real world economics

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We Need Our Hutton

This caught my eye:

“Debreu noted in his Nobel Prize lecture that the success of the mathematization of economic theory depended “on the fact that the commodity space has the structure of a real vector space”. We have shown that this is incorrect. The “price vector” is not a vector, and GET [General Equilibrium Theory] is therefore false. But we may go further and assert that not only was the proof incorrect, what was set out to be proved was not true in the first place. The real economy cannot be brought into equilibrium by adjusting prices. And indeed, the real economy is never in equilibrium.”

That’s the concluding paragraph in Philip George’s paper in the recently published Real World Economics Review #101.

The emperor, apparently, has no clothes.

But, then, we all knew that, didn’t we?

I wrote just yesterday about the difficulty we have in determining the efficacy of a supposed body of knowledge.  The arbiters of knowledge have a vested interest in maintaining the outward appearance of whatever it is they study.  They act like a priesthood intoning in ancient languages and using secret signs to distinguish themselves from the ordinary folk whom they intend to control or influence.  The problem is that we, those of us on the outside, can only rely on those arbiters for assurance that the efficacy they proclaim for themselves is actually, well, efficacious.  Worse, within a wide discipline such as economics, or applied mathematics as it has now become, the various sub-specialities are so specialized and the knowledge so arcane that anyone not within close proximity to it is unable to offer an opinion as to its validity.

This has become a fundamental and defining issue within economics.  The discipline needs good jolt of reality.  It needs a new direction.  It needs to shake off the errors of its past and begin anew.

The problem is that those errors, as George points out, are huge and have become iconic components of the discipline at large.  General equilibrium is one such component.

It doesn’t exist as a natural phenomenon.  It never did.  It never could.  No one has ever seen one.  No one has ever touched one.  No one has ever experienced one.  It exists only as a concept created for the purpose of allowing exploration of its properties, its values, and its potential as a comparison with the real world.  It is a unicorn.

But we don’t use unicorns as a starting point for the study of real-world horses.  We don’t say, for instance, that a horse is a unicorn without a horn.  No.  We study horses.  Unicorns are for fun.  They are pieces of imaginative excess designed to amuse and tantalize the young.  We can hardly argue that general equilibrium exists for fun.  Except, of course, for those who want to demonstrate their mathematical virtuosity.  Now, if George is correct, their obsession with showing off is revealed to have been a colossal side-show that diverted economics from contact not just with reality but also from mathematical principles.  The post-war rush to make economics mathematical was so intense that no one stopped to make sure it made any sense.

It didn’t.

But that manifest truth doesn’t stop economists from blundering along.  They live in such a bubble that even a major error, one that debilitates the entire enterprise, is insufficient to stop their momentum.  Like alchemists they don’t want mere chemistry to spoil their fun.  It would require a re-write of the discipline and would expose a whole lot of argument over the past few decades as being vapor rather than substance.  No to mention those august reputations that would need reconsideration.

So the question is how does economics get its much needed revamp?  It needs a kick-start similar to that Hutton gave geology.  When he wandered around outside and realized that the rocks he was looking at must have accumulated as layers over aeons, and that the odd intrusions into those layers suggested radical action over similarly long periods of time, he did not run home and seek the solace of a unicorn-like model in order to contrast and simplify what he saw.  Nor did he concern himself overly with the established timeline drawn as a thought experiment from ancient texts.  No.  He dealt with reality.  He dealt directly with the facts around him.  And, by so doing plunged our understanding of the world forward in a great upheaval whose explanatory power is immense and ongoing.

For decades such direct engagement has been lacking substantially in economics.  It has, instead, turned within itself and developed a wonderfully sophisticated toolkit to study its own imagination and imagined phenomenon, not those of a real economy.  It no longer questions its core assumptions.  It has forgotten why it is what it is.  It simply keeps building higher and higher into the air whilst paying little to no attention to whether it has a foundation resting on solid ground.  Even a giant like Keynes wan’t able to shift the momentum away from fantasy for long.

Perhaps the trouble began in the discipline’s founding myths.  Was it Smith’s fault?  When he used metaphor to describe the appearance of a coming together of the parts into a smoothly operating whole he was using metaphor.  He was not describing reality.  The words “as if” had very special meaning.  He separated, by using those words, reality from his imagined vision.  And he offered it in passing.  Yet subsequent economists became lost in the search for that vision.  They saw only the calm surface of the world around them and ignored the roiling depths below.  An economy is never, ever, in equilibrium.  It cannot be.  And no power of imagination can make it otherwise.

Now, I understand that the wise elders of the discipline will be chuckling at my naivety and lack of understanding of the arcane structure they know so well.  I acknowledge that.  To which I retort: what about the financial crisis?  What about that strange denizen of the economist’s jungle: “total factor productivity”?  Oh, and why admist all the perfection of the marketplace do business firms exist?  The elders might say that their constructions of imagination, such as general equilibrium, exist only to act as points of comparison so that they can compare the theoretically perfect with the empirically imperfect to illustrate, elucidate, or to explicate.

But what have they gained by so doing?

All that has happened is that they are where Hutton was when he began.  Looking at reality and trying to understand how it got that way.  The interim edifice of perfection is a complete waste of time.  In all its glorious perfection, it acts as an enormous distraction — the less wary might confuse it with reality.  And, as a point of comparison it offers us nothing.  It might as well have been a unicorn.

Hutton didn’t need one.  Why do economists?

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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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Unicorns and Free Markets

One of the more depressing features of the discourse on the parlous state of our economy is the constant refrain from some about the need to allow ‘free markets’ to do their magic and fix our ills.

That’s nice.

Or it would be were free markets not like unicorns.

Both are beautiful and captivating. Their features send us into paroxysms of joy and wonder. Their exploits and virtues are the stuff of great poetry or writing. They beguile us with the extent of their magical powers. They haunt us with endless dreams of what might have been.

Were they real.

Which neither are.

It is one thing for poets to wax lyrical about imaginary animals like unicorns in order to inflame our minds at the mythical. It is another for supposedly hard headed analysts to invoke free markets as an elixir of endless youth and vigor for our economy. Free markets are artifacts of our imaginations. They were invented in order that we could study the many differences between their imagined perfection and the grubby mess that is the real world. They allow us to identify all sorts of anomalies and quirks that clutter up real life and prevent it from ever being as pristine as the dream like wonderland we call a free market.

But there never has been, nor will there ever be, a truly free market. Like the unicorn they cannot nor do they exist. They remain a vivid and unfortunate reminder that human imagination and human reality inhabit two very different spheres. Call it a Platonic curse. I cannot abide Plato and his authoritarian views, nor can I stomach his obsession with the unreal. The notion that ‘pure’ forms exist, and that we are fatally compromised and thus shall never experience such purity is utter nonsense. It never existed in the first place, so it is hardly a failure not to experience such nirvana. Nonetheless Plato and his errors have infected our lives for more than two thousand years. Most notably in Christianity which is almost exactly built upon his faulty foundation – not that most Christians seem to notice or care. This is not an idle comparison: the exertions urged upon sinners bear a remarkable likeness to the exertions urged upon the unemployed. Both are deemed failures who should repent and improve themselves in order to be saved. Both are urged to hew more closely to a dogma remote from the front lines of modern living. No wonder Weber got lost in the Puritan work ethic.

And free markets?

They are a version of a Platonic ideal. They are unrealizable in the world of humanity. They turn to vapor and vanish the moment any contact with temporal considerations are introduced. They are a mist that distorts our dialog.

The reason is, of course, that markets in our real world and compromised daily by all sorts of stuff the free market dreamers call flaws. But they are not flaws at all: they are essential constructs and components of non-mythical markets.

The dream like free market is something that is suspended in mid air. It has no contact with geography, with man made institutions, nor with our incomplete cognitive ability – neither our instrumental nor our cognitive constraints limit its computational powers – and its denizens are unrecognizable as human. They are what Miroswski calls cyborgs in his book “Machine Dreams”. Only when real people and all their many imperfections are totally expunged from a free market can it become free. Only when it is released from the constraints of the law, custom, culture, religion, class, gender, and family can it rise above the mess of humanity and become free. And only when it is universal and not locked into a specific earthly location can it be free.

In other words it cannot be.

The analytical mythology that is the free market came into being because economists wanted to set up a laboratory model against which to compare the real world. I am being generous here. In my more cynical moments I would argue that they wanted to justify a certain way of life – they wanted to ‘prove’ that the interference of government was deleterious to the creation of wealth. So the cynic within me would say that the entire edifice of classical economics has been an effort to prove the superiority of decentralized markets over centralized or planned economies. This is not science it is politics. And the upshot has been the creation of an artifact we know as the free market, which, when stripped of all humanity, is indisputably superior in exactly the long sought for manner.

That economists still advocate this artifact as an exemplar of reality is shameful. They know full well that it is an imagined object.

Having opened Pandora’s box they have armed an ideologically motivated group to march off with the concept and impose, or try to impose it, on society. These ideological storm troopers engage in all sorts of social engineering in order to force reality more closely to align itself with the dreamscape. And by so doing they both undermine humanity and they introduce conflicts and distortions into the everyday workings of a real economy.

One outcome of this social engineering is the enormous change in the distribution of wealth we see today. As long as we acknowledge the conflict between democracy, which is a device for ensuring a more equable distribution of power and wealth, and capitalism, which necessarily results in exploitation and concentrations of power and wealth, we can maintain a balance. The conflict between the two enforces compromise. And all compromise leaves purists dissatisfied. The great era of the US economy – the 1950’s and 1960’s – was built upon this messy compromise. Once we allowed ourselves to be beguiled by the free market myth we sacrificed that balance. We unwittingly undermined democracy and favored capitalism.

We started to believe that unicorns were real.

And so, having arrived at the nearest we can to executing the dream here in the real world, after having deregulated and tossed aside as much constraint as we can, we are faced with the ugly moment of truth. Our pursuit of unicorns has been in vain. We are awake from the delusion. Reality requires limits to the market. Because only within limits do real markets exist.

That is the great lesson to be learned from the decades of Reagan illusion: once we strip away humanity in order to explore the magic of the free market, we should not then fall into the trap of thinking we are looking at something real. A market without the trappings of humanity is not a market. It is a unicorn like myth. It simply cannot be. However beautiful. However mysterious. However perfect.

So it saddens me to hear advocates of free markets get any air time in our current discourse on the economy. They are selling ideology not economic advice.

Snake oil has no place in our debate when the livelihoods of over nine million of our fellow citizens are at risk.

The unemployed deserve more than stories about unicorns. They deserve policies to restore growth. Policies based upon real world economics.