And their stories do obey the rules of plot structure - if they didn't, we wouldn't believe them.

TO BE NOTED: From Knowing and Making:

"Seven basic plots and the narrative of the economy

You've heard it before, in one variation or another: there are only so many stories in the world. Sometimes it's six, sometimes twenty - sometimes just one - but the idea is always the same: there's a limited number of ways a plot can turn out.

A few years ago, Christopher Booker picked up this idea, analysed it to death and produced an excellent book called The Seven Basic Plots. He picked out seven common story structures which, he argues, include all successful stories (others are possible but he suggests that they result in unsatisfying outcomes which do not ring true for us). His proposal comes down to psychology in the end - he makes a convincing case that specific kinds of story fit with our view of how the world should be, and therefore create a satisfying structure. It all comes down to our desire - and expectation - that people should get what they deserve.

His thesis applies to works of fiction and not to real life, of course. Real life doesn't behave according to our subconscious presumptions about what the world should do. But nor do we have access to accurate knowledge about what is happening in real life. Everything we learn - and especially everything we learn about economics - is mediated through the narrative of journalists, academics, authors or other interpreters. And their stories do obey the rules of plot structure - if they didn't, we wouldn't believe them.

It's easy to find each of these plots in the narratives of economic commentators and journalists. Each of the seven structures relates to a story about the economy that we've all seen, and reveals new insight into the subconscious quest for justice that makes the story appeal.

Overcoming the Monster

Not so hard, this one. It's the activist politician's narrative and it goes like this: the monster is the recession (or excessive debt, or the banking crisis) and we will muster the weapons at our disposal, stand firm and our clear view of truth and justice will slay the beast in the end.

The story, like many others, has five parts: the call (the first signs of financial crisis), initial success (the rescue of Bear Stearns), confrontation (the Fed tries and fails to save Lehman Brothers), final ordeal (the recession and mounting deficits), and miraculous escape (at the last moment, as the TARP money is finally running out, the stimulus works and the recession is defeated).

The appeal to justice is as simple as the story: the recession is bad (caused by the sins and venality of bankers, or US subprime borrowers depending on who's telling it) and we are good, so we must prevail.

Rags to Riches

It might seem that the story of the last two years is better described as riches to rags. But within this framework the classic story of poor boy made good still appeals. Business magazines remind us that "eight out of ten successful companies were founded in a recession" or show us the smart fund manager who shorted the banks or bet against CDOs at just the right time and walked away with a billion dollars.

But there's a more fundamental story which is captivating a wider segment of the economics community. And that is the rise of China.

The archetypal rags to riches storyline has a poor orphan, basically good at heart but in a bad situation, picked on by the bigger boys or girls. Through virtue and a deserved stroke of luck they start their rise to prominence, but are still taken advantage of by the more sophisticated, and less moral, rich folks. After a climactic crisis, they finally mature - surpassing the flawed rivals who could never reach the same potential - and rise to their true inheritance. Usually at this point, the orphan's true love comes back onto the scene, there's a wedding and the happy couple - China and India anyone? - rule over the kingdom for the rest of their lives.

This time, the venality is a sin shared by all of us in the West - profligate, decadent, addicted to debt to buy from the East the honest goods that we have forgotten how to produce - and the virtue is the poverty, redeemed by industriousness, of the developing world. The starting point can plausibly be anywhere in history - let's say the moment when India's cotton industry lost out to the UK's in the 18th century, or when China's silkworms were stolen by Europeans in the 15th - the crisis was the Asian currency run of 1997-98 and the lesson wisely learned was to build up trillion-dollar reserves. On this reading, it's perhaps the most literal example imaginable of rags to riches.

The Quest

The quest, it seems, is for The Solution - whatever policy, or institution, or restructuring will bring about an economic recovery.

A quest always begins with a call to a young hero, who sets out to find his destiny. This hero - let's call him Barack for the sake of argument - consults with wise men (Krugman, Summers), recruits his band of helpers (Geithner, Brown, and the reluctant but ultimately loyal Merkel), is almost led astray by temptation (protectionism, partisanship), passes between two deadly extremes (a $2 trillion stimulus and helicopter money, or no stimulus at all and letting the market sort it out), slays mythical beasts along the way (AIG, GM, Rick Santelli), and finally comes in sight of his goal. He must then pass three final tests (or in this case pass three final bills: the stimulus, the budget and...a healthcare bill? the Employee Free Choice Act? a mandate for the Federal Reserve to target nominal GDP futures?) to reach the solution.

In many Quest stories, the hero does not meet his princess at the end but is already married to her before he sets out, and remains loyal to her throughout. Ahhh. Sweet.

One note of caution: when the treasure is finally achieved, many heroes must spend the second half of the story returning to their starting point. That's the 2012 election campaign starting in a year's time, then.

Voyage and Return

A slightly different tenor to this story structure. This is the plot of Alice in Wonderland, H.G.Wells's The Time Machine, The Wizard of Oz or the Rocky Horror Picture Show.

In this story we start in the ordinary world and are suddenly called into a new and strange realm. Our initial reaction is puzzlement, and we do not know quite why we are here. After an initial fascination with the new world, we start to have some less pleasant adventures, and our focus turns desperately to home. But we are drawn deeper and deeper into a world we can neither understand nor control before finally - often through luck not judgement - escaping to return home, no richer but hopefully little poorer, and a little wiser.

Today, this story is told two ways. One is that the recession is the otherworld, and after wandering around for a while, happening across toxic assets and experimenting with strange bailouts, we will find the key - or be released naturally - and return to our normal life.

The other, perhaps darker, version is that the boom of the last seven years was Oz, and this is normality. We've returned from a thrilling but nightmarish era of colourful, debt-fuelled consumption to an ordinary life where we spend what we earn and gradually pay off the mortgage. The preferred interpretation is really the choice of the author, and I suspect that the first version of Voyage and Return is the popular interpretation among non-economists, while the latter is the morality tale of the Austrians.

The open question with Voyage and Return is what we learn from the experience. Will we be wiser and grow to understand and manage our world in a better way; or will we revert to type, relieved and lucky to have escaped a worse punishment?

Comedy

Comedy is a tough plot to summarise, because there are often so many extraneous events to distract the reader that it's hard to find a coherent thread. But Booker analyses it as follows:

Comedy consists of (a pair of) "below the line" protagonists (characters somehow in the 'shadow' of the more powerful "above the line" characters who are their social superiors) struggling against the elite, usually represented by one dominant 'dark' character. The struggles in part consist of mistaken or concealed identity; the story being resolved when the 'inferior' characters have a moment of recognition and turn the tables on the elite, taking their place at the head of the community - at which point, if it's Shakespeare, they all get married.

So who in the economic tableau represents these below-the-line figures? I'd hazard a suggestion: Nouriel Roubini and Nicholas Taleb. Scorned and neglected by the economics elite until 2007, their warnings ignored, 2008 was the moment when the tables turned. Their identity finally revealed, the ugly ducklings grow up to become black swans (wait, that's a different plot...) and the dukes and princes of the upper class - Greenspan, Wall Street and the general equilibriates - are humbled.

Who can be the dark figure against whom these heroes struggled? Hank Paulson, Bernie Madoff, Dick Fuld or the evil baron Goldman of Sachs? This is an unsatisfying storyline in the current context, perhaps because the end result is still so uncertain. And because, as Booker describes, a failure to recognise the truth can so easily turn Comedy to...

Tragedy

In this, most timeless of storylines, the protagonist enters into a forbidden course of action and gains immediate reward. The story accelerates as he (it is usually a he) starts to exert his new powers and enters a dream stage of self-satisfaction and success. But this success, amoral or immoral as it is, can never provide satisfaction and the hero is drawn to commit more and deeper sins. Soon he loses control of the situation and the dream turns to nightmare. Finally the darkness closes in and the protagonist, despairing, is destroyed.

Many commentators read the story of the economic crisis straight out of this book. Our indulgence in debt, consumerism, financial services, imports and deficits lit the touchpaper. For years we were able to live in luxury with the sinister powers of the devil (Greenspan? The Chinese government?) keeping inflation low and our lifestyle high. But this could not be sustained, and growth came at the expense of ever more debt, the money supply increasing through off-balance sheet financial instruments, and finally an uncontrolled rise in commodity prices pushed us over the edge (starving a billion innocent poor people into the bargain). We are now in the nightmare phase, clutching at trillion-dollar public deficits and printing hundreds of billions of pounds to let us clutch the dissolving remnants of our lifestyle. And soon will come destruction, with the insolvency of the state and a descent into chaos and war at worst, or autarky at best.

In this view, the financial system is too far gone to save, and the best we can do is learn to weave baskets and hope we haven't forgotten how to grow vegetables in our gardens.

And clearly this story has an appeal. Some people like to flagellate themselves and decry the immorality in what they have done. A larger group likes to blame others, who they see as more irresponsible than themselves. Some wish to see it as the government's fault. Whoever gets the blame, blame there must be. After all, if everything has gone so terribly wrong, surely somebody must be at fault?

Rebirth

Let me tell one last story - inspired partly by Paul Mason's Meltdown: The End of the Age of Greed, partly by a bit of economic data, and partly by my own instincts.

This story starts a bit like the last one. But to make it a little more personal, let's pick a young man named Stephen. Stephen is 24 years old, in the early part of his career. He's qualified as a computer programmer and gone to work in an investment bank, developing systems to help them value credit options.

He's well paid but is going to be even better paid next year, and the year after, so why not borrow a little now in advance of those well-deserved bonuses? The house he bought last year is already worth 20% more than he paid for it (of course some of that has come back in equity release already). A healthy amount of debt is part of modern life and nothing to be ashamed of.

Two years and many fun evenings later, his promotion to derivatives trader comes through as expected and he gets to play his part in extending the same debt to thousands of other Stephens. Of course he can see that some of them are not such good risks as he was, but that's not really his problem - when averaged out, surely the losses will be less than the returns on the loans.

Like any honest trader he is willing to put his money into his own products: this year's bonus and remortgage goes into a hedge fund - one of his clients, in fact - which should easily earn him a 40% return on leveraged CDO products. His new car is almost a necessary business expense - it shows his customers that he's doing well and that gives them confidence in him.

But as this perfect life reaches its peak, we start to see that there's something sour about it. The debts are starting to go bad, the capital layer of Stephen's bank looks thin and the economy is gradually catching on to the problems. The good angel - Roubini again - is warning him that this is the wrong path, while the bad angel - the rest of the financial system - urges him to up the stakes - it always worked before...

And then in autumn 2007 all hell breaks loose.

The forces of good are arrayed against towering mountains of debt and writeoffs which threaten the civilised world. The old leader - King Gordon - warns of the bloody war to be fought and the pain to be endured, as dark clouds gather overhead. Stephen, of course, is on the other side - the forces of banking which are determined at all costs to maintain their power and profits. Battle is joined.

The light armies win some early battles but soon Stephen's army has the upper hand. More debt, more assets and more free markets - they will easily roll over the resistance. The rhetoric from the banking world - we have enough capital now, value at risk is minimal - rings hollow, while the speeches of the good guys are baleful, warning of still worse pain ahead and the need for a final push.

That final push starts to make a difference, but more importantly there's something inherent in the banking philosophy which is unsustainable - it contains, in the classical sense of hubris, the seeds of its own destruction. In building up a tower of leverage of unparalleled height, the only-too-human capabilities of Stephen, and the thousands of Stephens alongside him, are overwhelmed. They can no longer see what they are carrying, and the moral hazard and escalating risk of the debt starts to bring the tower down around him.

And here is where, in Paul Mason's story and perhaps in this week's newspapers, the plot takes a twist away from the tragic. Stephen, after all, is still an intelligent person with other skills, and he can escape from under the falling marble masonry of the banking giants. The new leader of the armies of good, young prince Obama, has crested the Hill and with the sun behind him and the voices of angels singing, speaks for the first time of recovery - but a recovery built on new foundations. Stephen crosses the battlefield and, recognising and banishing the darkness inside him, joins the quest to create a new economy.

We're at this new beginning now. A revived era of technology and environmental progress, a rebalanced world economy, an approach to equality for the Chinese working class and the humbling of the proud generals of banking, is the rebirth promised by this storyline. What hints could we see at the start of the story? That edge of self-awareness, the fundamental honesty and capability in Stephen's heart, gave him enough strength to avoid the tragic downfall and return to the light, with a new future ahead instead of the violent death that's inevitable in the structure of tragedy.

Reality

Which of these stories is true? None of them of course, or all. The real world has too many protagonists, too much information and too much randomness for simple explanations of this kind.

But we seek meaning and we choose whichever of these stories conforms with our assumptions about justice and culpability. Do you think the bankers are at fault? Then the bankers must come to a deserved and sticky end. Is it consumers' fault? Then consumers will be punished with an endless recession. Was it the politicians? Then the infinite debts of the state will crush them in Sisyphean torment.

And who is the good guy here? If the financial sector was actually a force for improving the economy, it will ultimately be rewarded with a return to prominence (Mervyn King, perhaps?). If the public, or those who were prudent enough to save, were the essential source of virtue, they will inherit the kingdom of heaven (Peston). If the government's place is to coordinate and correct the selfishness of the individual, they are on their way to a permanently more substantial role in managing the economy (Krugman). And if you believe in the rational wisdom of man (Mankiw), then mankind will always be okay, while if you focus on the flaws and biases inherent in humanity (Thaler), then you will expect our potential to be kept always in check unless guided out of the swamp by science.

Our choice of story reveals us better than it reveals the economy. Economics can say little about the grand narratives of history - its successful tools are all there to adjust the small scale, the technical details, not to provide universal interpretations. There is no meaning to all this; it just is. "

Me:

Don said...

This is an excellent post. Narrative thinking, as I call it, also applies to "theories". In this crisis, we have looked for past occasions similar to this one, and have been invoking the names of figures and theories that seem to offer an explanation and hope. Hence, the focus on Keynes and the Great Depression.

These foci supply a hopeful narrative and road map for dealing with the current crisis. In fact, the main importance of these foci is in giving us a paradigm that we can test our various views against as the crisis progresses.

The main figures that I have relied on are Irving Fisher and Bagehot, with Keynes and Milton Friedman as well.

On the social and political aspects of the crisis, I have relied upon Burke and Hayek.

It's not that other opinions and theories aren't important to me, but that these figures provide the backdrop against which I see this crisis and judge other views.

As for Obama, FDR is a good example to follow, since he was actually pretty conservative, but took a pragmatic stance that served us well. We're here.

Don the libertarian Democrat

the construct may come into popular consciousness; what was previously invisible may become part of the furniture of the popular narrative

TO BE NOTED: From Understanding Society:

"Longue durée

Image: Making dikes on the Yellow River

Many historical changes take place on a human scale -- the Great Depression came and went within the lived experience of many millions of people, and they were able to tell comprehensible narratives of the beginning, middle, and end. Likewise with periods of political transition and upheaval -- the Vietnam war protests, the Reagan revolution, the Cold War. So these events can be scaled within the historical sensibilities of individuals who experienced them. But what about changes that are so extended and so gradual that they are all but imperceptible? How is history of the longue durée to be understood? (This posting picks up the thread from an earlier post on "historical tempo".)

The sorts of changes I have in mind here run along these lines: a long, slow increase of population density relative to available resources; a gradual shift in the gender ratio or age structure of a population; the gradual silting of a river system and estuary; a slow erosion of a traditional system of values; and an extended process of increasing or decreasing tolerance between intermixed religious groups. In each case it is possible for the changes to be slow enough to defy recognition by historical participants; and yet each of these slow processes may have very important historical consequences.

Paul Pierson addresses many of the issues raised by slow pace of historical processes in Politics in Time: History, Institutions, and Social Analysis. But in a somewhat different theoretical setting the topic was also of particular interest to some of the historians of the Annales school -- Fernand Braudel and Emmanuel Le Roy Ladurie in particular. We might say that these are examples of historical processes working "behind the backs" of the participants.

The question here is a simple one: what are the methods of observation and inference through which historians can identify and investigate these sorts of long, slow processes? And what is the standing of such processes insofar as they stand outside the scope of events of ordinary historical experience? Given that participants have no basis for identifying the long, slow processes within which they swim, what is the status of the historian's hypotheses about such processes?

As for the question of how historians can identify these kinds of century-long processes: this task is really no more challenging than the problem of arriving at hypotheses about unseen processes in other areas of science. It takes ingenuity and imagination to hypothesize how a gradual increase in local violence might relate to slow demographic trends; but once the historical demographer turns her eye in this direction, it is no great leap to hypothesize that a rising male-to-female ratio may be a part of the cause (as Valerie Hudson and Andrea Den Boer argue in Bare Branches: The Security Implications of Asia's Surplus Male Population). What is necessary, though, is a fairly rigorous ability to measure variables of interest at different points in time and to discover trends among these observations. In other words, the turn to cliometrics -- quantitative observation of historical trends -- is more or less essential to the history of the longue durée. And it is not too surprising that the Annales historians were deeply interested in demographic history, price series, and historical measurements of economic activity.

So this answers part of the question: a history of long processes requires careful observations of quantities over time, and it requires the formulation of causal hypotheses about how these trends influence other historical circumstances of interest. Jack Goldstone's efforts to link the occurrence of revolution to slow demographic processes falls in this category (Revolution and Rebellion in the Early Modern World). And Mark Elvin's treatment of the centuries-long struggle between officials and rivers in China to gain control of flooding and silting illustrates the historian's ability to take the long perspective (The Retreat of the Elephants: An Environmental History of China; see this posting on Elvin's work).

And what about the other question -- the status of historical conceptions of these long, slow processes? They are not abstractions from the historical self-understandings of participants. By hypothesis, participants cannot perceive these sorts of processes. Instead, they constitute a more hypothetical historical structure that may nonetheless play a future role in the narratives participants tell about themselves. A slow process of climate change may be imperceptible at a given point in time. But once it is identified and articulated by the analytical historian the construct may come into popular consciousness; what was previously invisible may become part of the furniture of the popular narrative.

So if we conceptualized historical episodes along the lines of life events, then the longue durée would be forever outside of history. If, on the other hand, we include in our definition of history all the structures and trends that can be identified by analytical history, then the history of the longue durée is entirely comprehensible. Moreover, it is apparent that ordinary historical apperception can itself incorporate the theories of historians. And in this sense, the longue durée can enter back into ordinary historical experience.

Posted by Daniel Little"

self, in this sense, is our work of art, a fiction created by the mind in order to make sense of its own fragments

TO BE NOTED: From The Frontal Cortex:

"Confabulations

Posted on: April 25, 2009 9:27 AM, by Jonah Lehrer

Just when you thought people couldn't get any sillier or more confused, psychologists uncover yet another innate foible. This one is called "choice blindness," and it refers to the ways in which people are utterly blind to their own choices and preferences. We think we want X, but then we're given Y, and so we invent all sorts of eloquent reasons why Y is actually a much better alternative and how we wanted Y all along. (What sort of fool would choose X?)

Lars Hall and Peter Johansson explain:

For example, in an early study we showed our volunteers pairs of pictures of faces and asked them to choose the most attractive. In some trials, immediately after they made their choice, we asked people to explain the reasons behind their choices.

Unknown to them, we sometimes used a double-card magic trick to covertly exchange one face for the other so they ended up with the face they did not choose. Common sense dictates that all of us would notice such a big change in the outcome of a choice. But the result showed that in 75 per cent of the trials our participants were blind to the mismatch, even offering "reasons" for their "choice".

Importantly, the effects of choice blindness go beyond snap judgements. Depending on what our volunteers say in response to the mismatched outcomes of choices (whether they give short or long explanations, give numerical rating or labelling, and so on) we found this interaction could change their future preferences to the extent that they come to prefer the previously rejected alternative. This gives us a rare glimpse into the complicated dynamics of self-feedback ("I chose this, I publicly said so, therefore I must like it"), which we suspect lies behind the formation of many everyday preferences.

This reminds me of the influential work done by Roger Sperry and Michael Gazzaniga on split-brain patients, who have had their two hemispheres disconnected. The scientists mischievously flashed different sets of pictures to each eye, which meant each hemisphere was getting a different set of inputs. For example, they would flash a picture of a chicken claw to the right eye and a picture of a snowy driveway to the left eye. The patient was then shown a variety of images and asked to pick out the image that was most closely associated with what they had seen. In a tragicomic display of indecisiveness, the split-brain patient's two different hands pointed to two different objects. The right hand pointed to a chicken (this matched the chicken claw that the left hemisphere witnessed), while the left hand pointed to a shovel (the right hemisphere wanted to shovel the snow.) When the scientists asked the patient to explain his contradictory responses, he immediately generated a plausible story. "Oh, that's easy," he said. "The chicken claw goes with the chicken, and you need a shovel to clean out the chicken shed." Instead of admitting that his brain was hopelessly confused, he wove his confusion into a neat explanation.

Gazzaniga blamed this behavior on "the interpreter" module, located somewhere in the left hemisphere. The basic idea is that the brain is constantly trying to weave a narrative out of the cacophony of reality - it's desperate to make sense of the world. Interestingly, much of this narrative is written in reverse, as we brazenly re-write what just happened. We conveniently forget that we didn't choose that attractive face, or that the shovel has nothing to do with the chicken shed. The ridiculous contradiction isn't suppressed - it's not even noticed. We end up happily justifying choices we didn't make.

Why do we do this? I like to think of these confabulations as necessary half-truths to preserve the unity of the self. At any given moment, our mind is overstuffed with disparate sensations and fleeting thoughts; our different hemispheres want different things and distinct blobs of brain pump out distinct emotions. Why, then, do we feel like a unified person? Why do I feel like "Jonah" and not like a collection of random and stray neural emanations? Because we tell ourselves a story. Just as a novelist creates a narrative, we create a sense of being. The self, in this sense, is our work of art, a fiction created by the mind in order to make sense of its own fragments. In Proust Was A Neuroscientist, I quote Virginia Woolf on this mental process:

Am I here, or am I there? Or is the true self neither this nor that but something so varied and wandering that it is only when we give rein to its wishes and let it take its way unimpeded that we are indeed ourselves?"

This process will take years to complete since, if properly done, it should get at the heart of the regulatory structure.

TO BE NOTED: From The WSJ:

"Good Government and Animal Spirits

Every talented player understands the importance of a strong referee.

By GEORGE A. AKERLOF and ROBERT J. SHILLER

The principal long-term result of the current financial crisis should be improved financial regulation. After the immediate crisis is over, we need to restructure our fragmented system. This process will take years to complete since, if properly done, it should get at the heart of the regulatory structure.

Chad Crowe

This is not as radical as it sounds, for while many observers equate U.S.-style capitalism with unconstrained free markets, the story is more complicated. Americans have long understood that for the economy to work well, government must play an important supporting role. They've also long understood the important role that self-regulatory organizations (SROs), such as trade associations and exchanges, play in cooperation with government regulation.

An understanding of animal spirits -- the human psychology and culture at the heart of economic activity -- confirms the need for restoring the role of regulators as guiding hands in a healthy, productive free-enterprise system. History -- including recent history -- shows that without regulation, animal spirits will drive economic activity to extremes.

The debate about the proper role of government in the economy goes far back in American history. At the beginning of the 19th century, the Democrats were fiercely opposed to government intervention, while the Whigs thought that the government should provide the backdrop for a healthy capitalism. On the federal level, this would mean support for a bank of the United States and a system of national roads, as part of the "American System" advocated by Henry Clay starting in the 1820s and supported by John Quincy Adams. Andrew Jackson and later Martin van Buren were against such federal government intrusions.

Controversy about the proper relationship of the government and the economy has continued since then. The recent economic turmoil has brought back to the table many questions that had been considered settled. People are seeking new answers, urgently.

There have been several major shifts in American history on this large issue: at the time of the Revolution; after the elections of Andrew Jackson and, later, of Abraham Lincoln; at the end of Reconstruction; during the Great Depression; and after the election of Ronald Reagan. Now we hope and expect we are seeing a shift that will be remembered in association with Barack Obama. If the president (with the help of Congress and our SROs) brings about this shift, it will be something far more important than the soon-to-be-forgotten stimulus and the bailouts he has overseen to date.

At the end of the 1980s, our economic system was remarkably well-adapted to weather any storm. For example, massive numbers of S&Ls failed during the decade. But government protections isolated this collapse into a microeconomic event that, while it cost taxpayers quite a bit of money, only rarely cost them their jobs.

Then the economy changed -- as it always does -- challenging the regulations that were in place. The housing market illustrates this perfectly.

Commercial and savings banks used to have reason to be careful initiating mortgages -- they would most likely hold the debt for years. But banks would increasingly sell the mortgages they initiated to others. And regulation did not adapt to reflect this change in the financial structure. The regulatory failure led to a profound systemic instability in our economy, which accounts for the severity of our economic crisis. Devising new regulatory structures that will allow financial innovation to proceed and yet prevent new such systemic problems is the major challenge to our creative capitalism today.

Public antipathy toward regulation supplied the underlying reason for this failure. The U.S. was deep into a new view of capitalism. Americans believed in a no-holds-barred interpretation of the game. We had forgotten the hard-earned lesson of the 1930s: Capitalism can give us real prosperity, but it does so only on a playing field where the government sets the rules and acts as a referee.

Contrary to a widespread impression the current situation is not really a crisis of capitalism. Rather we must recognize that capitalism must live within certain rules. And our whole view of the economy, with all of its animal spirits, indicates why the government must set those rules. It may be true that in the classical economic paradigm there is full employment. But with animal spirits, waves of optimism and pessimism cause large-scale changes in aggregate demand. Since wages are determined partly by considerations of fairness, these changes in demand do not translate uniformly into shifts in prices and tend to cause shifts in employment. When demand goes down, unemployment rises. It is the role of the government to mute those changes.

Moreover, entrepreneurs and companies do not just sell people what they really want. They also sell people what they think they want, and not infrequently what they think they want turns out to be snake oil. Especially in financial markets, this leads to excesses, and to bankruptcies that cause failures in the economy more generally. All of these processes are driven by stories. The stories that people tell to themselves -- about themselves, about how others behave, and even about how the economy as a whole behaves -- all influence what they do. These stories vary over time.

Such a world of animal spirits justifies the economic intervention of government. Its role is not to harness animal spirits but really to set them free, to allow them to be maximally creative. A brilliant player wants a referee, for only when the game has appropriate rules can he really show his talents. While the sports of baseball and football haven't changed much in the last century, the economy has -- and American financial regulation hasn't had an overhaul in 70 years. The challenge for the Obama administration, along with the U.S. Congress and our SROs, is to invent a new and better American version of the capitalist game.

Mr. Akerlof is the 2001 Nobel Laureate in Economics and a professor at the University of California, Berkeley. Mr. Shiller is professor of economics and finance at Yale University and chief economist at Macromarkets LLC. They are co-authors of the recently published "Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism" (Princeton)."

there is no such thing as an exhaustive and comprehensive telling of the story -- only various tellings that emphasize one set of themes or another

TO BE NOTED: From Understanding Society:

"Objectivity and bias in complex happenings

Complicated things happen: riots occur, military coups take place, governments collapse. The happenings consist of a myriad of events and actions, many social actors, and a range of political interests and grievances. We want to know what happened; who did what; and who is responsible for the course that events took. It is one of the tasks of journalists, commentators, and historians to arrive at accounts of complicated things that answer many of these questions. And we want those accounts to be objective, truthful, and unbiased. Each account is a creative act of selection and narrative construction; the analyst has to sort out the evidence that is available to him or her and arrive at a chronology and a causal interpretation that makes sense, based on the evidence.

What we want from the historian and the journalist is easily described, though achieved with difficulty. We want an account that provides an accurate and truthful narrative of the events, based on the best available factual and historical information. We want an account that avoids the biases of the actors, including especially those of the most powerful actors who have the greatest capacity to shape the story -- the government, the military, and the major parties. We want an investigator who is able to question his/her own initial assumptions -- sympathy for the underdog, patient acceptance of the government's good intentions, or whatever. And we want a narrative that provides a balanced synthesis of the many events of the time period into a storyline with a degree of coherence: what the major events were, what choices were made by the actors, what the motivations of the actors were, and perhaps -- who acted responsibly and who acted recklessly or out of narrow self-interest.

It has to be acknowledged at the start that there are often multiple truthful, unbiased narratives that can be told for a complex event. Exactly because many things happened at once, actors' motives were ambiguous, and the causal connections among events are debatable, it is possible to construct inconsistent narratives that are equally well supported by the evidence. Further, the intellectual interest that different reporters bring to the happening can lead to differences in the narrative: one reporter may be primarily interested in the role that different views of social justice played in the actions of the participants; another may be primarily interested in the role that social networks played, so the narrative is structured around network connections; and a third may be especially interested in the role of charismatic personalities, with a consequent structuring to the narrative. Each of these may be truthful, objective, unbiased -- and inconsistent in important ways with the others. So narratives are underdetermined by the facts. And there is no such thing as an exhaustive and comprehensive telling of the story -- only various tellings that emphasize one set of themes or another. That said -- it is entirely possible that a given event will have provided enough factual data in the form of witness reports, government documents, YouTube videos, etc., that the main sequence of events, cast of actors and responsibility for events are unambiguous.

The example I'm thinking of in particular is the recent period of demonstration and riot in Bangkok involving red shirts, followers of former prime minister Thaksin, and the government and military. (See several other posts here and here.) But other examples are easily found: the taking of the Bastille, the Haymarket Square riot in Chicago (pictured above), the return of Franco to Malaga, or the decision of General MacArthur to cross the Yalu River in Korea. Virtually every historical event is a complex happening; so the problems raised here are endemic to historical interpretation.

One of the important issues being debated right now in Thailand is the question of arriving at a balanced and fact-based judgment of the amount of force that was used by the military in dispersing the crowds of protesters on April 13-14. The government reports that it used minimal force -- paper bullets, firm orders to fire above the crowds when using live ammunition, and a very low number of casualties as a result. Critical observers suspect a different story; based on memories of past repression by the military in times of street demonstrations, there is suspicion that the amount of violence was much greater. Some commentators speculate that there may have been many more deaths than have been reported and that the bodies were secretly taken away; ambiguous videos are brought forward as evidence for this possibility. So how are we to sort out the truth of the matter?

We can raise the question of objectivity at two levels: the investigator and the narrative. So let's begin with the narrative itself -- what do we want in a good comprehensive piece of journalism that tells this story accurately and fairly? We want an account that lays out the causes, events, and actions that made up this period of several weeks of protest and reaction. We want to know what organizations and leaders took what actions at what time, to call forth what organized responses. We want to know what key decisions the government made. We want to know how the prime minister and the police and military deliberated about responses to massive demonstrations. We want to know how the several occasions of mob violence against officials and offices transpired. We want to know the crucial details of the final hours of confrontation between the military and the crowd, and the degree of violence that transpired at that point.

And what do we want from the investigator of this complex happening in Bangkok? We want a commitment to arriving at the most truthful account of the story possible; a commitment to considering the full range of empirical and factual evidence available; and an ability to tell the story without regard to one's antecedent affinities and loyalties. It shouldn't be a "yellow shirt" or a "red shirt" story; it should be a factual story, based on critical reading and assessment of the available evidence. In order to arrive at such an account, the honest reporter needs to exercise critical good sense about the sources and the interests that the conveyors of the information have: the biases of the government, the press, and the parties as they provide evidence and interpretation of the events. And we want this account to be as free as possible of the interfering influences of bias and political interest. We want an honest and comprehensive synthesis, not a one-sided spin.

The good news is -- both goals are possible. The standards and values associated with both good historical writing and good journalism lead at least some investigators to exert their talents and integrity to do the best job they can to use the evidence to discover the details of the story. Not all journalists are equally committed to these standards -- that's why we prefer the I. F. Stones to the Jayson Blairs of the world. But enough are committed that we've got a good shot at sorting out the realities and responsibilities of the complex happenings that surround us through their objective, fact-based reporting.

Posted by Daniel Little at 7:38 AM

In the long run, figuring out an effective way to regulate leverage, wherever and however it appears

From Mother Jones:

"Maintaining the Banks

— By Kevin Drum | Sun March 8, 2009 5:07 PM PST

Atrios sez:

I know I'll make this point a billion times before this is all over, but there's a difference between thinking that well run financial intermediaries (which, in theory, competition will create) are necessary for a modern economy and believing that the semi-oligopolistic system of financial intermediaries which have demonstrated beyond all reasonable doubt that they're at best incompetent and most likely some combination of incompetent and incredibly corrupt should be maintained at a cost of hundreds of billions of dollars (optimistically) in taxpayer money.

I don't really get this. Aside from the nitpicky point that the United States actually has one of the least oligopolistic banking sectors in the developed world, what's being argued here? That we should let the existing banks fail? That we should temporarily nationalize them? Which ones? And if we do, how should we treat all their creditors and counterparties? That's the big question (not whether shareholders should get wiped out — of course they should, but they're mostly wiped out already), and it doesn't go away just because we nationalize TitanoBank instead of shoveling cash down its gaping maw in return for preferred shares. In fact, it makes the question even more salient, since in a post-nationalization world Uncle Sam would be legally on the hook for all those claims.

As for the cost of all this, we might as well suck it up. We're way beyond the point of thinking we'll get out of this mess without spending a trainload of taxpayer dough one way or another. This debacle is going to cost us hundreds of billions of dollars no matter what we do.

And when it's over, guess what? Pretty much all the same people will be in charge. A few senior executives will be out of jobs, but that's about it. And the ones who replace them won't be much different. The fact is that these people did what they did not because they're stupid, but because the system practically begged them to act the way they did. That's what's broken, and fixing it depends mostly on what kind of new financial regulations we put in place going forward. I guess we're still in firefighting mode and don't have time to address that right at the moment, but I'd sure like to start hearing more about it sometime soon. In the long run, figuring out an effective way to regulate leverage, wherever and however it appears, is probably a lot more important than deciding which bureaucratic solution we should use to clean up the corpses currently littering the battlefield."

Me:
Narrow/Limited Banking

Submitted by Don the libertarian Democrat (not verified) on March 8, 2009 - 8:00pm.

Here's Taleb from Arnold Kling:

http://econlog.econlib.org/archives/2009/02/confidence_and.html

"Also, here is a video featuring Daniel Kahneman and Nassim Taleb. Taleb, like me, wants to get rid of risk-taking by banks, and leave non-insured institutions free to take whatever risks they want, as long as they are not creating risks for others. His solution is to nationalize banks. (me: why would this mean that they would not take risks? Suppose that Freddie Mac and Fannie Mae had been fully nationalized as of three years ago. Would they have taken more risk or less risk?)"

I would rather have Narrow/Limited Banking instead of nationalized banks:

"The FFA and “less is more” limited purpose banking won’t prevent asset markets from occasionally going nuts. But the functioning of financial markets will no longer be in question. Nor will con artists, parading as “financial engineers,” ever again be free to wreak havoc on the nation’s finances and its citizenry."

"Any new framework gives agents a reason to abandon their anchor to fear; and gives them a chance to reattach themselves to hope."

From Leigh Caldwell on Vox:

"This column argues responses to the recession should not be based on unrealistic expectations of rational behaviour. It argues that models of bounded rationality provide reasons that traditional macroeconomic policy responses may fall short and suggests more sophisticated solutions that could break the crisis’s psychological hold on markets.

Responses to the recession should not be based on unrealistic expectations of rational behaviour( TRUE ). We now know enough about real, flawed human psychology to be able to take some account of it in policy setting( I AGREE. BUT I SEE A PLACE FOR PHILOSOPHICAL ANALYSIS AS WELL. ).

The “homo economicus” model of rational agents, acting to maximise utility in the possession of all available information, is not realistic( TRUE ). It is hardly a credible way to look at human beings – but we tolerate it because it is simple enough( AND USEFUL ENOUGH ) to allow equilibrium analysis which often gives reasonable predictions (TRUE ).

However, these equilibrium models are not serving very well in today’s situation. Standard monetary policy and (to a lesser extent) Keynesian theories are based on rational-actor assumptions. They give broad recommendations about monetary loosening and fiscal expansion – which central banks and governments are rightly trying out. But growth is not resuming.

Bounded rationality is the broad term for behavioural models that do not follow the rational-maximiser formula. There is not yet a generally accepted alternative model. Lots of individual non-rational behaviours have been discovered, but they are grafted onto a rather clunky ‘rational actor with bits’ instead of forming a coherent behavioural model.

However, the best place to test a new theory is often at the edges of the old one, where the existing model breaks down. So the current troubles in the financial and real economy may be a good opportunity to try out some alternative models and see which give a reasonable description of what we see.( GO AHEAD )

Models of bounded rationality

Different models of bounded rationality vary basic assumptions of the rational agent model in different ways. Some of those assumptions are:

• Utility is discounted over time in a consistent way
• People have access to all relevant information
• All relevant information is expressed through market prices
• People can instantly weigh up the change in utility given by any buying or selling decision
• People act to maximise their utility

Therefore, the typical way to create a bounded rationality model is to relax one or more of these criteria.

The first class of model explores different time discount rates. Experiments show that people apply a high discount on utility( OR SAFETY ) in the present – they prefer £100 now to £120 next year – but a lower one in the future – they prefer £120 in four years to £100 in three (Loewenstein and Prelec 1992). This, arguably, contributes to explaining recent huge variances between overnight and three-month interest rates.

Perhaps our psychological instincts reflect a pragmatic sense of the risk of a promise not being fulfilled, and the modern financial system has evolved to provide a confidence in the future that does not come naturally. If so, then the financial markets are no longer successfully filling that role. This short-long imbalance is an important cause of disappearing credit( OK ).

A second kind of bounded rationality reflects the idea that people do not have access to all relevant information. Danielsson and de Vries (2008) discuss an important example – information asymmetry – and an interesting solution – enforced transparency( CATE. IS THIS YOUR IDEA? ). Many agents, short of crucial information, have had to make guesses; clearly this has led to many of the write-offs we have seen in the last 15 months.

A third approach relaxes the constraint that prices express all the information needed to make decisions. This classical assumption works only when there is a sufficiently liquid market, with defensible property rights. If enforceability is at risk (for instance when there is a significant chance of bankruptcy) then we can use derivatives or insurance to provide secondary price information about the risk of default( A GOOD USE OF CDSs ). If the market for these derivatives is not big enough or does not trade publicly, we lose that price signal.( OK )

In these situations, we need to use non-price signals to make economic decisions, and we do not have good models for interpreting those messages. This leads to inconsistent or irrational decisions on resource allocation.( OK )

A fourth category of model removes the assumption that people can make an accurate calculation of the utility that a decision will provide. These models include satisficing (Simon 1956) and rational ignorance (Downs 1957). Another is the concept of anchoring or habit – which suggests that we rely on familiar choices( OR NARRATIVES FROM HISTORY ) to avoid the mental effort and risk of picking alternatives. This behaviour can be seen in the credit markets, where an aggressive conservatism appears to be in control of lending decisions.

The fifth alternative to the rational model is to ask what happens if people do not act to maximise utility. Indeed, is there any single quantity called utility? Alternative models of decision making include multi-dimensional (“vector”) utility functions (for example Rios 1987), value modelling (Gordijn 2001) and psychological attempts to understand subconscious mental drivers – which have rarely been explored in economics. My own research suggests that a concept called “local utility gradient” drives behaviour.¹

Intuitively, the current financial environment seems to expose a lack of rationality in market participants( MY POINT ). The task for researchers is to find whether specific irrationalities provide evidence to support any particular behavioural models( YES ).

Policy implications

Whichever model of behaviour is assumed, policymakers should ask what the models indicate for macroeconomic policy. This question has been considered in a conference on “behavioural macroeconomics” at the Boston Federal Reserve in 2007.² No doubt the old solutions will work, given enough time. But today, with a much better understanding of economic behaviour, we could design more sophisticated solutions which would work faster.

A clear example comes from the concept of anchoring. Anchoring creates a tendency to fixate on one option too long when we might profitably switch to another –it limits the effects of all kinds of quantitative changes in policy. If a bank is scared to lend at a spread of 2.5%, anchoring implies it is unlikely to start lending when the spread increases to 3% or even 4%. This demands a qualitative change in conditions so that the bank can no longer make a simple marginal comparison but is forced to re-evaluate( EXACTLY. THIS IS THE POINT OF TARGETING INCENTIVES THAT CAN ALLOW A REASSESSMENT OF RISK. ) its likely returns from scratch.

The same effect is at play with fiscal easing. When state borrowing breached the government’s self-imposed 40% debt ceiling, the anchor was broken and little credibility may be given to promises of future prudence as debt reaches 45%, then 55% of GDP and beyond. However if a new anchor is created, say at the Eurozone’s 60% level, this creates a qualitative limit – immediately more credible than an arbitrary quantity. This anchor in turn can change behaviour in the government debt market because it gives agents( YES ) a new focus for their decisions.

If the utility gradient model is correct, it is better to enter the recession sharply – even at the cost of a big immediate reduction in GDP – if it creates an expectation that we have hit the bottom. When people believe it can only get better from here, they will act accordingly – investment and spending will start( A GOOD POINT ).

I do not suggest that behavioural and psychological considerations are the only cause of the crisis. But they make a substantial contribution to its persistence( OK ).

The paradoxical conclusion is that it may not matter what new institutions or new rules are designed – as long as something is done. Any new framework gives agents( YES ) a reason to abandon their anchor to fear( EXACTLY MY POINT ); and gives them a chance to reattach themselves to hope. This – the converse of Keynes’ paradox of thrift – is what will ultimately rescue the world economy.

References

Danielsson, Jon and Casper de Vries, “Money Market on Strike”, Financial Times Economists’ Forum 9 November 2008
Downs, Anthony. An Economic Theory of Democracy. New York: Harper, 1957.
Gordijn, Jaap and Hans Akkermans. “A Conceptual Value Modeling Approach for e-Business Development”. Proceedings of the Workshop Knowledge in e-Business, pp 29-36 (2001)
Loewenstein, G. and D. Prelec, “Anomalies in Intertemporal Choice: Evidence and an Interpretation”, Quarterly Journal of Economics 107, no. 2 (May 1992), pp 573-597
Rios, S., “An Interactive Sequential Approach to Multicriteria Decision Making”, Extracta Mathematicae 2, no. 1, pp 26-28 (1987)
Simon, Herbert. “Rational choice and the structure of the environment”. Psychological Review, 63, pp 129-138 (1956).

---

1 This research is underway and not yet published, but will be published as “Multidimensional utility and a model of bounded rationality”, by Intellectual Business in 2009. A summary of this and other ongoing research is available at http://www.intellectualbusiness.org/
2 Janet Yellen’s speech to this conference provides an excellent summary of relevant literature."

An excellent Human Agency Explanation approach.

"Paradoxically (and inconsistent with expected value), ambiguity preceding a terrible outcome might be worse than the outcome itself"

From the Edge:

---

"BRIAN KNUTSON
Psychologist, Stanford University

WHEN WAITING IS THE HARDEST PART

How might the psychology of individuals matter in today's market?

Herbert Simon famously proposed that individuals suffer from "bounded" rationality— they can't attend to or remember everything all the time. Thus, far from optimizing, people muddle through decisions and "satisfice" instead. However, bounded rationality might only add noise, and needn't systematically bias people's risk preferences. On the other hand, recent theorists have argued that anticipatory emotional states (e.g., fear, excitement) can bias peoples' risk preferences(AS IS HAPPENING NOW ), and have begun to develop tools that allow them to test their claims.

For instance, neuroeconomists—including a motley crew of economists, psychologists, neuroscientists, and others—study how the brain makes decisions. Neuroimaging techniques have advanced over the past ten years such that they now allow scientists to track second-to-second changes in the activity of deep subcortical regions. This means we can examine activity in regions of the brain implicated in emotion not only after a decision has been made, but also during and even prior to the decision.

What have these fancy techniques revealed so far? First, the brain responds to uncertain future outcomes in a specific region (i.e., the anterior insula), and ambiguity (not knowing the probabilities of uncertain outcomes) provokes even greater activation in this same region. Further, insular activation precedes risk avoidance in investment tasks, and is even more pronounced before people "irrationally" avoid risks (i.e., or violate the choices of a risk-neutral, Bayesian-updating "rational" actor). Inflict enough ambiguity on enough people and you can immediately sense that they might lean towards risk aversion( IN THIS, I AGREE WITH JOHN TAYLOR. I'M JUST SAYING THAT THE MAIN AMBIGUITY ABOUT THE STRENGTH AND SCOPE OF THE GOVERNMENT GUARANTEES WERE TRIGGERED BY LEHMAN. THE RIPPLE EFFECT OF THE FEAR AND AVERSION TO RISK AND ACCOMPANYING FLIGHT TO SAFETY TOOK SOME TIME TO RIPPLE THROUGH TO OTHER PARTS OF THE ECONOMY AND MARKETS. ).

What are some implications of these findings for the current crisis? Presently, we need to put a price on ambiguous derivatives (a job for the economists). As long as the value of these contracts remains unresolved, this could generate ultra-uncertainty, which will promote fear, which will keep money in peoples' mattresses and out of the market( TRUE ). In the future, we should regulate (or incentivize)( I PREFER INCENTIVIZE AND SUPERVISE ) against contracts that resist pricing( ILLIQUIDITY ).

Paradoxically( AS I'VE SAID, PARADOX IS BASIC TO HUMAN EXISTENCE AND TO A HUMAN AGENCY EXPLANATION AND NARRATIVE THINKING ) (and inconsistent with expected value), ambiguity preceding a terrible outcome might be worse than the outcome itself( YES ). This could apply to derivatives or any dangerous scenario. Imagine teetering on the edge of a cliff in broad daylight. You look down to see a river running over rocks 100 meters below. Now imagine teetering on the edge of another cliff in the dead of the night. You peer down into a void. Which do you prefer?"

This is a terrific post. It explains exactly what has been going on since the Lehman Bankruptcy. Not understanding the consequences of inserting mass and systemic ambiguity into our economic system is the main cause of our crisis. We certainly had problems in our economy, but as Brad DeLong has shown, the amount of money these problems added up to do not warrant the virulence of the response. Only a Human Agancy Explanation, such as the one above, can do that.

"In a sense, what we have is a a "just so" story, and not a theory"

Arnold Kling has a point about theories:

"Josh Hendrickson writes,

there are many so-called Keynesians who have been out there promoting policies that are quite the opposite. They have been promoting the re-capitalization of banks, forcing banks to lend, automotive bailouts, and a push toward developing "green" jobs. These attempts to micromanage the supply side of the economy are not consistent with Keynesian stimulus or that of modern macroeconomic theory( THAT DOESN'T MATTER. THEORIES ARE SIMPLY MORE OR LESS USEFUL ).

In my mind, there are three dots that need to be connected:

1. theory( KANTIAN: ECONOMICS: MORE OR LESS USEFUL )
2. the explanation for the recent crisis ( HUMAN AGENCY AND NARRATIVE THINKING )
3. policy to get us out of the crisis.( POLITICAL ECONOMY: PRAGMATIC:EXISTENTIAL:TRIAL AND ERROR )

Hendrickson is worried about the disconnect between (1) and (3). I agree. But I also worry that there is a disconnect between (1) and (2) and between (2) and (3).

Neither textbook macro nor modern theory is focused on sudden shifts in the risk premium( FEAR AND AVERSION TO RISK AND THE ACCOMPANYING FLIGHT TO SAFETY ), although I think it is impossible to describe the recent crisis without referring to such a shift. In a sense, what we have is a a "just so" story ( I'VE CALLED IT A NARRATIVE ), and not a theory. That in turn makes the connection between theory and policy rather tenuous( FOR ME, IT ALWAYS IS. IF THE QUANTS HAD UNDERSTOOD THIS, THEY WOULDN'T HAVE HAD SUCH FAITH IN THEIR THEORIES ).

"Keynes’s prescriptions were guided by his conception of money, which plays a disturbing role in his economics."

Robert Skidelsky on Keynes again in the NY Times:

"Among the most astonishing statements to be made by any policymaker in recent years was Alan Greenspan’s admission this autumn that the regime of deregulation he oversaw as chairman of the Federal Reserve was based on a “flaw”: he had overestimated the ability of a free market to self-correct and had missed the self-destructive power of deregulated mortgage lending. The “whole intellectual edifice,” he said, “collapsed in the summer of last year.”

I have to admit that it is astonishing.

"What was this “intellectual edifice”? As so often with policymakers, you need to tease out their beliefs from their policies. Greenspan must have believed something like the “efficient-market hypothesis,” which holds that financial markets always price assets correctly. Given that markets are efficient, they would need only the lightest regulation. Government officials who control the money supply have only one task — to keep prices roughly stable."

It is very important to understand, or tease out, beliefs from policies. For me, this is the difference between Politics and Political Theory and Political Economy and Economics. I don't believe markets are efficient. I do believe that the Fed's main function is to keep prices roughly stable, with a bias towards slight inflation.

"I don’t suppose that Greenspan actually bought this story literally, since experience of repeated financial crises too obviously contradicted it. It was, after all, only a model. But he must have believed something sufficiently like it to have supported extensive financial deregulation and to have kept interest rates low in the period when the housing bubble was growing. This was the intellectual edifice, of both theory and policy, which has just been blown sky high. As George Soros rightly pointed out, “The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil. . . . The crisis was generated by the financial system itself.”

This is not very clear. I don't see a lot of explanatory power here. Is the decline in housing prices like the price of oil? Is the tsunami of foreclosures like OPEC or is it part of the financial system itself? I also don't credit the power of low interests rates as the most important cause of the current crisis. Deregulation might have had a part in this drama as well, but I need a little more explanation of what that part entails.

"This is where the great economist John Maynard Keynes (1883-1946) comes in. Today, Keynes is justly enjoying a comeback. For the same “intellectual edifice” that Greenspan said has now collapsed was what supported the laissez-faire policies Keynes quarreled with in his times. Then, as now, economists believed that all uncertainty could be reduced to measurable risk. So asset prices always reflected fundamentals, and unregulated markets would in general be very stable."

So Laissez-Faire Policies entail believing that:
1) All uncertainty can be reduced to measurable risk ( Don't agree )
2) Asset prices always reflect fundamentals ( Don't agree. This involves perception and interpretation )
3) Unregulated markets are generally stable ( We don't have an unregulated market. I could say something banal and pronounce that well-regulated markets are stable. I guess that I just did, for all the lack of specificity and essentially tautological reasoning good it does me )

What's with the focus on Greenspan? Is this going to all be about Central Banks?

"By contrast, Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes."

I agree with Keynes here. Strangely, I thought that Hayek agreed with this.

"The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. The chief of these are the assumptions that the future will be like the past (witness all the financial models that assumed housing prices wouldn’t fall) and that current prices correctly sum up “future prospects.” Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.” (Today, you might add a further convention — the belief that mathematics can conjure certainty out of uncertainty.)"

I should say that I'm a big fan of his writing style, which favorably disposes me to him. I would say:
1) People fall back on Narratives
2) That the future follows from the past must in some sense be true, since day follows from night. I thought that Keynes believed that it was very hard to predict the future in various situations, not all situations. In other words, some events are easier to predict than others.
3) I would say that we are part of a society. Run with the crowd is too Mechanistic for my taste.
4) Math cannot conjure certainty from uncertainty, if I understand what he means.

"But any view of the future based on what Keynes called “so flimsy a foundation” is liable to “sudden and violent changes” when the news changes. Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic."

This all adds up to people aren't omniscient. I don't think that all markets are euphoric then panicked, then euphoric and then panicked, and I certainly don't believe that this is inevitable. If I did, then that would go a long way towards predicting it.

"Keynes’s prescriptions were guided by his conception of money, which plays a disturbing role in his economics. Most economists have seen money simply as a means of payment, an improvement on barter. Keynes emphasized its role as a “store of value.” Why, he asked, should anyone outside a lunatic asylum wish to “hold” money? The answer he gave was that “holding” money was a way of postponing transactions. The “desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude; and the premium we require to make us part with money is a measure of the degree of our disquietude.” The same reliance on “conventional” thinking that leads investors to spend profligately at certain times leads them to be highly cautious at others. Even a relatively weak dollar may, at moments of high uncertainty, seem more “secure” than any other asset, as we are currently seeing."

I'm a bit disturbed by this paragraph. I save money in order to have it in case I need it in the future for some unseen event. I find living in general disquieting, money much less so.

"It is this flight into cash that makes interest-rate policy such an uncertain agent of recovery. If the managers of banks and companies hold pessimistic views about the future, they will raise the price they charge for “giving up liquidity,” even though the central bank might be flooding the economy with cash. That is why Keynes did not think that cutting the central bank’s interest rate would necessarily — and certainly not quickly — lower the interest rates charged on different types of loans. This was his main argument for the use of government stimulus to fight a depression. There was only one sure way to get an increase in spending in the face of an extreme private-sector reluctance to spend, and that was for the government to spend the money itself. Spend on pyramids, spend on hospitals, but spend it must."

I call this a fear and aversion to risk and the accompanying flight to safety. I get the point, which is why I believe that a stimulus is worth a shot, after trying lowering interest rates. Is this supposed to be controversial?

"This, in a nutshell, was Keynes’s economics. His purpose, as he saw it, was not to destroy capitalism but to save it from itself. He thought that the work of rescue had to start with economic theory itself. Now that Greenspan’s intellectual edifice has collapsed, the moment has come to build a new structure on the foundations that Keynes laid."

That's basically my purpose. I believe that theories are of limited value, even Keynes' theories. I must not be in Greenspan's camp since I don't find any of this puzzling. As for Keynes, as I've said before, his theories will, in fact, end up being of limited worth as to specifics. We are looking to Keynes as a part of our Narrative that helps us deal with the present. It happens that the policies we're throwing at this crisis resemble Keynes enough that we are conjuring up his ghost to help us deal with it. That's fine. That's how we deal with crises. But we are essentially embarked on a trial and error ride that is more pragmatic than ideological, which is how it should be. It seems to me that what I've just stated is very Keynsian, if by that cognomen is meant one who uses what's truly valuable in Keynes' thought.

"Unfortunately the training that most quants get seems to actively discourage creativity. "

Paul Wilmott with another interesting post:

"Quantitative finance and risk management are not just about the numbers. Numbers play a part, but so does the human side of the business. When analyzing risk it is important to be able to think creatively about scenarios. Unfortunately the training that most quants get seems to actively discourage creativity."

The human side is what I call the Human Agency side. To be honest, philosophical education can also discourage creativity. Thinking about scenarios is what I call Narrative Thinking. Behind all this is a misunderstanding of the nature of math models and their tenuous, but useful, relationship to the world. By the way, if you want an example of Narrative Thinking, I would recommend Kierkegaard.

"Some of the following appeared on the BBC website in December 2008.

We've learned the hard way how important it is to measure and manage risk. Despite the thousands of mathematics and science PhDs working in risk management nowadays we seem to be at greater financial and economic risk than ever before. To show you one important side of banking I'd like you to follow me in an exercise with parallels in risk management"

It's interesting how this mirrors Skepticism. I believe that as science and rationality have advanced, the argument of the Skeptic has gotten stronger. I call this Paradoxical, and believe that human existence, and Human Agency, and Narrative Thinking, are inherently Paradoxical. The concept of Risk is no exception. The more you can understand and capture risk, the riskier life will seem.

"You are in the audience at a small, intimate theatre, watching a magic show. The magician hands a pack of cards to a random member of the audience, asks him to check that it's an ordinary pack, and would he please give it a shuffle. The magician turns to another member of the audience and asks her to name a card at random. "Ace of Hearts," she says. The magician covers his eyes, reaches out to the pack of cards, and after some fumbling around he pulls out a card. The question to you is what is the probability of the card being the Ace of Hearts?"

It's rigged. That's his job. The Magician, a good one, will always pull out the correct card.

"Think about this question while I talk a bit about risk management. Feel free to interrupt me as soon as you have an answer. Oh, you already have an answer? What is that, one in fifty two, you say? On the grounds that there are 52 cards in an ordinary pack. It certainly is one answer. But aren't you missing something, possibly crucial, in the question? Ponder a bit more.

One aspect of risk management is that of 'scenario analysis.' Risk managers in banks have to consider possible future scenarios and the effects they will have on their bank's portfolio. Assign probabilities to each event and you can estimate the distribution of future profit and loss. Not unlike our exercise with the cards. Of course, this is only as useful as the number of scenarios you can think of.

You have another answer for me already? You'd forgotten that it was a magician pulling out the card. Well, yes, I can see that might make a difference. So your answer is now that it will be almost 100% that the card will be the Ace of Hearts, the magician is hardly going to get this trick wrong. Are you right? Well, think just a while longer while I tell you more about risk and its management. "

The Magician can get it wrong. I call "scenario analysis" understanding the context, presuppositions, and beliefs underlying the situation.

"Sometimes the impact of a scenario is quite easy to estimate. For example, if interest rates rise by 1% then the bank's portfolio will fall in value by so many hundreds of millions. But estimating the probability of that interest rate rise in the first case might be quite tricky. And more complex scenarios might not even be considered. What about the effects of combining rising interest rates, rising mortgage defaults and falling house prices in America? Hmm, it's rather looking like that scenario didn't get the appreciation it deserved."

I'd say that it didn't get the fear and prudence it deserved.

"Back to our magician friend. Are those the only two possible answers? Either one in 52 or 100%? Suppose that you had billions of dollars of hedge fund money riding on the outcome of this magic trick would you feel so confident in your answers? When I ask this question of finance people I usually get either the one in 52 answer or the 100%. Some will completely ignore the word 'magician,' hence the first answer. Some will say "I'm supposed to give the maths answer, aren't I? But because he's a magician he will certainly pick the Ace of Hearts." This is usually accompanied by an aren't-I-clever smile! Rather frighteningly, some people trained in the higher mathematics of risk management still don't see the second answer even after being told."

I'm sorry, but I'm traumatized by the billions of dollars scenario. It's like a joke that can't be understood by some people, especially people with no sense of humor.

"This is really a question about whether modern risk managers are capable of thinking beyond maths and formulas. Do they appreciate the human side of finance, the herding behaviour of people, the unintended consequences, what I think of as all the fun stuff. And this is a nice question because it very quickly sorts out different types of thinkers."

Between people who have a good sense of humor and the humorless?

"There is no correct answer to our magician problem. The exercise is to think of as many possibilities as you can. For example when I first heard this question an obvious answer to me was zero. There is no chance that the card is the Ace of Hearts. This trick is too simple for any professional magician. Maybe the trick is a small part of a larger effect, getting this part 'wrong' is designed to make a later feat more impressive...the Ace of Hearts is later found inside someone's pocket. Or maybe on the card are written the winning lottery numbers that are drawn randomly 15 minutes later on live TV. Or maybe the magician was Tommy Cooper. Or it was all the magician's performance-anxiety dream the night before. When I ask non mathematicians this is the sort of answer I get."

In order for magic to work, you have to work with people's expectations. I think this limits the possible plays the magician has. One of them has to be that he picks the correct card.You see, the human mind will supply a context, so I disagree with him here.

"The answer one in 52 is almost the answer least likely to be correct! Magicians only rarely rely on probability. Clue: How many times did Houdini die during his Water Tiorture trick? (Unless the magician was using an ordinary deck of cards, was aiming to pull out a different card but accidentally pulled out the Ace of Hearts instead! Accidentally not making the intended 'mistake.')"

He can make a mistake. He's not a real "Magician".

"A member of wilmott.com didn't believe me when I said how many people get stuck on the one in 52 answer, and can't see the 100% answer, never mind the more interesting answers. He wrote "I can't believe anyone (who has a masters/phd anyway) would actually say 1/52, and not consider that this is not...a random pick?" So he asked some of his colleagues the question, and his experience was the same as mine. He wrote "Ok I tried this question in the office (a maths postgraduate dept), the first guy took a fair bit of convincing that it wasn't 1/52 !, then the next person (a hardcore pure mathematician) declared it an un-interesting problem, once he realised that there was essentially a human element to the problem! Maybe you have a point!" Does that not send shivers down your spine, it does mine."

The Human Element is uninteresting. What can that mean?

"Once you start thinking outside the box of mathematical theories the possibilities are endless. And although a knowledge of advanced mathematics is important in modern finance I do rather miss the days when banking was populated by managers with degrees in History and who'd been leaders of the school debating team. A lot of mathematics is no substitute for a little bit of commonsense and an open mind."

Throw in Philosophy as well old boy, and we'll call a wrap.

"How can we get quants and risk managers to think beyond the mathematics? I'm afraid I don't think we can, the way the majority of them are currently educated."

One never ceases being educated.