Markets could behave in ways described by the classical and New Classical theories, but they need not

TO BE NOTED: From the FT:

"Economists clash on shifting sands

By Robert Skidelsky

Published: June 9 2009 18:52 | Last updated: June 9 2009 18:52

History is replete with famous intellectual battles. In the natural sciences, these have usually led to decisive victories, with good science ousting bad. There are few Ptolemaic astronomers left, or believers in the phlogiston theory of combustion. In the social sciences, the situation is different. There have been famous battles galore, but no decisive victories. Indeed, it is characteristic of the social sciences that their battles are interminable, temporary defeats being followed by the regrouping of the defeated forces for a renewed assault.

That economics is not a natural science is clear from the inconclusive engagements that have punctuated its own history. A hundred years ago the classical theory reigned supreme. This “proved” that free markets were automatically self-adjusting to full employment. They were either continually at full employment or, if disturbed by an outside shock, rapidly returned to it. The only thing capable of wrecking the workings of the market’s invisible hand was the visible hand of government interference.

Then along came the Great Depression of 1929-32 and John Maynard Keynes. Keynes “proved” that markets had no automatic tendency to full employment. This failing of the invisible hand justified government policies to maintain full employment.

For 30 years or so Keynesianism ruled the roost of economics – and economic policy. Harvard was queen, Chicago was nowhere. But Chicago was merely licking its wounds. In the 1960s it counter-attacked. The new assault was led by Milton Friedman and followed up by a galaxy of clever young disciples. What they did was to reinstate classical theory. Their “proofs” that markets are instantaneously, or nearly instantaneously, self-adjusting to full employment were all the more impressive because now expressed in mathematics. Adaptive Expectations, Rational Expectations, Real Business Cycle Theory, Efficient Financial Market Theory – they all poured off the Chicago assembly line, their inventors awarded Nobel Prizes.

No policymaker understood the maths, but they got the message: markets were good, governments bad. The Keynesians were in retreat. Following Ronald Reagan and Margaret Thatcher, Keynesian full employment policies were abandoned and markets deregulated. Then along came the almost Great Depression of today and the battle is once more joined.

Haunters of the blogosphere will know that the main ground of the current engagement is about the effect of the “stimulus”. FT readers will have caught a faint whiff of the intensity of this battle in Niall Ferguson’s column of May 30, headed “A history lesson for economists in thrall to Keynes”. Prof Ferguson and Paul Krugman, the economist and New York Times columnist, had previously locked horns at a public symposium in New York on April 30. The historian had asserted that large fiscal deficits would push up long-term interest rates. This implied they would have a zero stimulatory effect: public spending would simply “crowd out” private spending. An enraged Mr Krugman responded on his blog that Keynes had proved that such crowding-out could occur only at full employment: if there were unemployed resources, fiscal deficits would not drive up interest rates without also expanding the economy. Prof Ferguson’s ignorant remarks only confirmed that “we’re living in a Dark Age of macroeconomics, in which hard-won know-ledge has simply been forgotten”.

However, this is not a debate between economists and historians. It is a battle within the economic profession – between the New Class-ical Economists and the New Keynesians. What is fascinating is that it is an almost exact rerun of the debate between Keynes and the British Treasury in 1929-30. The Treasury view was that bond-financed public spending was bound to diminish private spending by an equal amount. Keynes replied that if this were true it would apply to any new act of private spending. “In short, the fatalistic belief that there can never be more employment than there is is altogether baseless”.

Later the Treasury retreated to a more defensible position. The danger of extra government spending, it came to argue, lay not in the “physical” crowding out of resources but “psychological” crowding out. If doubts arose about the government’s solvency – a concern Prof Krugman has acknowledged – it might lead to capital flight, which would push up the cost of government borrowing.

Are we doomed to rehearse the same arguments time and again? In this particular debate, I am on Prof Krugman’s side, but I do not agree that Prof Ferguson’s position represents a retreat to a phlogiston state of economics. This is to take economics to be like a natural science, which Keynes never believed it was, because he thought its subject matter was much too variable over time.

Keynes’s view was that we need different economic models at different times. The beauty of his General Theory of Employment, Interest and Money was that it was general enough to accommodate a variety of models applicable to different conditions. Markets could behave in ways described by the classical and New Classical theories, but they need not. So it was important to take precautions against bad behaviour. Ultimately, the Keynesian revolution was a triumph not of good science over bad science, but of good judgment over bad judgment.

Lord Skidelsky’s ‘John Maynard Keynes: The Return of the Master’ will be published by Allen Lane in September

Copyright The Financial Times Limited 2009"

"For Schumpeter, there was something both noble and tragic about the spirit of capitalism."

Robert Skidelsky in the Guardian:

"Testifying recently before a United States congressional committee, former Federal Reserve chairman Alan Greenspan said that the recent financial meltdown had shattered his "intellectual structure". I am keen to understand what he meant.

Since I have had no opportunity to ask him, I have to rely on his memoirs, The Age of Turbulence, for clues. But that book was published in 2007 – before, presumably, his intellectual structure fell apart.

In his memoirs, Greenspan revealed that his favorite economist was Joseph Schumpeter, inventor of the concept of "creative destruction"( ALL THIS MEANS IS THAT BUSINESSES COME AND GO. IT IS NOT PROFOUND. ). In Greenspan's summary of Schumpeter's thinking, a "market economy will incessantly revitalise itself from within by scrapping old and failing businesses and then reallocating resources to newer, more productive ones". Greenspan had seen "this pattern of progress and obsolescence repeat over and over again".

Capitalism advanced the human condition, said Schumpeter, through a "perennial gale of creative destruction", which he likened to a Darwinian process of natural selection to secure the "survival of the fittest"( A VERY BAD ANALOGY. BUT COMMON. ). As Greenspan tells it, the "rougher edges" of creative destruction were legislated away by Franklin Roosevelt's New Deal, but after the wave of de-regulation of the 1970s, America recovered much of its entrepreneurial, risk-taking ethos. As Greenspan notes, it was the dot-com boom of the 1990s that "finally gave broad currency to Schumpeter's idea of creative destruction".

This was the same Greenspan who in 1996 warned of "irrational exuberance" and, then, as Fed chairman, did nothing to check it. Both the phrase and his lack of action make sense in the light of his (now shattered) intellectual system.

It is impossible to imagine a continuous gale of creative destruction taking place except in a context of boom and bust. Indeed, early theorists of business cycles understood this. (Schumpeter himself wrote a huge, largely unreadable, book with that title in 1939.)

In classic business-cycle theory, a boom is initiated by a clutch of inventions – power looms and spinning jennies in the 18th century, railways in the 19th century, automobiles in the 20th century. But competitive pressures and the long gestation period of fixed-capital outlays multiply optimism, leading to more investment being undertaken than is actually profitable. Such over-investment produces an inevitable collapse. Banks magnify the boom by making credit too easily available, and they exacerbate the bust by withdrawing it too abruptly. But the legacy is a more efficient stock of capital equipment.

Dennis Robertson, an early 20th-century "real" business-cycle theorist, wrote: "I do not feel confident that a policy which, in the pursuit of stability of prices, output, and employment, had nipped in the bud the English railway boom of the forties, or the American railway boom of 1869-71, or the German electrical boom of the nineties, would have been on balance beneficial to the populations concerned." Like his contemporary, Schumpeter, Robertson regarded these boom-bust cycles, which involved both the creation of new capital and the destruction of old capital, as inseparable from progress.

Contemporary "real" business-cycle theory builds a mountain of mathematics on top of these early models, the main effect being to minimise the "destructiveness" of the "creation". It manages to combine technology-driven cycles of booms and recessions with markets that always clear (ie there is no unemployment).

How is this trick accomplished? When a positive technological "shock" raises real wages, people will work more, causing output to surge. In the face of a negative "shock", workers will increase their leisure, causing output to fall.

These are efficient responses to changes in real wages. No intervention by government is needed. Bailing out inefficient automobile companies such as General Motors only slows down the rate of progress. In fact, whereas most schools of economic thought maintain that one of government's key responsibilities is to smooth the cycle, "real" business-cycle theory argues that reducing volatility reduces welfare!

It is hard to see how this type of theory either explains today's economic turbulence, or offers sound instruction about how to deal with it. First, in contrast to the dot-com boom, it is difficult to identify the technological "shock" that set off the boom. Of course, the upswing was marked by super-abundant credit. But this was not used to finance new inventions: it was the invention( ONE COULD ARGUE THIS ). It was called securitised mortgages. It left no monuments to human invention, only piles of financial ruin.

Second, this type of model strongly implies that governments should do nothing in the face of such "shocks". Indeed, "real" business-cycle economists typically argue that, but for Roosevelt's misguided New Deal policies, recovery from the Great Depression of 1929-1933 would have been much faster than it was.

Equivalent advice today would be that governments the world over are doing all the wrong things in bailing out top-heavy banks, subsidising inefficient businesses, and putting obstacles in the way of rational workers spending more time with their families or taking lower-paid jobs. It reminds me of the interviewer who went to see Robert Lucas, one of the high priests of the New Business Cycle school, at a time of high American unemployment in the 1980s.
"My driver is an unemployed PhD graduate," he said to Lucas. "Well, I'd say that if he is driving a taxi, he's a taxi-driver," replied the 1995 Nobel laureate.

Although Schumpeter brilliantly captured the inherent dynamism of entrepreneur-led capitalism, his modern "real" successors smothered his insights in their obsession with "equilibrium" and "instant adjustments". For Schumpeter, there was something both noble and tragic about the spirit of capitalism. But those sentiments are a world away from the pretty, polite techniques of his mathematical progeny."

I have to say that Schumpeter's world view was not close to mine. It was tragic, but more like the Eternal Return of Nietzsche. The current Mechanistic Economics is a melange of slightly useful theories and models. Nothing more.

"In fact, they are in the nature of swindles. "

Skidelsky on the New Straits Times:

"ECONOMICS, it seems, has very little to tell us about the current economic crisis( TRUE ). Indeed, no less a figure than former United States Federal Reserve chairman Alan Greenspan recently confessed that his entire "intellectual edifice" had been "demolished" by recent events. Scratch around the rubble, however, and one can come up with useful fragments. One of them is called "asymmetric information".

This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice-versa. Interesting things happen -- so interesting that the inventors of this idea received Nobel Prizes in economics.

In 1970, George Akerlof published a famous paper called The Market for Lemons. His main example was a used-car market. The buyer doesn't know whether what is being offered is a good car or a "lemon". His best guess is that it is a car of average quality, for which he will pay only the average price.

Because the owner won't be able to get a good price for a good car, he won't place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.

Another well-known example concerns insurance. This time it is the buyer who knows more than the seller, since the buyer knows his risk behaviour, physical health and so on.

The insurer faces "adverse selection", because he cannot distinguish between good and bad risks. He, therefore, sets an average premium too high for healthy contributors and too low for unhealthy ones. This will drive out the healthy contributors, saddling the insurer with a portfolio of bad risks -- the quick road to bankruptcy.

There are various ways to equalise the information available -- for example, warranties for used cars and medical certificates for insurance. But, since these devices cost money, asymmetric information always leads to worse results than would otherwise occur.

All of this is relevant to financial markets because the "efficient market hypothesis" -- the dominant paradigm in finance -- assumes that everyone has perfect information and, therefore, that all prices express the real value of goods for sale( IT'S A MODEL ).

But any finance professional will tell you that some know more than others, and they earn more, too. Information is king. But just as in used-car and insurance markets, asymmetric information in finance leads to trouble.

A typical "adverse selection" problem arises when banks can't tell the difference between a good and bad investment -- a situation analogous to the insurance market.

The borrower knows the risk is high, but tells the lender it is low( THIS IS FRAUD ). The lender who can't judge the risk goes for investments that promise higher yields. This particular model predicts that banks will over-invest in high-risk, high-yield projects, i.e. asymmetric information lets toxic loans onto the credit market.

Other models use principal/agent behaviour to explain "momentum" (herd behaviour) in financial markets.

Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no changes in conditions.

But a moment's thought will show why these models cannot explain today's general crisis. They rely on someone getting the better of someone else: the better informed gain, at least in the short-term, at the expense of the worse informed. In fact, they are in the nature of swindles( THAT'S EXACTLY WHAT THEY ARE ). So these models cannot explain a situation in which everyone, or almost everyone, is losing -- or, for that matter, winning -- at the same time.

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect knowledge about how the different parts of the economy fit together.

They differ only in believing that not everyone possesses it. In Akerlof's example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows well how likely it is to break down, and the buyer does not( FRAUD ).

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse( FRAUD ); but they are deceiving themselves that they know more than they do.

If only one person were perfectly informed, there could never be a crisis -- someone would always make the right calls at the right time.

But only God is perfectly informed, and He does not play the stock market.

"The outstanding fact," John Maynard Keynes wrote in his General Theory of Employment, Interest and Money, "is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made." ( TRUE )

There is no perfect knowledge "out there" about the correct value of assets, because there is no way we can tell what the future will be like( TRUE )

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behaviour arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety( THAT'S THE MAIN POINT. SAFETY ) in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge. It may then get nearer to explaining why we are where we are today. "

I'm wondering why he assumes that there are no laws concerning business transactions?

"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.