The past few weeks have been fraught on a number of fronts. Two of our most important industries: banking and auto making are decidedly sick. Unemployment is rising. Housing is still in the tank. Stores are having a hard time attracting customers. And the airwaves, news media, and blogosphere are all ablaze with experts, faux experts, and wannabes tossing around every pet theory under the sun. Amidst all this we have a new administration trying to avoid compounding the errors of its predecessors, and yet still trying to plug the holes its sees as the most dangerous. Its motto is that of medicine: “First do no harm.”
One of the reasons I find all this so compelling, some might say exhilarating, is that we find ourselves at a crucial moment in time. The policy steps we take and the solutions we use to fix our evident problems will define, most likely, the next two or three decades. For those of us who have a perspective on what that definition ought to be, now is the time to speak up. Having a voice on such formative and critical matters is both a privilege and a responsibility. One of America’s most cherished concepts of itself is exactly that: the ability to have a say is democratically available. The words: ‘We the People’ have concrete meaning and confer a responsibility on all of us to be involved. That’s why I run this blog. And I am sure that’s why all the others speak up too.
But, as Winston Churchill famously argued, democracy is awfully messy. So the noise can be raucous. And the debate heated. Human relations are, after all, human. That means they are imprecise, prone to excess, and riddled through with error. The only thing we all can ever know is that we were most likely mistaken just when we were most certain.
In fact I find certainty, or the notion that one can ‘know’ something with certitude to be a sure indicator of falsehood.
My first exposure to this rejection of certainty came a long time ago when I was studying philosophy. I am naturally skeptical with a deep rooted non-conformist streak that I attribute to my upbringing in Eastern England, which, long ago, was the center of rebellion against both the monarchy and the established church. Many of the original ‘pilgrims’ so celebrated here in America came from the towns and villages around where I grew up, and I have always felt a deep connection with the New England form of the American story. So when my education threw me up against Plato I naturally recoiled in horror.
He was wrong and I knew it. But he was Plato and I was me. So I tried to understand what I was missing.
Nothing as it turns out.
My savior was Karl Popper who was an emeritus member of the college I attended, and whose attack on Plato, Hegel and Marx – “The Open Society and Its Enemies” – allowed me to breath more easily. He led me to others including Machiavelli, Vico, Hume, and Darwin, and eventually guided me towards an acceptance of the futility or the arrogance inherent in the statement ‘I know’.
I don’t. Nor does anyone else. That should engender humility and openness in our enquiries and it should also allow us to embrace the foibles of our species, which is, after all, something of a parvenu on the world stage. One of the great triumphs of the recent past is that we realize that we know so little and that all we know can be overturned in the future. Indeed we should seek to overturn it ourselves, because it is the relentless questioning of what we currently accept as ‘truth’ that allows us to press forward and learn more.
Alongside Popper I sit Kant who seems to have spent his entire life trying to impose rigor on the fabric of morality even though he, in a moment of clarity, saw that ‘Out of the crooked timber of humanity, nothing straight was ever made’. So why did he bother? Because of his restless need to attempt to establish an ideal? I think it was more that he desperately wanted humanity not to be hewn from ‘crooked timber’, or rather he saw better than the rest of us that our ‘crookedness’ needed constraint. Hence his ‘categorical imperative.’
Absorbing all this while at the same time trying to learn economics led me to question what was then emerging as its new standard theoretical basis. There was far too much certitude built in and not enough humanity.
It is that error: the belief in certainty we are now paying the price for.
Standard economics, the kind you find in most textbooks here in the US, concerns itself with enquiry into the mechanisms and effects of markets. It asks questions about the ramifications of changes within the systems it studies, and it draws conclusions about the conditions necessary for an economy to reach an optimal allocation of resources.
Rather than studying actual economies and theorizing about actual objects within them, economists prefer to study abstracted models. These models are highly simplified and idealized versions of the world and are expressed mathematically as series of connected equations. The centerpiece of the standard theory is something called General Equilibrium Theory that purports to illuminate the conditions necessary for the achievement of optimal resource allocation. Surrounding this are bits and pieces that contribute to the whole by eliminating technical problems that interfere with the search for an optimum. These bits and pieces include such things as revealed preference theory, the efficient markets hypothesis, agent rationality and so on.
This all sounds arcane. It is. It is the handiwork of numerous extraordinarily bright people spread over decades. It is rigorous. It is thoroughly explored. It is expressed in enormous detail.
And it is of not much use.
Indeed in many ways it is a simple tautology.
It incorporates certainty in some of its details, and thus can never be representative of a real economy.
One of its central components is that the agents within an economy – Milton Friedman used to refer to them as ‘economic units’, I prefer to call them people – are rational and have full and costless access to perfect information. That is I know what you know, and we both know everything. Absolutely. No exceptions. We are omniscient. This is a necessary condition for the models to work. For if I know something you don’t, and I act upon it, there can be no assurance that the result of all the transactions of our economy would yield an optimal outcome. How would we know it was optimal? There may be actions we could take that would move us to a better outcome. But since you are not fully aware of what I know we cannot, either of us, arrive at an understanding of what an optimum may be.
Since they were searching for a model that resulted in an optimum economists were forced into eliminating reality. They started to tinker with an idealized system. That way they could explore its allocative properties, and the problems associated with changes to it. They believed they had established a laboratory within which they could study markets.
The odd thing is that they chose assumptions and axioms that predetermined the outcome: the object in their laboratory was a perfect or idealized market.
So it is not odd that economists became convinced that markets are the ideal method for allocating resources.
They went in a great long intellectual circle: they set up a idealized market in order to ‘prove’ that markets are ideal.
The fact that their assumptions are absurd – do you really know everything? – didn’t matter as long as the outcome was ‘correct’. And ‘correct’ was determined a priori: markets are better.
This may seem confusing. Let me re-state it: instead of studying the real world, economists study idealized models. Those models are descriptions of ideal markets. From this they determine that markets are ideal. Other forms of resource allocation, such as central planning, are deemed inefficient by comparison with markets on the basis of these models.
Milton Friedman, in 1953, was famously forced to defend the absurdity of these assumptions and this whole process of economic theorizing. It is his assertion that if the outcome is ‘correct’ then the absurdity of the input is irrelevant that I mentioned above.
So that is the state of economics.
The ideal. Certainty. Intertwined concepts threaded throughout the edifice.
A natural conclusion to draw from this effort is that markets are always correct in their pricing of something. If markets are efficient in the sense that Friedman and his ilk argue, then the prices expressed in those markets must, by definition, be ‘correct’. So a home price in 2002 of $125,000 is correct, and so is the 2007 price of $750,000, for the exact same home. And so is its price of $500,000 today.
It was this belief that allowed Alan Greenspan to ignore the asset price bubbles of the 1990′s and 2000′s. He reasoned, from his standard textbook position, that escalating prices were ‘correct’. Any correction in those prices must be an expression of underlying economic conditions that the market was capturing.
The problem I find with this is that it is vacuous statement. There is no analytical content in the notion that markets are always correct. It merely sets up a regress to explore for other phenomena causing change. For if markets are always correct they are never the cause of anything. They are simply blind mechanisms expressing something else. The causes of change must lay outside the system. To use the word economists have for such things: the causes are ‘exogenous’.
In that case people must be ‘exogenous’, since very few I know have the perfect information economists attribute to them.
That is to say the markets economists study, because they are ideal, have no people in them. The denizens of the models economists study are rational agents. Not people like you and me.
This bizarre pursuit of the ideal would be quaint and perhaps a little eccentric were it not for the very large fact that the standard models view that markets are ‘always correct’ is a very attractive ideological view also. It plays directly into the hands of those politicians who want to prevent the use of central planning, i.e. the government, in our economy.
In a way we should not be surprised by this confluence: economics has its origins in the intellectual discussion of the consequences of industrialization. Most of its early thinking was directed toward understanding the then newly emergent industrial economy and, naturally, many of the problems that attracted analysis were those that vexed politicians of the day. Trade; labor laws; the increasing complexity of society; poverty; wages; and so on represented different problems now that industrialization had irrevocably altered the social landscape. Even the basic components of economic modeling: land, labor and capital belie their origins in the debates of the mid 1800′s. The newly enriched commercial class longed for intellectual authority. As modern society shed its aversion to the accumulation of capital it needed new theories to justify the new social structure. From Aristotle to Aquinas the dominant intellectual tradition was to regard profit as immoral. This had to be replaced.
In parallel the commercial class wanted to throw off the yoke of government interference. Levels of taxation; the right to print money; and the respective roles of government and industry had to be worked out.
So starting in France with Boisguillebert and Cantillon; then in Britain with Smith, Ricardo, Malthus, and Mill modern economics began to take shape. At its core was the ‘magic’ of the market that Smith identified and immortalized with his metaphor of the ‘invisible hand’. This magic caused the self interest of individuals to be translated into social welfare. So instead of being venal the desire to make profit became a virtue.
And the commercial class was thus liberated from the Middle Ages.
But economics was not yet obsessed with the ideal. The great systems of Ricardo and Mill were not rigorous mathematics and they were referred to as ‘political economy’ in recognition of their relationship with current social issues.
The pursuit of certainty began in earnest much later.
As economics matured a growing need for rigor crept in. The contemporary triumphs of physics and the increased ‘formalization’ – mathematical expression – of science pressed economists toward their own adoption of formal theorizing. This desire accelerated quickly and decisively in the early 1900′s, such that by mid century mathematical modeling dominated. Paul Samuelson being the most prominent architect of the new method. Textbooks after him have been highly dependent on mathematics. Before him, in the work of Alfred Marshall, whose book was the standard text for decades, mathematical analysis was limited and confined to appendices.
With mathematics came rigor. The subject was no longer ‘political economy’ but rather simply ‘economics’ and the last vestiges of real world human action was hived off when economics and sociology parted company in the 1930′s. While the leading sociologist of his day, Talcott Parsons, was only too happy to carve out space for the nascent subject of sociology, the split left economics the poorer. It left thinkers like Veblen, Weber, Durkheim, and more recently Granovetter and Fligstein, looking in at what was increasingly a self-referential and formal exercise in applied mathematics.
And all the while the effort within economics was the exploration of Smith’s magic.
There was one exception: Keynes in the mid 1930′s. His argument became anathema to standard economists precisely because it built upon the insight that there are times when markets are not efficient. They are not always magical. Sometimes they can act perversely. Indeed they can spiral out of control. And the forces that cause this instability are within the system, they are not ‘exogenous’. Keynes thinking represented a shocking, and if correct, devastating critique of the then emerging standard view. For the next few decades Keynesian economics, because it seemed to describe reality so well dominated public policy, but beneath the surface economic theorists bridled at the notion the the magic was not ideal. They wanted to recapture certainty. Eventually the stagflation of the mid 1970′s undermined Keynes. Central to the counter attack was the undoing of the theory that related unemployment and inflation – the so-called ‘Phillips Curve’. Stagflation seemed to contradict Phillips. Only policies based upon the idealized system: for instance, the new monetary theories of Freidman, had effect. The Keynesian domination toppled and the new synthesized and formalized system of the ‘New Clasicists’ reigned supreme.
Now what we have is the sterility of the de-humanized General Equilibrium Theory and its hangers-on.
The consequence has just been played out.
The triumph of the new classicists and their unshakeable faith in markets led directly to Reaganism. It led to deregulation. It led to the political view that ‘government was the problem’. The triumphant world view was that markets, and their magic, if left alone would always produce a better allocation of wealth than any system in which the government played an active role.
Further, an offshoot of the new classical theory, the efficient markets hypothesis, laid the groundwork for modern portfolio theory and the ‘Black-Scholes-Merton’ model for options pricing. This latter was used, in turn, as the basis for the construction of the market for options. Up until Black-Scholes-Merton most states in the US regarded options as simple gambling. So no exchange for trading options could be built. The model changed that. The Chicago Exchange for trading options was permitted by the SEC partly because Milton Friedman called and persuaded its then head that the theory underlying options trading was impeccable. Nobel Prizes were handed out to its developers.
So the derivatives business owes its existence to the relentless pursuit of the ideal and the the belief in certainty the lie at the heart of the new classical system.
This idealized system, Smith’s magic, had moved from being a theory about the world, to being a technology deployed within the world.
But unlike technologies based upon physics or chemistry, this one had inherited a fundamental flaw: its reliance on the absurd assumptions that were necessary to force the new classical models to describe an ideal market. One outcome of this flaw was that derivatives traders used idealized distributions of probabilities in their own modeling: they employed a Gaussian distribution – the ‘normal’ or ‘bell’ curve – for loss event estimation. The real world rarely conforms to such a distribution, but it was embedded in the ideal world upon which the derivatives models were based. That was accepted theory, indeed it was ‘high’ theory. It was inviolate. No one could assert that it was incorrect.
As we now know that inherited flaw brought our economy to its knees.
It is not a trivial statement to suggest that new classical economic theory was a prime cause of our recent crisis. I believe it to be the case. Economic theorists have a responsibility that extends beyond the safety of their classrooms. It reaches right into the foreclosed homes, lost jobs, destroyed lives, and diminution of wealth that their obsession with ideal markets has wrought. That they defend themselves with arguments based upon the ideal is testimony to the bankruptcy of their thinking.
Economists like Barro, Lucas, and Mankiw are culpable. They share a burden along with their predecessors. They built models to explore markets. Instead they convinced politicians that markets are perfect. They became blinded by their own mathematics and its elegance. They built a system unrelated to reality that had little explanatory power outside the ideal, and no predictive power at all. They gave intellectual credibility to partisan and reckless fiscal policies, to ill thought out deregulation, and to the development of unsafe and unstable derivatives markets. They created and supported a world view that found expression in thirty years of public policy – through administrations of both political parties – and which still pervades the thinking of our business and governmental elites.
Their ideas have been discredited on a monumental scale.
To say that it is unfortunate that the new classicists triumphed and dominated economics is to minimize the scale of the human cost their pursuit of the ideal caused.
The ideal failed.
As it was always doomed to.
Humans are not ideal.
Theories describing human activity, like that in markets, cannot be based upon an acceptance of certainty. For there is no certainty.
We need a new economics. Perhaps based upon evolution, that encompasses behavior, geography, culture, relationships, psychology and above all is inclusive of learning with all its fallibility. It will be messy and imprecise. It may elude formalization at the outset. But it will be real. For we must rid ourselves of the ideal.
Because this crisis above all else was a failure of the ideal