The market is not capable of being rational,but people are

28 10 2009

images[1]The news that George Soros is creating and financing a new economic thinktank  called the Institute of New Economic Thinking (INET) should not be a surprise given both the destitution of modern economics and Soros’ own conviction that traditional economics is ‘a dogma whose time has passed’. As I have argued before there is little doubt that rational or free market theories have been discredited by the reality of the financial crisis, although this does not mean that we have really been living through a period of free market economics.

However, while a reassessment of the way forward for economics is way overdue, it seems unlikely, given its brief ,that this new Institute will help very much. For a start, as Anatole Kaletsky makes clear in the Times today, it will be heavily influenced by the Behavioural Economics school of thought. This rightly rejects the spurious rationality of mainstream economics but replaces it with a view based on the belief that people are basically irrational and the future unpredictable.

To gain a genuine understanding of unpredictable reality, some unorthodox economists may employ new mathematical techniques of non-linear dynamics and chaos theory. Others may revive the literary and anecdotal traditions of the great economists of the past, building on the work of sociologists, psychiatrists, historians and political scientists disdained by the present orthodoxy. INET will try to support these new schools of thought.

As I said in my review of a book by influential behavioural economists, 

We can agree with the BEs that the market, or capitalism, is not rational in the way that rational market theorists claim. The most singularly irrational aspect of capitalism is that decisions to invest are made by individual or groups of capitalists rather than by or in the interests of the majority of people. If the prospects for profitable investment look poor, because the expected rate of profit is too low or too risky, then money flows elsewhere. In the past ten years money flowed instead into apparently safe areas such as financial derivatives based on assets like housing etc . This created an unsustainable asset bubble which inevitably crashed and burned. Phil Mullan calls this the over financialisation of the western economies, the tendency for money to try to beget more money without going through the process of productive investment in new businesses.

Crises in the financial sector are an inevitable outcome of the over financialisation of western economies. The exact day when they will happen cannot be predicted, but the continuous instability and the tendency towards crisis contained within it will always remain. But it is not inevitable that we have to have economies of this sort. The danger of Behavioural Economics is that it condemns us to a future where the vagaries of the market are a given and the only question is how to manipulate and control the activities of the irrational people engaged within it.

Once we accept that human behaviour is irrational and the future unplannable and unpredictable then we have taken out what is unique about humanity, its ability to consciously and collectively organise and influence the future. One bright spot about the current recession is that it has revealed the bankruptcy of the prevailing economic orthodoxy. It would be a great shame if the vacuum thus created were to be filled by those who have the most disdain for human rationality. This weekend I and many others will be debating the future of the economy with experts such as Lord Skidelsky, Martin Wolf and Paul Mason at this event. Come and join us.

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After the recession-the return of Keynes or the end of economics?

21 10 2009

images[1]Robert Lucas, the University of Chicago economist, joked last year that “everyone is a Keynesian in a foxhole’. At first glance it certainly seems that the idea of government intervention to maintain economies in trouble has made a comeback. In the past year various governments have nationalised banks, introduced major stimulus programmes, prevented industries from collapsing, subsidised employment and printed money in order to combat the financial crisis.

Yet as Sean Collins has argued in his excellent review of Keynes: The Return Of The Master by Robert Skidelsky, whom I shall be debating next week at  this event  , the ragbag of anti-crisis measures put together around the world was not the product of any widespread conversion to Keynesianism. It was instead an ad hoc programme of state measures aimed at one thing-staving off financial collapse and its perceived consequences.

The Keynes they like is not the proponent of permanent state intervention to guarantee full employment. He is instead the man who said ‘in the long run we are all dead’. In so far as Keynesianism means anything today it represents the short term managerial approach to running economies which characterises the UK and other developed countries. Why has there been so much state intervention from governments which have been arguing for ‘light touch’ regulation for the past ten years? Because there is no alternative on the horizon.

The recession has effectively destroyed, at least for the time being, the belief in free markets that has governed most of the developed world since the discrediting of Keynes in the 1970s. As Sean Collins argues however, we should not go along with the thesis that the past thirty years have been about actual free markets. During this period the state has continued to intervene in the economy, although in different ways.

Nevertheless we have reached a point where economics itself has been discredited. As Daniel Yergin argues there are so many explanations for the recession that no coherent narrative has emerged. This vacuum is being filled by another legacy from Keynes. His belief in both the power of psychology and the essential uncertainty of the capitalism economy have become more influential in response to the recession. Both of these points are highlighted by Skidelsky in his book.

The falling back on psychological explanations for the crisis amongst behavioural economists is a rejection of real economics. The crisis has in roots in economic stagnation in the west, the consequent financialisation of western economies and global imbalances created by the relative dynamism of the BRICs. To ignore these causes and point to crowd psychology reduces the problem to one susceptible by state manipulation of people’s activity. In this sense it fits with the short termism we spoke of above. It represents an inability to face reality and think through what it would mean to create more dynamic western economies.

The elevation of uncertainty as a major problem is also wrong. Keynes, writing in the 1930s was obsessed with the threat of capitalist collapse. Faced with the Depression and looming global conflict this was not an unreasonable fear. It is to Keynes’ credit, in contrast with many who followed after him, that he understood that economics is about politics. His argument for full employment was that it was necessary to stave off revolution.

In fact one thing the recession has shown us is that capitalism is in general very stable and quite predictable. We are in the midst of a major recession but as I have noted before there has been very little social response. This is because capitalism is at root a system of social relations. No matter how bad the economy may get, as long as there is no organised alternative it will bounce back.

Emphasising the uncertainty and risks involved in capitalism today can only have one effect, one which Skidelsky himself recognises,’uncertainty imposes a kind of permanent fearfulness about the future which puts a damper on economic progress’. Skidelsky also criticises some of the behaviouralist economists, like Shiller, for ‘panic’ in the face of apparently irrational human behaviour in the run up to the recession.

There may be opportunities, due to the crisis within economics, to debate what kind of economy we need. This would entail rejecting the panic and uncertainty brigade and arguing for a longer term more strategic approach to the economy, more planning, more debate about where we want to go and above all more leadership.





After Lehman-another year older and deeper in debt

17 09 2009

images[10]The anniversary of the collapse of Lehman brothers has provoked an orgy of retrospective comment. I hesitate to call it analysis because, as Charlie McMenamin has pointed out, the striking thing about all the comment has been the lack of any concensus even on what to call what has happened, let alone to provide an explanation for it. Everybody from President Obama downwards is saying that there can be no return to business as usual. Yet in the absence of any proper understanding of what happened business as usual is precisely what we will get.

If there is one emerging theme to the discussion it is that the whole thing is the product of aberrant human behaviour. In other words, there are no rational economic explanations for what happened, it is simply the product of human greed and irrational behaviour. The influence of economic behaviouralism is now making itself felt in most discussions of the recession and its causes. This approach was summed up in a  recent article on the credit crisis in the New York Times which ended with this comment,

“Ultimately, bubbles are a human phenomenon,” said Robert Shiller, a Yale economics professor and Cassandra of the current crisis. “People just get a little crazy.”

And what do crazy people need? More supervision, more regulation and tighter control of course. That is why the main thing that governments are focussing on is to try to rein in the greedy bankers by regulating what they do and their bonuses more closely. The deeper reasons for the recession are being virtually ignored. One severe consequence will be that the short term managerial approach to our economies exemplified by the last ten years of bubble economics will  be enhanced while any prospect of longer term strategic planning will diminish further.

Meanwhile it is worth reminding ourselves that in the real world the recession has taken and continues to take a terrible toll. As Mervyn King has helpfully pointed out, the end of recession does not compensate for the loss of output, the real drop in the wealth within our societies. In the UK we are only now beginning to experience this in the shape of higher unemployment and less money for public services. The OECD is predicting that a further 25 million people in high income countries will lose their jobs by next year and the World Bank that 90 million people will be pushed into extreme poverty in the developing world.

World trade is still severely depressed. There is evidence of the strengthening of protectionist tendencies, expecially in debtor nations like the US. The central problem of the imbalances between the developing and exporting nations and the rest of the world remains exactly as it was when the financial crisis started. All that has really happened over the past twelve months is that the financial system has been protected from bankruptcy. A symptom of the problem, excessive dependence on the financial sector,  has been taken for the cause, the loss of productive  economic activity in countries such as the US and the UK.

Diminished belief in the rationality of the market does open a small window of opportunity. It is not possible to plan capitalist society, but the weakening of an intellectual justification for the market opens the door to the possibility of thinking about what the advantages of a planned economy in a democratic society would be compared to the short term, chaotic character of modern capitalism.





Why the behavioural economists are wrong, a review of ‘Animal Spirits’ (Part Two)

1 07 2009
  
Animal Spirits: How Human Psychology Drives The Economy, And Why It Matters For Global Capitalism, by George Akerlof & Rober Shiller

Animal Spirits: How Human Psychology Drives The Economy, And Why It Matters For Global Capitalism, by George Akerlof & Robert Shiller

BOOK REVIEW (Part Two)
Animal Spirits: How human psychology drives the economy and why it matters for global capitalism, by George Akerlof and Robert Shiller (published by Princeton University Press)

“Animal spirits…is an economic term, referring to a restless and inconsistent element in the economy. It refers to our peculiar relationship with ambiguity or uncertainty. Sometimes we are paralyzed by it. Yet at other times it refreshes and energises us, overcoming our fears and indecisions.” [1]

The first part of this review contested  Shiller and Akerlof’s claims that the recession is caused by the irrational behaviour of individuals. There is however much more in their book to challenge.

I once talked to a behavioural psychologist whose job was to improve the behaviour of children in the classroom. The first thing he told me was that to do his job properly he had to completely ignore the, often tragic, social backgrounds of the disturbed children. Instead, he focussed entirely on strategies for changing their behaviour by psychological tricks which were akin to those used to train dogs. I was reminded of this when reading Shiller and Akerlof’s approach to some major economic and social issues. They too ignore the historical and social factors which have led to many of the phenomena they discuss and instead present them as merely behavioural oddities.

Their view is that human economic behaviour is determined by a combination of five things: confidence, fairness, corruption, money illusion, and storytelling.

These are all relatively straightforward concepts, except perhaps for money illusion. Money illusion is a term used to explain why people will oppose wage cuts, even if the prices of what they buy are falling in deflationary times, more than they will fight for wage rises at a time of inflation when everything is getting more expensive.

Why do workers resist wage cuts and not fight as strongly for indexed linked rises?  Rather than a psychological reason, is it not more likely that workers understand that once they have conceded the need to accept pay cuts that they will have handed power to their bosses to do so again, to keep coming to the well? Is it not also likely that compared with this, the need to combat inflation, a future event which like all future events is uncertain, will seem less of a vital issue? The authors approach to this is typical of many of the points they make. They persistently choose to interpret attitudes arising from social and historical experience as hard wired psychology. Often this leads to observations which are so stunningly banal that you are left wondering whether these authors simply need to get out more. Take the following examples:

‘people rarely quit their jobs in recessions’[2]

‘people tend to want to work in higher paid industries’[3]

‘students…really don’t seem to care how much they save’ [4]

Their emphasis on the importance of storytelling also takes them away from understanding what is perfectly clear and rational behaviour based upon experience. They claim that the high savings rate in China and other new economies is down to the ‘story’ that ‘there is no shame in being poor in China, since this is viewed as a transitional state’[5], therefore people do not consume. However as many people have pointed out, in a country with often rudimentary social and medical insurance[6], savings are an essential to fall back on when times get tough.

The answer to most of the problems the authors riase is state action of one kind or another. For example, a discussion on racial discrimination in the US describes the situation of black Americans thus,

‘there is the notion among both blacks and whites that there are two groups, we and they. This very notion is part of daily reality. This notion – as much as low financial assets and skill levels – is responsible for the continued poverty of African Americans.’[7]

The experience of racism in the US is reduced to a ‘story’ which reinforces social stereotyping. The authors do not recognise that racism, where it exists, needs to be combatted through political means. Their suggestion instead is positive discrimination, action by the state.

Of course, there are many aspects of human behaviour which appear to be irrational. We can usually see them more clearly when we look at other people’s cultures rather than our own; and there’s the clue. Generally speaking these types of behaviour are the product of a specific cultural and social experience. Sometimes it is also true that we take our lead from what other people do, as in buying houses or shares in a rising market. But this is a perfectly rational thing to do in the absence of information as to why this is a bad idea.  Very few people can call the top or the bottom of any market, and those that do are often just lucky. In the mean time we all try to take as much advantage of it as we can.

The rise of behavioural economics is a symptom of the paucity of proper historical, political and economic analysis of society. In that sense it is just as much part of the voodoo culture of the day as the types of behaviour it disparages.

 

[1] Animal Spirits p4

[2] Ibid p103

[3] Ibid p103

[4] Ibid p116

[5] Ibid p128


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Why the behavioural economists are wrong, a review of ‘Animal Spirits’ (Part One)

24 06 2009
 

Animal Spirits: How Human Psychology Drives The Economy, And Why It Matters For Global Capitalism, by George Akerlof & Rober Shiller

Animal Spirits: How Human Psychology Drives The Economy, And Why It Matters For Global Capitalism, by George Akerlof & Robert Shiller

BOOK REVIEW (Part One)
Animal Spirits: How human psychology drives the economy and why it matters for global capitalism, by George Akerlof and Robert Shiller (published by Princeton University Press)

 

“Keynes appreciated that most economic activity results from rational economic motivations-but also that much economic activity is governed by animal spirits. People have non-economic motives. And they are not always rational in pursuit of their economic interests. In Keynes’ view these animal spirits are the main cause for why the economy fluctuates as it does.” [1]

One of the most frustrating aspects of the recession has been the absence of serious examination of its causes. Of course, there has been huge coverage of the events of the recession. But at the level of serious analysis there has been a dearth of proper public discussion. The political and public domain has been dominated by trivia such as bankers’ salaries or MPs’ expenses. Public debates have been restricted because there are few people who are able to discuss the economy and politics in the same breath. Yet it is impossible to make sense of one without the other.

The demise of politics and the political sphere as a meaningful forum for discussing the economy has encouraged the search for other explanations, outside the sphere of politics or traditional economics. Some people, including influential people within the Conservative Party in the UK, have turned instead to the behavioural economists (BEs), like Robert Shiller and George Akerlof, for explanations and guidance. Shiller and Akerlof’s case is that it is the behaviour of individuals within the market system and their psychology which explains much of what has gone wrong.

 Behavioural economists reject the view that the recession can be explained in traditional economic terms. In particular they have in their sights the rational market theorists, more commonly known as the free market proponents who have been influential since the time of Thatcher and Reagan, who argue that free markets can regulate themselves.  The upheavals of the past two years in the world economy have discredited the rational market theorists, as the blame for the recession has fallen on to the unregulated  nature of the financial markets. The BEs conclusion is that markets are susceptible to the irrational behaviour of individuals. This irrational behaviour requires state intervention to counteract it and to reintroduce stability. In the wake of the global recession this explanation and remedy is falling on fertile ground.

But the recession is not a crisis inflicted on an otherwise stable system by the behaviour of irrational individuals, as ‘Animal Spirits’ suggests. The problems of present day capitalism are the product of historical and economic developments within the system itself. The idea that anybody can say, as Gordon Brown did, that we can have neither boom nor bust, is plain wrong. The recession is just as intrinsic to modern capitalism as the boom which preceded it.

Whether it is the overdependence of the UK on financial services and public spending, the lack of any underlying productive dynamic to western economies in general, the crisis of the political class and its impact on the economy or the likely effects of the rise of China, none of these developments are explained or accounted for by Akerlof and Shiller. Their argument is that capitalism can work fine if it only had a little more regulation:

Capitalism can give us the best of all possible worlds, but it does so only on a playing field where the government sets the rules and acts as a referee.[2]

We can agree with the BEs that the market, or capitalism, is not rational in the way that rational market theorists claim. The most singularly irrational aspect of capitalism is that decisions to invest are made by individual or groups of capitalists rather than by or in the interests of the majority of people. If the prospects for profitable investment look poor, because the expected rate of profit is too low or too risky, then money flows elsewhere. In the past ten years money flowed instead into apparently safe areas such as financial derivatives based on assets like housing etc . This created an unsustainable asset bubble which inevitably crashed and burned. Phil Mullan [3] calls this the financialisation of the western economies, the tendency for money to try to beget more money without going through the process of productive investment in new businesses.

In addition, capitalism is less and less able to stand on its own two feet as it becomes more and more established. The state often has to step in to try to prop up ailing industries, as the US government recently did with General Motors, or to subsidise whole ones, as the EU does with farming. The growth of financialisation and state support together represent the throttling of dynamic economic development in the west. The truly dynamic parts of the world economy are now in the east.

The approach to explaining the recession taken by the BEs turns reality on its head. Capitalism as a system with inbuilt tendency to crisis is let off the hook and the individuals who suffer from the recession are blamed for it.

Part two of this review will follow shortly

 


[1] Animal Spirits p ix

[2] Ibid p173

[3] http://www.spiked-online.com/index.php/site/article/4244/

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Economists behaving badly: why individual behaviour is not to blame for the recession

27 05 2009

Bromley illustrationsLast week I attended a meeting with Robert Shiller, a behavioural economist and author of Animal Spirits.  As I have discussed previously, behavioural economics is becoming increasingly influential, particularly as an explanation for the recession and how to get out of it.  Essentially Shiller and others are offering psychological reasons for why people make apparently irrational decisions in the economic sphere.

Shiller’s argument last week boiled down to saying that the recession was caused by lack of confidence, an extension of FD Roosevelt’s proclamation during the 1930s depression that ‘all we have to fear is fear itself”. If you listen to the podcast you will see that in response to  questioning from  Richard Sedley and myself, Shiller is quick to concede that psychology cannot explain everything.


Two reasons why behavioural economics is on the rise

In the current climate of economic and political meltdown however, behavioural economics does not have to be a coherent theory of everything in order to be important. It is becoming increasingly influential because it plays a dual role in the current period of turbulence:

1)  it allows us to feel that it was the mistakes of the greedy bankers, driven by over confidence and corrupted by easy money that caused the recession. In that sense it takes away the necessity to think through what really caused the recession and the underlying political and economic problems that need to be resolved.

2)  if we are irrational beings as Shiller and others suggest, then the State is justified in stepping in to protect us from ourselves. Behavioural economics becomes another reason why the State needs to intervene more, not less, in all aspects of life.

This is why behavioural economics has been taken up by the Obama administration, the British Conservatives and people in New Labour. They are all looking for an explanation, any explanation, so that they can avoid tackling the really hard issues.