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(continuation of previous post on ET1%: Blindfolds Created by Economic Theory)

Economists have performed an amazing piece of magic, successfully creating a mass deception which has taken in the vast majority of the population of the world. Seeing through this complex and sophisticated trick requires separating, studying and understanding many different elements which all combine to create this illusion. One of the elements is a binary theory of knowledge, according to which theories are either true or false, and this is the only characteristic of theories that we should study. This prevents us from looking at the historical context in which the theories originate, and the functions that these theories serve, in terms of advancing the interests of powerful groups in the social struggles then going on. Social theories cannot be understood without this context, and hiding this context, and the relationships between knowledge and power, is an essential component of the WMD — weapon of mass deception — deployed by the economists to create a mass hallucination. In this post we analyze briefly the concept of Scarcity, which is at the heart of modern Economic Theory.

According to this concept, which was made central to Economics by Lionel Robbins in 1932 (Nature and Significance of Economic Science), there are not enough resources to satisfy the unlimited needs and wants of all people. Accordingly, solutions require increasing resources, or economic growth.  On the surface, this seems like a straightforward statement of the factual position: we need more resources in order to take care of the needs of the poor. Hidden beneath this simplicity is a strategy which is massively favorable to the interests of the top 1%. We bring out some of these hidden implications below.

1.     Failure to Distinguish Needs and Wants

Food supplies per capita have been steadily increasing over the past century, contradicting the Malthusian idea that population grows faster than food supply. In fact, as Gandhi said, “There is enough for everyone’s need, but not enough for everyone’s greed.” Today, there are sufficient resources on the planet to amply take care of the basic needs in terms of food, clothing, housing, health and education.  In particular, the money being spent on treatments for obesity is more than sufficient to provide for all the hungry on the planet. This illustrates the general principle that scarcity for some is caused by excess spending by others, and NOT BY LACK OF RESOURCES.  Concentration of wealth in a few hands is the cause of scarcity, and re-distribution, not growth, is the solution.

My paper on “The Normative Foundations of Scarcity” explains how three separate normative principles are built into the hidden foundations of scarcity. One of these three principles is treating needs and wants as being on par; for example, Samuelson and Nordhaus state the economists must strive to satisfy all needs and wants, whether they are genuine or artificial. This means that the desire of the millionaire for an alligator skin briefcase worth $10,000 dollars takes precedence over the demand of poor hungry children for milk and bread, since there is no money backing the latter demand. Furthermore, while genuine needs are satiable, and there is no shortage of resources to provide for all needs, wants are unlimited, and expand as they are fulfilled.

Islam prohibits, rather than encourages, fulfillment of artificial wants (idle desires, or Hawa). This is in direct opposition to Economists views, which tell us to not question or investigate the origin of wants, and treat them all equally.

ET90%: Genuine needs must be distinguished from, and given priority over, artificial wants. The fundamental problem of economics should be: how can we fulfill the (finite, satiable) basic needs of the entire population, rather than attempting the impossible task of trying to fulfill the insatiable wants of those with wealth, especially since these wants keep increasing as they are met.

Islamic principles are aligned with finding from happiness research that additional consumption over the level of basic needs has no correlation with happiness. Conventional economics embodies the ridiculous view that the purpose of our lives is to maximize the pleasure we obtain from consumption. In fact, consumption is just a necessaity for maintaining our lives, and lasting pleasure and fulfilment comes from pursuit of higher purposes. This is recognized by the Mahbubul-Haq and Amartya Sen theories about Human Development as being the goal of development.  For elaboration, see short post on “the Coca-Cola Theory of Happiness,” or the longer explanation in Prosperity as Human Development, not Wealth

2.     Emphasis on Growth rather than Redistribution

By pointing to shortage rather than excess wealth in the hands of the top 1%, scarcity points us in the WRONG direction regarding how to solve the economic problem. It suggests that we need to have additional resources, in order to be able to feed the poor. This ignores the fact the we currently already have enough resources to feed the poor, so the solution must lie elsewhere. It also ignores the fact that amazing growth has taken place over the past century, but the number of the poor has only increased, rather than decreasing. This is because the majority of the fruits of growth are captured by the rich and powerful, rather than going to the poor. For instance, recent research shows that 85% of the gains in growth have been captured by the top 1% over the past decade, while the bottom 50% have not gained anything.

Amartya Sen’s analysis reveals that famines are caused by lack of “entitlement” of the poor to food, rather than lack of food. Thus it is not scarcity, but the libertarian social norms of absolute rights to property, which need to be changed, to solve the problem of poverty.  The fundamental normative choice which must be made is the following: which of the two takes precedence, the right to property or the right to food and basic needs? Economists have sanctified the right to property over the right to food in the form of the Pareto Principle, and assert that we cannot say whether welfare would be improved if we take wealth away from the ultra-rich in order to feed the hungry. However, there are many ways to argue that the right of the poor takes precedence. For example, Cooter, R. and Rappoport, P (1984) ‘Were the Ordinalists Wrong About Welfare Economics?’ Journal of  Economic Literature, 22 (2) June, 1984, pp. 507-530 argue that we can use objective measures of well-being to show that transfers of superflous wealth of the super-rich to those who need it would lead to increased social welfare. Cardinal utility allowed for this type of reasoning, but ordinal measurement led to the idea that we could not compare welfare across persons, which violates both intuition and social consensus to the contrary. We can base a counter to ET1% on this idea.

ET90%: The responsibility of society to take care of basic needs of all members takes precedence over the right to property of the wealthy.

This principle is firmly endorsed by Islamic Economics. The Quran states that the poor have a right in the wealth of the rich, creating the “entitlement” that is identified as the key to prevention of famines by Amartya Sen. The cause of scarcity is the “stoppage” of the circulation of wealth, as commanded in the Quran. When the wealthy concentrate wealth in their banks, instead of allowing its free circulation, they prevent it from reaching the hands and mouths which need it. Islam offers a two pronged carrot and stick approach to the root problem which creates scarcity:

  1. The compulsory payment of zakah at the rate of 2.5% ensures that a small part of the wealth concentrated in hands of the rich should reach the poor.
  2. In addition, generosity is recognized and praised as a virtue, and the rich are encouraged to spend excess wealth on others who are needy.

It is well known that human behavior is strongly motivated by social recognition, and so recognition and praise for generosity create such behavior, which is an essential component of the solution to our economic problem. In fact, as explicitly recognized by Karl Polanyi in the Great Transformation (see also Gertrude Himmelfarb’s The Idea of Poverty), the market society creates poverty as a social problem by removing the entitlement of the poor to social support, so as to  create a labor market. This requires changing social norms so that selfishness and greed become praiseworthy, while generosity become irrational sentimentality. Solutions to problems of poverty require recognition of the subtle inculcation of pro-property and anti-poverty norms, without explicit mention, in ET1%. This conforms exactly to the necessity of deception to fool the poor into supporting ideas which favor the wealthy, which is the hallmark of ET1%.

3.  Scarcity Versus Abundance Thinking

A diverse literature has emerged from different sources which identifies scarcity as a way of thinking, rather than an objective condition. This is the familiar issue of whether the glass is half full or half empty. The insights from this literature conform to the Islamic view that “True richness is the contentment of the heart”. A rigorous analysis of how the psychology of scarcity affects our behavior and decisions, is given in Mullainathan, Sendhil, and Eldar Shafir. Scarcity: The new science of having less and how it defines our lives. Picador, 2014.

A conscious decision was made in Western societies to encourage greed, so as to create the accumulation of wealth. For instance, Keynes said that:

I see us free, therefore, to return to some of the most sure and certain principles of religion and traditional virtue – that avarice is a vice, that the exaction of usury is a misdemeanour, and the love of money is detestable, that those walk most truly in the paths of virtue and sane wisdom who take least thought for the morrow. We shall once more value ends above means and prefer the good to the useful. We shall honour those who can teach us how to pluck the hour and the day virtuously and well, the delightful people who are capable of taking direct enjoyment in things, the lilies of the field who toil not, neither do they spin.

But beware! The time for all this is not yet. For at least another hundred years we must pretend to ourselves and to every one that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer still. For only they can lead us out of the tunnel of economic necessity into daylight.

Keynes believed that sufficient would remove the problem of economic necessity, and lead to economic bliss. However, both empirical evidence and Islamic teachings show that this is not true. Surveys of millionaires show that they do not feel they have sufficient money for economic security. The Easterlin paradox shows that massive amounts of growth has not led to increased happiness. The reasons are simple. As wants are fulfilled, more are generated, since people seek to improve upon the average level of consumption. As stated in Islamic teachings, if you give a man a valley of gold, he will desire another one. Nothing will fill his stomach except the dust of the grave.

Once the psychological nature of scarcity is understood, the remedies for the problem take a radically different shape from those currently being pursued all over the globe. The following measures to handle scarcity are all in harmony with Islamic teachings and would form the basis of an ET90% designed to oppose ET1%

  1. Encourage Abundance thinking. For example, the Quran says that the Lord has provided bountifully for all.
  2. Prohibit envy, and prohibit conspicuous consumption — both of these steps are contained in Islamic teachings.
  3. Prevent excessive consumption (called israf and tabzeer in Islamic teachings), and encourage simple standards of living. This will prevent the rat-race for ever increasing living standrads, wihch causes harm to all.
  4. Encourage gratitude for the blessings we enjoy, and the feeling of contentment. Encourage generosity, which creates the feeling of abundance.
  5. Encourage social responsibility for each other, fostering cooperation and community, which creates social networks which are the source of comfort and support, creating psychological security.

For a more detailed discussion of Scarcity from an Islamic perspective see Scarcity: East and West Journal of Islamic Economics, Banking and Finance, Volume 6, Number 1, January-March 2010. p. 87-104. For a secular discussion of how the concept of scarcity appears objective, but conceals within its framework three different questionable normative judgments, see my paper on The Normative Foundations of Scarcity

 

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In my paper on “The Empirical Evidence Against Neoclassical Utility Theory: A Survey of the Literature”, I have argued that economic theories act as a blindfold, preventing economists from seeing basic facts about human behavior, obvious to all others. For instance, economists consider cooperation, generosity, integrity (commitments), and socially responsible behavior, as anomalies requiring explanation, while all others consider these as natural aspects of human behavior.

Far deeper insight into the blindfolds created by economic theory is obtained when we realize that these are not random mistakes, made due to defective reasoning or neglect of empirical evidence. If the shopkeeper systematically makes mistakes which always increase the total bill, we can conclude that the mistakes are purposeful. Similarly, strong and repeated commitment of exactly the same mistakes, flying in face of all empirical evidence, reveals the deep ideological commitments which create these systematic errors.  In particular, the goal of this note is to show that modern economics is not what it claims and pretends to be: an objective, factual and scientific description of the laws governing capitalist economies. Instead, it is actually a branch of moral philosophy, and provides a justification for the inequality and injustice built into the system, by “showing” that these are necessary for the functioning of the system, and the system itself is fair for all participants, and leads to the best possible outcomes.

Contrary to the Shakespearean claim that names do not matter, research shows that desert-dwellers recognize different types of sand using more than seventeen different names, while those who do not have these names in their language also cannot recognize these differences. To highlight the difference, and help recognize it, we will label conventional economics as ET1% — the Economic Theory of the top 1%. In contrast, Islamic Economics champions the cause of the poor, and can be called as ET90% — the economic theory of the bottom 90%. Below, we will illustrate how these two theories are diametrically opposed to each other in the context of eight core concepts of modern economics. We do not claim that this list of deceptions is complete – there are many more ideas which are misleading. However, an understanding of how these eight concepts, listed below, are used to deceive the public will provide sufficient evidence for our central thesis that economic theory should be recognized for what it is: ET1%.

  1. Scarcity
  2. Pareto Efficiency
  3. The Invisible Hand
  4. The Production Function
  5. GNP per Capita
  6. Separation of Economics from Politics/Power
  7. Private Property
  8. Utility Maximization

I will explain, in separate posts, how each of these is a deceptive concept. But before we discuss specific details of how these concepts deceive the general public, some basic principles must be highlighted. Note that the number “1%” is used metaphorically; the actual number of people who benefit massively from capitalism is far less. According to recent OXFAM statistics, about 60 people own more than half of the total wealth on this planet. In any case, the number of people at the top is too small to enable them to establish favorable political and economic systems by force. Instead, they must rely on persuasion. Their strategy is create theories which become widely accepted by the vast majority, which present the economic system as necessary, just, and efficient. As Karl Marx recognized, capitalism works not by force, but by persuading the laborers of the necessity and fairness of their own exploitation. In this process of persuasion, the middle 9%, including especially the intellectuals and the academia, play a crucial role. The educational institutions train and tame the populace into accepting injustice as a natural part of the system. Those who participate in this process of indoctrination are duly rewarded by being allowed the perks and privileges of managing the entire system on behalf of the elite 1%.

One implication of this is that ET1% must have the appearance of fairness and objectivity – that is the only way it can be persuasive to the bottom 90%. However, hidden beneath this appearance must be the reality that the theory is extremely favorable to the interests of the super-rich. Thus, by definition, ET1% is deceptive. We will show, in separate posts, how each of the eight concepts listed above satisfy these criteria, concealing a strong bias towards the rich hidden within an attractive framework which would appeal to all.  In this first post, we just provide an illustration of this principle to clarify the concept.

Mazdak was an ancient Persian prophet/philosopher who preached against private property, and argued in favor of communal ownership of all resources. This would obviously appeal to the poor, who would thereby acquire a share of ownership in the palaces, wealth, and luxuries of the rich. However, the practical effect of the philosophy was the opposite of this egalitarian dream. The rich and powerful were able to defend their properties, and also were able to occupy and take over the property – including wives and children – of the poor, because they had the power to enforce their will upon others. The philosophy provided a cover for their actions because it deprived the poor of their rights to their own property. This is exactly how ET1% works: by appealing to the poor, while working against their interests.

The root cause of our hopelessly defective economic theories is a fundamentally misguided model of human behavior. Modern economic theory assesses the impact of policies by replacing all human beings with homo economicus, which is a brain connected to a mouth and stomach. Because the heart and soul of human beings is removed from the picture before the economist begins his calculations, economists are routinely baffled by behavioral economics, based on actual behavior instead of hypothesis. Topping this deep ignorance is an amazing arrogance about “microeconomic foundations” — that even if macro is wrong, at least our micro theories rest on solid foundations! Such assertions leave me speechless; what can you say to someone who confidently claims to be Napoleon Bonaparte ?

Because of complete failure to understand human beings, economists subscribe to a ridiculous theory of human welfare — it is monotonic in consumption. All of us act as if our sole purpose in life is to maximize the utility obtained from consumption. Economists have never heard of the Buddha who taught that the root of suffering is attachment to material pleasures obtained from consumption. Yet the illusion that increasing consumption leads to increasing welfare has been clearly exposed by Easterlin. Economists continue to struggle to counter and explain away the Easterlin Paradox, since it contradicts their firm belief in the “Coca-Cola theory of happiness”. This is briefly described below, in an excerpt from my previous post on “The Search for Knowledge” :

The second idea that we must unlearn is the “Coca-Cola theory of happiness”, which is at the heart of modern economics. If a cool and refreshing drink makes a hot and thirsty man very happy, he should not deduce that he has stumbled upon the formula for a lifetime of happiness. It would be very foolish of him to build a hot sauna next to a refrigerator stocked with cases of cola, and market it as the ultimate pleasure machine. The economists’ idea that the purpose of our lives is maximization of the utility of lifetime consumption is equally foolish. Consumption and acquisition of material goods provide short run happiness but have zero correlation with long-term happiness. Long run happiness depends not on consumption, but rather on cultivation of character traits like gratitude, contentment, and compassion, as well as cultivation of social relationships – loving, and being loved.

Heterodox economists are attempting to find a technical fix to the problems of modern economic theory. In my view, we cannot launch a revolution by changing the equations we use. The changes required are much deeper — we need to change the way we understand human beings. We need to understand that “Revealed Preference” is a disastrous mistake — by avoiding thinking about the unobservable preferences in our hearts, and replacing them by observable behaviors, we prefer a shallow understanding to a deep understanding. The choice may be guided by feelings/emotions which are inherently unobservable, but we can learn about them by looking into our own hearts, since we are human beings. By ruling out introspection, and asking human beings why they do what they do, we rule out the possibility of understanding human behavior. Economists are religiously committed methodologically to “rational” behavior. They will not consider models of human behavior which allow humans to be whimsical or emotional. Even the alternative models, like Prospect Theory, which are being constructed, endow human beings with computational and informational capacities they do not possess. This blocks the possibility of knowledge. Unless we re-introduce the heart and soul into human beings, we will continue to fail to understand human behavior in any of the realms of economics, politics and society.

 

My article about the Battle of Methodologies, published in March 2018 issue of NewsLine Magazine:

Because of the universal spread and impact of Western educational systems, necessary for survival in the modern world, we have all learned to view the world through glasses manufactured in Europe. Just as a fish is unaware of the waters in which it swims, so we are unaware of the currents of history which have shaped European thought. Yet to understand the world we live in, and how our perceptions have been shaped by the dominance of West, it is essential to acquire an understanding of how the Western worldview has been radically transformed over the past few centuries. In this brief essay, we will discuss the “Methodenstreit”, the battle of methodologies, which took place in the late nineteenth century. While this is only one piece of the complex and multi-dimensional historical experiences of Europeans, the methodenstreit had a decisive impact on modern social science, which shapes our current understanding of human beings and their social, political and economic lives. The title of the book “How Economics Forgot History” about the methodenstreit by Geoffrey Hodgson accurately describes the impact of this battle on the discipline of Economics. In this battle, the German Historical School, championed by Schmoller and his colleagues, lost to the Austrian School of Menger, who favored a scientific and quantitative approach to economics.

But what is wrong with taking a scientific approach to the formulation and solution of economic problems, the reader might ask. This essay provides an answer to this question. The idea that economics is a “science” is firmly embedded in the foundations of modern economics. This means that economics provides us with a set of laws which have universal applicability across time and space, independent of social, political, geographic, and historic context. In fact, there are no such economic laws. How we organize our economic affairs differs in different societies, and also varies across time. The attempt to create a “scientific” economics resulted in forcing mathematical laws upon human behavior. Over the past few decades, psychologists who study actual human behavior have established that humans do not behave according to these laws. This has resulted in the creation of field of “Behavioral Economics,” and many researchers working in this area have been awarded Nobel Prizes (most recently, Richard Thaler) for discoveries which contradict the laws of behavior still being taught across the globe to students of economic theory. Despite discoveries that human beings are temperamental, driven by diverse and conflicting emotions, and free to make sudden changes in behavior, the scientific methodology of modern economics currently being taught to students across the globe continues to describe human beings as predictable robots subject to mathematical laws. The insights from behavioral economics are so radically in conflict with economic theory, that economists have not been able to assimilate them into the mainstream curriculum.

Similarly, the scientific method leads economists to ignore specific historical events in their vain quest for universal laws which describe economic systems. Essential insights about economics are lost due to this disregard of history.  For example, the two world wars, The Great Depression, The Bretton-Woods agreement, and Nixon’s revocation of gold backing for the dollar are events of central importance for understanding the economics of the twentieth century. However, economists do not study these events since they are particular and specific historical events, which cannot be described using universal scientific laws. On a larger scale, the birth of modern market society can be traced to the industrial revolution, which created possibilities of massive overproduction of goods in 18th century England. This overproduction concentrated a massive amount of wealth and power in the hands of a small group of people, who were able to use favorable historical circumstances to increase their wealth and power by expanding the role and influence of markets to the point that they came to dominate and destroy traditional societies all over the world. The deep insights which emerge upon connecting the historical context with economic theory have been brought out by Karl Polanyi in his magnum opus: “The Great Transformation: The Political and Economic Origins of Our Times.” One of the central themes of Polanyi is the dramatic contrast and opposition between values of traditional societies and the emerging modern market society. Traditional societies organize their economies on principles of redistribution and reciprocity, cooperatively taking care of all members. Furthermore, traditional societies value many characteristics like heroism, generosity, knowledge, spirituality, literature, arts, sports, etc. over and above the possession of wealth. In contrast, wealth becomes the primary marker of status in market societies, and becomes the main object of personal and collective endeavor. Studying the evolution of economic system and the co-evolution of economic theories adapted to the study of these systems in historical context yield deep insights not available using the currently dominant ‘scientific’ methodology.

An important consequence of the opposition between market values and social values is that traditional societies do not and cannot evolve into becoming market societies – this change is always brought about by a revolution, which destroys traditional values and replaces them by anti-thetical values of a market society. This revolution occurs on both the physical and material dimension, and, more importantly for our present essay, it also occurs on the ideological dimension. As Marx realized, capitalism produces laborers conditioned by education, tradition, and habits into thinking of the economy as subject to natural laws, and accepting their own exploitation as a necessary, fair, and just part of the system. Similarly, even though the market society provides enormous amounts of wealth and power for a few select members, expansion of the market into all human affairs requires this minority to create and popularize market ideologies. At the core of market ideologies is the idea that markets are governed by natural laws which provide equitable outcomes to all participants and create maximum wealth for all. This ideology runs counter to traditional ideas about social responsibility for the poor and disadvantaged, and suggests that interfering with market mechanisms will cause harm to everyone.

To understand the “origins of our times,” it is necessary to understand the parallel growth of market institutions which expand the scope and power of the marketplace, and the accompanying market ideologies which counter and negate traditional ideas about social norms. For example, exploiting the possibilities of massive overproduction created by the industrial revolution required the creation of consumers for these products. The globe was occupied by traditional societies which prized self-sufficiency as a virtue, and did not have markets for British goods. The productive capacities of the industrial society created the power to physically take over and colonize weaker societies all over the world. The destruction of local institutions for provision of social welfare, and the harnessing of all factors – labor, land, natural resources – to the global production of capitalist wealth was also accompanied by ideologies promoting the idea that this was the best path for all concerned. In particular, the economic theory of “comparative advantage” was invented to justify the absurd idea that it was in best interest of the colonies to remain engaged in the production of raw materials, leaving England to specialize in the production of industrial manufactures. Since it is easily refuted by empirical evidence, comparative advantage cannot be understood as a “scientific theory”. It can only be understood as a product of historical circumstances, as a part of a collection of theories required to justify the brutal processes of colonization and the accompanying destruction of local economies.

Since ‘comparative advantage’ was a manifestation of political power, effective counters also required political power. In Germany,  Friedrich List created the ‘infant industry argument” to support protectionist policies in Germany and Europe, which allowed European industries to catch up to England. Similarly, the American Revolution allowed the USA to implement protectionist policies which developed strong industries in North America. Colonies which did not have the political power to resist the ideology of comparative advantage remain agricultural economies providing raw materials to advanced economies to this day.  Like all major modern economic theories, comparative advantage can only be understood within its historical context, by seeing how the interests of the powerful imperialists were protected and advanced by the spread of this theory. The theory of free trade, which remains popular and widely believed by economists, is very similar. Wars by European powers against China and Japan were concluding by signing treaties which opened these countries to European goods, creating a market for industrialized European economies. Not only was free trade forced upon them by war, but the ‘theory of free trade’, which says that this was in their best interest, was forced upon them by the corresponding ideological war. It was the ability of China and Japan to resist this ideological war that has led to their economic success today. Similarly, it has been our failure to resist the invasion of ideologies and theories of the economic hit-men that has led to our poor economic performance for several decades.

The most important insight which emerges from studying history, politics, geography, and society in conjunction with economics is the deep inter-connections between all these spheres of human lives, and the impossibility of studying them in isolation. Like all of social science, modern economic theory derives directly from the analysis of economic systems of Western capitalist societies. The victory of the scientific and quantitative school over the German historical school in the battle of the methodologies created the misconception that this analysis is a “science” which is universally valid across time and space, for all societies. This has led to the current situation, where we teach and study capitalist economics relevant to modern European and USA economies but largely irrelevant to our economy, which is structured along different lines. At the same time, we do not study the success stories in patterns of the miraculous growth achieved by China and East Asian economies, which followed radically different policies. Discarding the blinders created by “scientific” pretensions of Western economics would create much-needed skepticism about the applicability of Western economic  theories to our radically different historical and cultural context, and also open our eyes to non-European models for prosperity which offer us substantially greater chances of success.

PostScript: For a more detailed discussion, see Origins of Western Social Sciences

The Islamic conception of “knowledge” differs radically from the western concept. Thus, necessarily, methods for seeking knowledge — research methodology — must also differ. This lecture explains some of the major differences in Eastern and Western approaches to knowledge.

An Islamic WorldView

Published in The Nation, 12th Mar 2018. This is a summary of a lecture at PPMI conducted for training of new inductees at the MoPD&R. An 85m video of the entire talk: Research Methodology Training Lecture:  shortlink: bit.do/azs4k

The Search for Knowledge (2265 word summary) 

As Muslims, we are asked to “seek knowledge from the cradle to the grave”. As a first step, it is essential to have clarity about our goals: “what is the knowledge we seek?”. Surprisingly, the definition of knowledge is a matter of ongoing debate and controversy.  To understand this better, it is useful to consider two categories – knowledge of the external world around us, and knowledge of our internal world. The two categories complement each other, and both are necessary for our personal and collective affairs. It should be obvious that the methods required to pursue these two types of knowledge…

View original post 2,127 more words

Romer writes that macro-economists casually dismiss facts, and the profession as a whole has gone backwards over the past few decades, losing precious and hard-won knowledge. He does not consider WHY this happened. What are the methodological flaws that create the possibility of moving backwards, losing knowledge, affirming theories known to be in conflict with facts. How is it that leading economists can confidently assert theories which border on lunacy, and receive Nobel Prizes instead of psychiatric treatment?

This is due to the famous AS-IF methodology of Friedman, which gave economists a license for lunacy.  Friedman came up with this defense of orthodoxy when numerous emprical investigation revealed clearly that firms did not maximize profits, did not know their marginal costs, typically used mark-up pricing, and did other things which did not square with neo-classical theories. Friedman’s argument has been universally condemned by logicians and philosophers as an instance of the logical fallacy of “Affirming the consequent” – the use of modus ponens in reverse. That is, Friedman says, in effect, that theory T implies observable consequence C. We observe C, and therefore we can affirm that T holds. This is obviously fallacious since many different theories, inconsistent with T, may also imply consequence C. Even more importantly, a false theory T will always imply consequences C* which are not observed — since the theory is false, it will have consequences which are false. Ignoring all of these problems,  Boland uses an instrumentalist interpretation to defend Friedman, just like all economics textbooks. He writes that even though critics universally condemn his logic, Friedman is right, and ALL the critics are wrong.

In my lecture on  AM2L07 (code for Advanced Micro II: Lecture 7) Methodological Mistakes: Prospect Theory and Psychology Protocols, I explain why Friedman is wrong and his critics are right by discussing this methodological debate within the concrete context of trying to understand search theory. Consider a hypothetical problem where a person is searching for the highest wage. He goes from one firm to next. At each point he is offered a job at a certain wage W. He can accept and quit searching, or reject the offer and go on searching. We want to find a theory which explains search behavior that we observe in lab experiments designed to emulate this situation.

In simple models, it is easy to show that optimal search sets a reservation wage W* and the laborer searches until he/she finds the first offer above this value. The Economist is committed to the assumption that humans are hyper-rational, and they maximize. ONLY theories satisfying these assumptions will be examined for validity. This means that there is NO QUESTION of looking at human behavior itself to see whether or not this hypothesis about behavior holds. Rather, the ONLY problem is to find the FUNCTION which is being maximized.  Economists start by using Expected Utility theory. A rather large number of empirical examples show that this theory does not match human behavior. Nonetheless, this continues to be the dominant theory of decision making under uncertainty and continues to be taught in textbooks, even though the theory is KNOWN to be wrong.

An improvement upon this is PROSPECT theory. By making ad-hoc modifications to probabilities, utilities, and FRAMING the problem in a suitable way, this theory can achieve a MUCH BETTER match to observed behavior than Utility theory. This theory preserves MAXIMIZATION – humans maximize something. However it abandons rationality — why should humans treat probabilities INCORRECTLY. Economists cannot stomach this observed failure of rationality and so AFFIRM theories solidly in conflict with observed facts about human behavior.

NEITHER of these approaches is scientific, since both dogmatically assert allegiance to the maximization principle regardless of observation. The articles by John Hey show how one can move beyond this to a genuinely scientific methodology. He explains how many researchers have investigated search behavior, but have only been concerned with whether or not it matched ASSUMED theories of behavior. INSTEAD he proposes to investigate how humans ACTUALLY behave, without imposing any assumptions about behavior in advance. He used psychological protocols, asking subject to think out loud about the process with which they arrive at the decision on whether to accept an offer or to go on to search for the next one. As can be expected, humans cannot make complex calculations that theory requires of them, and instead they use various heuristics and rules of thumb. These heuristic work fairly well, and get them reasonable close to what someone with full information and infinite computational capabilities could achieve. Nonetheless, the use of heuristics gives radically different results about what we could expect to see in markets where these behaviors, rather than the hypothesized AS-IF behavior is used. The full lecture is linked below

For lecture slides and reference materials, links to related articles, as well as the whole sequence of lectures, see the course website: Advanced Micro II (shortlink: bit.do/ee2018)

POSTSCRIPT: The process of lecturing, trying to explain to my students how their fellow students are being duped by economic textbook, always give me greater clarity. In this lecture, I examine three approaches to understanding human behavior in the process of searching for the best wage (or searching for the best price).

1: AXIOMATIC — represented by Expected Utility. Here we know in advance what human behavior is. We do not need to look at human behavior at all. If someone ELSE studies this behavior and finds that our theories do not match actual behavior, we say that the experiment must be wrong.

2: DESCRIPTIVE — represented by Prospect Theory. Unlike economists, experimentalists and behaviorists study actual behavior. When it fails to match Expected Utility, they came up with a new theory — prospect theory — which summarizes and encapsulates a description of how humans behave in decisions under uncertainty. Economists REJECT this picture because it shows how human behavior is IRRATIONAL – and this conflicts with their FUNDAMENTAL assumptions of rationality, which must be maintained regardless of any inconvenient facts or observations or introspection.

3: SCIENTIFIC: An accurate description permits us to proceed to the next stage, which is to try to understand the REASONS for this behavior. For example, we observe that most people are risk-averse. They prefer the certain outcome of $50 to a gamble with offers $0 and $100 with equal probabilty. Now we can ask why — this is with regards to unobservable, hidden motivations, about which we can never be certain. A good explanation for this is REGRET. Because of our psychological makeup, the flatness of the utility function in gains, a win of 100 does not feel vastly superior to a win of 50. But the real kicker is the feat that if I take a gamble and lose, I will feel so stupid. Avoiding the regret that might occur when I say I should have taken that certain $50 might be the explanation for risk aversion.

Actually, even “reverse Modus Ponens” is not a good description of Friedman’s methodology — there is an added F-Twist: If we can FIND some observations C such that theory T implies them, then we affirm theory T, and IGNORE any other implications of T which actually conflict with observations.

The METHODOLOGICAL point is the Friedman, like all nominalists and instrumentalists, GIVES up on the possibility of understanding human behavior. All he wants is a model which provides a SUPERFICIAL match to some observations. However, many many real life situations show that this is NOT ENOUGH — we need to have a deeper understanding, in order to be able to explain economic and social phenomena. See also previous related post on Economists Confuse Greek Methodology with Science

In Memoriam David Freedman (March 5, 1938–Oct 17, 2008) — March 5, 2018 would have been his 80th birthday.  I reproduce below an edited version of some memorial remarks I wrote, from

Editor’s Intro to International Econometric Review 

We would like to dedicate this issue to the memory of David Freedman, an outstanding
statistician whose legacy is closely related to the goals we would like to pursue in this journal.  One element of this legacy is the importance of undergraduate teaching; attempts to do explain the relevance and importance of statistics to undergraduates transformed the thinking and research of David. Increasing fragmentation of knowledge has led to a situation where specialists have no idea of how their patch of expertise relates to other portions of econometrics, how the whole body of econometrics ties into  economics, and how this body of knowledge relates to achieving broader human goals such as eliminating oppression, injustice, poverty and misery, and bringing happiness, joy, wonder and enlightenment into our lives. Teaching undergraduates is a useful antidote to this fragmentation. When we ask them to invest time and effort in learning difficult materials, we must justify this claim by showing them why it is useful in the context of real world examples. When we attempt to do this we will discover that, contrary to the impression created by our specialized education, no one has been there before us. That is, everyone in the knowledge field is a specialist and no one has a broad overview ranging from details of the theory to how these theories are applied in the context of serious real world applications which make a difference to the lives of people.
In his path-breaking undergraduate text Statistics, David documented the disastrous
consequences of this disconnect via many real world examples. A little exploration reveals how often bad theory with faulty assumptions using wrong types of data is used to guide policy. As a consequence, people who acquire the all round knowledge required to bridge the gap between theoretical knowledge and real world applications can make a big difference in changing the world for the better. David’s involvement in consulting and litigation testifies to his deep concern with using his knowledge to improve the lives of people. His more recent textbook Statistical Models explores how models work in the context of real world applications. Richard Berk, one of the commentators on David Freedman’s article in this issue, has provided a similar examination of regression models in his text: Regression Analysis: A Constructive Critique.
We would like to close with some advice to readers and contributors. John Hey summed up his experience of ten years of editorship of the Economic Journal as follows: “Many of the submissions do not appear to be written in order to further economic knowledge. … few economists ask themselves what are the crucial economic problems facing society. If they did so, they might well produce more relevant material.” Our brief moments on this earth are too precious to waste on pursuit of meaningless publications to add to our vitas. It will add meaning to our lives, depth to our knowledge, and create innovative and path-breaking research, if we make a serious attempt to serve humanity by solving the numerous real economic problems facing us globally.

In Memoriam: David Freedman

Our first issue of IER is dedicated to the memory of David Freedman. “Limits of
Econometrics” may be his last professional article – he had written it at my request for this  first issue. Unfortunately, he did not get a chance to revise it in response to the many
comments received. As a first draft, it may fall short of the standards of excellence set by
David in his numerous works – see his Berkeley website http://www.stat.berkeley.edu/~freedman/ for references – but, under the circumstances, it seems  best to print it as is, in tribute to his memory. We are also publishing comments on this article by Arnold Zellner and Richard Berk.
In 2003, David Freedman was awarded the prestigious John J. Carty Award for the Advancement of Science by the National Academy of Sciences, “for his profound contributions to the theory and practice of statistics, including rigorous foundations for
Bayesian inference and trenchant analysis of census adjustment.” More details about these contributions are available from the Wikipedia entry
http://en.wikipedia.org/wiki/David_A._Freedman_(statistician)
The obituaries cited below provide a broader perspective on his career and personality:
http://berkeley.edu/news/media/releases/2008/10/20_freedman.shtml
http://www.dailycal.org/article/103251/colleagues_friends_remember_eminent_statistics_pro
It is impossible to summarize his contributions, but I will focus on two issues which are
relevant both to the attached article, and to our underlying philosophy for this journal.
Close attention to real world applications, generated by demands of undergraduate teaching
and by consulting and litigation, changed the focus of David Freedman’s research from the
theoretical and abstract, to how these theories work in practice. His landmark text Statistics
(co-authored with Robert Pisani and Roger Purves) is based on serious examples from
economics, epidemiology, medicine, and social science. In his applied work, Freedman
emphasized exposing and checking the assumptions that underlie standard methods, as well as
understanding how those methods behave when the assumptions are false. Zellner’s comment
provides an econometricians perspective on the fundamental methodological issues which
govern the use of models in real life situations.
A central concern of Freedman was the disconnect between the requirements of real world
data analysis and the conditions under which models can produce reasonable answers. The
widespread use of models which make entirely inappropriate assumptions, together with
obliviousness to consequences of these errors was anathema to Freedman. His book on
Statistical Models discusses many professional highly cited articles which draw conclusions
not justified by the data, due to erroneous background assumptions. Because of these
critiques, many commentators remarked that if we take Freedman seriously, we will all be out of work. Richard Berk’s comment on Freedman’s article addresses this issue: how to proceed
if we take Freedman seriously.
It seems appropriate to close with the following quote from his colleague, Phillip Stark: “He
was just an extraordinary person and an extraordinary scientist. He was a truly exceptional
scholar-brilliant, meticulous and committed to truth.” His loss will be deeply felt in the
community of statisticians and econometricians.