LARS P. SYLL

Economics — nothing but an ideological paranoia

 

Economists have a tendency to get enthralled by their theories and models ​and forget that behind the figures and abstractions there is a real world with real people. Real people that have to pay dearly for fundamentally flawed doctrines and recommendations.

Let’s make sure the consequences will rest on the conscience of those economists.

Damon Runyon’s Law

The eminently quotable Robert Solow says it all:

To get right down to it, I suspect that the attempt to construct economics as an axiomatically based hard science is doomed to fail. There are many partially overlapping reasons for believing this …

A modern economy is a very complicated system. Since we cannot conduct controlled on its smaller parts, or even observe them in isolation, the classical hard- science devices for discriminating between competing hypotheses are closed to us. The main alternative device is the statistical analysis of historical time-series. But then another difficulty arises. The competing hypotheses are themselves complex and subtle. We know before we start that all of them, or at least many of them, are capable of fitting the data in a gross sort of way. Then, in order to make more refined distinctions, we need long time-series observed under stationary conditions.

Unfortunately, however, economics is a social science. It is subject to Damon Runyon’s Law that nothing between human beings is more than three to one. To express the point more formally, much of what we observe cannot be treated as the realization of a stationary stochastic process without straining credulity. Moreover, all narrowly economic activity is embedded in a web of social institutions, customs, beliefs, and attitudes. Concrete outcomes are indubitably affected by these background factors, some of which change slowly and gradually, others erratically. As soon as time-series get long enough to offer hope of discriminating among complex hypotheses, the likelihood that they remain stationary dwindles away, and the noise level gets correspondingly high. Under these circumstances, a little cleverness and persistence can get you almost any result you want. I think that is why so few econometricians have ever been forced by the facts to abandon a firmly held belief …

Robert Solow

Does competition really eliminate bad bosses?

But what of the argument that competition eventually eliminates bad bosses? True, it does sometimes; the relatively egalitarian John Lewis Partnership has done better than department stores such as House of Fraser or Debenhams, for example. But market forces are weak (and perhaps getting weaker).

One reason for this is simply state intervention; without this, almost all shareholder-owned banks with their high-paid CEOs would have vanished.

Another reason is that there isn’t really a properly-functioning market for CEOs. I own tens of thousands of pounds of shares, but I’ve never been asked to vote on a CEO’s pay. Instead, the vote is exercised by fund managers many of whom are more bothered by the relative performance of their funds than absolute performance. We have widespread agency failures in which mates pay each other. And as Milton Friedman said:

“If I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get.”

Unsurprisingly, then, there is little clear link between CEO pay and corporate performance. It might be that high pay is better explained by rent-seeking than as a reward for maximizing shareholder value – though as it’s almost impossible to know in most cases what constitutes maximal value, we might never know for sure.

In fact, my analogy with feudal lords is too generous to CEOs. Whereas (arguendo) a bad lord would pay for his incompetence perhaps with his life, bad CEOs walk away with fat pay cheques.

When so-called free marketeers try to defend bosses’ pay, they do the cause of free markets a huge dis-service by encouraging people to equate free markets with what is in effect a rigged system whereby bosses enrich themselves with no obvious benefit to the rest of us.

Chris Dillow

Revealed preference theory — much fuss about ‘not very much’

We must learn WHY the argument for revealed preference, which deceived Samuelson, is wrong. As per standard positivist ideas, preferences are internal to the heart and unobservable; hence they cannot be used in scientific theories. So Samuelson came up with the idea of using the observable Choices – unobservable preferences are revealed by observable choices … Yet the basic argument is wrong; one cannot eliminate the unobservable preference from economic theories. Understanding this error, which Samuelson failed to do, is the first knot to unravel, in order to clear our minds and hearts of the logical positivist illusions.

Asad Zaman

This blog post made me come to think about an article on revealed preference theory that yours truly wrote twenty-five years ago and got published in History of Political Economy (no. 25, 1993).

Paul Samuelson wrote a kind letter and informed me that he was the one who had recommended it for publication. But although he liked a lot in it, he also wrote a comment — published in the same volume of HOPE — saying:

Between 1938 and 1947, and since then as Pålsson Syll points out, I have been scrupulously careful not to claim for revealed preference theory novelties and advantages it does not merit. But Pålsson Syll’s readers must not believe that it was all redundant fuss about not very much.

Notwithstanding Samuelson’s comment, I do still think it basically was much fuss about ‘not very much.’

In 1938 Paul Samuelson offered a replacement for the then accepted theory of utility. The cardinal utility theory was discarded with the following words: “The discrediting of utility as a psychological concept robbed it of its possible virtue as an explanation of human behaviour in other than a circular sense, revealing its emptiness as even a construction” (1938, 61). According to Samuelson, the ordinalist revision of utility theory was, however, not drastic enough. The introduction of the concept of a marginal rate of substitution was considered “an artificial convention in the explanation of price behaviour” (1938, 62). One ought to analyze the consumer’s behaviour without having recourse to the concept of utility at all, since this did not correspond to directly observable phenomena. The old theory was criticized mainly from a methodological point of view, in that it used non-observable concepts and propositions.

The new theory should avoid this and thereby shed “the last vestiges of utility analysis” (1938, 62). Its main feature was a consistency postulate which said: “if an individual selects batch one over batch two, he does not at the same time select two over one” (1938, 65). From this “perfectly clear” postulate and the assumptions of given demand functions and that all income is spent, Samuelson in (1938) and (1938a), could derive all the main results of ordinal utility theory (single-valuedness and homogeneity of degree zero of demand functions, and negative semi-definiteness of the substitution matrix).

In 1948 Samuelson no longer considered his “revealed preference” approach a new theory. It was then seen as a means of revealing consistent preferences and enhancing the acceptability of the ordinary ordinal utility theory by showing how one could construct an individual’s indifference map by purely observing his market behaviour. Samuelson concluded his article by saying that “[t]he whole theory of consumer’s behavior can thus be based upon operationally meaningful foundations in terms of revealed preference” (1948, 251). As has been shown lately, this is true only if we inter alia assume the consumer to be rational and to have unchanging preferences that are complete, asymmetrical, non-satiated, strictly convex, and transitive (or continuous). The theory, originally intended as a substitute for the utility theory, has, as Houthakker clearly notes, “tended to become complementary to the latter” (1950, 159).

Only a couple of years later, Samuelson held the view that he was in a position “to complete the programme begun a dozen years ago of arriving at the full empirical implications for demand behaviour of the most general ordinal utility analysis” (1950, 369). The introduction of Houthakker’s amendment assured integrability, and by that, the theory had according to Samuelson been “brought to a close” (1950, 355). Starting “from a few logical axioms of demand consistency … [one] could derive the whole of the valid utility analysis as corollaries” (1950, 370). Since Samuelson had shown the “complete logical equivalence” of revealed preference theory with the regular “ordinal preference approach,” it follows that “in principle there is nothing to choose between the formulations” (1953, 1). According to Houthakker (1961, 709), the aim of the revealed preference approach is “to formulate equivalent systems of axioms on preferences and on demand functions.”

But if this is all, what has revealed preference theory then achieved? As it turns out, ordinal utility theory and revealed preference theory are – as Wong puts it – “not two different theories; at best, they are two different ways of expressing the same set of ideas” (2006, 118). And with regard to the theoretically solvable problem, we may still concur with Hicks that “there is in practice no direct test of the preference hypothesis” (1956, 58).

Sippel’s experiments showed “a considerable number of violations of the revealed preference axioms” (1997, 1442) and that from a descriptive point of view – as a theory of consumer behaviour – the revealed preference theory was of a very limited value.

Today it seems as though the proponents of revealed preference theory have given up the original 1938-attempt at building a theory on nothing else but observable facts, and settled instead on the 1950-version of establishing “logical equivalences.”

Mas-Collel et al. concludes their presentation of the theory by noting that “for the special case in which choice is defined for all subsets of X [the set of alternatives], a theory based on choice satisfying the weak axiom is completely equivalent to a theory of decision making based on rational preferences” (1995, 14).

When talking of determining people’s preferences through observation, Varian, for example, has “to assume that the preferences will remain unchanged” and adopts “the convention that … the underlying preferences … are known to be strictly convex.” He further postulates that the “consumer is an optimizing consumer.” If we are “willing to add more assumptions about consumer preferences, we get more precise estimates about the shape of indifference curves” (2006, 119-123, author’s italics). Given these assumptions, and that the observed choices satisfy the consistency postulate as amended by Houthakker, one can always construct preferences that “could have generated the observed choices.” This does not, however, prove that the constructed preferences really generated the observed choices, “we can only show that observed behavior is not inconsistent with the statement. We can’t prove that the economic model is correct.”

Kreps holds a similar view, pointing to the fact that revealed preference theory is “consistent with the standard preference-based theory of consumer behavior” (1990, 30).

The theory of consumer behavior has been developed in great part as an attempt to justify the idea of a downward-sloping demand curve. What forerunners like e.g. Cournot (1838) and Cassel (1899) did was merely to assert this law of demand. The utility theorists tried to deduce it from axioms and postulates on individuals’ economic behaviour. Revealed preference theory tried to build a new theory and to put it in operational terms, but ended up with just giving a theory logically equivalent to the old one. As such it also shares its shortcomings of being empirically unfalsifiable and of being based on unrestricted universal statements.

As Kornai (1971, 133) remarked, “the theory is empty, tautological. The theory reduces to the statement that in period t the decision-maker chooses what he prefers … The task is to explain why he chose precisely this alternative rather than another one.” Further, pondering Amartya Sen’s verdict of the revealed preference theory as essentially underestimating “the fact that man is a social animal and his choices are not rigidly bound to his own preferences only” (1982, 66) and Georgescu-Roegen’s (1966, 192-3) apt description, a harsh assessment of what the theory accomplished should come as no surprise:

Lack of precise definition should not … disturb us in moral sciences, but improper concepts constructed by attributing to man faculties which he actually does not possess, should. And utility is such an improper concept … [P]erhaps, because of this impasse … some economists consider the approach offered by the theory of choice as a great progress … This is simply an illusion, because even though the postulates of the theory of choice do not use the terms ‘utility’ or ‘satisfaction’, their discussion and acceptance require that they should be translated into the other vocabulary … A good illustration of the above point is offered by the ingenious theory of the consumer constructed by Samuelson.

Nothing lost, nothing gained.

References
Cassel, Gustav 1899. ”Grundriss einer elementaren Preislehre.” Zeitschrift für die gesamte Staatswissenschaft 55.3:395-458.

Cournot, Augustin 1838. Recherches sur les principes mathématiques de la théorie des richesses. Paris. Translated by N. T. Bacon 1897 as Researches into the Mathematical Principles of the Theory of Wealth. New York: The Macmillan Company.

Georgescu-Roegen, Nicholas 1966. “Choice, Expectations, and Measurability.” In Analytical Economics: Issues and Problems. Cambridge, Massachusetts: Harvard University Press.

Hicks, John 1956. A Revision of Demand Theory. Oxford: Clarendon Press.

Houthakker, Hendrik 1950. “Revealed Preference and the Utility Function.” Economica 17 (May):159-74.
–1961. “The Present State of Consumption Theory.” Econometrica 29 (October):704-40.

Kornai, Janos 1971. Anti-equilibrium. London: North-Holland.

Kreps, David 1990. A Course in Microeconomic Theory. New York: Harvester Wheatsheaf.

Mas-Collel, Andreu et al. 1995. Microeconomic Theory. New York: Oxford University Press.

Samuelson, Paul 1938. “A Note on the Pure Theory of Consumer’s Behaviour.” Economica 5 (February):61-71.
–1938a. “A Note on the Pure Theory of Consumer’s Behaviour: An Addendum.” Economica 5 (August):353-4.
–1947. Foundations of Economic Analysis. Cambridge, Massachusetts: Harvard University Press.
–1948. “Consumption Theory in Terms of Revealed Preference.” Economica 15 (November):243-53.
–1950. “The Problem of Integrability in Utility Theory.” Economica 17 (November):355-85.
–1953. “Consumption Theorems in Terms of Overcompensation rather than Indifference Comparisons.” Economica 20 (February):1-9.

Sen, Amartya (1982). Choice, Welfare and Measurement. London: Basil Blackwell.

Sippel, Reinhard 1997. “An experiment on the pure theory of consumer’s behaviour.” Economic Journal 107:1431-44.

Varian, Hal 2006. Intermediate Microeconomics: A Modern Approach. (7th ed.) New York: W. W. Norton & Company.

Wong, Stanley 2006. The Foundations of Paul Samuelson’s Revealed Preference Theory. (Revised ed.) London: Routledge & Kegan Paul.

On the limits of game theory

 

Back in 1991, when yours truly earned his first PhD​ with a dissertation on decision making and rationality in social choice theory and game theory, I concluded that “repeatedly it seems as though mathematical tractability and elegance — rather than realism and relevance — have been the most applied guidelines for the behavioural assumptions being made. On a political and social level, ​it is doubtful if the methodological individualism, ahistoricity and formalism they are advocating are especially valid.”

This, of course, was like swearing in church. My mainstream neoclassical colleagues were — to say the least — not exactly überjoyed.

For those of you who are not familiar with game theory, but eager to learn something relevant about it, I have three suggestions:

Start with the best introduction there is

and then go on to read more on the objections that can be raised against game theory and its underlying assumptions on e.g. rationality, “backward induction” and “common knowledge” in

and then finish off with listening to what one of the world’s most renowned game theorists — Ariel Rubinstein — has to say on the — rather limited — applicability of game theory in this interview (emphasis added):

What are the applications of game theory for real life?

That’s a central question: Is game theory useful in a concrete sense or not? Game theory is an area of economics that has enjoyed fantastic public relations. [John] Von Neumann [one of the founders of game theory] was not only a genius in mathematics, he was also a genius in public relations. The choice of the name “theory of games” was brilliant as a marketing device.
The word “game” has friendly, enjoyable associations. It gives a good feeling to people. It reminds us of our childhood, of chess and checkers, of children’s games. The associations are very light, not heavy, even though you may be trying to deal with issues like nuclear deterrence. I think it’s a very tempting idea for people, that they can take something simple and apply it to situations that are very complicated, like the economic crisis or nuclear deterrence. But this is an illusion. Now my views, I have to say, are extreme compared to many of my colleagues. I believe that game theory is very interesting. I’ve spent a lot of my life thinking about it, but I don’t respect the claims that it has direct applications.

The analogy I sometimes give is from logic. Logic is a very interesting field in philosophy, or in mathematics. But I don’t think anybody has the illusion that logic helps people to be better performers in life. A good judge does not need to know logic. It may turn out to be useful – logic was useful in the development of the computer sciences, for example – but it’s not directly practical in the sense of helping you figure out how best to behave tomorrow, say in a debate with friends, or when analysing data that you get as a judge or a citizen or as a scientist.

…

In game theory, what we’re doing is saying, “Let’s try to abstract our thinking about strategic situations.” Game theorists are very good at abstracting some very complicated situations and putting some elements of the situations into a formal model. In general, my view about formal models is that a model is a fable. Game theory is about a collection of fables. Are fables useful or not? In some sense, you can say that they are useful, because good fables can give you some new insight into the world and allow you to think about a situation differently. But fables are not useful in the sense of giving you advice about what to do tomorrow, or how to reach an agreement between the West and Iran. The same is true about game theory.

…

In general, I would say there were too many claims made by game theoreticians about its relevance. Every book of game theory starts with “Game theory is very relevant to everything that you can imagine, and probably many things that you can’t imagine.” In my opinion that’s just a marketing device.

Why do it then?

… What I’m opposing is the approach that says, in a practical situation, “OK, there are some very clever game theoreticians in the world, let’s ask them what to do.” I have not seen, in all my life, a single example where a game theorist could give advice, based on the theory, which was more useful than that of the layman.

…

Looking at the flipside, was there ever a situation in which you were pleasantly surprised at what game theory was able to deliver?

None. Not only none, but my point would be that categorically game theory cannot do it.

Abba Lerner and functional finance

According to Abba Lerner, the purpose of public debt is “to achieve a rate of interest which results in the most desirable level of investment.” He also maintained that an application of Functional Finance will have a tendency to balance the budget in the long run:

Finally, there is no reason for assuming that, as a result of the continued application of Functional Finance to maintain full employment, the government must always be borrowing more money and increasing the national debt. There are a number of reasons for this.

First, full employment can be maintained by printing the money needed for it, and this does not increase the debt at all. It is probably advisable, however, to allow debt and money to increase together in a certain balance, as long as one or the other has to increase.

Second, since one of the greatest deterrents to private investment is the fear that the depression will come before the investment has paid for itself, the guarantee of permanent full employment will make private investment much more attractive, once investors have gotten over their suspicion of the new procedure. The greater private investment will diminish the need for deficit spending.

Third, as the national debt increases, and with it the sum of private wealth, there will be an increasingly yield from taxes on higher incomes and inheritances, even if the tax rates are unchanged. These higher tax payments do not represent reductions of spending by the taxpayers. Therefore the government does not have to use these proceeds to maintain the requisite rate of spending, and can devote them to paying the interest on the national debt.

Fourth, as the national debt increases it acts as a self-equilibrating force, gradually diminishing the further need for its growth and finally reaching an equilibrium level where its tendency to grow comes completely to an end. The greater the national debt the greater is the quantity of private wealth. The reason for this is simply that for every dollar of debt owed by the government there is a private creditor who owns the government obligations (possibly through a corporation in which he has shares), and who regards these obligations as part of his private fortune. The greater the private fortunes the less is the incentive to add to them by saving out of current income …

Fifth, if for any reason the government does not wish to see private property grow too much … it can check this by taxing the rich instead of borrowing from them, in its program of financing government spending to maintain full employment. The rich will not reduce their spending significantly, and thus the effects on the economy, apart from the smaller debt, will be the same as if Money had been borrowed from them.

Abba Lerner

Even if today’s mainstream Cambridge economists do not understand Lerner, there once was one who certainly did:

I recently read an interesting article on deficit budgeting … His argument is impeccable.

John Maynard Keynes CW XXVII:320

According to the Ricardian equivalence hypothesis the public sector basically finances its expenditures through taxes or by issuing bonds, and bonds must sooner or later be repaid by raising taxes in the future.

If the public sector runs extra spending through deficits, taxpayers will according to the hypothesis anticipate that they will have to pay higher taxes in future — and therefore increase their savings and reduce their current consumption to be able to do so, the consequence being that aggregate demand would not be different to what would happen if taxes were raised today.

Robert Barro attempted to give the proposition a firm theoretical foundation in the 1970s.

So let us get the facts straight from the horse’s mouth.

Describing the Ricardian Equivalence in 1989 Barro writes (emphasis added):

Suppose now that households’ demands for goods depend on the expected present value of taxes—that is, each household subtracts its share of this present value from the expected present value of income to determine a net wealth position. Then fiscal policy would affect aggregate consumer demand only if it altered the expected present value of taxes. But the preceding argument was that the present value of taxes would not change as long as the present value of spending did not change. Therefore, the substitution of a budget deficit for current taxes (or any other rearrangement of the timing of taxes) has no impact on the aggregate demand for goods. In this sense, budget deficits and taxation have equivalent effects on the economy — hence the term, “Ricardian equivalence theorem.” To put the equivalence result another way, a decrease in the government’s saving (that is, a current budget deficit) leads to an offsetting increase in desired private saving, and hence to no change in desired national saving.

Since desired national saving does not change, the real interest rate does not have to rise in a closed economy to maintain balance between desired national saving and investment demand. Hence, there is no effect on investment, and no burden of the public debt …

Ricardian equivalence basically means that financing government expenditures through taxes or debts is equivalent since debt financing must be repaid with interest, and agents — equipped with rational expectations — would only increase savings in order to be able to pay the higher taxes in the future, thus leaving total expenditures unchanged.

There is, of course, no reason for us to believe in that fairy-tale. Ricardo himself — mirabile dictu — didn’t believe in Ricardian equivalence. In “Essay on the Funding System” (1820) he wrote:

But the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly. We are too apt to think that the war is burdensome only in proportion to what we are at the moment called to pay for it in taxes, without reflecting on the probable duration of such taxes. It would be difficult to convince a man possessed of £20,000, or any other sum, that a perpetual payment of £50 per annum was equally burdensome with a single tax of £1000.

The balanced budget mythology

I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked, [it] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires. We have taken away a belief in the intrinsic necessity of balancing the budget if not in every year, [and then] in every short period of time. If Prime Minister Gladstone came back to life he would say “oh, oh what you have done” and James Buchanan argues in those terms. I have to say that I see merit in that view.

Paul Samuelson

Samuelson’s statement makes me come to think of the following passage in Keynes’ General Theory:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is com­monly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authori­ty, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

Wonder why …

Markets as beauty contests