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Critiques of Economic Theories

This is the second lecture on Understanding the Rise and Fall of the Gold Standard — shortlink: bit.do/azifa2 — we start with a  Summary of First Lecture 

The first lecture discusses the Keynesian theory that the exact level of money in an economy is critically important – too little leads to recessions, while too much leads to inflations. Furthermore, domestic business cycles, and international financial crises are caused by pro-cyclical behavior of current artificial systems of money creation and international trade. Standard macro theories make it impossible to understand the economy because they assert that money is neutral, and does not affect the real economy – exactly the opposite of the Keynesian idea that the quantity of money is all important. Standard macro model currently in use throughout the world have no explicit role of money, banks, and credit, even though these factors are of central importance in understanding the world. Once we understand the vital role and function of money within an economy, it becomes possible to understand historical events of the twentieth century – whereas this is impossible using conventional macro theories. The first lecture summarizes how the colonial system came into being, and the monetary arrangement for a hard currency at the core and soft currencies in the periphery. This system of fiat currencies works fine within one system of colonies, where the value of money is decreed by sovereign fiat. For trading between different countries, the gold backed currencies were used. As European countries prospered by exploiting resources throughout the globe within their colonies, inter-European trade increased. The optimal quantity of money required for the domestic economy is not the same as that required for stable international exchange rates. The pro-cyclical money creation which is characteristic of the system creates cycles, and large cycles lead to crises on a routine basis. World War I was partly caused by the breakdown of the colonial trading system due to the end of expansion possibilities after the completion of the conquest of the globe. Efforts to restore the gold standard after World War I failed. The second part of the lecture discusses the post World War I history, with reference to the international financial architecture that emerged in the post-Gold era after World War I.

3100 Word Summary of Second Lecture on Global Financial Architecture

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In previous parts of this article (Understanding Macro I & Understanding Macro II), we have described how strict financial regulation and Keynesian prescriptions for full employment brought prosperity for the masses, but reduced corporate profits. This last part describes the successful counter-attack by corporations which reversed this state of affairs, causing a massive rise in the income shares of the wealthy 1% and a decline in the fortunes of the bottom 90%.

In the mid 70’s, when I was studying for my Ph.D. in Economics from Stanford, Keynesian economics ruled the roost; pre-Keynesian free market economics was confined to the Chicago School, and not considered intellectually respectable. This situation was reversed in the 90’s, when the Chicago School became dominant, while Keynesian economics was no longer considered respectable. The multi-dimensional strategy used to create this revolution on the academic front is described by Alkire and Ritchie in “Winning Ideas”, while the global strategy to transform socialistic economies into capitalistic free markets is described by Naomi Klein in The Shock Doctrine: The Rise of Disaster Capitalism. A common thread between the two is the patient preparation of detailed plans, while waiting for a crisis, which provides an opportunity to implement these plans.

The intellectual crisis that Chicago had been waiting for occurred in the early 70’s when the Arab Oil embargo, in retaliation for US support of Israel, led to stagflation in the USA. The simultaneous occurrence of high inflation and high unemployment was said to be in conflict with Keynesian theories, while the Chicago School theory of Milton Friedman was said to provide an explanation for the unexpected phenomena. This became widely accepted, and led to a substantial rise in the prestige of the Chicago School, and a blow to the Keynesians. The 1% capitalized on this by providing funds to Sveriges Riksbank, the Central Bank of Sweden, to create a simulated Nobel Prize for Economics, named the Sveriges Riksbank prize in honor of Alfred Nobel. The Nobel family protests against this appropriation of the prestige of the Nobel Prize were ignored, and the public was fooled into accepting this just like the genuine Nobels. In quick succession, roughly half of all the Nobel prizes were awarded to Chicago economists, interspersed with 50% going to randomly chosen others to create a semblance of neutrality. This led to a rapid rise in the academic prestige of the Chicago school.

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Lectures on First Steps towards Understanding Macroeconomics, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture( shorlink: bit.do/azifa)

3100 word summary of lecture:

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This continues a sequence of posts explaining how conventional economics is actually the economic theory of the top 1%: ET1%: Blindfolds created by Economic Theories. Eight central concepts of economic theory are shown to be deceptive – they have an appearance of objectivity, fairness, and equity, but actually conceal a strong bias in the favor of the wealthy. The previous post was the “Illusion of Scarcity.

We call the concept of “Pareto Efficiency” a swindle because it encapsulates a normative principle that property rights of the wealthy take precedence over the right to basic needs of the poor. However, it is disguised to have an appearance of scientific objectivity, while the opposite normative preference, which most people have, is said to depend on subjective and unreliable value judgments.

The principle of Pareto efficiency has a harmless and innocuous appearance. Who could object to the idea that if we give more material goods to everyone, then the society as a whole would be better off? However, we will show that Pareto Efficiency is deceptive and fully qualifies for the label ET1%. It appeals to everyone when we say that increasing social welfare requires giving more goods to all. But the hidden consequence of accepting this principle is that you cannot take wealth away from the super-rich to give to the hungry, because that would decrease the wealth of the super-rich. It also provides moral cover for increasing inequality, as we shall see. It also protects property rights against the taxation required to fulfill social needs of the poor.

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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

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

Preliminary Remarks: “The trouble is not so much that macroeconomists say things that are inconsistent with the facts. The real trouble is that other economists do not care that the macroeconomists do not care about the facts. An indifferent tolerance of obvious error is even more corrosive to science than committed advocacy of error.” From The Trouble with Macroeconomics (Paul Romer)

I do not understand why indifference to error is worse than committed advocacy. Tor an illustration of committed advocacy of error, see postscript below on 70 years of economists’ committment to a fallacious theory. Furthermore, the problem is not confined to macro. Microeconomists are also dogmatically committed to utility maximization, when in fact this hypothesis about consumer behavior is solidly rejected by empirical evidence; see: The Empirical Evidence Against Neoclassical Utility Maximization: A Survey of the Literature.

For the followup post, see “Understanding Macro II: Post-War Prosperity”

Understanding Macro: The Great Depression

Published in The Express Tribune, February 21st, 2018.

Due to frequent headlines, there is a substantial public awareness of core macroeconomic issues like unemployment, trade agreements, exchange rates, deficit, taxes, interest rates, etc. However, even professionals are often ignorant of the intellectual battles which have shaped modern macroeconomics, since this is not taught in typical PhD programmes in economics. This article attempts to provide the history of ideas which led to the emergence of macroeconomics, since this is an essential background required for informed analysis of these issues.

Lord John Maynard Keynes invented the entire field of macroeconomics in response to the Great Depression in 1929, which could not be understood according to economic theories dominant until then. According to the classical economic theory, forces of supply and demand in the labour market would ensure full employment. Keynes starts his magnum opus, The General Theory of Employment, Interest, and Money, with the observation that the economic theory cannot explain the long, persistent and deep unemployment that was observed following the Great Depression. Keynes set himself the goal of creating a theory which could explain wide fluctuations in levels of employment that he observed. He discovered that creating such a theory involved rejecting deeply held convictions, central to economic theory.

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