Friday, July 19, 2013

The macho of rationality

There seems to be a strange communal notion in the economics profession that one should always try to get by with the idea of complete human rationality; that any weakening of this assumption in one's theory is unseemly and more or less tantamount to cheating, as if you're not keeping a stiff upper lip and soldiering on like the rest of your colleagues who are trying to explain things with the rationality handicap fully in place and without making any concessions to reality. I don't know why economists don't agree to theorize with one hand tied painfully behind their back, or maybe with red hot needles inserted into their eyes, just to make the competition even tougher. The best economist is the most macho.

I recall seeing this attitude expressed forcefully in a paper from several years ago by UC Berkeley finance professor Mark Rubinstein. I wrote about that here and I might as just quote one bit:

"Rubinstein asserts that his thinking follows from what he calls The Prime Directive. This commitment is itself interesting:

When I went to financial economist training school, I was taught The Prime Directive. That is, as a trained financial economist, with the special knowledge about financial markets and statistics that I had learned, enhanced with the new high-tech computers, databases and software, I would have to be careful how I used this power. Whatever else I would do, I should follow The Prime Directive:

Explain asset prices by rational models. Only if all attempts fail, resort to irrational investor behavior.

One has the feeling from the burgeoning behavioralist literature that it has lost all the constraints of this directive – that whatever anomalies are discovered, illusory or not, behavioralists will come up with an explanation grounded in systematic irrational investor behavior.
Rubinstein here is at least being very honest. He's going to jump through intellectual hoops to preserve his prior belief that people are rational, even though (as he readily admits elsewhere in the text) we know that people are not rational. Hence, he's going to approach reality by assuming something that is definitely not true and seeing what its consequences are. Only if all his effort and imagination fails to come up with a suitable scheme will he actually consider paying attention to the messy details of real human behaviour."

There are multiple things I fail to get about this, the first being that this is not actually a good way to explain anything. Think of this. Suppose you observe some real world thing X (some market behavior) and you want to explain it. You assume A (rationality), build a model, and show that X comes out. Great! But then, your explanation really only hangs together is A is true. If someone rightly objects that A isn't true, then you've really explained nothing. The mystery stands: how is it that in a world in which A is not true, X can happen? You might say "well, A is almost true, so this is an approximate explanation." Maybe, but it would then be much better to go back and try again with assumption B (people are fairly rational with shortcomings of this or that specific sort) and show that X comes out. That would be an explanation one could believe. Rubinstein's presciption holds that this should only be a last resort, perhaps an admission of defeat. Oddly, the Prime Directive, it seems to me, holds that economists should stop seeking an explanation before they've actually found one (at least in cases, as is typical, in which A, rationality, is not true..... in really simple cases in which that assumption is plausible, games of tic-tac-toe and such, then sure.)

Anyway, Floyd Norris has a nice essay today touching on the thoughts of Ben Bernanke, Steve Keen and others, and exploring various topics including the widely held delusion prior to the crisis of how stability and efficiency were guaranteed by the wonders of modern financial engineering. As part of it, Bernanke makes more or less the same statement as Rubinstein (I've put it in bold, part way down):
The intellectual framework [FED economists prior to the crisis] used simply could not cope with the idea that financial stability can itself become a destabilizing factor, as investors and bankers conclude that it is safe to take on more and more risk.

For a time, the period before the collapse was known as the “Great Moderation,” a term that Mr. Bernanke helped to publicize in a 2004 speech. Low levels of inflation, long periods of economic growth and low levels of employment volatility were viewed as unquestioned proof of success.

And what brought on that success? In 2004, Mr. Bernanke, then a Fed governor, conceded good luck might have helped, but his view was that “improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation.”

In 2005, three Fed economists, Karen E. Dynan, Douglas W. Elmendorf and Daniel E. Sichel, proposed an additional explanation for the Great Moderation: the success of financial innovation.
“Improved assessment and pricing of risk, expanded lending to households without strong collateral, more widespread securitization of loans, and the development of markets for riskier corporate debt have enhanced the ability of households and businesses to borrow funds,” they wrote. “Greater use of credit could foster a reduction in economic volatility by lessening the sensitivity of household and business spending to downturns in income and cash flow.”

At least Mr. Bernanke’s hubris was not as great as that of Robert E. Lucas Jr., the Nobel Prize-winning University of Chicago economist. In 2003, he began his presidential address to the American Economic Association by proclaiming that macroeconomics “has succeeded: Its central problem of depression prevention has been solved.”   

In his speech last week, Mr. Bernanke cited several assessments of the Great Moderation, including the one by the Fed economists. None questioned that it was wonderful.

The Fed chairman conceded that “one cannot look back at the Great Moderation today without asking whether the sustained economic stability of the period somehow promoted the excessive risk-taking that followed. The idea that this long period of calm lulled investors, financial firms and financial regulators into paying insufficient attention to building risks must have some truth in it.”

One economist who would have expected that development was Hyman Minsky. In 1995, the year before Minsky died, Steve Keen, an Australian economist, used his ideas to set forth a possibility that now seems prescient. It was published in The Journal of Post Keynesian Economics.
He suggested that lending standards would be gradually reduced, and asset prices would rise, as confidence grew that “the future is assured, and therefore that most investments will succeed.” Eventually, the income-earning ability of an asset would seem less important than the expected capital gains. Buyers would pay high prices and finance their purchases with ever-rising amounts of debt.

When something went wrong, an immediate need for liquidity would cause financiers to try to sell assets immediately. “The asset market becomes flooded,” Mr. Keen wrote, “and the euphoria becomes a panic, the boom becomes a slump.” Minsky argued that could end without disaster, if inflation bailed everyone out. But if it happened in a period of low inflation, it could feed upon itself and lead to depression.

“The chaotic dynamics explored in this paper,” Mr. Keen concluded, “should warn us against accepting a period of relative tranquility in a capitalist economy as anything other than a lull before the storm.”

When I talked to Mr. Keen this week, he called my attention to the fact that Mr. Bernanke, in his 2000 book “Essays on the Great Depression,” briefly mentioned, and dismissed, both Minsky and Charles Kindleberger, author of the classic “Manias, Panics and Crashes.”

They had, Mr. Bernanke wrote, “argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behavior.” In a footnote, he added, “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.

It seems to me that he had both Minsky and Kindleberger wrong. Their insight was that behavior that seems perfectly rational at the time can turn out to be destructive. As Robert J. Barbera, now the co-director of the Center for Financial Economics at Johns Hopkins University, wrote in his 2009 book, “The Cost of Capitalism,” “One of Minsky’s great insights was his anticipation of the ‘Paradox of Goldilocks.’ Because rising conviction about a benign future, in turn, evokes rising commitment to risk, the system becomes increasingly vulnerable to retrenchment, notwithstanding the fact that consensus expectations remain reasonable relative to recent history.”

Thursday, July 18, 2013

Young economists -- go for it!

I'm really glad to see some economics students standing up for what they believe and taking action to start pushing their field in a better direction. This recent conference in Germany wasn't organized by the elders in economics, the esteemed and deserving (??) Nobel Prize winners of "greed, rationality and equilibrium" who OUGHT to be desperate to find better ideas and to lead the way, but by students acting on their own (with some help from INET). I'm encouraged by their energy and willingness to think openly:
Who are we? As students of economics at the University of Tübingen, Germany, we are organizing the second Rethinking Economics conference, in order to broaden our insights into modern economic thinking. As the summer conference in 2012 has shown that university education puts too little attention on issues of epistemology and the history of economic science, this year’s conference aims to stress the methodological plurality of recent economic research. Therefore we are seeking to promote the exchange with new economic thinkers of all strands and like-minded economics students.

Why rethink economics? Most of current economic research considers economics as a self-equilibrating system populated by rational individuals. It lacks interactions that can endogenously explain crises that we have seen in the real world. Alternative approaches, however, offer inspiring new perspectives to economic phenomena and provide ideas how the deficiencies of current economic paradigms may be solved. Frictions and irrationalities in general, and, for example, the nature and political economy of financial markets and systemic instability in particular, are not treated as unattractive deviations from theoretical ideals, but are incorporated as main features of the model. These theories show that aside from neoclassical approaches there are different ways of thinking about economics, which allow understanding economic dynamics better.

What is our objective? There has been an intense debate on the direction of economic research since the outbreak of the financial crisis. Our summer conference aims to offer an insight into modern strands of economics and to promote and accelerate new economic thinking among young students of economics. The conference will cover Complexity Economics, Agent-Based Modeling, Neuroeconomics, Postkeynesian Economics, and Behavioral Economics. These theories will be applied to topics such as non-equilibrium economics, contagion in the banking sector, instability of preferences, the links between the financial sector and the real economy, and empirical evidence on neoclassical assumptions from psychology, sociology, anthropology, and neuroscience.

Who can participate? The conference addresses students of economics and neighboring fields.  We invite open-minded economic thinkers of all semesters, and will therefore provide workshops that do not assume many previous knowledge of the topic discussed. Every lecturer will provide a reading list, which enables the participants to prepare themselves in advance. The conference will be complemented by a panel discussion open to the public, dealing with the future of economic modeling.
 Good for them.

Economics and Evolution

There's a minor dust up brewing over how much economists can learn from evolutionary theory, stimulated by this special issue of the Journal of Economic Behavior and Organization, entitled "Evolution as a General Theoretical Framework for Economics and Public Policy". I haven't yet read the papers in the issue, although they certainly look to be well-motivated, focused on policy relevant questions, and eager to draw insights from long study of evolution, which I think is a good idea as evolution is, in general, a lot smarter than we are. But it seems that Mark Thoma isn't impressed by the idea, or at least finds a Scientific American article discussing the special issue irritating in making a number of sweeping statements about economics that aren't justified.

In that Thoma is right (and I do often agree with him). For example, economists do have a huge body of work studying tragedies of the commons, their origins and how they might be avoided, and the article implies otherwise. He makes other criticisms as well, more or less justified, although he also seems rather touchy about the idea that economists haven't woken up to the deeper insights that evolutionary theory has to offer and remains stuck on restrictive game theoretical notions of equilibrium. One of the editors of the Special Issue, Barkley Rosser, offers a considered response:

Mark Thoma at economists view , has linked to a post by Jag Bhalla at Scientific American, who in turn links to the Evolution Institute, , where one finds a link to a special issue of the Journal of Economic Behavior and Organization (JEBO) that I have coedited with David Sloan Wilson and John M. Gowdy.  The special issue makes a play for increasing the use of evolutionary theory in economics.  Bhalla argues that this involves arguing that economics should not necessarily involve assuming people rationally maximize utility or that equilibrium analysis should be the focus of analysis.  Mark is unhappy about this characterization and disses the argument pretty hard.  Of course, he is welcome to his view.

Furthermore, he invokes Paul Krugman, quoting in full a speech that PK gave in 1996 to the European Society for Evolutionary Political Economy (while I am into such things, I know nothing of this group).  One can directly access PK's speech at , if one does not want to go through Mark's link.  It may well be that Krugman would now disavow parts of this speech, or at least pull his punches a bit, but it is a place where he puts on his neoclassical hat full force and defends orthodox economics full bore.  This may well not be inconsistent with his current stance as the critic of new neoclassical synthesis views, given that one can view him to some degree as an advocate of the old MIT-Samuelson "neoclassical synthesis" that adopted a neo-Keynesian ISLM approach to macro while essentially maintaining a position of full orthodoxy in microeconomics.  Let us grant that this orthodoxy includes emphasizing agents who are fully rational and maximize their well-defined utility that interacts with other economic agents to lead reasonably quickly to equilibrium, with this being the appropriate focus of analysis.

In any case, I think that PK's presentation of both evolutionary economics and evolutionary theory are seriously narrow and misleading.  He essentially argues that evolutionary theory is all about maximization and equilibrium and that those who focus on other approaches, including Stephen Jay Gould and Stuart Kauffman, are just peripheral losers within established evolutionary theory, which is represented by the work of Richard Dawkins.  He emphasizes the importance of evolutionary game theory developed by Maynard-Smith and then introduced into economics, where it is now more or less a part of standard economics.  He even notes that Hamilton and others allow for rewards for cooperation.  This is all true, and can even be viewed ironically as a form of microfoundations of macroevolution within evolutionary theory, although it is not the whole story.

One important point is that there are and have been many different branches of evolutionary economics.  Of course, economics influenced evolutionary theory from the beginning, notably through the influence of Malthus on Darwin and Wallace.  Some forms of evolutionary economics have always been completely consistent with fully orthodox neoclassical economics, most notably the arguments regarding firm survival and the pressure to maximize profits due to natural selection pressures within competition, as emphasized in the famous 1950 paper by Armen Alchian, followed up by Milton Friedman in his Essay on Positive Economics. 

Of course, Krugman and probably Thoma probably dismiss the oldest evolutionary school, the old institutionalists, who founded the AEA and once ran it, only to be overcome and replaced by the MIT neoclassical synthesis of Samuelson.  It is easy to dismiss them, but they have made many insights and continue to offer more, most notably through the Journal of Economic Issues.  An irony is that the person who coined the term "neoclassical economics" was none other than Thorstein Veblen, founder of the institutionalist evolutionary school.  I suspect that Krugman and Thoma probably consider many of his ideas to be quite relevant to our current situation.

Another evolutionary economics school, vaguely referred to by Krugman, is the neo-Schumpeterian school whose main leaders have been Nelson and Winter and their followers.  This school continues with many followers and journals such as Journal of Evolutionary Economics and Industrial and Corporate Change.  I do not see anybody seriously questioning that they have had much to offer regarding the study of technological change.

Krugman dismisses Stephen Jay Gould and his punctuated equilibrium view as some sort of evolutionary equivalent of John Kenneth Galbraith, an idea popular among the public, but dismissed within evolutionary theory itself.  I think that Krugman is seriously off on this characterization, and the idea of multiple equilibria and dynamic discontinuities is one that is certainly of great relevance in economics.  Just what is going on when we see major financial crashes?

Finally, there is the new complexity evolutionary theory, which is associated with Kauffman of the Santa Fe Institute, whom Krugman also dismisses.  This approach is deeply linked with what is probably the most serious competitor to the DSGE model in macro analysis, namely agent-based modeling.  Many of those models use genetic algorithms, and evolutionary ideas such as emergence are taken very seriously in this approach.  Indeed, this is an alternative way of doing micro foundations of macro, an issue that Krugman simply does not address at all, which does not necessarily depend on the old orthodoxy of rational agent utility maximization or convergence on equilibria within dynamic evolutionary processes.

Barkley Rosser
I would definitely further that point. I read that Krugman speech several years ago and enjoyed it; Krugman is someone who, it seems to me, reads widely and is open to ideas from other areas of science, although he admitted in the speech that he is "basically a maximization-and-equilibrium kind of guy". Rosser mentions Stephen Jay Gould and the idea of punctuated equilibrium. From my readings of Gould, that idea remained more or less qualitative with him and his co-author (Eldridge I think), but was subsequently developed in more detail by others such as physicist Per Bak. Their view was that ecosystems and ecologies aren't in a static equilibrium of any sort, but in a much more dynamic state through which vast avalanches of change occasionally ripple for perfectly ordinary reasons and having NOTHING to do with external shocks to the system. This is more at the forefront of our understanding of whole-system dynamics than is the old idea of evolutionary stable states and Nash equilibria (although these are still useful on shorter timescales for understanding interactions between a small number of species).

But the point Gould is perhaps more famous for is emphasizing that if one assumes that species have evolved to maximize their (local) fitness, then you open yourself to potentially huge errors of misinterpretation. You might try to interpret everything you see is an optimal solution to some problem, even if some of it, or even most of it, might have nothing to do with optimality. Sure enough, it turns out that an awful lot of what happens in evolution is driven not by genetic changes that increase fitness at all, but rather to changes that are entirely neutral; in essence, most evolution is random drift! If something like this were true in economics, the we might be making systematic errors in assuming the marketplace victory of one firm, technology, computer device or idea over another generally has something to do with its inherent superiority. It may simply reflect a series of random accidents. In principle, this might not be an odd or unusual thing, but the general rule across the board. Taking this possibility seriously would be a big shift for economics, I think, and something it would learn from evolution.

I won't drone on. The most important thing is that the evolutionary theory currently used in economics as a source of metaphor and mathematical models has been/is being cast aside in evolution and ecology by a richer mathematical framework that goes well beyond equilibrium. I hope some of this will be discussed in the special issue. Lots of us who aren't biologists haven't kept up with what is going on in biology and we're quite a bit out of date. For example, genes flow down through the generations, don't they, transmitted vertically from one generation to the next? There is no sideways or horizontal flow of genes between different organisms; we all know that. Indeed, that was the lore for 50 years at least and I only know that this idea is wrong because New Scientist a few years ago asked me to write an article about something called "horizontal gene transfer," which is one of the greatest recent discoveries in biology. 

We probably still know very little about evolution, but what we do know I expect will be a treasure of useful ideas about economics.

Economics As Religion

My latest Bloomberg column came out last night. It was stimulated in part by this recent paper by economists Daron Acemoglu and James Robinson, which I learned about from this short discussion by James Kwak. The paper is an excellent corrective to overconfidence in making simple-minded policy pronouncements based on incomplete theories. (The discussion brings to my mind Naseem Taleb's amusing and I think largely legitimate comment that society at large would be better off if most economics classes were immediately cancelled and replaced with something more benign, such as classes in gardening!).

The argument of Acemoglu and Robinson is fairly simple, but I think far reaching. They point out that economists in practice spend a lot of time thinking about market failures and how to prevent them, and derive much of their policy advice from this recipe. Of course, such analyses inevitably tap into the analytical machinery for welfare analysis (which, I admit, I find hard to take very seriously, but that's another story) and consider how some policy intervention, by removing obstacles to possible exchanges in the market, can improve welfare and economic efficiency. The trouble, they point out, is that the conceptual framework used in such analyses often simply dismisses as irrelevant other non-economic impacts of such policies, even though these may have huge societal ramifications. Here's how they describe one example:
Faced with a trade union exercising monopoly power and raising the wages of its members, many economists would advocate removing or limiting the union’s ability to exercise this monopoly power, and this is certainly the right policy in some circumstances. But unions do not just influence the way the labor market functions; they also have important implications for the political system. Historically, unions have played a key role in the creation of democracy in many parts of the world, particularly in western Europe; they have founded, funded, and supported political parties, such as the Labour Party in Britain or the Social Democratic parties of Scandinavia, which have had large effects on public policy and on the extent of taxation and income red istribution, often balancing the political power of established business interests and political elites. Because the higher wages that unions generate for their members are one of the main reasons why people join unions, reducing their market power is likely to foster de-unionization. But this may, by further strengthening groups and interests that were already dominant in society, also change the political equilibrium in a direction involving greater effifi ciency losses. This case illustrates a more general conclusion, which is the heart of our argument: even when it is possible, removing a market failure need not improve the allocation of resources because of its effect on future political equilibria. To understand whether it is likely to do so, one must look at the political consequences of a policy—it is not sufficient to just focus on the economic costs and benefits.
The paper goes on to analyze this problem in much greater generality, looking at the push to privatization in Russia, and the drive to deregulate financial markets over the past three decades in Western nations, and how both led to huge shifts in the wealth and political power of different social groups. In both cases, much of the intellectual groundwork for making these changes came from analyses that were ridiculously oversimplified and carried out with considerable disregard for the larger complexity of society. No doubt there were economists out there arguing against this kind of thing (Joseph Stiglitz comes to mind), but their voices certainly weren't loud enough nor were their arguments amplified well enough by others. [Note: To be clear, I am not at all against studying oversimplified models. But those who do should always make it clear that we know very little about what such models teach us about a real world that is vastly more complex.]

I've also referred implicitly or explicitly to a couple of other things in my column, which you might like to read for greater understanding or just for the sheer (and strange) pleasure of being pissed off and utterly baffled at the strange and arrogant things some people can believe. In the latter category, I strongly suggest this paper from a decade ago by U. of Chicago economist Edward Lazear entitled Economic Imperialism. He's fully in favor of it and sees the day not too far away when all the social sciences will have been set right by jettisoning older nonsense and adopting a consistent economic focus on the maximizing behavior of rational individuals which leads them to a social equilibrium. For Lazear, this seems to represent the path to wisdom every bit as much as the Bible does to a fundamentalist Christian. Lazear is (or was, at least), in particular, fond of everything done by his Chicago colleague Gary Becker. (On a related point, see Lars Syll, who quotes Daniel Kahneman remembering Becker's way of thinking: "I once heard Gary Becker [argue] that we should consider the possibility of explaining the so-called obesity epidemic by people’s belief that a cure for diabetes will soon become available.")

But on the more productive side, I really do highly recommend economist Robert Nelson's Economics As Religion as one of the most insightful books on economics I have read. His main point is to explore how economic analyses typically rest on hidden value judgements, even though they are presented as the product of a supposedly "value neutral" way of thinking. I think this is still true today as it was in 2001 when the book was published. When economists start talking about policies that will be "socially optimal", you should open your eyes wide and ask: on what conceivable grounds can you make such a pronouncement? You will inevitably find that what follows is a flurry of algebra the main purpose of which is to give a "sciency feel" to the argument and to obscure some hidden value judgements on which the entire conclusion depends (see the issues over the discounting of future costs, for example). Those judgements often enter in cost-benefit calculations where the economist decides which kinds of costs to include and which to ignore.

But maybe I'm too cynical. I would guess that most economics graduate students have probably read Nelson's book and know better today, but I don't know. I hope so.

Thursday, July 11, 2013

The Wall Street Journal weighs in on "econophysics"

Michael Casey has written a nice short essay in the Wall Street Journal on the topic of econophysics, and more generally the physics-inspired research program into economics and finance. I'm flattered to see that he gives my book a prominent mention. The article is definitely worth a read, no doubt... but then, I would say that, wouldn't I?

Monday, July 8, 2013

Steve Keen on economic self-cannibalism

Great article by Steve Keen, reflecting on 40 years of change as traditional neo-classical economics has become less important and less influential in his academic environment. One excerpt below, but worth reading the whole thing: 
I started out as a True Believer in what I didn’t even know was neoclassical economics when I began my Arts/Law degree at Sydney University in 1971. In 2013 – 40 years after I graduated from the Arts degree – I ended up as the world’s most famous unemployed economist. And from the outset of my days as a radical in economics, I could see this end game coming. Though I certainly didn’t anticipate my own redundancy (or that of 12 of my colleagues) at UWS, it was obvious that economics was on a hiding to nothing to collapse from the heart of any business degree to its appendix.

The reason is simple: neoclassical economics (and neoclassical economists) annoy the hell out of most other business academics. They have a ‘holier than thou’ attitude about the intellectual rigor of economics versus the wishy-washy (marketing) or mechanical (accounting) nature of other disciplines, and they frankly think that some (if not all) of these other disciplines are simply unnecessary.

In a dialectical reaction, many of their looked-down-upon companion subjects in business faculties evolved precisely because economics deigned their topics to be unimportant. The real-world needs of business (as well as some of the delusions of managers) gave rise to a panoply of business subjects whose practitioners returned in kind the contempt of the economists. By the early 1970s, the academics in these ‘inferior’ disciplines already outnumbered the economists, and as they grew in number, the contest for the scarce core units in business degrees intensified.

By alienating all their rivals, economists were on a hiding to nothing to be driven towards extinction. When it came to a vote at faculty level about what subjects were needed in a given degree (in the days when academics enjoyed a modicum of democracy), the hopelessly outnumbered economists would assert the centrality of economics to any business degree.

Their fellow faculty members would listen and nod – and then vote economics down.

I saw this firsthand when, as the two most prominent student activists in the ‘Day of Protest’ revolt at Sydney University in 1973, Richard Osborne and I were invited to speak to the Faculty of Economics about the proposal to investigate the Department of Economics. We spoke strongly in favour of the motion – as did Frank Stilwell, Evan Jones, Gavan Butler, Jock Collins, and several staff from other disciplines. We awaited the rejoinder from Hogan and Simkin, and when it came, it was devastating – to their own cause.

Simkin spoke on both their behalves. He noted that in 1969, when there had been a serious dispute in Economics, it had been preceded by one in Philosophy. Now in 1973, there was a serious dispute in Economics, and yet again it had been preceded by one in Philosophy.

That was it. We waited for the punch-line – correlation proving causation with a perfect linear regression between disturbances in Philosophy and copycat actions in Economics –but Professor Simkin evidently regarded making that deduction as an exercise for the remainder of the Faculty. Neither he nor Hogan said another word.

I ended the awkward silence that followed by noting that, even though the correlation was correct, it did not explain why the copycat effect always occurred in Economics – rather than in, say, Italian. There was something endogenous to the tribulations in economics, and they deserved investigation.

The Dean handed out the secret ballot forms, and the vote was taken. He announced the score: 24 to 14 in favour of investigating the Department. Richard and I and the soon-to-be Political Economy staff were jubilant – as were most of the Faculty – and we poured out of the boardroom in loud celebration.

As we headed towards the stairs down to the main quadrangle, I glanced back at the boardroom to see that Simkin and Hogan were still sitting, immobile, back in the boardroom. Not only had they not left their chairs, they had not moved – nor were they talking to each other. They simply sat there stunned, staring into the space in front of them, in obvious and profound shock. They had clearly not even entertained the prospect that the vote might go against them.

That was the first of many votes that neoclassical economists were to lose from that time on – and not only at Sydney University. Faculty after Faculty across Australia and the globe voted to progressively reduce the compulsory economics content of business degrees. And the neoclassical economists never changed their tactics – or rather, the lack of them. They never considered that they might need to alter their product – that would be too much like market research. Nor that they should perhaps lobby the other disciplines – that would be too much like politics.

Instead, the purity of the science was defended at every challenge – even as the diminishing time devoted to it resulted in a trivialised tuition replacing rigor. The other disciplines whose votes held the fate of economics in their hands continued to be disparaged and regarded as interlopers, who themselves should be expunged from university – even as the economists were the ones who were effectively being expunged.

The situation did not improve when managerialism replaced academic democracy, because the law of large numbers alone guaranteed that the bureaucratic overlords in Business Faculties would be drawn from almost any discipline other than economics. What was once done by the ballot was now done by decree (after, of course, due consultation), and the final result was that economics found itself expelled from what once were Faculties of Economics – and in the worst instances, abolished altogether – with a single first year subject preserved solely because Accounting standards require accountants to take at least one unit of economics.

What a dismal fate for the dismal science – the more so because it was so largely self-inflicted. If economics had been capable of reinvention in response to its unpopularity – as well as in a sane response to the discovery of its many internal logical and empirical contradictions – it could have preserved itself as a vital discipline. It perhaps could have even re-assimilated those competitor departments that its rarefied definition of economics had conjured into being.

But that did not happen. Schumpeter lives today in management departments rather than economics (though these days they cite Porter instead), precisely because neoclassical economists excluded him from the canon. Marketing evolved because economists disparaged the task of trying to find out what rational consumers must already know anyway. Operations Research developed because economists knew that calculus was all one needed: this Deming process control stuff was meaningless, given the immutable law of diminishing returns.

Thursday, July 4, 2013

Thinking again about time

I have a column coming out in Bloomberg in the next few days. The topic is time -- literally -- and how to think about it. For people reading the column, I thought I'd offer some links to things I've written here before exploring the topic in more detail, and also to some original papers that explore the ideas in much greater depth.

Much of the recent research on this topic has been done by Ole Peters of the London Mathematical Laboratory and Santa Fe Institute. The gist of his overall argument is that the usual ensemble averages used to compute "expected" returns in finance and economics are, in many cases, simply wrong. This is not the correct way to make decisions in the real world. We're all used to the idea of averaging over possible outcomes, weighted by the appropriate probabilities, and asking: is the result positive or negative? If positive, then the gamble or investment is worth it, if we can accept the risk. But this is not a legitimate way of thinking, for it averages over parallel worlds, not through time -- where we actually live.

The trouble is that usual average over different outcomes mixes potential worlds in which we go broke with others in we get rich, and does this mixing all at once, immediately, so that good outcomes coming from one path cancel out bad outcomes coming from other paths. Importantly, this mixing takes the often irreversible consequences of bad outcomes (bankruptcy, for example) out of the picture. If you make hugely risky investments, this average gives you full credit for all the wonderful possible outcomes, weighted appropriately for their likelihood, which of course seems sensible. What it doesn't do is account for the very real fact that the bad outcomes may effectively wipe you out entirely and take you out of the game, making it impossible to play again -- in which case you will never get to experience those eventual big payoffs.

I've written three earlier blog posts -- here, here and here -- exploring his idea from different angles. These give links to Peters original papers and also to some other valuable discussions of this fundamental way of thinking. One further paper of interest is this recent work by Peters and William Klein which looks at how the assumption of ergodicity is systematically violated by the process of geometric Brownian motion, which is of course a workhorse model in finance and economics.

I'd like to just quote one paragraph from the latter paper to make the point of how counterintuitive this stuff is. We're all very used to thinking in terms of ensemble averages. Average over all the outcomes, weighted by the appropriate probabilities, and this should give you a good handle on whether the gamble is worth taking or not. But this view is totally mistaken. Indeed, as Peters and Klein point out,
In Geometric Brownian Motion, it is possible for the ensemble average to grow exponentially, while any individual trajectory decays exponentially on su fficiently long time scales [1]. Multiplicative growth is manifestly non-ergodic. But precisely the opposite is often assumed in economics, for instance in [2], p.98: "If a gamble is `favorable' from the point of view of the expectation value [ensemble average] and you have the choice of repeating it many times [time average], then it is wise to do so. For eventually, your amount of money [is] bound to increase."

That first sentence really sums up the problem. You can do the ensemble average and say, "Hey, I expect to get exponential growth! Let's go for it." Then you actually play and find you get wiped out. Try again and still get wiped out. See that everyone who plays the same game also gets wiped out. Strange. You may eventually accept that thinking in terms of parallel worlds isn't quite the right thing to do.

Of course, Peters analyses are also closely linked to the famous Kelly criterion introduced by IBM mathematician John Larry Kelly in 1956. The theory of practical betting based on this criterion has been extensively developed by Ed Thorpe and many others. See this summary paper, for example. There is a huge literature on this, and I don't in any way want to imply that people in finance have not been thinking about this. Many have. However, the failures of the expected value approach through ensembles is not appreciated widely enough.

It goes without saying, of course, that everything becomes more uncertain and complicated in the usual case from real life -- especially in finance -- where one does not know that actual probability distribution from which outcomes are being drawn. Perhaps there is no such distribution. In this cases, Thorpe and colleagues rightly counsel even greater caution:
The theory and practical application of the Kelly criterion is straightforward when the underlying probability distributions are fairly accurately known. However, in investment
applications this is usually not the case. Realized future equity returns may be very different from what one would expect using estimates based on historical returns. Consequentlypractitioners who wish to protect capital above all, sharply reduce risk as their drawdown increases