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Linked below is a 95m Video Lecture on the previous post on Simple Model Explains Complex Keynesian Concepts“. In Chapter 2 of General Theory, Keynes has two points against the classical theory of the labor market. He points out that laborers react strongly (with strikes) against wage cuts, but show no similar reaction to inflation. This means that the decision to supply labor does not depend on the real wage — instead it must depend only on the nominal wage. The SECOND point, which he regards as fundamental, is that the bargain between firms and laborers is conducted in terms of nominal wage — this decision does not determine the real wage. The real wage is an emergent property; it comes out of the system as a result of collective decisions of all, and is not controlled by any two parties. One of the KEY contributions of the SIMPLE MODEL discussed in the previous post, and in the video lecture below, is to show how this works — regardless of how the laborers and landlords negotiate and decide on the nominal wage, the real wage does not change. It is amazing that there is no understanding of this — which Keynes calls the “fundamental point” in the literature on labor economics. Current labor textbooks seem to completely ignore Keynes, and I am not aware of an explication of this anywhere else either [Readers: please provide pointers to clear explanations elsewhere if you know of some]. This can be considered as the main contribution of the simple model explained in the video lecture linked below (and the previous post, linked above).

THIS post (below the video lecture on previous post) is actually an assignment to the students to construct variations on the simple model. However, I start by discussing a crucial methodological issue: the relation between models and reality. I explain how this has been radically misunderstood by economists, due to some fundamental mis-steps in Western philosophical tradition. As a result the working concept of an economic model is disastrously different from what it is supposed to be. I provide a very brief summary of the differences between current western concepts and the correct notion of a model, and explain it with some simple examples. An extended discussion of this concept, and a 45m video lecture on it, are also linked below. This is followed by some exercises in model building for students.

95m Video Lecture on: Simple Model Explains Complex Keynesian Concepts

1      Models and Reality

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[[For a 95m Video Lecture on this post, and related materials, see:   Models and Reality  ]]

In the context of the radical Macroeconomics Course I am teaching, I was very unhappy with the material available which tries to explain what Keynes is saying. In attempting to explain it better, I constructed an extremely simple model of a primitive agricultural economy. This model has a lot of pedagogical value in that it can demonstrate many complex phenomenon in very simple terms. In particular, Keynesian, Marxists, Classical and Neo-Classical concepts can be illustrated and compared within our model. We will show the failure of all neoclassical concepts of labor, Supply and Demand, equality of marginal product, value theory —  the whole she-bang — in an intuitive and easy to understand plausible model of a simple economy.

An agricultural economy produces only one good, say corn, using a simple fixed proportions production function. One Laborer working on One Acre of Land can produce 10 units of corn. All the land is owned by Landlords, and they do not do any work themselves. Rather they hire laborers to work their land. The economy functions according to the following rules. At the start of the period, Landlords hire laborers and pay them the going market wage rates in money. Then goods are produced and the market for goods opens. The Landlords retain some of the goods for themselves – this is their profit, or equivalently, their rent. The rest of the goods are put up for sale in the market. The laborers are the only consumers and they purchase the goods with the money they have earned in wages. That ends the period.

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I have just started teaching the standard Macroeconomics course for our Ph.D. Sequence. However, I will be teaching it using a historical and qualitative approach, that was abandoned in the post-Samuelson era. The course will be “inverted classroom” so readings, video lectures, and other exercises will be assigned outside of class, while discussions will take place in class. This would make it possible for outsiders to follow the course at a distance, since the materials would be available.

An Islamic WorldView

Advanced Macroeconomics II:  Preliminaries to STUDY prior to the FIRST Class on Mon 10th Sep 2018 — Teacher: Dr. Asad Zaman, VC PIDE.

Introduction: All required materials and links are available from Google Website: Keynesian Macroeconomics (https://sites.google.com/site/az4macro). This course will be radically different from routine Macroeconomics courses being taught all over the world. It is our ambition to enable the student to understand real world economics like the impact of China on global trade, the petro-dollar, Causes and effects of the Global Financial Crisis, Why IMF promotes austerity even though it harms weak economies, Current BOP Crises in Turkey and Pakistan, and a whole host of related ongoing economic issues. As opposed to this, conventional courses will teach students models and mathematics which have no bearing on reality, and which often teach the wrong lessons about how to understand and manage the economy. As a simple…

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Bergmann Barbara R The Economists’ Voice, 2007, vol. 4, issue 2, 1-4

Abstract: How do economists know what they know? In a call for a new empiricism Barbara Bergmann asserts that economists mainly make it up.

Summary of article:

The paper starts by explaining how biologists studied bottle-nose dolphins for thousands of hours, in order to arrive at conclusions about their behavior. In contrast, economists do not study firm behavior at all — they just sit in comfortable chairs, and invent the theory from scratch. They just make it up!

Behavioral economists who study actual behavior are not welcome guests at economics departments, because they bring the bad news that theories of economists do not correspond to real world observations. Barbara Bergmann describes how she invited Herbert Simon for a talk at University of Maryland. Her colleagues let her know that his talk about real behavior was a waste of their time — it was not economics!

In general, behavioral economists like Kahnemann and Tversky have recorded several significant conflicts between “rational” behavior prescribed by economic theory, and real human behavior. Vernon Smith, one of pioneers of experimental economics, suggests that the notion of “rationality” as used by economists, needs a reality check. However economists dismiss these conflicts by arguing that the behavior of students in labs motivated by small amounts of money does not represent real world business behavior. To overcome this objection would require behavioral and experimental economists to act like anthropologists, and actually go and live among the businessmen to learn how they actually behave.

While no one has actually done this, a few surveys of business behavior have been made,. In 1939, R. L. Hall and C. J. Hitch survey found that managers were unfamiliar with the concepts of marginal cost and marginal revenue, and that they did not use them when setting prices and output. Rather, they made an estimate of cost per unit at what they took to be some plausible level of sales, and then tacked on an amount for profit. “Professional economists received this  news with pained condescension and have succeeded in forgetting it.”  [[ Indeed, it was the need to defend economics from repeated observations of the stark contradictions between observed empirical realities and theoretical assertions that led Friedman to create his F-twisted methodology — see Friedman’s Methodology: A Stake through the Heart of Reason]]

Alan Blinder revived the survey method to study price-setting by business, and found more bad news. Almost 90% of firms set prices for their products, and hence the supply and demand model, which requires price taking behavior, does not apply to such firms!  Similarly, empirical tests have been made of discrimination by sending out matched pairs of candidates for job vacancies. These experiments provide strong evidence for discrimination by race and gender, conflicting with Gary Becker’s idea that profit maximization would lead to elimination of discrimination. Even though empirical evidence strongly supports existence of discrimination, Larry Summers used Becker’s theories to argue that there are very few women at Harvard because of genetic deficiencies in women, rather than discrimination at Harvard. After all, if Harvard discriminated, then it would lose the luster of its name, and be out-competed by Podunk University, which gave jobs to blacks and women!.

Empirical data show that in recessions, wages do not go down — rather, they remain fixed at pre-recession levels. Truman Bewley did a survey of 300 business establishments, to ask them why, and found a simple unanimous answer: it would adversely affect worker morale. However, economists disdain empirical evidence and have invented 25 different theories (listed by Bewley) as to why wages are sticky, without examining any empirical evidence.

Research on actual behavior in business settings is in its infancy. If we had more information about how businesses set prices, we could have better theories of why and how prices increase — i.e. inflation. [[ In this connection, see Daniel Tarullo: Monetary policy without a working theory of inflation]] Similarly, studying business investment and employment decisions would lead to substantially greater clarity on these sources of economic growth.

Barbara Bergmann argues that there is no doubt that the theories and policies advocated favor the rich and powerful, but that knowledge of ground realities of business behavior is likely to curb and counteract these tendencies. “For example, I submit that the idea that lowering taxes for the rich is the best way to stimulate production and employment
would be unlikely to survive a realistic accounting of consumer and business behavior.” She notes that while behavioral and experimental fields have made some progress in an an adverse environment, the prognosis for further progress does not seem favorable: “A
few years ago I had occasion to ask Truman Bewley whether he was training students at Yale to carry on research like that he did on wages. His answer, I am sorry to report, was, “No, that would ruin their careers.”

— See my related post on   Methodology of Modern Economics   for more evidence about how economists completely disregard empirical and observational evidence conflicting with armchair theories regarding an imaginary world which exists only in the minds of economists.

After the Global Financial Crisis, there has been a lot of re-thinking about Monetary Policy, as one might expect. In fact, in light of the magnitude of the failure, re-thinking efforts have been much less than proportional. There are many, many, different strands of thought, and personally, I do not have clarity on what needs to be done. Furthermore, the situation is rapidly changing, so that a solution for today would not be a solution for tomorrow.  The fundamental problem is private sector creation of money, and nobody wants to discuss this elephant-in-the-room. But there may be a good reason for this unwillingness — with the financial sector is firmly in control of the US Government, and the Euro area, it does not seem politically feasible to think about radical alternatives. The goal of this post is just to summarize a paper of Stiglitz expressing his post-GFC thoughts on Monetary Policy — without much in the way of comments and discussion. The full paper itself is linked at the bottom of the post.

Summary of Joseph Stiglitz paper on monetary policy:

  1. In response to GFC 2007-8, massive programs of QE (quantitative easing) have been launched all over the world. While these actions may have prevented another Great Depression, economic growth and employment has not been restored to pre-crisis levels.

History of Evolution of Thinking at Central Banks

  1. Monetary policy had been based on the quantity theory of money (QTM) MV=PQ, which posits a stable relationship between the quantity of money, and the GNP. However, starting in the 1980’s this equation became unstable – Velocity fluctuated erratically, and none of the measures of money showed any stable relationship to important real and nominal variables like the GNP, and even the interest rate.
  2. This failure of QTM should have prompted a deeper investigation of monetary theory, and reasons for its failure, but it did not. [Stiglitz is unaware of the research of Richard Werner, which explains the failure, and provides and alternative: The Quantity Theory of Credit]
  3. Instead of investigating WHY the quantity of money failed to have stable relationships with macroeconomic variables, Central Banks shifted to the use of interest rates as the main instrument for monetary policy.
  4. Post Crisis experience has led the problem that interest rates have hit 0%, but the economy has not responded in the manner expected – cheap credit should have led to borrowing for investments, stimulating production, and borrowing for consumption, stimulating demand and lifted the economy out of the recession. However this has not happened.
  5. In light of this experience, current thinking is that monetary policy has become ineffective because we have hit a liquidity trap at 0% interest rate. We cannot take it down further. Some efforts are being made to create negative interest rate policy in the hopes of breaking through the liquidity trap.

Stiglitz’s proposed solutions:

  1. The key variable which drives the economy is the supply of credit to investors and consumers. This supply, provided by private banks, does not respond in a systematic or mechanical way to either the quantity of money produced by the central bank, or the interest rates. This problem does not have much to do with 0% interest rate floor. What we need to do is to target the flow of credit directly, if we want to have an effective monetary policy.

Errors of conventional theories, models, and policies.

  1. Conventional macro models assume perfect information and liquidity, which makes banks unnecessary. Using a more realistic model with liquidity constraints, credit rationing and asymmetric information, Greenwald & Stiglitz (G&S) show that credit provision by banks depends on their net worth, perceptions of risk, and the regulatory framework.
  2. In abnormal situations like post-GFC, these other factors which affect the provision of credit by banks, can overwhelm the normal channels by which monetary policy operates, rendering it ineffective. To restore effectiveness, Central Banks must go outside the conventional channels, and utilize macro and micro prudential regulations.
  3. Even if Central Banks succeed in increasing supply of credit provided by private banks, this may fail to have desired effects of stimulating production and consumption. This happens when credit is provided for non-productive activities like lands and stocks, which increases their prices without creation production or consumption. Cheaply available money can flow to harmful speculative activities, instead of productive investment.
  4. Lowering interest rates to fight recession creates a jobless recovery (as observed in USA). Lower costs of capital lead firms to substitute machines for labor.

The problem is that we are asking too much from a single instrument. But most governments have eschewed using this broader set of instruments.

  1. Using aggregated macroeconomic models hides the distributional effects of monetary policy. Stimulus using monetary policy hurts the poor and the laborers, and enriches the wealthy, leading to increasing inequality.

CONCLUSIONS FOR PART 1:

  1. Conventional theories of how money works, which are the basis of monetary policy today, have been discredited. The transmission channel for conventional tools – interest rates, Open Market Operations, Reserve requirements – is very weak, and can be interrupted or disrupted by outside factors.
  2. Managing a complex economic system requires as many tools as one can manage; the single minded focus on short term interest rates as the instrument and inflation as the target substantially limits the possibilities for effective interventions by the Central Bank.

PART 2: Creation of a RADICAL New System which circumvents all of these problems.

  1. The total amount of credit creation should be directly under government control. This credit can then be allocated or auctioned to banks – banks can no longer create credit, unless they acquire/purchase the right from the government. In turn, the government can put conditions on allocating credit to banks to ensure that it is lent out for productive investments only, and not for speculation. Electronic money can ensure that the system works, since all money and credit creation can be monitored.
  2. In open economies, fluctuations in the exchange rates and in balance of payments create tremendous costs. These can be managed by a trading chit system which stabilizes the trade deficit or surplus at a pre-determined level. Every exporter is issues a trading chit equal in value to his exports. Every importer must acquire trading chits in order to be able to import. Since the value of export chits necessarily equals the value of import chits, this system will have exactly balanced trade with no surplus or deficit. If economic conditions dictate running a deficit, the government can issue 20% extra chits, over and above export earnings – this would stabilize the trade deficit, and hence also the exchange rates. This is of tremendous value in stabilizing the economy.

POSTSCRIPT: At the time I wrote this, I was not aware of Richard Koo’s work on balance sheet recessions. This issue, heavy debt liabilities, seems of central importance, and has been completely ignored by Stiglitz, and many other authors (though not Mian & Sufi: House of Debt). See the 10m Video: Koo: Balance Sheet Recessions or read the RWER paper by Koo: The World in Balance Sheet Recession

 

 

Introduction of my article Challenging the Current Economics Curriculum: Creating Challengers and Change.”  Chapter 2 of edited volume: “Challenging the Current Economics Curriculum” editors Maria Alejandra Madi and Jack Reardon

Introduction:

How does it happen that we have given our quiet assent to a situation where the richest 85 individuals have more money than the bottom 3.5 billion? Where vultures wait for starving children to die, while others eat luxurious meals on private resort islands? Where horrendous military and commercial crimes leading to deaths, misery, and deprivations of millions are routinely committed by highly educated men with multimillion dollar salaries in luxury corporate suites and government offices?

A core component of the answer to these critical questions is that we have been educated to believe that this is a normal state of affairs, which comes about through the operation of iron laws of economics. Economic theories currently being taught in universities all over the world are an essential pillar which sustains the economic system currently in operation.  These theories state that we (human beings) are cold, callous, and calculating. Microeconomic theory says rational individuals are concerned only with their own consumption. They are callous; completely indifferent to the needs of others. They maximize, calculating personal benefits to the last penny. They are cold – their decisions are not swayed by emotions of any kind. All this theorizing is not without power – it creates the world we live in, and the rules we live by.

We have even been taught that laissez-faire automatically brings about the best possible outcomes. We are told that the rich are efficient wealth producers and deserve their wealth, just as the poor deserve their poverty. To create a labor market to sustain capitalist production processes, we have been trained to believe that our lives are for sale to the highest bidder.

Besides, we have been educated to believe that we are powerless to change things. We have been trained to laugh at the idea that human lives are infinitely precious. We have been made to forget that each moment of our lives is unique – each moment contains potentials which never existed before, and will never come into being again. Only by re-defining what is worth living for, and what is worth dying for, can we strike at the heart of the capitalist process of production.

When we talk about curriculum change, we are talking about creating new theoretical foundations to observe and intervene in the world we live in. This is not a project for the faint-of-heart, especially because the rich and powerful spend huge amounts of wealth and energy in preserving this status-quo, and resist efforts to change these social realities with all their might. The project of speaking truth to power is severely handicapped by our education which conditions our vision of the truth.Our theories of knowledge state that good and evil do not exist. We have been taught rules of intellectual discourse which forbid appeals to the heart and soul. We have thereby been deprived of our most powerful weapons in the eternal battle against evil. Modern education has turned us into soulless zombies, consumption and sex machines, human resources, and inputs into the production function for wealth. The vast majority of the populace has been paralyzed with poisonous ways of thinking, and the small minority which retains the capacity for thought and action has also been badly damaged by these same poisons.

Before talking about curriculum change, we must redeem our souls. How can this be done?The first step in curriculum change requires the creation of teachers who have a clear understanding of the challenge that we face. These teachers must de-program themselves to cleanse their hearts. Given that we battle against overwhelming odds, our teachers must be rocks of courage, fortitude, and stamina. Also essential is a sense of humor to enable us to laugh at the massive forces arrayed against us – without this, we would die of despair. Also required is a deep commitment to the cause, which is giving hope to and enriching the lives of billions living, entirely un-necessarily, in abject conditions. Our hearts must be full of compassion, and feel the sharp pangs of the pain felt by the parents who have to choose between buying expensive medicines for the sick child, or food for the family. We have to empower ourselves, and believe that we can make a difference.

The world we live in is constructed from structures of thought that we have internalized, far more than bricks and concrete. Unfortunately, many of these dominant structures are poisonous to our own happiness as well as general welfare of mankind. Changing our ways of thinking is not just a matter of reading and understanding. Rather, the process involves acquiring new ways of looking at the world and new tools for manipulating reality – eerily parallel to the taking of a reality pill in a popular movie. Healing ourselves requires time, effort and cooperation of like minded friends.  A first step in creating a new curriculum must be detoxification of our own minds and hearts. In terms of the Gandhian precept, we have to  ‘Be the change that you wish to see in the world.’  This requires analyzing the nature of the toxins we have ingested, and their removal. Some of the broad areas which require work are listed below:

[For the full article, see pre-publication draft Chapter 2: Creating Challengers & Change of edited volume: “Challenging the Current Economics Curriculum” editors Maria Alejandra Madi and Jack Reardon]

Table of Contents (Section Headings:)

  1. Rethinking the human being: Redeeming the Heart and Soul 3
  2. Rethinking the Nature of Human Knowledge 5
  3. Goals and perspectives for human existence 6
  4. Rescuing Morality in Economics 7
  5. Overcoming Market Mentality 8
  6. The Metaphor of the Machine 10
  7. Conclusions 11

My paper is a survey of the huge amount of solid empirical evidence against the utility maximization hypothesis that is at the core of all microeconomics currently being taught today in Economics textbooks at universities all over the world. It is obviously important, because if what it says is true, the entire field of microeconomics needs to be re-constructed from scratch. Nonetheless, it was summarily rejected by a large number of top journals, before being eventually published by Jack Reardon as: ” The Empirical Evidence Against Neoclassical Utility Theory: A Review of the Literature,”  in International Journal of Pluralism and Economics Education, Vol. 3, No. 4, 2012, pp. 366-414.   Speaking metaphorically, my paper documents the solid evidence that the earth is a round sphere in world where educational institutions teach the widely held belief that the earth is flat. Readers of RWER blog will recall that when challenged on the failure of macroeconomics after the Global Financial Crisis, economists retreated to the position that while macro theory may be in a bad shape, at least Microeconomics is solidly grounded. My paper blows this claim out of the water. As a result, nothing is left of Micro and Micro, and of economics as whole. This supports my earlier claim that a Radical Paradigm Shift is required to make progress — patching up existing theories cannot work.

None of the several leading journals that I sent the paper to made any comments about any mistakes in my arguments. There were two main reasons which were stated for rejections. One was that the paper was “not appropriate” for the journal. This seems ridiculous; how can a paper which challenges the foundations of the subject be “inappropriate” (however, an explanation will be provided later). Two was that the results of the paper were well-known. I also sent the paper for comments to many leading economists. Kenneth Arrow, who was once a teacher of mine at Stanford, responded as follows “Thank you for the very complete and well-argued critique of the utility-maximization theory. Of course, the remaining question is, what should take the place of that theory?”.  This is just to document that the paper itself provides solid and irrefutable evidence against modern microeconomic theory. Given that the vast majority of economists continue to teach microeconomics based on utility maximization, and that this theory is widely believed by students of economics throughout the world, it would seem of great importance to document the empirical evidence against it and use it as a springboard for developing alternative theories, more consistent with empirical observations of human behavior. However, none of the mainstream journals displayed any interest in publishing this paper.

This leads to a puzzle, which requires some thought. As famous theoretical physicist Richard Feynman put it: “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with the experiment, it’s wrong.”  The experimental result — corresponding to the empirical evidence — is all important in physics, which is why there has been tremendous progress in physics. On the other hand, the economists display no interest in empirical evidence at all. This indifference of economists to empirical evidence which contradicts their theories has been noted by many; see previous post on “Quotes Critical of Economics” for the full quote briefly cited here:

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