Thursday, July 7, 2011

Economists never learn: or "It is difficult to get a man to understand something when his salary depends upon his not understanding it."

Yves Smith of fame has another awesome post demolishing economists' dogma. In The Sorrow and the Pity of Economists (Like DeLong) Not Learning from Their Mistakes she takes apart an argument by one of the few economists who is actually willing to admit to mistakes, and is to be respected for that, but is unfortunately stuck in a world of models that have nothing to do with the real world and misrepresent what the founder of macroeconomics said anyway. 

Delong says: There is only one real law of economics: the law of supply and demand. If the quantity supplied goes up, the price goes down

Unfortunately for the discipline of economics this is not true: Steve Keen's lectures on behavioural finance are a great place to become disabused of the notion that there are any laws of economics and the lectures provide an enlightening and insightful introduction to a more realistic approach to economics and finance. 

But back to Yves: 

No, it’s NOT the law, it’s a belief and it often is not operative...DeLong then argues that he and presumably his colleagues ignored the notions of John Hicks, the English economist who formalized the idea of Keynes’ General Theory and turned it into a special case of neoclassical economics. Keynes himself repudiated it, as did Hicks in his eighties....

Why would Keynes not like this treatment? Keynes, himself a successful speculator, did not think financial markets had any propensity to equilibrium, and there is separately reason to think the equilibrium assumption that the discipline has embraced to make its mathematics “tractable” is bollocks. The equilibrium assumption (more accurately, ergodicity) makes it impossible to incorporate any phenomena that are destabilizing, such as ones with positive (self-reinforcing feedback loops. Yet as we discuss short form in ECONNED (and George Cooper gives an elegant layperson treatment in The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy), financial markets have no propensity to equilibrium. They are inherently prone to boom-bust cycles.
Even though Hicks’ story, via DeLong, bears some resemblance to Keynes’ liquidity preferences idea, it posits different causal channels that render them fundamentally different. In really simple terms, there is a “loanable funds” market in which borrowers and savers meet to determine the price of lending. Keynes argued that investors could have a change in liquidity preferences, which is econ-speak for they get freaked out and run for safe havens, which in his day was to pull it out of the banking system entirely. Hicks endeavored to show that the loanable funds and liquidity preferences theories were complementary, since he contended that Keynes ignored the bond market (loanable funds) while his predecessors ignored money markets.
But that’s a deliberate misreading. Keynes saw the driver as the change in the mood of capitalists; the shift in liquidity preferences was an effect. (In addition, Keynes held that changes with respect to existing portfolio positions, meaning stocks of held assets, would tend to swamp flow effects captured by loanable funds models.)
Making money cheaper is not going to make anyone want to take risk if they think the fundamental outlook is poor. Except for finance-intensive firms (which for the most part is limited to financial services industry incumbents), the cost of money is usually not the driver in business decisions, Market potential, the absolute level of commitment required, competitor dynamics and so on are what drive the decision; funding cost might be a brake. So the idea that making financing cheaper in and of itself is going to spur business activity is dubious, and it has been borne out in this crisis, where banks complain that the reason they are not lending is lack of demand from qualified borrowers. Surveys of small businesses, for instance, show that most have been pessimistic for quite some time.
If you want to put it in more technical terms, what is happening is a large and sustained fall in what Keynes called the marginal efficiency of capital. Companies are not reinvesting at a rate sufficient rate to sustain growth, let alone reduce unemployment. Rob Parenteau and I discussed the drivers of this phenomenon in a New York Times op-ed on the corporate savings glut last year: that managers and investors have short term incentives, and financial reform has done nothing to reverse them. Add to that that in a balance sheet recession, the private sector (both households and businesses) want to reduce debt, which is tantamount to saving. Lowering interest rates is not going to change that behavior. And if you try to generate inflation in this scenario, when individuals and companies are feeling stresses, all you do is reduce their real spending (and savings power) and further reduce demand (and hence economic activity).

So what Keynes thought important was to get investors to stop being "freaked out", decrease their liquidity preference, and again see the marginal efficiency of capital as sufficient to warrant further investment. 

Back to Yves: 

Marshall Auerback, by e-mail, points out that liquidity trap thinking is based on the idea that banks lend out of bank reserves. It has been shown empirically that banks lend first and reserve creation follows (that is, when needed, central banks accommodate loan creation):
The liquidity trap idea seems to be predicated on the silly idea that banks lend out reserves and failure to do so is symptomatic of a liquidity trap. But idea that the build up of bank reserves represent a pot of funds that the banks will eventually loan out completely misunderstands the role of bank reserves. But as Randy Wray, Bill Mitchell, Scott Fullwiler, Stephanie Kelton and a host of others have noted before banks do not loan out reserves. Reserves facilitate the payments system – that is, the system that assures the millions of transactions between banks (as customers write cheques and deposit them throughout the banking system).
Banks do not make loans on the basis of the reserves they hold. They respond to demands from credit-worthy customers and have in mind what it will cost them to make the loans under current conditions. When the transactions that follow the creation of a loan transpire it might be that the is short of reserves to ensure the payments clear. It has various options. It can seek funds from wholesale markets (other banks or other lenders), use deposits (not an overnight option really) or, ultimately, it can source the funds from the central bank.
The point is that you can get various levels of bank reserves depending on how the central bank pursues its liquidity management in order to hit its target policy rate. None of those levels have any particular operational significance.
The mainstream then argue that if the central bank mops up these reserves it will be less inflationary than if it leaves them in the system. This view is based on the spurious – banks lend reserves argument. The inflation risk associated with government spending is the same whether the government issues debt to match its deficit or not. The inflation risk arises from the impact of the spending on the state of capacity in the economy.
This is why fiscal stimulus is vastly more effective than monetary policy at times like these: it has a direct impact on overall conditions, by stimulating demand. Government spending creates more income for businesses and ultimately, consumers. Everyone’s income is ultimately someone else’s spending. If government increase spending, it will increase the incomes of at least some people in the economy, and the improvement in their fortunes (if they believe the new income level will be sustained) will lead them to spend more, improving the affairs of yet more people.
So the stimulation of demand is to be achieved by an improvement in overall conditions and this can best be done through fiscal policy, the aversion to which is not a matter of economics but ideology as pointed out by  Edward Harrison from creditwritedowns.

But the important point is that because his General Theory was unfortunately written in a manner that few could understand too well, the wrong lessons have been drawn from Keynes and propounded all these years. It is my contention that Keynes was not only the founder of macroeconomics, but also a behavioral economist, and his insights into the psychology of investors and the economy are invaluable and should be taken to heart. 

In my post on Hyman Minskys financial instability hypothesis there is a long quote from Keynes's 1937 article in the Quarterly Journal of economics, where he explained his views more clearly: 
Actually, however, we have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. Sometimes we are not much concerned with their remoter consequences, even tho time and chance may make much of them. But sometimes we are intensely concerned with them, more so, occasionally, than with the immediate consequences.

Now of all human activities which are affected by this remoter preoccupation, it happens that one of the most important is economic in character, namely. Wealth. The whole object of the accumulation of Wealth is to produce results, or potential results, at a comparatively distant, and sometimes at an indefinitely distant, date. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders Wealth a peculiarly unsuitable subject for the methods of the classical economic theory. This theory might work very well in a world in which economic goods were necessarily consumed within a short interval of their being produced. But it requires, I suggest, considerable amendment if it is to be applied to a world in which the accumulation of wealth for an indefinitely postponed future is an important factor; and the greater the proportionate part played by such wealth-accumulation the more essential does such amendment become.

By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealthowners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to he summed.

How do we manage in such circumstances to behave in a manner which saves our faces as rational, economic men? We have devised for the purpose a variety of techniques, of which much the most important are the three following:

(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.
(2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture.
(3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average. The psychology of a society of individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgment.

Now a practical theory of the future based on these three principles has certain marked characteristics. In particular, being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled Board Room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface.

Perhaps the reader feels that this general, philosophical disquisition on the behavior of mankind is somewhat remote from the economic theory under discussion. But I think not. Tho this is how we behave in the market place, the theory we devise in the study of how we behave in the market place should not itself submit to market-place idols. I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.

I daresay that a classical economist would readily admit this. But, even so, I think he has overlooked the precise nature of the difference which his abstraction makes between theory and practice, and the character of the fallacies into which he is likely to be led.
So this is the crux of Keynes's theory and even an ostensibly Keynesian economist such as Brad DeLong unfortunately fails to draw the correct lessons from the theory. As pointed out by Yves and many others who contribute to the current discussion of the dismal state of the dismal science, it is confidence and lack thereof that determines economic recovery or depression, and not the sacred cows of supply and demand.

No comments:

Post a Comment

your thoughts are welcome

Wikinvest Wire