Sunday, October 16, 2011

Rational Expectations and the Invisible Hand

Ira Basen writes in the Globe and Mail (Canada) Here:

“Economics has met the enemy, and it is economics”

“Rational-expectations theory and its corollary, the efficient-market hypothesis, have been central to mainstream economics for more than 40 years. And while they may not have “wrecked the world,” some critics argue these models have blinded economists to reality: Certain the universe was unfolding as it should, they failed both to anticipate the financial crisis of 2008 and to chart an effective path to recovery.

“The great classical economists of the late 18th and early 19th centuries had no problem connecting to the real world – the Industrial Revolution had unleashed profound social and economic changes, and they were trying to make sense of what they were seeing. Yet Adam Smith, who is considered the founding father of modern economics, would have had trouble understanding the meaning of the word “economist.”

What is today known as economics arose out of two larger intellectual traditions that have since been largely abandoned. One is political economy, which is based on the simple idea that economic outcomes are often determined largely by political factors (as well as vice versa). But when political-economy courses first started appearing in Canadian universities in the 1870s, it was still viewed as a small offshoot of a far more important topic: moral philosophy.

In The Wealth of Nations (1776), Adam Smith famously argued that the pursuit of enlightened self-interest by individuals and companies could benefit society as a whole. His notion of the market's “invisible hand” laid the groundwork for much of modern neoclassical and neo-liberal, laissez-faire economics. But unlike today's free marketers, Smith didn't believe that the morality of the market was appropriate for society at large. Honesty, discipline, thrift and co-operation, not consumption and unbridled self-interest, were the keys to happiness and social cohesion. Smith's vision was a capitalist economy in a society governed by non-capitalist morality.

But by the end of the 19th century, the new field of economics no longer concerned itself with moral philosophy, and less and less with political economy. What was coming to dominate was a conviction that markets could be trusted to produce the most efficient allocation of scarce resources, that individuals would always seek to maximize their utility in an economically rational way, and that all of this would ultimately lead to some kind of overall equilibrium of prices, wages, supply and demand.
Political economy was less vital because government intervention disrupted the path to equilibrium and should therefore be avoided except in exceptional circumstances. And as for morality, economics would concern itself with the behaviour of rational, self-interested, utility-maximizing Homo economicus. What he did outside the confines of the marketplace would be someone else's field of study.

As those notions took hold, a new idea emerged that would have surprised and probably horrified Adam Smith – that economics, divorced from the study of morality and politics, could be considered a science. By the beginning of the 20th century, economists were looking for theorems and models that could help to explain the universe. One historian described them as suffering from “physics envy.” Although they were dealing with the behaviour of humans, not atoms and particles, they came to believe they could accurately predict the trajectory of human decision-making in the marketplace.

In their desire to have their field be recognized as a science, economists increasingly decided to speak the language of science. From Smith's innovations through John Maynard Keynes's work in the 1930s, economics was argued in words. Now, it would go by the numbers.

The turning point came in 1947, when Paul Samuelson's classic book Foundations of Economic Analysis for the first time presented economics as a branch of applied mathematics. Without “the invigorating kiss of mathematical method,” Samuelson maintained, economists had been practising “mental gymnastics of a particularly depraved type,” like “highly trained athletes who never run a race.” After Samuelson, no economist could ever afford to make that mistak

The extracts from an interesting article in the Globe and Mail (Canada) are part of a more trenchant criticism of the state of modern economics, as it is taught in the top universities in North America as the public face of the discipline. I have touched on the Homo economicus model that has dominated the subject since it was invented in the 1870s and which evolved into the Max U paradigm, and eventually under the flood of mathematics into the myths of ‘rational expectations’ and ‘efficient markets’ hypotheses.

Moreover, Paul Samuelson’s influence on economics is mentioned regularly on Lost Legacy, because, by distorting what Adam Smith actually wrote – and the limited context in which he did so – in his singular use of the IH metaphor, was stretched by Samuelson to be about the optima caused even by ‘selfish motives’ This view of economics spread rapidly from 1948 and the 20th edition of his big seller, Economics: an introductory analysis, and was bolstered by the immense prestige of his Foundations of Economics Analysis, but, regrettably, led economists into a dead-end in a sophisticated mathematical analysis of an imaginary world, but, alas, not an understanding of the real world immediately beyond their windows.

Their greatest triumph was the victory of the ‘capitalist’ explanation over the socialist planned economies of the Soviet and Chinese blocs, based on two major errors: the success of the western economies was not based on the success of their mathematical models, but was based on the quite separate success of capitalism, albeit as in impure social arrangement; and the failures of the planned economies were based on the equally false practice of socialism, maintained for a while in a semblance of success when bolstered by its inevitable old-fashioned tyranny.

Ira Basen covers a lot of ground but in doing so he buys the modern, Samuelson, myth of the Adam Smith of ‘an invisible hand’:

In The Wealth of Nations (1776), Adam Smith famously argued that the pursuit of enlightened self-interest by individuals and companies could benefit society as a whole. His notion of the market's “invisible hand” laid the groundwork for much of modern neoclassical and neo-liberal, laissez-faire economics.”

No sir! Adam Smith fame for that assertion arose despite his not arguing that view point as a general proposition for all the workings of capitalist political economy. Instead Smith’s was a very narrow statement: he said that those merchants who considered ‘foreign trade’ too risky for their capital preferred to invest in the ‘domestick industry’ led by their private perceptions of the risks (the actual object of the metaphor of ‘an invisible hand’), which in consequence added to ‘domestick revenue and employment’ (arithmetically, the whole is the sum of its parts) and that this was to the public good. It was not their intention – their intention was to avoid the risks of exporting capital, and even specifies what those risks consisted of for the domestic merchant:

In the home-trade his capital is never so long out of his sight as it frequently is in the foreign trade of consumption. He can know better the character and situation of those whom he trusts, and if he should happen to be deceived, he knows better the laws of the country from which he must seek redress” (WN IV.ii.6: p 454).

Those who swear by the ‘optima outcome, despite ‘selfishness’, etc., ignore that earlier paragraph, and when it is drawn to their attention (e.g., David Friedman) they ignore its significance. In short, Samuelson’s version and those whom uncritically followed him remain wedded to the invention of a mystical invisible hand despite the facts that are evident in the whole argument of Adam Smith.

Smith makes a quantitative point about the outcome of a larger domestick output, specifically that the spending of their profits by merchants on their consumption and their net investment within the ‘great wheel of circulation’, benefits the public (especially the labourers) and that in itself is a public good. He did not align the unintended consequences to markets, nor any moral considerations. In poor Scotland, Smith saw domestick expenditures as a necessary improvement on the considerable levels of poverty prevalent at the time. It was not a new ‘theory, or ‘paradigm’ - it was pure common sense.
It was not a prediction or an imperative of how market economies function, or should function. It was an observation of a specific instance, clearly defined, and was no ever-lasting characteristic of what today we call capitalism. Other merchants at the time also avoided foreign trade for all kinds of reasons – insufficient capital anyway, active in non-exportable trades, no foreign contacts, fully committed domestically, and so on. They were not ‘led by an invisible hand’. Many local merchants were fully engaged in local affairs and needed no other incentive to do differently, indeed many contrived through domestic means to prevent foreign trade from entering their markets in a system Smith called ‘mercantile political economy’, from which they made local monopoly profits.

That the academic discipline of economics from the late 19th century onwards sought other tools to make it more ‘scientific’ is now history, and since 2008 has faced a crisis of confidence – of which the modern shibboleths of rational expectations and efficient prices are but an example – is slowly becoming obvious. Old paradigms do not quit their dominance easily. The priesthood is far more resilient than the shrillness of their defenders suggests. Expect a struggle, perhaps over many years – even decades – but such articles as Ira Basen’s suggest some places to start, despite his errors on the IH metaphor. I commend it to you to read in full (follow the link).

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