Different knowledge disciplines mean different things by the verb “to understand”. For economists and physicists, a domain or a problem is not understood unless and until it is modeled, and often only by a particular type of model. For most economists, for instance, agent-based models do not provide understanding, because they only show sufficient and not necessary conclusions. For mechanical engineers, understanding usually only comes from a physical prototype. For computer programmers, understanding happens through and with the writing of a software programme for the problem. For legal scholars, it arises with and from the writing of a narrative text reflecting on the problem and its issues.
Here is economist and game theorist Ariel Rubinstein on models in economics:
Continue reading ‘Economic models as fables’
Archive for the ‘Economics’ Category
Page 2 of 7
Specialization
Our modern, technologically-advanced, societies require very specialized knowledge and expertise to function. In such societies, it benefits individuals to specialize. Despite the beliefs of management consultants and the old Bell System, it is not true that everyone can do anything.
In the 1950s and 1960s, for instance, the British Government successfully promoted the development of a highly-specialized cadre of nuclear energy physicists and engineers, able to design, build and operate nuclear power stations. Once that technology became mature, however, Government policy shifted and it was thought that country could purchase nuclear power technology “off the shelf”; the country had no need for the skills involved (it was argued) and thus de-skilled. The French government took a different view, with the consequence today that young French nuclear engineers are in high demand in Britain.
Just as it benefits individuals to specialize, so too with cities and regions. If there are many companies in the same industry near to one another, recruitment of specialized, skilled staff is easier, exchanges of ideas and business occurs more often, and collaborative partnerships and common campaigns are facilitated. This is why, for example, the world’s leading commercial insurance companies operate near to one another in Trinity Square, London, and have done for centuries. This is why Stamford, CT, is a similar centre for insurance companies. This is why, despite the so-called abolition of distance by the Internet, the key US companies in telemedicine all operate within a few blocks of one another in Manhattan. Michael Porter’s work on regional industrial clusters has been rightly compelling in explaining the causes and consequences of these phenomena.
But what of countries? Most national borders are historical or geographic artefacts, contingent accidents of history that could well be otherwise. So, prima facie, what is true of regions should also be true of countries: it should benefit countries to specialize. Since David Ricardo’s theory of comparative advantage in 1817, economists have believed that countries gain from specialization in the production of goods for which they have relative advantage (despite the theory’s flaws). Why then do many people think it necessary for countries to NOT specialize, to have strong services sectors AND strong manufacturing industries AND a strong agricultural base? Many Marxists seem to think this – that all countries should have large manufacturing sectors – and none I have questioned has ever been able to give me a good justification as to why. (Perhaps believing that a proletarian revolution is a necessary stage of every country’s history leads one to believe that an industrial working class is also necessary, and hence a large manufacturing sector.)
Since the Great Global Recession of 2007-?, conventional public policy wisdom in Britain has been that the country’s economy needs “rebalancing” to reduce the role and proportion of financial and professional services, and increase the role of manufacturing. But why? Surely, most jobs in services are better paid, have better working conditions, and are generally more intellectually and emotionally challenging, than the repetitive, dirty, noisy, foul-smelling, physically-demanding jobs of factories. Of course, modern factories are often clean, quiet, and air-conditioned, because robots, unlike people and trades unions, refuse to work in any other conditions.
Now, according to The Economist, the British Government is planning to throw money at industrial sector strategy again – “picking winners” is the term of art. Not only did this fail last time Britain did it (in the 1960s and 1970s), but even MITI – the once all-powerful Japanese Ministry of International Trade and Industry – failed at it. Japanese attempts to enter the avionics industry were a bust, for example, despite MITI’s great desire, focus, power, and resources.
I can see a valuable role for government in overcoming problems of collective action – for example, when the actors lack knowledge of each other’s capabilities, beliefs or intentions, or when there are network effects or externalities associated to actions, or when it is in everyone’s interest to do something, but in no one’s interest to be the first to do that something. In these cases, government can can bring relevant actors or stakeholders together; it can convene; it can co-ordinate; it can develop common visons for the future; it can suggest, request, cajole, morally suade, and even harry participants to act for the collective good against their own self-interest. But none of these government actions or policies requires the government to choose winning companies or perhaps even winning sectors or regions. And none requires vast sums of money.
Destroying the Greek economy
Ambrose Evans-Pritchard in The Telegraph:
The Troika originally said that Greece’ economy would contract by 2.6pc in 2010 under the austerity regime, before recovering with growth of 1.1pc in 2011, and 2.1pc in 2012.
In fact, Greek GDP remained in an unbroken free-fall. It did not grow in either year. It contracted a further 7.1pc in 2011, 6.4pc in 2012.
Roughly speaking, the Troika misjudged the scale of economic decline over three years by 12pc of GDP. The total decline will be around 25pc, surely a Great Depression.
Don’t tell it was hard to foresee. The Greek Labour Institute and the think tank IOVE produced very accurate forecasts. The truth is that the Troika’s ideology of “expansionary fiscal contraction” is bunk, and doubly dangerous when compounded by tight money.
Like the Spartans, Thebans, and Thespians at the Pass of Thermopylae, the Greeks were sacrificed to buy time for the alliance.
Instead of applause, they were then vilified for their heroic efforts by ill-informed and self-interested Dutch, Finnish, Austrian, and German politicians. A squalid episode.
CIA and Sachs
I have been arguing against the ideas of wunderkind economist Jeffrey Sachs since his ruthless shock therapy advice in Latin America a quarter-century ago. Now he has written some JFK hagiography which contains both errors of fact and interpretation. We read:
Worse still, tensions intensified in the months between JFK’s election victory in November 1960 and his assumption of office on 20 January 1961. A long-awaited Khrushchev-Eisenhower summit failed when a CIA spy-plane was shot down in Soviet airspace just weeks before the scheduled meeting. This was par for the course: no agency did more damage more consistently to the cause of peace than the malign and bungling CIA. But Eisenhower compounded the CIA’s damage by brazenly denying the spy mission, only to have the Soviets produce both the plane’s wreckage and the captured US pilot for a global audience.
Kennedy came into office in 1961 hoping to reach a series of arms-control treaties with the Soviet Union, specifically a ban on nuclear arms testing to be followed by a nuclear non-proliferation treaty. Yet as an initially inexperienced leader, JFK drifted with events instead of leading them. The CIA reprised its spy plane bungling in a far larger and more dangerous debacle, by staging an invasion of Cuba by Cuban exiles. When the attempt immediately collapsed on the beach of the Bay of Pigs, Kennedy repeated Eisenhower’s blunder by brazenly (and ridiculously) lying to Khrushchev about the US role in the attempted invasion.”
Although planning for the Bay of Pigs operation began before Kennedy became President, he had had plently of time to cancel it. Moreover, the White House – and he, JFK!, himself personally – interfered in its planning right up to the actual event. Indeed, the specific site in Cuba of the invasion was changed – at JFK’s order, and despite CIA’s great reluctance – just 4 days before the scheduled date. Afterwards, JFK knew that he was the one ultimately responsible for its failure – responsible not merely in a hierarchical or legal sense, but actually, morally and operationally, responsible, and to his credit he took public responsibility for the operation. He did still later sack the leadership of CIA, though, since somebody needed to be punished for his failure. But his hagiographers and those who wish to attack CIA continue to put all the blame on “CIA bungling”, while the anti-Kennedy right usually blame the failure of the operation on Kennedy’s repeated refusal to provide USAF air cover for the invaders as they fought on the beach.
The chief problem of the Bay of Pigs, as I have remarked before (here and here), was not poor planning or ineffective operations or betrayal by JFK, but was existential: the operation’s aim was to convince the Castro regime that Cuba was being invaded by the full overhwelming might of the USA military and to thus scare them into running away, without actual US forces invading anything. To have used actual US military forces (including USAF airplanes) would have risked the operation escalating into a major conflagration with the USSR, Cuba’s supporters. A similar bluffing game had worked for CIA in Guatamela in 1954, but Fidel Castro was made of sterner stuff than Jacobo Arbenz, and he called the US’s bluff. To say the failure was merely due to “bungling” by CIA betrays both a lack of knowledge of the facts of the operation, and a lack of understanding of its Cold War context, when small events in far-away places often had global ramifications.
And the shooting-down of the U2 spy plane? Another bungle? “no agency did more damage more consistently to the cause of peace than the malign and bungling CIA”? I’ve not done a survey of the activities US Government agencies in the Cold War period, so I could not possibly argue that there were not other US government agencies with worse records of damage to peace than that of CIA. However, I’m sure Sachs hasn’t done a survey either, so I will take this statement as exaggerated for rhetorical effect. But even excluding the comparison, did CIA’s activies consistently damage the cause of peace? In a war, it is vital for each side to understand the enemy’s plans and intentions. This is even more so in a cold war, when much offensive and defensive activity may be undertaken indirectly or through proxies or be part of some long-term game of influence. For the West, spy agencies such as CIA played the major part in understanding the enemy’s motivating beliefs and their plans and intentions. (The same role was played by KGB and its sister agencies for the Eastern bloc.) The U2 plane shot down was part of a long-term, high-altitude espionage program that provided the West with valuable information about Soviet activities not otherwise obtainable. U2 spy planes run by CIA, for instance, first told the US Government in September and October 1962 that there were Soviet long-range missiles being installed in Cuba.
Again, to ignore or overlook this function betrays a lack of understanding of the nature of the Cold War context, when knowledge about the enemy and their actual, true, beliefs and intentions was hard to come by – for both sides. Arguably, no agencies did more to advance the cause of peace, and to prevent the Cold War escalating into a hot one, than CIA and KGB.
Glasperlenspielen
Lars Pålsson Syll on “orthodox, mainstream, neoclassical economics”:
Economic theory today consists mainly in investigating economic models.
Neoclassical economics has since long given up on the real world and contents itself with proving things about thought up worlds. Empirical evidence only plays a minor role in economic theory (cf. Hausman [1997]), where models largely functions as a substitute for empirical evidence. But “facts kick”, as Gunnar Myrdal used to say. Hopefully humbled by the manifest failure of its theoretical pretences, the one-sided, almost religious, insistence on mathematical deductivist modeling as the only scientific activity worthy of pursuing in economics will give way to methodological pluralism based on ontological considerations rather than formalistic tractability.
If not, we will have to keep on wondering – with Robert Solow and other thoughtful persons – what planet the economic theoretician is on.” [page 54]
I agree with the general thrust of this essay, which resonates with some of my own thoughts on the Glass Bead Game of Economics, for example, here and here.
Mind you, I don’t agree with everything that Syll says in this essay. For example, he argues that good predictive capabilities require models to bear resemblance to their target domains. But we know many counter-examples to this claim, from Newton’s model of planetary motion to Friedman’s billiard players. Prediction and explanation are two orthogonal dimensions of a model, which may or may not be related in any particular case.
His essay also overlooks the fact that the so-called “real world” which is the target domain of economic models contains, at least in the case of macro-economics, mostly humanly-constructed artefacts, such as the “variables” known as inflation and unemployment rates. Having sat in working parties defining and redefining such artefacts, I am always surprised that any economist could possibly imagine they are modeling an independent reality.
Reference:
Lars Pålsson Syll [2010]: What is (wrong with) economic theory? Real-world Economics Review, 55: 23-57.
Shackle on Rational Expectations
The Rational Expectations model in economics assumes that each economic agent (whether an individual or a company) can predict the future as perfectly as the modelers themselves. To anyone living outside the rarified bubble of mathematical economics, this is simply ridiculous. It is clear that no one associated with that theory has ever made any real business decisions, or suffered their consequences.
Here is non-mainstream economist George Shackle, writing to Bryan Hopkins on 1980-08-20:
‘Rational expectations’ remains for me a sort of monster living in a cave. I have never ventured into the cave to see what he is like, but I am always uneasily aware that he may come out and eat me. If you will allow me to stir the cauldron of mixed metaphors with a real flourish, I shall suggest that ‘rational expectations’ is neo-classical theory clutching at the last straw.
Observable circumstances offer us suggestions as to what may be the sequel of this act or that one. How can we know what invisible circumstances may take effect in time-to come, of which no hint can now be gained? I take it that ‘rational expectations’ assumes that we can work out what will happen as a consequence of this or that course of action. I should rather say that at most we can hope to set bounds to what can happen, at best and at worst, within a stated length of time from ‘the present’, and can invent an endless diversity of possibilities lying between them. [Italics in original]
Of course, unlike John Muth or Robert Lucas, Shackle had actual real-world experience of investment decision-making from his experience during WW II on national infrastructure planning.
Reference:
George L. S. Shackle [1980]: Letter to Bryan Hopkins. Quoted in: Stephen L. Littlechild [2003]: Reflections on George Shackle: Three Excerpts from the Shackle Collection. The Review of Austrian Economics, 16 (1): 113-117.
De mortuis nil nisi bonum
In a posthumous tribute to one of my late university lecturers, I read:
His [name of university] years were characterised by his love and enthusiasm for teaching. His dedication to his students was reciprocated in their affection for him. The large Economics I classes that he taught (numbering in some cases up to 400 students) were legendary.”
Although I would prefer not to speak ill of the dead, these words are a distortion of the historical truth, or at the least, very incomplete. The lecturer concerned was certainly legendary, but mostly for his vituperative disdain for anyone who did not share his extreme monetarist and so-called “economic rationalist” views. It is true that I did not know ALL of my fellow economics students, but of the score or so I did know, no one I knew felt they received any affection from him, nor did they reciprocate any. Indeed, those of us also studying pure mathematics thought him innumerate. He once told us, in a thorough misunderstanding of mathematical induction, that any claim involving an unspecified natural number n which was true for n=1, n=2, and n=3 was usually true, more generally, for all n. What about the claim that “n is a natural number less than 4“, I wondered.
As I recall, his lectures mostly consisted of declamations of monetarist mumbo-jumbo, straight from some University of Chicago seminar, given along with scorn for any alternative views, particularly Keynesianism. But he was also rudely disdainful of any viewpoint, such as many religious views, that saw value in social equity and fairness. Anyone who questioned his repeated assertions that all human actions were always and everywhere motivated by self-interest was rebuked as naive or ignorant.
In addition to the declamatory utterance of such tendentious statements, his lectures and lecture slides included very general statements marked, “Theorem“, followed by words and diagrams marked, “Proof“. A classic example of a “Theorem” was “Any government intervention in an economy leads to a fall in national income.” His proof of this very large claim began with the words, “Consider a two-person economy into which a government enters . . . ” The mathematicians in the class objected strongly that, at best, this was an example, not a proof, of his general claim. But he shouted us down. Either he was ignorant of the simplest forms of mathematical reasoning, or an ideologue seeking to impose his ideology on the class (or perhaps both).
I remained sufficiently angry about this perversion of my ideal of an academic discipline that I later wrote an article for the student newspaper about the intellectual and political compromises that intelligent, numerate, rational, or politically-engaged students would need to make in order to pass his course. That such a lecturer should be remembered as an admirable teacher is a great shame.
Krugman speaking truth to power
When the economic history of the Great Global Recession of 2007- ? comes eventually to be written, let it be recorded that many of us were profoundly opposed from the outset to the economic austerity policies pursued by Governments and central banks in Europe and elsewhere. Not only are these policies selfish, class-based, and unfair, they are also ineffective. Those of us who had heard of Keynes knew they would be ineffective before they were tried. In the case of the “rescue” of southern and peripheral Europe by northern European troikas, they are also being imposed undemocratically and unfairly, rewarding northern European private investors and bank shareholders at the expense of ordinary southern European citizens. (The effective interest rates on troika loans to Greece, which are much higher than current market rates, are truly rapacious.)
Only a handful of economists in this period are speaking truth to power. The most prominent of these is Paul Krugman. He has nailed the bastards again, in this oped article last week. Some excerpts:
The bad metaphor — which you’ve surely heard many times — equates the debt problems of a national economy with the debt problems of an individual family. A family that has run up too much debt, the story goes, must tighten its belt. So if Britain, as a whole, has run up too much debt — which it has, although it’s mostly private rather than public debt — shouldn’t it do the same? What’s wrong with this comparison?
The answer is that an economy is not like an indebted family. Our debt is mostly money we owe to each other; even more important, our income mostly comes from selling things to each other. Your spending is my income, and my spending is your income.”
Krugman could also have added that most families, unlike Governments, cannot increase their income by increasing their spending.
So what happens if everyone simultaneously slashes spending in an attempt to pay down debt? The answer is that everyone’s income falls — my income falls because you’re spending less, and your income falls because I’m spending less. And, as our incomes plunge, our debt problem gets worse, not better.
This isn’t a new insight. The great American economist Irving Fisher explained it all the way back in 1933, summarizing what he called “debt deflation” with the pithy slogan “the more the debtors pay, the more they owe.” Recent events, above all the austerity death spiral in Europe, have dramatically illustrated the truth of Fisher’s insight.
And there’s a clear moral to this story: When the private sector is frantically trying to pay down debt, the public sector should do the opposite, spending when the private sector can’t or won’t. By all means, let’s balance our budget once the economy has recovered — but not now. The boom, not the slump, is the right time for austerity.
As I said, this isn’t a new insight. So why have so many politicians insisted on pursuing austerity in slump? And why won’t they change course even as experience confirms the lessons of theory and history?
Well, that’s where it gets interesting. For when you push “austerians” on the badness of their metaphor, they almost always retreat to assertions along the lines of: “But it’s essential that we shrink the size of the state.”
Now, these assertions often go along with claims that the economic crisis itself demonstrates the need to shrink government. But that’s manifestly not true. Look at the countries in Europe that have weathered the storm best, and near the top of the list you’ll find big-government nations like Sweden and Austria.
And if you look, on the other hand, at the nations conservatives admired before the crisis, you’ll find George Osborne, Britain’s chancellor of the Exchequer and the architect of the country’s current economic policy, describing Ireland as “a shining example of the art of the possible.” Meanwhile, the Cato Institute was praising Iceland’s low taxes and hoping that other industrial nations “will learn from Iceland’s success.”
So the austerity drive in Britain isn’t really about debt and deficits at all; it’s about using deficit panic as an excuse to dismantle social programs. And this is, of course, exactly the same thing that has been happening in America.
In fairness to Britain’s conservatives, they aren’t quite as crude as their American counterparts. They don’t rail against the evils of deficits in one breath, then demand huge tax cuts for the wealthy in the next (although the Cameron government has, in fact, significantly cut the top tax rate). And, in general, they seem less determined than America’s right to aid the rich and punish the poor. Still, the direction of policy is the same — and so is the fundamental insincerity of the calls for austerity.
The big question here is whether the evident failure of austerity to produce an economic recovery will lead to a “Plan B.” Maybe. But my guess is that even if such a plan is announced, it won’t amount to much. For economic recovery was never the point; the drive for austerity was about using the crisis, not solving it. And it still is.”
Alan Greenspan in 2004
Alan Greenspan, then Chairman of the US Federal Reserve Bank System, speaking in January 2004, discussed the failure of traditional methods in econometrics to provide adequate guidance to monetary policy decision-makers. His words included:
Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy.”
The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario.”
Digital aspen forests
Brian Arthur has an article about automated and intelligent machine-to-machine communications creating a second digital economy underlying the first physical one, in the latest issue of The McKinsey Quarterly here.
I want to argue that something deep is going on with information technology, something that goes well beyond the use of computers, social media, and commerce on the Internet. Business processes that once took place among human beings are now being executed electronically. They are taking place in an unseen domain that is strictly digital. On the surface, this shift doesn’t seem particularly consequential—it’s almost something we take for granted. But I believe it is causing a revolution no less important and dramatic than that of the railroads. It is quietly creating a second economy, a digital one.
. . . .
We do have sophisticated machines, but in the place of personal automation (robots) we have a collective automation. Underneath the physical economy, with its physical people and physical tasks, lies a second economy that is automatic and neurally intelligent, with no upper limit to its buildout. The prosperity we enjoy and the difficulties with jobs would not have surprised Keynes, but the means of achieving that prosperity would have.
This second economy that is silently forming—vast, interconnected, and extraordinarily productive—is creating for us a new economic world. How we will fare in this world, how we will adapt to it, how we will profit from it and share its benefits, is very much up to us.”
Reference:
W. Brian Arthur [2011]: The Second Economy. The McKinsey Quarterly, October 2011.