Sunday, October 04, 2009

The Policy Rot Rooted in Modern Economics

John Cassidy writes on: “Rational Irrationality: The Real Reason That Capitalism Is So Crash-Prone” in The New Yorker (5 October). Normxxx comments, parenthetically, on Cassidy’s thoughts in normxxx ruminates...

NB: [[comments in double-square brackets are normxxx’s]]

Because financial markets consist of individuals who react to what others are doing, theories of 'free-market economics' are often less illuminating than the Prisoner's Dilemma, an analysis of strategic behavior that game theorists associated with the RAND Corporation developed during the early nineteen-fifties. Much of the work done at RAND was initially applied to the logic of nuclear warfare, but it has proved extremely useful in understanding another 'explosion-prone' arena: Wall Street.

Imagine that you and another armed man have been arrested and charged with jointly carrying out a robbery. The two of you are being held and questioned separately, with no means of communicating. You know that, if you both confess, each of you will get ten years in jail, whereas if you both deny the crime you will be charged only with the lesser offense of gun possession, which carries a sentence of just three years in jail. The best scenario for you is if you confess and your partner doesn't: you'll be rewarded for your betrayal by being released, and he'll get a sentence of fifteen years. The worst scenario, accordingly, is if you keep quiet and he confesses.

What should you do? The optimal joint result would require the two of you to keep quiet, so that you both got a light sentence, amounting to a combined six years of jail time. Any other strategy means more collective jail time. But you know that you're risking the maximum penalty if you keep quiet, because your partner could seize a chance for freedom and betray you. And you know that your partner is bound to be making the same calculation. Hence, the rational strategy, for both of you, is to confess, and serve ten years in jail. In the language of game theory, confessing is a "dominant strategy," even though it leads to a disastrous outcome. [[What you are trying to do is minimize your maximum possible loss.: normxxx]]

The Prisoner's Dilemma is the obverse of Adam Smith's theory of the invisible hand, in which the free market coordinates the behavior of self-seeking individuals to the benefit of all. Each businessman "intends only his own gain," Smith wrote in "The Wealth of Nations", "and he is in this, as in many other cases, led by an invisible hand to promote [[a socially positive: normxxx]] end which was no part of his intention". But in a market environment the individual pursuit of self-interest, however rational, can give way to collective disaster. The invisible hand becomes a clenched fist.”

Regular readers of Lost Legacy should spot the source of John Cassidy’s understandable error of interpreting Adam Smith’s so-called “theory” of ‘an invisible hand’ in the way that he does.

Cassidy starts innocuously: “the free market coordinates the behavior of self-seeking individuals to the benefit of all” and by quoting a phrase, popular with modern economists since the 1950s who have taught (and believed) it to read, “to promote [[a socially positive: normxxx]] end which was no part of his intention". Modern economists have spread their false conclusion that is caused by the presumed, but not specified context, in which Smith used the metaphor of “an invisible hand” (WN IV.ii.9: 456).

Smith’s point was less general than a “theory” and much more mundane.

Due to the arithmetic rule that the ‘whole is the sum of its parts’, every additional amount of local investment increases the total amount of local investment (a public benefit). It didn’t matter what caused each additional amount of investment because the individual amounts achieved the outcome of higher levels of annual domestic investment, promoting greater annual output of the “necessaries and conveniences of life”, along with higher domestic employment and a contribution of the “progress to opulence”, a not unimportant consequence for poor, unemployed labourers, and matter of general concern for Adam Smith.

But what caused the preference for local investment among some, but not all, merchant traders? In the specific case that Smith mentions the metaphor of “an invisible hand” (and, interestingly, this is the only occasion in which he does so in Wealth Of Nations), the motive is a merchant’s sense of the security of his investment.

You see, there are two groups of merchants involved in Smith’s discussion (paragraphs 1 – 9 of chapter 2, Book IV, of Wealth Of Nations, pages 452-456); those that are risk-averse to the extra risks of sending their capital abroad comprising the prices of the goods they sell and goods they buy for the return trips. There are the risks of sea travel, risks from dealing with people of less well-known, or unknown, reputation, risks from dealing with a foreign judicial system if they need to seek legal remedies, and the risks of accidents or piracy.

These risks, compared to dealing locally with people they know, with court systems and magistrates they also know, and the lesser risks of their being in sight of their capital stock and that which they buy in return, are perceived by some merchants to be lower than senind capital abroad.

Provided, says Smith, that the profits from local trade are “not much less, or equal” to foreign trade, taking account of the rate of turnover of their capital – 3 or 4 times annually domestically, compared to 3 or 4 years to return in foreign trade, some merchants preferred to invest locally and, from those that did, they added to domestic capital investment and, unintentionally, contributed to the public benefit.

I think we can agree that Smith’s narrow observation that in these circumstances (and in many others, but not all others!) the metaphor of being “led by an invisible hand” is a striking way of putting it, which is what good metaphors are meant to do (see Adam Smith’s Lectures in Rhetoric and Belles Lettres”, [1763], 1983, Lecture 6, pp 25-32, esp. p 29). However, the “invisible hand” metaphor is not a “theory” or a “principle”, and the modern transformation of the popular, 18th-century metaphor into a general theory is manifestly a fallacy, and a dangerous one at that, as John Cassidy’s example shows.

The cause of the credit crunch? Unambiguously and without doubt, it was caused by the people who taught and believed the nonsense of an actual “invisible hand” that magically ensured that “the free market coordinates the behavior of self-seeking individuals to the benefit of all” (and all variations to that affect). It most certainly was “ideology”, as John Cassidy says, but it was never anything that Adam Smith asserted, despite hose who used his name as a sort of holy authority for claiming that the “ideology” was worthy of the attention given to it since the 1950s.

What is really worrying is that John Cassidy also reports that:

Many leading economists still have a vision of the 'invisible hand' satisfying wants, equating costs with benefits, and otherwise 'harmonizing' the interests of the many. In a column that appeared in the Times in May, the Harvard economist Greg Mankiw, a former chairman of the White House Council of Economic Advisers and the author of two leading textbooks, conceded that teachers of freshman economics would now have to 'mention' some issues that were previously relegated to more advanced courses; such issues as the role of financial institutions, the dangers of leverage, and the perils of economic forecasting.

And yet "despite the enormity of recent events, the principles of economics are largely unchanged," Mankiw [[baldly: normxxx]] stated. "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."

Mankiw was referring to the 'textbook' economics that he and others have been teaching for decades: the economics of Adam Smith and Milton Friedman. In the world of such utopian [sic] [academic, ivory-towered?] economics, the latest crisis of capitalism is always a blip. As memories of September, 2008, fade, many will say that the Great Crunch wasn't so bad, after all, and skip over the vast government intervention that prevented a much, much worse outcome.”

Professor Mankiw is the author of one of the more popular undergraduate textbooks in North America. Cassidy reports: “teachers of freshman economics would now have to 'mention' some issues that were previously relegated to more advanced courses; such issues as the role of financial institutions, the dangers of leverage, and the perils of economic forecasting.”

This is not re-assuring! The same teachers may mention some aspects of more advanced courses, but as long as they still teach the same old rubbish about the “invisible hand” as a theory allegedly saying that the “self-interested actions of individuals” are led by an “invisible hand” to assure the public benefits, or “harmony”, or “equilibrium”, or even in extreme cases, that individuals acting from “selfishness” do so, then the rot at the centre of modern economics remains.

For as long as the invisible hand myth remains, then Lost Legacy, and similar Blogs, have a role to play in trying to clarify the damage done by the invention of a role for a metaphor to explain the wonder of markets(which phenomena do not need such fantasies, and nor does Adam Smith deserve to be associated with such nonsense). They demean economics, much as the Roman emperor, Caligula (AD 12-41) demeaned Rome by appointing his horse to the office of Consul.

[I have not commented on the Prisoner’s Dilemma issue in John Cassidy’s article in The New Yorker, but shall do so later; it too has some interesting lessons]

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