Thinking about thinking

7 Feb, 2021 at 15:42 | Posted in Economics | 6 Comments

Unfortunately, the greater part of economic controversies arise from confronting dogmas. The style of argument is that of theology, not of science … In economics, new ideas are treated, in theological style, as heresies and as far as possible kept out of the schools by drilling students in the habit of repeating the old dogmas, so as to prevent established orthodoxy from being undermined …

Image result for joan robinson further contributionsOn the plane of academic theory, the importance of the Keynesian revolution was to show that all the familiar dogmas are set in a world without time and cannot survive the simple observation that decisions, in economic life, are necessarily taken in the light of uncertain expectations about their future consequences.

Orthodox theory reacted to this challenge, in true theological style, by inventing fanciful worlds in which the difference between the past and the future does not a rise and devising intricate mathematical theorems about how an economy would operate if everyone in it had correct foresight about how everybody else was going to behave.

Mainstream — ‘orthodox’ — economists extensively exploit ‘rational choice’ assumptions in their explanations. That is probably also the reason why the theory has not been able to accommodate well-known anomalies in its theoretical framework. That should hardly come as a surprise to anyone. Mainstream theory with its axiomatic view on individuals’ tastes, beliefs, and preferences, cannot accommodate very much of real-life behaviour. It is hard to find really compelling arguments in favour of us continuing down its barren paths since individuals obviously do not comply with, or are guided by, ‘orthodox’ theory.

Looking, e.g., at the special branch of mainstream theory called game theory, it is — apart from a few notable exceptions — difficult to find really successful applications of the theory. Why? To a large extent simply because the boundary conditions of game theoretical models are false and baseless from a real-world perspective. And, perhaps even more importantly, since they are not even close to being good approximations of real-life, game theory is lacking predictive power. This should come as no surprise. As long as mainstream economic theory sticks to its ‘rational choice’ foundations, there is not much to be hoped for.

Game theorists can, of course, marginally modify their tool-box and fiddle with the auxiliary assumptions to get whatever outcome they want. But as long as the ‘rational choice’ core assumptions are left intact, it seems a pointless effort of hampering with an already excessive deductive-axiomatic formalism. If you do believe in a real-world relevance of game theoretical ‘science fiction’ assumptions such as expected utility, ‘common knowledge,’ ‘backward induction,’ correct and consistent beliefs etc., etc., then adding things like ‘framing,’ ‘cognitive bias,’ and different kinds of heuristics, do not ‘solve’ any problem. If we want to construct a theory that can provide us with explanations of individual cognition, decisions, and social interaction, we have to look for something else than — as Robinson eloquently puts it — “invented fanciful worlds.”

Building theories and models on unjustified patently ridiculous assumptions we know people never conform to, does not deliver real science. Real and reasonable people have no reason to believe in ‘as-if’ models of ‘rational’ robot-imitations acting and deciding in a Walt Disney-world characterised by ‘common knowledge,’ ‘full information,’ ‘rational expectations,’ zero  transaction costs, given stochastic probability distributions, risk-reduced genuine uncertainty, and other laughable nonsense assumptions of the same ilk. Science fiction, with its “invented fanciful worlds,” is not science.

Much work done in mainstream theoretical economics is devoid of any explanatory interest. And not only that. Seen from a strictly scientific point of view, it has no value at all. It is a waste of time. And as so many have been experiencing in modern times of austerity policies and market fundamentalism — a very harmful waste of time.

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  1. Here is a decision in my “economic life” that I was prevented from taking “in the light of uncertain expectations about [its] consequences”:
    .
    I bought one share of Gamestop (GME) stock for $380. It has dropped to ~$60. However, I discovered last week that I could sell one call option, expiring on February 19, on GME at a 280 strike price for $380. In other words, if GME stays below $280 (currently at around $60) for a week, I collect $380 and fully fund my GME purchase. I would come out ahead, since I would then have one GME share for free.
    .
    The risk is that GME goes up to $280 before Friday February 12, or one week from when I wanted to buy the short call option. Then I would have to sell 100 shares of GME for $280 each, or $28,000. So in the worst case scenario, I would have to buy 100 shares of GME at $280 (or possibly higher) and supply them to the buyer of the call option I sold. But I could buy back the option before it expired, to lower my loss. The option would rise above my purchase price as the stock rises so I would lose something but more like $10,000 maximum (less if I sold sooner). However, that loss scenario only applies if the GME stock price, currently around $60, rises to $280 within a week. Is that a good bet?

    I wasn’t able to place my bet, due to restrictions on options trading. I have to apply for approval, and likely have to phone in orders on GME options because of further ad hoc regulations on that specific stock.
    .
    I was prevented from making a bet with pretty good odds to wipe out my losses on GME. Is that not harmful?
    .
    We will see by Friday if my bet would have paid off. If GME does not breech $280 over the course of this week, my bet would have effectively made my GME share free.
    .
    Note: prices have changed since Friday, so even if my broker approves me for the right level of options trading, that bet has disappeared. However, I could make safer bets with options by buying a call at a lower strike price so if the short call is exercised, I would use the long call at a lower strike to buy the shares to supply to the higher strike call buyer. I would be buying low and selling high.
    .
    Economists who don’t understand these trades have no business advocating taxes or other restrictions on them …

    • If you were reading carefully, the first date should be February 12 not February 19.
      .
      The general point is that I feel I was unfairly prevented from making a bet that would have more than made up for my losses on GME, because of regulations designed mostly by politicians and economists telling a lot of stories that have no relation to the decisions I am faced with in my individual time-series.

    • “I wasn’t able to place my bet, due to restrictions on options trading”
      .
      I am not familiar with the US derivatives markets but is the rule you speak of longstanding or recent?
      .
      Does it only apply to GME?
      .
      Is it the broker’s rule? a stock exchange rule? an SEC rule? someone else’s rule?

      • Here is an informational twitter thread: https://twitter.com/KralcTrebor/status/1354952691856896000
        .
        Applications for options trading are a broker’s decision. Recent restrictions on GME stock specifically probably trace back to Dodd-Frank. Instead of mandating higher margin requirements, Dodd-Frank should have left room for market makers to hedge high volatility by buying volatility derivatives. The Fed should be the ultimate liquidity guarantor.
        .
        Current regulations likely caused GME stock to fall by artificially suppressing demand, and are now preventing me from recuperating my loss using options. The big guys aren’t so restricted. The regulations are helping the big guys at my expense.

      • “Current regulations likely caused GME stock to fall by artificially suppressing demand”
        .
        I’d say GME collapsed because it burnt itself out. Nothing to do with rules of the game. It was inevitable.

      • I’d say you’re ignoring artificial demand throttling that just happened to help the big shorts.
        .
        Anyway, the point is: I found a way to recoup the cost of my GME long. If you look at https://www.nasdaq.com/market-activity/stocks/gme/option-chain/call-put-options/gme—210212c00280000 you see the call I wanted to sell. On February 5, I could have sold it for as much as $7; and then, I could have bought it back at today’s price of $0.32. Buying the call back at a cheaper price nets me a profit that would have reimbursed me for the GME share I purchased. Closing out the call option by buying it back also frees me from any obligations. My risk is gone as soon as I close out the call.
        .
        The bet I found Friday was so good, even Ole B. Peters would have taken it! Or would he take the other side, betting me $380 that GME would reach $280?
        .
        A market maker was willing to take the other side and buy the call I wanted to sell, because they have algorithms that spread their risk and have my call sale insured six ways from Sunday.
        .
        I can but hope that other GME longs with options-trading approval figured out that they could sell out-the-money calls to recoup their losses on GME. If they had 100 shares, they could sell covered calls.
        .
        This should be the GME story: it is possible to hedge your long exposure, even now, using options. You can sell options to recoup your cost basis.
        .
        This is an example how financial innovation allows reduction of risk, and how option bets are very different from the simple examples Lars and Ole B. Peters use in their stories. We should be talking about how to use options combinations to place sure, low-cost bets with defined risks and frequent, high payouts. We should be discussing the mechanics of how to use options to come out ahead even if you went long on GME.
        .
        Options markets are one important place we can observe prices and their movements. Economists should learn about options bets and use them instead of anachronistic models of simple bets on urns …


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