Paul Krugman — a methodological critique

16 Jan, 2019 at 16:03 | Posted in Economics | 50 Comments

Alex Rosenberg — chair of the philosophy department at Duke University and renowned economic methodologist — has an interesting article on What’s Wrong with Paul Krugman’s Philosophy of Economics in 3:AM Magazine. Writes Rosenberg:

theoryKrugman writes: “So how do you do useful economics? In general, what we really do is combine maximization-and-equilibrium as a first cut with a variety of ad hoc modifications reflecting what seem to be empirical regularities about how both individual behavior and markets depart from this idealized case.”

But if you ask the New Classical economists, they’ll say, this is exactly what we do—combine maximizing-and-equilibrium with empirical regularities …

One thing that’s missing from Krugman’s treatment of economics is the explicit recognition of what Keynes and before him Frank Knight, emphasized: the persistent presence of enormous uncertainty in the economy … Why is uncertainty so important? Because the more of it there is in the economy the less scope for successful maximizing and the more unstable are the equilibria the economy exhibits, if it exhibits any at all …

Along with uncertainty, the economy exhibits pervasive reflexivity: expectations about the economic future tend to actually shift that future … When combined, uncertainty and reflexivity together greatly limit the power of maximizing and equilibrium to do predictively useful economics. Reflexive relations between future expectations and outcomes are constantly breaking down at times and in ways about which there is complete uncertainty.

I think Rosenberg is on to something important here regarding Krugman’s neglect of methodological reflection.

When Krugman responded to my critique of IS-LM this hardly came as a surprise.  As Rosenberg notes, Krugman works with a very simple modelling dichotomy — either models are complex or they are simple. For years now, self-proclaimed “proud neoclassicist” Paul Krugman has in endless harping on the same old IS-LM string told us about the splendour of the Hicksian invention — so, of course, to Krugman simpler models are always preferred.

In a post on his blog, Krugman has argued that ‘Keynesian’ macroeconomics more than anything else “made economics the model-oriented field it has become.” In Krugman’s eyes, Keynes was a “pretty klutzy modeler,” and it was only thanks to Samuelson’s famous 45-degree diagram and Hicks’s IS-LM that things got into place. Although admitting that economists have a tendency to use ”excessive math” and “equate hard math with quality” he still vehemently defends — and always have — the mathematization of economics:

I’ve seen quite a lot of what economics without math and models looks like — and it’s not good.

Sure, ‘New Keynesian’ economists like Krugman — and their forerunners, ‘Keynesian’ economists like Paul Samuelson and (young) John Hicks — certainly have contributed to making economics more mathematical and “model-oriented.”

wrong-tool-by-jerome-awBut if these math-is-the-message-modellers aren’t able to show that the mechanisms or causes that they isolate and handle in their mathematically formalized macromodels are stable in the sense that they do not change when we “export” them to our “target systems,” these mathematical models do only hold under ceteris paribus conditions and are consequently of limited value to our understandings, explanations or predictions of real economic systems.

When it comes to modelling philosophy, Paul Krugman has earlier defended his position in the following words (my italics):

I don’t mean that setting up and working out microfounded models is a waste of time. On the contrary, trying to embed your ideas in a microfounded model can be a very useful exercise — not because the microfounded model is right, or even better than an ad hoc model, but because it forces you to think harder about your assumptions, and sometimes leads to clearer thinking. In fact, I’ve had that experience several times.

The argument is hardly convincing. If people put that enormous amount of time and energy that they do into constructing macroeconomic models, then they really have to be substantially contributing to our understanding and ability to explain and grasp real macroeconomic processes. If not, they should – after somehow perhaps being able to sharpen our thoughts – be thrown into the waste-paper-basket (something the father of macroeconomics, Keynes, used to do), and not as today, being allowed to overrun our economics journals and giving their authors celestial academic prestige.

Krugman’s explications on this issue are really interesting also because they shed light on a kind of inconsistency in his art of argumentation. For years now, Krugman has repeatedly criticized mainstream economics for using too much (bad) mathematics and axiomatics in their model-building endeavours. But when it comes to defending his own position on various issues he usually himself ultimately falls back on the same kind of models. In his End This Depression Now — just to take one example — Paul Krugman maintains that although he doesn’t buy “the assumptions about rationality and markets that are embodied in many modern theoretical models, my own included,” he still find them useful “as a way of thinking through some issues carefully.”

When it comes to methodology and assumptions, Krugman obviously has a lot in common with the kind of model-building he otherwise criticizes. And as Rosenberg rightly notices:

When he accepts maximizing and equilibrium as the (only?) way useful economics is done Krugman makes a concession so great it threatens to undercut the rest of his arguments against New Classical economics.


  1. “the persistent presence of enormous uncertainty in the economy”
    Note that the uncertainty is entirely psychological. No physical resource uncertainty has affected economies like the US for a century, if ever. Maybe rationing in World War II but that was a result of a psychological, political decision to engage in war.
    Also, finance has figured out how to hedge uncertainty. The only uncertainty in 2008 was, will the Fed print enough money to backstop wanton private credit creation?

    • There was that whole lead in gasoline thing, and there was the small matter of the hole in the ozone from using freon in cans of aerosol hair spray, and now we are facing the imminent collapse of the global ecology and massive extinction of species from global warming, but yeah, tell yourself “uncertainty” is simply a matter of subjective psychology and never a matter of ignorance biting the human race in the butt.

      • Sure, the only real scarcity is knowledge.
        My point is that you can make money from any uncertainty. Keynes and Knight perhaps lacked Fischer Black’s insights on how to split up risk and sell it to those who want it.
        Inflation profits some; those inflation profiteers can hedge against drops in inflation by entering into an inflation swap with someone who fears inflation. Both sides are thus hedged. And the swap contract itself takes on a market value, further aiding both sides maintain their balance sheet funding ratios.
        It is not clear to me that Keynes or Knight envisioned such financial solutions to the uncertainty of inflation. They did not have Black’s work to consult; but what is the excuse of today’s economists?

        • A. Financialization is one thing that helped destroy the Roman Empire and many other empires, and may be doing the same to the US.

          B. If you are sufficiently amoral, you can make money off selling addictive drugs to people; so maybe making money should not be the sole indicator of economic good

          C. How do those that don’t have much capital hedge against uncertainty? They can’t really, so they just have to take the punishment inherent from those that succeed in hedging

          • C. The best hedge is an inflation-protected basic income. The idea is to disconnect provisioning of real goods and services from financial markets; let the rich play their games, keeping score with money, in completely virtual realms that I am free to live without participating in.
            Have you read A Day in the Life of an Exotics Derivative Trader?
            What if that guy’s screens were feeding him data generated by a game program? Would he even know, or care? He could have as much fun talking to his London, without affecting billions with his panics …

  2. Why is uncertainty so important? Because the more of it there is in the economy the less scope for successful maximizing and the more unstable are the equilibria the economy exhibits, if it exhibits any at all …

    Uncertainty in human affairs is pervasive; it is not a “quantity” that can be bounded. An essential point — the essential point posed by conceptualizing “uncertainty” — is that uncertainty means, if it means anything, that its reciprocal — knowledge — can not be reliably bounded: you never know what you don’t know. Uncertainty is a label for the shadows cast by the light of knowledge: dark, fuzzy, shifting, hiding surprises and the certain potential for learning of consequences that we cannot yet anticipate.
    It follows 1.) “maximizing” successful or otherwise cannot be defined and economists are wrong to do theory as if its definition is so trivial as to not to be required to justify behavioral rules predicated on it; 2.) “learning” precludes the possibility of both steady-state stasis as well as a stable dynamic path projected indefinitely.
    It is also not possible to do a priori analytic theory after adopting a general axiom of uncertainty. An axiom of uncertainty makes every relation in analysis mathematically intractable: the modeler cannot calculate a definite solution. An analytic theory under an axiom of certainty or bounded uncertainty may be tractable, but it will not be isomorphic with the real economy and handwaving out the window in the place of operational modeling and study of the actual, institutional economy is just stupid.
    When Krugman says he wants a simple model, what he means is that he wants a simple analytic model, and he wants to be able to pretend that analytic model is descriptively accurate enough to give him “insight” that he can rely on. He loves analytic insight!
    And, when Krugman says he’s “seen quite a lot of what economics without math and models looks like — and it’s not good” what he means is that he’s seen a bit of institutional economics, economics that uses factually accurate descriptions and operational models in the study of the actual, institutional economy, the economy that copes more-or-less with pervasive uncertainty by institutional means and he does not know how to handle it in large part because the actual institutional economy makes a complete hash of the complacent presumptions of textbook neoclassical theory. The Krugman who can tout the idiocy of the loanable funds doctrine is not going to be able to digest the way the banking and payments system actually works to create credit any more than the prophet of IS/LM can make sense of the way financial markets use a vast panoply of related interest rates in an orgy of “reflexive relations”.
    In short, both Alex Rosenberg and our gracious host are way too mild and too kind.

    • “dark, fuzzy, shifting, hiding surprises and the certain potential for learning of consequences that we cannot yet anticipate.”
      You can represent all possible future market states in a matrix and use linear algebra optimization to solve Ax=b, where b is your minimum desired payout, A is your matrix of all possible future market states, and x is your optimal portfolio.

      • “handwaving out the window in the place of operational modeling and study of the actual, institutional economy is just stupid.”
        Goldman Sachs, JP Morgan use linear algebra and derivatives to hedge anything, like the 2008 “uncertainty”. They both came out ahead because they have techniques of preparing for any uncertainty.

        • Financial market players, in the absence of effective public regulation and financial repression, have an incentive to artificially create financial volatility which they can then turn around and profitably “insure” against. In common language, these are predatory frauds and, for the economy as a whole, from the standpoint of a general, public interest, highly dysfunctional.
          That Goldman Sachs could profit from the misery they contributed so much to creating is less telling in a way than the determination of most mainstream economists to avoid acknowledging that systematic control frauds were a major cause of the GFC of 2008.

          • Right, but trying to regulate bankers is not going to work. For one thing, the regulators are in bed with the regulated. Better to acknowledge that bankers are creating risk-free credit assets that circulate as money, expose the mechanisms, and ask: why are we holding public budgets to constraints that finance has figured out how to relax?

      • Just because you think you can represent all possible future states is barely smug comfort – the probabilities assigned to those states are largely if not totally subjective.
        The cards reality deals and their a priori probabilities are unknowable.
        If such things were knowable, there would be no crises – patently not the case.
        Your beating the derivatives as the great saviour of humanity drum seems utterly futile.

        • No probabilities needed to construct a matrix of all possible future market states: just represent each stock as going up, down, or staying even. Put that in a matrix. No probabilities are assigned.
          Then put your minimum desired payout in a vector b.
          Then use constraint relaxation and other techniques to derive an optimal portfolio, x.
          Derivatives are another way to hedge. You can speculate, or you can be a matched book dealer like the ones who made money throughout the last crisis.
          Lehman Brothers’ derivative book was liquidated without even using up their already-posted collateral. Lehman Brothers was not really in that much trouble; regulators deliberately decided to make an example of them, for political/psychological/ideological reasons. Barclays was ready to buy them out but British regulators said no. Barclays ended up getting the derivative book anyway, much cheaper …

          • And what of those that got seriously burnt irrespective of their hedging?
            Were there no of those?

            • UBS did not hedge enough. JP Morgan, Goldman Sachs did. AIG failed to deliver as promised but the Fed stepped in with unlimited liquidity and GS got paid.
              UBS made more money from derivatives before 2008 though than it wrote down during the crisis …

          • “No probabilities are assigned.”
            Then that seems even more absurd than otherwise. In effect, 100% probability is assinged to designated outcomes.

            • Sure, it’s kind of like a Max Ent model in natural language processing. You don’t need any probabilities though. Just construct the matrices and run your optimization algorithm.

          • Contracts are only sound if the counterparty can deliver which may not always be the case, not matter how good the hedging.
            Perhaps this is the quintessential evidence of a crisis – counterparties fail in their contractual obligations.

            • The only real uncertainty in 2008 was whether the Fed would act as insurer-of-last-resort. They did, and stand ready to do so again …

          • Hedging is not a panacea. If all risk is diversified away then why bother, may as well go and buy a treasury at the risk free rate.

            • The idea is you get a positive spread on Treasuries. You make a corporate risk-free rate which is higher than the Treasury rate.

          • You may think you did not assign probabilities, but how sure are you that you did not assign each outcome equivalent probabilities by unacknowledged assumption?

            • Please see the Financial Engineering and Risk Management Part I MOOC
              In particular, the Background Material videos, Review of Matrices and Review of Linear Optimization describe how to hedge perfectly. (You probably have to sign up, for free, to see these.)
              It’s more complicated than I let on, you need complete segments of markets and high rank. But I will bet you there are a lot of quants doing this today to make risk-free profits for finance firms.

  3. Aren’t you all awfully certain that uncertainty exists? Is that inconsistent? Not that there’s anything wrong with inconsistency, it’s just good to be aware …

    • It’s funny but where I see uncertainty, in GDP figures, for example, economists see absolute certainty. I want statisticians to report the standard error in their estimates of GDP as I learned to do when reporting survey results. But economists are certain GDP is accurate to several decimal places and are quite happy to scale other imputed variables by GDP, dropping the error terms, as if the measurements are 100% certain …

  4. “UBS did not hedge enough….. UBS made more money………”
    This does not answer the question

    • You can read the Shareholder’s Report on UBS Writedowns yourself. They wrote down some $50 billion, because they did not take out insurance on the top tranche Mortgage-Backed Securities they held. But before 2007, I bet they made more than $50 billion from the MBS assets, paying themselves large bonuses.
      So they lost in 2007 and 2008, but they didn’t have to.
      The Fed was bailing out insurers who couldn’t pay off on claims, like AIG.

  5. “The only real uncertainty in 2008 was whether the Fed would act as insurer-of-last-resort. ”
    And that’s what saved the financial industry, not hedging.

    • The Bernanke put. Why wouldn’t they do it again?

  6. “You make a corporate risk-free rate which is higher than the Treasury rate.”
    The rate of return is not fully hedged against all risk. Fully hedging the risk would bring your return back to the treasury rate. So what’s the point?

    • JP Morgan and Goldman Sachs figured out how to make higher returns than Treasuries, and hedged all risks. Counterparty risk for the insurers was assumed by the Fed. The Fed paid nothing to expose themselves to AIG’s risks because they printed money (digitally).

      • I think this is a perverse perspective on the matter.

        • The truth is perverse, my friend.

  7. Sir John and Maynard Would Have Rejected the IS-LM Framework for Conducting Macroeconomic Analysis
    By Mario Seccareccia and Marc Lavoie

    “In a recent op-ed dated March 14, “John and Maynard’s Excellent Adventure”, Paul Krugman defends John Hicks’ original 1937 interpretation of Keynes’s General Theory that cast macroeconomics within a general equilibrium framework, but without the current insistence on the micro foundations that so concerns today’s general equilibrium macro theorists. Krugman is absolutely right. One should not be concerned with the so-called micro foundations of macroeconomics, because what is truly macroeconomics cannot be derived from micro analysis, as for example the famous paradox of thrift, whereby micro behavior gives rise to macro paradoxes that cannot be understood from choice-theoretic microeconomic reasoning.
    But while we agree with Krugman’s criticism of the hordes of “micro-foundation” revisionists that now dominate economics, we are curious why he did not mention Sir John Hicks recantation of IS-LM analysis (see “ IS-LM: An Explanation”, Journal of Post Keynesian Economics, 3 (2) (Winter 1980-81);). Many of us remain deeply sceptical about the usefulness of the IS-LM framework for interpreting a real world characterized by uncertainty, crises, and institutional transformations that hardly bring the economy towards any equilibrium, never mind “general” equilibrium. But even if we abstract from these complications with the usual excuse of rendering the analysis simple for pedagogic purposes, the original Hicksian IS-LM model and its various textbook extensions (usually constructed with some sort of Phillips curve add-on) are extremely problematic. The difficulties have really little to do with the view that it’s too aggregative by representing only three markets: product, money, and bond markets – which is the criticism to which Krugman seems to be pre-emptively alluding in his article.

    The first and obvious problem is that, even in the three-market aggregative model, there can never be such a thing, even at the conceptual level, called general equilibrium. To get that we must presume that there are independent functions of investment and saving and, at the same time, independent demand and supply functions for money. But one of the most basic criticisms that Keynes himself had come to recognize immediately after writing the General Theory is that the supply of money is not some exogenous variable that can be independently pitted against a distinct demand for money function. In a sophisticated monetary economy, the supply of money must be treated as a purely endogenous variable as many modern post-Keynesians and also neo-Wicksellians have come to recognize. Hence, the idea of money market equilibrium is meaningless, since one cannot conceptually ever be out of equilibrium when the two cannot be defined independently of one another.

    However, the problem also arises on the product market side. Keynes had long debated the issue of I=S equilibrium, as for instance, also in 1937, with Swedish economists who made use of notions such as ex ante (or planned) investment and ex ante saving . While Keynes said that one can perhaps give some meaning to ex ante investment (in terms of business enterprises planning capital expenditures), at the macroeconomic level one cannot meaningfully describe saving as being anything that can actually differ from investment. Admittedly, this leads to a debate about the meaning and nature of the multiplier as a “disequilibrium” concept. But our point is that if the “supply” of money can never be independent of the “demand” for money and if saving can never be independent of investment, then what use is the IS-LM analysis that presumes exactly that independence?

    Moreover, if one were to postulate an infinitely elastic LM curve (as one can infer from David Romer, “ Keynesian Macroeconomics without the LM Curve”, Journal of Economic Perspectives, 2000;) to deal with this lack of independence between the money demand and supply, then the question is what insight does the latter construction provide? It seems that everyone except Paul Krugman believes that short-term interest rates are policy determined, and that they are not set in the way the traditional IS-LM analysis suggests. This means that an increase in investment (entailing a rightward shift of the IS curve) will not lead to an increase in short-term interest rates unless the central bank chooses to raise its central bank rate. Moreover, if the LM curve is flat at any level of interest rates, then what characterizes a liquidity trap and what is it? It certainly cannot be the traditional “flat” lower portion of an otherwise upward-sloping LM curve. Krugman’s liquidity trap is an LM curve that is flat at the zero rate of interest. But what does the IS-LM model have to say about long-term rates of interest? Krugman leaves us in the dark here. And what can the IS-LM model tell us about how the central bank is able to control and set short-term interest rates and what can it tell us about the consequences of quantitative easing on real output or price inflation? We believe that this model cannot really teach us anything about these issues; one needs an institutional analysis, not a rudimentary and misleading instrument.

    Keynes himself was ambivalent about the role of interest rates in determining fixed capital formation (with his contrasting views in chapters 11 and 12 of the General Theory) and few would argue that business investment is strongly sensitive to changes in the rate of interest, as depicted in the traditional textbook loanable funds model. Ironically, nowadays, it is household spending on consumer durables and housing that is much more highly interest elastic and this feature is often muddied in the way this latter spending is represented in the “I” portion of the IS relation…”

    • Thank you Jan … and for the above thread on banks I seem to remember that GS got a get out of jail card with a new shiny license post GFC, so that’s a political outcome of which without the entire discussion is moot.

      • The banks came up with hedging schemes that should have worked, but the insurance piece was immature. The Fed rewarded their effort by bailing them out of their jam. Certainly that was a political decision. For me, the point is that the Fed proved against market testing that it has unlimited liquidity, and we should now politically use that power to fund basic income, say.

        • Concur that the events supports MMT views and should forward more debate about what is on offer WRT policy formation by an issuer, contra to the past, being polite here, overshoot.

          Sadly the usual suspects can just invoke national security and then its unquestionable [hence the endless need for dark forces], regardless of how it effects the non ascended e.g. some of this in just rhetorical GT gaming – frustrating I know … ask Philip.

          I would question this hedging when hard architecture that supports the IT network is so vulnerable, say on the bottom of the sea e.g. seismic events not long ago blacked out the markets for some hours and its estimated billions were lost during the event. Curious observation to reconcile most of the worlds wealth is actually at the bottom of the oceans in the form of information flowing through tubes.

          I guess what I’m trying to say is yes we have a good model of of what dominate issuers have on offer, with the caveat, that politics [national or geo] have concerns due to the international state of affairs due to the abstinent investor dilemma – see Veblen.

          I would only add that as Lars points out and I share his views that this is more about social psychology as a result of atomtisic individualism in a financial matrix with expectations of income in perpetuity, be it leveraged or hard capital because of contracts [tm].

          Sorry to gab on mate, but, I can’t support the UBI perspective which has roots in the Chicago school camp and is being pushed by the AMI camp. Yes I know Graeber made a case on philosophical grounds, but I have sociological and transitional concerns about that e.g. rights to productivity, front running by dominate providers of good or services, inflationary issues w/o the appropriate means to avoid the pitfalls.

          • Regarding physical cables, I wonder if JP Morgan has thought of that, and doesn’t have some plan in place to restore damage quickly? Or use satellites, or other redundant networks?
            Regarding social psychology, indeed psychology is the greatest risk (not physical scarcity or damage). The only real uncertainty in finance is whether a panic will occur and that too can be hedged with futures in the VIX for example, or by relying on an implicit Fed put.
            The Fed could make its put explicit by selling panic insurance. The Fed should sell a derivative index of the External Finance Premium, which Bernanke describes as countercyclical in his recent paper. Banks could thus hedge by buying shares in the EFP when it is low and selling when it is high (which means their other funding sources have spiked in price).

    • I believe our host here showed that Hicks, himself, renounced IS-LM

    • “at the macroeconomic level one cannot meaningfully describe saving as being anything that can actually differ from investment.”

      Sure you can. And, really, normal people (non-economists) do it intuitively for good reason.
      Our common-sense notions of “savings” as both a foregoing of consumption out of current money income and an accumulation of money and financial claims are pretty easy to distinguish from “investment” as current spending on durable (“capital”) goods expected to generate a future stream of services valuable to production or consumption activity.
      “Savings” can be monetary and financial while “investment” is the creation of tangible and intangible resources for future streams of production (or consumption) services: houses, factories, etc. Whether an automobile is a “consumer durable” or “capital equipment” is a matter of convention, but it is certainly distinguishable from a checking account at a bank and macro-economically meaningful to do so.
      In the double-entry bookkeeping of the national accounts, it can be presumed that every sale is a purchase, and every act of lending is an act of borrowing. Making savings and investment two sides of the same coin, however, as the national accounts conventionally do, is doing violence to the economic reality and the common sense of words. What’s being unnecessarily obscured is the role of money, credit and financial leverage in the macro-economy.

  8. “It is not clear to me that Keynes or Knight envisioned such financial solutions to the uncertainty of inflation.”

    What about uncertainty of investment?

    How does one hedge a $30b LNG project? Sure it can be laid off to some extent. The risk is spread but not eliminated.

    • Fischer Black in 1970: “Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk; and one would bear the risk of default. The last two would not have to put up any capital for the bonds, although they might have to post some sort of collateral.”
      You borrow money for the project. If you default, someone else pays. If rates change, someone else pays. The counterparties put up collateral, which might be another bond funding another LNG project, or a Mortgage-Backed Security, or some other corporate bond that won’t be due until after original bond is due. Thus the “shell game” can continue indefinitely.
      In a panic, the Fed backstops the credit and interest rate dealers.
      For hedging price risk once the plant is operational, see
      Unfortunately, I cannot copy and paste from that document. They say hedging price risk is still undeveloped in LNG markets but as LNG markets become more liquid, the same futures and swaps that are currently used to hedge oil and coal prices will be available to “lock in profit margins by hedging procurement contracts linked to LNG price indices with LNG futers and swaps.”

      • s/futers and swaps/futures and swaps

        • As I said, the risk is spread not eliminated. Some party has the risk.

          • “Risk” is always a confusing concept, because it has at least two components: some indeterminate variable probability of an outcome actually occurring and the “value” of that outcome. As a risk reduction strategy, you can act to reduce the probability of an undesired outcome or, alternatively, you can try to reduce the negative value of an undesired outcome, or, alternatively again, improve your ability to respond to an outcome in ways that ameliorate the outcome. Driving a car entails a risk: you can drive more carefully; you can wear a seat belt; you can appeal to the state to design and administer a system of roadways and traffic control that reduces risk; you can appeal to the state to administer a system of emergency health care. Financially, you insure against the costs of an accident to yourself or others (who may have legal claims in the untoward event).
            Presumably, financial insurance has some behavioral effects in the overall system of managing traffic, licensing, arbitration of legal disputes, et cetera: maybe the most reckless potential drivers are inhibited from driving to some degree; maybe the worst automobile designs are discouraged, et cetera.
            Overall, though, it certainly cannot be claimed that the availability of medical and collision insurance eliminates the “risk” of accidents: people are still injured, maimed or killed and though financial payments follow, they do compensate fully. And, if you think about it, it is not clear that we would want insurance to fully compensate for the risk of accidents even if it were possible: the practical fact that drivers with insurance are not appreciably more indifferent to the risk of accidents than uninsured drivers is critical to making the system of insurance work; insurance can not survive the moral hazard. As a society and community, we want drivers to carry insurance, especially liability insurance. But, we would not want unrelated third-parties to place bets on reckless drivers, and thereby gain an incentive to encourage the recklessness of those drivers, hoping to collect a payout from an accident, but without a risk of loss in the event of the accident.
            Insuring automobile driving rests on the portfolio principle: the risk “is spread not eliminated”, as you say.
            Derivatives, it seems to me, are not necessarily so benign. A derivative can be structured that does not spread financial risk, but may amplify it. The argument for derivatives is usually that their use can enhance risk management for the holders of large portfolios. I do not think that is generally true and certainly it has not been argued adequately here by Robert Mitchell. In my auto insurance example, I would be very cautious about the possibility I raised of betting on the misfortunes of drivers known to be reckless. (Of course, I also think self-driving cars are an idiotic idea; the most important safety feature of a car is that the driver is in the car and cares about not-having-an-accident. 😉

            • People make bets on risky drivers: see NASCAR.
              Financial insurance is not like car insurance because if you lose a bet and insurance pays, you are made whole without going to the hospital.
              Derivatives can be used to “lock in future profits” (quoting the KPMG document linked above). The Fed stands as insurer of last resort; and as 208 proved, the Fed has market-tested unlimited liquidity. Unlimited currency swap lines between major central banks insure the Fed against the risk that some other currency like the Euro becomes the world’s reserve currency.
              “certainly it has not been argued adequately here by Robert Mitchell”
              I hope to continue the argument, because Goldman Sachs has been convinced and uses derivatives to enrich itself, and public banks should too.

          • The Fed proved it can absorb all the insurance risk in 2008, and the dollar got stronger. Supposedly they fixed the immature insurance piece. But if it breaks again or some other part breaks, why wouldn’t the Fed fix it again by printing (digitally) money? The only reason I can think of is, they would have to want a recession, which given the perversity of human nature is possible, and the only real risk here.
            Tl;dr: the only real risk is whether the Fed will use its proven unlimited liquidity as insurer, or dealer, of last resort.

  9. John Hicks, IS-LM: An Explanation, Journal of Post Keynesian Economics, 3

  10. Modelling based on equilibrium is worthless to a genuine empirical science of economics because equilibrium has the same function in economics that circular orbits had in pre-Keplerian astronomy: an idealized but empirically false axiom that leads to ever-greater mathematical complexity and ever-greater divergence from reality the more it is elaborated to make it match empirical observation.

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