LARS P. SYLL

The efficient market hypothesis — pseudoscientific mumbo-jumbo​

The efficient market hypothesis — EMH — argues there is no free lunch and prices are ‘right.’ Well, as we all know, that is not true. Noise does influence asset prices and the law of one price is blatantly violated again and again.

Of course, THERE ARE IDIOTS, as Larry Summers once (in)famously put it. When visiting Chicago, look around …

The price is often wrong, and sometimes very wrong … If policy-makers simply take it as a matter of faith that prices are always right, they will never see any need to take preventive action. But once we grant that bubbles are possible, and the private sector appears to be feeding the frenzy, it can make sense for policy-makers to lean against the wind in some way.

Central banks around the world have had to take extraordinary measures to help economies recover from the financial crisis. The same people​ who complain most about these extraordinary measures​ are also those who would object to relatively minor steps to reduce the likelihood of another catastrophe. That is simply irrational.

Richard Thaler

Mathematical economics — an unmixed evil

Balliol Croft, Cambridge
27. ii. 06
My dear Bowley,

I have not been able to lay my hands on any notes as to Mathematico-economics that would be of any use to you: and I have very indistinct memories of what I used to think on the subject. I never read mathematics now: in fact I have forgotten even how to integrate a good many things.

But I know I had a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules — (1) Use mathematics as a short-hand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This last I did often.

I believe in Newton’s Principia Methods, because they carry so much of the ordinary mind with them. Mathematics used in a Fellowship thesis by a man who is not a mathematician by nature — and I have come across a good deal of that — seems to me an unmixed evil. And I think you should do all you can to prevent people from using Mathematics in cases in which the English language is as short as the Mathematical …

Your emptyhandedly,
Alfred Marshall

Keynes’ beauty contest

Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each​ competitor has to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

J M Keynes General Theory

Still the best description of the logic of financial markets. Professional money management is at heart a guessing game where investors try to guess what other investors guess about other investors guess about the future …

Why game theory never will be anything but a footnote​ in the history of social science

Half a century ago there were widespread hopes game theory would provide a unified theory of social science. Today it has become obvious those hopes did not materialize. This ought to come as no surprise. Reductionist and atomistic models of social interaction — such as the ones mainstream economics and game theory are founded on — will never deliver sustainable building blocks for a realist and relevant social science. That is also — as yours truly argues in the latest issue of real-world economics review — the reason why game theory never will be anything but a footnote in the history of social science.

Heavy use of formalism and mathematics easily foster the view that a theory is scientific. But although game theory may produce ‘absolute truths’ in imaginary model worlds, in the real world the game theoretic models are nothing but — as Rubinstein (2012a) puts it — fables. Fables much reminiscent of the models used in logic, but also like them, delivering very little of value for social sciences trying to explain and understand real-life phenomena. The games that game theory portrays are model constructs, models without significant predictive capacity simply because they do not describe an always much more complex and uncertain reality …

Although some economists consider it useful to apply game theory and use game theoretical definitions, axioms, and theorems and (try to) test if real-world phenomena ‘satisfy’ the axioms and the inferences made from them, we have argued that that view is without warrant. When confronted with the real world we can (hopefully) judge if game theory really tells us if things are as postulated. The final court of appeal for models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, model building is little more than hand-waving that give us rather little warrant for making inductive inferences from the model world to the real world.

The real challenge in social science is to accept uncertainty and still try to explain why different kinds of transactions and social interactions take place. Simply conjuring problems away by assuming patently unreal things and treating uncertainty as if it was possible to reduce to stochastic risk, is like playing tennis with the net down. That is not the kind of game that scientists working on constructing a relevant and realist science want to play.

McCloskeyian rhetoric

This is not new to most of you of course. You are already steeped in McCloskey’s Rhetoric. Or you ought to be. After all economists are simply telling stories about the economy. Sometimes we are taken in. Sometimes we are not.

Unfortunately McCloskey herself gets a little too caught up in her stories. As in her explanation as to how she can be both a feminist and a free market economist:

“The market is the great liberator of women; it has not been the state, which is after all an instrument of patriarchy … The market is the way out of enslavement from your dad, your husband, or your sons. … The enrichment that has come through allowing markets to operate has been a tremendous part of the learned freedom of the modern women.” — Quoted in “The Changing Face of Economics – Conversations With Cutting Edge Economists” by Colander, Holt, and Rosser

Notice the binary nature of the world in this story. There are only the market (yea!) and the state (boo!). There are no other institutions. Whole swathes of society vanish or are flattened into insignificance. The state is viewed as a villain that the market heroically battles against to advance us all.

It is a ripping tale.

It is shallow and utterly misleading.

Peter Radford

‘Rational choice’ history — a case of models not fitting the facts

Rational choice history is in a worse situation than that of either mechanistic biology in the seventeenth century or of sociobiology today. The analogy would be appropriate if it were mainly a question of refining the theories and of gathering more evidence. One could refine theory by incorporating bounded rationality and quasi-rational choice, so as to match more closely the way in which actual decisions are made. One could gather more evidence by paying careful attention to sources that illuminate the beliefs and goals of the actors …

The need for modesty appears in two ways. First, as I have been at some pain to emphasize, one should avoid the postulate of hyperrationality. Collective action, iterated games, and credibility are simple ideas that can be and have been refined to yield rococo (or baroque?) constructions that no longer bear any relation to observable behavior. To be useful, they have to be constrained by what we know about the limitations of the human mind. Second, because formal analysis has nothing to say about the motivation of the agents, it cannot by itself yield robust predictions. Although it is extremely useful to know that the structure of material interests in a given case is that of a one-shot Prisoner’s Dilemma, that fact does not by itself imply anything about what the agents will do. If they have nonmaterial or even nonrational motivations, they might behave very differently from the noncooperative behavior we would expect if they were exclusively swayed by material interests. If they are in fact observed to cooperate, then we will have to search for nonmaterial or nonrational motivations. Rational choice theory tells us what to look for, not what we will find.

 Jon Elster