Philosopher John Gray has a review in the LRB of Akerlof and Shiller’s new book on the errors of mainstream economics, a review which mentions the sadly-neglected economist George Shackle. Shackle, unlike most academic economists, actually worked in industry and Government and had made investment decisions, and knew whereof he wrote.
If Akerlof and Shiller’s grip on the history of economic thought is shaky, they also fail to grasp why Keynes rejected the idea that markets are self-stabilising. Throughout Animal Spirits they portray him as reintegrating psychology with economic theory. No doubt this was one of Keynes’s goals, but it is not his most fundamental revision of economic orthodoxy. Among his other accomplishments he was the author of A Treatise on Probability (1921), in which he tried to develop a theory of ‘rational degrees of belief’. By his own account he failed, and in his canonical General Theory of Employment, Interest and Money (1936) he concluded that there was no way anyone could make forecasts. Future interest rates and prices, new inventions and the likelihood of a European war cannot be predicted: there is no ‘basis on which to form any calculable probability whatever. We simply do not know!’ For Keynes, markets are unstable less because they are driven by emotion than because the future is unknowable. To suggest that the source of market volatility is unreason is to imply that if people were fully rational markets could be stable. But even if people were affectless calculating machines they would still be ignorant of the future, and markets would still be volatile. The root cause of market instability is the insuperable limitation of human knowledge.
Later economists have made much of a distinction between risk, which can be assessed in terms of quantifiable likelihood, and uncertainty, where probabilities cannot be attached to possible outcomes. The trouble is that when attempting to forecast the course of the economy we often cannot confidently distinguish between the two. Even our list of possible outcomes may turn out to have omitted the ones that are most important in shaping events. Such an omission was one of the factors that led Long-Term Capital Management, a highly leveraged hedge fund set up by two Nobel Prize winning economists, to fail in 1998-2000. The information used in applying the formula did not include the possibility of such events as the Asian financial crisis and Russia’s default on its sovereign debt, which destabilised global financial markets and helped destroy the fund. The orthodoxy that came unstuck with the collapse of LTCM was not faulty because it neglected the vagaries of human moods; its mistake was to think that the unknown future could be turned into a set of calculable risks and, in effect, conjured out of existence, which was impossible. Several centuries earlier, Pascal – one of the founders of probability theory – had come to the same conclusion, when in the Pensées he asks ironically: ‘Is it probable that probability brings certainty?’
The central flaw of the economic orthodoxy against which Keynes fought in the 1930s was to imagine that an insoluble problem – human ignorance of the future – had been solved. The error was repeated in the 1990s, when economists came to believe that complex mathematical formulae could tame uncertainty in the murky world of derivatives. Steeped in history as they were, this was a delusion that none of the classical economists entertained. It began to shape economics only towards the end of the 19th century, with the rise of Positivism, according to which the natural sciences are the only legitimate repository of human knowledge. It was the formative influence of this philosophy on the Chicago School that enabled the orthodoxy of the 1930s to re-emerge triumphant, and the result was an immense boost to the prestige of economics as a discipline. Economists could claim to be scientists, who with the aid of their mathematical magic could pierce the veil that conceals the future.
The hegemony of Positivism in economics obscured Keynes’s scepticism about probabilistic knowledge, his most important contribution to the discipline. G.L.S. Shackle set Keynes’s argument out systematically in his neglected masterpiece Epistemics and Economics: A Critique of Economic Doctrines (1972). Shackle is probably the only significant economist to have been influenced both by Keynes and by his arch-rival, F.A. Hayek. He knew both of them well, but argued that neither had digested the full implications for economics of our ignorance of the future. Hayek said that governments could never know enough to plan the economy successfully – a claim vindicated by the miserable record of central planning in Communist countries. At the same time, he attributed near omniscience to markets, and never doubted that if left to its own devices the economy would liquidate mistaken investments and return to equilibrium. Against this, Keynes had shown that there is no market mechanism that ensures revival; economic contraction can be self-reinforcing, and only government action can then create a way out.
Shackle took Keynes’s argument a step further, and showed that no economic policy can ensure economic stability indefinitely. ‘Keynesian’ policies are no exception to this rule. Deficit financing and monetary expansion may have worked well in the conditions that existed after the Second World War. It is not clear that they will be so effective today, when globalisation has brought a freedom of capital movements that did not exist then. The lesson of Shackle is that we must be resourceful in devising new remedies, while not losing sight of the fact that none of them works for long.
Akerlof and Shiller claim that their account of the role of psychology helps to explain the financial crisis. ‘Our theory of animal spirits,’ they say, ‘provides an answer to a conundrum: why did most of us utterly fail to foresee the current economic crisis? How can we understand this crisis when it seems to have come out of the blue with no cause?’ They are right that part of the answer lies in an intellectual default within economics, but they seem oblivious of the role of ideology in producing this default. The deformation of economics was not the result only of factors internal to the discipline, it was also part of the short-lived Western triumphalism that followed the end of the Cold War.
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Keynes and the classical economists before him knew that there is no realm of market exchange that obeys laws of the kind that can be formulated in the natural sciences. Economics and politics are not separate branches of human activity, and economic life cannot be studied independently of social divisions and political conflicts among populations, along with their cultures and religions. Familiar to Keynes and most of the economists of his generation, these truisms have been forgotten, or rejected, by many economists today. The result is an economic imperialism that tries to explain every human activity in terms of a conception of rational action that does not work even when applied to the behaviour of markets.
Of course, there is a standard response to these observations, which is that unrealism in economic theories doesn’t matter. As developed by Milton Friedman, among others, this is in effect a version of instrumentalism, a tenable position in the philosophy of science. For instrumentalists, the goal of science is not a true representation of the world; it is to organise our observations into a theoretical framework that serves practical goals, such as prediction and control. But what practical goals have been served by the type of economics dominant over the past two decades? It has been useful neither in making predictions nor in responding to unforeseen developments.
Akerlof and Shiller intend their analysis to contribute to an intellectual reformation in economics, as a consequence of which the discipline will become more useful to policy-makers. It must be doubted, though, that the authors will succeed in persuading economists of the inadequacy of the conception of rational action. The profession is one of the few areas of human activity in which that conception is applicable. In its intra-academic varieties, at any rate, economics is insulated from the world not only by its narrow explanatory methodology but also because it rewards the mathematical modelling that resulted in nearly all of its members failing to anticipate the financial crisis. As institutionalised in universities, the notion of rational decision-making is self-perpetuating. Economics as currently practised may have only a slight grip on market behaviour, but it seems to be powerfully predictive of the behaviour of economists.”
John Gray : We Simply Do Not Know! London Review of Books, 31 (22): 13-14, 19 November 2009. Review of: Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, by George Akerlof and Robert Shiller. (Princeton).
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