## Economics and reality

30 Jan, 2019 at 11:24 | Posted in Economics | 7 Comments‘Modern’ economics has become increasingly irrelevant to the understanding of the real world. In his seminal book *Economics and Reality* (1997), Tony Lawson traced this irrelevance to the failure of economists to match their deductive-axiomatic methods with their subject

It is — sad to say — as relevant today as it was twenty years ago.

It is still a fact that within mainstream economics internal validity is everything and external validity nothing. Why anyone should be interested in that kind of theories and models is beyond imagination. As long as mainstream economists do not come up with any export-licenses for their theories and models to the real world in which we live, they really should not be surprised if people say that this is not science, but autism!

Studying mathematics and logic is interesting and fun. It sharpens the mind. In pure mathematics and logic, we do not have to worry about external validity. But economics is not pure mathematics or logic. It’s about society. The real world.

*Economics and Reality* was a great inspiration to yours truly twenty years ago. It still is.

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“But economics is not pure mathematics or logic.”

Not entirely true. Coherent thinking about money and banking in particular is founded on an understanding of elementary accounting, which is effect a type of algebra, featuring closure in logic. The General Theory is replete with the development of applicable accounting at the macro level. That’s because Keynes’s formal education was grounded in comprehensive mathematical thinking – unlike modern day DSGE-using charlatans. Heterodox people like MMT have picked up on this. And it is impossible to explain the ignorance of people like Krugman when it comes to money and banking operations without acknowledging the failure of mainstream economics to educate itself on elementary accounting. Fancy word stuff like endogenous money is just elementary accounting reflecting logic operational steps in money creation and use.

Comment by JKH— 30 Jan, 2019 #

“But economics is not pure mathematics or logic.” As a statement of identity or definition, it is (or should be) self-evidently false.

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The length of a shadow can be deduced by means of geometry, but the shadow in itself is not mathematics. A demand function can be expressed algebraically, but demand in itself is not mathematics. The rate of exploitation can be expressed as a ratio, but exploitation in itself is not mathematics. Etc.

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Mathematics (as a discipline) provides tools that can be used by other disciplines. These tools are, in general terms, useful in economics because so many economic concepts have quantitative properties, as well as there being quantitative relations between them. But like all tools, their usefulness diminishes when they are poorly applied or set to work on inappropriate tasks. I would have thought this is a motherhood statement, but I suppose this is in fact a kind of ontological and epistemological claim. Pythagorean (and I have met a few mathematical economics Pythagoreans) would strenuously disagree – it’s ALL mathematics in the end: demand, supply, money, nationalism, love, virtue, you name it.

Comment by Edward Mariyani-Squire— 30 Jan, 2019 #

The problem with balance sheets is that they have footnotes that change the assumed math operations so they can be inconsistent. Derivatives for example are usually not reported fully on balance sheets; footnotes contain statements like “the derivative is reported at fair value; where fair value cannot be observed, a best estimate is made.” Such statements require a lot of faith in the private accountants. They can easily hide income in a footnote and you would not know it from looking at the balance sheet.

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I have examined the regulatory filings of a local utility, PSE. On page 122.6 the “Fair Value Measurements of Derivatives” section illustrates my point. Unfortunately I cannot copy and paste from that document as it is only available as a photocopy. See https://www.utc.wa.gov/regulatedIndustries/utilities/Documents/PSE%20FERC%20Form%202%202013%20(R)%20-%20150.pdf

Comment by Robert Mitchell— 30 Jan, 2019 #

As Hudson points out how can fair value [binary price clearing] be determined when one can bet 3+ ways and the ever present smoothing out or hiving off risk that derivatives enables … reminiscent of subbing out contracts multiple times in various industries IMO, mostly premised on income stream dynamics where “first in best dressed” realizes the lions share of price taking – contractually vs risk dynamics extenuated into the future holders expectations of stable income streams.

Comment by skippy— 1 Feb, 2019 #

Basically the accountants can value the derivative instruments in many different ways, and no one is checking because regulators are behind in knowledge. Economists typically assume derivatives are a zero-sum game, because the Net Present Value of swaps at inception is zero.

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However when you look at documents such as JP Morgan’s “Derivatives and risk management made simple” (https://www.jpmorgan.com/jpmpdf/1320663533358.pdf), you see passages like:

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“In this example, Scheme A swaps a variable rate payment for a fixed one, with changes in the variable payment dependent upon changes in an inflation rate calculated on a nominal amount. In this example, the scheme funding status (net ratio of assets to liabilities) will remain unaffected and thereby the position is hedged.” (page 7)

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In other words, if your payments on a swap increase, the NPV of your liabilities decrease along with the swap contract value on the asset side; your net funding ratio is unaffected. Your balance sheet might shrink but your terms of credit or cost of capital is unaffected by a “loss” on a swap.

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Thus saying that swaps are zero-sum is really disingenuous because you don’t lose on your funding ratio even if you “lose” on the swap.

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These kinds of tricks can be used to understate derivatives’ real value to firms on balance sheets.

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In the particular case of PSE (which represents the kind of real-world balance sheet that economists should be studying and talking about, rather than ideological models), I bet you that the “fair value” they assign to their derivative contracts in their regulatory filings are crafted to hide the real value of the contracts to the firm. If I could look at their real books, I bet they are making far more from derivative contracts than they report.

Comment by Robert Mitchell— 1 Feb, 2019 #

@JKH: “‘But economics is not pure mathematics or logic.’ Not entirely true.”

It’s the “pure” which makes the statement entirely true. The “pure” refers precisely to what is expressed at more length as, “It is still a fact that within mainstream economics internal validity is everything and external validity nothing.”

When external validity matters in mathematics, that is referred to as applied mathematics, rather than as “pure” mathematics. And if mainstream economists were to aspire to the status of applied mathematicians, they might find out that they have a problem on exactly the issue of why there is any warranted relationship between what happens in their models and the economic reality that it purports to model.

Comment by BruceMcF— 31 Jan, 2019 #

I have been commenting on the real economics Blog,

Here is my Post there in a blog

https://longhairedmusings.wordpress.com/2019/02/02/heisenberg-godel-and-chomsky-walk-into-a-bar-neo-classical-economics-is-the-joke/

Just a quick post I will read all the comments sections on the posts which get my attention and join the conversation properly when I have a better appreciation of the Folk I am introducing myself too.

For now Hi my name is Roger and I live in Sweden, I am a Welshman with a Swedish Family, which is why I live here.

Hi.

Comment by rogerglewis— 2 Feb, 2019 #