Economics

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The Lucas Mystique

There is this thing in economics called the Lucas Critique. You see it pop up every so often and hear it referred to in revered tones. It is, apparently, very important and very, very, insightful. It has a lot to do with the state of economics today. Which, as you know, I think of as being lamentable.

What is this Critique?

Well, in a nutshell, it says that there are special features of an economy that are “deep”, by which it means they don’t move about in the face of policy changes. Other features, presumably the “shallow” ones do. This is important because it implies that policy makers have to be sure that the things they are trying to influence don’t slip and slide about too much in reaction to their policies and, in effect, neutralize those policies. In short: Lucas says people take policy into account, make suitable adjustments, and thus render some – if not all – policies ineffective.

Not quite. The only policies that are ineffective are those that are based on those “shallow” features. Which, it turns out, happens to be pretty much anything Keynesian.

Why?

Because Keynes focused on macro effects and dealt with large scale or aggregate features of the economy. Things like aggregate demand for instance. He didn’t spend much time mucking around with the behaviors of individual people of businesses. Or, at least, he felt comfortable dealing with aggregates and presumed they had analytical validity. Lucas argued that such aggregates are not “deep” because they do not take into account the possible adjustments made by people and firms when confronted by policy changes.

To get around this problem Lucas and his followers urged economists to rebuild their models of the economy – the ones used for policy advice – on the more substantial “deep” features that offered a more concrete basis for analysis. Since these were presumed to be those features theorized about within what is called microeconomics, new models of the economy, and therefore macroeconomics, had to henceforth be built on what is nowadays called a “micro-foundation”.

How nice.

Or at least it would be were those micro foundations worth a lick. Which they aren’t. They are absurd. What the Lucas Critique effectively reduced economics to was a combination of applied math  built on top of the results of what is a kind of psychology. Bad psychology. Other worldly psychology. Economists who operate within the confines set by the Lucas Critique build huge model superstructures on the decidedly sandy foundations of nutty and wholly unrealistic views of how people act.

Since real people tend to be a little idiosyncratic, odd, and sometimes unreliable, and since it is difficult to model such traits, economists swept them under the carpet and hypothesized something altogether different. That something being easier to fit into mathematical models and thus manipulate.

Since economists find it easier to model rational behavior, people became rational in the models. And not just rational in the manner of being sensible, but hyper rational in the manner of being an automaton.

Since people sometimes differ even when they’re being rational, economists decided to use only one – a “representative” – in their models. They did the same for businesses. Not only this, they decided that all the goods and services in the economy – hair cuts and motor cars – are substitutes for each other. This helps get around the knotty problem of what people do when they make decisions on what to spend they money on. Not that economists allow them to change their minds in the models. And not that money is ever really built in either. Getting rid of money was quite a coup because it meant economists didn’t have to worry about why people might not spend everything they earned. Instead economists could simply focus on a moneyless economy and study “real” things like widgets and corn bushels. You know, the stuff we all buy.

These micro-founded models are the ones that failed to predict the crash. No wonder. They are “deep”. So deep they are lost in the mud at the bottom of a very deep and opaque analytical imaginary world where the light of the real world never penetrates.

Nonetheless the Critique stands proudly as a totem of great insight.

It provides cover for those who want to deny the real world. Those who deny that the whole is greater than the sum of its parts. Those who deny that properties emerge at various levels of aggregation and are not thus based on anything below them. Those who prefer to deny that humans are diverse and complicated. Those who prefer to limit themselves the very special circumstances of the highly unlikely possibility of an equilibrium. Those who are desperate to laud market magic as the panacea to all that ails an economy. And those who, for some unimaginable reason, seem to think that modern economics has something useful to say about a society’s ability to accrue and distribute wealth.

The Critique is not a critique. It is a mystery. A Mystique. Another of a line of great sounding insights that melt into commonsensical vapor when probed. Of course we ought to take people into account when we model an economy. Of course their reactions to policy matter. Duh. Only an economist would think this is an insight worthy of having a special name.

Lucas gave his critique in the context of his program to introduce rational expectations into economics., but his critique does not depend on rationality. It depends simply on the observation that people have expectations and adjust them when the suite of facts they face changes. Wow. People change their minds periodically. Who knew?

Economics has endured an epic decades long journey into irrelevance partially instigated by the Lucas Critique, and the paraphernalia of the micro-foundations it elevated to canonical status. Meanwhile Keynesian analysis has reemerged as the relevant focal point for policies that actually solve problems.

Lucas lost. Critique and all.

Now, if only we could get people to understand that “market clearing” and “equilibrium” are not the same thing. But that’s another topic.

 

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Too Big To Prosecute?

Add another advantage to being a big business: apparently you’re too big to prosecute. I came across an article in the New York Time’s DealBook concerning the deal being made between JP Morgan Chase and the government. The bank had, it seems, turned a rather blind eye to the evil machinations of Bernie Madoff and his epic fraud.

So far so good. Banks are supposed to be on the look out for such schemes and to blow the whistle rather than fatten up on fees derived from them.

But here’s the rub:

According to the article prosecutors came perilously close to filing a criminal complaint, but demurred because of the potential unintended consequence of having the entire bank unravel and collapse. This has been a fear of the government’s since its pursuit of Arthur Andersen over its negligence with respect to  Enron drove it out of business. Andersen’s demise cost us 28,000 jobs, although I doubt any were lost long term. here’s the relevant paragraph from the article:

“The government has been reluctant to bring criminal charges against large corporations, fearing that such an action could imperil a company and throw innocent employees out of work. Those fears trace to the indictment of Enron’s accounting firm, Arthur Andersen, which went out of businesses after its 2002 conviction, taking 28,000 jobs with it. Ever since, prosecutors have increasingly relied on deferred-prosecution agreements, which rebuke companies without threatening their health. …”

This strikes me as yet another example of the way in which big business benefits from absurd and unjustified deference from our regulators. A smaller business or an individual would, most likely, not have been treated so politely. After all if a corporation is an individual for the precise purpose of presenting the public with a prosecutable “person” – which was the old premiss for treating a business as a person before the Supreme Court mistook money for free speech in the Citizen’s United case – then the knock on effect of lost jobs ought not play a factor. There is muddled logic afoot.

If a company is a single person for legal purposes, it cannot also be several thousand people for economic purposes. If we are so concerned about all those jobs, then we need to open up the company and allow a more direct prosecution of individuals who commit crimes on its behalf. We prosecute individuals within corporations for their personal crimes all the time, so we have no problem seeing a difference between crimes committed by the business and crimes committed by people who happen to work for the business. The Madoff case seems to be one where the prosecutors think the business itself committed crimes, or at least transgressed the law, and yet refuse to follow up fully on that thought for fear of consequences that are outside of the proscribed punishments.

So JP Morgan Chase gets away with it, not because the prosecution thought it was innocent, but because it is so darned large and might cause a knock-on panic on Wall Street.

Now I get that the prosecutorial hesitancy might be based on the higher standards of proof required in a criminal case, but the article clearly implies it was more than this. I hope not. I would hate to think our regulators were so afraid of big banks that the quiver and quake rather than enforce the law.

That can’t be hastening. Can it?

Oh, and about the fine being levied: it sounds very large, but as we have all been painfully made aware, so is JP Morgan Chase. It will hardly notice the fine, which right now is said to be $2 billion. It’s about time that fines against big businesses were sufficient to grab the attention of management and shareholders. Enough, that is, to get them to weigh the risks of engaging in dodgy business before the fact. And enough to force shareholders to ditch managers who ignored the law after the fact.

I doubt Jamie Dimon will be fired because he runs a criminal organization. Look for yet another internal reorganization; yet another renewal of focus on “trying harder not to do wrong”; yet another PR campaign; yet another employee awareness campaign; and yet more meaningless handwringing in the executive suite. In other words yet more nothing.

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Are You Being Served?

That was the title of an old British sitcom. It is also an appropriate question in today’s economy. David Cay Johnston does us all a favor by focusing our attention on the plight of our modern era domestic class.

I have written about this topic both directly and tangentially for years: inequality is the defining issue of our era. And what makes it most vexing is that we created the current situation via deliberate policy. It was not an accident. Nor was it some unfortunate unintended consequence of a mysterious force like a free market or globalization. It could have, and should have, been avoided.

As you know I place the economic schism of contemporary America in the context of what I see as the conflict between capitalism and democracy.

Capitalism, however we define it, tends to lead to significant concentrations of wealth. We know this because we have ample historic evidence of such an effect. Both our recent Gilded Ages were associated with huge and increasing disparities of income. And both were followed by massive collapses of the economy.  We know full well what a relatively unfettered capitalist economy looks like. We just lived through one.

Democracy , which ought not be conflated with freedom, has an opposite effect. It tends to result in a more even distribution of wealth because of the redistributive consequences of policies that appeal to the majority of voters. We know this too: the evidence of the post-war era throughout the western world supports it, as does the recent counter attack by plutocrats like Mitt Romney. His infamous 47% comment is hardly the stuff of a true believer in democracy. It was the rage of a plutocrat feeling put upon by the desires of the masses. He called them moochers. We call them voters.

When you get the two forces out of balance you end up damaging society. Too mush capitalism and you arrive at today’s inequality. Too much democracy and you lose the innovative edge that drives future prosperity. The trick is to find an acceptable middle ground where the pay-off to capital is still enough to boost growth, but not enough to plunge us all back to the dark ages of outright laissez-faire, exploitation, and mass hardship.

In my mind, growing up as I did in the UK, nothing more epitomizes a divided society than the Edwardian era. It was an age of huge wealth, rapid growth, great power, and a massively divided society. Domestic servants – my grandmother included – were a very large part of the economy. While on the surface society was both prosperous and successful, the imbalance caused by those deep divisions in wealth made it both fragile and unsustainable. When society came into contact with a disorienting event that fragility gave rise to a great reorganization of society, even though the reorganization took a generation to work through.

That even came in the form of the First World War, which shattered not just the prior complacency of the ruling class, but empowered the masses who bore the brunt of its suffering. Then came the Great Depression as a second and confirming shock after which democracy took hold sufficiently to lead to the rise of the modern middle class. We would all do well to remember that the modern middle class is not the natural progeny of market based economics, but is, instead, the offspring of the democratically enabled redistribution of wealth implied by the post-war social contract. The permanent and increasing integration of women in the workforce; the provision of retirement and other government backed benefits; and the acceptance of a balance between the returns to wages and the returns to capital all were political results of the tilt away from pure capitalism towards a greater balance with democracy. Those masses that the right wingers so revile asserted themselves through the ballot box and brought the often vacuous phrase “We the People” to life.

But after nearly forty years of regression, the near worship by our elite of market based solutions to each and every problem, the relentless pursuit of profit at the expense of wages, and the toxic criticism of the role of government we are back, as Johnston argues, in a neo-Edwardian era. Only this time it’s worse.

Whereas domestic servants like my grandmother were given room and board along with their pitiful pay, today’s equivalents are not. They both pay taxes – despite what the Romneys of the world say – and they pay for their own room and board. They are thus worse off than their predecessors. They are also more exposed to the neglect and exploitation of the maxims undergirding modern big business. As corporate America pursues profit at any expense, and decouple productivity growth from wages, it acts to drive down those wages and thus the ability of workers to progress. Big business has done more to destroy the concept of opportunity and to deconstruct our middle class than any other force. Companies like Walmart and MacDonald’s have made it socially acceptable to pay wages so low that many of their employees have to rely on welfare to sustain themselves.

Of course we all benefit from being able to buy incredibly cheap products. But the cost to society is huge. And, amongst other things, one major and little commented upon side effect of the low wage economy is that we, the taxpayers, end up having to provide welfare for those caught in it. So those supposed low costs, which is the big benefit society is supposed to reap from a low wage regime, is an illusion. We end up subsidizing the profits of the likes of Walmart whose workers can only work for those low wages as long as taxpayers help out and chip in welfare to top up their incomes.

This is not a sustainable balance for our society. We ought not subsidize the greed of the Walton family whose low wage policy means we have to pay extra in taxes to support their workforce via welfare. They ought to be able to pay for their own workers. And they ought to pay a living wage.

Recent rumblings and resistance amongst low wage workers suggest that we have hit a tipping point. Or that we are close to one. The business model that companies like Walmart employ, which is based on exploitive wages offset by taxpayer subsidy, is, in fact, far worse than the old Edwardian domestic service model. The older exploitation was partially offset by a paternalism that sugar coated it for a while. Now the exploitation is both unabashed and lauded by a large part of our elite who, brought up on a steady diet of market magic economic theories, see nothing wrong with lowering wages and imposing greater burdens on those least able to carry that burden. After all, as we are told, poverty is a great incentive to the poor to get to work. And to get to work at any wage they can find. Which is usually lower than a living wage.

In this vein Rand Paul, whose economic ideas are based on the fictions of Ayn Rand and the Austrian School of thought, can credibly argue that unemployment assistance hurts workers because it stops them from seeking low wage work. This is another throw back to pre-democratic days. Samuel Smiles wrote a very popular book in the Victorian era arguing exactly the same thing. It was called “Self Help” and was aimed at the poor who, Smiles argued, could help themselves by pursuing the puritan virtues of hard work and self reliance. Government aid was seen as a hindrance to self help by conservatives then as it is is now.

But in the interim, between that old era, and today’s replication of it, we experienced the alternative. An age of government assisted and democratically enabled redistribution to mitigate the many evils of capitalism without surging all the way to outright socialism.

Marx saw the emergence of modern democracy as a step along the road to socialism. He was wrong. It was a bulwark against socialism. Modern capitalists, our plutocrats and the elite that enable them, would do well, though, to recall Marx’s insights. Capitalism has within it the engine of its own destruction. This is because of its massive and destructive influence of society. In modern terms this influence is the inequality that now threatens us all. They would do equally well to recall that it was democracy that provided sufficient respite and prevented all out socialism from emerging throughout the western world.

Getting that balance correct is crucial. Right now we have it wrong.

Are you being served?

If so, think twice. You may be the one in service.

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When is a Contract a Contract?

Dean Baker complains about AIG bonuses being honored because they’re contracts, whereas Detroit and, possibly, Chicago city employees pensions are in line to be slashed despite being contracts.

Such is life in a plutocracy.

This really ought not surprise anyone. The rules for the elite are, and have always been, different. A contract to pay the CEO of a large financial company that had to be saved by taxpayers and whose activities contributes mightily to the enormous economic crisis we are still trying to leave behind is considered sacrosanct. After all it is a contract. And we know what that means. Well it means we have to pay up even though its morally repugnant, smacks of corruption, and is just plain daft. The contract has to stay.

But those workers out in Detroit, they contributed to the problems Detroit had. They pretty much drove it into bankruptcy because of their padded employee benefits and wages. Chicago looks like it’s going down the same road. Those contracts are the cause of the problem. The city has every right to break the contract as part of its bankruptcy proceedings. In this case the contract is repugnant, possibly corrupted by unions influence, and is just plain daft. It has to go.

It used to be comforting to think that the saying “one rule for the rich, another for the poor” was just that: a saying. We could all pretend that America was a land of equal laws, even though we all knew deep down that rich folk can always get away with stuff we can’t.

Now, in these years of crisis, we are exposed to the ugly truth far too frequently. Big business and rich people have one set of laws. The rest of us another. In their laws a contract is inviolate. To break it you have to have extreme extenuating circumstances and/or a well paid lawyer. In our laws a contract is a suggestion. To break it you have to be a creditor who has friends amongst the elite and/or a well paid lawyer.

We are hearing a great deal lately about how those onerous public employee pensions are breaking that back of our cities. A line is forming as cities compete to break longstanding agreements with workers. Rich suburbs are trying to separate themselves from less well off inner cities in order to pay lower taxes and avoid supporting the old infrastructure that many commuters complain about as they go to work each day. The media is writing screeds about how old union contracts are now hopelessly expensive, and about how much of each year’s operating revenue is shelled out to support retirees as opposed to fixing today’s potholes.

Yes, perhaps, those contracts were a bad deal. But they were negotiated in good faith. They were, and still are contracts.

And, yes, I get that sometimes a contract is worthless if there’s no means to honor it. Perhaps that’s where Detroit actually is. Yet again, that’s exactly where AIG was.

So I wonder, why is it acceptable to honor one and not the other? And if we can bail out GM, why can’t we bail out Detroit? After all they used to be one and the same, back in the day when a contract was contract.

Before the plutocracy, that is.

 

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What Sustainability?

I can understand why capitalists are opposed to democracy: the impulse of the masses is – usually – to redistribute some of the loot downwards to their own pockets and away from those who “earned” it. I suppose it all depends on what you mean by “earned”.

I have a harder time understanding why some progressively minded folk are equally opposed to democracy. For instance, in practically every left of center journal or conversation we will trip over comments decrying “infinite growth”, the lack of “sustainability”, and other evils stemming from the breakout to general prosperity the last two hundred years has seen. As I see it this criticism is anti-democractic. The masses have benefited mightily from the surge in economic activity. They will be the first to suffer from its ending. The rich and the powerful, after all, have always and will always, find ways to immunize themselves from the evils of deprivation. they will simply scarf up a greater percentage of the spoils for themselves.

The language of the sustainability advocates veers towards the apocalyptic. The end is nigh. The earth is headed to ecological disaster. We must stop growth dead in its tracks in order to preserve resources and to prevent climatic catastrophe. And this imminent disaster is usually laid at the feet of something called global capitalism. An example of this attitude can be found in this Salon article by Tim Donovan.

You will notice that in Donovan’s case the article’s reference to technology is a red herring. It isn’t technology that can’t save us, he seems to argue, but own our inability to marshal technology. We know what we have to do, we don’t seem able to do it.

That’s politics, not economics. It’s still an issue, but it isn’t one to do with either economic theory or technology.

The key question, to me at any rate, is: sustainable with reference to what?

To our current level and type of technology? To our current resource mix? To our current state of knowledge?

To me concepts like sustainability are relational. They are contextual. So too is the notion of scarcity. This is one of the problems I have with much of contemporary economics. It argues as if today’s context is the only context. Which, of course, it isn’t. Sustainability and scarcity were not the same in 1800 as they are today. Nor will today’s versions be the same as they will be two hundred years hence.

An example: I live in Vermont. A hundred and fifty years ago Vermont was largely stripped of its forests and was a state of rolling farmland with a larger population than today’s. Now the state is heavily forested and its farming is different. Which of those two versions of Vermont was/is hurtling towards apocalypse? Or another example: the earth’s supply of oil reserves was not a constraint a thousand years ago, it is only a constraint in the context of modern technology. It is not, necessarily, a constraint in the future. Maybe. Maybe not.

This is not an argument for inaction. It is an argument for more throughout about what we mean. Especially if the consequences of our reaction is to cause growth to come to a screeching halt. Rather than simply decrying the consequences of industrialization and its unequivocal impact on our climate as an evil associated with capitalism, we ought to think what impact our reaction might have on democracy. Is it possible to force a halt to growth and not disrupt our social freedoms? How will we allocate our newly static wealth? For a call to end growth is a call to end the accumulation of more wealth.

And it isn’t just the sustainability advocates who fall foul of this analytical error. We get a taste of it in recent discussions about stagnation. Only this time the argument is usually from the right wingers. There the error is expressed in terms of our having reached an end to high growth because recent innovation isn’t having the same impact on productivity. The much heralded benefits of “digitization” seem not to have had the life changing impact that the availability of electricity did, so, the argument goes, we ought to recalibrate what we think our growth potential is. And that re-calibration is, inevitably, downward.

So we have both left and right suggesting the great era of growth is past us. One side because it cannot envisage growth as positive given supposed resource constraints. The other because it cannot imagine how newer technologies might have the life altering impact of those that came before.

The problem, as it appears to me, is one of limited imagination. My view is that the economy evolves as we learn and as we learn to apply what we learn. It ratchets up on itself. Such learning is not limited to the invention of new technologies, but also includes how we organize our societies for our benefit. In this way I see the emergence of democracy, which in its modern incarnation is a post industrial phenomenon, as a social technology we put in place to mitigate the more egregious depredations of pure capitalism. I agree with Deirdre McCloskey: it isn’t just so-called scientific advance that builds our knowledge store and enriches us, but it is also our social advance, and in this case, our acceptance that there are rewards to innovation which spillover to the rest of us and so we ought to tolerate within bounds those who benefit from innovation.

Note thought the word “advance”.

Contemporary society is not static. It is propelled by innovation. We capture some, but all, of that forward movement as “growth”. We measure growth very roughly in things like GDP, which is a flawed measure, but is not a hopeless one either.

At which point let me introduce another frustration I have with my sustainability advocating friends: that GDP measures bad things like pollution clean-up as accreting wealth does not condemn it necessarily. Why? because pollution clean up generates activity, jobs, wages and so on, and GDP tries to capture all such activity. Yes, it would be nice if all economic activity was positively based. But is not a clean-up positive? And what if the source of the needed clean-up is a natural disaster? Recovering from a mistake is a way to learn. We consider that a move forward, we do not attribute it a permanently negative tone. We do not place all our value on the error and none on the subsequent recovery. So why do we impugn GDP because it also includes recovery from mistakes and errors such as pollution?

All this is just my way of suggesting that much of the call for sustainability to feature in a new economics is premature until we decide what we mean by sustainability. There are those, for instance, who argue that economics already handles the issue: the much heralded price system will deal with the problem. Presumably as resources are run down they become more scarce and thus more pricey. Then there is the well known problem, already embedded in economics, of externalities and how to deal with them.

It isn’t as if contemporary economics isn’t riven through with flaws. It is. Its model of human behavior is, in my opinion, a naive farce. Its theoretical closure, and its careless tossing outside of what ought to be inside the system being studied is breathtaking. And then the insistence on building upwards from that limited and naive foundation simply compounds the errors and condemns the entire enterprise to irrelevance.

I’m just not so sure that our fix would include a special nod to sustainability early on. I think a solid general theory would handle the issue anyway. We don’t need to create a special case.

And, as I said, sustainable with respect to what?

We need to figure out the moving parts, don’t we?

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