economic theory

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The Greek Experiment

Let me congratulate the Greeks for taking the first, but only the first, step towards a more civilized economic policy. I am intrigued by the prospect of Yanis Varoufakis as economic minister deep in argument with any of the large number of radicals that infest European economic posts. And, yes, they are the radicals. The notion that aggressive austerity measures can engender growth and can be mostly benign with respect to employment, wages, and other immediate aspects of economic life is a radical, almost extreme, idea honed most recently to protect wealthy elites from having to engage with the rest of the societies inside which they exist. Against this form of radicalism people like Varoufakis, despite being smeared as radicals themselves, are more orthodox than not. At least they realize that economies are not mere models to manipulate, but are collections of people whose futures and dignity are surely worthy of consideration alongside such abstractions as markets or efficiency.

Any economy that is suffering 28% unemployment and which has experienced a drop of about 25% in GDP is a candidate for a shift in economic policy because it is evident that the existing policy – the one that produced those levels of unemployment – is not working. The experiment of imposing extreme austerity in order to protect the Greek banking system, which is what the Greek crisis resolves to, is an absurd and inhuman failure.

The austerity imposed on Greece in return for financial support was supposed to achieve a twofold result: Greek debts were targeted to decline as the government’s budget was brought into balance; and the Greek economy’s competitiveness was expected to recover making it possible to eliminate Greece’s chronic trade account deficits.

While it is true that Greek competitiveness has recovered somewhat – the trade balance now has a modest positive balance – the recovery is an illusion: it is more a function of the collapse of Greek demand for imported goods than it is a sudden recovery for Greek exports.

What about that collapse of an appetite for imports?

When your economy sheds nearly one million jobs in the space of a few years, demand is bound to plummet.

And when you deliberately create such an implosion all sorts of other bad things happen. Such as the pernicious decline in prices called deflation. Whilst the notion that prices are declining may seem attractive to those of us still living with memories of 1970’s double digit inflation, they are, in fact, a very bad phenomenon. The most obvious nasty outcome being that it makes the repayment of debt more difficult: since, under deflation, the real purchasing power of wages has risen [you can buy more goods with the same amount of cash], and since the debt is denominated as a fixed quantity at the moment it is created, the implication is that the inflation adjusted value of debt also rises. The result being that someone has to forgo more goods in future to pay down the same amount of debt as in the past. Not only this but cashflows for businesses diminish – they are selling the same number of things but at lower prices – this forces employers to reduce wages and/or employment, which, in turn reduces the purchasing power within the economy and hence demand.

It is easy to think through why deflation is so harmful potentially.

Yet those who seek to impose austerity blithely ignore the deflationary threat. Indeed they often imagine that they are fending off the precise opposite. The delusion is extraordinary.

More to the point the entire construct of austerity fueled growth is an imaginary one that is both novel and bizarre. All the evidence suggests it being a total illusion, yet it has a grip on the minds of key policy makers, especially in Europe.

So the Greek experiment is not what Varoufakis might start to suggest as sound economic policy, but what has been enforced on Greece these past few years.

We are not entering a period of economic experimentation, we are exiting one.

It is a lesson we ought to learn here in the US where the experiment of extreme economics has, for the past thirty years, resulted in a whole host of bad outcomes for average American families. It is time to return to an economics that acknowledges the purpose of policy being to enhance the lives of those who comprise the economy, and not to treat those lives as just one variable in an elegant equation where the ultimate goal is efficiency and not dignity.

People will choose dignity over efficiency more often than orthodox economists want to believe. This does not mean people will avoid tough trade-offs, it means that people need to be assured that policy makers take them into account when prescribing policies that have life damaging outcomes.

In a nutshell: if we had more unemployed economists we might, possibly, have an economics more sensitive to the human condition than that which now dominates policy. Perhaps the Greeks can lead the way.

 

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Economics Is What?

This week’s Economist magazine includes an article designed to uplift the hearts of depressed economists everywhere. It devotes a whole page under the headline “Meet the market shapers”, to a catalog of what it regards as cutting edge examples of economists doing useful stuff at the ‘micro’ level. By micro in these cases the Economist means working inside or alongside a business firm.

All the cases in the article are about some clever folk doing some clever analysis that, so we are told, really and truly helps the firms in question do better. In particular a theme emerges that the work seems to help the firms match what they have to sell with people who are likely, though not certain, to buy.

Naturally, although the magazine doesn’t admit to any added value in this, all the firms cited are Silicon Valley start ups and the like. As we know all Silicon Valley firms are very, very smart – they disrupt the dullards who have only managed to survive a few decades by shooting into orbit and surviving [gasp] for months and even years. So to help firms that are already clever is a real feather in anyone’s cap.

All this cutting edge stuff has the Economist really excited. Not only does it give the story a full page, but it even devotes one of its editorial columns to explaining what micro-economists do:

“they hone in on a particular area, often a single type of market or firm, and try to find out how it works”

Then:

“Armed with vast data sets produced by tech firms, macroeconomists can produce startlingly good forecasts of human behavior.”

Call me skeptical.

I have a few of issues here I need to address.

First: there is nothing inherently economic about big data analysis. Anyone armed with the right technical and analytical background could do the work being described in the article. Indeed they have. Analysts in other disciplines were comfortable with large-scale analysis before economists were. While I have no doubt about the quality of the work, what I do doubt is that it has anything to do with economics. If all it takes to be called a micro-economist is to be working on market or firm level analysis, albeit using some fancy math, then there are droves of such people most of whom would never dream of calling themselves economists. The word ‘analyst’ seems to fit rather nicely. That the analysts happens to have a PhD in economics is merely an indicator of how economics has become a technical training and left behind being a science devoted to investigating economies. So quite why technical analysis can be claimed as a triumph for, or the exclusive territory of, economics is something I cannot fathom.

Second: while I have no doubt the results are of value to the firms where the economists work, if they are ‘startlingly good forecasts of human behavior’, then I have to assume that the analysis ignored anything taught in standard micro-economics classes. If there is one claim economics cannot make is that it has a deep and well grounded understanding of human behavior. It has gone out of its way to ignore human foible in order to compress behavior into a suitable shape for its own ends. For instance, the entire theory of rational choice is absurd on its face except to economists who wanted something they could base their imaginary economies on. No one can credibly claim that standard micro is a model of actual human behavior. All the work underway in behavioral economics is finally unmasking micro’s naivety. Besides anyone familiar with thinking outside of the tunnel vision of economics would be aware of the ghastly simplification and muddle that micro is when compared with the higher understanding that exists outside. No one looking in can avoid being stunned at the silliness embodied in what standard economics treats as basic knowledge. So, I repeat: for the work the Economist cites to be ‘startlingly good’ I have to assume it isn’t based on economics. Which, perhaps, is why the Economist is startled.

Yes there is a world out there. A real one. And a real world where there are analysts with a good grip on reality.

Thirdly: The entire premiss of the article, and the Economist’s breathless expose of the work, is a touching example of how standard economists are driven to take credit – for economics – for just about anything that sounds both clever and remotely accurate. After the economic crisis of 2007/2008 exposed the dismal shambles that occupies the once highly regarded intellectual space called economics, with its fragmented and contradictory explanations, overly formal methods, stale thinking, and ideological taint, of course economists want to rehabilitate their art. Instead of fixing its many and manifest errors they have taken the easy way out: they invade other spaces and re-brand their technical methods as being economics. In other words they no longer even worry about the economy, they are now content to be technicians-for-hire, and number-crunchers par excellence.

One last thing: the Economists bravely ends its article with this:

“While they are too busy to realize it such firms are also providing the best defense of economics against its critics. Far from being unrealistic and out of touch, the role of chief economist will design the way that the firm works.”

On the contrary. The message is almost the opposite. Because economics is unrealistic and out of touch, economists have had to look for work elsewhere – where their inability to understand the economy is not an impediment. As for designing how the firm works: I think there are plenty of other hands at work there, and if a young person is setting out to have such influence, there are many, many, shorter and cheaper avenues towards that goal. Most of which avoid micro-economics like the plague.

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More Uncertainty

Actually, now I think more about it, how can we ever have ‘more’ uncertainty? The massiveness of our lack of knowledge about the future surely reduces that word ‘more’ to trivial irrelevance.

As the wise G.L.S. Shackle taught us: anything beyond about ten years into the future is so opaque as not to exist at all other than in our imaginations. Which is why all business has to accommodate itself within the narrow future. Anything other than the short term is not worth the risk. Or, rather, we ought to leave such risks to the body politic which has the greatest ability to absorb the loss caused by error.

The basic state of nature is that it hides from us what its unfolding will produce. We simply cannot know. People who state otherwise are fooling themselves and are blind to reality. They have substituted some form of faith for acceptance of our real condition.

I think it was Frank Knight who cut to the chase of the problem: we need to predict the future in order to conduct our lives within some recognizable pattern. To predict the future we depend, explicitly or not, on its similarity to the past. But the very fact we need to predict the future suggests that we are aware that it will be different from the past. So we are caught in a paradox. If the past and the future are the same we need no prediction. We simply need memory. We need not concern ourselves at all with change. Yet we observe change. And the very existence of change invalidates, at least in part, our reliance on the past as knowledge about the future.

Much of modern economics exists in an alternative world where none of this interferes with the perfect, clockwork like, working of allocative logic. To economists in that tradition an economy is a mechanism for allocating resources and the entire problem is fully specified: there are no uncertainties whatever. Around the edges of their theories it might appear that they have acknowledged their deviation from reality, but at the central core of their work there still persists a leap of faith that dooms them to be forever disconnected from an actual economy.

And Robert Lucas is hopelessly wrong when he argues that economic reasoning has no value whenever uncertainty prevails. Perhaps his doesn’t, but proper economic reasoning, that is to say economic reasoning that bends itself to the centrality of uncertainty, is of great value because it helps us explicate and inform policy to mitigate uncertainty.

Plus it allows us to perceive an economy as more than a simple, mechanical, allocative machine. It is also a discovery device. It is a source of novelty. Uncertainty engenders responses such as innovation, risk taking, and exploration. Those things are a source of enrichment and the accumulation of knowledge.

It is also critical to remember that the growth in knowledge is itself uncertain. We cannot prove either the truth or falsity of what we claim to know with any certainty. We are doomed to live in perpetual, and to some disconcerting, doubt. But it is precisely this doubt that propels us to uncover new knowledge.

It is also this doubt that ought ensure we excise due care in the construction of social policy. Since we can never know for sure what the impact of a policy is we need to proceed cautiously, acting boldly only where we see the damage of uncertainty being potentially greatest.

The failure of the great libertarian economic agenda of the last thirty years is due exactly to its lack of admittance of uncertainty. Those who advocated great programs of deregulation, fiscal shift, and trade liberalization made claims of certainty with respect to the outcomes of those programs. They defied reality. They ignored the limits of their own knowledge and foisted the consequences of those limits onto the rest of us. Many of them had a scarcely hidden political agenda to upend the safety and progress of the post-war middle class. Others, though, believed, with an unbecoming fervor, in the cause of ‘free-market’ economics. They, because they admit of no uncertainty, saw no need to provide continuing protection against the vicissitudes of life. For them it was a matter of creating sufficient incentives and allowing people to make their own plans about how to deal with what they regard as the simple calculations of life. Not only did they deny the existence of potentially damaging unknowns, they even denied the existence of limits on our ability to understand, and to handle, what we do know.

The tragic consequences of their cynicism and hubris are what we see around us in the dysfunction of the economy, growing inequality, environmental degradation, and the disconnection of our economic leadership from the realities faced by everyday people.

The great irony of this is that the false system upon which they based their policy advice, the system that failed to acknowledge limits and the uncertainties we face was based on a series of conjectures they call, collectively, ‘rational expectations’. It is a system which, in its defiance of reality, also defies reason. Thus it is the very epitome of irrationality.

So, perhaps, we can admit of one certainty: they were arrogant fools. And, perhaps another: we must ignore them henceforth.

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Quick Thought on a New Beginning

Imagine that you sit down one day with some friends and announce that you are going to invent economics. Great. Economics, you say, will be the study of the economy and its various properties. Great again.

Hmmm. Now comes the hard part.

What, exactly, is an economy?

Gulp.

I don’t know. Do you.

It’s sort of whatever you want it to be at the moment you are talking about it.

Is it a market? In which case, we have to do this, what is a market? That used to be easy back in the old days. It was a physical space. It was a space people went to to exchange stuff. But was is a market today? The internet? A supermarket? A stock exchange? All of them I suppose. It’s a logical space as much as a physical space which makes it seem a little abstract. It still involves people though. If not directly, then indirectly. After all the entire purpose of a market is to function as a space within which transactions take place. And transactions involve people, don’t they.

Maybe.

Is an economy one market? Or many markets? Do those many markets have to intersect? Or can they simply co-exist? Are there many spaces or one space? Are they nested? Are they aggregated? Is the aggregate, which doesn’t exist other than as an abstraction because it exists only as a quantity, an economy? If so, what properties does it have other than those of the markets of which it forms the aggregate?

Phew.

Or is this all a red herring?

Perhaps an economy is a group of people doing transacting. In which case it would seem to be much less abstract and more behavioral. Maybe.

Or is it simply a set of transactions? In which case we would need to investigate the properties of transactions. Whatever that may mean.

Or maybe an economy is all these things?

Is it a history of all these things? Do past transactions, and past generations, constitute part of the current economy? Perhaps, if they have contributed to it.

And then there’s the usual point of confusion: how do we account for the economy once we’ve decided what it is? In money terms? Economists have a terrible time understanding money – which is why many of them like to think in non-money terms. They call non-money terms ‘real’ just in order to annoy us all because we know that most, but not all, ‘real’ economies only function with some sort of money.

And do only those transactions conducted in markets get counted when we add up the economy? What about the others?

It gets very difficult doesn’t it?

Which is why most active economists never actually bother worrying about making the economy explicit when they discuss it. They simply hope we all understand what they are talking about.

Which we do. Don’t we?

 

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Uncertain Causes

When you throw a feather out of a tenth story window it eventually hits the ground, but only after fluttering about for a while and following an often circuitous route downwards. Throw a ten ton lump of lead out and the route tends to be a lot more direct. Gravity wins the day in both cases. It’s just that in one other forces and environmental effects play a much larger role.

In economics the role of gravity is played by uncertainty. It is the dominant force underlying all action. Most often its presence is best detected by the reaction of people to it: they make plans and seek other ways to offset it. Our institutions, for example, are a way to channel activity along more predictable lines and thus keep uncertainty at bay as long as possible.

Eventually uncertainty wins. It undoes our plans by throwing up an event entirely unexpected. We then have a choice: do we repeat one of our tried and true actions on the basis that it has worked – at least sort of – in the past? Or do we invent a brand new action and see if it works in these new circumstances. Whichever we choose we learn something: either we learn that our old trick has new application, or we learn a new trick.

So uncertainty is a driver of learning. Pushing back the boundaries of the unknown, wherein uncertainty lurks the most, is how we make progress.

I look at scarcity as a form of uncertainty. It is uncertain because we cannot be sure how we can counter it. Say we need a scarce resource, what will we do if, or when, it runs out? That’s a major uncertainty. It’s one that hovers over us today as we worry about our supplies of oil. How do we react? By trying to find alternatives to the scare resource? Or by being better at using what limited supplies we have?

We learn in the face of uncertainty.

Then there’s a more problematic form of uncertainty: things we have no clue about until they arrive to confront us. In these cases our learning is always retrospective. We figure out what we would have done had we known about the event ahead of time. We then add that new piece of learning to our bag of tricks and it becomes something we can use in future were a similar event to show up.

Like gravity, uncertainty is always in the background, but other forces may mitigate its presence such that we ignore it and focus on them instead. It never goes away, however.

Another way of looking at it is to compare order with disorder.

Our economy is a process that endlessly cycles disorderly stuff into orderly, and thus useful things, and then back into disorder via consumption, depreciation, depletion and other quasi-entropic channels. A totally disordered environment is full of uncertainty. A totally ordered environment is, on the contrary, full of certainty. Our experience of life is between the two because life itself is a form of order. This is the meaning behind Karl Popper’s comment that ‘all life is problem solving’. Not only does he mean that all life is a solution to a problem, he also means that when we observe problem solving we are observing life.

In our economy we establish order by using our creativity. We carve away an almost infinite number of possibilities and focus on one. A pile of iron ore has enormously many possible uses. It can take an enormously large number of forms, shapes and so on. But we force into just one. We establish a  particular order. One that has specific use to us. And through use we gradually erode that order: we depreciate the object, we expend it, we allow it to rust and gradually deform. Ultimately we abandon or recycle it. Either way we undo our creativity through consumption. The iron isn’t lost – it still exists – but it is now disordered and of no immediate value. Although it might be if we learn how to recapture it for future use.

All this means that our economy is a human response to the uncertainty we are faced with in our surroundings. It is a particular response to our need to supply ourselves with what we need to survive and thrive.

But our environment is not static. It is altered by our activity. That is to say our past creativity acts to shape the environment we now face. And our current creativity helps shape the environment we will face in future. The endless feedback loops between what we do and what we find around us provide another layer to our uncertainty. As do the feedback loops that connects what we each do with what our fellow economic actors do.

As actors we react to uncertainty. We invent projections of the future so we can create an appropriate order to match that future. Uncertainty, of course, means that our projection and the actual revealed future rarely match exactly, but we manage as long as the two don’t diverge radically.

Our economy is intentional. It is not simply the playing out of some preordained or clockwork-like response to an event or situation. It is more nuanced than that. Those feedback loops mean that there are causes for subsequent events that exist at various layers of activity and not just at the base layer of individual action. Those causes emerge from our interaction and our consequent constant exchange of ideas, thoughts, emotions and so on. This is why orthodox economics founders so easily. It dismisses or underutilizes those higher levels of causation and allows only the base layer to enter into its analytical process.

This is also the main source of unreality in orthodoxy: it disavows human intentionality inasmuch as it restricts our behavior to a highly limited and entirely  predictable set of actions. It assumes one set of reactions – an extreme form of rigorous rationality – to events, and, by so doing, it eliminates the possibility of change in the face of interaction. This is easy to do if you want to invent an entirely logical and internally consistent system. But it is not a reflection of reality, so it has no applicability in the real world.

An economy conceived as a reaction to uncertainty cannot be understood, or even modeled, axiomatically. For its very nature is to evolve and mutate through time. It is not necessarily internally consistent or even logical. It is idiosyncratic, path dependent, and liable to lurch occasionally in different directions. Its choice of solutions to uncertainty may not be optimal: all that it needs is viability. It may get locked into paths of activity that prove, longer term, be to highly suboptimal. All it needs to do is to provide for survival. It needs to subsist and persist.

Uncertainty prevents it, ever except by luck, from arriving at the sort of pristine optimal equilibrium that orthodox economists set as the desired consequence of the economic systems they study. Indeed, the notion of such a system actually existing is so bizarre that it seems pointless – to me – to bother with it at all. I suppose that within the entire set of all possible configurations of the economy, one such pristine example must exist, but the likelihood of it being the one we are living in is infinitesimally small.

So, I repeat, why bother studying it? Especially when we appear to know so little about the one we are living in.

But, that’s uncertainty for yo.

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