Arrow

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Damn Facts

It seems appropriate to mention increasing returns today.  After all, this is the day on which several of our modern titans of industry are appearing before Congress to respond to the concerns raised by the gargantuan size that their respective businesses have grown to become.  The CEOs of Apple, Amazon, Google, and Facebook are all under the gun to defend the enormous clout that each wields in the modern marketplace.  Today is the culmination of a long investigation by Congress into the problems, or perceived problems, that these four companies represent.  Whatever the outcome the simple fact that the four are being clustered into one band of rogues taints them with an aura of indecency we normally associate with the pharmaceutical, banking, or tobacco industries.  That’s bad company to keep.

But back to increasing returns.

It’s one of those topics that economists like to tuck away and discuss out of the glare of public gaze. It represents a considerable challenge to the foundation of contemporary economics.  Economists love letting us know that they know about the potential various errors that might devastate the core of what they believe, but they equally love sweeping such anomalies under the rug so as not to have to re-invent their discipline.

And the big four tech companies being hauled before Congress today are each a pretty good example of the problem.  More exactly, they are all good examples of the existence of increasing returns as a fact in the real world.  Facts can be so annoying when you want to preserve your theory.  Economists have made a habit of collecting awkward facts and discussing them offline so that the central theory they love so dearly can be preserved from embarrassment.  Those brave souls who set off to examine the awkward facts get great praise and often serious support from their less brave colleagues.  They are, after all, inoculating the entire discipline against the charge that it ignores facts.  You can almost hear them say: No it doesn’t, just look at Professor so-and-so over there, they’re checking it out.  See?  Economics is really diverse and inclusive.  Under their breath, of course, you can hear them muttering that they hope Professor so-and-so doesn’t get so far that the Big Theory has to be torn down and replaced.

You can get a hint of this in some odd places.  For instance, Ken Arrow wrote about it in his Foreword to Brian Arthur’s 1994 collection of papers published under the title “Increasing Returns and Path Dependence in the Economy”.  Commenting on how the English School, particularly Ricardo and John Stuart Mill, dropped the concern Adam Smith had for increasing returns he says:

“Other analysts in different traditions, especially the French metahemtician and economist, A.A. Cournot (1838), saw clearly enough the incompatibility of increasing returns and perfect competition and developed theories of monopoly and oligopoly to explain the economics system implied by increasing returns.  But this tradition acts like an underground river, springing to the surface only every few decades.”

Arrow goes on to mention luminaries such as Chamberlin, Robinson, Young, and Kaldor all of whom have dared to bring increasing returns back to the main table only to be rebuffed as malcontents or misfits.

Indeed you get the feeling from Arrow that his own attitude is ambivalent.  He tells us that those aforementioned luminaries developed the ideas “though far from completely”.  Damning praise.  Perhaps Arrow, one of the modern greats and with a reputation that would have made him impervious to criticism might have helped complete the journey?  But no.  He spent his capital on the silly nonsense called general equilibrium, hoping, no doubt, that no anomalies popped up to reduce his effort to dust.

I must give Arrow his due, he confesses that the onerous requirements needed to make neoclassical general equilibrium work — let’s all admit that those requirements are other-worldly — look as if they undermine the entire project’s credibility.  So the wonderful edifice he helped articulate and bring into being achieves not much at all.  The excact same criticisms can be leveled against it that its defenders leveled against central planning in the infamous “socialist planning debates ” of the 1920s and 1930s.  Arrow is being honest when he observes that if even a single person anywhere in the economy can set a price (as opposed to being a passive price taker):

“the superiority of the market over centralized planning disappears.  Each individual agent is in effect using as much information as would be required by a central planner”

So general equilibrium is not a statement about the real economy, it is a statement about what economists would like to talk about — notably artificial markets.  I have often remarked, and not always in jest, that economists do not study economies, they study economics.  The two are very different.  Not least because economies often contain damn facts that poke holes into preferred theories.

A slightly different manifestation of this problem is the infamous Friedman position on the reality of assumptions in modeling.  There’s nothing wrong with making what appear to be extreme assumptions if the subsequent analysis produces some insight of value.  Friedman himself says that the goal of science is to make “valid and meaningful predictions about phenomenon not yet observed.”   This, naturally, begs the question concerning which phenomena he speaks of.  Most people, I would wager, look at economics as the discipline focused on making statements about markets, industries, firms, and whole economies.  It is not, according to people like Friedman, at all about the economic behavior of individuals.  This is odd because the entire effort following in the Friedman tradition has been to theorize about the collective phenomena only as aggregates of individuals.  This leads to the absurdity of Thatcher’s claim that there is no such thing as society.  She was making an ideological statement.  But it was based upon firm Friedmanite foundations.  The problem with this is that the corpus of statements about the collective phenomena are built on knowledge and assumptions that are, according to Friedman, not within the purview of economics.  If we are to believe this, then so-called “micro-foundations” are merely speculation exogenous to the core of economics and cherry picked in order to facilitate desired statements about aggregate behavior.  This conundrum exists only because those following in Friedman’s footsteps want to avoid being accountable for any prediction of individual human behavior based on that speculative basis.  Individual behavior is, remember, not the subject of economics, it is just an assumption that economists make in order to examine the bigger picture.  So what if the facts belie the validity of that speculation?  We can leave that to the behavioralists — another worthy subgroup working on the fringes and inoculating the mainstream against the charge of ignorance.

I have, as I usually do, digressed somewhat.  But the existence of things like increasing returns and realistic individual behavior lurk constantly outside the fences of economics and spring up, to use Arrow’s analogy, periodically to embarrass the mainstream.  They never appear to barge all the way in.  Somehow economics manages to push them away and consign them to specialist study as interesting sidelines.  They are treated as oddities and not the norm, so the conversation can continue much as before.

Which means, ultimately, that economics stagnates unwilling to expand its core range to encompass facts that are difficult to scrunch into its perfectly competitive general equilibrating world.  What then is positioned as advance is simply an ever more detailed discussion of the same stuff.  Decade after decade.  This is not a novel observation.  Leontief, hardly an non-person in the galaxy of economic stars, agrees:

“If the great 19th-century physicist James Clerk-Maxwell were to attend a current meeting of the American Physical Society, he might have serious difficulty in keeping track of what was going on.  In the filed of economics, on the other hand, his contemporary John Stuart Mill would easily take up the thread of the most advanced arguments among his 20th-century successors.  Physics, applying the method  of inductive reasoning from quantitatively observed events, has moved on to entirely new premises.  The science of economics, in contrast, remains largely a deductive system resting upon a static set of premises, most of which were familiar to Mill and some of which date back to Adam Smith’s Wealth of Nations.”

One last thing, speaking of stagnation: the current burgeoning “trade war” between the U.S. and China is often viewed through the lens of Ricardian analysis.  Comparative advantage encourages trade between nations.  So standard economics tells us that trade is a “good thing”.  But the current trade between the two is not actually trade between nations.  It is a complex of privately determined, shareholder driven, supply chain relationships.  Where is the comparative advantage?  Where is the nation?  Who benefits?  Simple little models built in the Ricardian tradition fail completely to get at the current facts.

Stagnation.

Damn facts.

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Ideas That Must Be Forgotten

Much of what we are told as being advances in economics are diversions or delusions that serve only to trap us in a cul-de-sac. Sometimes that becomes a very long road to nowhere. Sometimes, it seems, economics will never return to being about actual economies, but will always be doomed to stay the plaything of a select group of very clever savants separated from the world by their contempt for its complex messiness.

I am not one of those to indulge in endless territorial fights over purity of thought. What matters to me is practical application. I measure the usefulness of an economic idea by the illumination it throws on a real world problem and on its ability to assist us better our collective lots in life. I frankly don’t care if it is the precise meaning that some long ago dead theorist gave to an idea. Our current divination of that meaning may have strayed from purity, but it might also work. Battles over intellectual turf are meaningless except for a very few whose reputations are involved. Other than that, who cares?

Thus I admit I find the current argument over IS/LM a sideshow. I realize that the Hicksian version of Keynes is impure. I realize that Hicks himself came to regret having given life to it. But, in a crude and first cut kind of way it works. Does that imply I want to dump the pure Keynes? No. No it doesn’t. But I would prefer to go into battle with the impure kind rather than with the absurdity of the orthodox alternative. It would be better to go into battle with the pure kind, but that isn’t in most arsenals nowadays. And we must go to battle. There’s an economy to understand.

This leads me back to my problem: all those ideas that block progress.

You see in a recent blog post Paul Krugman tells us about the origins of Keynes-via-Hicks, and how jolly useful it has been — to him anyway — as he thinks about the economic crisis that began in 2007/2008. Buried in that post is a question:

“What’s the minimum interesting general equilibrium problem? The answer is, an economy with three goods, which means that there are two relative prices. You can think of such an economy as having three markets, but because of adding up you only need to look at two – if any two are in equilibrium, so is the third.”

Actually I don’t find any general equilibrium problem interesting. Not even minimally. I don’t think of general equilibrium as being an interesting topic, at least not in the context of a modern and vastly complex economy. I have said this before, but let me repeat myself: I wish that economics would forget about equilibrium for a while and focus on disequilibrium which, to me at least, is the more normal, empirically abundant, and thus interesting topic.

And I know I have said this before too: I regard the landmark effort of the likes of Arrow and Debreu with the utmost respect. They demonstrated clearly the irrelevancy of general equilibrium. They showed it cannot exist except under the most extreme and utterly unreal circumstances. Their work ought to have killed off the idea for good, but it didn’t. General equilibrium arose from that death stronger. It became the central plank of all subsequent orthodox thought. I have no idea why because it makes no sense. Then again, sense and economics are uneasy bedfellows at the best of times.

This is not to say that economies don’t sometimes display periods of stability. Many complex systems settle periodically into such periods where the moving parts, their relationships, and the outcomes seem to act in some sort of harmony. Then something disturbs that harmony and off the system goes through a period of disequilibrium searching for new stability somewhere else.

Economic orthodoxy places the source of the disturbance outside the system. In other words the source of disequilibrium, the impulse for change, sits outside the economy — or at least the economy as defined by those who adhere to equilibrium analysis.

I find this deeply unsatisfying. It is like saying that the cause of the change in today’s weather wasn’t a change in weather, but was something else. Something made the weather change, but that thing cannot be weather itself. This is ludicrous.

At a basic level this is simply an admission that economists don’t understand the economy as a process through time, but have isolated it at a particular point in time, frozen it, and then described it. It is freeze frame economics. In freeze frame economics we need a projector attendant to restart the motion. We need something outside the movie to get us to the next frame. This reliance on outside influences means that the narrative of the movie — the story we are trying to understand — is also situated outside the frozen frame. Indeed it is outside all the frozen frames because each one has to be compelled into motion by an external force and that external force is the narrative.

Economists have thus removed the very object we need to get a handle on: why economies change through time. Which is not the same as understanding how the integral parts relate and fall into a stable relationship with each other.

I suppose this is just my way of saying that economics is more than the study of the allocation of scare resources against the endless needs/wants of humanity. It is also the history of the development of those needs/wants, and the arc of the complex set of relationships that allows us to invent, produce, move around, exchange and ultimately consume the things that satisfy those needs/wants. For within that complex history is the impulse that keeps the entire system in motion.

Economists, because of ideas like equilibrium, place that impulse outside the sphere of their analysis. This is unfortunate. It is what makes economies interesting things to think about.

Let me leave you with this quote from a wise book called “The Great Wave” by David Hackett Fischer:

“In economic history, equilibrium is the exception rather than the rule. A free market restores equilibrium only to break it down again, and to set in motion a new sequence of imbalances and instabilities with all the troubles that follow in their train. In the full span of modern history, most free market have been in profound disequilibrium most of the time — often dangerous and destructive disequilibrium.”

Economists have, I think, settled on the easier side of the problem. Perhaps they ought to move on to the other, more difficult side.

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Smith’s Curse

I am not easily swayed by talk of curses. They make for good gossip and a laugh, but have no explanatory legitimacy. All except Smith’s Curse. Adam Smith that is. Here’s why:

Ever since Adam Smith wrote, just once, about the mysteries of the “hidden hand”, economics has had its brains addled by the allure of those magical powers Smith postulated as the reason he saw order rather than chaos around him. His was possibly the first insight into what is now called the self-organizing properties of a complex system.

The problem with this is the absurd lengths to which economists have gone in order to give credence to Smith’s insight. Instead of embracing the muckiness, and infuriatingly indirect nature of complex systems, they have gone the other way entirely. They have been driven to simplify at inordinate and quite ridiculous length in order that they come up with the answer Smith first thought of. Their tools and methods are wrong. Their desire runs deep. That combination makes for some pretty ugly reasoning. This doesn’t mean that complex systems are not comprised of very simple components. It’s just that they are not deterministically thus constructed. Therein lies the big error of orthodox economics. It is still rooted in a mechanical vision where the economy is a vast machine playing out in an orderly fashion from a set of basic assumptions.

When we observe apparent order, such as we see in the confines of a well behaving market, we must be careful not to interpret that observation as implying that the underlying system is, itself, well ordered. Disorderly systems are far more common. In fact they are the norm. Yet sometimes they give rise to patterns that belie their true nature.

This was Smith’s error. And by making such an error he bequeathed economists a long lasting curse.

They imagined that markets are orderly structures. They are not. They have people in them, which means they are can be whimsical, subject to fashion, or tightly ordered and efficient all at the same time. They are human, not magical.

We could simply end at this point by saying that the rest is history. Economics, or at least its orthodox versions, has labored long and hard to detect and theorize about the mystical forces necessary to ensure, not just orderly outcomes, but orderly workings. In a deterministic system the outcome is orderly because the systems itself is precise. It plays out along known and predictable lines. Hence the theories of people like Walras who conceived of the economy as giant machine capable of arriving at a single best solution to the problem of allocating resources. Only his machine needed help. He wasn’t able to solve his equations without the assistance of an external “auctioneer” who directed the traffic to make sure everything resolved itself neatly. Some of us think of this as cheating, but to the orthodox it was simply a challenge to try harder.

As Walrasian thinking became to pervade orthodoxy all sorts of bells an whistles were added to try to get around the fictional auctioneer. The humans within the system were invested with superhuman powers of calculation and information. Gathering information was made costless. What people wanted or needed was crushed into something called utility so it could be fitted within a mathematical structure. Time was reduced to a single point by using the trick of futures markets. And so on. Smith’s curse drove a great many intelligent people to extraordinary and, frankly, almost psychotic, lengths to discover and articulate the magic he imagined lying beneath the surface.

In the end orthodox economics was reduced to getting rid of humans in order to make things work well at all. And even then the prime movers of the final edifice, Arrow and Debreu, were not sure of the relevance or use of the monster they created.

This is because there isn’t any use. It was always a wild goose chase. The order Smith saw was a chimera. A mirage beckoning economists and no one else.

Now here’s the really big problem with Smith’s Curse:

It can make clever people do bad things.

Ever since the 1930’s classical economics has taken on a morally superior tone. It has been preached rather than taught. Free markets are, according to the orthodox, superior because they produce “the right answer” without any intervention by governments. Thus they are untainted by the wants, requirements, and biases of mere mortals. Markets march, so they say, to the beat of immutable forces that are impervious to human intervention. So they are ideals we should strive to achieve. As if Smith was channeling Plato when he devised his curse.

If this sounds vaguely religious, you are not the first to notice the resemblance.

In the hands of folks like Hayek and Friedman classical economics was used as an ideal bulwark against the intrusion of the dark side of human calculation. Hayek meant it when he talked about “The Road To Serfdom”. Friedman meant it when he wrote about being “Free To Choose”. Both imagined that a free society whose economic relations were determined by the forces that drive unfettered markets cannot end up in a bad spot. It just works out that way. It just is. Perhaps a mystery. But it just is. Worse: whenever silly and limited humans get involved things will alwatys go awry. Those of us who a tad more skeptical are told to keep our tawdry questions to ourselves and not to sully the beauty of the free market vision. We should allow the faithful to go on believing. Their faith unquestioned because it is unquestionable.

Such was their fervor, and such was the hold Smith’s Curse held over them, that no amount of foolishness was allowed to sway their thinking. Thus Friedman could write, presumably in earnest, that no matter now ridiculous, absurd, or other worldly the assumptions needed to make a free market systems superior in theory – let alone practice – those assumptions were justified if they drove the theory to the “correct answer”. By which he meant the answer he, like Smith, first thought of. Where there is science in this is questionable. But you have to admire the zealotry.

Now comes the damage I mentioned.

So smitten by Smith’s Curse are orthodox economists that they engage in social engineering. By their own logic people like Hayek and Friedman should aver all attempts at imposing a system upon society. After all that way lies the road to serfdom. And surely we – the rest of us – are free to choose. Yet Friedman in particular, and his army of righteous followers, think nothing of advocating all sorts of changes to society in order to get things ordered the way most conforming to their theoretical views. This is why Friedman was a major, if not the major, force behind establishing a free wheeling derivatives market. You know like the one that just blew up the world economy. This explains the ardor with which orthodox economists advocate deregulation, the dismantling of social safety nets, and other community oriented devices. Their faith drives them to preach and alter anything they deem inappropriate. Like society, or any construct with word word “social” in it.

So in the end Smith’s curse has produced a prodigious paradox: the theorists most stricken by his vision are both the most ardent advocates of freedom, and the most determined social interventionists at the same time. They think nothing of forcing the rest of us to conform to their utopian visions. More to the point: the past few decades have been a prolonged social experiment in free market economics. In any number of places orthodox economists have influenced society in an effort to make reality reflect their theories. Society, as it had evolved by the 1970’s, needed to be saved. It needed to be shunted back into its rightful place. If that meant imposing order and restricting the choices of others, so be it. Nothing should get in the way of the neoclassical crusade.

This is, of course, back to front. In respectable science theory reflects or explains reality.

But then it might not come up with the right answer. And Smith’s Curse would lose its grip.

And it’s such a warm and fuzzy feeling when slip into the dreamworld described by that curse.

It can’t just be a myth can it?

I don’t know. Maybe we should ask the unemployed.

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It’s Love “Schumpi” Day

When last I wrote here I repeated a quote by Joseph Schumpeter, that Paul Krugman used to lambast the classical opposition to government interference in the economy.

True to form, I was immediately set upon by the one man Austrian economist defense force – Stephan – who managed to dig out the original text from which the quote was cut. His purpose being to draw my attention to the softer tones used elsewhere in that document.

I agree. Schumpeter was not as clear cut a terror as Krugman made him out to be. While we all know Schumpeter as the inventor of the phrase: “the gales of creative destruction of capitalism”, he was so much more.

His influence was muted by the fact that his long career always seemed to leave him out of the limelight, he was eclipsed by Keynes for instance, and never part of a dominant school of thought. He was a teacher, at Harvard, of a number of subsequent “Nobel” prize winners, but his books and papers put him outside of the emerging mainstream of American economic theory.

In many ways Keynes was more orthodox than Schumpeter.For instance, Keynes, for all his rebellion against classical theory, was still committed to static equilibrium style thinking. That in his system equilibrium could imply less than full employment was startling, and controversial. But his thinking was focused on the properties of economies as they tend toward or away from such equilibrium. It was Patinkin who pointed out that Keyne’s great innovation was to locate the equilibrating force within his novel conception of “effective demand”. Everything else in The General Theory flows from that idea, and the tools Keynes used were borrowed and adapted from others, such as theeconomist Fisher.

By contrast, Schumpeter was never interested in equilibrium. He saw the economy as in perpetual flux and never in the kind of static equilibrium that has come to dominate orthodox economics since the mid-20th century. This is why he was led to discuss “creative destruction”. The central actor in his conception of an economy was the capitalist innovator driven by profit to search for new products and new methods of production. It was this innovation that, in Schumpeter’s view, provided the engine driving wealth creation and social welfare generally. Along the way capitalists make mistakes, they over produce or over invest, this leads to periods of adjustment and the need to revalue assets. These periods are what we call recessions or depressions, and are the times when those mistakes are wiped away. Hence the destruction. Naturally once the adjustment has been made and past mistakes expunged, the now chastened capitalist class powers forward again, driven once more by the profit motive, only this time free of the encumbrance either over valued assets or ill advised investments. Hence the creative aspect to Schumpeterian economics.

Drucker draws the difference between Schumpeter and Keynes nicely. Keynes, he said was merely a heretic. Schumpeter was a full blown infidel.

Unfortunately for Schumpeter his notion of an economy being dynamic and subject to cyclical upheaval flew directly in the face of classical theory whose goal was to place economics firmly into a Newtonian firmament both mechanical and determinist. This misfortune was compounded by the success of people like Arrow and Debreu who, a few years after Schumpeter’s death, were able to create the mathematics necessary to articulate a model of general equilibrium and thus obviate the need for younger theorists to explore the seeming chaos of the Schumpeterian world.

Oddly, sixty years after his death, Schumpeter seems more relevant than before. His ideas could be re-cast as being evolutionary, and the great theme of evolution is one possible way in which economics can regain the relevance and connection with reality it lost after Arrow-Debreu. His importance to current events is even more significant when we consider his long view for capitalism. It was a system, he thought, that would choke itself on its own success. Not through the results posited in the Marxist critique, but because of something altogether more mundane: he feared that capitalism would spawn a great bureaucracy populated by elitist “hangers-on” to the entrepreneurial machine. These elitists would be highly educated workers like lawyers, accountants, and bankers who would eventually sap the system of its vitality through their ability to impose non-productive costs on the innovative process. They would rent seek, draw off funds, and starve capitalists of the means to keep the engine running.

This scenario sounds eerily familiar. It also accords with the work of a protege of his nemesis. It was Minsky, a follower of Keynes, who correctly developed a theory describing the instability within finance – one of Schumpeter’s feared bureaucracies. So, perhaps, within a Minsky moment we can detect the imprint of Schumpeterian creative destruction.

If so, there is hope for a conjunction of the theories of two of greatest non-classical thinkers of twentieth century economics.

And we need all the new ideas we can get.