A Behavioral Perspective of Decision Making Under Risk and Uncertainty

Here is the first part of a paper of mine that is available on the Social Science Research Network. Although the paper is several years old and I do not necessarily still agree with everything I had to say back then, I still stand by by the criticism of neo-classical economics and firmly believe that the manner in which economics is practiced at present makes it at best irrelevant and at worst dangerous and destructive. I do not still think that behavioral economics--that is, adding more "realistic" behavioral assumptions to the neo-classical model in order to allow for irrationality and to explain irrational outcomes-- is the way forward, or even a good program to adopt, adapt and work with. Some of these points can be found in my post on ecological rationality here. But, as I said, the criticism is still valid and therefore I am posting an excerpt from the paper here for anyone interested to peruse.

A Behavioral Perspective of Decision Making Under Risk and Uncertainty

by Doru Lung

Abstract

The global financial crisis that began in 2007 was not predicted by standard economic theory which assumes rational actors, efficient markets and equilibrium. Alternative explanations of economic behavior that are based on psychological regularities which are observed in human behavior were until recently relegated to the fringes of the discourse regarding economic phenomena. It will be argued that this has proven to have been a mistake. Psychology has a long history in economic thought, but its influence on economic theory has ebbed and flowed over the years. Keynes had important psychological insights, but they have not been focused upon sufficiently in the last decades. Since the late 1970´s, though, new theories have emerged that are behavioral in nature. That is, they attempt to explain economic phenomena by being based on empirically observed psychological regularities of human behavior. This paper will show that psychology needs to be taken into consideration when reasoning about economic phenomena. The assumption of rationality that is prevalent in much of economic theory is based on a series of axioms and assumptions that are unrealistic. It will be argued that when reasoning about economic phenomena, that theory should be adopted which has more empirical support. The findings are that adopting a behavioral perspective of decision making has more explanatory and predictive power.   

Keywords: economics, behavioral economics, behavioral finance, behavioral corporate finance, rationality, efficient markets, psychology

Word count: 6675

A slightly different version of this paper formed part of the literature review of my dissertation for the Master of Business Administration degree of the University of Wales, but it has never been published before.

A Behavioral Perspective of Decision Making Under Risk and Uncertainty

by Doru Lung

“However unwillingly a person who has a strong opinion may admit the possibility that his opinion may be false, he ought to be moved by the consideration that however true it may be, if it is not fully, frequently, and fearlessly discussed, it will be held as a dead dogma, not a living truth” John Stuart Mill (Mill 1859 / 2008, p45).

On July 26, 2009 the on-line edition of the Guardian newspaper reported on the response given to the Queen of England by economists after she had asked why no one had seen the credit crisis coming. As reported by the Guardian´s economics editor Heather Stewart, the answer cited “a failure of the collective imagination of many bright people...[a] psychology of denial...[and] wishful thinking combined with hubris.” Nevertheless, Professor Tim Besley of The London School of Economics, one of the signatories of the explanation addressed to the Queen, “denied that economics as a profession had been discredited by the scale of the crisis, but admitted that unconventional ideas - about how herd psychology and bouts of irrationality can grip financial markets, for example - had sometimes received "less play" during the boom years” (Stewart 2009, p1). Less august audiences than the Queen may ask themselves whether it would not perhaps be fruitful to have a look at some of these “unconventional ideas” in order to see whether they have more explanatory and predictive power than the conventional ones.

The global financial crisis that began in 2007 has drawn attention to the academic theories which underpinned most, if not all, regulation and risk management, as well as the assumptions of many financial market actors.  Many observers have asked themselves just how the economist community as a whole seemed to be taken utterly by surprise by the events that eventually unfolded. Some critics, such as Stiglitz (2010) or Akerlof (2010), place partial blame on the efficient markets hypothesis (EMH) and its postulate of  rational behavior on the part of investors. The EMH is accused of not being an accurate description of the behavior of financial markets and for having played a major part in the complacent behavior leading up to the ensuing economic meltdown. The efficient markets hypothesis states “that financial prices efficiently incorporate all public information and that prices can be regarded as optimal estimates of the true investment value at all times. The efficient market hypothesis in turn is based on more primitive notions that people behave rationally, or accurately maximize expected utility, and are able to process all available information” (Shiller 1998, p1). Assuming that people rationally pursue their perceived self-interest and that on average the prevailing market result (price) correctly represents the best estimate of fundamental value given all available information is a powerful theoretical statement which, if accepted unquestioningly, can be used to explain away any mis-allocation of resources, excessive valuation, boom or bust. Unfortunately, trusting "the market" has led to some rather suboptimal outcomes: a quick perusal of any major newspaper will show that the ongoing turmoil in financial markets, the demise of some storied institutions and the bailout of others, the deepest recession since the 1930´s, sovereign debt crises, and millions of jobs lost are just some of the consequences of the boom and bust sequence whose effects are still being felt. "The market" is at any time the sum of the decisions of individuals in the face of risk or uncertainty. Studying how individuals really make decisions, therefore, can provide a better understanding of the functioning of markets and the behavior of investors. In what follows a critical look will be taken at the postulate of rationality in standard economic theory and the efficient markets hypothesis, and evidence of deviations from rationality as posited by standard economic theory from the fields of Behavioral Economics and Behavioral Finance will be presented.   

Not only has the efficient markets hypothesis come under fire, but the standard neo-classical economic model (SEM) has also been accused of having failed for both descriptive as well as normative purposes. Smith (2010), for example, sees academic economics as having given intellectual respectability to the deregulatory movement that led to the subprime crisis, ensuing credit crunch, recession and overall economic turmoil. That standard economic theory is not a good description of reality has not stopped massive amounts of theorizing from being done on the basis of rather unrealistic assumptions. In his The Methodology of Positive Economics Friedman (1953) famously set forth the view that the realism of the assumptions does not matter as long as the predictions generated by the model are useful. This instrumentalist approach, however, is on precarious footing because when reality fails to conform to the model, it is not reality that is wrong. Rabin (2000) counters Friedman´s view by stating that "[c]eteris paribus, the more realistic our assumptions about economic actors, the better our economics. Hence, economists should aspire to making our assumptions about humans as psychologically realistic as possible" (Rabin 2000, p3). Rabin (2000) goes on to say that there is no reason that tackling economic questions should require an economic agent with 100% rationality, 100% self interest, 100% self-control, and many other assumptions that are used in economics but are not supported by the empirical behavioral evidence. Wilkinson (2008) sets forth the view that precision and psychological plausibility should be added as criteria for economic theory in addition to the criteria of congruence with reality, generality, tractability and parsimony. He goes on to show that adding realistic behavioral assumptions to economic theory does indeed fulfill all of the criteria mentioned above, and that the results are supported by empirical evidence. And Hausman reminds us that it is necessary to "look under the hood," that is, to evaluate the assumptions on which theory is based, especially “when extending the theory to new circumstances or revising it in the face of predictive failure” (Hausman 2008, p.185).

Are economic agents truly rational in the sense postulated by economic theory? This is a fundamental question whose answer has serious implications for academics, policy makers and, of course, market participants. The efficient markets hypothesis breaks down when market agents fuel bubbles that to everyone´s consternation eventually burst. Shiller (2002; 2006) shows us that markets are too volatile when compared to any discounted dividend model, and they can deviate from any measure of fundamental value, being prone to bubbles and busts. The huge swings in asset prices in both directions are just one indication that markets are not always efficient and that participants' behavior in the market does not conform to definitions of rationality.  Bromiley (2005) points out that if markets indeed tended toward equilibrium and were efficient and populated by rational agents, then there would be nothing to study since the optimal strategic decision would have already been made. A significant amount of empirical evidence has resuscitated the theory that (to use Keynes's [1936] felicitous phrase) animal spirits play a part in the determination of asset prices (see e.g. Akerlof and Shiller 2009) and has given birth to alternative theories that are behavioral in nature.

For the rest of the paper please go to the Social Science Research Network and download it.

Financial weapons of mass destruction strike again: naked

On October 23, 2008, in the middle of the biggest financial crisis since the Great Depression, Reuters ran an article entitled: “Greenspan says was ‘partially’ wrong on CDS regulation.”

“Former Federal Reserve Chairman Alan Greenspan acknowledged he was "partially" wrong in his belief that some trading instruments, specifically credit default swaps, did not need regulation.

Henry Waxman, the Democrat who chairs the U.S. House of Representatives Committee on Oversight and Government Reform, cited a series of public statements by Greenspan saying the market could handle regulation of derivatives without government intervention.

"My question is simple: Were you wrong?" Waxman said.

Greenspan said he was "partially" wrong in the case of credit default swaps, complex trading instruments meant to act as insurance for bond buyers against default.

"I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such that they were best capable of protecting their own shareholders and the equity," Greenspan said.

When asked by Waxman if his ideology pushed him to make bad decisions, Greenspan said he found a "flaw" in his governing ideology that has led him to reexamine his thinking” (Dixon 2008).

CDS is an acronym for Credit Default Swap, a credit derivative that resembles insurance in that the buyer pays a premium to the seller in order to protect against the default of another entity. The purchaser of a CDS may have an insurable interest in the entity on which CDS’s are being written, by being a creditor or a bondholder, for example, which consequently means that a legitimate interest in protection against default exists, and the purchase of CDS’s can be seen as constituting a hedge, or a way of managing risk. In case the purchaser does not have an insurable interest, however, the purchase of a CDS is termed “naked” and constitutes nothing more than speculation that the entity on which the CDS is written will default. In case of default or a credit event the seller of the CDS has to pay the CDS holder the previously agreed upon sum, as stipulated in the contract. So while this may seem to be a fairly straight-forward insurance-type product, the fact that these instruments are traded OTC, or “over the counter,” however, means that no one really knows who has written how many CDS’s, on whom, for how much, to whom they have been sold, or whether there is any money to pay out in case of a default. This last point came into focus quite clearly when American International Group (AIG) had to be bailed out by the US taxpayer to the tune of over $180 billion in large part because they did not have any money to pay out on the Credit Default Swaps they had written (Sjostrom Jr. 2008).  

As reported by the BBC, back in 2003, when the notional amount of the entire derivatives market was only $85 trillion, Warren Buffet famously likened them to time bombs and “financial weapons of mass destruction,” some of which seemed to have been devised by “madmen,” and the whole derivatives industry was similar to “hell... easy to enter and almost impossible to exit” (BBC 2003). While Buffet did not specify CDS’s at the time, by September 2011, when, as reported by The Bank of International Settlements (BIS 2011), the entire derivatives market had swollen to over $700 trillion and the notional amount of Credit Default Swaps outstanding was still $32 trillion, down from $62 trillion in 2007, the Financial Times had no problem running an article titled:”CDS: modern day weapons of mass destruction.” The article by Chapman (2011) cited a paper by Calice, Chen and Williams (2011) which found that “for several countries including Greece, Portugal and Ireland the liquidity of the sovereign CDS market has a substantial infuence on sovereign debt spreads,” meaning that CDS’s could contribute to rising bond yields and thus push up borrowing costs and increase the risk of default by sovereign countries. Faced with contagion in the Eurozone and a possible cascade of defaults, the German government, on whose shoulders much of the cost of bailing out the periphery falls, demanded a ban on “naked short selling” and, especially, “naked” CDS’s as well (Baker and Peel 2011).

In an article calling for a ban on “naked” CDS’s Wolfgang Münchau (2010) noted that a “naked CDS...is a purely speculative gamble [without even] one social or economic benefit [which is something that] even hardened speculators agree on. [Moreover a] universally accepted aspect of insurance regulation is that you can only insure what you actually own [and not] even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss,” especially if you proceeded to light a match to the house or push the boss of a cliff, which, after keeping in mind the findings from above, is what the whole thing amounts to. Greece, Portugal, Ireland, Spain, Italy are all facing ruinous borrowing costs in late 2011 and it is utterly uncertain whether the Eurozone will make it through 2012.

Credit Default Swaps are consequently living up to the moniker given derivatives by Warren Buffett: “financial weapons of mass destruction.” Alan Greenspan, Robert Rubin and Larry Summers refused to consider regulation of CDS’s back in 1997 when Brooksley Born testified before Congress that trading in unregulated derivatives would "threaten our regulated markets or, indeed, our economy without any federal agency knowing about it" (van den Heuvel 2008). They refused, due to the belief noted above that the self-interest of rational economic agents and organizations would be sufficient to prevent the taking on of too much risk and “was such that they were best capable of protecting their own shareholders and the equity.” After admitting that this belief was wrong and that he had found a flaw in his worldview, his ideology, the disciple of Ayn Rand also admitted that: “This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year” (Andrews 2008). We are still dealing with the fallout and should prepare for worse, as reported by zerohedge, who address the meaning and significance of the derivatives market number reported by the BIS being

the biggest ever reported in the financial world: the number in question is $707,568,901,000,000 and represents the latest total amount of all notional Over The Counter (read unregulated) outstanding derivatives...Indicatively, global GDP is about $63 trillion if one can trust any numbers released by modern governments...

for the six month period ended June 30, 2011, the total number of outstanding derivatives surged past the previous all time high of $673 trillion from June 2008, and is now firmly in 7-handle territory: the synthetic credit bubble has now been blown to a new all time high. Another way of looking at the data is that one of the key contributors to global growth and prosperity in the past 10 years was an increase in total derivatives from just under $100 trillion to $708 trillion in exactly one decade. And soon we have to pay the mean reversion price. 

What is probably just as disturbing is that in the first 6 months of 2011, the total outstanding notional of all derivatives rose from $601 trillion at December 31, 2010 to $708 trillion at June 30, 2011. A $107 trillion increase in notional in half a year. 

There is much more than can be said on this topic, and has to be said, because an increase of that magnitude is simply impossible to perceive without alarm bells going off everywhere, especially when one considers the pervasive deleveraging occurring at every sector but the government. All else equal, this move may well explain the massive surge in bank profitability in the first half of the year. It also means that with banks suffering massive losses, and rumors of bank runs and collateral calls, not to mention the aftermath of the MF Global insolvency, the world financial syndicate will have no choice but to increase gross notional even more, even as the market value continues to get ever lower, thus sparking the risk of the mother of all margin calls: a veritable credit fission reaction.

But no matter what: the important thing to remember is that "they are all hedged" - or so they say, a claim we made a completely mockery of a few weeks back. So ex-sarcasm, the now parabolic increase in derivatives means that when the bilateral netting chain is once again broken, and it will be (because AIG was not a one off event), there will simply be trillions more in derivatives that no longer generate a booked cash flow stream for the remaining counterparty, until at the very end, the whole inverted credit0money pyramid collapses in on itself. 

Because once the whole bilateral netting chain is broken, net becomes gross. And gross market value becomes total notional outstanding. And, to quote Hudson, it's game over. 

Expect to see gross market value declines persisting even as the now parabolic increase in total notional persists. At this rate we would not be surprised to see one quadrillion in OTC derivatives by the middle of next year.

And, once again for those confused, the fact that notional had to increase so epically as market value tumbled most likely means that the global derivative pyramid scheme (no pun intended) is almost over.

   

Towards Ecological Rationality

Economics as a discipline has detached itself from both psychology and political philosophy in an unfortunate turn of events that has led what used to be known as political economy to become an exercise in obfuscation through mathematics. By assuming what was supposed to be proven, and by blurring the lines between descriptive and normative theory, economics as it is currently practiced has become increasingly irrelevant to the description of the interaction of people going about their business. By forgetting that the economy is in the end comprised of people and instead hypothesizing a rational representative agent economics has assumed away that which it is supposed to describe and explain.

The problem is that economics divorced from political philosophy and psychology has been the cause of much mischief and suffering. It was thought that self-regulating efficient markets populated by rational economic agents pursuing their own interest would ensure the best possible outcome for everyone. But this Panglossian “invisible hand” was invisible precisely because it was not there. Ask Alan Greenspan, who, when asked by US congressmen why the crisis was not foreseen, admitted to finding a flaw in his worldview, his ideology (Andrews 2008). Four years on and the Global Financial Crisis is arguably still ongoing. Part of the blame can be laid squarely in the lap of neo-classical economics, which became obsessed with physics envy in its use of mathematics yet all the while almost obsessively ignoring psychology and real people. This unfortunate state of affairs needs to be rectified and getting rid of the rational representative agent with his well-ordered, transitive preferences is a first step. .

When the student of psychology is first confronted with the idea espoused in standard economic theory that people (or economic agents as they are called) are rational, have well defined preferences, take into account all relevant information in forming their preferences and making decisions, make decisions that maximize their utility (with utility being a catch-all phrase for anything someone perceives as good), and take into consideration only their own well-being when forming preferences or making decisions; well, then the student of psychology must first ask him- or herself whether this is a normative or a descriptive theory; second, whether this behavior being perceived as normative is something to be desired; and, third, if this behavior is also supposed to be descriptive, then beings of which planet, exactly, are being described.

That economics needs to do some soul-searching is not necessarily well accepted in the academic discussions about economic theory. Some accept as normative the rationality posited in economics and point out that human decision makers deviate from this posited rationality in a systematic and predictable manner; others claim that the deviations from rationality that are observed and discussed in much of the behavioral literature are either: a) artifacts of the population; b) artifacts of the (tricky) methodology used; c) not important because irrational actors are driven from the market by rational actors so that only rational outcomes prevail; or, d) not important because the rationality posited in economics is neither normative nor descriptive but rather a methodological stance. These disagreements are fundamental and irreconcilable but not necessarily the only two ways of looking at the issue at hand.

The heuristics and biases approach to decision making that has developed around the work pioneered by Daniel Kahnemann and Amos Tversky seems to accept as normative the rationality posited in economics while aiming to provide a better descriptive theory of decision making by pointing out that humans are loss averse, susceptible to anchoring or framing effects, affected by the representativeness bias, and in general do not make decisions in a manner that conforms to the rationality posited in economic theory because they are prone to deviate from this rationality due to an extended list of heuristics and cognitive and behavioral biases that lead to sub-optimal outcomes. This school of thought has blossomed into the relatively new field of behavioral economics, with the application of the insights gleaned therefrom leading to the even newer fields of behavioral finance and behavioral corporate finance. These disciplines aim at providing the theories of economics and finance with more realistic behavioral foundations by utilizing more realistic assumptions about the behavior of economic agents. That is, behavioral economics accepts as normative economic rationality but argues that because it is unrealistic descriptively better assumptions about how people behave are needed. While the finding that “people are sometimes irrational” may not strike one as being too profound, it is a mark of progress that has been achieved only after decades of argument.

The reason why behavioral economics was slow to catch on at first is because economic theory was under the spell of the representative rational agent. Standard neo-classical economic theory is based on a series of special assumptions. If the assumptions of the standard economic model were true, then there would be no need for any further psychological research since: “economic agents are rational, economic agents are motivated by expected utility maximization, an agent´s utility is governed by purely selfish concerns, in the narrow sense that it does not take into consideration the utility of others, agents are Bayesian probability operators, agents have consistent time preferences according to the discounted utility model, [and] all income and assets are completely fungible" (Wilkinson 2008, p5). These assumptions might strike one as being somewhat unrealistic but in his The Methodology of Positive Economics Milton Friedman (1953) famously set forth the view that the realism of the assumptions does not matter as long as the predictions generated by the model are useful. This became known as the “as if” approach. That is, it does not matter whether people actually behave in the manner postulated or whether the assumptions made are realistic since if the results in the aggregate fit the hypothesis, then it can be assumed that people have to behave “as if” they were only rationally pursuing their enlightened self-interest (that is, by taking into account all available information in order to arrive at the decision that most maximizes their subjective expected utility), because if they did not, then they would be driven from the market by rational agents who did indeed behave in the manner dictated by standard economic theory.

Berg and Gigerenzer (2010) raise a fundamental question that not only undermines behavioral economics’ claim of greater psychological realism but neo-classical economics’ normative claim of rationality and selfish expected utility maximisation as well: Is there any evidence that people who behave rationally in the economic sense do better than those who do not behave in a manner that conforms to the rationality of neo-classical economics? In addressing this question they point out that “[t]he discussion of methodological realism with respect to the rational choice framework almost necessarily touches on different visions of what should count as normative.  It is a great irony that most voices in behavioral economics, purveyors of a self-described opening up of economic analysis to psychology, hang on to the idea of the singular and universal supremacy of rational choice axioms as the proper normative benchmarks against which virtually all forms of behavior are to be measured.  Thus, it is normal rather than exceptional to read behavioral economists championing the descriptive virtues of expanding the economic model to allow for systematic mistakes and biased beliefs and, at the same time, arguing that there is no question as to what a rational actor ought to do” (Berg and Gigerenzer 2010, p23). Furthermore, what they call the tension between “descriptive openness and normative dogmatism” is interesting precisely because “almost no empirical evidence exists documenting that individuals who deviate from economic axioms of internal consistency (e.g., transitive preferences, expected utility axioms, and Bayesian beliefs) actually suffer any economic losses” (Berg and Gigerenzer 2010, p24). Most importantly, then, neither do those who deviate from rational choice theory earn any less money, nor are they any less happy or live shorter lives. This most important finding has been overlooked or disputed for too long.

Berg and Gigerenzer thus point the way towards an ecological rationality that is not only more realistic than rational choice theory but also more human. According to Rieskamp and Reimer (2007, p1) “[h]uman reasoning and behavior are ecologically rational when they are adapted to the environment in which humans act. This definition is in stark contrast to classical definitions of rationality, according to which reasoning and behavior are rational when they conform to norms of logic, statistics, and probability theory.” Thus, according to this definition, behavior is rational if it suits the purpose at hand, with the normative aspect of neo-classical economics’ rational choice theory being dispensed with, and no further sleep being lost worrying whether preferences are ordered or transitive.    

Instead of accepting as normative rational choice theory and simply characterizing the manner in which people actually make decisions as anomalies or biases a movement towards ecological rationality would mean, then, that a new standard of rationality of correspondence or fit between the demands of the situation and the behavior of the person would be set, and this new standard of rationality is not only computationally and thus energetically parsimonious, but also evolutionarily plausible and probable. By taking into account philosophy -- what is rationality -- and psychology -- how do people actually behave -- economics as a discipline will no longer be an exercise in mathematical obfuscation but will once again concern itself with people going about their business, its original intent.

References

Andrews, Edmund L. (2008). ‘Greenspan Concedes Error on Regulation’. The New York Times October 23, 2008. Available at: http://www.nytimes.com/2008/10/24/business/economy/24panel.html [accessed May 28, 2010]

Berg, Nathan and Gigerenzer, Gerd (2010). ‘As-If Behavioral Economics: Neo-Classical Economics in Disguise’ History of Economic Ideas, Vol. 18, No. 1, pp. 133-166, 2010. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1677168 [accessed May 28, 2010]

Friedman, Milton (1953). ´A Methodology of Positive Economics´. Ch. 7 in Hausman, Daniel M. ed.  (2008). The Philosophy of Economics: An Anthology, 3rd edition. New York, NY: Cambridge University Press

Rieskamp, Jörg and Reimer, Thorsten (2007). Ecological Rationality. Max Plank Institute for Human Development, Berlin, Germany. Available at:
http://web.ics.purdue.edu/~treimer/Rieskamp_Reimer_2007.pdf [accessed May 28, 2010]

Wilkinson, Nick (2007). An Introduction to Behavioral Economics: A Guide for Students. New York: Palgrave Macmillan

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 nakedcapitalism.com/ 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.

But at the end of the day: "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!"      

ECONNED -– The Movie, Um, Video!

Awsome video from Yves Smith!

ECONNED – The Movie, Um, Video!
A very talented movie/commerical/trailer editor, who for some bizarre reason insists on going nameless (but if you want his coordinates, don’t hesitate to ping me) assisted by Ben Fisher in a major role (finding images and video clips) and Richard Smith in a minor role (extensive sanity checking) put this together.

This may inspire McLuhan-esque debates, since I wanted something true to the medium, as in visceral and immediate, rather than the usual talking head sort of piece.

Enjoy! Oh, and turn the sound up

Buy this book! Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism

Make sure you get the upcoming book from my friend Yves Smith of www.nakedcapitalism.com fame.

Countdown 3/2/10: Excerpt from Econned
Folks, the time has come when I must start shamelessly promoting my book, Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, which is being released March 2, 2010.

I thought the extract below would give readers an idea of what the book is about, with one caveat. Econned goes into some detail about crisis mechanisms (as in why it got as bad as it did) and has unearthed a heretofore unexamined hedge fund trading strategy that turned the subprime mania into the detonator of the global debt bomb (and yes, we have the goods).

Enjoy!

In 1776, Adam Smith published The Wealth of Nations. In it, he argued that the uncoordinated actions of large numbers of individuals, each acting out of self-interest, sometimes produced, as if by “an invisible hand,” results that were beneficial to broader society. Smith also pointed out that self-interested actions frequently led to injustice or even ruin. He fiercely criticized both how employers colluded with each other to keep wages low, as well as the “savage injustice” that European mercantilist interests had “commit[ted] with impunity” in colonies in Asia and the Americas.

Smith’s ideas were cherry-picked and turned into a simplistic ideology that now dominates university economics departments. This theory proclaims that the “invisible hand” ensures that economic self-interest will always lead to the best outcomes imaginable. It follows that any restrictions on the profit-seeking activities of individuals and corporations interfere with this invisible hand, and therefore are “inefficient” and nonsensical.

According to this line of thinking, individuals have perfect knowledge both of what they want and of everything happening in the world at large, and so they pass their lives making intelligent decisions. Prices may change in ways that appear random, but this randomness follows predictable, unchanging rules and is never violently chaotic. It is therefore possible for corporations to use clever techniques and systems to reduce or even eliminate the risks associated with their business. The result is a stable, productive economy that represents the apex of civilization.

This heartwarming picture airbrushes out nearly all of the real business world. Yet uncritical allegiance to these precepts over the last thirty years has produced a world in which corporations, especially in finance, are far less restricted in their pursuit of profit. We show in this book how this lawless environment has led the financial services industry to pursue its own unenlightened
self-interest. The industry has become systematically predatory. Employees of industry firms have not confined their predation to outsiders; their efforts to loot their own firms nearly destroyed the industry and the entire global economy. Similarly destructive behavior by other players, often viewed through a distorted lens that saw all unconstrained commercial behavior as virtuous, added more
fuel to the conflagration.

Some economists have opposed this prevailing ideology; indeed, comparatively new lines of inquiry focus explicitly on how economic actors can fool themselves or others into making poor, even destructive, choices.

But when the economics profession has used the megaphone of its authority to dominate discussions with policymakers and the public, it has spoken with one voice, and the message has been the one described here. We therefore confine our criticism to these particularly influential ideas.

Theories that fly in the face of reality often need to excise inconvenient phenomena, and mainstream economics is no exception. Idealizing the rational aspects of business decisions means refusing to notice behavior that is predatory, destructive, criminal, or simply stupid. Believing that risk is manageable through mechanical systems has required not just unrealistic assumptions but also willful
blindness to clear signs of danger.

We offer here another point of view. This book lays bare both the actions leading to the credit crisis and the economic constructs that defended, facilitated, and even exacerbated this behavior. Our case makes clear that if our economic system is to harness the self-interest of individuals to achieve the general
good, it must be supervised within a democratic society and responsive to criticism by outside voices of those who are unafraid to think independently.