectic. That insight is Keynes’s greatest legacy.

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But then, once the flirtation and seduction are over, her flaws become evident. I have been thinking about these flaws again, having just read Deirdre McCloskey’s superb 2002 pamphlet, The Secret Sins of Economics.  Many of McCloskey’s criticisms are ones I (and many others) have made before, but some are new.   I decided, for comparison, to list here my chief complaints with this blemished beauty, this feline seductress, Our Lady of the Catallacts.  Date her if you wish, but you should read these accounts by her ex-lovers before you do.

First, she is blinkered, often unable to see what is obvious to anyone else – that we are all shaped by social and cultural forces, and peer pressures.   Instead, Catwoman and her acolytes invariably assume an individualist explanation for any economic or social phenomenon, and then seek to demonstrate it.  McCloskey calls this a focus on the P-variables (price, individual prudence, profit, the profane) as distinct from the S-variables (solidarity, speech, stories, shame) which Anthropology, that Indiana Jones of academic disciplines – creative, unruly, a thorn in everyone else’s side – has focused on.   A classic example is Levitt and Dubner’s Freakonomics.

Because of her blindness to the social, Cat Lady mostly ignored (until recently) major aspects of society, such as Institutions, legal frameworks, norms, and power relationships, aspects which can make or fail the marketplaces she says she studies.   She can’t claim that no one mentioned these to her, since 19th-century economists such as Karl Marx made the study of these aspects the work of a lifetime, and their study has continued to the present by sociologists and anthropologists and political scientists.

She has also been blind to anything historical or temporal, as if all her work stood outside the mundane and messy world in which we live.  This blindness manifests itself most strongly in the complete disregard (until recently) for endowments:  how did we get to where we are?  So, for example, free trade theory says that if England produces textiles more cheaply than Portugal, and Portugal produces wine more cheaply then England, the two should trade textiles for wine, and wine for textiles.   And the choice of these products is a subtly clever one, obfuscating much, since wine needs sunshine and not too much rain, while textiles (in the 18th and early 19th centuries) needed lots of rain, in order that the damp air would ensure cotton threads did not break when woven by machines.   So, Portugal’s sunshine and Northern England’s rain, being part of the God-given climate, were natural advantages, beyond the control or manipulation of any temporal human powers.  Free trade seems to have been ordained by the Almighty. But why consider only England’s textiles and not Ireland’s?    The answer is that Ireland had no textile industry to speak of.  And just why is that?  After all, much of Ireland is as damp as the valleys of Lancashire.   The reason is that the owners of northern English textile factories lobbied the British authorities to exclude Irish-made textiles from entering England.  When Ireland lost its own Parliament in a hostile takeover by Westminster, this protectionism for English textiles was entrenched, and the growing British Empire provided the critical masses of customers to ensure bonuses in Bury and Bolton and Burnley.     (Is it any wonder that people in Ireland and India and elsewhere sought Independence, when colonialism so powerfully stifled economic aspirations.)  Northern England has no natural comparative advantage in textile production, at least, not when compared to Ireland, but an artificial, man-made advantage.  The same type of advantage, in fact, that South Korea today has in ship-building, or the USA in most computer and aerospace technologies.   Where, in the mainstream theory of free trade, are these aspects studied, or even mentioned?

And when, angered by these failings, you face her with them, the wench promises you that that was all in the past, and she will be different from now on.  Path dependence and network goods and institutional economics are all the rage, she says.   But then you find, she’s still up to her old tricks:  She says she’s building models of economic phenomena in order to understand, predict and control, just like physicists do.  But, although it looks like that’s what she’s doing, in fact her models are not models of real phenomena, but models of stylized abstractions of phenomena.  Her acolytes even use that very word – stylized – to describe the “facts” which they use to calibrate or test their models.

Of course, she will say, physicists do this too.  Newton famously assumed the planets were perfect spheres in order to predict their relative movements using his theory of gravitation.   But physicists later relax their assumptions, in order to build revised models, in a process that has continued since Newton to the present day.  Physicists also allow their models to be falsified by the data they collect, even when that data too is stylized, and overturned.     Instead, Catwoman is still assuming that people are maximizers of individual utility, with perfect foresight and unlimited processing capabilities, obeying the axiom of the irrelevance of independent alternatives, when all these assumptions have been shown to be false about us.   When was the last time a mainstream economic model was overturned?

Indeed, here is another of her flaws:  her loose grasp of reality.  She says we are always, all of us, acting in our own self-interest.  When you quiz this, pointing out (say) a friend who donated money to a charity, she replies that he is making himself feel better by doing something he thinks virtuous, and thus is maximizing his own self-interest.  Her assumption, it turns out, is unfalsifiable.   It is also naive and morally repugnant – and false!  Anyone with any experience of the world sees through this assumption straight away, which is why I think our feline friend is borderline autistic.   She just does not know much about real people and how they interact and live in the word. Who would want to step out with someone having such views, and unable to reconstruct them in the light of experience?

And, despite her claims to be grounded in the material world (Paul Samuelson:  “Economics is the study of how people and society end up choosing, with or without the use of money, to employ scarce productive resources that would have alternative uses,  . . .”), she sure is fond of metaphysical entities for which no hard evidence exists:  invisible hands, equilibria, perfect competition, free trade, commodities, in fact, the whole shebang.   As marketers say, the existence of a true commodity is evidence that a marketing manager is not doing his or her job.  In comparison, Richard Dawkins with his memes is a mere amateur in this creation of imaginary objects for religious veneration.

One could perhaps accept the scented candles and the imaginary friends if she was a little more humble and tolerant of the opinions of others.  But no, the feline femme fatale and her acolytes are among the most arrogant and condescending of any academic disciplines.  Read the recovering Chicago economist McCloskey for an account of this, if you don’t believe me.   McCloskey’s anecdotes and experiences were very familiar to me, especially that sneer from an economist who thinks you’ve not acted in your own self-interest – for example, by helping your colleagues or employer with something you are not legally required to do.  Indeed, the theft by economists from philosophers of the word “rational” to describe a very particular, narrow, autistic behavior is the best example of this.   Anyone whose behavior does not fit the models of mainstream economics can be thus be labeled irrational, and dismissed from further consideration as if insane.

Date her at your peril!  You have been warned!

If Akerlof and Shiller’s grip on the history of economic thought is shaky, they also fail to grasp why Keynes rejected the idea that markets are self-stabilising. Throughout Animal Spirits they portray him as reintegrating psychology with economic theory. No doubt this was one of Keynes’s goals, but it is not his most fundamental revision of economic orthodoxy. Among his other accomplishments he was the author of A Treatise on Probability (1921), in which he tried to develop a theory of ‘rational degrees of belief’. By his own account he failed, and in his canonical General Theory of Employment, Interest and Money (1936) he concluded that there was no way anyone could make forecasts. Future interest rates and prices, new inventions and the likelihood of a European war cannot be predicted: there is no ‘basis on which to form any calculable probability whatever. We simply do not know!’ For Keynes, markets are unstable less because they are driven by emotion than because the future is unknowable. To suggest that the source of market volatility is unreason is to imply that if people were fully rational markets could be stable. But even if people were affectless calculating machines they would still be ignorant of the future, and markets would still be volatile. The root cause of market instability is the insuperable limitation of human knowledge.

Later economists have made much of a distinction between risk, which can be assessed in terms of quantifiable likelihood, and uncertainty, where probabilities cannot be attached to possible outcomes. The trouble is that when attempting to forecast the course of the economy we often cannot confidently distinguish between the two. Even our list of possible outcomes may turn out to have omitted the ones that are most important in shaping events. Such an omission was one of the factors that led Long-Term Capital Management, a highly leveraged hedge fund set up by two Nobel Prize winning economists, to fail in 1998-2000. The information used in applying the formula did not include the possibility of such events as the Asian financial crisis and Russia’s default on its sovereign debt, which destabilised global financial markets and helped destroy the fund. The orthodoxy that came unstuck with the collapse of LTCM was not faulty because it neglected the vagaries of human moods; its mistake was to think that the unknown future could be turned into a set of calculable risks and, in effect, conjured out of existence, which was impossible. Several centuries earlier, Pascal – one of the founders of probability theory – had come to the same conclusion, when in the Pensées he asks ironically: ‘Is it probable that probability brings certainty?’

The central flaw of the economic orthodoxy against which Keynes fought in the 1930s was to imagine that an insoluble problem – human ignorance of the future – had been solved. The error was repeated in the 1990s, when economists came to believe that complex mathematical formulae could tame uncertainty in the murky world of derivatives. Steeped in history as they were, this was a delusion that none of the classical economists entertained. It began to shape economics only towards the end of the 19th century, with the rise of Positivism, according to which the natural sciences are the only legitimate repository of human knowledge. It was the formative influence of this philosophy on the Chicago School that enabled the orthodoxy of the 1930s to re-emerge triumphant, and the result was an immense boost to the prestige of economics as a discipline. Economists could claim to be scientists, who with the aid of their mathematical magic could pierce the veil that conceals the future.

The hegemony of Positivism in economics obscured Keynes’s scepticism about probabilistic knowledge, his most important contribution to the discipline. G.L.S. Shackle set Keynes’s argument out systematically in his neglected masterpiece Epistemics and Economics: A Critique of Economic Doctrines (1972). Shackle is probably the only significant economist to have been influenced both by Keynes and by his arch-rival, F.A. Hayek. He knew both of them well, but argued that neither had digested the full implications for economics of our ignorance of the future. Hayek said that governments could never know enough to plan the economy successfully – a claim vindicated by the miserable record of central planning in Communist countries. At the same time, he attributed near omniscience to markets, and never doubted that if left to its own devices the economy would liquidate mistaken investments and return to equilibrium. Against this, Keynes had shown that there is no market mechanism that ensures revival; economic contraction can be self-reinforcing, and only government action can then create a way out.

Shackle took Keynes’s argument a step further, and showed that no economic policy can ensure economic stability indefinitely. ‘Keynesian’ policies are no exception to this rule. Deficit financing and monetary expansion may have worked well in the conditions that existed after the Second World War. It is not clear that they will be so effective today, when globalisation has brought a freedom of capital movements that did not exist then. The lesson of Shackle is that we must be resourceful in devising new remedies, while not losing sight of the fact that none of them works for long.

Akerlof and Shiller claim that their account of the role of psychology helps to explain the financial crisis. ‘Our theory of animal spirits,’ they say, ‘provides an answer to a conundrum: why did most of us utterly fail to foresee the current economic crisis? How can we understand this crisis when it seems to have come out of the blue with no cause?’ They are right that part of the answer lies in an intellectual default within economics, but they seem oblivious of the role of ideology in producing this default. The deformation of economics was not the result only of factors internal to the discipline, it was also part of the short-lived Western triumphalism that followed the end of the Cold War.

. . .

Keynes and the classical economists before him knew that there is no realm of market exchange that obeys laws of the kind that can be formulated in the natural sciences. Economics and politics are not separate branches of human activity, and economic life cannot be studied independently of social divisions and political conflicts among populations, along with their cultures and religions. Familiar to Keynes and most of the economists of his generation, these truisms have been forgotten, or rejected, by many economists today. The result is an economic imperialism that tries to explain every human activity in terms of a conception of rational action that does not work even when applied to the behaviour of markets.

Of course, there is a standard response to these observations, which is that unrealism in economic theories doesn’t matter. As developed by Milton Friedman, among others, this is in effect a version of instrumentalism, a tenable position in the philosophy of science. For instrumentalists, the goal of science is not a true representation of the world; it is to organise our observations into a theoretical framework that serves practical goals, such as prediction and control. But what practical goals have been served by the type of economics dominant over the past two decades? It has been useful neither in making predictions nor in responding to unforeseen developments.

Akerlof and Shiller intend their analysis to contribute to an intellectual reformation in economics, as a consequence of which the discipline will become more useful to policy-makers. It must be doubted, though, that the authors will succeed in persuading economists of the inadequacy of the conception of rational action. The profession is one of the few areas of human activity in which that conception is applicable. In its intra-academic varieties, at any rate, economics is insulated from the world not only by its narrow explanatory methodology but also because it rewards the mathematical modelling that resulted in nearly all of its members failing to anticipate the financial crisis. As institutionalised in universities, the notion of rational decision-making is self-perpetuating. Economics as currently practised may have only a slight grip on market behaviour, but it seems to be powerfully predictive of the behaviour of economists.”

Reference:

John Gray [2009]: We Simply Do Not Know!  London Review of Books,  31 (22): 13-14, 19 November 2009.  Review of: Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, by George Akerlof and Robert Shiller. (Princeton).

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