## The arrow of time and the importance of time averages and non-ergodicity (wonkish)

31 October, 2012 at 21:39 | Posted in Economics, Statistics & Econometrics | 10 Comments

Time is what prevents everything from happening at once. To simply assume that economic processes are ergodic and concentrate on ensemble averages – and a fortiori in any relevant sense timeless – is not a sensible way for dealing with the kind of genuine uncertainty that permeates open systems such as economies.

Ergodicity and the all-important difference between time averages and ensemble averages are difficult concepts that many students of economics have problems with understanding. So let me just try to explain the meaning of these concepts by means of a couple of simple examples.

Let’s say you’re offered a gamble where on a roll of a fair die you will get €10  billion if you roll a six, and pay me €1 billion if you roll any other number.

Would you accept the gamble?

If you’re an economics students you probably would, because that’s what you’re taught to be the only thing consistent with being rational. You would arrest the arrow of time by imagining six different “parallel universes” where the independent outcomes are the numbers from one to six, and then weight them using their stochastic probability distribution. Calculating the expected value of the gamble – the ensemble average – by averaging on all these weighted outcomes you would actually be a moron if you didn’t take the gamble (the expected value of the gamble being 5/6*€0 + 1/6*€10 billion = €1.67 billion)

If you’re not an economist you would probably trust your common sense and decline the offer, knowing that a large risk of bankrupting one’s economy is not a very rosy perspective for the future. Since you can’t really arrest or reverse the arrow of time, you know that once you have lost the €1 billion, it’s all over. The large likelihood that you go bust weights heavier than the 17% chance of you becoming enormously rich. By computing the time average – imagining one real universe where the six different but dependent outcomes occur consecutively – we would soon be aware of our assets disappearing, and a fortiori that it would be irrational to accept the gamble.

[From a mathematical point of view you can  (somewhat non-rigorously) describe the difference between ensemble averages and time averages as a difference between arithmetic averages and geometric averages. Tossing a fair coin and gaining 20% on the stake (S) if winning (heads) and having to pay 20% on the stake (S) if loosing (tails), the arithmetic average of the return on the stake, assuming the outcomes of the coin-toss being independent, would be [(0.5*1.2S + 0.5*0.8S) – S)/S]  = 0%. If considering the two outcomes of the toss not being independent, the relevant time average would be a geometric average return of  squareroot[(1.2S *0.8S)]/S – 1 = -2%.]

Why is the difference between ensemble and time averages of such importance in economics? Well, basically, because when assuming the processes to be ergodic,ensemble and time averages are identical.

Assume we have a market with an asset priced at €100 . Then imagine the price first goes up by 50% and then later falls by 50%. The ensemble average for this asset would be €100 – because we here envision two parallel universes (markets) where the assetprice falls in one universe (market) with 50% to €50, and in another universe (market) it goes up with 50% to €150, giving an average of 100 € ((150+50)/2). The time average for this asset would be 75 € – because we here envision one universe (market) where the asset price first rises by 50% to €150, and then falls by 50% to €75 (0.5*150).

From the ensemble perspective nothing really, on average, happens. From the time perspective lots of things really, on average, happen. Assuming ergodicity there would have been no difference at all.

Just in case you think this is just an academic quibble without repercussion to our real lives, let me quote from an article by Ole Peters in the Santa Fe Institute Bulletin from 2009 – On Time and Risk – that makes it perfectly clear that the flaw in thinking about “rational” decisions in terms of ensemble averages has had real repercussions on the functioning of the financial system:

In an investment context, the difference between ensemble averages and time averages is often small. It becomes important, however, when risks increase, when correlation hinders diversification, when leverage pumps up fluctuations, when money is made cheap, when capital requirements are relaxed. If reward structures—such as bonuses that reward gains but don’t punish losses, and also certain commission schemes—provide incentives for excessive risk, problems arise. This is especially true if the only limits to risk-taking derive from utility functions that express risk preference, instead of the objective argument of time irreversibility. In other words, using the ensemble average without sufficiently restrictive utility functions will lead to excessive risk-taking and eventual collapse. Sound familiar?

On a more economic-theoretical level the difference between ensemble and time averages also highlights the problems concerning the neoclassical theory of expected utility that I have raised before (e. g. in Why expected utility theory is wrong).

When applied to the neoclassical theory of expected utility, one thinks in terms of “parallel universe” and asks what is the expected return of an investment, calculated as an average over the “parallel universe”? In our coin tossing example, it is as if one supposes that various “I” are tossing a coin and that the loss of many of them will be offset by the huge profits one of these “I” does. But this ensemble average does not work for an individual, for whom a time average better reflects the experience made in the “non-parallel universe” in which we live.

Time averages gives a more realistic answer, where one thinks in terms of the only universe we actually live in, and ask what is the expected return of an investment, calculated as an average over time.

Since we cannot go back in time – entropy and the arrow of time make this impossible – and the bankruptcy option is always at hand (extreme events and “black swans” are always possible) we have nothing to gain from thinking in terms of ensembles.

Actual events follow a fixed pattern of time, where events are often linked in a multiplicative process (as e. g. investment returns with “compound interest”) which is basically non-ergodic.

Instead of arbitrarily assuming that people have a certain type of utility function – as in the neoclassical theory – time average considerations show that we can obtain a less arbitrary and more accurate picture of real people’s decisions and actions by basically assuming that time is irreversible. When are assets are gone, they are gone. The fact that in a parallel universe it could conceivably have been refilled, are of little comfort to those who live in the one and only possible world that we call the real world.

Our coin toss example can be applied to more traditional economic issues. If we think of an investor, we can basically describe his situation in terms of our coin toss. What fraction of his assets should an investor – who is about to make a large number of repeated investments – bet on his feeling that he can better evaluate an investment (p = 0.6) than the market (p = 0.5)? The greater the fraction, the greater is the leverage. But also – the greater is the risk. Letting p be the probability that his investment valuation is correct and (1 – p) is the probability that the market’s valuation is correct, it means that he optimizes the rate of growth on his investments by investing a fraction of his assets that is equal to the difference in the probability that he will “win” or “lose”. This means that he at each investment opportunity (according to the so called Kelly criterion) is to invest the fraction of  0.6 – (1 – 0.6), i.e. about 20% of his assets (and the optimal average growth rate of investment can be shown to be about 2% (0.6 log (1.2) + 0.4 log (0.8))).

Time average considerations show that because we cannot go back in time, we should not take excessive risks. High leverage increases the risk of bankruptcy. This should also be a warning for the financial world, where the constant quest for greater and greater leverage – and risks – creates extensive and recurrent systemic crises. A more appropriate level of risk-taking is a necessary ingredient in a policy to come to curb excessive risk taking.

## Economists – people being paid for telling stories justifying inequality

30 October, 2012 at 20:54 | Posted in Economics | 2 Comments

If economics was an honest profession, economists would focus their efforts on documenting the waste associated with protectionist barriers for professionals. They devoted endless research studies to estimating the cost to consumers of tariffs on products like shoes and tires. It speaks to the incredible corruption of the economics profession that there are not hundreds of studies showing the loss to consumers from the barriers to trade in physicians’ services. If trade could bring down the wages of physicians in the United States just to European levels, it would save consumers close to \$100 billion a year.

But economists are not rewarded for studying the economy. That is why almost everyone in the profession missed the \$8 trillion housing bubble, the collapse of which stands to cost the country more than \$7 trillion in lost output according to the Congressional Budget Office (that comes to around \$60,000 per household).

Few if any economists lost their 6-figure paychecks for this disastrous mistake. But most economists are not paid for knowing about the economy. They are paid for telling stories that justify giving more money to rich people. Hence we can look forward to many more people telling us that all the money going to the rich was just the natural workings of the economy. When it comes to all the government rules and regulations that shifted income upward, they just don’t know what you’re talking about.

Dean Baker

In case you’re in doubt, you might better have a look at e. g. what Harvard economist and George Bush advisor Greg Mankiw writes on the rising inequality we have seen for the last 30 years in both the US and elsewhere in Western societies:

Even if the income gains are in the top 1 percent, why does that imply that the right story is not about education?

I then realized that Paul [Krugman] is making an implicit assumption–that the return to education is deterministic. If indeed a year of schooling guaranteed you precisely a 10 percent increase in earnings, then there is no way increasing education by a few years could move you from the middle class to the top 1 percent.

But it may be better to think of the return to education as stochastic. Education not only increases the average income a person will earn, but it also changes the entire distribution of possible life outcomes. It does not guarantee that a person will end up in the top 1 percent, but it increases the likelihood. I have not seen any data on this, but I am willing to bet that the top 1 percent are more educated than the average American; while their education did not ensure their economic success, it played a role.

## Why IS-LM still isn’t good enough (wonkish)

30 October, 2012 at 16:01 | Posted in Economics | Comments Off on Why IS-LM still isn’t good enough (wonkish)

Matias Vernengo has a piece today on Naked Keynesianism giving us yet another clue to why IS-LM – and its different hybrids – still isn’t up to the task of helping students to grasp the essentials of modern monetary economies:

Wendy Carlin and David Soskice have an interesting post at Voxeu.org on “How should macroeconomics be taught to undergraduates in the post-crisis era.” They explicitly follow … a New Keynesian framework. Which is an ISMP model with price rigidities …

In their view, the monetary authority can move the economy to the equilibrium rate, but the equilibrium rate is not controlled by the authorities. I would suggest that the central bank actually has control of the key variable, which is not natural at all, and as Keynes suggested is conventional, the normal rate of interest. And that could be set at a level which will not lead to full employment, particularly for distributive reasons. In my view the essential feature of a more relevant macro model would be the elimination of the natural rate, the idea that the system has a tendency to bounce back to the trend …

And by the way, the model says nothing about how income distribution affects spending.Yet, the main reason behind the crisis has been the fact that workers had to get indebted, since income has stagnated. So income distribution has to be brought back to macroeconomics. Not enough Kalecki, with their New (but still neoclassical) version of Keynesianism, that is the problem with Carlin and Soskice.

## Economic myths that destroy our society and democracy

29 October, 2012 at 17:40 | Posted in Economics, Politics & Society | 1 Comment

The Romney campaign has defended inequality or brushed it aside. To do so, it has employed a handful of economic myths. Here are a few of the most important:

(1) America is a land of opportunity. While rags-to-riches stories still grip our imagination, the fact of the matter is that the life chances of a young American are more dependent on the income and wealth of his parents than in any of the other advanced countries for which there is data. There is less upward mobility — and less downward mobility from the top — even than in Europe, and we’re not just talking about Scandinavia.

(2) Trickle-down economics works (a k a “a rising tide lifts all boats”). This idea suggests that further enriching the wealthy will make us all better off. America’s recent economic history shows the patent falsehood of this notion. The top has done very well. But median American incomes are lower than they were a decade and a half ago. Various groups — men and those without a college education — have fared even worse. Median income of a full-time male worker, for instance, is lower than it was four decades ago.

(3) The rich are the “job creators,” so giving them more money leads to more and better jobs. This is really a subset of Myth 2. But Romney’s own private sector history gives it the lie. As we all know from the discussion of Bain Capital and other equity firms, many made their money not by creating jobs in America but by “restructuring,” “downsizing” and moving jobs abroad, often using debt to bleed the companies of money needed for investment, and using the money to enrich themselves. But more generally, the rich are not the source of transformative innovations. Many, if not most of the crucial innovations in recent decades, from medicine to the Internet, have been based in large measure on government-financed research and development. The rich take their money where the returns are highest, and right now many see those high returns in emerging markets. It’s not a surprise that Romney’s trust fund invested in China, but it’s hard to see how giving the rich more money — through more latitude to escape taxation, either through low taxes in the United States or Cayman Islands hide-aways — leads to a stronger American economy.

(4) The cost of reducing inequality is so great that, as much as idealists would like to do so, we would be killing the goose that lays the golden egg. In fact, the engine of our economic growth is the middle class. Inequality weakens aggregate demand, because those at the middle and bottom have to spend all or almost all of what that they get, while those at the top don’t. The concentration of wealth in recent decades led to bubbles and instability, as the Fed tried to offset the effects of weak demand arising from our inequality by low interest rates and lax regulation. The irony is that the tax cuts for capital gains and dividends that were supposed to spur investment by the wealthy alleged job creators didn’t do so, even with record low interest rates: private sector job creation under Bush was dismal. Mainstream economic institutions like the International Monetary Fund now recognize the connection between inequality and a weak economy. To argue the contrary is a self-serving idea being promoted by the very wealthy.

(5) Markets are self-regulating and efficient, and any governmental interference with markets is a mistake. The 2008 crisis should have cured everyone of this fallacy, but anyone with a sense of history would realize that capitalism has been plagued with booms and busts since its origin. The only period in our history in which financial markets did not suffer from excesses was the period after the Great Depression, in which we put in place strong regulations that worked. It’s worth noting that we grew much faster, and more stably, in the decades after World War II than in the period after 1980, when we started stripping away the regulations. And in the former period we grew together, in contrast to the latter, when we grew apart.

As I have explained in detail elsewhere, the cost of these myths goes far beyond the damage to our economy, now and in the future. The fabric of our society and democracy is suffering.

Joseph Stiglitz

## All you ever wanted to know about Modern Monetary Theory

29 October, 2012 at 16:53 | Posted in Economics | 1 Comment

Challenging conventional (neoclassical) wisdom on modern monetary theory, economics professor L. Randall Wray in this new book presents a thought-provoking analysis of how money is created and functions. Instead of the usual mainstream economic textbook mystifications of the nature of money, we are here given a theory that shows what’s really going on in modern monetary economies.

## S = I ?

29 October, 2012 at 11:10 | Posted in Economics | 3 Comments

For those still having problems with understanding the nuts and bolts of what’s wrong with textbook versions of the savings and investment nexus, perhaps this little lecture might help:

Q: If consumers spend less and save more, does this mean investment must increase?

A: Absolutely not. Someone increasing their saving does not automatically imply that some firm will decide to buy more capital goods.

Q: But surely savings equals investment by identity in the national accounts.

A: Indeed. Total output = total income = total expenditure = Y. In the most simple model of a closed economy without government, income (Y) = consumption (C) + saving (S), but also expenditure (Y) = consumption (C) + investment (I). So S=I by definition. But here investment includes what is called ‘stockbuilding’ or ‘inventory accumulation’, which includes goods that firms wanted to sell but could not. To make this clear, lets split measured investment (I) into these two components: I=DK (buying new capital goods) +DS (stockbuilding). So if people consume less (C falls), but investment in new capital (DK) stays the same, measured investment rises because firms accumulate inventories of the goods that consumers did not buy (DS rises).

Q: But this situation cannot continue, as firms may be losing money.

A: Exactly. They will cut back on their output, incomes will fall, consumption may fall further, and savings will also fall, cutting back on the initial increase that we started with.

Q: When will this process stop?

A: When firms stop accumulating inventories i.e. when DS=0. Then, and only then, will S=DK.

Q: But how can this be? We have assumed that DK stayed the same, and we started with an increase in S?

A: You have not been paying attention. Each time firms reduce their output to match lower demand, incomes and savings fall. Eventually the initial rise in savings is reversed, because overall income has fallen.

Q: Got it. But textbooks make a big thing about aggregate savings equalling investment. If it is just an accounting identity, why is it important?

A: What the textbooks really mean is that we eventually end up with a position in which S=DK. And that is important, for the reasons we have just discussed. It is called the paradox of thrift. A desire by consumers to increase savings ends up just reducing output, and savings do not increase at all. (Of course they are still saving more of their income: S/Y has gone up, but because Y has fallen, not because S has increased.)

Q: But I thought with all this ‘just in time’ production stuff, firms did not hold many inventories any more.

A: Well we could short circuit the story by forgetting about inventories and having firms accurately forecast what demand will be, and therefore what their output should be. In practice what we call involuntary inventory accumulation can still be important when looking at quarterly movements in national output.

Q: But is it realistic to assume investment – I mean DK – stays the same if savings are initially higher? If there are more savings around, it becomes cheaper to borrow, which will encourage investment, right?

A: It might, but it might not. In particular, if output is falling, firms may be reluctant to add to their capital stock.

Q: But won’t interest rates keep falling until they do? After all, the asset market has to clear.

A: Savers have an alternative, which is to just keep their savings as money.

Q: But they will put the money in a bank, and the bank will lend it.

A: Maybe, but the bank may just decide to hold on to the cash.

Q: It seems to be really important what people do with their additional savings.

A: Perhaps. But I think the key point is that, most of the time, the person doing the saving is different from, and has different motives to, the person doing any investing. A highly complex financial system links the two. And in that system, there will be lots of opportunities for the additional savings to be parked as money.

Q: Money seems very important here. It is why the extra saving does not have to find its way into more investment.

A: I think that’s right.

Q: If people hold the extra savings as money, will that not increase money demand. What happens if the central bank keeps the money supply fixed?

A: People hold money not just as a way of saving, but also to buy and sell things. And if less is being consumed, there is less need for money on this account. It is difficult to predict what will happen to the total demand for money, which is why central banks nowadays focus on determining short term interest rates rather than the money supply.

Q: That’s not what it says in my textbook. It says the central bank fixes the money supply.

A: Yes I know. I’m afraid it’s a bit out of date. Don’t ask me why.

Q: So if the central bank determines the interest rate, why don’t they ensure the interest rate is low enough to encourage firms to buy more capital goods?

A: That is what they would like to do. There are two problems. First, it may take some time for the monetary authorities to work out what is happening, and what the right interest rate is. (I could talk about real and nominal rates here, but let’s leave that for another day.) Second, nominal interest rates cannot go below zero, and maybe we would need negative interest rates to persuade firms to raise investment enough.

Q: My textbook also says that the classical model assumes interest rates adjust so S=I, by which I assume they mean S=DK. Does that mean the classical model is wrong?

A: Only if you think it applies at all times, and that there is no other reason why output cannot fall. However if we assume that the monetary authorities eventually are able to chose the right interest rate, then the classical model is fine when thinking about economies over a long enough time horizon.

Q: This all seems like common sense. I feel a bit stupid not to have understood this before.

A: Don’t worry, you are not alone.

Simon Wren-Lewis: Savings Equals Investment?

## Neoclassical economics – visionless and trying to escape responsibility

29 October, 2012 at 09:24 | Posted in Economics | 1 Comment

Roger Backhouse and Bradley Bateman has a nice piece in New York Times on the lack of perspectives and alternatives shown by mainstream economists when dealing with the systemic crises of modern economies:

Economists do much better when they tackle small, well-defined problems. As John Maynard Keynes put it, economists should become more like dentists: modest people who look at a small part of the body but remove a lot of pain.

However, there are also downsides to approaching economics as a dentist would: above all, the loss of any vision about what the economic system should look like. Even Keynes himself was driven by a powerful vision of capitalism. He believed it was the only system that could create prosperity, but it was also inherently unstable and so in need of constant reform. This vision caught the imagination of a generation that had experienced the Great Depression and World War II and helped drive policy for nearly half a century …

In the 20th century, the main challenge to Keynes’s vision came from economists like Friedrich Hayek and Milton Friedman, who envisioned an ideal economy involving isolated individuals bargaining with one another in free markets. Government, they contended, usually messes things up. Overtaking a Keynesianism that many found inadequate to the task of tackling the stagflation of the 1970s, this vision fueled neoliberal and free-market conservative agendas of governments around the world.

THAT vision has in turn been undermined by the current crisis. It took extensive government action to prevent another Great Depression, while the enormous rewards received by bankers at the heart of the meltdown have led many to ask whether unfettered capitalism produced an equitable distribution of wealth. We clearly need a new, alternative vision of capitalism. But thanks to decades of academic training in the “dentistry” approach to economics, today’s Keynes or Friedman is nowhere to be found.

And Philip Mirowski has an equally interesting article on opendemocracy.net explaining why neoclassical economists

don’t seem to have suffered one whit for the subsequent sequence of events, a slow-motion train wreck that one might reasonably have expected would have rubbished the credibility of lesser mortals.

## Vinst – den skattefinansierade välfärdssektorns dödgrävare

29 October, 2012 at 09:07 | Posted in Politics & Society | Comments Off on Vinst – den skattefinansierade välfärdssektorns dödgrävare

Den socialdemokratiska partistyrelsen har lagt förslag om nationella kvalitetslagar för ordning och reda i välfärden. Syftet är att förbättra kvaliteten och avsevärt begränsa vinsterna.

Detta är ett viktigt beslut. Socialdemokraterna går nu till val med löfte om vinstbegränsning.

Men beslutet rymmer också problem. Mest problematiskt är att partistyrelsen inte föreslår någon formell reglering. Sverige ska förbli det enda land i Europa som saknar regler för vinstuttag i välfärden. Inte ens skolan ska fredas från vinstintressen …

Den skarpa ideologiska skiljelinjen mellan borgerlig och socialdemokratisk politik har alltid handlat om synen på marknaden. Socialdemokraterna ser att marknadens räckvidd behöver begränsas, i syfte att värna gemensamma intressen som familjebildning, hälsa, social sammanhållning och miljö. Borgerligheten har i olika grad förespråkat marknadens frihet.

Ett problem med förslaget om nationella kvalitetslagar är det saknar en konsekvent idé om vad marknaden kan – och inte kan – göra. Det sägs å ena sidan att marknaden inte klarar att lösa välfärdens kvalitetsproblem. Å andra sidan bejakas i förslaget både vinstuttag och marknad. Det saknas tydlighet i såväl analys som värderingar.

Vissa åtgärder, som öppna böcker, syftar uppenbarligen till att förbättra marknadens funktion. Med mer information kan brukare lättare välja rätt och verksamheten kan kontrolleras.

Men andra åtgärder, som möjligheten att sätta stopp för nyetableringar, syftar tvärtom till att försämra marknadens funktion. En marknad utan fritt tillträde kan ju aldrig bli en effektiv konkurrensmarknad. Vinstens disciplinerande funktion går om intet när nya konkurrenter inte får komma intill. Istället får politiker makt att dela ut exklusiva rättigheter till lokal näringsverksamhet. Vore det inte rimligt att företag som ges exklusivt tillträde till en stängd marknad också har ett tak för vinsten? …

Staten [bör] behandla alla medborgare med samma omsorg och respekt … Det är en princip som jag ställer mig bakom, men jag menar att vi idag bör ställa oss frågan om det överhuvudtaget är möjligt att följa denna princip på en välfärdsmarknad, där marknadslogiken i långa stycken har ersatt de normer som bärs av demokratin. Vad händer med medborgarskapet, när staten, som har uppdraget att behandla alla medborgare lika, delegerar skolor och sjukhus till vinstdrivande företag, som har ett intresse av att skilja ut lönsamma medborgare från olönsamma? Och vad händer med socialdemokratins allra viktigaste mål: jämlikheten, när marknadskonkurrens och valfrihet driver fram bristande likvärdighet och segregation? …

Jag vill hävda att det aktuella förslaget om vinstbegränsning i välfärden, Nationella kvalitetslagar – för ordning och reda i välfärden, tyvärr i allt väsentligt bärs av marknadsliberala idéer.

De bärande värden som lyfts i förslaget om nationella kvalitetslagar är effektiv användning av skattemedel och att alla ska ha rätt att välja.

Dessa värden kan framstå som självklart positiva, men de står inte desto mindre i tydlig konflikt med de värden som socialdemokratin historiskt har hävdat.

Vi har hävdat idén att välfärdspolitik är en produktiv investering, inte en kostnad att minimera.

Vi har hävdat att idén att jämlikhet – alla människors lika värde – är ett överordnat mål för samhällsbygget.

Vi har hävdat att frihet – och valfrihet – har en gräns. Friheten måste vara hållbar. Den måste vila på en bädd av solidaritet.

Man kan inte annat än hålla med denna eminenta ekonomihistoriker i den analys hon gör. Frågan är nu om landets socialdemokratiska gräsrötter kan leva med partiledningens kompromissförslag. Risken är tyvärr stor att  Socialdemokraterna – om man håller fast vid förslaget – förlorade nästa val redan i fredags.

## Saving doesn’t finance investment

28 October, 2012 at 17:18 | Posted in Economics | 3 Comments

An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, — it is a net diminution of such demand …

If saving consisted not merely in abstaining from present consumption but in placing simultaneously a specific order for future consumption, the effect might indeed be different. For in that case the expectation of some future yield from investment would be improved, and the resources released from preparing for present consumption could be turned over to preparing for the future consumption … In any case, however, an individual decision to save does not, in actual fact, involve the placing of any specific forward order for consumption, but merely the cancellation of a present order. Thus, since the expectation of consumption is the only raison d’être of employment, there should be nothing paradoxical in the conclusion that a diminished propensity to consume has ceteris paribus a depressing effect on employment.

The trouble arises, therefore, because the act of saving implies, not a substitution for present consumption of some specific additional consumption which requires for its preparation just as much immediate economic activity as would have been required by present consumption equal in value to the sum saved, but a desire for “wealth” as such, that is for a potentiality of consuming an unspecified article at an unspecified time. The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished.

J M Keynes General Theory

## Smart Chicago professor Steven Levitt – not so smart after all …

28 October, 2012 at 16:16 | Posted in Economics, Statistics & Econometrics | 3 Comments

In an interview not so long ago, Steven Levitt (Mr Freakonomics) answered the question how he could tell the difference between a smart person and a not-so-smart person:

Well, one good indicator of a person who’s not so smart is if they vote in a presidential election because they think their vote might actually decide which candidate wins. . . . there has never been and there never will be a vote cast in a presidential election that could possibly be decisive.

Statistics professor Andrew Gelman aptly retorted:

I have no problem if Levitt wants to argue that it doesn’t matter who wins the election—-I disagree with him, given the evidence that the positions of the Democratic and Republicans in the U.S. are farther apart on economic issues than are left and right groupings in many other countries, but Levitt can make that argument if he wants to. And I have no problem if Levitt wants to say that, for a one in a million or one in ten million chance, he doesn’t think it’s worth it to vote … But I don’t think Levitt is making sense when he writes that “there never will be a vote cast in a presidential election that could possibly be decisive.” A low probability is not a zero probability …

This confuses a lot of people, so I can understand Levitt missing the point, but it’s important. Just cos you don’t know whether a particular vote was decisive, that doesn’t mean a single vote can’t be decisive. Or, to put it another way, when he says “virtually impossible,” I’d say “1 in a million to 1 in 10 million if you live in a swing state.”

## Trickle-down economics

27 October, 2012 at 22:24 | Posted in Varia | Comments Off on Trickle-down economics

## Paul Krugman – the IS-LM-organ-grinder

27 October, 2012 at 19:06 | Posted in Economics | 3 Comments

Howard Davies has an interesting article on Project Syndicate about  the shortcomings of modern mainstream economics:

But what of the core disciplines of economics and finance themselves? Can nothing be done to make them more useful in explaining the world as it is, rather than as it is assumed to be in their stylized models?

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 … 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.

And there is disturbing evidence that news of the crisis has not yet reached some economics departments … 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!

Great critique, and you would of course expect even IS-LM-organ-grinder Paul Krugman to concur. But no – instead Krugman complains that

The truth is that basic macroeconomics, the stuff that is still taught in textbooks, has been very, very useful in this crisis. The problem is that half the profession and most policy makers turned their back on this kind of economics.

What is the magic silver bullet that Davies missed? Good old IS-LM of course!

I’m starting to get rather tired of  PK:s endless tirades about the splendour of the Hicksian invention. Why? Well, read this for a starter:

I accordingly conclude that the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate. I have deliberately interpreted the equilibrium concept, to be used in such analysis, in a very stringent manner (some would say a pedantic manner) not because I want to tell the applied economist, who uses such methods, that he is in fact committing himself to anything which must appear to him to be so ridiculous, but because I want to ask him to try to assure himself that the divergences between reality and the theoretical model, which he is using to explain it, are no more than divergences which he is entitled to overlook. I am quite prepared to believe that there are cases where he is entitled to overlook them. But the issue is one which needs to be faced in each case.

When one turns to questions of policy, looking toward the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected-if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached …

I have paid no attention, in this article, to another weakness of IS-LM analysis, of which I am fully aware; for it is a weakness which it shares with General Theory itself. It is well known that in later developments of Keynesian theory, the long-term rate of interest (which does figure, excessively, in Keynes’ own presentation and is presumably represented by the r of the diagram) has been taken down a peg from the position it appeared to occupy in Keynes. We now know that it is not enough to think of the rate of interest as the single link between the financial and industrial sectors of the economy; for that really implies that a borrower can borrow as much as he likes at the rate of interest charged, no attention being paid to the security offered. As soon as one attends to questions of security, and to the financial intermediation that arises out of them, it becomes apparent that the dichotomy between the two curves of the IS-LM diagram must not be pressed too hard.

John Hicks: “IS-LM: an explanation” Journal of Post Keynesian Economics (1980)

## Ramberg visade upp facklig vinstförespråkare i all sin torftighet

27 October, 2012 at 16:03 | Posted in Politics & Society | 1 Comment

Det här landet är tyvärr fullt av slöa, slappa, lata och loja journalister.

Men det finns undantag. Ett av dem är Tomas Ramberg.I Ekots lördagsintervju lät han aldrig Kommunals ordförande Annelie Nordström komma undan med de vanliga undanglidningsmanövrerna. Ramberg hade fått vittring och släppte aldrig bytet.

Här var annars ett gyllene tillfälle att klart och tydligt tala om att Kommunal nu vill se till att undanröja möjligheterna för vinstdrivande bolag att verka inom vård, omsorg och skola. Men så blev det inte. Nordström svajade  istället – som vanligt. Skattefinansierade vinstdrivande företag ska enligt Nordström få finnas kvar inom nämnda sektorer. I stället ska man fortsätta ställa större “krav” på företagen. Men detta har vi ju hört förr. Löst och till intet förpliktigande tal. Det hade varit bättre om fackordföranden klart och tydligt deklarerat  att vinstdrivande bolag inom vård, omsorg och skola inte hör hemma i ett svenskt välfärdssamhälle.

Det är bara att lyssna och njuta av intervjun. Naknare än så här i all sin torftighet har man sällan hört en ledande facklig förespråkare för vinstintressen i skattefinansierade välfärdsföretag.

## Econometrics with Gretl

27 October, 2012 at 12:04 | Posted in Statistics & Econometrics | 1 Comment

Thanks to Allin Cottrell and Riccardo Lucchetti we today have access to a perfect tool for doing and teaching econometrics – Gretl. And, best of all, it is totally free!

Professor Lee Adkins now has a new version (1.041) of his Gretl manual to Hill, Griffith & Lim’s Principles of Econometrics (4th ed, 2011). In this new version Adkins shows the full power of the scripting language of Gretl, called Hansl. There is also new material on Monte Carlo simulation, loop constructions etc, that certainly will please the more advanced users. But as in earlier versions, Adkins also amply shows how increadibly easy it is to operate this statistics/econometrics program.

Gretl is up to the tasks you may have, so why spend money on expensive commercial programs?

So just go ahead. I promise, with a program like Gretl and a manual like this, even econometrics can be fun!

## S vinstförslag – ytterligare ett i raden av politiska självmål

26 October, 2012 at 23:26 | Posted in Politics & Society | 2 Comments

Det är synd att partiledningen i S inte lyssnar på klokt folk inom de egna leden. För de finns. S-kvinnornas ordförande Lena Sommestad skrev t ex nyligen så här i en principiellt viktig och intressant artikel på sin blogg:

För snart två år sedan, i februari 2011, debatterade jag Stockholms skolmarknad med skolborgarrådet Lotta Edholm i Agenda … Jag hävdade att den kommersiella skolmarknaden skapade segregation och sämre skolresultat.

Min fråga till Lotta Edholm den gånger var: Marknad i skolan till vilket pris?

I dagens DN presenteras nu de förödande resultaten av Lotta Edholms skolpolitik. “Skillnaderna mellan skolorna växer – och sämst går det för skolor i fattiga områden” (DN Stockholm, papperstidningen). Lotta Edholm ställs till svars, med rätta.

Verkligheten talar nu ett tydligt språk. Den kommersialiserade skolan sviker de elever, som allra bäst behöver skolan.

Jag menar att det är hög tid att ta strid för de värden, som vi vill ska bära svensk skola. För ett par veckor sedan ställde sig Uppsala Arbetarekommun bakom en motion till Socialdemokraternas partikongress, med kravet på att vinst inte längre ska accepteras som det övergripande målet för skolverksamhet. Det centrala argumentet för detta är skolans centrala roll i ett samhälle präglat av demokrati, jämlikhet och tankens frihet …

Idag skiktas samhället inte bara efter klasslinjer, utan också efter etnicitet. Forskning har visat hur den kommersiella skolmarknaden resulterar i ökad segregation efter etniska linjer …

Det är viktigt att Socialdemokraterna nu gör klart vilka värden som vi vill ska bära vårt samhälle. Skolpolitiken formar framtiden. Om vi vill ha en stark demokrati och jämlika livschanser, så måste vinstintressena bort från skolan.

## Why central banks don’t control the money supply

26 October, 2012 at 16:47 | Posted in Economics | Comments Off on Why central banks don’t control the money supply

## So what

26 October, 2012 at 11:05 | Posted in Varia | Comments Off on So what

## Lärare och kunskap – obligatorisk läsning för skolpolitiker

26 October, 2012 at 10:55 | Posted in Education & School | 1 Comment

Vetenskapsjournalisten David Warshs bok Kunskap och nationers välstånd – som handlar om den amerikanske ekonomen Paul Romers uppmärksammade och revolutionerande teori om sambandet mellan kunskap och tillväxt – borde vara obligatorisk läsning för landets alla skolpolitiker.

I Sverige har levnadsstandarden mätt som per capitainkomst ökat med en faktor på över 50 sedan mitten av 1800-talet. Överlag är människor i västvärlden idag mer tjugo gånger rikare än vad de var för ett och ett halvt sekel sedan. Dess befolkning har en förväntad livstid som är nästan dubbelt så hög som förfädernas. Vad har skapat denna ökning i välfärd och levnadsstandard?

Och samtidigt: varför skiljer sig idag per capitainkomst och tillväxttakt i olika länder åt mer än någonsin? Varför har skillnaden mellan rika och fattiga länder ökat? Hur kan det komma sig att världens rikaste länder i början av det tjugoförsta århundradet har en per capitainkomst som är mer än trettio gånger större än den i de fattigaste länderna?

”En verkligt god förklaring är praktiskt taget sömlös” skrev Adam Smith 1776 i Wealth of Nations. Finns det en sådan förklaring för samhällsvetenskapernas och mänsklighetens kanske viktigaste problemfält – den ekonomiska tillväxten?

Paul Romers artikel ”Endogenous Technological Change” (1990) – där kunskap görs till tillväxtens viktigaste drivkraft – är nog det närmsta vi för närvarande kan komma.

Romer gör en betydelsefull åtskillnad mellan vanliga objekt (bilar, kylskåp, datorer) och kunskaper (formler, matrecept, patent). Kunskaper är för Romer ett slags instruktioner eller recept som talar om hur vi kan använda våra resurser för att producera nyttigheter. Med bättre kunskaper kan tillväxten öka även om de materiella resurserna är begränsade. Kunskaper är icke-rivaliserande så till vida att en persons nyttjande av kunskap inte minskar andras möjlighet till brukande av samma kunskap. Till skillnad från människor (med sina speciella färdigheter och utbildning) och ting (aktier, maskiner, naturtillgångar) styrs kunskap av stigande avkastning. Ett föremål (en portion mat) kan bara konsumeras av en enskild person vid ett tillfälle, medan kunskap (matreceptet) kan användas av hur många som helst när som helst.

Romer har övertygande visat på kunskapsproduktionens betydelse för skapandet av nationernas välfärd. Och om idéer och kunskaper spelar en så avgörande roll för långsiktig tillväxt och välfärd borde betydligt mer av debatten – istället för räntor och skattesatser – handla om utbildningsstrategier, forskningssatsningar och lärarlöner. Att kunna hantera spänningen mellan att skapa kunskapsbefrämjande institutioner och samtidig se till att så många som möjligt får nytta av kunskapen är en av politikens främsta uppgifter.

Kunskap är makt. Detta gäller också inom ekonomi. Bill Gates och Ingvar Kamprad är levande bevis på att kunskap om något som andra inte har kunskap om kan göra en rik. Och kanske än viktigare: kunskap är det som ligger till grund för våra möjligheter att skapa långsiktig välfärd.

Ödets vagn löper förvisso inte på skenor. Men kunskap är likväl, som Romer visar, det lokomotiv som driver den ekonomiska tillväxten och människors välfärd framåt.

## Poverty? Is that something you can eat?

25 October, 2012 at 20:28 | Posted in Economics, Politics & Society | 3 Comments

RICHARD EPSTEIN: What’s good about inequality is if, in fact, it turns out that inequality creates an incentive for people to produce and to create wealth, it’s a wonderful force for innovation.

PAUL SOLMAN: Aren’t many of the top 1 percent or 0.1 percent in this country rich because they’re in finance?

RICHARD EPSTEIN: Yes. Many of the very richest people in the United States are rich because they are in finance.

And one of the things you have to ask is, why is anyone prepared to pay them huge sums of money if in fact they perform nothing of social value? And the answer is that when you try to knock out the financiers, what you do is you destroy the liquidity of capital markets. And when you destroy the liquidity of those markets, you make it impossible for businesses to invest, you make it impossible for people to buy home mortgages and so forth, and all sorts of other breakdowns.

So they should be rich. It doesn’t bother me.

PAUL SOLMAN: Are you worried that a small number of people controlling a disproportionate share of the wealth can control a democratic system?

RICHARD EPSTEIN: Oh, my God no.

PBS-interview with libertarian professor of law Richard Epstein

## When the economy is like a pack of wild horses

25 October, 2012 at 18:54 | Posted in Economics | 2 Comments

Andrew Haldane is England’s Executive Director for Financial Stability. Olaf Storbeck recently inteviewed him about the crisis of contemporary economics and the way forward.

I am just trying to make sense of the real world. The workhorse model we used in economics is no longer working properly. Hence we are compelled to think innovatively, to seek insights from disciplines beyond our own. We are looking for systems behaviour that matches what we can see happening in the real world. In some ways we are just borrowing ideas from other disciplines.

What are the issues of contemporary macroeconomics?

With the benefit of hindsight, we built an edifice, a set of models, that were quite peculiar in the assumptions they made . For example, we drifted away from the notion of having a multiplicity of equilibria. We also forgot that we could even get stuck in the wrong equilibrium, which is one way of making sense of where we are today. We drifted away from the notion that systems could become dynamically unstable when stretched or stressed too much. It is hard to think of a system outside of economics, whether from the natural world or from social sciences, that doesn’t have a multiplicity of equilibria and doesn’t behave peculiarly when stretched or stressed and can which be destabilising. However, in modern macro, the notion of equilibrium was a singular stationary, stabilising concept.

Can you give a concrete example, please?

Back in the 20s, when macro was beginning to find its feet, Knut Wicksell used the metaphor, when explaining economic systems, of the rocking horse. Imagine you are hitting a rocking horse with a stick: The horse moves according to a pretty regular pattern. That metaphor is a fairly accurate summary of how we approached economic modelling theoretically and empirically for a century.

If the economy doesn’t resemble a rocking horse, what’s a more appropriate description?

Instead of beating a rocking horse, imagine hitting a pack of wild horses with a stick. What happens next? Well, the truth is: you don’t know. One possibility is nothing happens at all. Maybe the horse you beat runs off in one direction. Most likely, however, the horse runs off scared and panics all the other horses who then also charge off in a direction that is impossible to predict ex ante.

25 October, 2012 at 10:30 | Posted in Education & School | Comments Off on Evidensbaserad skola

Yours truly har idag en artikel – Den evidensbaserade skolan – en chimär – i nättidningen Skola och samhälle. Läs den!

## Reaganomics

24 October, 2012 at 09:52 | Posted in Varia | 5 Comments

## Ben Bernanke and MMT

23 October, 2012 at 20:08 | Posted in Economics | 5 Comments

In this interesting video Federal Reserve Chairman Bernanke basically says that idle balances don’t chase goods and services and that a fortiori we don’t have to be overly afraid that quantitative easing will spill over into inflation. And – which actually is the most interesting part of the speech – he also confirms the Modern Monetary Theory view that the financing of these operations is made possible by simply crediting a bank account and thereby – by a single keystroke – actually creating money.

One of the most important reasons why we’re still stuck in depression-like economic quagmires is that people in general – including most mainstream economists – simply don’t understand the workings of modern monetary systems. The result is totally and utterly wrong-headed austerity policies, emanating out of a groundless fear of creating inflation via central banks printing money, in a situation where we rather should fear deflation and inadequate effective demand.

## Leverage cycles (wonkish)

23 October, 2012 at 17:22 | Posted in Economics | Comments Off on Leverage cycles (wonkish)

John Geanakoplos has a great lecture at Yale University on why central banks should pay much more attention to leverage cycles.He is forcefully arguing that one of the missing ingredients in the macro models used by central banks today are endogenous default and endogenous lending terms distinct from the interest rate. Focussing to much on interest rates have made them unable to recognise that changes in the perception of potential defaults can have serious repercussions on economic activities. It has also made central banks unable to detect the financial bubbles and to a faulty understanding of the nature of debt and leverage. In short – central banks have to a large degree based their policies on the wrong models.

## Fiscal multipliers and economic history

23 October, 2012 at 15:10 | Posted in Economics | Comments Off on Fiscal multipliers and economic history

The IMF grabbed headlines and upset officials earlier this month when it released an analysis which concluded that, starting in 2009, the fiscal policy multiplier has actually been considerably larger than previously supposed (IMF 2012). The Fund’s new estimates, which range from 0.9 to 1.7, suggest that Europe’s policies of austerity are in fact directly responsible for the fact that the continent’s recessions have been even deeper than initially forecast.

We are shocked – shocked – to find that there’s multiplication going on in here.

Actually, not so shocked. This is of course just what standard theory would suggest: that the fiscal multiplier will be unusually large when there is little monetary response to the fiscal impulse, whether because interest rates are at the zero lower bound or for other reasons. One might object that the ECB has, in fact, reacted to the Eurozone slowdown by easing. To this we would respond: not so much. What matters in this context are not targeted interventions like last year’s Long-Term Refinancing Operations or this (or next?) year’s Outright Monetary Transactions, which are designed to enhance the operation of particular markets and help specific sovereigns. What matters for the multiplier are economy-wide measures like interest rate cuts and quantitative easing. To date, the latter has been non-existent, while the former have been underwhelming.

In the classic movie Casablanca, Captain Renault expressed shock when publicly describing an uncomfortable fact of which he was privately aware. We suspect that European officials, while also expressing shock and outrage over the IMF’s uncomfortable finding, were similarly aware of what was going on ‘in here’ well before the Fund brought it to the world’s attention. The question now is whether, having been forced to go public, they are finally prepared to translate that awareness into action.

Barry Eichengreen & Kevin O’Rourke

## One of my favourite blogs

23 October, 2012 at 10:55 | Posted in Economics | Comments Off on One of my favourite blogs

One of my favourite blogs is Naked Keynesianism.

One example of the interesting articles regularly published there is a piece – posted yesterday – by Matias Vernengo on  purchasing power parity:

In a previous post I suggested that there might some problems with using Purchasing Power Parity (PPP) measures of income per capita …

PPP was developed by Gustav Cassel as an extension of the Quantity Theory of Money (QTM) to international matters. The quantity of money determined domestically the internal price level, and the exchange rate was determined as the ratio of domestic and foreign prices (or vice versa depending on how you define the exchange ratio), or in dynamic versions, the change in the exchange rate was defined as the difference of the inflation rates.

Wicksell was very critical of Cassel’s theory, as I note in my paper … He basically suggested that the rate of interest, the natural rate determined by the productivity of capital and the savings decisions of economic agents, was the key variable, not the money supply. Hence, the bank rate, if it was lower than the natural rate, would not only generate his famous cumulative process of inflation, but it would also lead to flows of capital, provided that it was not in line with the bank rate of interest in other countries, and would basically determined the foreign exchange rate [note that Wicksell, and not the Keynes of the Tract, as is often argued, is the first, in 1919, to defend what we would today refer to as the uncovered interest parity condition].

From our perspective what matters here is that, even within the marginalist approach, the notion that the Quantity of Money, and prices, determine the equilibrium exchange rate is ultimately incorrect, once money is endogenous, as Wicksell assumed [note that the modern consensus in macroeconomics, both the New Keynesians and the so-called New Neoclassical Synthesis, assume an exogenous rate of interest, using some sort of rule, typically a variation of Taylor’s rule]. Further, if we assume free capital movement, which implies a uniform rate of profit, marginalism would require that capital would flow to places in which it is scarce, and eventually (in the long run) the rate of profit or the natural rate of interest would be equalized. Hence, the exchange rate that would be establish after the process is complete, would correspond to the uniform natural rate, which governs the bank rate, which as we saw is what Wicksell suggested determines exchange rate. So there must exist a natural exchange rate that corresponds to the natural rate of interest …

It is obvious that there are ‘imperfections’ and the natural rate of interest is not equalized in the real world, so the exchange rate also deviate from the natural rate. But that isn’t the main problem with the mainstream view. As we saw, the capital debates undermine the theoretical basis for a natural rate of interest, and hence for a natural exchange rate (or a natural rate of unemployment for that matter). Hence, it is the Keynesian (and Sraffian) institutional rate of interest, as determined by monetary authorities that rules the roost.

## How neoclassical economics contributed to causing today’s crisis

22 October, 2012 at 19:01 | Posted in Economics | 1 Comment

Oxford professor John Kay has a very interesting article on why economists have tended to go astray in their – as my old mentor Erik Dahmén used to say – tool sheds. The article is essential reading for all those who want to understand why mainstream – neoclassical – economists actively have contributed to causing todays’s economic crisis rather than to solving it.

Perhaps this becomes less perplexing to grasp when considering what one of its main proponents today – Robert Lucas – maintained already in 1983:

My thesis in this lecture is that macroeconomics in this original sense has succeeded: its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.

And this comes from an economist who has built his whole career on the assumption that people are hyper rational “robot imitations” with rational expectations and next to perfect ability to process information. Mirabile dictu!

## Andreas Cervenka – lysande!

21 October, 2012 at 20:04 | Posted in Economics | 2 Comments

Nyligen skrev Andrew Haldane på den brittiska centralbanken Bank of England
en artikel med rubriken: Vad har ekonomerna någonsin gjort för oss? Han konstaterar
att stora delar av ekonomkåren någongång på 1990-talet tycks ha smittats av ett

Som alla farliga virus har även detta ett krångligt namn: DSGE, på svenska dynamisk
stokastisk allmän jämviktsmodell.

För att göra en lång historia kort innebar det alltmer frekventa användandet av dessa
av matematiska samband. Ungefär som ensambarn som hellre stannar kvar i pojkrummet och bygger låtsasvärldar i
mekano än går på tonårsdisco.

Det finns en uppenbar risk att missa den så kallade helhetsbilden.

Enligt Andrew Haldane valde ekonomerna att i sina modeller mer eller mindre
strunta i företeelser som banker, finansmarknader och pengar. Som av en händelse
följdes detta av den största skuldexplosionen i mänsklighetens historia.

Vad har då denna yrkeskår lärt av krisen? På sina håll inte så mycket, tycks det. En
annan ekonomipristagare, Robert Lucas, har försvarat sig med att finanskrisen inte
kunde förutses eftersom ekonomisk teori förutser att sådana händelser inte kan förutses.
Slutet gott, allting gott.

För att skapa verklig förändring krävs det kanske att någon rullar in en liten symbolisk
handgranat i de akademiska äggtoddycirklarna. Här har kommittén som ska utse nästa års ekonomipristagare en
unik möjlighet. Vad skulle kunna skicka starkare signaler än att annonsera vinnaren
i form av ett annorlunda pressmeddelande: ett tomt vitt papper.

Andreas Cervenka, SvD 21/10 2012

## Latvia – the ultimate Keynes Killer?

21 October, 2012 at 17:11 | Posted in Economics, Politics & Society | 2 Comments

Some people seem to consider the case of Latvia the ultimate Keynes Killer, showing austerity policies suffice to get you out deep recessions and not having to fall back on Keynesian stimulus.

Hmm …

What are the facts? Latvia today has a real GDP that still is 15% below its pre-crisis peak. Its unemployment rate is 16%. Indeed an impressive success …

## Keynes vs. Bayes on information and uncertainty (wonkish)

20 October, 2012 at 19:17 | Posted in Economics, Theory of Science & Methodology | Comments Off on Keynes vs. Bayes on information and uncertainty (wonkish)

Neoclassical economics nowadays usually assumes that agents that have to make choices under conditions of uncertainty behave according to Bayesian rules (preferably the ones axiomatized by Ramsey (1931), de Finetti (1937) or Savage (1954)) – that is, they maximize expected utility with respect to some subjective probability measure that is continually updated according to Bayes theorem. If not, they are supposed to be irrational, and ultimately – via some “Dutch book” or “money pump” argument – susceptible to being ruined by some clever “bookie”.

Bayesianism reduces questions of rationality to questions of internal consistency (coherence) of beliefs, but – even granted this questionable reductionism – do rational agents really have to be Bayesian? As I have been arguing elsewhere (e. g. here and here) there is no strong warrant for believing so, but in this post I want to make a point on the informational requirement that the economic ilk of Bayesianism presupposes.

In many of the situations that are relevant to economics one could argue that there is simply not enough of adequate and relevant information to ground beliefs of a probabilistic kind, and that in those situations it is not really possible, in any relevant way, to represent an individual’s beliefs in a single probability measure.

Say you have come to learn (based on own experience and tons of data) that the probability of you becoming unemployed in Sweden is 10%. Having moved to another country (where you have no own experience and no data) you have no information on unemployment and a fortiori nothing to help you construct any probability estimate on. A Bayesian would, however, argue that you would have to assign probabilities to the mutually exclusive alternative outcomes and that these have to add up to 1, if you are rational. That is, in this case – and based on symmetry – a rational individual would have to assign probability 10% to becoming unemployed and 90% of becoming employed.

That feels intuitively wrong though, and I guess most people would agree. Bayesianism cannot distinguish between symmetry-based probabilities from information and symmetry-based probabilities from an absence of information. In these kinds of situations most of us would rather say that it is simply irrational to be a Bayesian and better instead to admit that we “simply do not know” or that we feel ambiguous and undecided. Arbitrary an ungrounded probability claims are more irrational than being undecided in face of genuine uncertainty, so if there is not sufficient information to ground a probability distribution it is better to acknowledge that simpliciter, rather than pretending to possess a certitude that we simply do not possess.

I think this critique of Bayesianism is in accordance with the views of John Maynard Keynes’ A Treatise on Probability (1921) and General Theory (1937). According to Keynes we live in a world permeated by unmeasurable uncertainty – not quantifiable stochastic risk – which often forces us to make decisions based on anything but rational expectations. Sometimes we “simply do not know.” Keynes would not have accepted the view of Bayesian economists, according to whom expectations “tend to be distributed, for the same information set, about the prediction of the theory.” Keynes, rather, thinks that we base our expectations on the confidence or “weight” we put on different events and alternatives. To Keynes expectations are a question of weighing probabilities by “degrees of belief”, beliefs that have preciously little to do with the kind of stochastic probabilistic calculations made by the rational agents modeled by Bayesian economists.

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