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Zombies never die, and that's even more true of zombie ideas.
The assumption that the market economies of the developed world are self-stabilizing turned out to be a false assumption, but at the same time it was the main assumption upon which neoliberal economic policy and political decisions (deregulation) has been based for the past 30 years. Unfortunately the press examines the intentions and the prospects of legislative passage and prospective modes of implementation of policy proposals far more closely than they examine the reliability of the assumptions underlying the proposals.
The bastards (aka neoliberal economists) really making the key decisions for our pretty stupid "deciders" based government always knew macro policy interventions "after the fact" (sweeping after the bubble burst) were not optimal, but rely on them the nevertheless due to their ideological bent.
Inability to question the assumptions underling neoclassic economic theories, due to the dominant religious dogma of neoliberalism which can be called "free market fundamentalism" (and which is not unlike bolshevism -- extremes meet) is the root cause of recent economic fiasco in the USA. Reagan-Bush era gave us several very telling examples of this perverse feedback loop when first politic creates and promotes voodoo economics and then this voodoo becoming so entrenched that it in turn start influencing politic creating a point of no return: ideological zugzwang for the USA.
The resulting unstable economic system ("casino capitalism") suffered a first shock with the financial crisis of 2008. This may not be the last shock.
When people call "assumptions" theories, they give a foundational basis to a series of empirical observations that they take for hard fact. In essence this is religious approach.
Here is an interesting book review published recently by the Economist ( Market Idol, Nov 12th 2009; review of How Markets Fail: The Logic of Economic Calamities. By John Cassidy.
JOHN CASSIDY'S new book is a sequel of sorts. In his previous work, "Dot.Con", which came out in 2002, he chronicled the follies of the stock-market bubble of the late 1990s. In "How Markets Fail", Mr Cassidy, a British writer for the New Yorker, recounts the story of America's housing boom and its devastating bust. It is more than just an account of the failures of regulators and the self-deception of bankers and homebuyers, although these are well covered. For Mr Cassidy, the deeper roots of the crisis lie in the enduring appeal of an idea: that society is always best served when individuals are left to pursue their self-interest in free markets. He calls this "Utopian economics".
This approach turns much of the book into a very good history of economic thought. Mr Cassidy starts in 1776 with Adam Smith and his butchers, brewers and bakers, who supplied their wares as if guided by an unseen hand. Smith's analysis was made richer in the 1940s by Friedrich von Hayek, the Austrian who saw market prices as signals of which goods were scarce and which were abundant. Hayek's idea of the free market as a machine for processing and transmitting information "was one of the great insights of the 20th century," writes Mr Cassidy.
The book gives a detailed account of how the formal "proof" of the efficiency of free markets evolved. The breakthrough was made in the early 1950s by Kenneth Arrow, an American economist, and Gérard Debreu, a French mathematician who died in 2004. Mr Cassidy admires the maths, but points out that their findings rely on some unrealistic assumptions, something the two theorists were quite open about. Arrow and Debreu's "general equilibrium theory" seemed to give the stamp of scientific approval to unfettered markets. And it may have made it harder to challenge the purist free-market views of Alan Greenspan, the Federal Reserve chairman until 2006 whom Mr Cassidy partly blames for the dotcom and housing bubbles.
Having set out the tenets of Utopian economics, the author then pokes holes in them. Individual self interest does not always benefit society, he argues, and draws on a deep pool of research (what he calls "reality-based economics") to support his case. Markets fail if prices send the wrong signals. For instance, an increase in house prices ought to discourage new homebuyers. In practice, however, higher prices are a spur to buyers who hope to benefit from further rises. For would-be homeowners, the signal is that it is time to buy; for banks, that it is time to lend. Those who suspect a bubble face the same dilemma as textbook prisoners: it makes sense to act sensibly only if others do so too. Since that cannot be relied upon, it is safer to go with the herd. The result of such individually rational behavior is a housing and credit boom, followed inevitably by a nasty bust.
Markets also flounder when there is hidden information-if sellers know more than buyers, for example-and when the prices paid by individuals do not fully reflect social costs, such as pollution. Such failures were evident in the build-up to the current crisis: dud mortgages were packaged as supposedly safe bonds to investors; banks did not factor in the wider costs of bad debt when making risky loans. Policymakers should have intervened to curb the excesses but were hamstrung by free-market ideology.
"How Markets Fail" is an ambitious book, and one that mostly succeeds. Despite its title, it makes rather a good case for market economics; what it rails against is "free market idolatry". Its call for a better balance between individual autonomy and state oversight might have seemed off-centre just a few years ago. Now its prescription is firmly in the mainstream.
The dominance of free market fundamentalism in the US has tremendous political implications: the notion that markets can do what is best translates into "best for who". And that happen to be financial oligarchy. Serving financial oligarchy became the modus operandi for the key government officials. Some of them like Greenspan were in retrospect as close to white color criminals like Madoff as one can get. Bubbles drive sharks into a frenzy. Greed, stupidity, and fraud were institutionalized by the people doing God's work. A lot of effort was required to run ads that said, "No questions asked."
|"Between the collapse of communism and the outbreak of the subprime crisis, an understandable and justified respect for market forces mutated into a rigid and unquestioning devotion to a particular, and blatantly unrealistic, adaptation of Adam Smith's invisible hand."|
Understanding of externalities is very important feature of government policy. after all market is one-dimensional and is driven by the profit. An example: In France, when France Telecom was given the task of rolling out DSL throughout the country, it was not allowed to "cherry pick" the sweet markets in large cities alone. All communities, large and small, were required to be integrated within the broad-band network. Whereas in the US, there are today large parts of rural America still on dial-up. Without a Federal agency behind them to kick-ass, then companies will take the path of least resistance and optimize profit. The public be damned. The same but on a mach larger and more complex scale is applicable to Health Care ...
A good indicator of impotency of modern economic theory is overreliance on monetary policy. It has its place, just as does fiscal policy making. Let's keep it in our bag of tricks. But lauding it as the only tool at our disposal, for whatever purpose (typically of personal advancement in the press), is pure Lysenkoism.
As the economic dynamic changes and disequlibrium many became dangerous due to positive feedback loop inherent in economical events, prudent regulation requires safety mechanism found in physical system with similar characteristics (safety valve in boilers, etc). When empirically, we observe cause and effect, obtain a "theory of control and adjustment", parade that theory in the press ... then realize that the causes and effects indicate a particular conditional state (of the economy) which may be highly transient.
It might be this is why Keynesian Economics was popular after the Great Depression, then went out of fashion in late 60th and was replaced by market fundamentalism which crashed in 2008. Fashion is a powerful force in economic theory which makes it to some extent more common with woman fashion design them with mathematical disciplines like physics.
And then, there is the Celebrity Effect of economic gurus. Or as Descartes once opined, "Cogito ergo sum", the modern day version of which is "I get written up in the press, so therefore I am a bona fide peddler of modern economic thought".
We are learning by doing (OJT) and by doing we have come to realize that pat theories about economic development are wholly incomplete in terms of credible and effective means of policy decision making. The consequences of this error are put of the shoulders of taxpayers. That is, people do suffer because of a blind faith (ardent but erroneous) that often guides policy making.
We live in interesting times, methinks.
The problem in thinking here is the equilibrium paradigm. Equilibrium NEVER exists. If there is a glut the price falls below the marginal cost/revenue point, if the seller is desperate enough it falls to zero! Ignoring disequilibrium dynamics means this obvious (it should be obvious) point is simply ignored. The assumption of general equilibrium leads to the assumption of marginal productivity driving wages. You are not worth what you produce, you are worth precisely what somewhat else would accept to do your job.
Lafayette said in reply to reason...
I could not agree more. A Market-Economy is a dynamic in constant disequilibrium, changing positively and negatively around a mean. The mean is very rarely an "equilibrium".
likbez said in reply to reason...
Never say never. There some stationary points at which equilibrium probably exists for a short period of time. But as the whole system has positive feedback loop built-in and is unstable by definition. So you are right in a sense that disequilibrium is the "normal" state of such a system and equilibrium is an exception.
And the problem is more growth, is more growth is a trick we cannot always do in a finite resource technologically sophisticated world. (At least not growth as it is currently seen.) We need to start thinking in much longer term time scales. Saying that we have enough oil for 30 years, is not optimistic - it is an imminent crisis - or do we want our grandchildren to see the end of the world?
April 27, 2012 | Economist's View
Rajiv Sethi continues a recent discussion on macroeconomic models:John M
On Equilibrium, Disequilibrium, and Rational Expectations, by Rajiv Sethi: There's been some animated discussion recently on equilibrium analysis in economics, starting with a provocative post by Noah Smith, vigorous responses by Roger Farmer and JW Mason, and some very lively comment threads (see especially the smart and accurate points made by Keshav on the latter posts). This is a topic that is of particular interest to me, and the debate gives me a welcome opportunity to resume blogging after an unusually lengthy pause.
As Farmer's post makes clear, equilibrium in an intertemporal model requires not only that individuals make plans that are optimal conditional on their beliefs about the future, but also that these plans are themselves mutually consistent. The subjective probability distributions on the basis of which individuals make decisions are presumed to coincide with the objective distribution to which these decisions collectively give rise. This assumption is somewhat obscured by the representative agent construct, which gives macroeconomics the appearance of a decision-theoretic exercise. But the assumption is there nonetheless, hidden in plain sight as it were. Large scale asset revaluations and financial crises, from this perspective, arise only in response to exogenous shocks and not because many individuals come to realize that they have made plans that cannot possibly all be implemented.
Farmer points out, quite correctly, that rational expectations models with multiple equilibrium paths are capable of explaining a much broader range of phenomena than those possessed of a unique equilibrium. His own work demonstrates the truth of this claim: he has managed to develop models of crisis and depression without deviating from the methodology of rational expectations. The equilibrium approach, used flexibly with allowances for indeterminacy of equilibrium paths, is more versatile than many critics imagine.
Nevertheless, there are many routine economic transactions that cannot be reconciled with the hypothesis that individual plans are mutually consistent. For instance, it is commonly argued that hedging by one party usually requires speculation by another, since mutually offsetting exposures are rare. But speculation by one party does not require hedging by another, and an enormous amount of trading activity in markets for currencies, commodities, stock options and credit derivatives involves speculation by both parties to each contract. The same applies on a smaller scale to positions taken in prediction markets such as Intrade. In such transactions, both parties are trading based on a price view, and these views are inconsistent by definition. If one party is buying low planning to sell high, their counterparty is doing just the opposite. At most one of the parties can have subjective beliefs that are consistent with with the objective probability distribution to which their actions (combined with the actions of others) gives rise.
If it were not for fundamental belief heterogeneity of this kind, there could be no speculation. This is a consequence of Aumann's agreement theorem, which states that while individuals with different information can disagree, they cannot agree to disagree as long as their beliefs are derived from a common prior. That is, they cannot persist in disagreeing if their posterior beliefs are themselves common knowledge. The intuition for this is quite straightforward: your willingness to trade with me at current prices reveals that you have different information, which should cause me to revise my beliefs and alter my price view, and should cause you to do the same. Our willingness to transact with each other causes us both to shrink from the transaction if our beliefs are derived from a common prior.
Hence accounting for speculation requires that one depart, at a minimum, from the common prior assumption. But allowing for heterogeneous priors immediately implies mutual inconsistency of individual plans, and there can be no identification of subjective with objective probability distributions.
The development of models that allow for departures from equilibrium expectations is now an active area of research. A conference at Columbia last year (with Farmer in attendance) was devoted entirely to this issue, and Mike Woodford's reply to John Kay on the INET blog is quite explicit about the need for movement in this direction:
The macroeconomics of the future... will have to go beyond conventional late-twentieth-century methodology... by making the formation and revision of expectations an object of analysis in its own right, rather than treating this as something that should already be uniquely determined once the other elements of an economic model (specifications of preferences, technology, market structure, and government policies) have been settled.
There is a growing literature on heterogeneous priors that I think could serve as a starting point for the development of such an alternative. However, it is not enough to simply allow for belief heterogeneity; one must also confront the question of how the distribution of (mutually inconsistent) beliefs changes over time. To a first approximation, I would argue that the belief distribution evolves based on differential profitability: successful beliefs proliferate, regardless of whether those holding them were broadly correct or just extremely fortunate. This has to be combined with the possibility that some individuals will invest considerable time and effort and bear significant risk to profit from large mismatches between the existing belief distribution and the objective distribution to which it gives rise. Such contrarian actions may be spectacular successes or miserable failures, but must be accounted for in any theory of expectations that is rich enough to be worthy of the name.
Farmer: "A ball rolling down an inclined plane is an example of a physical system in disequilibrium. When it reaches the bottom of the plane, friction ensures that the ball will come to rest. That is an equilibrium. But it is not what we mean by an equilibrium in economics."
I speak as a physics instructor, and I have certain ideas about equilibrium. The physics example above is one example. In chemical equilibrium, a reaction proceeds at equal rates in both directions so the overall numbers of molecules remain constant in time. Static equilibrium has something stationary -- total force and total torque are both zero.
Energy on the earth's surface and atmosphere cycles around, and is on average [i]almost[/i] in dynamic equilibrium -- incoming energy equals outgoing energy on the average, but in the midst of large cycles.
My notion of equilibrium: overall quantities remain constant in time. These include examples of unstable equilibrium, where even a tiny change causes it to fall away.
I couldn't follow the paragraph following the one I cited, but if equilibrium in economics means something different from physical and chemical equilibrium, are we hopelessly confusing ourselves by speaking a different language?
John M: "are we hopelessly confusing ourselves by speaking a different language?"
Perhaps. We use a similar notion to the one you use to describe chemical equilibrium in search theories of the labor market. 10% of the labor force lose a job in a month but an equal number of new entrants find a job. The unemployment remains constant over time. We would refer to that as an equilibrium.
But a different notion of equilibrium has also crept into economic discourse. Two firms each make a plan to set the price of their products over a the next six months. Each firm sets a different price every month.
The price sequence chosen by firm A is chosen optimally given the price sequence chosen by firm B, and vice versa. We say that the plan of firm A is a best response to the plan of firm B if neither firm can increase its profits by choosing a different sequence of actions. Together, the plans constitute a Nash Equilibrium, named after the mathematician John Nash.
John M -> Roger Farmer...Herman said...
It's been over a decade since I studied anything resembling game theory, but I do recall something (a non-economic game) with the result equivalent to this:
Firm A chooses Plan 1. Firm B's optimal response is Plan 2. But A's optimal response to Plan 2 is Plan 3. Then B's optimal response to Plan 3 is Plan 4. Then A's optimal response to Plan 4 is back to Plan 1. In other words, the trajectory of plans is a never-ending square cycle.
I also recall (again, it's vague) that Nash Equilibrium only occurs if both firms use random combinations (with certain probabilities) of their two plans. Of course, such a random combination itself would be considered a plan.
I would find it bizarre if the sequence of bubble-collapse-recovery-bubble-collapse-recovery etc. would be considered an equilibrium situation, when in fact it's chaotic.
On the notions of equilibria in economics and their strengths and limitations this might be relevant:
"The Virtues and Vices of Equilibrium, and the Future of Financial Economics"
J. Doyne Farmer and John Geanakoplos (2008)
"The use of equilibrium models in economics springs from the desire for parsimonious models of economic phenomena that take human reasoning into account. This approach has been the cornerstone of modern economic theory. We explain why this is so, extolling the virtues of equilibrium theory; then we present a critique and describe why this approach is inherently limited, and why economics needs to move in new directions if it is to continue to make progress. We stress that this shouldn't be a question of dogma, and should be resolved empirically. There are situations where equilibrium models provide useful predictions and there are situations where they can never provide useful predictions. There are also many situations where the jury is still out, i.e., where so far they fail to provide a good description of the world, but where proper extensions might change this. Our goal is to convince the skeptics that equilibrium models can be useful, but also to make traditional economists more aware of the limitations of equilibrium models. We sketch some alternative approaches and discuss why they should play an important role in future research in economics. "
"This article is the outcome of an eight year conversation between an economist and a physicist. Both of us have been involved in developing trading strategies for hedge funds, giving us a deep appreciation of the difference between theories that are empirically useful and those that are merely aesthetically pleasing. Our hedge funds use completely different strategies. The strategy the economist developed uses equilibrium methods with behavioral modifications to trade mortgage-backed securities; the strategy the physicist developed uses time-series methods based on historical patterns to trade stocks, an approach that is in some sense the antithesis of the equilibrium method. Both strategies have been highly successful.
We initially came at the concept of equilibrium from very different points of view, one very supportive and the other very skeptical. We have had many arguments over the last eight years. Surprisingly, we have more or less come to agree on the advantages and disadvantages of the equilibrium approach and the need to go beyond it. The view presented here is the result of this dialogue."
By Sell on News, a global macro equities analyst. Cross posted from MacroBusiness
Having just watched the second episode of All Watched Over By Machines of Loving Grace by my favourite documentary maker Adam Curtis, in which he tells the "story of how our modern scientific idea of nature, as a self-regulating ecosystem, is actually a machine fantasy", I am once again struck by what an absurd body of ideas, or more accurately, self delusions, much of modern economic prejudice-masquerading-as-theory is.
Curtis, in this episode, shows that the idea that there was a balance of nature was always flimsy, never supported by the empirical evidence, and based on extreme, self proving over simplifications. Ecological thought is about on the same level as economic thought, it seems. Nature is not in balance at all. Consequently all those ideas about self correcting systems - you know, Adam Smith's so called invisible hand - also turn out to be a fantasy. The neo-liberal assumption that markets are like an ecology, a natural system that will self correct provided it is left alone, is also looking rocky. If, indeed, markets are natural systems - and they are not, they are created systems - then they will not self correct. The vegetative metaphor is extremely unpersuasive.
Curtis does not explore the implications for economics, his interest lies more in how we have given up the power to act because we have allowed machine driven systems to take us over. But what he traces is extremely damaging for General Equilibrium theory, a central plank of much economic "theory" and the basis of micro-economics.
General Equilibrium theory basically borrows the vegetative metaphor, that there is a "balance of nature" and applies it to markets. This was always a nonsense move, because markets are not natural, they are artificial. As Curtis shows, it is double nonsense, because even if the metaphor holds, it leads to the opposite conclusion. That markets will probably not incline towards equilibrium at all. Quelle surprise.
In one sense, the assumption that there will eventually move towards equilibrium is typical of the kind of circular arguments of which economists are so fond. Balance is implied in the transactional structures. Balance sheets have to, well, balance; assets must match liabilities. Prices must reflect some sort of balance between supply and demand. That is what a price is. Debts must be repaid from income. And so on. In the artificial rules of finance, equilibrium is implicit.
But of course that is not what happens, especially when you allow markets to be "free", and especially when you allow financial markets to be "free" to make up their own rules. They are not self organising systems that incline towards balance. They become out of control exercises in chaos that move towards anything but equilibrium. I cite the GFC, the Great Depression, the Latin American debt crisis, Japan's asset bubble, the Asian financial crisis and ever so much more, even back to Tulipmania.
Accordingly, what needs to happen, in financial markets in particular, is that equilibrium is ENFORCED, and continually at that. I recognise that such enforcement is difficult in today's global markets, but the idea that if things are left free, the system will self correct - which was Alan Greenspan's now exploded assumption - is just plain wrong. It is a system of rules. When traders are left to make up their own rules, the system of rules will be weakened and may collapse. Ergo, continually enforce the rules to ensure that the necessary balances are maintained.
Curtis goes on to show how the vegetative metaphor was used to justify the networking of machines, especially the internet and social media. That is exactly the type of shift that has occurred in finance, with machines being used increasingly to unleash the forces of financial "freedom" (derivatives, algorithmic trading, the mechanisation of risk models, etc.) that is supposed to lead to a self correcting system but which actually leads to its exact opposite. It must, quite frankly, be stopped before it does more harm to our system of money. Not that I see much hope of that happening.
It is always fascinating how bad ideas become so popular. No-one is better than Curtis at showing how it happens, although he does not really explain why it happens. Perhaps it is simply mysterious. Perhaps it is what Chesterton meant when he said that when people give up older beliefs they do not then believe in nothing, they believe in anything. Perhaps it is just that metaphors are powerful, we must have them, and we have become susceptible to very bad ones.
I don't know. What I do know is that it is about time to jettison the assumption that markets, left free, will be self correcting and incline towards equilbrium. The opposite is the case. And human beings need to be put at the centre of human systems, not pushed to the side as just components in a "system" (how that is happening now is beautifully documented by Curtis). That, in turn, means putting the consideration of morality (an equilibrium that actually makes some sense) back into the consideration of economics.
Tomas Sedlacek's book, The Economics of Good and Evil: The Quest for Economic Meaning from Gilgamesh to Wall Street, might be a good place to start to reconstruct the entire discipline from the ground up. This is what he had to say in a recent interview:psychohistorian
So, "Does the system behave the way we want it to behave?" is ultimately a moral question, one that we are banned from asking. In economics, this is exactly the sort of a question we're not allowed to ask, because economics is supposed to be a positive science, not a normative science. The difference is clear: positive statements should describe things as they are ("facts only, baby"), whereas a normative statement describes things the way we want them to be.
Let's take Milton Friedman, who was, of course, the biggest proponent of positive economics. He wrote the famous essay "Economics as a Positive Science." In that essay, on the first page, you will find the following sentence: "Economics should be a positive science." Now, please tell me if that is a positive or a normative statement. [Laughter]Marat
I never did figure out where we voted to build throw away crap instead of the most long lasting, reparable equipment. I still use a toaster built in 1928.
Its all kabuki to hide the machinations of the global inherited rich around the world. Its too important and complicated for us little people to understand…….you just need more FAITH.Jose L Campos
Ah, but the piece of evidence your missing for your conclusion is that the "true free market", which we have never seen in history, isn't anything like that. Those 'bad things' only occur with actually existing markets not the one in my head.Fiver
It is a true blessing that all theories are partially false. If they were right we would live in an unchanging boring world. As it is the world does not follow rules it creates them.John Merryman
Having not seen the series, but only read this piece, and the Wiki entry linked below, I of course cannot be definitive, but it sure seems to me on spec that this fellow's portrayal of systems, feedback and ecology is both simplistic and dated. And while economists may still believe in a hydraulic balance-sheet "equilibrium", ecologists (and physicists, and biologists, and systems theorists, and…) have been quite clear that change is constant, that any appearance of "equilibrium" is temporary, and that in complex systems there are any number of possible states that are stable, or in apparent "equilibrium" over time.
To my mind, the principle of feedback is essential to understanding anything at all about the modern human being – a complex entity that shapes and is shaped by what it shapes – we are what we're making. Our very minds and our array of mediated systems are essentially fusing. The logic of this truly thoughtless fealty to the God of Technology is that of the hive – and is at fundamental odds with human growth.
There is what Stephen Jay Gould called "punctuated equilibrium." That systems tended to settle into increasingly regular rhythms and then collapsing for any number of reason. Apparently it was originally called catastrophism and supposedly competed with evolution, but the social bias was against it.
Then there is complexity theory. Linear ordered systems, in a non-linear chaotic environment and how these interact and intermingle.
I think of it as top down structure, versus bottom up energy. When they work together, then it's a process of gradual evolution, as energy changes the structures it is absorbed by, but when these structures become too rigid to absorb new energy, they start loosing more energy than they gain and disappear, as the energy starts new structures.
Economics has nothing on physics, when it comes to reality free speculation, but that's another topic for another universe.
"It is always fascinating how bad ideas become so popular."
Surely the fact that these bad ideas all benefit the 1% at the expense of the rest of us explains part of their popularity. That and the fact the the 1% control the mainstream media and dominate business schools and university economics departments as well.
What I honestly don't understand is how anyone can raise the question of how obvious bullshit becomes accepted as Gospel, but then fail to mention the profound corruption of public discourse by moneyed interests.JCC
"Having just watched the second episode of All Watched Over By Machines of Loving Grace"
The episode seems to be blocked from viewing everywhere I have looked, including the link provided. Anyone know if it is available somewhere?John Merryman
Rex, I have had no problem with this link:
If one takes a Gaian perspective on the evolution of life on this planet, it is in the process of growing a central nervous system, in the form of human civilization. We just happen to be at an extremely adolescent and wasteful stage.annieb
Why do people believe bad ideas? Because they want simple answers, and most bad ideas are simplistic extensions of good ideas which actually work in narrow contexts. It is the inability to evaluate the concept-context match or mismatch which dooms most popular 'explanations' to mediocrity or far, far worse.
As a corollary, most people do _not_ want to understand how any particular thing works. They want simple rules which they can remember, and the food pellet to reliably arrive when they depress the lever. This is why God the Singular was invented, for example; an incredible hypothesis which no one in the preceding 150,000 years had believed, but by far the most simplistic hypothesis generated to that time. (Economics was not far behind.)
Organicist metaphors are a natural, so to speak, and have both the clarity of simplicity and the putative evidence of stable effect. They were widely tried in the nineteenth century to explain any kind of systemic interaction one might think of; tried after God the Singular had been cast in a poor light which made the props of humankind holding Him up all too evident. But organicist metaphors simply failed upon closer inspection by some of those dratted nerds who actually are compelled to find out how things actually _do_ work by, you know, looking at them working rather than talking about them some where at a comfortable remove. The economics we have now depends entirely upon an armature of nineteenth century philosophy and empirical evidence. Every other discipline cobbled together at that time has moved on to incorporate actual, you know, evidence. Economics refused, perfering nice, simple-minded theory that allowed Mammon the Singular to remain hoisted above in a good light. I can't think of a more vapid body of study then later 20th century economics. (Unless one considers _all_ of 20th century philosophy a body of study, a dubious contention which its participants would be only to happy to discuss enroute to tenure.) Economics has been the last bastion of organicist metaphors tarted up as a 'positive' achievement. When those who wish to do economic investigation finally accept that they lack the evidence to mathematize their subject but have to return to empirical (typically historical) study, the practice will have returned to its 18th century origins for a chance to start over and get it right(er) this time around.
It may not be entirely accurate to describe nature as a chaotic system; there are local stabilities. What defines nature in an interesting way, specifically large, inter-dependent processes or environments, is that they self-modifiy. That is, their action transforms their environment so that they inherently breach the limiting parameters of their stable states in many instances. I would describe nature more as an aggregate of dynamical systems. Sound familiar, citizens? I could say more, but I once did; Yves has it archived somewhere . . . .
On a final note, I never thought for a second someone would be able to condense the colossal and vain intellectual vacancy of Milton Friedman into a single sentence of six words-but wouldn't you know, he did it himself for us! Thanks for the citation there, that's priceless.craazyman
"Perhaps it is just that metaphors are powerful, we must have them, and we have become susceptible to very bad ones."
Read George Lakoff. He's of course best known recently for his ideas about "framing" and in particular how bad the Democrats are at it (and how well the Republicans have done it) but his work on the centrality of metaphor to cognition is really fascinating. In particular, that the more abstract a concept, the more layers of metaphor we require to express it. Sound like economics?Moneta
If you step far enough back and isolate your time frame, any natural system appears to be in a state of equilibrium.
If you move closer or expand your time frame, the details emerge - pradation, ominivorism, death and recycling.
You just have to understand your point of view and its implications, which very few do in reality.bigsurtree
Good point. While I was reading the article, I was thinking about how I would see earthif I were on the moon.
From that vantage point, I would affirm with great conviction that our economic system has no choice but to follow natural laws.John M
We live in the Happy Holocene, where man has left his primitive state and the animal kingdom altogether. That's why we have things like money, the great transcendent symbol of terrestrial autonomy. And we build weapons to protect this chimera. Western Civilization really isn't much more than a series of wars of ideas with occassional breathing room for resting up for the next one. And of course real bodies have to be sacrificed so the "winner de jour" feels like a true, proud gorilla.John M
"The neo-liberal assumption that markets are like an ecology, a natural system that will self correct provided it is left alone, is also looking rocky."
I found this statement to be supremely ironic. I've always thought that "free-market economists" should study ecology to gain insights on how free markets might behave. There are the chaos, the catastrophes, the routine crashes, mass slaughter, occasional mass extinctions, etc. Nature might balance things out, but the process is terrible for the individuals involved. Old Mother Nature is a Witch with a capital B.
Then we have a whole branch of economics, "Ecological Economics," where the idea is that economics should be enlightened by the laws of physics and nature, rather than oblivious to them.Trestle Rider
Of course, this statement here also displays a prejudice: "story of how our modern scientific idea of nature, as a self-regulating ecosystem, is actually a machine fantasy".
This is actually a bigoted description of how modern science views nature. Almost portrays science as oblivious to nature, rather than a very accurate description of how nature behaves. Who among scientists view nature as a "self-regulating ecosystem" - at least in the science they work at, as opposed to someone's more distant opinion?Moneta
When any individual action is always limited in power and influence, it is easier for self correcting equilibrium to operate. But when an individual action can wield significant power, and multiple individuals can wield it, then the larger body cannot move to equilibrium as easily.
Unless and until too big to fail dies as a philosophy, and true price discovery of assets is restored, we will face further erosion of economic stability.Moneta
Perhaps it is what Chesterton meant when he said that when people give up older beliefs they do not then believe in nothing, they believe in anything
I'm one of those people who, over the last few years, has gone through a change in my belief system and can appreciate Chesterton's theory.
A couple of years ago, I told a friend I had no idea what I believed in anymore and therefore, had no idea how to bring up my kids. The law of unintended consequences seemed to prevail. Basically, all I could engage in was lassez-faire.
I used to think we could regulate systems to maintain equilibrium. I now believe we can only do it with simple systems and since the economy is too complex and our human brains are limited, it's a lost cause.
When things are stable for a long time, due to heuristics, people become confident and less fearful and will take on more risk, naturally leading to a more unstable system.
When conditions are good, populations grow until they get too big for their environment. Because of globalization, we have not felt it yet but I think we will. I still believe Malthus got it right but was too early.Blissex
And when I say laissez-faire, I'm not talking about letting them run wild in restaurants. I'm talking about values and skill development.Moneta
But the economy is by and large on a stable path. It has relatively small (few percent) oscillations around a long term path.
The few percent oscillations are still rather uncomfortable (but only on the downside) though, and thus endless past debates about fine tuning and the Great Moderation and other fantasies.
That the economy is largely on a stable path may be due to Keynes' largely forgotten observation that almost all capital is long lived.
A point that if Economics were not almost pure propaganda would have been studied extensively.
Because the miracle is indeed the long term stability, not the short term all small oscillations.John M
You sound complacent, as if we have nothing to worry about.
Being in North America, it's hard to imagine ourselves with nothing to eat and bad quality of life, like billions on this planet.
Yes, on a global level, the economy might be fairly stable, but at the ponctual level, not necessarily.
We could also go through centuries of expansion and suddenly go through a calamity, and in that grand scheme of things, it could look unstable for us. But when you look at it over thousands of years, it could be totally expected over a long term cycle.Blissex
"When conditions are good, populations grow until they get too big for their environment. Because of globalization, we have not felt it yet but I think we will. I still believe Malthus got it right but was too early."
Malthus was definitely right. It's simple math.
Then there's the human psychological aspect leading to the following conclusion: either the problem is hitting us now, or we have time to continue to procrastinate until the problem hits us.Moneta
"But what he traces is extremely damaging for General Equilibrium theory, a central plank of much economic "theory" and the basis of micro-economics. General Equilibrium theory basically borrows the vegetative metaphor, that there is a "balance of nature" and applies it to markets."
That is a fantasy. General Equilibrium Theories were based on admiration for Laplacian style physics. It is based on the vision of the economy as an orrery, a machine of loving grace that has springs and counterweights and is therefore always exactly balanced.
All in the service of Social Darwinism, as the central truthiness of General Equilibrium theories is that the distribution of income is a mathematical fact and rewards the best and brightest for their superior productivity.
Some economists have been trying to introduce elements of non-mechanical vision such as prey-predator inspired dynamics or chaos theory or catastrophe theory based maths but they have been rejected because then the central truthiness becomes impossible to support, even using deliberate mathematical mistakes like those used in General Equilibrium theories.
But the inspiration for General Equilibrium theory is not darwinism; it is Laplacian physics.Sauron
Social Darwinism, as the central truthiness of General Equilibrium theories is that the distribution of income is a mathematical fact and rewards the best and brightest for their superior productivity.
That's where the discourse always gets complicated. Darwin never implied that the strongest and brightest got the rewards. His theory was that those rewarded were those who had the right genetics and characteristics required to survive in the altered environment. A bug might be a weakling in a humid setting but thrive with a weather change.
Because of the general level of truthiness in public discourse, it's hard to separate those who transfer the right sicentific priciples from one domain into the next from those who mix it all up.Matt
There are many reasons why people believe bad ideas. Just a few (some have already been mentioned above.)
They are poor thinkers/not too bright.
The ideas are advocated by people regarded as experts.
"Everyone" seems to believe it. Obvious this consensus can be manufactured.
It flatters them.
It comforts them.
It benefits them.
The alternative is unpalatable.
I think you're making the wrong distinction. The Great Depression was an equilibrium condition – it probably would have continued indefinitely if not for the massive fiscal stimulus of WW2. It was an equilibrium condition, but it was a highly undesirable equilibrium condition.
The real lie of free market economics is not that it produces equilibrium, but that it produces a desirable equilibrium. The desirable state of economic affairs is an equilibrim, but an unstable one. That's why we need active regulation of the market.F. Beard
I don't understand the analogy, and I am not going to watch the documentary due to time constraints.
Admittedly Ecology was my worst subject in my Biology major, and it has been a long time, but that's not the way I remember Ecology.
Take predator-prey dynamics. If the population of predator increases to the point that it wipes out the prey, the predator hunts itself into extinction. The equilibrium being discussed is that the one population impacts the likely survival of the other population. The same is true of global warming. Its not about control. It is about the dependency of one variable on another variable.
If one dies, the other dies. Its an argument over limited resources. The same also happens if the prey is killed off by some external disease. Its not a control thing. Its about the self limitations of the system described.
Doesn't modern economics do the exact opposite? Doesn't it assume that systems are not limited. That the predator can reach new equilibriums of greater and greater wealth? So, the "market" regulates itself by ensuring the outcomes people want.
The difference here being that the outcome the predator wants in nature is not what happens. The predator wants to survive rather than go extinct. It does not want to destroy it system, but ultimately does. Don't capitalists argue that their competition, if left unregulated by outside forces, will somehow not hit the wall of scarcity?
Am I missing something here?
Not one mention of banks in the article. Yet the banks have a government enforced money monopoly in our so-called "free market economy".
The conclusion fails because the premise is false -- that we have a free market economy. We do not. Instead it is free market for everyone EXCEPT the banks who exist by government privilege such as a lender of last resort, government deposit insurance, legal tender laws for private debts and the capital gains tax on potential non-usury based money forms such as common stock.
Via Angus at Kid's Prefer Cheese:
Is Macroeconomics just looking under the streetlamp?: A fascinating new paper by Ricardo Caballero basically says yes:"In this paper I argue that the current core of macroeconomics-by which I mainly mean the so-called dynamic stochastic general equilibrium approach-has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in "fine-tuning" mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in "broad-exploration" mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected."
The piece is well worth reading both for its own arguments and the list of interesting "periphery" papers mentioned and cited.
Caballero says "we should be in "broad-exploration" mode." I can hardly disagree since that's what I meant when I said "While I think we should see if the current models and tools can be amended appropriately to capture financial crises such as the one we just had, I am not as sure as [Bernanke] is that this will be successful and I'd like to see [more] openness within the profession to a simultaneous investigation of alternatives."
Here's a bit more from the introduction to the paper:The recent financial crisis has damaged the reputation of macroeconomics, largely for its inability to predict the impending financial and economic crisis. To be honest, this inability to predict does not concern me much. It is almost tautological that severe crises are essentially unpredictable, for otherwise they would not cause such a high degree of distress... What does concern me of my discipline, however, is that its current core-by which I mainly mean the so-called dynamic stochastic general equilibrium approach has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. ...To be fair to our field, an enormous amount of work at the intersection of macroeconomics and corporate finance has been chasing many of the issues that played a central role during the current crisis, including liquidity evaporation, collateral shortages, bubbles, crises, panics, fire sales, risk-shifting, contagion, and the like.1 However, much of this literature belongs to the periphery of macroeconomics rather than to its core. Is the solution then to replace the current core for the periphery? I am tempted-but I think this would address only some of our problems. The dynamic stochastic general equilibrium strategy is so attractive, and even plain addictive, because it allows one to generate impulse responses that can be fully described in terms of seemingly scientific statements. The model is an irresistible snake-charmer. In contrast, the periphery is not nearly as ambitious, and it provides mostly qualitative insights. So we are left with the tension between a type of answer to which we aspire but that has limited connection with reality (the core) and more sensible but incomplete answers (the periphery).This distinction between core and periphery is not a matter of freshwater versus saltwater economics. Both the real business cycle approach and its New Keynesian counterpart belong to the core. ...I cannot be sure that shifting resources from the current core to the periphery and focusing on the effects of (very) limited knowledge on our modeling strategy and on the actions of the economic agents we are supposed to model is the best next step. However, I am almost certain that if the goal of macroeconomics is to provide formal frameworks to address real economic problems rather than purely literature-driven ones, we better start trying something new rather soon. The alternative of segmenting, with academic macroeconomics playing its internal games and leaving the real world problems mostly to informal commentators and "policy" discussions, is not very attractive either, for the latter often suffer from an even deeper pretense-of-knowledge syndrome than do academic macroeconomists. ...
I find it encouraging that Caballero has reached this conclusion, and was sufficiently motivated to write a paper about it.
It's a pretty damning commentary on the state of modern macro , if you ask me. Basically , he's saying : " We got nothin' , and we had better get somethin' , fast. So , anybody got any ideas ? "
Under different circumstances , this would be hilarious.
MT: "I find it encouraging that Caballero has reached this conclusion, and was sufficiently motivated to write a paper about it."
Having read the paper, a few points. Some positive, others not so much.
1. For the chairman of the MIT Economics dept to say this is a big deal.
2. Cabarello is a macroeconomist but not a DSGE modeler. Do NK DSGE modelers like Woodford agree with his critique?
3. It was most refreshing to read a prominent macroeconomist criticize the use of ratex in GE models.
4. He seems to recognize that the existing 'microfoundations' approach looks to be a dead end.
5. Cabarello's 'periphery' seems oddly limited. While he mentions Sargent and Hansen on Robust Control and Sims on Information Theory, there is no mention of agent based computational economics which is very flexible and allows for interaction, heterogeneity, bounded rationality, emergence etc. There is no mention of Frydman's and Goldberg's work on IKE either. Nor is there any mention of 'heterodox' approaches - maybe they are considered infra dig at MIT?
I do not completely agree when Caballero says:
"This distinction between core and periphery is not a matter of freshwater versus saltwater economics. Both the real business cycle approach and its New Keynesian counterpart belong to the core."
It was Lucas' own answer to the Lucas Critique - that the deep structural parameters in the economy were those related to tastes and technology - that motivated DSGE in the first place.
It was partly the political appeal of RBC models to conservative thinkers and policymakers, and the acclaim accorded the makers of the RBC models in the form of Nobel Prizes, that forced Freshwater economists to squeeze their more realistic models into the methodological straitjacket of DSGE.
Saltwater macroeconomists may use DSGE, but only because the Freshwater macroeconomists have made it the conventional wisdom in the profession that anyone who does not use DSGE is a dummy.
That's an interesting bibliography Caballero's got. His periphery doesn't seem all that far out into the periphery; out there in the unmapped heterodox lands he might find some of the DSGE critiques he seems to be looking for.
Mark, John Hart (the math prof at the U of O) asked me one afternoon, "Why do economists use exact math?
It's rather hilarious they do that when it's nowhere near an exact discipline." I thought his son, who happens to be an economist, (he used to be at Harvard by the way), could answer that question for him.
Why do economits use exact math?
Maybe the reason why is the root of the problem. John would think so.
Rajiv Sethi continues the discussion on the state of modern macroeconomics:On Buiter, Goodwin, and Nonlinear Dynamics, by Rajiv Sethi: A few months ago, Willem Buiter published a scathing attack on modern macroeconomics in the Financial Times. While a lot of attention has been paid to the column's sharp tone and rhetorical flourishes, it also contains some specific and quite constructive comments about economic theory that deserve a close reading. One of these has to do with the limitations of linearity assumptions in models of economic dynamics:When you linearize a model, and shock it with additive random disturbances, an unfortunate by-product is that the resulting linearised model behaves either in a very strongly stabilising fashion or in a relentlessly explosive manner. There is no 'bounded instability' in such models. The dynamic stochastic general equilibrium (DSGE) crowd saw that the economy had not exploded without bound in the past, and concluded from this that it made sense to rule out, in the linearized model, the explosive solution trajectories. What they were left with was something that, following an exogenous random disturbance, would return to the deterministic steady state pretty smartly. No L-shaped recessions. No processes of cumulative causation and bounded but persistent decline or expansion. Just nice V-shaped recessions.Buiter is objecting here to a vision of the economy as a stable, self-correcting system in which fluctuations arise only in response to exogneous shocks or impulses. This has come to be called the Frisch-Slutsky approach to business cycles, and its intellectual origins date back to a memorable metaphor introduced by Knut Wicksell more than a century ago: "If you hit a wooden rocking horse with a club, the movement of the horse will be very different to that of the club" (translated and quoted in Frisch 1933). The key idea here is that irregular, erratic impulses can be transformed into fairly regular oscillations by the structure of the economy. This insight can be captured using linear models, but only if the oscillations are damped - in the absence of further shocks, there is convergence to a stable steady state. This is true no matter how large the initial impulse happens to be, because local and global stability are equivalent in linear models.
A very different approach to business cycles views fluctuations as being caused by the local instability of steady states, which leads initially to cumulative divergence away from balanced growth. Nonlinearities are then required to ensure that trajectories remain bounded. Shocks to the economy can make trajectories more erratic and unpredictable, but are not required to account for persistent fluctuations. An energetic and life-long proponent of this approach to business cycles was Richard Goodwin, who also produced one of the earliest such models in economics (Econometrica, 1951). Most of the literature in this vein has used aggregate investment functions and would not be considered properly microfounded by contemporary standards (see, for instance, Chang and Smyth 1971, Varian 1979, or Foley 1987). But endogenous bounded fluctuations can also arise in neoclassical models with overlapping generations (Benhabib and Day 1982, Grandmont 1985).
The advantage of a nonlinear approach is that it can accomodate a very broad range of phenomena. Locally stable steady states need not be globally stable, so an economy that is self-correcting in the face of small shocks may experience instability and crisis when hit by a large shock. This is Axel Leijonhufvud's corridor hypothesis, which its author has discussed in a recent column. Nonlinear models are also required to capture Hyman Minsky's financial instability hypothesis, which argues that periods of stable growth give rise to underlying behavioral changes that eventually destabilize the system. Such hypotheses cannot possibly be explored formally using linear models.
This, I think, is the point that Buiter was trying to make. It is the same point made by Goodwin in his 1951 Econometrica paper, which begins as follows:Almost without exception economists have entertained the hypothesis of linear structural relations as a basis for cycle theory. As such it is an oversimplified special case and, for this reason, is the easiest to handle, the most readily available. Yet it is not well adapted for directing attention to the basic elements in oscillations - for these we must turn to nonlinear types. With them we are enabled to analyze a much wider range of phenomena, and in a manner at once more advanced and more elementary.And sixty years later, it remains largely unheeded.
By dropping the highly restrictive assumptions of linearity we neatly escape the rather embarrassing special conclusions which follow. Thus, whether we are dealing with difference or differential equations, so long as they are linear, they either explode or die away with the consequent disappearance of the cycle or the society. One may hope to avoid this unpleasant dilemma by choosing that case (as with the frictionless pendulum) just in between. Such a way out is helpful in the classroom, but it is nothing more than a mathematical abstraction. Therefore, economists will be led, as natural scientists have been led, to seek in nonlinearities an explanation of the maintenance of oscillation. Advice to this effect, given by Professor Le Corbeiller in one of the earliest issues of this journal, has gone largely unheeded.
Economist John Maynard Keynes had a weakness for rhetorical flourishes. At the end of his classic The General Theory of Employment, Interest, and Money, he wrote: "Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist." To author John Cassidy, it's a quote that applies to the practical decision-makers of our own time-and that explains the roots of our own Great Recession.
In his ambitious How Markets Fail: The Logic of Economic Calamities, Cassidy, an economics writer for The New Yorker, offers a powerful argument that the current generation of investors and policymakers has been manacled by what he calls the "utopian" free-market school of economics. In an effort to debunk that "ideology," which he sees as holding sway in academia and among policymakers in recent decades, Cassidy marshals a deep understanding of economic intellectual history, deftly explaining the principal ideas of such towering figures as Adam Smith, Friedrich von Hayek, Léon Walras, Kenneth Arrow, Milton Friedman, and Robert Lucas. This long view allows him to place in context the free marketers' notion that self-interest and competition "equals nirvana." In the author's words: "Between the collapse of communism and the outbreak of the subprime crisis, an understandable and justified respect for market forces mutated into a rigid and unquestioning devotion to a particular, and blatantly unrealistic, adaptation of Adam Smith's invisible hand." And it was this faith, he goes on to say, that led Alan Greenspan, among others, to turn a blind eye to what was happening in the real world of money and business.
Cassidy has his intellectual heroes, too. They are the advocates of what he calls "reality-based economics"-grappling with market failures, disaster myopia, speculative frenzies, and other economic complexities. John Maynard Keynes, the great scholar of economic-crisis management, is one such thinker. So are the experimental psychologists Amos Tversky and Daniel Kahneman, the mathematician Benoit Mandelbrot, and Hyman Minsky, the expert on financial manias. "Reality-based economics ... affords the concept of market failure a central position, recognizing the roles that human interdependence and rational irrationality play in creating it," writes Cassidy. "If further calamities are to be avoided, policymakers need to make a big mental shift and embrace this eminently practical philosophy."
How Markets Fail is a nuanced book. That's a major attraction in an era when shrill commentators bicker crudely about government vs. markets and liberty vs. socialism. Even the portrait of Greenspan, perhaps the closest figure to a villain in Cassidy's account, is drawn with a measure of empathy. Yet this book can provoke angry questions in the mind of the reader. Why did so many smart economists, including Robert Lucas and Eugene Fama, refrain from protesting as their ideas were hijacked and abused by demagogic politicians and messianic think tanks? The scholars knew the exceptions, the qualifications, and the heroic assumptions that lay behind their market models. Why, then, didn't they take issue with the op-ed and cable-TV table-pounders who twisted their thinking?
Cassidy agrees with free-market advocates that the market performs wonders, but he believes its reach is limited. In that spirit, he favors greater government regulation of the financial-services industry. Although he doesn't dwell much on practical ideas for reform, he argues that it's necessary to tame Wall Streetplus or minus now that financiers have learned they can privatize profits during good times and socialize losses in bad. He admires the changes that came out of the Great Depression, such as the Glass-Steagall Act, which separated banking from investment banking. Even if current legislators aren't willing to go that far, banks must be required to keep more capital on hand and be given limits on how much debt they can accumulate, he says. He considers the proposed Financial Product Safety Commission a sensible idea. "The proper role of the financial sector is to support innovation and enterprise elsewhere in the economy," he writes. "But during the past 20 years or so, it has grown into Frankenstein's monster, lumbering around and causing chaos."
The author doesn't offer the reader any juicy bits of gossip. There aren't any vivid recreations of tense negotiations over an investment bank's future. Yet he brings ideas alive. More important, the reader comes away persuaded that reality-based economics can play a critical role in what the 18th century British conservative Edmund Burke called "one of the finest problems in legislation, namely, to determine what the state ought to take upon itself to direct by the public wisdom, and what it ought to leave, with as little interference as possible, to individual exertion."
Let's hope the legislators in Washington share this principled view of their role. Cassidy makes a compelling case that a return to hands-off economics would be a disaster.
November 15, 2009 | NYTimes.com
Two leading financial journalists have made worthy additions to the increasingly crowded shelf of books on our recent economic failure. In very different ways, John Cassidy and Andrew Ross Sorkin address the critical question of what exactly happened on Wall Street. Until we settle on at least a rough answer, we won't have a prayer of preventing the next crisis.
Sorkin, a reporter and business columnist for The New York Times, has written what his publisher calls "a true-life financial and political thriller": 600 pages of dramatic scene play and salty dialogue in which powerful bankers and government regulators clash on the precipice of global depression. Since the broad outlines of these events are well known by now, "Too Big to Fail" can't deliver on the thriller billing. But Sorkin's prodigious reporting and lively writing put the reader in the room for some of the biggest-dollar conference calls in history. It's an entertaining, brisk book.
Although Sorkin doesn't attempt much deep analysis, he does concisely summarize what he thinks all the maneuvering and sweaty panic add up to: "The calamity would definitively shatter some of the most cherished principles of capitalism," he writes. "The idea that financial wizards had conjured up a new era of low-risk profits, and that American-style financial engineering was the global gold standard, was officially dead."
Cassidy's much shorter "How Markets Fail" offers a brilliant intellectual framework for Sorkin's narrative. In the process, Cassidy, a writer for The New Yorker, also sheds skeptical light on Sorkin's conclusions. The calamity of 2008 didn't shatter principles of capitalism; there isn't a static set of capitalist principles to destroy. Capitalism has meant different things to different thinkers and economic players.
The recent debacle demonstrated the foolishness of one theory of capitalism: a utopian version of free-market theology that happens to have dominated American economic thinking for two generations. Sadly, the financial wizards Sorkin portrays so colorfully are still very much with us, and their simplistic mythology is far from "officially dead."
Cassidy traces ideas about capitalism from Adam Smith's 18th-century "invisible hand" through Alan Greenspan's hands-off philosophy toward regulating banks as chairman of the Federal Reserve from 1987 to 2006. The theory that Greenspan inherited from Milton Friedman, high priest of the Chicago School, "says simply: self-interest plus competition equals nirvana," Cassidy writes. Greenspan applied this idea in various contexts, perhaps most notably when he opposed government oversight of an increasingly manic Wall Street casino culture based on his faith that rival financiers would police one another and not take potentially self-destructive risks. The blind faith that Greenspan exemplified turned out to be flat wrong. "For him to claim that the market economy is innately stable wasn't merely contentious," Cassidy writes; "it was an absurdity."
Greenspan, as Cassidy recounts, credited Adam Smith, the bookish Scotsman, as a pivotal influence. "Our ideas about the efficacy of market competition have remained essentially unchanged since the 18th-century Enlightenment, when they first emerged, to a remarkable extent, largely from the mind of one man, Adam Smith," Greenspan asserted in his 2007 memoir, "The Age of Turbulence." But how carefully, Cassidy asks, did Greenspan and his ilk read what their hero actually wrote?
Smith did observe that butchers and brewers pursuing individual enrichment tend to produce societal advantages. When it came to financial institutions, though, Smith advocated government restrictions - for example, preventing banks from issuing too many promissory notes to unworthy borrowers. "Such regulations may, no doubt, be considered as in some respects a violation of natural liberty," Smith wrote. "But these exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments."
Cassidy writes: "Alan Greenspan and other self-proclaimed descendants of Smith rarely mention his skeptical views of the banking system. . . . The notion of financial markets as rational and self-correcting mechanisms is an invention of the last 40 years."
Not coincidentally, Greenspanism serves the interests of two important institutions: the virulently antigovernment "movement conservatism" that became a political force in the United States beginning in the 1960s and the Wall Street titans that gained startling influence in an American economy marked by the closure of plants making cars, clothes, electronics and steel.
Big banks are different from ordinary companies. When a factory or a trucking firm or a chain of retail stores goes bankrupt, groups of employees and shareholders may suffer terribly. But the damage is contained. When major financial institutions simultaneously make reckless bets with borrowed money, and then approach collapse, the entire economy can freeze up. Credit disappears. Businesses can't borrow for payroll. Layoffs ensue. Consumers stop spending. Stocks plummet.
Without careful oversight, financial markets tend naturally toward excess and crisis. The easy-lending housing bubble was preceded by the dot-com stock craze of the 1990s, and before that by the savings-and-loan fiasco of the 1980s, and so on back through time.
Many sensible economists and business leaders - advocates of capitalism, all - have acknowledged the perilous aspects of self-interested financial enterprise without suggesting a switch to Soviet-style central planning or preindustrial feudalism. Cassidy's favorite is the redoubtable Hyman Minsky, who taught at Washington University in St. Louis and served for years as a director of the charmingly named Mark Twain Bank in that heartland city. No radical, Minsky studied how to create conditions in which businesses can thrive. "From the early 1960s until shortly before his death in 1996," Cassidy writes, "Minsky advanced the view that free-market capitalism is inherently unstable and that the primary source of this instability is the irresponsible actions of bankers, traders and other financial types. Should the government fail to regulate the financial sector effectively, Minsky warned, it would be subject to periodic blowups, some of which could plunge the entire economy into lengthy recessions." Sound familiar?
With the pithiness of a talented journalist, Cassidy translates Minsky's scholarship into the helpful theory of "rational irrationality." The individual, short-term actions of a bond trader or subprime lender may make sense in that they will yield a quick profit, but taken together and unchecked by stern rules and a public-spirited overseer, the behavior of the herd can destabilize the entire system in a manner that, in retrospect, seems pretty crazy.
It's rational for a mortgage company to loan $500,000 to a borrower who can't pay back the money if the lender can immediately sell the loan to a Wall Street investment bank. It's also rational for the investment bank to bundle a bunch of risky home loans and resell them - for a tidy profit, of course - to hedge funds as a bond. Such bonds, known as mortgage-backed securities, were attractive to hedge funds and other investors because they paid relatively high interest. Sure, the bonds were risky (remember that the home buyers never really should have qualified as borrowers in the first place), but many investors bought a form of insurance against the bonds' defaulting. The sellers of this insurance, called credit default swaps, assumed they'd be able to collect premiums and never have to pay out very much because real estate prices would keep rising forever - so those original dubious borrowers would be able to refinance their unrealistic loans. Everyone felt especially rational about all of this because prestigious credit-rating agencies issued triple-A stamps of approval for the exotic, high-interest securities. Never mind that the rating agencies were paid - i.e., bought off - by the very investment banks peddling the mortgage-backed securities.
In "Too Big to Fail," Sorkin skillfully captures the raucous enthusiasm and riotous greed that fueled this rational irrationality. The brokers and bankers and traders he brings to life couldn't resist doing one more insanely hazardous deal because, well, everyone else was doing it, and the profits were too alluring. The only event likely to disrupt the party was if real estate went bust all across the country. And then, that's exactly what happened. The most sobering aspect of Cassidy's fine work is that "American-style financial engineering," as Sorkin calls it, isn't dead at all. Some of the most headstrong captains of Wall Street have been sidelined earlier than they expected, with egos bruised and fortunes reduced. But Congress and the Obama administration are proposing regulatory reforms that tinker with the current system rather than overhaul it. Wall Street, having never really atoned for its latest destructive frenzy, is now winning concessions that weaken the modest proposed reform initiatives with loopholes. "Evidently, the White House has swallowed the Wall Street line" on reining in exotic financial products, Cassidy writes. He fails to add that the big banks are spending millions on lobbyists to push their line in Washington. Legislation to provide oversight of credit default swaps and other derivatives would allow so many exemptions that it may turn out to have little meaning. Neither the Federal Reserve nor the Securities and Exchange Commission appears to have the mettle to impose strict limits on the kind of gambling with borrowed money that drove storied investment banks out of business or into the hands of taxpayer-backed rescuers. And no one in a position of authority has had the temerity even to suggest that we ought to revisit the deregulatory moves of the 1990s - backed by Greenspan and executed by the Clinton administration - that allowed the creation of unmanageable financial monstrosities like Citigroup, which would have disintegrated absent a huge amount of federal aid. These goliaths are now considered, in the words of Sorkin's title, "too big to fail." Protected by an implied taxpayer safety net, they have a built-in motivation to start taking absurd risks again, as memories of the trauma of 2008 begin to fade.
Greenspan, to his credit, admitted in Congressional testimony in October 2008 that his assumption about self-correcting financial markets had flaws. But he's gone from the public stage, and the rest of the country's power elite seem to have forgotten his striking apology. We need a new-generation Hyman Minsky to teach us to fear rational irrationality - and this time, we need to act before things come apart.Paul M. Barrett, a frequent contributor to the Book Review, is an assistant managing editor at BusinessWeek.
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Last modified: March 12, 2019