A farmer is offered a choice between, on the one hand, getting a horse if it is raining tomorrow and a cow if it is not raining and, on the other hand, a cow if it is raining and a horse if it is not. He prefers getting a horse to getting a cow; this is a ‘pure preference’. But which of the offered alternatives does he prefer? Assume that he professes to be indifferent as between them. How shall we then understand his attitude?
To this question there is an answer, first proposed by F. P. Ramsey, which has later come to play a great role in so-called Bayesian decision theory …
Ramsey thought that an attitude of indifference here means that the person rates the two events, ‘rain’ and ‘not rain’, as equally probable. Accepting this, one can then proceed as follows:
Assume that our farmer is next presented with this option: On the one hand a horse if it is raining and a sheep if it is not raining and, on the other hand, a cow if it is raining and a hog if it is not raining. Again he says he is indifferent. This, on Ramsey’s view, means that the value to him of a cow is as much less the value of the horse as the value of a sheep is less than that of a hog. With this the way is open to a metrization of value and the introduction of utility functions. This done, one can use attiyudes of indifference in other, more complex, conditional options for defining arbitrary degrees of (subjective) probability. The product of the value of a good an dthe probability of its materialization is called expected utility. Attitudes of preference in options aim at maximizing this quantity.
Ramsey’s method is elegant and ingenious. Nevertheless, it seems to rest on a mistake. It ignores the distinction between two senses of ‘indifference’.
The farmer who, when presented with the first of the above two options, professes an attitude of indifference can do so for one or two reasons. Either he ‘simply has no idea’ about the chances of rainfall for tomorrow and therefore cannot make up his mind about which alternative is more to his advantage.
This does not mean that he thinks rain and not-rain equally likely; he simply suspends judgement. Or, he considers them equally likely and therefore judges the two alternatives to be equally advantageous. He could, for example, support his attitude with the argument that if he repeatedly opted for one of the alternatives, no matter which one, on average half the number of times he would ‘probably’ get a horse, which is to his advantage, and half the number of times a cow, which is to his disadvantage. So, therefore, he is indifferent as between the alternatives. It is, in other words not his judgement of indifference which gives meaning to the probabilities for him; but it is his prior estimate of the probabilities which determines his attitude of indifference. This estimate, moreover, seems normally to go with a corresponding expectation of frequencies.
As is well-known, Keynes used to criticize the more traditional economics for making the fallacy of composition, which basically consists of the false belief that the whole is nothing but the sum of its parts. Keynes argued that in the society and in the economy this was not the case, and that a fortiori an adequate analysis of society and economy couldn’t proceed by just adding up the acts and decisions of individuals. The whole is more than a sum of parts.
This fact shows up already when orthodox – neoclassical – economics tries to argue for the existence of The Law of Demand – when the price of a commodity falls, the demand for it will increase – on the aggregate. Although it may be said that one succeeds in establishing The Law for single individuals it soon turned out – in the Sonnenschein-Mantel-Debreu theorem firmly established already in 1976 – that it wasn’t possible to extend The Law of Demand to apply on the market level, unless one made ridiculously unrealistic assumptions such as individuals all having homothetic preferences – which actually implies that all individuals have identical preferences.
This could only be conceivable if there was in essence only one actor – the (in)famous representative actor. So, yes, it was possible to generalize The Law of Demand – as long as we assumed that on the aggregate level there was only one commodity and one actor. What generalization! Does this sound reasonable? Of course not. This is pure nonsense!
How has neoclassical economics reacted to this devastating findig? Basically by looking the other way, ignoring it and hoping that no one sees that the emperor is naked.
Having gone through a handful of the most frequently used textbooks of economics at the undergraduate level today, I can only conclude that the models that are presented in these modern neoclassical textbooks try to describe and analyze complex and heterogeneous real economies with a single rational-expectations-robot-imitation-representative-agent.
That is, with something that has absolutely nothing to do with reality. And – worse still -something that is not even amenable to the kind of general equilibrium analysis that they are thought to give a foundation for, since Hugo Sonnenschein (1972) , Rolf Mantel (1976) and Gerard Debreu (1974) unequivocally showed that there did not exist any condition by which assumptions on individuals would guarantee neither stability nor uniqueness of the equlibrium solution.
So what modern economics textbooks present to students are really models built on the assumption that an entire economy can be modeled as a representative actor and that this is a valid procedure. But it isn’t, as the Sonnenschein-Mantel-Debreu theorem irrevocably has shown.
Of course one could say that it is too difficult on undergraduate levels to show why the procedure is right and to defer it to masters and doctoral courses. It could justifiably be reasoned that way – if what you teach your students is true, if The Law of Demand is generalizable to the market level and the representative actor is a valid modeling abstraction! But in this case it’s demonstrably known to be false, and therefore this is nothing but a case of scandalous intellectual dishonesty. It’s like telling your students that 2 + 2 = 5 and hope that they will never run into Peano’s axioms of arithmetics.
For almost forty years neoclassical economics itself has lived with a theorem that shows the impossibility of extending the microanalysis of consumer behaviour to the macro level (unless making patently and admittedly insane assumptions). Still after all these years pretending in their textbooks that this theorem does not exist – no one of the textbooks I investigated even mention the existence of the Sonnenschein-Mantel-Debreu theorem – is outrageous.
Countries that have joined the Europen Monetary Union have not only lost their capacity to issue debt in a currency over which they are their own masters. They have also lost the possibility of using their own instruments of economic policy in the form of interest rates and exhange rates.
Because of this they have also almost no other possibility of getting their costs in line than through “internal devaluation” by burdensome austerity measures. Measures that have driven the economies of Greece, Spain, Italy, Ireland and Portugal to the brink of disaster.
Since the countries of the euro area do not have their own currencies they cannot deal with crisis in a proper way. Had these countries had their own currencies they could have devalued their currencies and much more easily been able to restore their competitiveness and adjust to the shock of the financial crises of 2008.
Being “sort of” Keynesian, yours truly don’t often find the occasion to approvingly quote Milton Friedman. But on this issue I have no problem:
If internal prices were as flexible as exchange rates, it would make little economic difference whether adjustments were brought about by changes in exchange rates or equivalent changes in internal prices. But this condition is clearly not fulfilled. The exchange rate is potentially flexible in the absence of administrative action to freeze it.
At least in the modern world, internal prices are highly inflexible. They are more flexible upward that downward, but even on the upswing all prices are not equally flexible. The inflexibility of prices, or different degrees of flexibility, means a distortion of adjustments in response to changes in external conditions. The adjustment taes the form primarily of price changes in some sectors, primarily of output changes in others.
Wage rates tend to be among the less flexible prices. In consequence, an incipient deficit that is countered by a policy of permitting or forcing prices to decline is likely to produce unemployment rather than, or in addition to, wage decreases. The consequent decline in real income reduces domestic demand for foreign goods and thus demand for foreign currency with which to purchase these goods. In this way it offsets the incipient deficit. But this is clearly a highly efficient method of adjusting to external changes. If the external changes are deep-seated and persistent, the unemployment produces steady downward pressure on prices and wages, and the adjustment will not have been completed until the deflation has run its sorry course.
The argument for a flexible exchange rate is, strange to say, very nearly identical with the argument for daylight savings time. Isn’t it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock, even though all want to do so. The situation is exactly the same in the exchange market. It is far simpler to allow one price to change, namely, the price of foreign exchange, than to rely upon changes in the multitude of prices that together constitute the internal price structure.
Yours truly har i dag en artikel om skolan i nättidningen Skola och samhälle:
Skolan ska vara en ö i en värld full av intensiva förändringar. För att kunna lära sig saker krävs koncentration och möjligheter till avskärmning. I vår hypermedialiserade värld är kanske just det sistnämnda speciellt viktigt. I det ständiga digitala brus som unga människor omger sig av dygnet runt, behövs öar av distans, lugn och möjligheter till reflektion, sållning av brus och bearbetning av information till kunskaper. Inte för att permanent dra sig undan livsvärldens bekymmer och besvär, utan för att – med den styrka, färdigheter och perspektiv som en kunskaps- och medborgarskapsgrundad skola kan ge – bättre kunna tackla de ständiga reala omvandlingar som kännetecknar våra liv.
Ska man lära något nytt i skolan måste den vara något annat än en förlängning av elevers vardag och liv. Ska skolan kunna katalysera och förändra måste den vara något annat och inte identiskt med sin omgivning.
I dagens samhälle måste skolan få fungera som något annorlunda, ett alternativ till de eroderande marknadskrafter som idag hotar samhällsbygget genom att reducera samhällsmedborgare till konsumenter. Kunskap är en nödvändig förutsättning för att kunna bjuda stånd mot denna utveckling. När inte familjen eller samhället står emot måste skolan kunna stå upp och ta tillvara det uppväxande släktets genuina emancipatoriska intressen.
Om skolan ska kunna utgöra ett förverkligande av varje elevs potential snarare än tidsbundna och kontingenta fakticitet måste den kunna bygga broar till elevens livsvärld, samtidigt som den behåller distansen och avståndet mellan skola och samhälle.
George Soros has put generous funding behind the Institute for New Economic Thinking (INET). The Bank of England has also tried to stimulate fresh ideas. The proceedings of a conference that it organized earlier this year have now been edited under the provocative title What’s the Use of Economics?
Some of the recommendations that emerged from that conference are straightforward and concrete. For example, there should be more teaching of economic history …
Many conference participants agreed that the study of economics should be set in a broader political context, with greater emphasis on the role of institutions. Students should also be taught some humility. The models to which they are still exposed have some explanatory value, but within constrained parameters. And painful experience tells us that economic agents may not behave as the models suppose they will.
But it is not clear that a majority of the profession yet accepts even these modest proposals. The so-called “Chicago School” has mounted a robust defense of its rational expectations-based approach, rejecting the notion that a rethink is required. The Nobel laureate economist Robert Lucas has argued that the crisis was not predicted because economic theory predicts that such events cannot be predicted. So all is well …
We should not focus attention exclusively on economists, however.
Arguably the elements of the conventional intellectual toolkit found most wanting are the capital asset pricing model and its close cousin, the efficient-market hypothesis. Yet their protagonists see no problems to address.
On the contrary, the University of Chicago’s Eugene Fama has described the notion that finance theory was at fault as “a fantasy,” and argues that “financial markets and financial institutions were casualties rather than causes of the recession.” And the efficient-market hypothesis that he championed cannot be blamed, because “most investing is done by active managers who don’t believe that markets are efficient.”
This amounts to what we might call an “irrelevance” defense: Finance theorists cannot be held responsible, since no one in the real world pays attention to them!