London Review of Books

OK I can hear the yawn. Who is John Gray after all? Well, a really clever fellow that’s who. He has written some very controversial stuff, he taught at my alma mater, and is one of the world’s foremost intellectuals. His canvas is more extensive than most. He is quite capable of offering a reasoned and sound critique of most aspects of society. So his review of what has become a best seller, a book called “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters For Global Capitalism” by George Akerlof and Robert Schiller should be on everyone’s reading list. His article that is, not necessarily the book. His article appears in the London Review of Books. Allow me to precis his argument for you. Bear with me this is important as we dig out from our self inflicted crisis.

The premiss of the Akerlof and Schiller book is that the wheels have come off modern economic theory. It fails on so many points that it has been severely diminished as a body of thought. In fact the failures of economic theory contributed mightily to the crisis we find ourselves in.

Those of you who follow my own thinking regularly will realize I like that conclusion. I too attribute a great burden to modern economic theory, especially its obsession with rationality and equilibrium neither of which do I see manifested anywhere on planet earth other than in the heads of economists.

The Akerlof/Schiller thesis goes this way: because humans are irredeemably irrational any theory based upon rationality is doomed, a priori, to failure. In order to rebuild credibility the authors suggest that economics embrace the research and findings of a new variation of the subject called ‘behavioral economics’.

So far so good.

We can all agree up to this point.

But Gray goes further. And this is his big contribution: he argues that Akerlof/Schiller misunderstand Keynes. Don’t forget that Keynes has seen a resurgence in popularity lately largely because he argued that markets are not efficient and that they fail. Just as our economies did, indeed, fail last year. The very title of the Akerlof/Schiller book reflects their acknowledgement of Keynes. The phrase ‘animal spirits’ was a Keynesian term.

What Gray points out, and what forms the central point of his critique, is that Keynes went much further than Akerlof/Schiller appear ready to. According to Gray, Keynes argued that economics is faced with an insurmountable problem: we have no way of predicting the future. Uncertainty pervades our environment and no amount of clever categorization or analysis can obviate this fact. We fool ourselves monumentally when we classify something as being ‘risky’. For those of you who need a refresher, there is a tradition beginning back in the 1930’s with analysts like Frank Knight that distinguishes between ‘risk’ and ‘uncertainty’. Something that is uncertain lies beyond any conceivable analysis. It remains in the realm of guesswork. But something deemed to be ‘risky’ is contained within our analytical capacity: we presume to ‘know’ the outcome of a risk, and we simply assign a probability to that outcome. Thus we can argue that outcome ‘A’ has a 30% chance of occurring. The moment we do this we create the illusion that a risk is somehow more manageable. We think we can mitigate its effects. This notion undergirds the heart and soul of much modern finance.

It is also wrong.

As Gray tells us, Keynes wrote an extensive theory of probability, and declared himself defeated by uncertainty. It is simply unknowable. Worse: what we call a risk is likewise unknowable since our presumption about outcomes is a method of truncating our descent into subsequent uncertainty. We are fooling ourselves. We, as Akerlof and Schiller rightly point out, are irrational. We like to trim away uncertainty by inventing neat tricks. We invent solutions to things we have no idea about. Most of modern religion is a result of this effort to explain away phenomena that were beyond the ken of our bronze age ancestors. Efforts to avoid the gnawing fear created by uncertainty abound.

One of them being modern economic theory whose relationship with uncertainty is best described as being non-existent.

This hasn’t stopped economics from vectoring into all sorts of mathematical wizardry. Those models that led us all down the garden path last year, the ones that predicted the performance of Mortgage Backed Securities, or the ones that banks relied on for risk management, are all couched in shiny math. It looks good on paper and can fool just about everyone.

Which is why it is so pernicious.

Gray’s larger point, which is what makes his article so thought provoking, is that economics alone is not to blame. We have allowed the ideology the lies underneath economic theory to hold sway in all walks of life. It is very hard to discuss the current crisis precisely because the predominant view remains that markets are excellent allocators of economic goods and services. They may be OK, but good they are not. Or at least we cannot rely on them all the time.

That’s uncertainty creeping back in.

The fact that our worldview is so restricted by the free market ideology prevents us from even seeing alternative strategies for success. Gray posits China as an example. As a counter factual to the free market dogma China’s recent growth is a powerful rebuttal. Few China’s economic policies would pass muster in an economics class as taught here, yet the growth is indisputable. How come?

Gray argues that economists have a blind spot to history. They ignore inconvenient events in order to maintain the efficacy of their near religious adherence to the free market gospel. They ignore the origins of the American economy and its initial growth within a fierce protectionist jacket. They ignore the Asian ‘miracle’ of the past few decades. And they ignore the teaching of their own heroes like Adam Smith who saw the ‘hidden hand’ as a very imperfect and easily twisted process. Adam Smith was concerned about the impersonality of a market and the damage it could do to a community. He was a precursor to Karl Marx’s views on alienation.

The moderns though have rephrased Smith to conform with their ideology. And they have forgotten Marx completely, even though his place as one of the great classical economists is assured in history.

Instead they choose to restrict economics to a mathematical expression of contained risk and constrained optimization. They have deliberately cast aside any connections with politics, sociology, and institutions or culture. By so doing they have, in Gray’s view, produced an impoverished and doomed enterprise.

I agree wholeheartedly.

No economics that ignores its environment, including things such as geography, the values of its people, their ability to connect with outsiders and each other, their cultural and technological constructs, and above all else their level of knowledge, can hope to explain what a real economy does. These thing are all inextricably linked with our every day social and economic discourse. They must reside within, not without, an economic theory.

Thus Gray asserts that Akerlof and Schiller, while they are making clear improvements on orthodox theory, are still missing the larger point: Keynes was right. We simply do not know.

Read his article, it is time well spent.