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Critiques of Economic Theories

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

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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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After the 1920s, the theoretical and methodological approach to economics deeply changed. Based on a criticism of Marshall’s work and legacy, a new generation of American and European economists developed Walras’ and Pareto’s mathematical economics. As a result of this trend, the Econometric Society was founded in 1930.

The constitutional assembly was held in  Cleveland, Ohio, during the annual joint meeting of the American Economic Association and the American Statistical Association. The Norwegian economist Ragnar Frisch played an important role in the Econometric Society that was founded to enhance studies based on the theoretical-quantitative and the empirical-quantitative approach to economic problems. In this way, the  founding fathers believed that  economic thinking could be as rigorous as the one that dominates the natural sciences.

At the 5th European Meeting of the Econometric Society, in 1935, Jan Tinbergen presented a paper on ‘A mathematical theory of business cycle policy’ that followed the Econometric Society’s guidelines. His causal explanation of the business cycle began with a priori economic-theoretical considerations about explanatory variables and then he proceeded to test a model.

In the late 1930s, John Maynard Keynes and other economists objected to this recent “mathematizing” approach. Keynes, as editor of the Economic Journal, wrote  a negative review of Tinbergen’s 1939 book A Method and its Application to Investment Activity. This book  presented an statistical testing of business cycle theories based on the application of the method of  multiple regression and  mathematical framing in the form of a specified model. At the core of Keynes’ concern lied the question of methodology. Recalling his own words:

Am I right in thinking that the method of multiple correlation analysis essentially depends on the economist having furnished, not merely a list of the significant causes, which is correct so far as it goes, but a complete list? For example, suppose three factors are taken into account, it is not enough that these should be in fact veræ causæ; there must be no other significant factor. If there is a further factor, not taken account of, then the method is not able to discover the relative quantitative importance of the first three. If so, this means that the method is only applicable where the economist is able to provide beforehand a correct and indubitably complete analysis of the significant factors. The method is one neither of discovery nor of criticism. It is a means of giving quantitative precision to what, in qualitative terms, we know already as the result of a complete theoretical analysis. (Keynes 1939: 560)

In this paragraph, it is clear that Keynes doubted the use of inductive methods of generalization and statistiicial inference to build economic theories because of the peculiarity of the economic systems characterized by:

  • a low degree of homogeneity,
  • a high degree of complexity
  • the lack of stability through time.

Indeed, on behalf of the peculiarities of the economic systems, Keynes highlighted that econometrics turns out to be a method not of testing or of discovery, but of measurement of selected variables.

 

refeences

Keynes, J. M.,  Professor Tinbergen’s Method, The Economic Journal, Vol. 49, No. 195 (Sep., 1939), pp. 558-577. Published by: Blackwell Publishing for the Royal Economic Society. Stable URL: http://www.jstor.org/stable/2224838

Tinbergen, J. A Method and its Application to Investment Activity. Geneva: League of Nations, 1939.

1000 word summary of Quaid-e-Azam Lecture at PSDE 33rd AGM held on 14th Dec, 2017 at Islamabad. Published in Express Tribunethe Nation 13th Jan 2018. 43m Video Lecture on YouTube:

The main thesis of our lecture is that our quest for prosperity has failed to deliver the sought-after goals because we have misunderstood the meaning of prosperity , and looked for it where it cannot be found. We base our economic policies on modern economic theory, which is based on the amazing assumption that human beings act to maximize lifetime consumption, since this is the sole source of human welfare. Human beings are far more generous and cooperative than the assumptions of economic theory allow for. Even more important is Richard Easterlin’s discovery that enormously increased levels of consumption do not bring about corresponding increases in happiness. Consumption only brings short-run happiness; long-run happiness has no correlation with consumption, and is far better correlated with character traits like generosity and gratitude. Mindless pursuit of wealth, implemented by policies to maximize growth, has led to increasing misery, instead of prosperity . Growth-oriented policies have destroyed family lives, engaging all members in production of wealth, and they have damaged our environment, destroying the future of our species for short run gains. Can this damage be reversed? Can we improve human lives and welfare, and also stave off the impending environmental crisis? At the core of the crisis we face is the prioritization of wealth over human beings. A market economy cheapens human beings because it is based on the idea that human lives are commodities for sale in the labor market. Reversing these priorities requires the recognition that all human lives are infinitely precious, with amazing potentials and capabilities for growth in dimensions unknown. Taking this principle seriously would require re-writing all economics textbooks, and radically re-organizing our economic, political and social institutions. Taking collective responsibility to ensure that all members of a society get the chance to develop their capabilities would be a new definition of prosperity , very different from GNP per capita, which is the current focus of policy makers across the globe.

Modern economic theory makes accumulation of wealth the goal of economic activity, and values human lives only to the extent that they contribute to production. How can we reverse these priorities, putting the enrichment and empowerment of human lives at the center, and valuing wealth only to the extent that it is helpful in achieving this goal? The first requirement is to win the battle of ideas, creating consensus on the prioritization of human beings over material wealth. To do this, we need to recognize modern economic theory for what it is, instead of what it claims to be. To accomplish this goal, it is useful to label modern economic theory as Economic Theory of the Top 1% — or ET1% — and explain how all aspects of this theory are designed to portray increasing wealth of the top 1% as the goal of society, and also to show that this serves to benefit the entire society. For example, use of GNP per capita as a yardstick of social welfare exactly fits this description, since gains to the top 1% are first divided over the entire population and then measured, thus appearing to be generally beneficial, when in fact they are not. Overcoming this deception will involve replacing ET1% by ET90% — a new economic theory for the bottom 90%.

Karl Marx clearly recognized the deceptive nature of economic theory, and stated that functioning of capitalism requires convincing the laborers of the necessity and fairness of their own exploitation. ET1% does this by arguing the growth is the best policy to pursue for all, since benefits which obviously accrue to the rich will eventually trickle down to the poor. In contrast, Marx offered us ET90% by asking for a shift from each according to his abilities (to gather wealth) to “each according to his needs”, thereby prioritizing the needs of the poor over growth to provide more wealth to the already wealthy.

As a prescription for change, Marx urged the laborers of the bottom 90% to unite, and throw off their chains.  Experience shows that we can successfully unite laborers to revolt against the capitalists, but after the revolution, control necessarily remains in the hand of a small minority. The nature of power is such that this small minority is likely to be corrupted by it, and use it for personal gains, and to oppress the majority. Just like democracy has failed to give ‘power to the people’, so alternative systems of government also fail.

The Islamic solution works along different dimensions. It seeks to co-opt the rich and powerful, instead of killing them off, and replacing by another set of rich and powerful. This is done by creating social norms of generosity and social responsibility. Fourteen centuries ago, the revolutionary teachings of Islam led backwards and ignorant Arabs to world leadership. These teachings include the ideas that the best leader is the servant of the people, that power is given to us in order to protect the weak, and wealth is meant to be given to the needy. Widespread acceptance of these ideas created a society which provided basic needs, health care, and education to all members using the institutions of Waqf, and the norms of collective social responsibility and brotherhood. Because these ideas have been forgotten, they continue to have the same revolutionary potential today, as they did 1400 years ago. The most important first step in this revolution is sensitizing our hearts to feel compassion for sufferings of all mankind. The feeling that all of the creation is the family of God, and service to humanity, and all living creatures, is the highest form of worship, is essential motivation for the Herculean efforts required to create revolutionary changes required to reverse the increasing concentration of wealth at the top and misery at the bottom.

huntergatherer

As a preliminary demonstration, and an explanation of the “Three Methodologies“, we assess how they work in primitive hunter-gatherer societies.

A hunter-gatherer is a human living in a society in which most or all food is obtained by foraging (collecting wild plants and pursuing wild animals), in contrast to agricultural societies, which rely mainly on domesticated species.

There are many characteristics of such societies forced by the material conditions of production. Since existing food supplies in any one location are soon exhausted, such societies are generally nomadic. Here are some philosophies, and political and social structures that would naturally arise in hunter-gatherer nomadic societies.

Philosophy: Since human beings are directly dependent on the environment, the idea of “Mother Earth” and a close relationship with nature can be expected to develop. This stands in contrast with urban lifestyles which are remote from nature; it is this detachment from nature which has permitted the widespread environmental destruction which is currently taking place.

Politics: Typical Hunter-Gatherer societies are egalitarian. This is because everyone derives a living directly from nature, and is mobile. If one subgroup is oppressed, they can simply leave, so there is not much room for powerful groups to exercise large amounts of power and control over other groups. Furthermore, in subsistence economies, one cannot afford slaves because there is generally not enough surplus food to feed them. So economic conditions favor egalitarian political structures; nonetheless, human ingenuity can sometimes overcome such obstacles.

Property: Since property of nomads is confined to what they can carry with them, it is necessarily limited. Illustrative of hunter-gatherer attitudes towards property is the Cherokee Constitution of 1839, which states: “The lands of the Cherokee Nation shall remain common property”.

We now consider insights yielded into the study of such societies by the three methodologies discussed in the previous post

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'Are you sure this isn't the point in which we should stop following the invisible hand of the marketplace?'

Rafi Amir-ud-Din and Asad Zaman “Failures of the ‘Invisible Hand
Forum for Social Economics Vol. 45, Iss. 1, 2016 pp 41-60.

Textbooks, like Mankiw, state that the four claims listed below are at the center of modern economics. Our goal in this paper is to show that all four of these claims are wrong.

1.      Participants in market economies are motivated by self-interest. (SI) – In fact, cooperation, service, recognition and status in community, and reciprocity are very strong motivators of human behavior.

2.      Decentralized market economies work very well, and maximize the welfare of society as a whole. (FM:  free markets). As illustrated by the Global Financial Crisis, unregulated markets lead with regularity to disasters and crises.

3.      The reason for excellent functioning of decentralized market economies is that all participants are motivated by self-interest. This self-interest works better than love and kindness in terms of promoting social welfare.  (GG:  greed is good). This is absolutely false, and the opposite of the truth – love and kindness work much better at promoting social welfare.

4.      The principles listed above were summarized in the concept of the “Invisible Hand” by Adam Smith. (AS). Adam Smith can be blamed for many wrong ideas, but this is not one of them. In fact, free market economists attribute this theory to Adam Smith to create legitimacy for their ideas. 

Detailed presentation of the paper is available in the following 1 hr. video.

Because of Western dominance, brilliant thinkers from the East get very little attention in global media. Even though brilliant economists from East Asia and China have created globally acknowledged economic miracles in their countries, none of them have received a Nobel Prize. On the other hand, Western economists whose theories were demonstrably in conflict with the events that took place in the global financial crisis — like Lucas, and Fama — have received Nobels. One of our greatest un-sung Eastern Heroes is Mahbubul Haq. My recently published article describes the revolution he created in economic thought:
HDI

Goethe starts his famous East-West Divan with a poem about the journey (Hegire), both physical and spiritual, from the West to the East. In this essay, we consider the analogous journey from Western to Eastern conceptions of development. This involves switching from viewing humans as producers of wealth, to viewing wealth as a producer of human development. To start with the Western conceptions, both Adam Smith and Karl Marx defined economic growth as the process of accumulation of wealth. The range of diversity of Western thought is bounded by the Left-Right spectrum. Ideas on which both extremes agree command widespread consensus in the West. Consequently, a core concept of modern economic theory is that wealth is the means and ends of the process of economic development. Unfortunately, due to the dominance and influence of Western paradigms, this concept has been widely accepted and adopted in the East today.

Mahbubul Haq was indoctrinated into the Western development paradigm which gives primacy to wealth at leading universities, Yale and Harvard. He got the chance to apply these economic models as the chief economist in Pakistan during the ’60s. However, because of his Eastern upbringing and heritage, he was able to see the murderous message at the heart of the cold mathematics of the Solow-Swan growth models. These models focus on savings, created by reducing present levels of consumption, as the only route to the accumulation of greater future wealth.

Mahbubul Haq realised what is not mentioned in the economics textbooks: obsession with production of wealth requires us to use the sordid and cruel tactic of making workers produce wealth, and refusing to allow them to consume it, in order to buy machines and raw materials. He was clear-sighted enough to see the consequences of these policies: wealth did indeed accumulate, but it went into the pockets of the 22 families, without providing relief to the misery of the masses. Today the global application of capitalist growth strategies has led to a dramatic increase in inequalities both inside nations and across nations. Just one among many horrifying inequality statistics is that the top 13 individuals now have more wealth than the bottom 3.5 billion on the planet.

Dissatisfaction with state-of-the-art Western growth theories led Mahbubul Haq to a revolutionary insight, taken from the heart of the traditions of the East, and having no parallels in current Western economic theories. Instead of capital, Mahbubul Haq placed human beings at the centre of the process of economic growth, returning to the ancient wisdom that “human beings are the means and ends of development”. Even though he was called a heretic for going outside the boundaries of contemporary economic thought, the pragmatic genius of Mahbubul Haq sought to minimise differences and create bridges to conventional thinking in order to achieve acceptance for his radically different approach to development.

His Human Development Index (HDI) was a master stroke, combining two inherently incompatible conceptions of development in a compromise which ceded ground to wealth in order to create international visibility for poverty. His friend and classmate Amartya Sen was reluctant to accept the HDI because of certain inherent flaws in this marriage of fire and water, but eventually agreed to its practical necessity. The pragmatic approach of Mahbubul Haq paid off handsomely when the HDI measure achieved global recognition as rectifying major defects in the standard GDP per capita. Widespread acceptance and use of HDI has led to a radical change in the discourse on development, by adding poverty, health, education and other soft social goals to the pure and simple-minded pursuit of wealth. The revolutionary ideas of Mahbubul Haq have led to improvements in the lives of millions, as global consensus developed on the social goals embodied in the MDGs and SDGs.

The Human Development approach of Mahbubul Haq was carried further by Amartya Sen, who defined development as the freedom to develop human capabilities. This notion, closely aligned with Eastern thought, was so alien to orthodox economists that they rejected it. Consequently, a new human-centred field of development studies emerged, which combined many streams of dissent from orthodoxy. Unfortunately, leaders at the helm of policymaking in the poor countries of the world are trained in orthodox economic theories, and have not assimilated the radical lessons of Mahbubul Haq, acquired from bitter experience. The paths to genuine development lie open, but with their backs to the doors, they are unable to see them.

Conventional growth theories create the mindset that the game is all about wealth creation. We will worry about our poor population only after we acquire sufficient wealth to feed them. The poor are a burden on the development process because providing for them takes away from money desperately needed to finance development of infrastructure, purchase of machinery and raw material, and industrialisation. We cannot afford to feed the poor, if we want to grow rapidly. The human development paradigm stands in dramatic contrast to this currently common mindset among planners. Instead of utilising humans to produce wealth, we utilize wealth to develop human capabilities. Our human population, our poor, are our most precious resource. This point of view receives strong support in the empirical findings of a recent World Bank study entitled “Where is the Wealth of Nations?” The study finds that the wealthiest nations are rich because they spend money to develop their human resources, and not because of natural resources.

Thus, instead of being a burden, our poor are our most efficient means to development. If we use available wealth to improve their lives, to empower them, to educate them, and to provide them with the support they need, they can rapidly change the fate of the nation. Furthermore, they are also the end of the development process — that our goal is NOT to produce more and more wealth, a la Adam Smith and Karl Marx — but to ensure that our people lead rich and fulfilling lives. If we use our energies to achieve this goal, we have already arrived at the destination — we do not need to wait for a distant future where sufficient wealth will accumulate to enable us to take good care of our people.

Published in The Express Tribune, May 20th, 2017.