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Invisible Hand Hypothesys: The Theory of Self-regulation of the Markets

The hidden hand of the market never works without a hidden fist

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  Neoclassical economics—and especially that derived from Milton Friedman’s pen — is mad, bad, and dangerous to know.

Steve Keen

 

The reason that the hand may be invisible is that it is simply not there

Joseph Stiglitz,
 Nobel Prize lecture

  "Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone."

- JM Keynes

I think that any student of neoclassical economics noticed that it is more of a religion then science. It’s beliefs are called “assumptions.” They aren’t evidenced-based. They are designed to make detached from reality models work.  The concept of "Invisible hand" is the central concepts of secular region of neoclassic economics if we view it as a cult. It is the same central concept as the concept of benevolent God in Christianity. And it demonstrates that neoclassical economy is totally faith-based system, which has been  debunked empirically for almost a century now, but whole followers refuse to engage the evidence. Implicit assumption is the in Ideal Market whenever anything goes wrong it's because people are imperfect and sinned. And if we think about the next logical question in this line of thinking  is "Are all going to heaven if we  follow neoclassical economics postulates?"  The crisis of 2008 suggests that we might not :-)

One is a theological notion, touted by Adam Smith, that the markets are governed by the "invisible hand". Although Smith's important and insightful work was deservedly highly influential, (and nevertheless can even be read and understood by ordinary persons -- unlike most present day academic economic writing.) the "invisible hand" has unconsciously become part of the theological basis of academic economics.

It implicitly contains two mostly wrong postulates:

Both those postulates imply the idea of financial market self-regulation which is, of course, a fallacy promoted by corrupted academics pursuing their own financial interests (see Hegel on Wall Street - NYTimes.com)

The second assumption became a base of the mathematical masturbation immensely popular since 70th. The latter produced forecasts detached form the reality because the reality has been abstracted to the point where the real dynamics was substituted imaginable dynamic of artificial theological world of permanent equilibrium. The key point is the complex reality of  human behavior (or what George Soros called reflexivity of the markets). The naive, head-in-the-sand approach of neo-classical academic economists created a discipline that analyzed non-existent world of "unilateral" modeling. According to reflexivity theory humans are "rationalizing beings", not "rational beings", and positive feedback loops are the reality with which regulators need to deal with in the same way as in any system with potential positive feedback loops. That means that predictions and opinions stemming from the adherents of theological approach should be treated with the same caution as predictions and opinions of bizarre religious sects.

"The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold," they write. "In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession's insistence on constructing models that, by design, disregard the key elements driving outcomes in real world markets."

The paper, generally referred to as the Dahlem report, condemns a growing reliance over the past three decades on mathematical models that improperly assume markets and economies are inherently stable, and which disregard influences like differences in the way various economic players make decisions, revise their forecasting methods and are influenced by social factors. Standard analysis also failed, in part, because of the widespread use of new financial products that were poorly understood, and because economists did not firmly grasp the workings of the increasingly interconnected global financial system, the authors say.

The myth of invisible hand is also closely related to the myth about market self-regulation. The argument of Adam Smith [1776], the founder of modern economics, that free markets led to efficient outcomes, “as if by an invisible hand” has played a central role in these debates: it suggested that we could, by and large, rely on markets without government intervention.

About "invisible hand" deification, see The Invisible Hand, Trumped by Darwin - NYTimes.com

One of the most important counterargument against market self-regulation is existence of so called  “Minsky moments”:

“Minsky” was shorthand for Hyman Minsky, an Amercan macroeconomist who died over a decade ago.  He predicted almost exactly the kind of meltdown that recently hammered the global economy. He believed in capitalism, but also believed it had almost a genetic weakness. Modern finance, he argued, was far from the stabilizing force that mainstream economics portrayed: rather, it was a system that created the illusion of stability while simultaneously creating the conditions for an inevitable and dramatic collapse.

In other words, the one person who foresaw the crisis also believed that our whole financial system contains the seeds of its own destruction. “Instability,” he wrote, “is an inherent and inescapable flaw of capitalism.”

Minsky believed it was possible to craft policies that could blunt the collateral damage caused by financial crises. As economists re-embrace Minsky’s prophetic insights, it is far from clear that they’re ready to reckon with the full implications of what he saw.

Misnky theory was not well recived due to powerful orthodoxy, born in the years after World War II, known as the neoclassical synthesis. The older belief in a self-regulating, self-stabilizing free market had selectively absorbed a few insights from John Maynard Keynes, the great economist of the 1930s who wrote extensively of the ways that capitalism might fail to maintain full employment. Most economists still believed that free-market capitalism was a fundamentally stable basis for an economy, though thanks to Keynes, some now acknowledged that government might under certain circumstances play a role in keeping the economy - and employment - on an even keel.

Economists like Paul Samuelson became the public face of the new establishment; he and others at a handful of top universities became deeply influential in Washington. In theory, Minsky could have been an academic star in this new establishment: Like Samuelson, he earned his doctorate in economics at Harvard University, where he studied with legendary Austrian economist Joseph Schumpeter, as well as future Nobel laureate Wassily Leontief.

But Minsky was cut from different cloth than many of the other big names. The descendent of immigrants from Minsk, in modern-day Belarus, Minsky was a red-diaper baby, the son of Menshevik socialists. While most economists spent the 1950s and 1960s toiling over mathematical models, Minsky pursued research on poverty, hardly the hottest subfield of economics. With long, wild, white hair, Minsky was closer to the counterculture than to mainstream economics. He was, recalls the economist L. Randall Wray, a former student, a “character.”

So while his colleagues from graduate school went on to win Nobel prizes and rise to the top of academia, Minsky languished. He drifted from Brown to Berkeley and eventually to Washington University. Indeed, many economists weren’t even aware of his work. One assessment of Minsky published in 1997 simply noted that his “work has not had a major influence in the macroeconomic discussions of the last thirty years.”

Yet he was busy. In addition to poverty, Minsky began to delve into the field of finance, which despite its seeming importance had no place in the theories formulated by Samuelson and others. He also began to ask a simple, if disturbing question: “Can ‘it’ happen again?” - where “it” was, like Harry Potter’s nemesis Voldemort, the thing that could not be named: the Great Depression.

In his writings, Minsky looked to his intellectual hero, Keynes, arguably the greatest economist of the 20th century. But where most economists drew a single, simplistic lesson from Keynes - that government could step in and micromanage the economy, smooth out the business cycle, and keep things on an even keel - Minsky had no interest in what he and a handful of other dissident economists came to call “bastard Keynesianism.”

Instead, Minsky drew his own, far darker, lessons from Keynes’s landmark writings, which dealt not only with the problem of unemployment, but with money and banking. Although Keynes had never stated this explicitly, Minsky argued that Keynes’s collective work amounted to a powerful argument that capitalism was by its very nature unstable and prone to collapse. Far from trending toward some magical state of equilibrium, capitalism would inevitably do the opposite. It would lurch over a cliff.

This insight bore the stamp of his advisor Joseph Schumpeter, the noted Austrian economist now famous for documenting capitalism’s ceaseless process of “creative destruction.” But Minsky spent more time thinking about destruction than creation. In doing so, he formulated an intriguing theory: not only was capitalism prone to collapse, he argued, it was precisely its periods of economic stability that would set the stage for monumental crises.

Minsky called his idea the “Financial Instability Hypothesis.” In the wake of a depression, he noted, financial institutions are extraordinarily conservative, as are businesses. With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”

As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers - what he called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit.

Once that kind of economy had developed, any panic could wreck the market. The failure of a single firm, for example, or the revelation of a staggering fraud could trigger fear and a sudden, economy-wide attempt to shed debt. This watershed moment - what was later dubbed the “Minsky moment” - would create an environment deeply inhospitable to all borrowers. The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system.

From the 1960s onward, Minsky elaborated on this hypothesis. At the time he believed that this shift was already underway: postwar stability, financial innovation, and the receding memory of the Great Depression were gradually setting the stage for a crisis of epic proportions. Most of what he had to say fell on deaf ears. The 1960s were an era of solid growth, and although the economic stagnation of the 1970s was a blow to mainstream neo-Keynesian economics, it did not send policymakers scurrying to Minsky. Instead, a new free market fundamentalism took root: government was the problem, not the solution.

Moreover, the new dogma coincided with a remarkable era of stability. The period from the late 1980s onward has been dubbed the “Great Moderation,” a time of shallow recessions and great resilience among most major industrial economies. Things had never been more stable. The likelihood that “it” could happen again now seemed laughable.

Yet throughout this period, the financial system - not the economy, but finance as an industry - was growing by leaps and bounds. Minsky spent the last years of his life, in the early 1990s, warning of the dangers of securitization and other forms of financial innovation, but few economists listened. Nor did they pay attention to consumers’ and companies’ growing dependence on debt, and the growing use of leverage within the financial system.

By the end of the 20th century, the financial system that Minsky had warned about had materialized, complete with speculative borrowers, Ponzi borrowers, and precious few of the conservative borrowers who were the bedrock of a truly stable economy. Over decades, we really had forgotten the meaning of risk. When storied financial firms started to fall, sending shockwaves through the “real” economy, his predictions started to look a lot like a road map.

“This wasn’t a Minsky moment,” explains Randall Wray. “It was a Minsky half-century.”

Minsky is now all the rage. A year ago, an influential Financial Times columnist confided to readers that rereading Minsky’s 1986 “masterpiece” - “Stabilizing an Unstable Economy” - “helped clear my mind on this crisis.” Others joined the chorus. Earlier this year, two economic heavyweights - Paul Krugman and Brad DeLong - both tipped their hats to him in public forums. Indeed, the Nobel Prize-winning Krugman titled one of the Robbins lectures at the London School of Economics “The Night They Re-read Minsky.”

Today most economists, it’s safe to say, are probably reading Minsky for the first time, trying to fit his unconventional insights into the theoretical scaffolding of their profession. If Minsky were alive today, he would no doubt applaud this belated acknowledgment, even if it has come at a terrible cost. As he once wryly observed, “There is nothing wrong with macroeconomics that another depression [won’t] cure.”

But does Minsky’s work offer us any practical help? If capitalism is inherently self-destructive and unstable - never mind that it produces inequality and unemployment, as Keynes had observed - now what?

After spending his life warning of the perils of the complacency that comes with stability - and having it fall on deaf ears - Minsky was understandably pessimistic about the ability to short-circuit the tragic cycle of boom and bust. But he did believe that much could be done to ameliorate the damage.

To prevent the Minsky moment from becoming a national calamity, part of his solution (which was shared with other economists) was to have the Federal Reserve - what he liked to call the “Big Bank” - step into the breach and act as a lender of last resort to firms under siege. By throwing lines of liquidity to foundering firms, the Federal Reserve could break the cycle and stabilize the financial system. It failed to do so during the Great Depression, when it stood by and let a banking crisis spiral out of control. This time, under the leadership of Ben Bernanke - like Minsky, a scholar of the Depression - it took a very different approach, becoming a lender of last resort to everything from hedge funds to investment banks to money market funds.

Minsky’s other solution, however, was considerably more radical and less palatable politically. The preferred mainstream tactic for pulling the economy out of a crisis was - and is - based on the Keynesian notion of “priming the pump” by sending money that will employ lots of high-skilled, unionized labor - by building a new high-speed train line, for example.

Minsky, however, argued for a “bubble-up” approach, sending money to the poor and unskilled first. The government - or what he liked to call “Big Government” - should become the “employer of last resort,” he said, offering a job to anyone who wanted one at a set minimum wage. It would be paid to workers who would supply child care, clean streets, and provide services that would give taxpayers a visible return on their dollars. In being available to everyone, it would be even more ambitious than the New Deal, sharply reducing the welfare rolls by guaranteeing a job for anyone who was able to work. Such a program would not only help the poor and unskilled, he believed, but would put a floor beneath everyone else’s wages too, preventing salaries of more skilled workers from falling too precipitously, and sending benefits up the socioeconomic ladder.

While economists may be acknowledging some of Minsky’s points on financial instability, it’s safe to say that even liberal policymakers are still a long way from thinking about such an expanded role for the American government. If nothing else, an expensive full-employment program would veer far too close to socialism for the comfort of politicians. For his part, Wray thinks that the critics are apt to misunderstand Minsky. “He saw these ideas as perfectly consistent with capitalism,” says Wray. “They would make capitalism better.”

But not perfect. Indeed, if there’s anything to be drawn from Minsky’s collected work, it’s that perfection, like stability and equilibrium, are mirages. Minsky did not share his profession’s quaint belief that everything could be reduced to a tidy model, or a pat theory. His was a kind of existential economics: capitalism, like life itself, is difficult, even tragic. “There is no simple answer to the problems of our capitalism,” wrote Minsky. “There is no solution that can be transformed into a catchy phrase and carried on banners.”

It’s a sentiment that may limit the extent to which Minsky becomes part of any new orthodoxy. But that’s probably how he would have preferred it, believes liberal economist James Galbraith. “I think he would resist being domesticated,” says Galbraith. “He spent his career in professional isolation.”

Stephen Mihm is a history professor at the University of Georgia and author of “A Nation of Counterfeiters” (Harvard, 2007). © Copyright 2009 Globe Newspaper Company.


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Old News ;-)

[Nov 13, 2015] When Economics Works and When it Doesn't

Notable quotes:
"... model one under which the efficient markets hypothesis is correct-and that's a model where there are a number of critical assumptions: one is rationality (we rule out behavioral aspects like bandwagons, excessive optimism and so on); second, we rule out externalities and agency problems ..."
"... to liberalize as many markets as possible and to make regulation as light as possible. In the run-up to the financial crisis, if you'd looked at the steady increase in house prices or the growth of the shadow banking system from the perspective of the efficient markets hypothesis, they wouldn't have bothered you at all. You'd tell a story about how wonderful financial liberalization and innovation are-so many people, who didn't have access before to mortgages, were now able to afford houses; here was a supreme example of free markets providing social benefits. ..."
"... But if you took the same [set of] facts, and applied the kind of models that people who had been looking at sovereign debt crises in emerging markets had been developing-boom and bust cycles, behavioral biases, agency problems, externalities, too-big-to-fail problems-if you applied those tools to the same facts, you'd get a very different kind of story. ..."
"... "efficient markets hypothesis": ..."
"... tendency in the policy world to liberalise as many markets as possible and to make regulation as light as possible ..."
Economist's View

Part of an interview of Dani Rodrik:

Q. You give a couple of examples in the book of the way theoretical errors can lead to policy errors. The first example you give concerns the "efficient markets hypothesis". What role did an overestimation of the scope and explanatory power of that hypothesis play in the run-up to the global financial crisis of 2007-08?

A. If we take as our central model one under which the efficient markets hypothesis is correct-and that's a model where there are a number of critical assumptions: one is rationality (we rule out behavioral aspects like bandwagons, excessive optimism and so on); second, we rule out externalities and agency problems-there's a natural tendency in the policy world to liberalize as many markets as possible and to make regulation as light as possible. In the run-up to the financial crisis, if you'd looked at the steady increase in house prices or the growth of the shadow banking system from the perspective of the efficient markets hypothesis, they wouldn't have bothered you at all. You'd tell a story about how wonderful financial liberalization and innovation are-so many people, who didn't have access before to mortgages, were now able to afford houses; here was a supreme example of free markets providing social benefits.

But if you took the same [set of] facts, and applied the kind of models that people who had been looking at sovereign debt crises in emerging markets had been developing-boom and bust cycles, behavioral biases, agency problems, externalities, too-big-to-fail problems-if you applied those tools to the same facts, you'd get a very different kind of story. I wish we'd put greater weight on stories of the second kind rather than the first. We'd have been better off if we'd done so.

djb said...

"efficient markets hypothesis": magical thinking

Jerry Brown said...

I can't get that link to open. Dani Rodrik says "there is a natural tendency in the policy world to liberalise as many markets as possible and to make regulation as light as possible". Is that in general? Or is that a part of the efficient market hypothesis?

[Oct 18, 2015] Alan Kirman interview: everything You Need to Know about Laissez-Faire Economics

Notable quotes:
"... That's the idea that is underlying our whole social and philosophical position ever since. Economics is trying to run along side that. Initially the idea was to let everybody do what they want and this would somehow self-organize. But nobody said what the mechanism was that would do the self-organization. John Stewart Mill advanced the same position. He had the idea that people had to be given, as far as their role would permit, the possibility of doing their own thing, and this would be in the interests of everybody. And gradually we came up against this difficulty that we couldn't show economically, in a market for example, how we would ever get to such a position. I think what happened was on the one hand people became obsessed with proving there was some sort of socially satisfactory situation that corresponded to markets in equilibrium, and on the other hand, there was a lot of effort made, right up to the 1950's, to try to show that a market or an economy would converge on that. But we gave up on that in the 70's when there were results that showed that essentially we couldn't prove it. So the theoreticians gave up but the underlying economic content and all of the ideology behind it has just kept going. We are in a strange situation where on the one hand we say we should leave markets to themselves because if they operate correctly and we get to an equilibrium this will be a socially satisfactory state. On the other hand, since we can't show that it gets there, we talk about economies that are in equilibrium but that's a contradiction because the invisible hand suggests that there is a mechanism that gets us there. And that's what we're lacking–a mechanism. Is that clear more or less? ..."
"... Theory of Moral Sentiments ..."
"... Nowadays, if you take a very primitive version of the invisible hand, people say something like "greed is good". Somehow, if everyone is greedy and tries to serve their own interest, it will get to a good position socially. Adam Smith didn't have that view at all. He had the view that people have other things in mind. For example he said that one of the strongest motivations men have is to be seen to be a good citizen and therefore would do things that would appear to other people to be good. If you have motivations like that then you can be altruistic and you're not behaving like the strict Homo economicus ..."
"... Walras wasn't someone who pushed hard for laissez faire, but he started to build the weapons for trying to understand whether all markets could get into equilibrium. He wasn't so interested, himself, on whether the equilibrium was good for society; in other words, Adam Smith's original position. I would say that Walras was more a person who was worried about the very existence of equilibrium and he tried desperately at various points to show how we might get there. I don't think he was arguing in favor of laissez faire. I wouldn't regard Walras as being strictly in that tradition. ..."
"... Pareto was concerned about the idea of the invisible hand himself. He said: "Look, what I want to show you is that the competitive equilibrium is a social optimum. He was the person to define what we now call a Pareto optimum, a situation in which you cannot make one person better off without making somebody else worse off-which is a pretty weak criterion, but still is a criterion for some sort of social efficiency. He was interested in the relationship between the two, so he brought us back on track to what I interpret as the invisible hand. Then, we can make a huge jump it you want to the first theorem of welfare of economics. That, mistakenly, is often referred to as the invisible hand theorem. But it is nothing about the invisible hand. It just says that if you are in a competitive equilibrium, then that will be a Pareto optimum, in the sense that I have just mentioned. You couldn't make someone better off without making someone else worse off. That's all it says. It does not say that if you leave a society alone it will get there, but thousands of people have interpreted it in that way. ..."
"... He had a different position from Walras company and he wasn't very consistent in his views. According to Hayek, Walras said that nobody influences prices but take prices as given, and then somebody, not specified, adjusts them until they get to equilibrium. There is some mechanism out there. ..."
"... The Road to Serfdom ..."
"... He believed that people with little information of their own, like ants, would somehow collectively get it right. It was a very different view of the world than Walras. ..."
"... he was a pioneer in two respects. First of all, he grasped the idea of self-organizing and decentralized processes-that the intelligence is in the system, not in any individual, and secondly cultural group selection, that the reason economic systems were like this is because of some past history of better systems replacing worse systems. The wisdom of the system was the product of cultural group selection, as we would put it today, and that we shouldn't question its wisdom by tampering with it. Is that a fair thing to say? ..."
"... Yes, that's a fair thing to say and I think it is what Hayek believed. He didn't actually show how it would happen but you're absolutely right-I think that's what he believed and he thought tampering with this system would make it less perfect and work less well, so just leave it alone. I don't think he had in mind, strictly speaking, group-level selection, but that's clearly his idea. A system that works well will eventually come to outstrip other systems. That's why he was advising Thatcher. ..."
"... He was much less naïve than Friedman. Friedman has a primitive natural selection argument that if firms aren't doing better than other firms they'll go bust and just die. That's a summary of Friedman's evolutionary argument! But Hayek is much more sophisticated-you're absolutely right. ..."
"... Friedman and Hayek didn't see eye to eye at all, as I understand it. Hayek was actually very concerned that Friedman and other mathematical economists took over the Mont Pelerin Society, if I understand it correctly, but now let's put Friedman on center stage, and also the society as a whole and the creation of all the think tanks, which caused the society to become politically influential. ..."
"... "Greed is Good" sounds so simplistic, but what all of this seems to do is to provide some moral justification for individuals or corporations to pursue their own interests with a clear conscience. It's a moral justification for "Greed is Good", despite all of the complexities and all of the mathematics-that's what it seems to come down to. Am I wrong about that? ..."
"... Macroeconomic models are still all about equilibria, don't worry about how we got them, and their nice efficient properties, and so forth. They are nothing to do with distribution and nothing to do with disequilibrium. Two big strands of thought-Keynes and all the people who work on disequilibrium-they're just out of it. We're still working as if underlying all of this, greed-we don't want to call it greed, but something like greed-is good. ..."
"... Nowadays, you hear all the time about how neoliberal ideology and thought is invading European countries and is undoing forms of governance that are actually working quite well. I work a lot in Norway and Scandinavia and there you hear all the time that Nordic model works and at the same time it is being corrupted by the neoliberal ideology, which is being spread in some sort of cancerous fashion. Please comment on that-Current neoliberalism. ..."
"... We're always, always, worrying about efficiency. People like to say that this is efficient or not efficient. The argument is, we know that if you free up markets you get a more efficient allocation of resources. That obsession with efficiency has led us to say that we must remove some of these restraints and restrictions and this sort of social aid that is built into the Scandinavian model. I think that's without thinking carefully about the consequences. ..."
"... just to make my position clear, the idea of no regulations is absurd. For a system that is basically well adapted to its environment, then most of its regulations are there for a reason, as you say, but one of the things that everyone needs to know about evolution is that a lot of junk accumulates. There is junk DNA and there is junk regulations. Not every regulation has a purpose just because it's there, and when it comes to adapting to the future, that's a matter of new regulations and picking the right one out of many that are wrong. The question would be, how do you create smart regulations? Knowing that you need regulations, how do you create smart ones? That's our challenge and the challenge of someone who appreciates complexity, as you do. How would you respond to that? ..."
evonomics.com

What you always wanted to know about the "let it be" philosophy

I'll bet money that Alan Kirman is the only economist with animated ants running around his email signature. Highly regarded by mainstream economists, he is also a critic of equilibrium theory and proponent of new economic thinking that takes complex systems theory into account. It was my privilege to work with Alan and Germany's Ernst Strungmann Forum to organize a conference titled "Complexity and Evolution: A New Synthesis for Economics" that was held in February 2015 and will result in a volume published by the MIT press in 2016.

After the conference was over, I sought Alan out to help me understand the complex history of laissez faire, the "let it be" philosophy that underlies mainstream economic theory and public policy.

DSW: I'm so happy to talk with you about the concept of laissez faire, all the way back to its origin, which as I understand it is during the Enlightenment. Then we can bring it up to date with some of its formalized versions in economic theory. Tell me what you know about the early history of laissez faire.

AK: I think the basic story that really interests us is that with the Enlightenment and with people like Adam Smith and David Hume, people had this idea that somehow intrinsically people should be left to their own devices and this would lead society to a state that was satisfactory in some sense for everybody, with some limits of course–law and order and so on. That's the idea that is underlying our whole social and philosophical position ever since. Economics is trying to run along side that. Initially the idea was to let everybody do what they want and this would somehow self-organize. But nobody said what the mechanism was that would do the self-organization. John Stewart Mill advanced the same position. He had the idea that people had to be given, as far as their role would permit, the possibility of doing their own thing, and this would be in the interests of everybody. And gradually we came up against this difficulty that we couldn't show economically, in a market for example, how we would ever get to such a position. I think what happened was on the one hand people became obsessed with proving there was some sort of socially satisfactory situation that corresponded to markets in equilibrium, and on the other hand, there was a lot of effort made, right up to the 1950's, to try to show that a market or an economy would converge on that. But we gave up on that in the 70's when there were results that showed that essentially we couldn't prove it. So the theoreticians gave up but the underlying economic content and all of the ideology behind it has just kept going. We are in a strange situation where on the one hand we say we should leave markets to themselves because if they operate correctly and we get to an equilibrium this will be a socially satisfactory state. On the other hand, since we can't show that it gets there, we talk about economies that are in equilibrium but that's a contradiction because the invisible hand suggests that there is a mechanism that gets us there. And that's what we're lacking–a mechanism. Is that clear more or less?

DSW: Yes, but it was very fast! I want to pull us back to the early times and make a couple of observations. First of all, that the first thinking about laissez faire came at a time when government was monarchy and absolutist rule. The whole struggle of the Enlightenment, to have a more egalitarian and inclusive society, was part of this. Am I right about that?

AK: Absolutely right. There was a social and philosophical revolution, precisely because of that. Men were trying to liberate themselves from a very hierarchical and monarchical organization. And economics tried to go along with that. There were good reasons and I think that even now there is no reason to say that there is anything wrong with the liberal position. On the other hand, what we can't show is that there is anything that would enable a liberal approach like that to get things under control. So you're right. It was a reaction to very autocratic systems that led the whole of the laissez faire and liberal position to develop.

DSW: Right. So laissez faire made a lot of sense against the background of monarchy and controlling church and so on. Now I know that Adam Smith invoked the invisible hand metaphor only three times in the entire corpus of his work and it is said that his first book on moral sentiments is much more nuanced than the popular notion of the invisible hand. Could you speak a little more on Adam Smith? On the one hand he's an advocate of laissez faire but on the other hand he is very nuanced in both of his books but especially in his Theory of Moral Sentiments. What do you have to say about that?

AK: Right. Adam Smith was fully cognizant of the fact that man is motivated by many things. Nowadays, if you take a very primitive version of the invisible hand, people say something like "greed is good". Somehow, if everyone is greedy and tries to serve their own interest, it will get to a good position socially. Adam Smith didn't have that view at all. He had the view that people have other things in mind. For example he said that one of the strongest motivations men have is to be seen to be a good citizen and therefore would do things that would appear to other people to be good. If you have motivations like that then you can be altruistic and you're not behaving like the strict Homo economicus. Adam Smith didn't take the strong position that people left entirely to their own selfish devices will make things OK. He had the view that man is much more complicated and governed by his emotions. He talks a lot about sympathy, which we would now call empathy.

DSW: That's great! Now let's talk about Walras and what his ambitions were to come up with the first mathematical justification for laissez faire, as I understand it.

AK: Actually, Walras himself didn't talk so much about laissez faire. He at that time had a very simple idea, that the amount of goods that people wanted to supply at a given price would be the amount that people would want to buy; i.e, demand at that price, so if those two were equal then that was the equilibrium price. Then he said that if we have many markets, how can we be sure that they will simultaneously be cleared, because after all if you raise the price in one market then that will effect the price in other markets. If you raise the price of bananas then the price of oranges will be effected, and so forth. He said "my problem is to solve the market clearing for all goods", but he was not so interested in the underlying philosophical context. Walras wasn't someone who pushed hard for laissez faire, but he started to build the weapons for trying to understand whether all markets could get into equilibrium. He wasn't so interested, himself, on whether the equilibrium was good for society; in other words, Adam Smith's original position. I would say that Walras was more a person who was worried about the very existence of equilibrium and he tried desperately at various points to show how we might get there. I don't think he was arguing in favor of laissez faire. I wouldn't regard Walras as being strictly in that tradition.

DSW: OK, that's new for me. So what about the rise of so-called neoclassical economics. At what point did it become toward demonstrating what I understand is the first fundamental theorem of economics-laissez faire leads to the common good and that being justified by some mathematical apparatus. Where does that come from, if not from Walras?

AK: We missed a very important step, which is [Vilfredo] Pareto. Pareto was concerned about the idea of the invisible hand himself. He said: "Look, what I want to show you is that the competitive equilibrium is a social optimum. He was the person to define what we now call a Pareto optimum, a situation in which you cannot make one person better off without making somebody else worse off-which is a pretty weak criterion, but still is a criterion for some sort of social efficiency. He was interested in the relationship between the two, so he brought us back on track to what I interpret as the invisible hand. Then, we can make a huge jump it you want to the first theorem of welfare of economics. That, mistakenly, is often referred to as the invisible hand theorem. But it is nothing about the invisible hand. It just says that if you are in a competitive equilibrium, then that will be a Pareto optimum, in the sense that I have just mentioned. You couldn't make someone better off without making someone else worse off. That's all it says. It does not say that if you leave a society alone it will get there, but thousands of people have interpreted it in that way.

DSW: OK. So where do we go from here? Tell me a little about agency theory, which is also something that seems to imply, if I understand it, that the only responsibility of corporations is to maximize their profits. The economy will work well if that's their only obligation.

AK: That's not exactly a sideline but a development where people are worrying about firms in addition to individuals. When you are just dealing with individuals in a simple economy, when they are exchanging goods there is no problem. When you get firms in there you need to ask "What's the objectives of these firms?" The objective, the argument is, is if they maximize profit then they are maximizing their shareholders' benefits and so therefore we get to the idea of increasing the welfare of society as a whole. But there is a huge leap there, because we haven't specified closely in our models who owns these firms and how ownership is transferred between these people. So I think there is a fuzzy area there, which is not completely included in the theory.

DSW: Please give me a thumbnail history of the Mont Pelerin Society and the role it played in advancing economic theory and policy. So this would be Hayek, Friedman and all that.

AK: The great hero of that society was Hayek. He had a different position from Walras & company and he wasn't very consistent in his views. According to Hayek, Walras said that nobody influences prices but take prices as given, and then somebody, not specified, adjusts them until they get to equilibrium. There is some mechanism out there. That was Walras. Hayek said "Not at all!" He said - actually he was a horrid man.

DSW: Wait a minute! Why was he a horrid man? You can't just glide over that!

AK: The reason I say that is-he had very clever ideas-but he was extremely bigoted, he was racist. There is a wonderful interview with him that you can find on You Tube, where he says (imitating Hayek's accent) "I am not a racist! People accuse me of being a racist. Now it's true that some of the Indian students at the London School of Economics behave in a very nasty way, typical of Indian people…" and he carries on like this. So that's one reason he is horrid. A second thing is that if you don't believe he is horrid, David, I will send you his book The Road to Serfdom, which said that if there is any planning going on in the economy, it will inevitably lead you to a fascist situation. When he produced that book it had a big success, particularly in the United States, and what is more, he authorized a comic book version of it, which is absolutely dreadful. One Nobel Prize winner, [Ronald] Coase, said "you are carrying on so much against central planning, you forget that a large part of our economy is actually governed by centrally planned institutions, i.e., big firms, and these big firms are doing exactly what you say they can't do. Hayek shrugged that off, but what he did in his book was say that if any planning goes on then eventually you are all going to wind up in a fascist state where you'll be shot if you don't do what you're told to do. At the end of the book there is some poor guy who's being shot because he wants to be a carpenter or a plumber, or something like that. It's terrible! And the irony of the whole situation is that comic book was issued and financed by General Motors, and GM of course is one of those corporations that Hayek didn't see were centrally planned institutions. That's way I say that Hayek was a dreadful person.

Hayek's idea was, there is no way that people could know what was going on and could know what the prices of goods are. Everyone has a little piece of information of their own, and in acting upon it, this news gets out into the market. So, for example I buy something such as a share, and you say "Oh, Kirman bought a share, so something must be going on there, based on information that he had that I didn't have", and so forth. Hayek's idea was that this mechanism-people watching each other and getting information from their acts, would lead you to the equilibrium that would be a socially optimal state. But again, he never specified closely what the mechanism was. He has little examples, such as one about shortage of tin and how people would adjust, but never really specified the mechanism. He believed that people with little information of their own, like ants, would somehow collectively get it right. It was a very different view of the world than Walras.

DSW: So he was a pioneer in two respects. First of all, he grasped the idea of self-organizing and decentralized processes-that the intelligence is in the system, not in any individual, and secondly cultural group selection, that the reason economic systems were like this is because of some past history of better systems replacing worse systems. The wisdom of the system was the product of cultural group selection, as we would put it today, and that we shouldn't question its wisdom by tampering with it. Is that a fair thing to say?

AK: Yes, that's a fair thing to say and I think it is what Hayek believed. He didn't actually show how it would happen but you're absolutely right-I think that's what he believed and he thought tampering with this system would make it less perfect and work less well, so just leave it alone. I don't think he had in mind, strictly speaking, group-level selection, but that's clearly his idea. A system that works well will eventually come to outstrip other systems. That's why he was advising Thatcher. Just trust the markets and let things go. Get rid of the unions, and so forth. So it's clearly he had in mind that interfering with that system would just lead you to a worse social situation. He was much less naïve than Friedman. Friedman has a primitive natural selection argument that if firms aren't doing better than other firms they'll go bust and just die. That's a summary of Friedman's evolutionary argument! But Hayek is much more sophisticated-you're absolutely right.

DSW: I think Hayek was explicit about cultural group selection, and Friedman-I've paid quite a bit of attention to his 1953 article on positive economics, in which he makes a very naïve evolutionary argument. Friedman and Hayek didn't see eye to eye at all, as I understand it. Hayek was actually very concerned that Friedman and other mathematical economists took over the Mont Pelerin Society, if I understand it correctly, but now let's put Friedman on center stage, and also the society as a whole and the creation of all the think tanks, which caused the society to become politically influential.

AK: Yes, I think that it coincided very nicely with conservative ideology and people who had really strongly liberal-not in the Mills sense (you have to make this distinction particularly in the United States where these words have different meanings), but really completely free market leave-everybody-to-their own-thing libertarian point of view. Those people found it a wonderful place to gather and reinforce themselves. And Hayek was a strong member of that. Another was Gary Becker, but I don't know how directly. Becker had the economics of everything-divorce, whatever. You'd have these simple arguments, but not necessarily selection arguments, often some sort of justification in terms of a superior arrangement. The marginal utility of the woman getting divorced just has to equal the marginal utility of not getting divorced and that would be the price of getting divorced, and that sort of stuff. Adam Smith would have rolled over in this grave because he believed emotions played a strong role in all of this and the emotions that you have during divorce don't tie into these strict calculations.

DSW: This is a tailor-made ideology for powerful interests, powerful people and corporations who simply do want to have their way. Is that a false statement to make?

AK: No, I think that's absolutely right. They can benefit from using that argument to advance their own ends. As someone once said, if you think of saying to firms, we're going to diminish their taxes, no firm in its right mind would argue with that. Even though they might think deep down that there are other things that could be done for society. There are some things which are part of this philosophy which is perfect for firms and powerful interest groups. You're absolutely right. And so they lobby for this all the time, pushing for these positions that are in fact in their own interest.

DSW: So, at the end of the day, "Greed is Good" sounds so simplistic, but what all of this seems to do is to provide some moral justification for individuals or corporations to pursue their own interests with a clear conscience. It's a moral justification for "Greed is Good", despite all of the complexities and all of the mathematics-that's what it seems to come down to. Am I wrong about that?

AK: I think you're absolutely right. What's interesting is that if you look at various economic situations, like today the first thing that people tell you about the Greeks is that they are horrid ideological people. But the people on the other side have an equally strong ideology, which is being justified by the sort of economic models that we are building. Remember that even though we had this discussion about how this became a real difficulty in theoretical economics, in macroeconomics they simply carried on as if these theoretical difficulties hadn't happened. Macroeconomic models are still all about equilibria, don't worry about how we got them, and their nice efficient properties, and so forth. They are nothing to do with distribution and nothing to do with disequilibrium. Two big strands of thought-Keynes and all the people who work on disequilibrium-they're just out of it. We're still working as if underlying all of this, greed-we don't want to call it greed, but something like greed-is good.

DSW: Could I ask about Ayn Rand and what role she played, if any? On the one hand she was not an economist, she was just a philosopher and novelist. On the other hand, she is right up there in the pantheon of free market deities alone with Smith, Hayek and Friedman. Do you ever think about Ayn Rand. Does any economist think about Ayn Rand?

AK: That's an example of my narrowness that I never read Ayn Rand, I just read about her. I think it would be unfair now to make any comments about that because I'd be as uninformed as some people who talk about Adam Smith. What I should do at some point is read some of her work, because she is constantly being cited on both sides as a dark bad figure or as a heroine in the pantheon as you said, with Hayek and everybody else. I just admit my ignorance and I don't know if Rand had a serious position on her own or whether she is being cited as a more popular and easily accessible figure.

DSW: Fine! I'd like to wrap this up with two questions. This has been a wonderful conversation, by the way. Nowadays, you hear all the time about how neoliberal ideology and thought is invading European countries and is undoing forms of governance that are actually working quite well. I work a lot in Norway and Scandinavia and there you hear all the time that Nordic model works and at the same time it is being corrupted by the neoliberal ideology, which is being spread in some sort of cancerous fashion. Please comment on that-Current neoliberalism. What justifies it? Is it spreading? Is that a good thing or a bad thing? Anything you would like to say on that topic.

AK: I think that one obsession that economists have is with efficiency. We're always, always, worrying about efficiency. People like to say that this is efficient or not efficient. The argument is, we know that if you free up markets you get a more efficient allocation of resources. That obsession with efficiency has led us to say that we must remove some of these restraints and restrictions and this sort of social aid that is built into the Scandinavian model. I think that's without thinking carefully about the consequences. Let me tell you my favorite and probably not very funny story about how economists are obsessed with efficiency. There were three people playing golf; a priest, a psychoanalyst, and an economist. The got very upset because the guy in front was playing extremely slowly and he had a caddy to help him. So these guys get very upset and they start to shout and say "Come on, can we play through please! You can't waste all of our afternoon!" They sent the priest up to find out what was going on and he came back absolutely crestfallen and said "You know why that poor guy is laying so slowly? It's because he's blind. I'm so upset because every Sunday I'm preaching to people to be nice to others." He turns to his psychoanalyst friend and say's "Joe, what do you think?" Joe says "I have these guys on my coach every week. I'm trying to help them live with this problem and here I am screaming at this guy. It's horrible!" Then they turn to the economist and say "Fred, what do you think?" Fred says "I think that this situation is totally inefficient. This guy should play at night!" As you can see, this is a very different attitude to how the world works.

I think what has happened is, because of this mythology about totally free markets being efficient, we push for that all the time and in so doing, we started to do things like-for example, we hear all the time that we have to reform labor markets in Europe. Why do we want to reform them? Because then they'll be more competitive. You can reduce unit labor costs, which usually means reducing wages. But that has all sorts of consequences, which are not perceived. In model that is more complex, that sort of arrangement wouldn't necessarily be one that in your terms would be selected for. When you do that, you make many people temporary workers. You have complete ease in hiring and firing so that people are shifting jobs all the time. When they do that, we know that employers then invest nothing in their human capital. When you have a guy who may disappear tomorrow-and we have a lot of these temporary agencies now in Europe–which send you people when you need them and take away people when you don't. Employers don't spend anything on human capital. We're reducing the overall human capital in society by having an arrangement like that. If you're working for Toyota, Toyota knows pretty much that you'll be working all your lifetime, so they probably invest quite a lot in you. They make you work hard for that, but nevertheless it is a much more stable arrangement. Again, the idea that people who are out of work have chosen to be out of work and by giving them a social cushion you induce them to be out of work-that simply doesn't fit with the facts. I think that all the ramification of these measures-the side effects and external effects-all of that gets left out and we have this very simple framework that says "to be competitive, you just have to free everything up." That's what undermining the European system. European and Scandinavian systems work pretty well. Unemployment is not that high in the Scandinavian system. It may be a little bit less efficient but it may also be a society where people are a little bit more at ease with themselves, than they are in a society where they are constantly worrying about what will happen to them next. The last remark I would make is that to say "you've got to get rid of all those rules and regulations you have"-in general, those rules and regulations are there for a reason. Again, to use an evolutionary argument, they didn't just appear, they got selected for. We put them in place because there was some problem, so just to remove them without thinking about why they are there doesn't make a lot of sense.

DSW: Right, but at the same time, a regulation is a like a mutation: for every one that's beneficial there are a hundred that are deleterious. So…

AK: You are an American, deep at heart! You believe that all these regulations are dreadful. Think of regulations about not allowing people to work too near a chain saw that's going full blast, or not being allowed to work with asbestos and so forth. Those rules, I think, have a reason to be there.

DSW: Well of course, but just to make my position clear, the idea of no regulations is absurd. For a system that is basically well adapted to its environment, then most of its regulations are there for a reason, as you say, but one of the things that everyone needs to know about evolution is that a lot of junk accumulates. There is junk DNA and there is junk regulations. Not every regulation has a purpose just because it's there, and when it comes to adapting to the future, that's a matter of new regulations and picking the right one out of many that are wrong. The question would be, how do you create smart regulations? Knowing that you need regulations, how do you create smart ones? That's our challenge and the challenge of someone who appreciates complexity, as you do. How would you respond to that?

AK: I think you're absolutely right. It's absolutely clear that as these regulations accumulate, they weren't developed in harmony with each other, so you often get even contradictory regulations. Every now and then, simplifying them is hugely beneficial. But that doesn't mean getting rid of regulations in general. It means somehow managing to choose between them, and that's not necessarily a natural process. For example, in France when I arrived here it used to take about a day and a half to make my tax return. Now it takes around about 20 minutes, because some sensible guy realized that you could simplify this whole thing and you could put a lot of stuff already into the form which they have received. They have a lot of information from your employer and so forth. They've simplified it to a point where it takes me about 20 minutes a year to do my tax return. It used to take a huge amount of time.

DSW: Nice!

AK: What's interesting is that you have some intelligent person saying "let's look at this and see if we can't make these rules much simpler, and they did. I have conflicting views, like you. These things are usually there for a reason, so you shouldn't just throw them away, but how do you select between them. I don't think that they necessarily select themselves out.

DSW: I would amend what you said. You said that some intelligent person figured out how to make the tax system work better in France. Probably not just a single intelligent person. Probably it was an intelligent process, which included intelligent people, but I think that gets us back to the idea that we need systemic processes to evaluate and select so that we become adaptable systems. But that will be systemic thing, not a smart individual.

AK: You're absolutely right. I shouldn't have said smart individual because what surely happened was that there was a lot of pressure on the people who handle all of these things, and gradually together they realized that this situation was becoming one where their work was becoming almost impossible to achieve in the time available. So there was some collective pressure that led them to form committees and things that thought about this and got it together. So it was a natural process of a system, but it wasn't the rules themselves that selected themselves out, as it were. It was the collectivity that evolved in that way to make it simpler.

DSW: There's no invisible hand to save the day.

AK: (laughs). Joe Stiglitz used to say that we also need a visible hand. The visible hand is sometimes pretty useful. For example in the financial sector I think you really need a visible hand and not an invisible hand.

DSW. That's great and a perfect way to end. I'm so happy to have had this conversation, Alan, and to be working with you at the conference we just staged and into the future.

AK: A pleasure. Always good to talk with you.

Alan Kirman is professor emeritus of Economics at the University of Aix-Marseille III and at the Ecole des Hautes Etudes en Sciences Sociales and is a member of the Institut Universitaire de France. His Ph.D. is from Princeton and he has been professor of economics at Johns Hopkins University, the Universite Libre de Bruxelles, Warwick University, and the European University Institute in Florence, Italy. He was elected a fellow of the Econometric Society and of the European Economic Association and was awarded the Humboldt Prize in Germany. He is member of the Institute for Advanced Study in Princeton. He has published 150 articles in international scientific journals. He also is the author and editor of twelve books, most recently Complex Economics: Individual and Collective Rationality, which was published by Routledge in July 2010.

http://fpif.org/open-fire-open-markets-asia-pacific-pivot-trans-pacific-partnership/

Markets: The Asia-Pacific Pivot and Trans-Pacific Partnership Christine Ahn,

Thomas Friedman once said the hidden hand of the market needs the hidden fist of the military. The TPP and the Obama administration's Pacific Pivot pack both.
January 14, 2014 | Foreign Policy In Focus

By increasing U.S. market access and influence with China's neighbors, Washington is hoping to deepen its economic engagement with the TPP countries while diminishing their economic integration with China.

... ... ...

"The hidden hand of the market," as New York Times columnist Thomas Friedman famously wrote in the 1990s, "will never work without a hidden fist." The Asia-Pacific Pivot, a one-two neoliberal-militaristic punch, packs both.

Of all people in the world, Hawaiians know this especially well. Once a sovereign nation, Hawai'i was the starting point for America's century of imperialism and conquest in the Pacific. Most people don't know this critical history, but what fueled the overthrow of Hawai'i's monarchy was trade. During the 1800s, American merchants were profiting handsomely from exporting sugar from Hawai'i to the United States. When faced with new tariffs that the U.S. government imposed to protect the domestic sugar industry in the American South, the exporters orchestrated a coup with the U.S. marines to overthrow the islands' queen and annex Hawai'i so that Hawaiian sugar would not be subject to tariffs.

With the world facing the pressing issues of global climate change, biodiversity loss, rising food prices, and declining sources of fossil energy, what is now needed more than ever are policies that promote local, sustainable economies that ensure the well-being of their people and protect the ecosystems upon which all of our lives depend.

Local communities seem to get it - new laws like the GMO restrictions recently passed in Hawai'i are a step in that direction. But with multinational elites and the U.S. government pushing undemocratic monstrosities like the Pacific Pivot and the TPP, prospects for a more genuine security appear more distant than ever.

Foreign Policy In Focus columnist Christine Ahn is a Senior Fellow of the Oakland Institute and Co-chair of Women De-Militarize the Zone (DMZ).

[Oct 26, 2013] Hyperglobalisation and metropolitan gravity

Metropolitan gravity of invisible hand... ;-)

NOT long ago, Paul Krugman published a little blog post documenting some calculations he had run on trade growth in America from 1997 to 2011. Foreign trade soared over the period, growing more than twice as fast as output. Domestic trade, by contrast, had grown less than GDP. Mr Krugman wrote:

I think this makes sense: the forces behind hyperglobalization - reduced transportation and communication costs leading to vertical disintegration of production - are encouraging mainly long-range trade to save a few percent on labor costs, not shipping stuff between U.S. cities. Interregional trade seems even to be lagging GDP, possibly because our cities are becoming less specialized than they used to be. (What does Atlanta do for a living, exactly?)

I responded that while growth in domestic trade in goods might be lagging GDP, total domestic trade-including trade in services, but also in the domestic value-added of what are nominally imports (like the engineering and design in an iPhone)-has probably been soaring. I still think that is right. But after reading Mr Krugman's recent and related paper on the subject (for which he was doing the calculations that inspired the blog post), I think we are not so much disagreeing as talking about different things. The story Mr Krugman tells in his paper is both fascinating and important.

When economics students are first introduced to theories of international trade they are instructed in the magic of comparative advantage. Imagine two countries, Britain and France, which both produce just two goods, grain and cotton textiles. Britain is better than France at producing both, but it is much better at producing cotton textiles and only a little better at growing grain. If the two countries then specialise, with each focusing on the product it is relatively better at producing, then they can exchange textiles for grain with each other and each wind up better off.

In the early 1930s Eli Heckscher and Bertil Ohlin expanded on this idea. They reckoned that comparative advantage was likely to be driven by "factor endowments". If Britain has relatively more capital than France while France has relatively more labour than Britain, then Britain will specialise in capital-intensive production and France will specialise in labour-intensive production. Which may correspond to British production of cotton textiles and French production of grain.

These were beautiful, elegant explanations for why countries should and would trade with each other. But postwar empirical studies revealed a slight problem: actual trade did not at all seem to match these models. America and Europe not only did not trade according to their factor endowments. They overwhelmingly sold the sorts of goods to each other that they also bought! Britons didn't sell the French cotton textiles in order to buy French grain. They sold the French Rovers and bought Citroens.

It was the effort to resolve this puzzle that led to the new trade theory, and Mr Krugman's contributions helped earn him a Nobel prize. New trade theory begins by explaining that markets aren't perfectly competitive. Instead, there might be increasing returns to scale in production: production costs fall with the quantity produced. There are many potential reasons why that might be the case; perhaps, as in car manufacturing, there are very large set-up costs. The implication of increasing returns, however, is that competition is limited because new entrants cannot initially price their goods competitively.

What does that have to do with trade? Well, consumers like variety, and variety is limited by the extent of the market. Trade increases the effective market size, so that more producers and more variety becomes economical. You might imagine a world in which a closed American market supports three automobile companies (call them Ford, Chrysler, and General Motors) and a closed French market also supports three (Peugeot, Renault, and Citroen). If America and France then open their markets to trade the larger combined market might support five automobile companies. The least profitable of the companies would go bust (and, in the real world, promptly be bailed out). But consumers in both economies would enjoy greater consumption variety, and America and France, against all odds, would sell each other cars.

Back then to the question of interregional versus international trade. Trade between rich-world markets-including that between two American regions or metropolitan areas-is not going to be dependent on factor endowments. Dallas and Chicago trade with each other, quite extensively as it turns out, despite the fact that the human capital and resource profiles of the two cities are similar and firms in each place have roughly the same technological capability. Interregional trade is not Ricardian. It is instead rooted in increasing returns and the sort of intra-industry trade that was explained by Mr Krugman's new trade theory.

Rapid trade growth over the past generation ("hyperglobalisation") is a different story, however. That trade has been associated with the incorporation in the global market of very large emerging economies that do have profoundly different factor endowments from rich-world economies: most notably in their relative abundance of cheap labour.

Now, that's a very interesting thing for Mr Krugman to have observed and described. There are interesting implications, as well. As Chinese labour becomes relatively less cheap and abundant (due to continued catch-up growth, demographic change, and other factors), the gains from comparative-advantage-oriented trade between China and the rich world will decline. Instead, we would anticipate trade between China and the rich world to more closely resemble trade within the rich world: "peer" firms in both countries will sell relatively similar goods to both markets.

But I don't think we should quite leave things there. Mr Krugman concludes his paper with the same message found in his blog post: that lagging goods trade in America is a product of increased homogeneity across America. But there is another dynamic worth considering.

As Mr Krugman notes, the great transport and communication innovations of the past generation did not necessarily reduce shipping costs. Rather, they reduced shipping time while also making international coordination of shipments cheaper and easier. The result has been, in Richard Baldwin's phrase, a "second unbundling". The first unbundling represented globalisation's geographic separation of production and consumption more than a century ago. The second is the geographic separation of stages of production. And one then has to ask how stories of the determinants of international trade apply to each of these various stages.

Return to the example of the iPhone. Design and engineering work and the production of critical components operate in an increasing returns world. Assembly, by contrast, seems to be governed by comparative advantage. As I noted in my prior blog post, one implication of this sort of unbundling is that measures of goods shipments between American cities will understate the amount of goods trade that is actually intra-American (since a percentage of the value of Apple products consumed in America should count).

But that's still a somewhat dissatisfying narrative. The question is: why should assembly be driven by factor abundance while design is not? It's obviously not because emerging markets can't produce sufficiently talented engineers; they do, and quite often those engineers go to Silicon Valley to work.

Mr Krugman has wrestled with these dynamics as well. Increasing returns can also generate geographic concentration. In the presence of certain positive externalities, productivity spillovers or complementarities or what have you, firms in one geographic area grow more productive as the area itself grows larger: more firms, higher productivity, more firms. So in one sense, increasing-returns-driven trade is what you get when the productivity benefits of local spillovers outweigh the potential gains from taking advantage of factor-price gaps. As the spillover benefits to bits of a supply chain erode (either because falling transport cost enable one to reap such benefits at greater distance, or because technology maturation means there is less of the tinkering and experimentation that seems to work best in clusters) those bits escape the pull of metropolitan gravity and fall toward places where the factors the bits rely on are cheapest.

That does present another question: does factor-price equalisation only apply across areas that are subject to Heckscher-Ohlin-type trade? It shouldn't if factors are mobile. Labour costs shouldn't vary all that much for similarly skilled workers in a common labour market, since if they did workers would move from low wage places to high wage places until they were equalised. If some sort of wedge were to impede such migration, however...

Ghentis

I think due emphasis needs to be given to the university systems in these developed countries. Apple and Google are successful in part due to the nearby top-tier universities like UCal and Stanford. Here you have tens of thousands of students who get paid nothing but have a relentless drive to produce the next greatest thing. And of course venture capital is centered around these areas to facilitate that.

The Chinese certainly have engineers who can design every bit as well as an American engineer. But do they have the open academic and collaborative environment of these universities? Or do they have venture capitalists willing to throw around millions of dollars on a whim? I don't think that infrastructure is there yet, nor might it ever come.

Despite the billions of dollars spent in R & D by countries like Japan, Taiwan, and Korea, even they have not been able to replicate a Silicon Valley-like environment. There's no isolated reason for this, but I would suggest that American universities play a strong role.

edwardong

@RA - you had me, right up until the link to the other blog about the housing wedge, which is wrong for all sorts of reasons. We need to find another wedge.

Second, the data above is for goods only, not services. Employment in the US economy is what, 80% services? Concluding that there is a housing wedge for labour in manufacturing (<20% of the economy) would be ignoring the dynamics in 80% of the economy.

chernyshevskyOct 24th, 21:16

Few people familiar with the tech world would attribute Apple's success solely to their design prowess. Much like in the fashion or entertainment business, nominative power plays a big role in high technology. Basically, certain firms like Apple get to define what excellence is. If Apple announces that it'll support Technology A, then people will start to believe that it represents the future. Conversely if Apply says Technology B is rubbish, then people will assume without further investigation that Technology B is indeed rubbish.

[May 20, 2013] Keynes on Laissez-Faire

Gavin Kennedy follows up on a recent post from Brad DeLong on Keynes and laissez faire:

Keynes on Laissez-Faire, by Gavin Kennedy: I read the Keynes quote below in Brad Delong's Blog:
As John Maynard Keynes shrilly stated back in 1926:
"Let us clear… the ground…. It is not true that individuals possess a prescriptive 'natural liberty' in their economic activities. There is no 'compact' conferring perpetual rights on those who Have or on those who Acquire. The world is not so governed from above that private and social interest always coincide. It is not so managed here below that in practice they coincide. It is not a correct deduction from the principles of economics that enlightened self-interest always operates in the public interest. Nor is it true that self-interest generally is enlightened… individuals… promot[ing] their own ends are too ignorant or too weak to attain even these. Experience does not show that… social unit[s] are always less clear-sighted than [individuals] act[ing] separately. We [must] therefore settle… on its merits… "determin[ing] 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.
Comment
My "Collected Writings of John Maynard Keynes" are kept in France, so I was able to re-read "The End of Laissez-Faire" from Volume IX: "Essays in Persuasion" (pp 272-94. Macmillan).
The paragraph quoted by Brad Delong is fairly typical of the tone and language of the Essay. While Keynes's main focus is on laissez-faire, it also strikes at the general proposition now widespread across the discipline, usually wrapped in the extreme neoclassical fable that:
[Adam] Smith proclaimed the principle of the 'Invisible Hand'; every individual in pursuing his own selfish good was led, as if by an invisible hand, to achieve the best good for all, so that any interference with free competition by government was almost certain to be injurious (Samuelson, Economics: an introductory analysis, 5th edition, McGraw-Hill, p 39).
Keynes, rightly, points out that Adam Smith never used the words laissez-faire. And on the single occasion where he used the IH metaphor in Wealth Of Nations, it is a travesty to impute, let alone blatantly assert, that his words can be stretched to mean what Samuelson's wild inference takes them to mean.
However, on this occasion I shall not develop that theme.
I want to return to laissez-faire, accepting how Keynes expresses his demolition of the popular idea that laissez faire has or ought to have traction in it. I completely agree. And before my libertarian friends jump on me, I should point out that the meaning drawn from the incident between the merchant, Legendre and the French Minister, Colbert, is not entirely innocent of a narrow self interest.
'Laissez-nous faire' is not advocated as a universal principle for merchants and their customers; it was a very partial principle for merchants only – "laissez-nous faire" cries Legendre ("leave us alone!"). And that is the point of my own libertarian reservations about the slogan itself and its origins.
French markets were highly regulated and supervised by government inspectors. Yes, I agree an abomination. This placed consumers at the mercy of the decisions of local magistrates. Freeing merchants from the administrative burdens of the inspectors could, indeed, be a tentative step forward but freeing merchants from interference from competing merchants puts consumers at the mercy of the intentions of the merchants, which, as experience shows, is a high-risk strategy and generally one that has woeful consequences. As it was, experience in England and Scotland had been deeply marked by the monopolizing consequences of merchant tradesmen free, under governments, through the dead-hand of the Guilds in towns where they held sway, and ruthlessly protected by the Apprenticeship Acts that virtually eliminated competition. No laissez-faire there!
Moreover, laissez-faire became the rallying cry for merchants and industrialists in the 19th century to rally support for resisting government legislation against the excessive hours in mills and mines and the employment of very young children and women. It was also the common slogan of the anti-corn law agitation aimed at lowering the wages of labourers under the guise of removing barriers to farm imports.
Neither of these laissez-faire campaigns were the disinterested motives of the beneficiaries. Mill owners preferred laissez-faire to protect themselves from interference in the arduous, unsafe employment conditions and long hours they imposed on the males, females and children whom they employed; Mine owners likewise employed women and children underground at lower wages than adult men. Both wrapped themselves in laissez-faire flags to wipe up the blood of their employees when they demanded their own freedoms and not those of their labourers or their customers.
On these issues I agree with Keynes.

Big Ugly:

You say "French markets were highly regulated and supervised by government inspectors. Yes, I agree an abomination." -

Are you sure that you want an unregulated food industry without government inspectors? Or an unregulated construction industry? Look how that worked out for Bangladesh???

The challenge is to regulate fairly.

Alex Blaze:

I didn't know that "laissez-faire" was the 18th century version of "Leave rich people aloooooooooooooooooooooooooone!"

Good to know! We should never have dropped the "nous," though, and people should stop pronouncing the "ss" as if it were a z instead of an s as in snake. It's not even the way English pronunciation works!

On substance, I agree with Keynes too. Especially since his argument isn't just about laissez-faire. It's also about the dumb argument people use to support it: it's natural to let people keep all their junk, so la-la-la-can't-hear-you we don't need to argue anymore. Considering these people don't have an even passing familiarity with anthropology, much less the background needed to pronounce something natural or unnatural, just telling them they're on-face wrong suffices. The fact that it's so rare to hear someone say that a certain "natural right" doesn't exist shows how powerful it is to just throw it out there.

paine said in reply to Alex Blaze...

"uncle ...touch nothing" market policy

Ryan Stevens:

I remember listening to a lecture by Bernard Harcourt years ago decrying how our perceptions of french bread markets as exemplars of over-regulations are odd in light of the myriad of regulations and arbitrary rules set by the Chicago Board of Trade. His paper on this subject, which is highly enlightening for just historical value, is here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1278067.

His argument is persuasive, though it seems to give little credence to how individual police officials could hold arbitrary sway over the market and enforce at their own whims. Just thought I'd through my two cents here.

Beatrice H.:

An Inquiry Into the Nature and Causes of the Wealth of Nations can be downloaded directly from the Project Gutenberg site, as well as some of John Maynard Keynes' works.

Adam Smith's only mention of the invisible hand is in this section

"every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain; and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention."

What many laissez-faire proponents fail to note is that Smith was talking about individuals, not corporations. Smith was against mercantilism and against corporations, which during his time were known as "joint stock companies" which he said actually harmed the functions of the free market.

KateJ said in reply to Beatrice H....

In fact, one could say his stance against "mercantilism" (the derogatory label he assigned to the polyglot of economic thinking coming before him) was a polemic against the overly-influential merchant interests that pressured governments to enact trading (and incorporation) policies in their favor.

anne said in reply to Beatrice H....

http://ebooks.adelaide.edu.au/s/smith/adam/s64w/chapter22.html

1776

Wealth of Nations
By Adam Smith

Of Restraints upon the Importation from Foreign Countries of such Goods as can be produced at Home

btg said in reply to Beatrice H....

when I read this, it is clear that Smith meant something more along the lines of "the wisdom of crowds" than the idea that "the market is god" and government intervention is wrong/laissez faire is the best solution (save for the usual libertarian accepted exceptions of defense, criminal justice and jails)

Main Street Muse said...

"It is not a correct deduction from the principles of economics that enlightened self-interest always operates in the public interest."

Yes. I cannot believe there is ANYONE in this day and age who thinks that "enlightened self-interest always operates in the public interest."

It is simply not true. And if models are being constructed on such a fragile foundation, shame on the economists who are doing this.

One hopes the pix of pollution in China is evidence enough that regulations exist for a reason - to protect citizens from the unregulated greed of corporations (all those many "people" Romney loves!)

John Cummings said...

We need to rebuild the ancient Vedic castes: 1.Brahmins: Priests 2.Kshatriyas: soldiers 3.Vaishyas: merchants 4.Shudras: laborers/artisons 5.The final caste would be the "slaves" or as in modern times the degenerates and destroyers of culture.

Only the first 4 castes will be granted freedom. The final caste would do "good works" to they redeem themselves to their tribe.

Reply Sunday, May 19, 2013 at 06:34 PM

The Blorch said in reply to John Cummings...

Politicians are the merchants. To get elected, they buy their votes wholesale. The pay using a revolving line of credit. As collateral, they put up focus group tested talking points sprinkled generously over their speeches and interviews.

Once elected, the politicians sell their vote retail to the wealthy special interest at a price yielding hefty profits.

hapa said...

i remember saying to someone here a while ago that keynes was "a laissez-faire kind of guy" or some such. it comes out to the question of 'belief' in markets. are they what they are, or would you call them miraculous? among people who see them having good & bad qualities, then keynes seems to have wanted them given pretty free hand.

one thing's for sure, if the corporations have their way, the fetters will NEVER come off, neither through the legislatures nor the courts. so everything else they say about the miracles is junk, or worse, attempting to bias the next jury.

Reply Sunday, May 19, 2013 at 06:49 PM

The Blorch said in reply to hapa...

That's my problem with libertarians. Of course well funded interests are going to solicit the favorable interventions from the government that ossify their rents in place. The libertarians are against it in principle but what can you do? Them that gots gets.

But when poorly funded, loosely organized interests initiate advocacy for government intervention to redirect policy in favor of resource challenged constituencies, the libertarians smell blood and grab on like sharks, pulling and twisting.

As the libertarians fail to prevent intervention from institutional wealth (which they obliged by dogma to do) but are able to find common cause with institutional wealth in stomping out the burgeoning interventions of resource challenged upstarts, they promote policy outcomes biased towards the rich.

What's grating, is they don't knowledge this convenient discrepancy. It's convenient because they can solicit support from wealthy, institutional donors. In other words, Libertarians are a complete scam!

Reply Sunday, May 19, 2013 at 08:16 PM

C.B. said in reply to The Blorch...

Libertarians like myself have failed in reducing rents AND reducing the welfare state. You somehow interpret the former as a result of passive acceptance, and the latter a result in spite of aggressive rejection. Please, explain where this interpretation comes from.

Libertarians, for example, were some of the most virulent critics of the bank and auto bailouts. How does that factor into your simplistic analysis?

[Jul 07, 2012] Both The Market and Government Are Irrational

March 14, 2012 | PaulCraigRoberts.org

One of the great economic myths is that markets are rational. Not a day passes without this myth being disproved scores of times, but the myth persists.

For example, today (March 14) Bank of America/Merrill Lynch reported that "yesterday US markets started the day off with a strong rally after the solid retail sales report. . . . tailwinds are helping boost global equity markets today."

The "solid retail sales report" for February consists of 1% nominal gain. That is, the increase is not deflated by the month's inflation rate, which will be released on March 16. In other words, if very much of the 1%nominal gain in retail sales is due to higher prices, the inflation adjusted gain will not be statistically significant. The "rational market" took off without waiting to find out whether the gain was real.

Moreover, as statistician John Williams has established, the official Consumer Price Index (CPI) understates inflation. If an honest measure of inflation was used, retail sales could be in negative territory.

The "rational market" loves deception as long as it provides an excuse for equities to rise. The Federal Reserve's focus on "core inflation," which does not include rising food and energy prices, allows Federal Reserve officials to maintain that the inflation rate remains below target. By pretending that there is no inflation, the Federal Reserve continues to support banks with near zero interest rates while depriving savers and retirees of interest income. With no income from savings, people are forced to consume their capital. Thus, the Federal Reserve's policy makes bankers richer and the country poorer.

Meanwhile, those whose old age security is based on pensions are confronting insecurity. Many with private pensions were harmed by the financial crisis. Those dependent on Social Security and Medicare are finding that these programs are being blamed for budget deficits caused by multi-trillion dollar wars of choice. Those expecting pensions from state and local governments are finding that governments are unable to make good on underfunded pension benefits.

State and local governments counted on a growing economy and rising consumer incomes to provide the tax base to make good on underfunded pensions. These governments did not foresee that US corporations would destroy their tax base by moving manufacturing, engineering, IT, research and design jobs overseas. The absence of growth in real incomes for the vast majority of the people and the capture of productivity gains by capital at the expense of labor have added to the budget woes of most state and local governments.

John Rauh at Northwestern University estimates that the unfunded obligations of state and local governments amounts to $4,400,000,000,000, an amount that is within the ballpark of Joseph Stiglitz and Linda Bilmes' estimate of the cost of the Iraq and Afghanistan wars.

Money that could have saved Americans' pensions instead was allocated to profits for armament corporations and to advance Israel's territorial hegemony.

When the Occupy Wall Street movement says that Washington rules for the benefit of the 1%, OWS is not far off the mark.

Adam Smith Would Neither Recognize Nor Approve Of Our Financial, Monetary, Economic Or Legal Systems

July 31, 2011 | naked capitalism (originally at Washington's Blog)

The father of modern economics – Adam Smith – is used as a poster child to support the status quo that we have today. Smith is invoked as the patron saint of free market economics.

In fact, Smith would neither recognize or approve of our current financial, monetary, economic or legal systems.

I noted last year:

Americans have traditionally believed that the "invisible hand of the market" means that capitalism will benefit us all without requiring any oversight. However, as the New York Times notes, the real Adam Smith did not believe in a magically benevolent market which operates for the benefit of all without any checks and balances:

Smith railed against monopolies and the political influence that accompanies economic power …

Smith worried about the encroachment of government on economic activity, but his concerns were directed at least as much toward parish councils, church wardens, big corporations, guilds and religious institutions as to the national government; these institutions were part and parcel of 18th-century government…

Smith was sometimes tolerant of government intervention, "especially when the object is to reduce poverty." Smith passionately argued, "When the regulation, therefore, is in support of the workman, it is always just and equitable; but it is sometimes otherwise when in favour of the masters." He saw a tacit conspiracy on the part of employers "always and everywhere" to keep wages as low as possible.

Paul Krugman pointed out:

Adam Smith … may have been the father of free-market economics, but he argued that bank regulation was as necessary as fire codes on urban buildings, and called for a ban on high-risk, high-interest lending, the 18th-century version of subprime.

And Damon Vrabel wrote:

It seems ridiculous to point this out, but sovereign debt implies sovereignty. Right? Well, if countries are sovereign, then how could they be required to be in debt to private banking institutions? How could they be so easily attacked by the likes of George Soros, JP Morgan Chase, and Goldman Sachs? Why would they be subjugated to the whims of auctions and traders?

A true sovereign is in debt to nobody and is not traded in the public markets. For example, how would George Soros attack, say, the British royal family? [Vrabel is presumably referring to Soros' currency speculation against the British pound and other currencies.] It's not possible. They are sovereign. Their stock isn't traded on the NYSE. He can't orchestrate a naked short sell strategy to destroy their credit and force them to restructure their assets. But he can do that to most of the other 6.7 billion people of the world by designing attack strategies against the companies they work for and the governments they depend on.

The fact is that most countries are not sovereign (the few that are are being attacked by [the big Western intelligence services] or the military). Instead they are administrative districts or customers of the global banking establishment whose power has grown steadily over time based on the math of the bond market, currently ruled by the US dollar, and the expansionary nature of fractional lending. Their cult of economists from places like Harvard, Chicago, and the London School have steadily eroded national sovereignty by forcing debt-based … currencies on countries.

We long ago lost the free market envisioned by Adam Smith in the "Wealth of Nations" [the book widely considered to be the foundation of modern economic theory]. Such a world would require sovereign currencies…. Only then could there be a "wealth of nations." But now we have nothing but the "debt of nations." The exponential math of debt by definition meant that countries would only lose their wealth over time and become increasingly indebted to the global central banking network.

Smith also knew that trust was a basic ingredient of a sound economy. As I noted in March:

In 1998, Paul Zak (Professor of Economics and Department Chair, as well as the founding Director of the Center for Neuroeconomics Studies at Claremont Graduate University, Professor of Neurology at Loma Linda University Medical Center, and a senior researcher at UCLA) and Stephen Knack (a Lead Economist in the World Bank's Research Department and Public Sector Governance Department) wrote a paper called Trust and Growth, arguing:

Adam Smith … observed notable differences across nations in the 'probity' and 'punctuality' of their populations. For example, the Dutch 'are the most faithful to their word.'John Stuart Mill wrote: 'There are countries in Europe . . . where the most serious impediment to conducting business concerns on a large scale, is the rarity of persons who are supposed fit to be trusted with the receipt and expenditure of large sums of money' (Mill, 1848, p. 132).

Enormous differences across countries in the propensity to trust others survive
today.

***

Trust is higher in 'fair' societies.

***

High trust societies produce more output than low trust societies. A fortiori, a sufficient amount of trust may be crucial to successful development. Douglass North (1990, p. 54) writes,

The inability of societies to develop effective, lowcost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World.

***

If trust is too low in a society, savings will be insufficient to sustain
positive output growth. Such a poverty trap is more likely when institutions -
both formal and informal – which punish cheaters are weak.

Because strong enforcement of laws against fraud is a basic prerequisite for trust, I believe Smith would be disgusted by the lack of prosecution of Wall Street fraudsters today.

And Smith warned against the pitfalls of fiat currencies unpegged to anything real:

The problem with fiat money is that it rewards the minority that can handle money, but fools the generation that has worked and saved money.

It is certain that Smith would rail against our current financial, monetary, economic and legal systems as violating the most important foundations of sound economics.

JTFaraday

Yeah, but outside a handful of conservative intellectual historians no one knows or cares what Adam Smith had to say. Much of what Adam Smith had to say became embedded in *liberal* economic assumptions in the 20th c, likewise upheld by now near-extinct moderate Republicans in an act of *true* bipartisanship, at which point it could be safely "forgotten."

Since then, Adam Smith has been under attack under the *sign* of "liberalism" by the Ayn Randians and ubiquitous social Darwinists who make up the right wing revolutionary front.

When these people donate money to universities, it isn't Wealth of Nations (let alone the Moral Sentiments) that they want to get on the curriculum:

"If you're going to spend a lot of money endowing a professorship, it's only rational to ensure that the professor whose salary you're paying advances your interests, right? After all, when the Kochs invested millions in George Mason University, they got the incredibly influential anti-environmental regulation nonprofit Mercatus Center out of the deal. The least FSU can do for its cash is teach "Atlas Shrugged" in a business ethics class. (Which is something that Randian-run bank BB&T has made happen, also at Florida State University.) (Yes, BB&T received billions of dollars of TARP money.)

Today's rich libertarian knows the real ticket to winning the future is filling schools with people who agree with you. (This hasn't worked for the left, but that may be because they spent all their time in control of academia rigorously critiquing texts instead of just inventing pseudo-scientific justifications for gutting the welfare state and eliminating the tax burden of very rich people.)

But is buying an academic a good investment? Sure! Just ask the DeVos family, who - when they're not pushing "education reform" - are keeping Austrian economics afloat at their weird fake Michigan university. As Andrew Leonard reported yesterday, DeVos-funded ideas have made it all the way to the chairman of the House Ways and Means Committee!"

http://www.salon.com/news/politics/war_room/2011/05/12/buying_professors_kochs

Face it: Adam Smith, like Teddy Roosevelt, is a liberal pantywaist.

Foppe:
Haha: (FTA)

How many economists, exactly? Well, just two actually - and both of them happen to be employed at Northwood University, an educational titan described by one of the economists quoted in the article as "a private institution of higher learning dedicated to the principles of individual liberty, the free market, and limited government."

Northwood's credo has resulted in ample support from such conservative philanthropists as Amway founder Richard DeVos. With campuses in four states but a total student body around the size of a large high school, Northwood University was memorably described in an entertaining Texas Monthly article in 1986 as an institution for "those who find Southern Methodist University too liberal."

This characterization is amply justified by a look at the curriculum vitae of professor Richard Ebeling, who was quoted in the ConnectMidMichigan story and who will be testifying Wednesday at a hearing before the House Financial Services Subcommittee on Domestic Monetary Policy and Technology (chaired by Rep. Ron Paul) "on the role of debt in the monetary system." Formerly the Ludwig von Mises Professor of Economics at Hillsdale College, Ebeling is a strong advocate of a return to the gold standard and the author of several books on "Austrian economics." For Ebeling, the accusation that President Obama is attempting to lead the United States down the path to socialism is moot: We are all already socialist - the mere existence of the Federal Reserve proves it: "Central banking is monetary central planning," writes Ebeling. "The United States and, indeed, virtually the entire world operate under a regime of monetary socialism."

Moopheus:

"A true sovereign is in debt to nobody and is not traded in the public markets."

Except of course that for as long as there has been both money and governments, governments have carried debts. Monarchs carried debts, both personal and national. Some literally lost their heads over it. (If we brought back that practice, I'd bet today's "crisis" would get solved right quick!) Perhaps it is true that in Ye Olde Days, there wasn't the same sort of open market for that debt as there is today, but so what? The only reason today's monarchs can't be attacked by bond vigilantes is that today's monarchs are figureheads on state welfare.

F. Beard:

And Smith warned against the pitfalls of fiat currencies unpegged to anything real: George Washington

Ah, here's a fly in the ointment. Government fiat is "real"; it is backed by the real ability of government to require that taxes be paid with it. The problem with fiat is not that it is unbacked but that we are required to use it for all debts, not just government ones – taxes and fees.

Thus the US Government and the banks are able to impose a "stealth inflation tax" on the population.

Rodger Malcolm Mitchell:

Why do we care what Adam Smith said in a different time under different circumstances? Are we so devoid of fact and logic, we must instead bow down to the words of a man who died 200+ years ago?

I always am suspicious of people who quote the bible and long dead philosophers:

1. The quotes invariably are selectively chosen and selfishly misinterpreted.

2. The issues and facts today invariably are different from the issues and facts of long ago.

Again, anyone who cares what Adam Smith said has replaced the power of personal reason with the crutch of celebrity.

Rodger Malcolm Mitchell

[Oct 27, 2010] Gonzalo Lira On The Identity Of The False Religion Behind The Mask Of Economic Science

The point with most economics, and with neoliberal economics worst of all, is that it assumes that egotistical behavior will lead to optimum outcomes.
zero hedge

mikla:

I think he was using irony, because he was referring to ClimateGate, the climate 'scientists' who were fudging data in order to provide the results they were looking for.

Ok. My response is still that at least the people pretending to do "climate studies" actually have the good sense to fabricate plausible results, even if they have to hide their falsified data. Economists are too stupid to do even that.

The real question is whether the oligarchy is dumb, or whether they benefit from the boom-crash economy.

They are mere snake oil salesmen. The provide nothing, through deceit and fraud, in exchange for a paycheck. They are comprised of (1) true idiots, and (2) mercenaries willing to rationalize any concept to curry favour from the central planners.

Citxmech:

According to Popper, science seeks the [small-t] pragmatic "truth" by posing questions in a falsifiable manner and disseminating the results for public scrutiny - thus a well-formulated hypothesis that yields the predicted results will be accepted by the scientific community... until it doesn't. Inconsistent hypotheses will be reconciled by continued attempts at falsification of the incompatible hypotheses until consistency is achieved. A hypothesis that consistently yields good results will be elevated to "theory" status. Re-evaluation of theories are scientific revolutions. The big-T truth is, of course, never attained - but we get further from ignorance as the process continues.

Under Popper's paradigm, macro probably fits into the "pseudo-science" category with things like psychology, where complex inter-related dynamic systems are attempted to be understood by unfalsifiable gross oversimplifications.

Sean7k:

If you read my other posts, you will see exactly what my "logical" conclusions are and how to implement them. All guided by Austrian theory. I want to see the system destroyed- you want to live within it- good luck with that. I have a fall back position that mitigates the worst parts of monetarism- do you?

Any idea what your avatar really means? I just see a lot of Yin.

jm:

You and I both have to live within it. There's no alternative. There is no grand revolution coming to the rescue that puts all the bad guys on the bottom (or jail) and ushers in a golden age of freedom and non-bullshit. You should work for evolution.

Real revolutions leave everyone worse off, poorer, and most likely mourning the loss of loved ones. And then a new set of skimmers takes over on top.

Russian peasants were all-in on killing the kulaks with a sickle. A couple of years later Stalin was killing them with a hammer.

zaknick:

I think you're wrong. There is no way these scumbags can get away with this murderous madness they call our reality. They've hollowed out the American economy (the true basis of their own power) handing out so-called free trade agreements which were just bribes in exchange for bankster interests in unfathomable wealth overseas (not in China's case where they finally obtained what they always wanted: slave laborers).

I also fail to see how most folks come out poorer after a revolution with the inequality rates of today. Do you not understand that the wealth production capability of this nation was stolen? Financial garbage was the biggest export by far in the US. A revolution that squeezes the oligarch's interests opens up economic opportunity for entrepreneurs which is

  1. A job and wealth creator,
  2. The way nature meant it to be until these bankster supported bandits took over the economy as if it was their own little plantation and we their slaves.

It is untrue that after major changes a new prosperous for all economy cannot emerge from the ashes of the curse of the present system, especially with the talent on tap in America and the gutting of decrepit monopolies and policies that stink of fascism.

jm:

Sure, I could be wrong. But venom and anger about how things are doesn't make a brighter future.

You talk about "murderous madness"... injustice, sure. It has happened everyday since humans lived. But to talk of murderous madness is so rhetorically out of proportion that it is an injustice to people that have actually been killed and tortured and murdered. There is real murderous madness in this world, but not here. Let's both hope murderous madness never really happens here.

You and I have every right to be angry about how awful things are, but it can't absolve everyone of responsibility. I'm not going to try and assign blame, because everyone had a part in making this shit sandwich... everyone take a bite. Shared sacrifice and time.

I'm all for innovation and entreprenuership. But I'll let return on capital decide how nature decides on things.

Bankster bandits taking over. People with money bribe politicians. This is how it has always been and always will be. Revolutions just make a new set of people that bribe a new set of politicians. After the herd gets thinned out, of course.

No doubt that prosperity is possible here. But when you talk about "emerging from ashes", that's an obstacle to it. You unleash that and there's nothing but pain and trouble. It is easy to trivialize this. At everyone's peril.

Peace.

zaknick:

There are literally millions of innocent people and children around the world and right here in the goood ole US of A who would disagree with you negation of murderous insanity.

As to everything else you said, I would rather be free than a slave to other men and their games. Dylan said something like, "you play with my world like it's your own little toy". That to me is un-freaking-acceptable. Capisce? Most of the misery in this world is man-made. I'll worry about the next bunch of fascists when the time comes, for now I'll concentrate of opposing them any way I can which is why I spout off so much around here.

Franklin, Jefferson, Lincoln, Garfield, JFK all knew and warned us of the dangers we face today. I have known peace and prosperity and I know it can exist no matter what you say.

Peace

Walter_Sobchak:

jm you are a defeatist. zaknick you are an idealist. Civilization is fascism.

B9K9:

My father, the long time MIC intelligence operative, taught me the most important rule:

He who complains has already lost.

Some may notice that my posts never promote any ideals, nor complain about how things actually are, or deplore that the pace of change is too slow, etc.

Nope, they're usually just straight observations about how things actually work, with a little bit of monetary mechanics thrown in to support certain conclusions.

Life is really quite simple: we are born, grow & develop, decline & die. During our peak growth & development stage(s), we must compete for scarce resources in order to support the offspring that typically result from successful mating strategies. Evolutionary pressures have resulted in the manifestation of certain behaviors centered around organizational power.

Societies & cultures are simply amalgamations of individuals, so they tend to mirror and replicate individual behavior. The quest for power consolidation is a key foundational element of government. Since most people are ill equipped to survive this type of environment, the strong always rise to the top.

However, and this is a huge however, as noted above, these self-same societies, cultures & governments are also subject to the immutable laws of nature: they are born, grow & develop, then enter a period of decline and die.

What does this mean to us? Simple - don't bother complaining. Just let nature takes its course. If a society/culture/government is presently in a growth & development stage (ie at its peak power), it is a waste of time/energy to complain or attempt to effect meaningful change. OTOH, if it is entering the decay/death cycle, one need not do anything other than perhaps give a gentle 'push'.

The USA, as it is presently constructed, is in terminal decline. The Fed cannot fight the math - they needed some incredible new growth component to bc theories, it might profit one to think about the larger scale cycle(s) that are playing out in real time. From the ashes a new form of organization will arise - will you make it through the bottleneck and/or benefit from the new paradigm?

I suggest this is what people should be contemplating and planning.

philgramm

B9K9,

This is one of the more profound posts I have read here on ZH. There are very smart readers on this site but I often sense the immense frustration that the readers (myself included) feel with the current paradigm. It seems the smart thing to do is try to prepare for the inevitable collapse in this boom/bust cycle and to try to live as true to oneself as possible without being a pawn. Oh.......and try to have a laugh or two along the way (I can always count on ZH readers to provide my daily dose of yucks)

Cognitive Dissonance:

It matters not whether your followers have benefited from your preaching. It matters only that your disciples do as they are taught and continue to weave their wool and deceive their sheep.

As long as the economic shock and awe troops aka economists, money managers and financial product salesmen continue to support the masters of the universe, the followers will continue to get coal in their statements and be told it's divine diamonds in the rough.

Login or register to post comments by zaknick on Tue, 10/26/2010 - 17:31 #678941

Exactly. Like psychiatrists and psychologists (maybe not all) are just drug peddlers making up quackery as they go along with big pharma's part of the fascist plan. It really is criminal to push pills on somebody who's unwell emotionally for 30 years doing God knows what to them (the FDA sold out long ago) and never "fixing" the issue.

I could go on and on about so much corruption in the society but why bother... if you don't know by now, you're one of the sheep headed for slaughter.

Sabremesh:

You are missing the point. It doesn't matter if he has mischaracterised Austrian economics - it is still a dogma. Economics is the charlatanry of our age, and future generations will look back at us with the same contempt for believing in it that we currently hold for earlier civilizations who swore by astrology and divination by entrails.

Cognitive Dissonance:

You are missing the point. It doesn't matter if he has mischaracterised Austrian economics - it is still a dogma.

Ummmm,

Did you by some chance hit the wrong "reply" button? Because I said nothing about Austrian economics and was commenting directly to the author about the main theme of his article, a False Religion Behind The Mask Of Economic Science.

Escapeclaws:

"Economics is the charlatanry of our age"

What about psychology and psychiatry (psychology with drugs)? Those guys do all their research on captive populations in mental hospitals. Pray you never end up in one. Remember lobotomy and shock therapy? That's their version of physicists using supercolliders to study elementary particles. Of course we all know that physics can't hold a candle to psychiatry or economics when it comes to rigorous analysis.

Now they forcefeed patients risperidon like french farmers force feeding geese to make fois gras. The patients develop so many secondary symptoms that the psychiatrists tell the families that the twisted bodies and projected tongues are the result of their debilitating mental disease which the industrial strength drugs are designed to combat.

Sounds like what Bernanke is doing to the economy by force feeding ZIRP and QE. And like psychiatrists, the Fed is accountable to none.

AnAnonymous:

Is total baloney.

If he is going to bash Austrian economics, he should at least take the time to bother learning what it says.

Funny, funny. Most of the comments section confirms economics as a religion.

Lets focuse a bit on religions.

One common tactics is to tell that people have first to study their religion before being critical of it. Of course.

A disbeliever/misbeliever/unbeliever/other believer start to learn the religion. In the end, it turns itself into a toddler as his knowledge will be validated by the new authority.

Guy learns the religion for 20 years. He comes back but his knowledge is deemed not accurate enough. More over, you need a certain life experience to understand.

So what? Let your kids learn the religion. But later, it appears that your kids are not born in the religion. You need to be born in the religion etc...

In the end, the guy family is found to be converted.

It is more an abrahamic religion thing to be fair on other religions.

This said, economics worshippers use the same tactics. Hidden conversion.

Austrian schools of economics is not less a religion than any other school of economics. Their praexology is the deus ex machina per excellence.

This said, religions do not prevail one over the other by terms of facts but matter of opportunity.

The roman empire wealth was accumulated under other auspices than Christianity. Christianity was established in Europe by a state decision, no matter what the Christians like to claim on separation between religion and government.

It is a matter of opportunity. And the Austrian school of economics might the next trendy economics religion.

Not because it is truer. But because the opportunity is right there.

zloty owadow:

Easily observable fact: Economics is not a science simply because each branch of genuine science takes great pains to accurately measure anything which is studied. Many scientists have spent their lives creating better and more accurate rulers, so that other scientists can measure more accurately. This is a key part of science.

Economic "scientists" on the other hand insist on making their rulers (viz. currencies) more and more rubbery and inaccurate. Their research reports then create more problems in measurement process by adjusting hedonic oscillators, extrapolating extispicetic functions, and encouraging coprophagic denial factors until the printing of such nonsense is simply a bad joke.

Imagine asking a physicist: "How fast is speed of light?" and his reply is:

"What year? In 1920, it was 300,000 kilometers per second, but in 2010 it is 3,295,500 kilometers per second!"

You would immediately think "He is bogus, he is a joker!" All the time we are talking about, from 1920 to 2010, the speed has not changed, but the ruler has stretched...quite a lot. This is the picture of an economist. The bad joke is, we all take them seriously and allow them to talk as if they are also learned people who have something to say which may help us and our civilization. In fact the situation is much worse than this humourous reductio ad absurdum because it is done on purpose. Economics is not a branch of science, it is a branch of thievery which makes necrophilia look like a wholesome career.

aarskever :

A bit hit and miss in your sketch of the field and its problems.

First of all, yes, religion is just one type of behavior that is based on an ideological set of beliefs.

Yes, orthodox (and most other types of) economics is like religion, but for a different reason than you mention here. The point with most economics, and with neoliberal economics worst of all, is that it assumes that egotistical behavior will lead to optimum outcomes. That is, the 'invisible hand' of the market is actually a providential god that will magically make us behave in an altruistic fashion by behaving egotistically. How idiotic is that? As anyone who has heard of game theory knows, optimal outcomes - especially in prisoner's dilemmas - are reached through mutual cooperation, and not through mutual treachery. Yet neoliberals have been teaching business majors for 30 years now that people should never behave altruistically, as this would 'upset the market'.

And this is why economics today is religion: it assumes that the best outcomes are generated by unchecked self-interest. But even though everybody knows that life just isn't that easy, for some reason everyone has come to believe it. Certainly markets are hard to predict, and trying to control them is dangerous (See the Fed's current actions); but it hardly follows from these two statements that therefore we must not try to influence anything, because then and only then the 'best outcome' will make its grand entrance. That's not just an idiotic belief in the rationality or fairness of the market, it's grotesque. You don't help people by trying your hardest to screw them, in order to maximize your own pathetic profits, you hurt them. Yet hurting - in the newspeak of Neoliberals - is helping.

calltoaccount:

"They anaylze data for christ sakes"

just like Mishkin analyzed Iceland for 120k? a huge proportion in US on Fed payroll, or beneficiaries of corporate thinktank cash; they are coverup lipstick and makeup; hacks for hire.

like truth-trashing mortgage pushers, credit raters, CDO CDS market manipulators and bribe-fueled fraud enablers of all stripes- they do it for the dough-- and because everybody else is doing it.

THE DORK OF CORK:

Excellent article - the prince / priest dynamic is at the core of politico - economic developments since the dawn of civilization.

The Priest control peoples minds while opportunistic princes who detect weakness in the control framework appeal to the masses for direct power.

The pond has been stagnant for some time, with the priestly algae blocking the light from reaching the ecosystem.

The system will die unless the pond is oxygenated.

The Austrian solution is absurd as very limited government would merely create a power vacuum that would be filled by Tamerlane like figures who will fill the chaos with violence and extreme malice.

A powerful government with limited powers is what is needed, not the weak government with unlimited powers of the present or a Austrian fantasyland of exponential contractual interconnections only and completely ignoring the responsibility of government to balance the power balance between various players before they gain a critical mass of unlimited consolidation of power.

Variance Doc:

I normally like reading Mr. Lira's articles, but this one does not have the quality of the previous posts.

First, there needs more fact checking. For example, he claims "...Myron Scholes, Robert Merton and Fischer Black...invented options pricing..." This is simply not true. Options and pricing have very long history BEFORE these guys came along; it just wasn't a unified approach. What these guys did was bring in models from mathematical physics - stochastic processes, and apply them to the options pricing problem. It is a beautiful application of math; their work does deserve the Nobel memorial prize! What this did was to establish a coherent way to CALCULATE a fair price, assuming some (unrealistic) market conditions, for European options.

Second, it claims people never can be predictable (modeled). This is not true either. Economics assumes equilibrium exist and thus economists are able to use some basic mathematical models, masturbate with the math, sit back and marvel how smart they are. This is the state of the art in econ today. Not very impressive. Take away the assumptions behind the math, and the cookie crumbles - forecasts/predictions are way off, dogs and cats living together, printing money is the answer, etc. What is needed is far more advanced math to model non-equilibrium settings and this is where the economist's brain fails. It is possible (I believe) to model people, we (non-economists) just have not invented the math yet.

The state of the art in econ today is very primitive, and that is why there are all these debates about deflation/inflation, Neo-classical vs. Neo-Keynesians vs. Austrians, etc, and no concrete answers.

ebworthen:

Go apply mathematics to your significant other and see how far it gets you...

tomdub_1024 on Tue, 10/26/2010 - 21:58 #679574

Been tossing this idea/theory/whatever around in my head a while...a steady state economy...

http://en.wikipedia.org/wiki/Steady_state_economy

Not saying that I joined the "church" or anything like that, but from a middle class perspective, kinda makes some sense at a local/family/personal level the past 20-30 years.

I never did really buy the "continuous growth" "continuous improvement" mantras of the 80's-00's...I mean, in Biology class, and observations in wilderness, demonstrated to me rather tersely the concept of "the edge of the petri dish", and what happens to what lives within the petri dish at that point the edge is reached.

And we must always throw in reversion to mean, and that history is non-linear, cyclical instead.

Just musings at this time, seems every orthodoxy is reaching frayed limits these days, so why not entertain heretical ideas, if only in mental exercise?

I know that many sci-fi writers (Heinlein and Asimov especially), toyed with this idea.

Winisk
Conservation and equilibrium are not allowed in economic discussions :) Populations will grow until they are constrained by a greater force. That is the natural way. Our economy will grow until it can't. It always struck me as odd that the pro-reproduction and immigration policy is considered healthy and promoted while any discussion of voluntary birth control is hushed. Perhaps a primer on the science of populations should be on the reading list. Nevermind, I forgot that we humans are bestowed with supernatural qualities.

ddtuttle

The reason economics isn't a science has nothing to do with economics per se and everything to with politics & power: by controlling economics you control the economy. This obvious fact has been a key strategy for the power elite for centuries if not millennia.

What people think governs how they behave, and when you control how they behave with money, you can make sure it flows into your pocket. But how exactly does this happen in our modern society, where academic work is subjected to peer review and stringent standards of intellectual excellence? Easy.

The saying "money doesn't grow on trees" does not really hold for banks. They create it out of thin air, so why fuck around with trees? They hire most of the economists, and the front man must deflect scrutiny from how the system really works. "Pay no attention to the man behind the curtain." The fractional reserve banking system, which is the holy of holies at the core of modern economics, has several properties.

So economics is coerced into becoming propaganda that states the banking system is the cornerstone of the complex financial world of today. Banks perform a valuable socially beneficial service. Because banks can also get caught out by this bi-polar cycle of manias and recessions, they thought up a really neat idea: let's create a new bank whose sole purpose is to manufacture new money and give it to us when we get ourselves into trouble. This way we make money when things are hopping, and we don't loose money when it turns out we fucked everything up again. This fine institution was actually created and is called the Creature from Jekyl Island, aka the Federal Reserve. It's whole purpose is to create money out of thin air and give it to troubled banks. It's liabilities are guaranteed by the US government and the US taxpayer.

Matt Tiabbi's wonderful contribution to the english language "a vampire squid wrapped around the face of humanity, sticking its blood funnel into anything that smells like money", was aimed at GS, but is really a better description of the Fed. This power structure is the force corrupting economics. Of course, economics will never be precise like physics, but it is possible to make it more precise than the mess we have now. Yes, at its core are the actions of people and their money, which we all know can be emotionally charged. But, money comes in mathematically precise denominations, and the vast majority of people can at least add and subtract numbers, so eventually people gravitate towards a solution of self interest, which in its broadest strokes is predictable. Its a little like phase changes in physics. A super saturated solution can exist indefinitely, but eventually it precipitates out; its hard or impossible to say when, but we know what its going to do.

Turbulence is another unpredictable quantity in physics, but it operates within fairly strict confines and within known time frames. Precise short term predictions are impossible, but long term approximate ones are fairly accurate.

For an even better example of how precise economics can be check out Steve Keen's web site. Because he's in Australia, the Fed can't blacklist him. Awesome stuff.

[Oct 05, 2010] Hegel on Wall Street - By J.M. BERNSTEIN

It's sad that we cannot jail pompous and corrupt academicians like Larry Summers.
October 3, 2010 | NYTimes.com

The Stone is a forum for contemporary philosophers on issues both timely and timeless. Tags: Ethics, Hegel, Philosophy (Des);, TARP, the economy

As of today, the Troubled Asset Relief Program, known as TARP, the emergency bailouts born in the financial panic of 2008, is no more. Done. Finished. Kaput.

Last month the Congressional Oversight Panel issued a report assessing the program. It makes for grim reading. Once it is conceded that government intervention was necessary and generally successful in heading off an economic disaster, the narrative heads downhill quickly: TARP was badly mismanaged, the report says, it created significant moral hazard and failed miserably in providing mortgage foreclosure relief.

Propounding peace and love without practical or institutional engagement is delusion, not virtue. That may not seem like a shocking revelation. Everyone left, right, center, red state, blue state, even Martians - hated the bailout of Wall Street, apart of course from the bankers and dealers themselves, who could not even manage a grace moment of red-faced shame before they eagerly restocked their far from empty vaults. A perhaps bare majority, or more likely just a significant minority, nonetheless thought the bailouts were necessary. But even those who thought them necessary were grieved and repulsed. There was, I am suggesting, no moral disagreement about TARP and the bailouts - they stank. The only significant disagreement was practical and causal: would the impact of not bailing out the banks be catastrophic for the economy as a whole or not? No one truly knew the answer to this question, but that being so the government decided that it could not and should not play roulette with the future of the nation and did the dirty deed.

That we all agreed about the moral ugliness of the bailouts should have led us to implementing new and powerful regulatory mechanisms. The financial overhaul bill that passed congress in July certainly fell well short of what would be necessary to head-off the next crisis. Clearly, political deal-making and the influence of Wall Street over our politicians is part of the explanation for this failure; but the failure also expressed continuing disagreement about the nature of the free market. In pondering this issue I want to, again, draw on the resources of Georg W.F. Hegel. He is not, by a long shot, the only philosopher who could provide a glimmer of philosophical illumination in this area. But the primary topic of his practical philosophy was analyzing the exact point where modern individualism and the essential institutions of modern life meet. And right now, this is also where many of the hot-button topics of the day reside.

Hegel, of course, never directly wrote about Wall Street, but he was philosophically invested in the logic of market relations. Near the middle of the "Phenomenology of Spirit" (1807), he presents an argument that says, in effect: if Wall Street brokers and bankers understood themselves and their institutional world aright, they would not only accede to firm regulatory controls to govern their actions, but would enthusiastically welcome regulation. Hegel's emphatic but paradoxical way of stating this is to say that if the free market individualist acts "in [his] own self-interest, [he] simply does not know what [he] is doing, and if [he] affirms that all men act in their own self-interest, [he] merely asserts that all men are not really aware of what acting really amounts to." For Hegel, the idea of unconditioned rational self-interest - of, say, acting solely on the motive of making a maximal profit - simply mistakes what human action is or could be, and is thus rationally unintelligible. Self-interested action, in the sense it used by contemporary brokers and bankers, is impossible. If Hegel is right, there may be deeper and more basic reasons for strong market regulation than we have imagined.

The "Phenomenology" is a philosophical portrait gallery that presents depictions, one after another, of different, fundamental ways in which individuals and societies have understood themselves. Each self-understanding has two parts: an account of how a particular kind of self understands itself and, then, an account of the world that the self considers its natural counterpart. Hegel narrates how each formation of self and world collapses because of a mismatch between self-conception and how that self conceives of the larger world. Hegel thinks we can see how history has been driven by misshapen forms of life in which the self-understanding of agents and the worldly practices they participate in fail to correspond. With great drama, he claims that his narrative is a "highway of despair."

Hegel's "knight of virtue" is a fuzzy, liberal Don Quixote tramping around a modern world in which the free market is the central institution. The discussion of market rationality occurs in a section of the "Phenomenology" called "Virtue and the way of the world." Believing in the natural goodness of man, the virtuous self strives after moral self-perfection in opposition to the wicked self-interested practices of the marketplace, the so-called "way of the world." Most of this section is dedicated to demonstrating how hollow and absurd is the idea of a "knight of virtue" - a fuzzy, liberal Don Quixote tramping around a modern world in which the free market is the central institution. Against the virtuous self's "pompous talk about what is best for humanity and about the oppression of humanity, this incessant chatting about the sacrifice of the good," the "way of the world" is easily victorious.

However, what Hegel's probing account means to show is that the defender of holier-than-thou virtue and the self-interested Wall Street banker are making the same error from opposing points of view. Each supposes he has a true understanding of what naturally moves individuals to action. The knight of virtue thinks we are intrinsically good and that acting in the nasty, individualist, market world requires the sacrifice of natural goodness; the banker believes that only raw self-interest, the profit motive, ever leads to successful actions.

Both are wrong because, finally, it is not motives but actions that matter, and how those actions hang together to make a practical world. What makes the propounding of virtue illusory - just so much rhetoric - is that there is no world, no interlocking set of practices into which its actions could fit and have traction: propounding peace and love without practical or institutional engagement is delusion, not virtue. Conversely, what makes self-interested individuality effective is not its self-interested motives, but that there is an elaborate system of practices that supports, empowers, and gives enduring significance to the banker's actions. Actions only succeed as parts of practices that can reproduce themselves over time. To will an action is to will a practical world in which actions of that kind can be satisfied - no corresponding world, no satisfaction. Hence the banker must have a world-interest as the counterpart to his self-interest or his actions would become as illusory as those of the knight of virtue. What bankers do, Hegel is urging, is satisfy a function within a complex system that gives their actions functional significance.

Actions are elements of practices, and practices give individual actions their meaning. Without the game of basketball, there are just balls flying around with no purpose. The rules of the game give the action of putting the ball through the net the meaning of scoring, where scoring is something one does for the sake of the team. A star player can forget all this and pursue personal glory, his private self-interest. But if that star - say, Kobe Bryant - forgets his team in the process, he may, in the short term, get rich, but the team will lose. Only by playing his role on the team, by having an L.A. Laker interest as well as a Kobe Bryant interest, can he succeed. I guess in this analogy, Phil Jackson has the role of "the regulator."

The series of events leading up to near economic collapse have shown Wall Street traders and bankers to be essentially knights of self-interest - bad Kobe Bryants. The function of Wall Street is the allocation of capital; as Adam Smith instructed, Wall Street's task is to get capital to wherever it will do the most good in the production of goods and services. When the financial sector is fulfilling its function well, an individual banker succeeds only if he is routinely successful in placing investors' capital in businesses that over time are profitable. Time matters here because what must be promoted is the practice's capacity to reproduce itself. In this simplified scenario, Wall Street profits are tightly bound to the extra wealth produced by successful industries.

Every account of the financial crisis points to a terrifying series of structures that all have the same character: the profit-driven actions of the financial sector became increasingly detached from their function of supporting and advancing the growth of capital. What thus emerged were patterns of action which, may have seemed to reflect the "ways of the world" but in financial terms, were as empty as those of a knight of virtue, leading to the near collapse of the system as a whole. A system of compensation that provides huge bonuses based on short-term profits necessarily ignores the long-term interests of investors. As does a system that ignores the creditworthiness of borrowers; allows credit rating agencies to be paid by those they rate and encourages the creation of highly complex and deceptive financial instruments. In each case, the actions - and profits - of the financial agents became insulated from both the interests of investors and the wealth-creating needs of industry.

Despite the fact that we have seen how current practices are practically self-defeating for the system as a whole, the bill that emerged from the Congress comes nowhere near putting an end to the practices that necessitated the bailouts. Every one of those practices will remain in place with just a veneer of regulation giving them the look of legitimacy.

Related More From The Stone Read previous contributions to this series.

Go to All Posts " What market regulations should prohibit are practices in which profit-taking can routinely occur without wealth creation; wealth creation is the world-interest that makes bankers' self-interest possible. Arguments that market discipline, the discipline of self-interest, should allow Wall Street to remain self-regulating only reveal that Wall Street, as Hegel would say, "simply does not know what it is doing."

We know that nearly all the financial conditions that led to the economic crisis were the same in Canada as they were in the United States with a single, glaring exception: Canada did not deregulate its banks and financial sector, and, as a consequence, Canada avoided the worst of the economic crisis that continues to warp the infrastructure of American life. Nothing but fierce and smart government regulation can head off another American economic crisis in the future. This is not a matter of "balancing" the interests of free-market inventiveness against the need for stability; nor is it a matter of a clash between the ideology of the free-market versus the ideology of government control. Nor is it, even, a matter of a choice between neo-liberal economic theory and neo-Keynesian theory. Rather, as Hegel would have insisted, regulation is the force of reason needed to undo the concoctions of fantasy.

--------------------------------------------------------------------------------

J.M. Bernstein is University Distinguished Professor of Philosophy at the New School for Social Research and the author of five books. He is now completing a book entitled "Torture and Dignity."

STANLEY FISH:

7:28 pmMost people believe money the root of all evil. This is erroneous. As Shaw wrote, albeit perhaps facetiously, It is a lack of money that creates problems. But this is true even more so: Ignorance is the handmaiden of evil, however you may define evil. Now, if you begin with the premise of ignorance as evil, we are all in trouble. And it follows that a lack of understanding of economics leads many to blame bankers and lack of regulation for our current ills. But please realize banks provide and facilitate and foster growth through the lending of money, to raise the standard of living of many and all eventually. Economic expansion inevitably falters at the hands of supply eventually outstripping demand. But this too shall pass. And, in time, growth resumes. You just have to be aware of the economic cycles involved, and, most importantly, when demand exceeds supply, buy, and, conversely, sell when your neighbor buys. Economics is akin to evolution. People have a hard time actually seeing it work; when it succeeds, it really succeeds and outdoes itself, and, when it temporarily fails (private demand weakens), evolution and economics both truly fail, because both complexities are too difficult to grasp for our shortsighted minds.
by 20 Readers 2.Marie Burns Fort Myers, Florida
7:31 pmArguments that market discipline, the discipline of self-interest, should allow Wall Street to remain self-regulating only reveal that Wall Street, as Hegel would say, "simply does not know what it is doing." -- J. M. Bernstein

Alan "Greenspan ... acknowledged under [Congressional] questioning that he had made a 'mistake' in believing that banks, operating in their own self-interest, would do what was necessary to protect their shareholders and institutions. Greenspan called that 'a flaw in the model ... that defines how the world works.'" [AP, 10/23/08]

Alan Greenspan should have read Hegel.

This is a beautifully-wrought essay, a fine example of butting philosophy up against the real world. A number of economists, of course, have made the same essential argument you make -- that is, that bankers themselves should welcome regulation as the market can only achieve its ultimate capitalistic goals if it is regulated -- but your weaving the Wall Street morass into Hegelian thought is taking the economists' argument a step deeper.

If Greenspan should have read Hegel, there is no chance Chris Dodd would have cracked open the book. As Al Gore said recently,

"It's virtually impossible for participants in the current political system to enact any significant change without first seeking and gaining permission from the largest commercial interests who are most affected by the proposed change."

The problem, as you so clearly lay out, is that "the largest commercial interests" don't really know or care what is in the long-term best interests of themselves & of the economy it is their purpose to facilitate. The bankers, et al., are instead intent on their short-term goals of "restock[ing] their far from empty vaults." The Dodd-Frank law is a good example of the old saw: "Be careful what you wish for." Too bad the rest of us also have to pay for the bankers' shortsighted wishes.

The Constant Weader at www.RealityChex.com

djg:
7:31 pm"What market regulations should prohibit are practices in which profit-taking can routinely occur without wealth creation; wealth creation is the world-interest that makes bankers' self-interest possible. Arguments that market discipline, the discipline of self-interest, should allow Wall Street to remain self-regulating only reveal that Wall Street, as Hegel would say, "simply does not know what it is doing."

so after everything that has happened and a new bank bill that does nothing - Jamie Dimon promotes fraudulent conveyances in the form of phony foreclosures via robo-affadavits

the market responds and people dont want to take the chance on buying the foreclosed houses - market goes down some more and takes prices with it - and the banks appraisers discount the properties again --- no weatlh creation here !!!!! - it looks like - and no regulations "after" the bank bill is in place and then to make it more clear - - - he is fighting the appointment of Elizabeth Warren to protect the market and stop these practices he is promoting....... which destroy wealth - does he know what he is doing??? as hegel said - prima facia

spike91nz New Zealand

7:31 pmYour article appears to me to be "spot on", as they say. It is amazing to me that there is so much animosity toward regulations when it clearly in the interest of business to have regulations setting a reasonable threshold of participation and protection against risks of any one member taken to maximize personal profits at the expense of the others. The idea of an unbounded identity, an identity without reference to it mutually defining context, seems to me a fantasy of convenience. If it really were a struggle of individuals against all, this dialogue would be being held by saber tooth tigers. On an individual basis we are poor competition against the power of the beast, but, when organized for common purpose, we dine on the beast and spin stories of the hunt around the fire.

stearm74 vienna, austria
7:32 pm Well, great article.

But we all knew this until the followers of Aynd Rand and some crazy economists of the so-called Austrian School decided to destroy all economic and social institutions.

Now, they have a television platform -Fox News-, millions and millions of dollars, a political party -the Tea Party- and have been finally able to infiltrate the GOP.

As an historian of philosophy, I should add that Hegel was not first to cast his doubts on the dreams of the utopians and on the dreams of the Mandevillians (fable of the bees).

We should mention ALL classical liberals -from Locke to Hume- and then, naturally, Kant (and poor old Rousseau!)

In the history of economic ideas, Adam Smith followed the same logic and reached the same conclusion on the need of institutionalized management of a market economy. Alfred Marshall too. All economists in between, and all the economists worth of the name.

But what happened in the last 30 years? All forgotten! And a perverse ideology financed by a group of fascist multibillionaires has become "common sense" for ordinary citizens in the US and elsewhere.

In the meanwhile, the Chinese Communist Party rediscovered Locke, Kant, and Smith, and probably read Hegel freed from Marx's misunderstandings.

All great philosophers and social scientists of the past would agree that it is better a market economy within an authoritarian state than a market economy with no state.

And the Chinese economy "magically" grows.

Steve Lexington:
7:32 pmWhat a pleasure to see something intelligent commenting on Hegel's connection to the modern world. My only concern is that Bernstein uses only The Phenomenology with its succession of failed consciousnesses, without also consulting the more positive Philosophy of Right.
Maynard California
7:32 pmYour philosophy is impeccable, Professor Bernstein, but your grasp of economics is shaky. The function of Wall Street has not been "the allocation of capital" since the collapse of Bretton Woods in 1971. Your arguments make sense if "capital" is synonymous with "money" and money is defined as a store of value, a unit of account, and a medium of exchange.

Wall Street still functions to facilitate the exchange of capital for goods and services, but, because the money (which the capital, goods and services are denominated in) exists and is valued at the pleasure of, and only at the pleasure of the bankers, the function of the banker is now to create and revalue capital as desired. This is a perverse function, and because creation of capital is similar to allocation of capital, you and many others have not noticed the change.

Of course, bankers do not actually create capital, goods or services. However, the entire basis of the economy is predicated on assuming the fiction that they can do so and do so. That is why the economy's behavior does not match the expectations of those who believe that the banker's role is to properly allocate capital. In the old system, bankers manipulated capital for the primary purpose of increasing overall wealth. In the current system, bankers create capital for the primary purpose of transferring wealth. The system is working in the bankers' interest - as intended; as inevitable.

James F Traynor Punta Gorda

7:32 pmHoorah! Let's hear it for Hegel
Bjorn Norway
7:32 pmGreat text, but I'd say the referee plays the regulator in your Kobe Bryant example.
Todd Princeton
7:32 pmIt seems Bernstein has not read Fish's recent piece on the Tea Party. If he did, he would have known that any characterization of either side as "delusional" is misguided. Why? Because its persuasive power is zero. What Bernstein really proposes is to naturalize ("it's just the sane thing to do") a left-wing effort at regulation. While I agree with that effort, Bernstein leaves the content of it at, well, zero. Regulate the market how? For what end? How much, how little? Rather than naturalizing one's position--it's all soooo self-evident to a sane person----why not make the case for something, like neo-Keynesianism. Which is spare me (this distorted brand of) Hegel, and give me some solid analysis (like Krugman). Convince me of the rightness of your claim, don't just assert it's indubitable rightness.
Dan P East Village
7:32 pmI think there was a moral disagreement between some supporters and some oppoonents of the the Wall Street bailout program. Some of the moral disagreement was independent of the effects of the bailout, whether economically beneficial or harmful. This is why the debate took on such a nasty tone.

Strict libertarians wold not support the TARP program even if granting long term financial benefit because they probably believe that such intervention is "immoral". Utilitarians, on the other hand, would argue that, if effective in the short and long term (including other assumptions), the TARP program was moral. Such a view is consequentialist and is dependent on the effectiveness of the program.

Hence, it is arguable that there was in fact not universal moral agreement on the TARP program.

jimtsutsui Laguna Hills, CA

7:33 pmI agree that reading philosophy like Hegel should be a requirement to earn an MBA. I don't think GREED, is directed by philosophical precepts. Greed, is not a philosophy. I think greed is more an animal drive for survival against all others. Greed is more a genetically-inherited instinctive reaction in human beings. Like the squirrel who stores acorns for the winter, this isn't a philosophical decision, but purely mechanical. Greed results in irrational, unethical, illegal, and immoral behavior in human beings. In the basketball analogy, greed is equivalent to EGO. Did Kobe Bryant, examine his role with the Lakers, and in doing so see the logic that in order to achieve more championship rings, he needed to give up the ball more, and become more of a facilitator? Was it his EGO he overcame? Did he see his team mates as part of himself. Did his love and camaraderie with his team mates and coaching staff override his animal instinct to score more baskets himself? Now his coach, Phil Jackson, is known to introduce books and influences outside the normal coaching realm to his teams. Maybe Phil even assigned chapters from Hegel's writings for Kobe and Lamar Odom to read. Perhaps that might be a saving grace to the denizens of Wall Street. Just as there is a mandate for "anger management" and "harassment" trainings in the work place, perhaps philosophy lessons need to be mandated by government on Wall Street rather than just mere regulations. You can always find a way around a rule or policy, but when you transform the individual, the need for regulation disappears, and moral, ethical, legal, and integral behavior takes place. Ultimately it is the tribe, the team, and society that must decide what to do with people who only pursue their self-interest, and relieve themselves in the public water hole, or lead the league in points scored but have a losing season, or make millions of dollars, but leave their investors bankrupt...
jones va
9:30 pmTARP was a vehicle for thew Democrat majority in Congress to pay off the NYC banking cartel for past and future campaign donations
stearm74 vienna, austria
9:31 pmA metaphysical analysis of the angry mob should be complemented by a materialistic understanding of the forces behind the angry mob.

The nihilism of the mob is a precondition for fascism, but a mob with a lot of money and a television platform -that is, backed by some powerful interest groups- makes Fascism come to power.

Howard K Peoria
9:50 pmSince Hegel's words mean whatever you want to think they mean, when someone cites him, gibberish is to be expected.

I'm not sure which planet Bernstein is on, but here on Earth, TARP funds staved off a depression, were well accounted for, and completely paid back, with perhaps a bit of profit.

Or is the point that TARP was not a program for dismantling capitalism?

Jan Sand Helsinki

9:50 pmMonetary wealth is validated by its operation within the social context. In effect it is one of the necessary stimulants to the wealth and health of society as a whole. But when this stimulant is accrued to only one small sector of society it undermines the basic function for which it was designed. And if society in general loses access to this fundamental element then society itself breaks down and money ceases to have any value at all. The massive allocation of money to only one sector of society destroys society and whatever regulations necessary to prevent the distorted allocation must be enacted to promote not only the health but the very existence of society.
John McCumber Los Angeles CA
9:50 pmBrilliant article! One more point: the "way of the world" individualism that Hegel diagnosed is no natural outgrowth; it was aided and abetted by the United States government as a philosophical antidote to Marxism. Alex Abella, in his "Soldiers of Reason," tells the story. In other words, the dominance of free market "individualism" in American life is in part the result of massive state indoctrination--an irony that Hegel would have appreciated.
by 23 Readers 18.Skydaemon Canada
9:50 pmThe problem is a bit deeper than this though.

The overweighted size of the financial sector in America essentially allowed it to capture the political system., as it will in the prelude to any future collapse of this sort. A captured political system will gleefully unwind any regulations that stand in the way of a financial industry the politicians don't have the sophistication to understand. It's not just that politicians are corrupted, it's that they don't even know they're doing something wrong when they destroy the regulatory protections that exist.

America did have sufficient regulations to avoid this implosion. But the financial sector got their captured politicians to unwind them all in the decades leading up to the collapse, and there were no opposing voices at the time.

In a nutshell, this is why the regulatory approach doesn't work. It only has persistence in normal times when there's no threat. Economic regulation in a democracy is inherently pro-cyclical. The real problem is devising some means to prevent an ignorant political system from being captured and pressed into serving the financial sector during asset bubbles or other "feel good" time periods of apparent, yet illusory, success.

I'm unaware of any suggestion for how to accomplish that. The current implementation of democracy is too weak to fend of capitalism's advances when it matters.

The usage of Canada as a coimparative model is not particularly valid. Canada had several traits which wouldn't be duplicatable. Including: A nationally smaller (relative to gdp), publically despised banking sector. Being seen aiding a banker in Canada during the 90s was political suicide. Which meant regulators and politicians weren't captured. An economy with strong ties to the oil sector, which is publically understood to boom and bust with harsh economic cycles - nobody in oil country is confused about the inability of the economy to boom forever. Canada also underwent a harsh repairing of its finances a decade ago when all this was getting underway. The public mood was considerably different than in America. Then there were some better regulations which were slightly less encouraging of speculation in real estate to begin with.

Anyway, the comparison to Canada is interesting, but it doesn't suggest much that could apply to America for the future.

Mario Rizzo New York City

9:51 pmWith all the philosophers Professor Bernstein could have chosen for enlightenment about self-interest -- David Hume, Adam Smith, Joseph Butler, Francis Hutchison, Immanuel Kant, et al. -- he chooses the obscurantist, Hegel. What an achievement.
Gerard Harbison Lincoln, NE
9:51 pmI miss the guy who wanted to eliminate carnivores.
by 9 Readers 21.Stuart Boston
9:51 pmThe time to write legislation was about two minutes after Obama's inauguration. Instead, this neophyte leader sprinted off in other directions, incapable of focusing the country's attention on what was most important. As a result, he squandered an opportunity to truly redirect the course of history; and he created a sense of disbelief...in the financial sector and in the entire private sector. This, they realized, is a man who sees all sides to an argument; and the longer we awaited resolution to our crisis, the longer we became insecure with the President's leadership. And the longer our self-interested capitalists had to mount their defense.

Very sad, indeed.

A failure of self-interested industry players. And a tragic failure of leadership.

GypsySF Santa Fe, NM

9:51 pmProf. Bernstein--

I have not read "Phenomenology of Spirit" in years, and you are to be commended for attempting to apply Hegelian thought to contemporary America.

But isn't it much more to the point to say that if you reduce regulation, as happened from Regan to George W., and thus let the sharks loose, that economic disaster ensues? If a free market means the absence of moral restraint and no care for the common good, then credit default swaps, cdos, and economic bubbles follow, surely as the wheel of the cart follows the beast that draws the cart. (See Dhammapada, 1:1)

George Stanciu http://thethreebigquestions.wordpress.com/

George Stanciu http://thethreebigquestions.wordpress.com/

JohnG Lansing, NY

9:52 pmExcellent, a truly elegant demonstration of the power of philosophy. Now when they say, "Greed is good", instead of the weak response "No, greed is bad", which only makes them laugh, we can say, "No, greed is stupid." --and tell them why. We take the argument from the world of ethics, for which they have no use, into the world of actions and results, to which they must pay attention.
Roger Henry Beaver Dam ,WI
9:52 pm Excellent ,excellent analysis. What is puzzling me is the ever increasing revelation of fraud in loan application and now fraud by sworn officers of banks doing foreclosures as to their examination of documents. These are legal , court supervised activities, being performed fraudulently and no legal consequences to those performing the frauds. Oh yes, a few banks will pay a few million to the government in settlements stipulating no admission of guilt, but the people performing these crimes go merrily on their way. When crime is rewarded, more crime results. Institutions didn't sign the documents,people did. Until people are brought to justice for their misdeeds, no reform will result.
tom barnes Atlanta
9:52 pm"Hegel was right when he said that we learn from history that man can never learn anything from history." George Bernard Shaw Read more here: http://bit.ly/cffVyy

Pure Competition and the Soup Pot of the Enemy By Mark Thoma

Jul 7, 2010 | CBS MoneyWatch.com

In economic models, the pursuit of self-interest by agents operating in competitive markets results in the greatest gains for society as a whole. This is the individual hand metaphor used by economists to explain how the the maximization of gains by each individual also maximizes gains for society more generally.

Is it true that the pursuit of self-interest always leads to a socially optimum outcome?:

Nsikoism & The Soup Pot of the Enemy: A Nigerian description of a political culture in which individuals act in blind self interest – thwarting the efforts of others – just as crabs attempt to escape a basket. (Nsiko = crabs)

In 2008, the governor of Imo state Nigeria, Ikedi Ohakim, attributed the problems facing the Niger Delta to a nsiko mentality – as Ochereome Nnanna explained in Vanguard:

According to [Ohakim], the nsiko (crabs) once they find themselves in a basket, act foolishly. Every one of them wants to escape from the basket to freedom.

But rather than each of them concentrating on their individual escape bids they engage in pulling each other down. In the end no one escapes and each crab ends in the soup pot of the enemy. This is unlike snails, which are slower but wiser in that they concentrate in escaping rather than fighting each other.

There's actually a good lesson here about when competition leads to a socially optimal outcome and when it doesn't. What is the difference in these two cases? One of the assumptions that makes the pursuit of individual interests coincident with maximizing societal gains is that there are no externalities. That is, the actions of one agent does not impose costs or benefits on other agents. When the snails attempt to get out of the basket, their individual paths do not interfere with the paths of other snails. The escape attempt by one snail does not impost costs (or benefits) on other snails. If they had hands or claws to grab other snails ahead of them to try to lift themselves out it might be different, but they don't.

Not so with crabs. The attempt by one crab to escape by grabbing the one above it pulls the crab above it down and imposes an externality. That is, the attempt to escape imposes a cost on other crabs and makes them all worse off (very much so in this case since they end up in the soup).

This is equivalent to a firm that is able to pollute without paying the costs. The pollution imposes costs on other agents, and in doing so drives the economy away from its socially optimal position. The solution for humans is to make the polluting entity pay the full costs of their actions, e.g. impose a tax on the pollution they cause or enact a prohibition against it. For crabs that would mean, say, the death penalty for grabbing a crab above you (if there is no grabbing, all will escape). Unfortunately, however, crabs have a bit of difficulty looking into the future, evaluating the costs and benefits of their actions, and making a rational choice, so this wouldn't work. Some humans have this trouble too, but for the most part we expect people to respond to well-constructed incentives in a way that redirects individual behavior toward what's best for all. That's the rationale behind proposals for a carbon tax or its functional equivalent, cap-and-trade. It's an attempt to prevent some agents in the economy from pulling the rest of us down into the globally warming pot of soup.

[May 08, 2010] FRBSF Economic Letter: Is the "Invisible Hand" Still Relevant? (44)

Steven LeRoy asks if "free markets", i.e. markets free of government intervention, generally perform better than markets where government intervenes:

Is the "Invisible Hand" Still Relevant?, by Stephen LeRoy, FRBSF Economic Letter: The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. Vilfredo Pareto's later formulation was more precise than Smith's, and also highlighted the dependence of Smith's proposition on assumptions that may not be satisfied in the real world. The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith and Pareto are accurate for modern economies.
The single most important proposition in economic theory is that, by and large, competitive markets that are relatively, but generally not completely, free of government guidance do a better job allocating resources than occurs when governments play a dominant role. This proposition was first clearly formulated by Adam Smith in his classic Wealth of Nations. Except for some extreme supporters of free markets, today the preference for private markets is not an absolute. Almost everyone acknowledges that some functions, such as contract enforcement, cannot readily be delegated to market participants. The question is when and to what extent-not whether-private markets fail and therefore must be supplanted or regulated by government.
The answer to that question is something of a moving target, with views of the public and policymakers tending to ebb and flow. In much of the latter part of the 20th century, support for Smith's pro-private-market verdict gained favor, as reflected in the partial deregulation of financial and nonfinancial markets in the 1980s and subsequent decades. The financial and economic debacle of the past few years, however, has led many to revisit this question, particularly in Europe, but also in the United States and elsewhere. To many, financial markets in the last several years appeared dysfunctional to an extent that was never imagined possible earlier. Did Adam Smith get it wrong about private markets?
This Economic Letter discusses two versions of the argument in favor of private markets: that of Adam Smith in the 18th century and that formulated in the 19th century by the Italian sociologist and economist Vilfredo Pareto. The discussion in this Letter points to the key assumptions in the arguments. Differing views on the degree of applicability of those assumptions underlie a good deal of the debate over the appropriate balance between relying on markets versus government intervention. Also important are views on the effectiveness of government involvement.
Competitive markets work: Adam Smith
In 17th and 18th century England prior to Smith it was taken for granted that economic and political leadership came from the king, not from private citizens. If the king wanted to initiate some large economic project, such as expanding trade with the colonies, he would encourage formation of a company to conduct that project, such as the East India Company. The king would grant that company a monopoly, usually in exchange for payment. Smith thought that these monopoly grants were a bad idea, and that instead private companies should be free to compete. He called on the king to discharge himself from a duty "in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it toward the employments most suitable to the interests of the society." (Smith 1776 Book IV, Chapter 9)
Thus, Smith's conclusion was that private markets worked better if they were free from government supervision, and for him it was just about that simple. Smith's idea received its biggest challenge when the Soviet Union achieved world power status following World War II. In the 1960s, reported gross national product grew at much higher rates in the Soviet Union than in the United States or western Europe. Such authorities as the Central Intelligence Agency estimated that, before long, Soviet gross national product per capita would exceed that in the United States. To many, it looked as though centrally planned economies could achieve higher growth rates than market economies.
Economists who saw themselves as followers of Smith took issue. To them, it was simply not possible for centrally planned economies to achieve higher standards of living than market economies. As Smith put it, government could not be expected successfully to superintend the industry of private people. Too much information was required, and it was too difficult to structure the incentives. G. Warren Nutter, an economist at the University of Virginia, conducted a detailed study of the Soviet economy, arguing that the CIA's estimates of Soviet output were much too high (Nutter 1962). At the time, those findings were not taken seriously. But, by the 1980s, we knew that Nutter had been correct. If anything, the Soviet Union was falling further and further behind. By 1990, this process came to its logical conclusion: the Soviet empire disintegrated. Score a point for Adam Smith.
Competitive markets work: Vilfredo Pareto
By the 19th century, economists had largely abandoned the informal and literary style of Smith in favor of the more precise-if less engaging-style of today's economics. Increasingly, economists came to appreciate the role of formal mathematical model-building in enforcing logical consistency and clarity of exposition, although that development did not get into high gear until the 20th century. Under the leadership of Pareto and others, Adam Smith's argument in favor of private competitive markets underwent a major reformulation.
Pareto's version of the argument is usually taken to be a refinement of Smith's. But, for the present purpose, it's best to emphasize the differences rather than the similarities. First, Pareto provided a more precise definition than Smith of efficient resource allocation. An allocation is "Pareto efficient" if it is impossible to reallocate goods to make everyone better off. Or, to put it another way, you cannot make someone better off without making someone else worse off. This idea captures part of what we usually mean by "good performance," but not all of it. For example, attaining a reasonably equal income distribution is often taken to be part of what we mean by good performance, but an equal income distribution is not an implication of Pareto efficiency. Indeed, public policies designed to reduce the degree of income inequality can involve redistribution of income, making some better off and others worse off. (See Yellen 2006 for a discussion of income inequality.)
Pareto reached the remarkable conclusion that competitive markets generate Pareto-efficient allocations. In competitive markets, prices measure scarcity and desirability, so the profit motive leads market participants to make efficient use of productive resources. The English economist F.Y. Edgeworth made a similar argument at about the same time as Pareto. Economists Kenneth Arrow and Gérard Debreu presented precise formulations of the Pareto-Edgeworth result in the 1950s and 1960s.
A mathematical proof that competitive allocations are Pareto efficient required a characterization of a competitive economy that is more precise than anything Smith had provided. For Pareto, unlike Smith, it was not enough that the economy be free of government intervention. The essential characteristic for Pareto was that a buyer's payment and a seller's receipts from any transaction be in strict proportion to the quantity transacted. In other words, individuals cannot affect prices. This assumption is satisfied, to a close approximation, by the classical competitive markets, such as those for corn, wheat, and other agricultural commodities. The assumption rules out monopoly and monopsony, in which individual sellers and buyers are large enough to be able to manipulate prices by altering quantities supplied or demanded. When monopolists and monopsonists can distort prices in this way, allocations will not be Pareto efficient.
Pareto's efficiency result was first formulated in mathematical models of economies that were static and deterministic-that is, models in which time and uncertainty were not explicitly represented. In the 20th century, economists realized that the validity of the Pareto-efficiency result does not depend on these extreme restrictions. Arrow and Debreu showed that allocations will be Pareto efficient even in economies in which time and uncertainty are explicitly represented. They showed that, in any economy, there is an irreducible minimum level of risk that somebody has to bear. In a competitive economy with well-functioning financial markets, this risk will be borne by those who are most risk tolerant and who therefore require the least compensation in terms of higher expected return for bearing the risk. This is exactly as one would expect-risk-tolerant participants use financial markets to insure the risk averse. These aspects of equilibrium are discussed in standard texts on financial economics (such as LeRoy and Werner 2001).
However, demonstrating these results mathematically depends on assuming symmetric information-that is, assuming that everyone has unrestricted access to the same information. Such an assumption is less unrealistic than excluding uncertainty altogether, but it is still a strong restriction. The advent of game theory in recent decades has made it possible to relax the unattractive assumption of symmetric information. But Pareto efficiency often does not survive in settings that allow for asymmetric information. Based on mathematical economic theory, then, it appears that the argument that private markets produce good economic outcomes is open to serious question.
Nonmathematical economists such as Friedrich Hayek proposed an argument for the superiority of market systems that did not depend on Pareto efficiency. In fact, Hayek's argument was the exact opposite of that of Arrow and Debreu. For him, it was the existence of asymmetric information that provided the strongest rationale in favor of market-based economic systems. Hayek emphasized that prices incorporate valuable information about desirability and scarcity, and the profit motive induces producers and consumers to respond to this information by economizing on expensive goods. He expressed the view that economies in which prices are not used to communicate information-planned economies, such as that of the Soviet Union-could not possibly induce suppliers to produce efficiently. This is essentially the same as the argument against socialism discussed above.
Reevaluating the balance between markets and the government
The financial crisis that we have just experienced puts the question about the appropriate balance between reliance on markets and government intervention on center stage. Those who believe that unregulated markets generally work well express the view that misconceived interference by the government was the major cause of the crisis. In contrast, those who take a more critical view about the functioning of private markets believe that the crisis stemmed mainly from the destructive consequences of factors such as information asymmetries in financial markets and distortions to incentives that encouraged excessive risk-taking. The problem was not government involvement per se, but rather government's failure to place checks on destructive market practices.
This latter view dominates most of the recent proposals for financial reform. And, while the particulars of financial reform are still to be determined, it appears that current sentiment is less supportive of Adam Smith's verdict on the efficiency of markets than was the case prior to the financial crisis. At the same time, it seems clear that neither extreme view of the causes of the financial crisis is accurate. Reforms based only on one of these views to the exclusion of the other will not lead to a set of changes that will guarantee improvement of the performance of financial markets and prevent recurrence of financial crisis. The problems are complex, and sweeping changes in the regulatory structure could do more harm than good. A better strategy may be to identify specific problems in the financial system and introduce regulatory changes that address these clearly defined weaknesses, such as executive compensation practices that encourage excessive risk-taking.

In response, I'll point, once again, to Markets Are Not Magic which makes the point that for all of the nice properties identified by Pareto and others to hold, having markets that are free of government intervention is not enough. To obtain optimality, markets must be competitive, and a competitive marketplace requires some fairly restrictive assumptions to hold, assumptions that, in many cases, can only be satisfied with government intervention.

When it comes to government intervention, the one thing I wish people would understand is the difference between free markets and competitive markets. Markets that are free of government oversight are also free to exploit consumers in a variety of ways, from fraud to higher than necessary prices. Markets that are free, but not competitive, do not necessarily result in the best possible outcome.

When problems do exist, we should still ask if government intervention will actually help, but I believe we have been far too cautious in intervening to solve market failures. For example, as I've discussed many times, obvious market failures exist at almost every stage of mortgage markets, from the real estate agent, appraisers, and loan originators all the way through the securitization process. Somehow, we were led to believe that these failures that were so profitable to those able to exploit them would fix themselves. But they don't, and didn't, and the belief that they would caused us to stand by and do nothing as these markets departed further and further from the competitive ideal.

Hopefully we've learned something about the need for government oversight and intervention to correct problems, but it's not yet clear that we have. In coming months, we will see an attempt by market fundamentalists to tell a story about the economy recovering on its own despite government intervention. We'll hear all about the miraculous self-healing properties of the economy, and we will be told that it would have been even more miraculous if the government would have stayed out of the way.

When they try to sell you this story, remember that these are many of the same people who went to the government, hat in hand, begging for the government to give them the help they needed to save their too big to fail bank (OK, maybe the hats weren't in hand, maybe they demanded a bailout with the economy held hostage, but the point is that they wanted and needed the bailout). Their arguments are self-serving, just as Adam Smith said they'd be, and your interests are not the primary concern of the people trying to resist stricter government regulation and oversight of the financial industry. You'd be well advised not to buy the market fundamentalism they'll be selling.

Posted by Mark Thoma on Monday, May 3, 2010

Limitations of invisible hand

"I think Joseph Stiglitz captures the situation best:

Adam Smith, the father of modern economics, is often cited as arguing for the "invisible hand" and free markets: firms, in the pursuit of profits, are led, as if by an invisible hand, to do what is best for the world. But unlike his followers, Adam Smith was aware of some of the limitations of free markets, and research since then has further clarified why free markets, by themselves, often do not lead to what is best. As I put it in my new book, Making Globalization Work, the reason that the invisible hand often seems invisible is that it is often not there.

Whenever there are "externalities"-where the actions of an individual have impacts on others for which they do not pay or for which they are not compensated-markets will not work well. Some of the important instances have been long understood-environmental externalities. Markets, by themselves, will produce too much pollution. Markets, by themselves, will also produce too little basic research. (Remember, the government was responsible for financing most of the important scientific breakthroughs, including the internet and the first telegraph line, and most of the advances in bio-tech.)

But recent research has shown that these externalities are pervasive, whenever there is imperfect information or imperfect risk markets-that is always.

Government plays an important role in banking and securities regulation, and a host of other areas: some regulation is required to make markets work. Government is needed, almost all would agree, at a minimum to enforce contracts and property rights.

The real debate today is about finding the right balance between the market and government (and the third "sector"-non-governmental non-profit organizations.) Both are needed. They can each complement each other. This balance will differ from time to time and place to place.

(from an interview is part of a series on Managing Globalisation)

As for specific recommendations for the regulation of financial markets, I think that some smoothing of the failures mentioned above could help: stricter requirements for operational risk reporting, dissociation of the ratings agencies and the securities rated, structural changes with risk sharing, so that failure is absorbed by more than the poor sap left holding the asset, and lots more. Now who should make these changes, and how? Well, this is inevitably the realm of policy-makers subject to similar failures previously described. Again, the possibility of such failures needs to be addressed at the level of policy makers as well. I am hopeful that this is not as pathologically recursive as it sounds.

Why capitalism fails

The Boston Globe

jazad wrote:

I agree with nicknock - Americans do need to rethink and reeducate themselves in a number of areas. We've been brainwashed since Watergate to think "liberalism", and "socailism" are bad things. They are not. The whole idea of the American Dream is a lie.

What really bothers me is how so many people (especially on the right), are so narrow-minded and allow their prejudices to prevent them from even discussing issues (like health care). Even without the facts, they'll lay down their lives to disagree or even destroy the entire economy rather than listen to the opposition with an open mind.

I know all this because I used to be one of these people who eagerly listened to haters like Rush Limbaugh, and was more interested in being "right" than solving the problem. Looking back, I feel a little guilty about how ignorant and misinformed I was and often wonder how I became that way. It wasn't just one thing, e.g. media, upbringing - I believe it's just the underlying, subtle way one is educated in suburban America..

And to jmfay - I now live in England. Unlike many of the other people who comment here, I'm probably one of the few who have had the opportunity to live extensively in both countries, and I can honestly say I'm better off in England. I miss many things about the U.S., i.e. inexpensive designer clothes, S.U.Vs and electronic gadgets - and especially places like Dunkin Donuts, Papa Ginos and Piccadilly Pub, but when it comes to the basics, i.e. health, housing and education for your children - England is better.

One of the biggest differences I have noticed (after 12 years) is that Brits are brought up to care and be aware about what's happening in the rest of the world. Granted maybe that's because they're a part of Europe, but I get a sense that the majority here have the attitude that no matter where you live, we are all in this together. Everybody has the same basic needs, and in society, if one suffers, we all suffer.

In America, I always got a sense it was us versus them. During my life in New England and LA, I always felt like it was a race to collect the most material goods, have that second car or house on the Cape, date the cheerleader, etc. -almost as if my entire existence and status in society depended on these material things. A rather hollow existence.

So you have to ask yourself - do I really need all those things? How can you accept a society where so many homeless families have no food, while others are billionaires? It doesn't make sense. Everybody has the right to life, liberty and pursuit of happiness...but there's nothing wrong with helping the misfortunate to achieve these ideals. That's what makes us "good", "decent" human beings - and isn't that what being an American is all about?

[Oct 19, 2009] Spare Us From the Invisible Hand by Gavin Kennedy

Patrick Kilbride writes in Chamber Post HERE:

"Free People, Free Minds, Free Markets"

'In the 18th-century, Adam Smith left us with the indelible image of markets producing desirable social outcomes through the work of an "invisible hand." '

Comment

In an otherwise neat argument for both liberty and free markets, Patrick Kilbride spoils his case with modern nonsense about Adam Smith and his use of the metaphor of "an invisible hand".

Smith did not use the metaphor when explaining either how markets work generally (Books I and II, Wealth Of Nations) or how some, but not all, merchant traders preferred to invest locally following their concerns about the higher risks of investing abroad or in shipping (Book IV.ii, Wealth Of Nations).

In fact, a close reading of the only place in Wealth Of Nations where he used the metaphor of an invisible hand, shows that he first explains in detail the circumstances leading some, but not all, merchant traders to behave as they did (paragraphs 1 to 8, chapter 2, Book IV), and only then deploys the metaphor for the consequences of their specific behaviour ("intending their own security"), conforming to the arithmetic rule that the whole (the national annual output of wealth, including local employment) is the sum of its parts – the more merchant traders who are risk averse, despite the high profits from foreign and colonial trade, the greater the total annual wealth, including domestic employment.

Modern economists have invented a whole new meaning to Smith's singular use of the metaphor, giving it the characteristics of a "law" of markets, though it was never stated as such by Adam Smith.

The modern invented meaning is commonly taught in first year economics courses and textbooks, and such is the effect of it on modern economists, it is extremely difficult to dislodge it – they seldom actually read Wealth Of Nations or even the relevant paragraphs (1 thru 8) and, by relying on a truncated extract from paragraph 9 only, they remain solidly convinced that Adam Smith explicitly stated what their tutors told them he wrote.

This gives succour to hostile critics of markets who throw the "invisible hand" back at them ("invisible fist" or, as seen recently, "invisible middle finger", and such like). But there is no actual "invisible hand", it does not exist and never did. The metaphor is just that, a metaphor, and one that was popular in literature, sermons, and poems in the 17th and 18th centuries – I have a list of 59 examples of its uses, besides Smith's.

Mathematicians called it into being when "proving" that general equilibrium in an imaginary market, loaded with assumptions that removed all semblances of real world economies, was a theoretical possibility (Debreu, Arrow). Others (Samuelson, Freidman) and among them propagandists against Soviet communist planning, used the metaphor to good effect – Stalin needed the gulags to enforce planning, but free markets had an "invisible hand" that did its work without menace.

Editors of Time, Newsweek, Wall Street Journal, Financial Times and assorted media journalists loved the "invisible hand", Nobel Prize winners sang it praises, and the epigones believed in its miraculous powers with the passionate certainties of Jihadists.

Worse, the invisible hand became an alibi of last resort, flaunted all round as if it existed. When it "failed", the invisible hand was dumped among wails and the gnashing of teeth in wholesale "confessionals" (Alan Greenspan).

Markets suddenly became naked – they always were naked, but the veil of the invisible hand obscured their nakedness. It never was the answer to everything that could go awry in the normal condition of disequilibrium in all economies, much of it excited to crises by public policy interventions by legislators and those who influenced them.

Smith was right about them and the damage they could inflict – fortunately "there is a lot of ruin" in an economy, as he might have put it in another context...

invisible hand A Research Agenda

cross posted with Gavin Kennedy

Rdan here...Gavin Kennedy in his blog Adam Smith's Lost Legacy notes how the 'invisible hand' is used in modern economics and especially the media, and begins to lay out the challenge. The entire post follows:

Monday, October 05, 2009

A Research Agenda

"Even Adam Smith, the canny Scot whose monumental book, 'The Wealth Of Nations'(1776), represents the beginning of modern economics or political economy – even he was so thrilled by the recognition of an order in the economic system that he proclaimed the mystical principle of 'the invisible hand': that each individual in pursuing his own selfish good was led, as if by an invisible hand, to achieve the best good of all, so that any interference with free competition was almost certain to be injurious. This unguarded conclusion has done almost as much harm as good in the past century and a half, especially since too often it is all that some of our leading citizens remember, 30 years later, of their college course in economics."

(Paul A. Samuelson, Economics: an introductory analysis, 1st edition, p 36, 1948, McGraw-Hill, New York.)

Comment

This paragraph, from one of the world's most popular textbooks by the distinguished Nobel Laureate, Paul Samuelson, encapsulates the modern myth of the invisible hand, which is often sanctified with the other myth that Adam Smith was its original inspiration.

Samuelson's warning that the "unguarded conclusion" had already done "as much harm as good" was soon discarded and was as soon forgotten by his colleagues (including by Samuelson himself in the eighteen editions of his textbook, Economics, that followed to 2009).

The metaphor of "an invisible hand" is now ubiquitous in almost all economics textbooks (miss-teaching generations of students), in many articles in peer-reviewed journals, in campus lectures, policy statements, political debates, mainstream media, and among scores of economic Blogs across the global Internet.

My current research is about the making of those myths from their early beginnings in the 20th century up to today's treatment of the "invisible hand", its credibility somewhat mixed of late following the global "credit crunch" of 2007-09, and what might be the main causes of its popularity, how it developed into a "Panglossian" error of perception, why it is mythical and why the popular belief that it is related to anything written by Adam Smith endures even when the evidence to the contrary is so strong.

In writing about the history of an idea throughout a period from the 1770s to the 21st century there is a danger that the appeal limits itself to a tiny band of specialist historians, presumably divorced from the interests of modern readers.

Well, that may be the case if my subject was, say, a history of the anachronistic labour theory of value, more suited as a PhD subject. But the essential beauty of a study of the evolution of the metaphor of the "invisible hand", and its promotion into a major "idea", "concept", "theory", even "paradigm" of economics, is that despite its longevity (much older than Adam Smith's ambivalent use in the 18th century), the metaphor in its modern forms entered serious discourse and gained its undeserved credibility among academics and policy makers at the highest-level of politicians in the world's legislatures, who applied its implications in their real "hands off" versus "hands on" treatments of the economies they managed.

In short, from the 1950s onwards, the metaphor of the invisible hand became operational, and not just descriptive, in practice.

How and why did this happen? What have been, and are, the consequences for economic policy and practice? What evidence is there, besides Samuelson's 1948 warning about it doing "almost as much harm as good", that any economists over the past 60 years realised the emptiness of the myth? What happened from their belief in Panglossian outcomes from mythical invisible hands to their actual policy recommendations? Does modern capitalism need the invisible hand myth or would it be better off without it?

These and related themes are the central questions to be addressed throughout Lost Legacy.

Selected Comments

coberly

a compelling image, simple and easy to understand even for people who don't understand much. Very useful for the politics of "don't tax me, and don't regulate my business."

it is the equivalent of the earth centered view of the universe, and like ptolemaic astronomy it is well supported by sophisticated math and common observation. as long as you don't ask too many questions. Or even one good one.

[Jul 12, 2009] Economic View - The Invisible Hand, Trumped by Darwin - NYTimes.com

July 11, 2009

IF asked to identify the intellectual founder of their discipline, most economists today would probably cite Adam Smith. But that will change. Economists' forecasts generally aren't worth much, but I'll offer one that even my youngest colleagues won't survive to refute: If we posed the same question 100 years from now, most economists would instead cite

Darwin, renowned for the theory of evolution, was a naturalist, not an economist, and his view of the competitive struggle was different from Smith's in subtle but profound ways. Growing evidence suggests that Darwin's view tracks economic reality much more closely.

Smith is celebrated for his "invisible hand" theory, which holds that when greedy people trade for their own advantage in unfettered private markets, they will often be led, as if by an invisible hand, to produce the greatest good for all. The invisible hand remains a powerful narrative, but after the recent economic wreckage, skepticism about it has grown. My prediction is that it will eventually be supplanted by a version of Darwin's more general narrative - one that grants the invisible hand its due, but also strips it of the sweeping powers that many now ascribe to it.

Smith's basic idea was that business owners seeking to lure customers away from rivals have powerful incentives to introduce improved product designs and cost-saving innovations. These moves bolster innovators' profits in the short term. But rivals respond by adopting the same innovations, and the resulting competition gradually drives down prices and profits. In the end, Smith argued, consumers reap all the gains.

The central theme of Darwin's narrative was that competition favors traits and behavior according to how they affect the success of individuals, not species or other groups. As in Smith's account, traits that enhance individual fitness sometimes promote group interests. For example, a mutation for keener eyesight in hawks benefits not only any individual hawk that bears it, but also makes hawks more likely to prosper as a species.

In other cases, however, traits that help individuals are harmful to larger groups. For instance, a mutation for larger antlers served the reproductive interests of an individual male elk, because it helped him prevail in battles with other males for access to mates. But as this mutation spread, it started an arms race that made life more hazardous for male elk over all. The antlers of male elk can now span five feet or more. And despite their utility in battle, they often become a fatal handicap when predators pursue males into dense woods.

In Darwin's framework, then, Adam Smith's invisible hand survives as an interesting special case. Competition, to be sure, sometimes guides individual behavior in ways that benefit society as a whole. But not always.

Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance, as in the antlers arms race. In the marketplace, such reward structures are the rule, not the exception. The income of investment managers, for example, depends mainly on the amount of money they manage, which in turn depends largely on their funds' relative performance.

Relative performance affects many other rewards in contemporary life. For example, it determines which parents can send their children to good public schools. Because such schools are typically in more expensive neighborhoods, parents who want to send their children to them must outbid others for houses in those neighborhoods.

In cases like these, relative incentive structures undermine the invisible hand. To make their funds more attractive to investors, money managers create complex securities that impose serious, if often well-camouflaged, risks on society. But when all managers take such steps, they are mutually offsetting. No one benefits, yet the risk of financial crises rises sharply.

Similarly, to earn extra money for houses in better school districts, parents often work longer hours or accept jobs entailing greater safety risks. Such steps may seem compelling to an individual family, but when all families take them, they serve only to bid up housing prices. As before, only half of all children will attend top-half schools.

It's the same with athletes who take anabolic steroids. Individual athletes who take them may perform better in absolute terms. But these drugs also entail serious long-term health risks, and when everyone takes them, no one gains an edge.

If male elk could vote to scale back their antlers by half, they would have compelling reasons for doing so, because only relative antler size matters. Of course, they have no means to enact such regulations.

But humans can and do. By calling our attention to the conflict between individual and group interest, Darwin has identified the rationale for much of the regulation we observe in modern societies - including steroid bans in sports, safety and hours regulation in the workplace, product safety standards and the myriad restrictions typically imposed on the financial sector.

Ideas have consequences. The uncritical celebration of the invisible hand by Smith's disciples has undermined regulatory efforts to reconcile conflicts between individual and collective interests in recent decades, causing considerable harm to us all. If, as Darwin suggested, many important aspects of life are graded on the curve, his insights may help us avoid stumbling down that grim path once again.

The competitive forces that mold business behavior are like the forces of natural selection that molded elk. In each case, we see instances of socially benign conduct. But in neither can we safely presume that individual and social interests coincide.

Robert H. Frank, an economist at Cornell, is a visiting faculty member at the Stern School of Business at New York University.

[Jun 5, 2009] The great crash of the Chicago school of economics by Andrew Leonard

April 28, 2009 | Salon.com

It's been a bad year for the University of Chicago Economics Department. And I'm not just talking about Alan Greenspan's remark to Congress that he "made a mistake" about the ability of markets to self-regulate themselves. I'm talking hard, cold, quantifiable facts: Neither themost recent Nobel prize for economics nor the John Bates Clark award given to the best economist under the age of forty went to a card-carrying member of the "Chicago School."

For any other economics department, missing out on the big prizes wouldn't be such a big deal. You can't win 'em all, you know; any economist knows that down to the marrow of his or her rationally-expecting bones. And the John Bates Clark award, up until this year, was only given out every other year, which makes one's chances of grabbing one even tougher. Still, for the University of Chicago, these awards have practically become a birthright. No other econ department has racked up nearly so many.

Don't take my word for it: Here's the University of Chicago, hyping itself:

Since 1969, when the Nobel Prize in economic sciences was first awarded, twenty-four recipients of that prize have been faculty, students, or researchers in the Department of Economics, Law School, or Graduate School of Business (GSB) at the University of Chicago, including Milton Friedman and George Stigler. Five Nobel laureates are currently members of the department: Gary S. Becker, Robert W. Fogel, Robert E. Lucas, Jr., James J. Heckman, and Roger B. Myerson. In addition, four of the six recipients of the American Economic Association's Walker Medal were members of the faculty (J. M. Clark, F. H. Knight, Jacob Viner, and T. W. Schultz). The John Bates Clark Medal has been awarded to five Chicago economists: Milton Friedman, Gary S. Becker, James J. Heckman, Steven Levitt, and Kevin M. Murphy. Since World War II, the department has had, relative to its size, a larger number of faculty than any other serving as presidents of the American Economic Association. Former faculty members and students currently hold leading positions as economists inside and outside academic life.

Does this year's double-whiff mark the beginning of a trend? I'll leave it to the quants to crunch the data. But here's where it's gets really embarrassing. It must have been a hard pill to swallow for the hard-core Chicago schoolers when Paul "John Maynard Keynes is my hero" Krugman won the Nobel Prize last year. Sure, everyone knows he is a brilliant economist who was always considered on the short-list, but to have the single most ferocious propagandist for government intervention in the economy get the highest approbation possible in the discipline has to be psychologically brutal for your average free market fundamentalist.

But to my mind, the news that U.C. Berkeley's Emmanuel Saez won the John Bates Clark award should be even more of a nightmare for the heirs of Milton Friedman. David Warsh does a nice job of summing up his research here, but the gist is this: Saez has done more than any other economist to document and prove the steady growth of income inequality in the United States. I don't know what Saez's politics are like, but his research has been employed as devastating artillery in the ongoing economic policy wars fought between liberals and conservatives.

I'm not going to cut it too fine: I think you can very well blame the Chicago school for the fiasco of growing income inequality in the U.S. Nice triumph for deregulated capitalism, boys! Ronald Reagan listened closely to Milton Friedman and the Chicago school godfather's disciples have been rife in the Republican administrations that have dominated the White House ever since the Californian swept into Washington and started blaming government for our problems. Well guess what? It didn't work so well. The rich got richer and then screwed the pooch.

About damn time other economics departments started getting the shiny medals.

What a load of Bollocks

May 25th, 2009 | Steve Keen's Debtwatch
9 Comments

Two prominent economics textbook writers have recently written that the Global Financial Crisis (GFC) shows that the world needs more economics rather than less.

Writing in the New York Times, Gregory Mankiw could see some need to modify economics courses a bit in response to the GFC, but overall he felt that:

"Despite the enormity of recent events, the principles of economics are largely unchanged. Students still need to learn about the gains from trade, supply and demand, the efficiency properties of market outcomes, and so on. These topics will remain the bread-and-butter of introductory courses." (That Freshman Course Won't Be Quite the Same, New York Times May 23 2009)

Writing on a blog The East Asia Forum, authors Doug McTaggart, Christopher Findlay and Michael Parkin wrote that:

"The crisis has also brought calls for the heads of economists for failing to anticipate and avoid it. That idea, too, is wrong: much economic research pointed to the emerging problem.

More economic research (and teaching), not less, is the best hope of both emerging from the current crisis and of avoiding future ones." (The state of economics, East Asia Forum, May 21 2009)

What a load of bollocks.

The "principles of economics" that Mankiw champions, and the "More economic research (and teaching)" that McTaggart et al are calling for, are the major reason why economists in general were oblivious to this crisis until well after it had broken out.

If they meant "Principles of Hyman Minsky's Financial Instability Hypothesis", or "More Post Keynesian and Evolutionary economic research", there might be some validity to their claims. But what they really mean is "principles of neoclassical economics" and "More neoclassical economic research (and teaching)"–precisely the stuff that led to this crisis in the first place.

Neoclassical economic theory supported the deregulation of the financial system that helped set this crisis in train. See for example this New York Times report on the abolition of the Glass-Steagall Act in 1999 "CONGRESS PASSES WIDE-RANGING BILL EASING BANK LAWS" (New York Times November 5th 1999). The reporter Stephem Labaton noted that:

The opponents of the measure gloomily predicted that by unshackling banks and enabling them to move more freely into new kinds of financial activities, the new law could lead to an economic crisis down the road when the marketplace is no longer growing briskly…

Then he observed that

Supporters of the legislation rejected those arguments. They responded that historians and economists have concluded that the Glass-Steagall Act was not the correct response to the banking crisis because it was the failure of the Federal Reserve in carrying out monetary policy, not speculation in the stock market, that caused the collapse of 11,000 banks. If anything, the supporters said, the new law will give financial companies the ability to diversify and therefore reduce their risks. The new law, they said, will also give regulators new tools to supervise shaky institutions.

This is a very apt description of the role of neoclassical economists over the last 40 years: every step of the way, they have argued for deregulation of the financial system. Now we have McTaggart and colleagues making the self-serving claim that:

The current crisis is a failure of regulation that calls for not more regulation, but the right regulation.

So the same economic theory that supported the abolition of Glass-Steagall, amongst many other Depression-inspired controls, is suddenly going to be able to do a volte-face and tell us what "the right regulation" might be? Garbage.

What is really needed is a thorough revolution in economic thought. First and foremost this has to be based on empirical reality, and from this perspective almost everything that current textbooks treat as gospel truth will end up in the dustbin.

Coincidentally, many non-neoclassical economists whose writings have been put into the dustbin by today's economics orthodoxy will be back on the shelves once more. Minsky, Schumpeter, Keynes, Veblen and Marx don't rate a mention in in most current economic textbooks; they had better feature in future texts, or by 2060 or so we'll be back here again.

Though I'm clearly annoyed at Mankiw's and McTaggart's drivel, I'm not surprised by it–in fact I predicted it (I doubt that they can point to anything they wrote prior to the GFC that predicted it!). I said the following in an article "Mad, bad, and dangerous to know" published on March 12 2009 in issue 49 of the Real World Economics Review:

Despite the severity of the crisis in the real world, academic neoclassical economists will continue to teach from the same textbooks in 2009 and 2010 that they used in 2008 and earlier…

they will interpret the crisis as due to poor regulation,…

They will seriously believe that the crisis calls not for the abolition of neoclassical economics, but for its teachings to be more widely known. The very thought that this financial crisis should require any change in what they do, let alone necessitate the rejection of neoclassical theory completely, will strike them as incredible.

Sometimes, I would like to be wrong…

Finally, what lesson did neoclassical economists take from the Great Depression? That the Federal Reserve caused it via poor economic policy. Who do current neoclassical economists blame for this crisis? The Federal Reserve of course, for poor economic policy:

By 2007, fuelled by the Federal Reserve's egregious policy errors, markets were moving into unsustainable bubble territory. The Fed by this time had realized the problem was getting out of hand and had moved interest rates up sharply-too sharply-and burst the house price bubble. (McTaggart et al).

But who staffs the Federal Reserve? Neoclassical economists of course…

Please, let's not fall for this nonsense a second time. Keynes tried to free us from neoclassical economic thinking back in the 1930s, only to have neoclassical economists like John Hicks and Paul Samuelson eviscerate Keynes's thought and re-establish a revitalised neoclassical economics after the Depression was over. This time, let's do it right and get rid of neoclassical economics once and for all.



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