economic theory

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Bankers and Externalities Galore

Ah! A teachable moment.

As a matter of fact very many such moments. How does the continued existence of the big banks act as a disproof of free market theory?

A cursory familiarity with the news shows us plenty of examples of what economists call “externalities”. These are pernicious events that fall outside the set of events that orthodox economics can explain. The disaster imposed on the world by incompetent bankers and the environmental disaster unfolding in Hungary are just two examples.

The point with an externality is that it is an event orthodox economics has no way of including using its normal methodology. This is because that methodology relies on the incentives that flow from private ownership of property. Economists use private property as the bedrock of their entire explanation of the economy’s workings. The interplay between supply and demand is based upon freely associating individuals who have complete knowledge of prices and have total control of the resources they are exchanging. Since they own the stuff being exchanged they bear the consequences of the transaction. So economists suppose that this ownership will induce rational behavior. In other words economists assume that people will behave rationally because they have to face up to the profit or loss of transacting – no one else is responsible, no one else bears a cost.

But this is a limited and flawed view of the real world. We all can easily rattle off events where the consequence of a transaction or event was borne by someone other than the owner of the property involved. The recent banking crisis was created by stupid bankers making dumb trades oblivious to their consequences. One reason for their stupidity was that there was no incentive within the system for them to wise up. They knew that they could screw up and not have to pay a related price. The taxpayers picked up the tab for the incompetence and selfishness of the bankers who, by and large, escaped scot free. Even those bankers who lost jobs never paid the full price of the damage they inflicted on society: they are not the ones paying for the unemployment checks being mailed out by the millions each week. Yet their actions are the root cause for those checks being mailed.

Similarly, in Hungary the company whose dam burst and flooded an entire town with toxic sludge is not going to be the sole source of compensation and or only group to bear the clean up cost. Society at large will, inevitably, be involved.

This is why those who defend free markets are living in a dream world. The defense of a free market system relies entirely on the smooth operation of an incentive structure for the actions of individuals. In the magical world of a free market such incentives induce behavior that sums up to benefit social welfare. The whole benefits from the greed of the individual. This is the logical end point of Adam Smith’s “invisible hand”. For Smith’s vision to play out in reality, rather than be a metaphor, the economy must be all inclusive. It cannot have externalities. The notion that private actions have public, and not exclusively private, consequences destroys the theory before it even gets going. The logic dissolves.

There have been many attempts to jig the theory by kluging on addendum bits and pieces to account for externalities. But they all fail. The free market system stands or falls by being entirely private with entirely private incentives driving entirely private consequences. Externalities undermine the logic and allow – indeed they ensure – anti-social outcomes will arise from private exchange. Where the consequences of private actions leak into the public domain free markets theory collapses and fails to explain or predict what’s going on in an economy.

This is harsh, of course. Defenders of free markets will point to the mountain of literature written describing the results of externalities and other “market failures”. Theorists have devoted miles of ink to descriptions of such failures. That’s all well and good. Perhaps they would have been better served expending that energy and time on developing a theory that included, rather than excluded, such events. You know: a theory based on the real world.

Meanwhile we rely on the kluges to help us develop policies to offset the exploitation of externalities by private entities like GE who dumped waste into the environment for decades, never bore the cost, and thus handed unearned wealth to their shareholders for years. GE was safe in its knowledge that it trashing of the environment as creating costs it would not have to account for in its income statement. The profits it reported were thus inflated by that omission. Its stock price rose way beyond it true economic value, precisely because economics had no way of making it include those costs.

Likewise bank stocks were wildly overstated during the run up to the recent crisis because they failed to account for the losses inherent in the anti-social investments being traded and gambles with on Wall Street. The traders who created those losses are now reaping huge personal gains in the form of record bonuses because the taxpayers have underwritten their renewed gambling.

The common theme throughout this story is that we have an economy where private gains and public losses are often – too often – associated. Any market driven system suffers from this fundamental design flaw. Societies offset the flaw by imposing regulatory costs, hopefully sufficient to induce socially beneficial behavior. But in societies like ours, where money buys influence, it is always possible for those who benefit by damaging society, to protect themselves from bearing the full cost of any externality they wish to impose on the rest of us. Pollution is rarely punished to the full extent of its social cost. People who gain by polluting are thus earning unwarranted or anti-social profits, or “rents”, at the cost of society as a whole. Not all pollution is environmental. The banking crisis was also a form of pollution.

The trick when dealing with polluters is to reduce their ability to earn those excessive rents. Make them pay. Had we succeeded there would be far fewer bankers, and those left would be a great deal poorer than they are. That they still exist, and that they still pollute, is evidence of the failure of free market theory.

As they say in math: Quod Erat Demonstrandum. QED.

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The Role Of Uncertainty in Economics

So much of economic theory needs to be replaced. We now realize that. I am especially focused on getting rid of the artificiality of rationality and complete knowledge from our thinking. At best they are crude approximations to real life. At worst they totally undermine our ability to deal with real world economic issues. They obscure reality, which to me is riven through with uncertainty.
Indeed, it seems to me that uncertainty is the central fact motivating all economic activity. Without it we would be living in some kind of nirvana devoid of the problem of scarcity. Uncertainty bedevils all living things. It motivates the invention of problem solving, competition, cooperation, and search. More to the point the process of learning is a response to the constant need to press back against the shadows uncertainty casts. It causes us to create boundaries within which we protect and control resources. It impels us to plan in order to invent viable futures to act out. It forces us to build institutions to stabilize our relationships and thoughts. It encourages us to develop cultures to enable association, network, and interchange. And it requires us to be relentless in our creativity in order to fend off the degradation and consumption of whatever exists today.
Above all else it manifests itself as entropy and the perpetual loss of order in our lives and surroundings. That is the greatest threat of all. One solution we have arrived at in our defense is the construction of economies. For an economy is simply the imposition of a kind of order – a system – within which we can exchange, create, and consume so we can survive despite the prevalence of uncertainty in our environment.
It is because such an order necessarily involves our geographic locale, our institutions, our cultures, our depth of knowledge, our technologies, and the networks we construct with each other, that economics is profoundly heterodox in nature. In other words, that heterodoxy is directly derived from the problem represented by uncertainty that economic systems seek to “solve”.
This is why orthodox economics and its simplistic focus on the mechanism of constrained allocation fails to account for the richness of real world economics systems, and why it is insufficient either as an explanatory or predictive account of real economies. Economic theories must confront uncertainty, else they are not dealing with economics.

Addendum:

This is a re-post from an entry I made on the Real World Economics Review blog.

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Larry Summers To Go

Hurrah.

I am not a fan of Larry Summers. I will not miss his ego, his stifling presence, and his lack of progressive attitude. He served at a time when we needed strong action to put the economy back on a more sustainable path following decades of neglect and deregulation. His primary contributions were to water down the stimulus; to fend off stronger bank regulation; and to throttle the voices of those with a less market oriented viewpoint. All in all a weak performance.

In particular he acted as enabler of the continual search for middle ground that has undermined the economic policy process under Obama. There was no middle ground to find. The alternatives were clear. We could continue along free market deregulated path such as that of Reagan and Bush; or we could restore balance and acknowledge the crucial role that governments play in the stabilization of economies. We continue to watch volatility increase or we could work to mitigate it. We could reduce inequality or we could be indifferent to it. And so on.

Summers was an exponent of free market economics in his first foray to Washington. When the free market magic started to fade he modified his views, but at no point did he fully embrace the alternative. Thus, when the stimulus was being put together he supported the smaller package as being sufficient to stop a free fall, even though he knew full well that it was insufficient to kick start a strong recovery. Why did he get stuck in this middle ground? Because he is still a free market solutions guy. His conversion to interventionist economics is only skin deep. He believed that all the government should do was to limit the damage. After that the markets would recover and we would take off back on track. He was terribly mistaken. That decision alone contributes enormously to the frustration we all feel as the economy continues to drift.

Add to this his extraordinary hubris, in his own mind he is a towering figure in the trade, and we arrive at a relatively unsavory character given the context within which he worked.

I welcome his departure.

That, of course, immediately opens the discussion as to a replacement. Already we are being prepared for the selection of a more corporate biased person to help salve the criticism that Obama is somehow anti-business. It should be no surprise that I sincerely hope such a selection is the pipe dream of the Chamber of Commerce rather than a true possibility. We do not need more pandering to business. We need someone with solid crisis fighting credentials. Someone who is not beholden to corporate or any other special interest. Most importantly we need someone who can explain why it is that we need to put the government back into the economy where it belongs. The free for all that produced the crisis does not need another apologist. Nor do we need another retread from the Clinton era – Clinton was a committed free market type too, as the financial deregulation of his tenure attests. Finally whoever gets the job must be able to articulate the delicate balancing necessary to undo the fiscal debacle of the Reagan Bush regimes – the long term deficit is their construction – and yet protect the short stimulus still needed to prevent our slide into a Japanese style malaise.

Given the counter intuitive nature of the policies we need, and the ongoing popularity of the anti-government, tax cutting approach that created the crisis, I do not envy the person who steps in. That Summers didn’t do as much as he should to lay the groundwork only makes the task more difficult.

While there are plenty of people capable of doing the job,two questions pop up:

Do they want to step into the muck while the political will for change is so sorely lacking?

Has Obama the courage to select a strong pro-government player?

I wouldn’t; and he hasn’t.

Summers replacement will be a fudge.

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Econ 101: The Problem of Time

Time represents a special problem for economic theory. It gets in the way. It makes things messy. It introduces … gasp … the possibility of uncertainty. This latter being the really big problem.

As those of you who follow my ongoing opposition to textbook economics realize I have a major beef with the notion of markets as specified in the standard texts. That beef being based on the ridiculously unreal assumptions – contortions would a more apt description – that standard theory has to go through in order to “prove” that free markets always clear, and that they represent a preferable mechanism for resource allocation than the major alternative known as central planning.

Those of you familiar with the textbook explanation will notice that in order to arrive at the “correct” solution economists have to rig their theory. They make astounding leaps of faith. They assume, for instance, that all the actors on the economic stage have equal and costless access to all the necessary information needed to make rational decisions. They assume we are all omniscient. Not only that, but they assume we can process all that information instantaneously. We are prodigious calculators in their eyes. They go on and assume that their definition of rational is the only one we would use. This is convenient because it implies that once we have acquired all that information, and once we have calculated what to do, we will act in exactly the same way that an economist would. They don’t expect us to behave this way in actuality, but they expect that our behavior mimics what an economist would have done.

Thus standard theory assumes a world full of super rational automatons acting as if they were all economics PhD’s.

Very realistic.

It gets worse.

That’s where time enters the fray.

The problem is that to “prove” that markets always produce a socially beneficial result standard theory can admit of no uncertainty. It would muddy the waters and complicate things. It would mean that there is no single configuration of the economy that provides the maximum welfare. And the search for the single point is what drives standard theorists. An economy riven through with uncertainties could have more than one acceptable solution. Were that the case it could nor be assured that the market was any better than central planning.

Sometimes standard theory goes to even more absurd lengths to protect the sanctity of the markletplace.

Economists are obsessed with equilibrium – that singular point at which everything settles and welfare is maximized. But to get to equilibrium a market has to go through the motions of getting stuff produced, moved and bought. These are things that take time. But as I said time introduces uncertainty. So it is eliminated. The production, movement, and purchase a of goods and services is assumed to be instantaneous. That way markets can discover the prices at which they can clear. In something called general equilibrium theory, which is still the cornerstone of modern economics even though it has been attacked for decades, the bidding process during which market clearing prices are fixed is carried out by a disembodied “auctioneer” who sits outside the system, but collects and distributes information to producers and consumers. The haggling of a rowdy market is thus reduced to an auction during which everyone knows everything all at the same time. Neat. For those of you who are asking about time: the modernized version of the theory assumes that there are futures markets that embody sufficient information that future delivery of goods can be compressed into a current decision making process. The future is discounted into the present. And the ugly prospect of uncertainty magically melts away.

Even neater.

This is, of course absolutely ridiculous. But it is necessary to jump through these hoops if you want to preserve the sanctity of market magic. What economists have done is to create a system so convoluted and silly that they hope you don’t notice. The mathematics are extraordinarily elegant. The creators of the model won the Nobel Prize. Their creation dominates theorizing to this day.

They saved market magic, and that’s all that counts.

As Milton Friedman argued: it doesn’t matter how crazy the assumptions are as long as the result is correct. That begs the question as to how we know if the answer is correct. His view was that if markets arrive at an optimal solution in the model, we know the assumptions are OK.

I have a heretical view of all this.

I think Keynes was right in arguing that uncertainty is endemic. Markets may or may not be good allocators of resources. We don’t know. They may or may not arrive at equilibrium. We don’t know that either.

But I go further than this: I don’t think time exists.

There is no such thing as time. It is not a property of the universe. It is simply a convention, a scorecard, with which we keep track of change.

My view is that we exist in states of the universe. Each state is unique. Each is a full configuration of the entire system. Think of each such state as a single point in an infinite space of similar points. When we move from point A to point B we experience change: the configuration is slightly different. Since the two points are sequential we denote the movement as the passage of time. But in fact we have simply changed configurations. A history is a long string of points connected by a common thread. That thread being the observer through whose eyes the universe is being observed. As the observer jumps from state to state he or she experiences change. The trajectory thus created follows a path through the state space of the universe. It is not time passing, it is the universe changing.

Now what makes things change?

Entropy and the laws of physics that dictate creativity.

Creativity is the elimination of information. That sounds counter intuitive. But it is simple. When we create something we specify it. By being specific we eliminate all the alternative things we could have done. We reduce the choices to one. Thus when we build something from a lump of iron we start with a huge variety of things we could do. But we end up with just one of those things. We have eliminated the rest. We have reduced the amount of information.

Conversely, when we use things we add back that information. We do this in two ways. The iron thing we just made wears out. The iron returns to its original state albeit via the process of rusting. The iron remains, but the thing we specified is “used up”. The amount of iron available in the universe remains. The thing created does not. This is an approximation. But it explains the principle. This loss of information through the use and consumption of things is the process of entropy at work.

Entropy is often called the “arrow of time” because it has profound implications. It says that any closed system – the universe, of your cup of coffee – will always move from an more organized state towards a less organized state. In other words we lose track of the order. We lose specificity.

Economies can be thought of as such systems.

They are constantly moving from one state to another. Each state is a full configuration of the system. Each is unique. Each has different information content. As entropy tears away at the specifics of our products, we produce more. In a system dependent upon human intentionality like an economy the role of the laws of physics is played by our innovative and productive capacity. We marshall knowledge in order to fend off entropy. We locate, gather, and deploy resources in order to meet our economic goals. Those actions are creative. They allow us to configure the economy in order to meet our requirements. We combine natural resources with energy and our know how to make stuff. that stuff is a specification. It implies the reduction of entropy in the universe. But as we consume that stuff entropy re-asserts itself, and the laws of physics are preserved.

This view of what an economy is doing does not require us to speculate about equilibrium. It requires us to speculate about the search for resources; about the impact of their location; about the way in which we learn to use them; about the way in which technologies are developed; about the level of knowledge in society and the institutional or cultural constraints on its use; and about the structure of the networks or processes through which resources are transformed into products and moved to consumers.

None of this requires us to muddy things with time. Instead we simply observe how the economy moves through its state space as the process of search drives it onward.

But enough.

Time represents a problem to standard theory. Just not in my world.

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What is ‘Wealth’?

Amidst all the furor over the Goldman Sachs fraud scandal and the drama surrounding bank reform – actually lack of drama since the Republicans have wheeled out their ‘just say no’ policy platform – I noticed a little discussed letter going from the Congressional Budget Office to a Republican Congressman evaluating the impact of climate change legislation on household wealth.

Which leads to a very interesting topic: what do we mean by wealth?

The point is simple.

Any legislation that imposes limits on climate affecting activities is almost bound to reduce household wealth. A good example of this which is already in effect is the mileage requirement on cars. In order to make cars that meet the law’s guidelines the auto manufacturers add stuff to engines and exhaust systems that raise the cost of a car. That additional cost represents a loss to the household who buys the car – that extra cost is money not available for buying something else. So household wealth is diminished by the environmental impact law.

It is hard to imagine any environmental impact law that would not reduce household wealth.

Why?

Because that’s the point of most such laws: to make pollution more expensive. That implies making people pay for dumping waste into the atmosphere of anywhere else for that matter.

We can reduce pollution in two simple ways: make it more expensive; or make it illegal. Either way we are reducing wealth. We are either making something more expensive or we are removing it altogether from the menu of things people are allowed to do. Since both these strategies reduce individual choice they impose a cost on those individuals affected.

So it easy to see why a Republican would ask the CBO to evaluate climate change laws in the light of the impact on household wealth. It is the political equivalent of a ‘gimme’ in sports. The Congressman can easily turn around and bemoan the loss households suffer – and the massive cost that environmental policies usually represent.

But that misses a huge point.

The answer is distorted by the way in which we measure wealth.

Because economists talk about wealth in terms of GDP, or the amount of stuff we buy each year, they miss anything that is not explicitly purchased. Anything that someone does for themselves rather than by buying it doesn’t count as wealth in this calculation. So when you paint your own house that doesn’t add to GDP, but if you pay to have it painted it does – the painters wages count, but your use of your free time doesn’t. This is odd, since the additional value that you may perceive by looking at a freshly painted home is the same in both cases.

The reason economists ended up with this method of scorekeeping is rooted in the efforts of the early economists – back in the 1800’s – to place a value on work. Since they saw work as a cost because it diminished your leisure time, it was work and all the stuff you buy with the money you earn from work, that ended up being the thing they wanted to measure. Leisure time is never counted in household wealth, even though its loss is the starting pint for all economic thinking. Anyone who is self-sufficient and does not buy things is counted as being ‘poor’ – they fail to register much in GDP terms.

This is obviously a flaw in the system economists use, and it is a flaw they are well aware of. In their defense it is practically impossible to place a value of free time. It is too subjective. And so the best objective way is to look at what goes on when people give it up – in other words we can get at the value of free time by evaluating the things people do instead of enjoying leisure. We assume that they would prefer free time, but that when they work they get more ‘wealth’ from that work than they would from the same amount of time spent in leisure.

In a sense we look at the negative of a picture to get a view of the positive.

Another distortion in wealth comes from another basic premise of economics. This is the focus on the individual person as the epicenter of wealth creation. This focus has a huge downside in that anything that does not belong to a specific person or household is not counted as belonging to anyone. It simply disappears from the calculation of wealth.

A very clear example of this distortion is the environment. None of us own it. yet we all use it. It clearly factors into our view of life and thus into our wellbeing, but since no one ‘owns’ it we don’t count it as part of our wealth.

This is obviously major problem, and produces some of the most difficult issues in economics. When a person acts in such a way as to diminish the environment, that person is passing on a ‘cost’ to us all – our way of life is diminished. But there is no way of adding up what that cost would be so as to reduce GDP appropriately, because the value of the environment was never part of GDP in the first place.

Again this error in economics can be traced back to the subject’s origins when no one particularly cared about the environment and the entire focus was on measuring the extraordinary growth in material wellbeing that the industrialization was producing.

This essential materialism haunts us to this day. Anything that is not material fails to enter the lists of wealth even tough we all agree that such things are plentiful and very valuable.

Most of would agree that the things in life we most treasure are not material but intellectual, cultural, familial, or spiritual. None of which make the grade for economics.

Those ‘treasured’ memories may be the most valuable things you have but they don’t ad a dime to GDP unless you can sell them.

Which brings me back to the CBO and its letter.

Clearly the question being asked of the CBO is loaded. Off course environmental legislation is likely to reduce household wealth – as long as we are restricted to looking at wealth through the prism of privately owned or generated material stuff.

If we expand our horizon and include publicly accessible things like the environment then the answer is not clear. In fact it is likely that the sum total of our society’s wealth increased. Yes a particular household had less wealth. But the rest of us no longer had the cost of paying for the clean up of that pollution.

A good example of this is the famous GE toxic dumping case.

The shareholders of GE got a free ride on society for decades because the company whose shares they owned dumped waste into a public space – the Hudson river. This meant that the cost of cleaning up that waste was borne by the public and not by the person[s] messing the place up. Consequently the profits of GE and its stock price failed to take into account to full or ‘true’ cost of its operations. They benefitted from the inability of economists to measure the value of the Hudson being clean. In fact they took advantage of that failure, and pocketed the profits. Eventually environmental laws forced GE to pay for the clean up. This meant that GE’s wealth went down as a result of those laws.

But was that the end of the discussion?

According to the Republican congressman soliciting the CBO advice, the answer would be yes. Household – or in the GE example, business – wealth went down.

But total social wealth went up. We, the non-GE folks, got our clean river back. We no longer were subject to the ‘cost’ of a dirty river.

Reasonable people argue both sides of this kind of discussion.

But at its heart the debate is not about our environmental laws, it is about the way in which we measure wealth.

Right now we get it wrong.

It is trite to say that there’s more to life than money. Economists have never found a way to measure the entirety of our wellbeing. So we are stuck with things like GDP, which is a very poor substitute.

But since it is true, that there is more to life than money, we should all be very wary when we discuss laws and policies that appear to reduce ‘household wealth’. That measure is only a fraction of our true wealth and occasionally reducing it adds immeasurably -literally – to the total elsewhere.

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