LARS P. SYLL

Euro austerity – the Latvian experience

Economics textbooks – scandalous intellectual dishonesty

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.

Milton Friedman was right on the value of having your own currency

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.

On the self-destruction of the eurozone

Eugene Fama and the Economics of Denial

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!

Howard Davies

Inequality and moral behaviour

Modern macroeconomics – science without aspirations?

The problem is that the new theories, the theories embedded in general equilibrium dynamics of the sort that we know how to use pretty well now—there’s a residue of things they don’t let us think about.
They don’t let us think about the U.S. experience in the 1930s or about financial crises and their real consequences inAsia and LatinAmerica. They don’t let us think, I don’t think, very well about Japan in the 1990s. We mayn be disillusioned with the Keynesian apparatus for thinking about these things, but it doesn’t mean that this replacement apparatus can do it either. It can’t. In terms of the theory that researchers are developing as a cumulative body of knowledge—no one has figured out how to take that theory to successful answers to the real effects of monetary instability. Some people just deny that there are real effects of monetary instability, but I think that is just a mistake. I don’t think that argument can be sustained.

Robert Lucas

Isn’t that like having seismological and meteorological sciences that can’t help us explaining or predicting earthquakes or hurricanes? Maybe we should have just a little higher aspiration level as scientists? After all, if uncertainty is all around in the economy and – as Lucas has said – “in cases of uncertainty, economics reasoning will be of no value,” then why should be bother with economics at all? I’m just wondering …  

Keynes on conventions and managing uncertainty

In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out quite so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalise our behaviour by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities. We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield.

Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.

…

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

General Theory

Paul Krugman – a pathetic old fool?

Calmfors – både rätt och fel om en misslyckad ekonomiprofession

Lars Calmfors hade i går en artikel i DN där han gör några viktiga iakttagelser om finanskrisen och ekonomiprofessionens misslyckande i samband med denna:

Finanskrisen var ett misslyckande för ekonomprofessionen. Vi borde ha varnat mer för de finansiella riskerna. Det fanns visserligen en medvetenhet om att de globala obalanserna, med stor amerikansk utlandsupplåning, kunde leda till en hårdlandning. Men den kom att ta sig andra vägar än som förutsetts och blev mycket värre. Finansmarknadernas risktagande var vida större än vad de flesta ekonomer hade kunnat föreställa sig. Kunskapen om olika finansiella instrument och hur de flätade samman aktörer var alldeles för liten.

Ett systemfel inom ekonomisk forskning var bristande integration mellan makroteori (som analyserar hur den ekonomiska aktivitetsnivån bestäms) och finansiell ekonomi. Makroforskningen lade inte tillräcklig vikt vid det finansiella systemets betydelse för konjunktursvängningarna. Forskningen i finansiell ekonomi var mer inriktad på enskilda finansiella instrument än på finansmarknadernas betydelse för den makroekonomiska utvecklingen.

…

En orsak till felbedömningarna var alltför stor tilltro till teoretiskt eleganta analysmodeller. Alltför liten vikt lades vid empiriska generaliseringar av tidigare ekonomisk-historiska erfarenheter av finansiella kriser som stod i strid med antaganden om rationellt beteende. Större kunskaper i doktrinhistoria hade förmodligen också hjälpt ekonomkåren till mer skepsis gentemot för tillfället dominerande synsätt.

Tyvärr följer Calmfors upp denna riktiga diagnos med ett halsbrytande omdöme om professionens insatser på eorokrisens område:

När det gäller eurokrisen förtjänar emellertid nationalekonomerna enligt min mening ett gott betyg. De obalanser som kan uppkomma därför att en gemensam penningpolitik inte passar ett enskilt land med avvikande konjunkturutveckling var väl analyserade. Det fanns även många varningar för att överhettningarna och fastighetsprisbubblorna i Irland och Spanien måste leda till krascher.

Här “glömmer” ju Calmfors bort att både han själv (efter många våndor) och lejonparten av ledande svenska nationalekonomer traskade patrull och tyckte att Sverige skulle gå med i eurosamarbetet. Det hade nog varit klädsammare om Calmfors et consortes hade framfört ett stort tack till Nils Lundgren, Sören Wibe, yours truly och andra inom professionen som var klarsynta nog att se vart detta misslyckade megaprestigeprojekt skulle leda.

Förtjänar “gott betyg”? Ska man då också räkna in alla europellejönsande ekonomkollegor? Ska man då också räkna in t ex Harry Flam – som tycker att man ska lägga munkavle på broderlandets utrikesminister när denne han fräckheten att säga det vi alla vet – att euron är på väg att kapsejsa och att varje ansvarstagande regering måste förbereda för denna eventualitet? Ska man då också räkna in Carl Bastiat Hamilton – som ju sämre det går för euron skriker desto gällare om nödvändigheten av att Sverige ska ansluta sig? Jag bara undrar.