Kay and King: What's going on here?

"Probabilistic reasoning may appear beautiful and appealing, but sadly its applicability to real-world problems is limited."

In Radical Uncertainty: Decision-Making Beyond the Numbers, John Kay and Mervyn King explain that the future is not calculable and it is a mistake to assume that we can probability-weight uncertain future outcomes as part of a realistic decision making process. This book is helpful as a history of how economics has (or has not) dealt with uncertainty as well as a pretty practical guide for dealing with everyday decisions in the real world. "It is a book about how real people make choices in a radically uncertain world, in which probabilities cannot be meaningfully attached to alternative futures."

In summarizing this book I feel that non-economists might be inclined to say that everything it states is pretty obvious. For example, George Soros' explanation of reflexivity and the need for economic models to reflect real behaviors was viewed as "juvenile" by a leading academic (not an economist). But I think that critique misses the point: even if most humans understand that the world is uncertain and people don't think based on expected utility, many of the economic models used by central bankers and lawmakers simply don't get it. This book is an important step in explaining how the world of economics differs from the world.

The book is divided into 5 parts:

1. Introduction: The Nature of Uncertainty
2. The Lure of Probabilities
3. Making Sense of Uncertainty
4. Economics and Uncertainty
5. Living with Uncertainty

Kay and King explain that expressing uncertainty in probabilistic terms became increasingly common in the 17th century, and in the past two decades probabilistic reasoning has come to dominate the description and analysis of decision-making under uncertainty. In this 'decision science' for rational choice under uncertainty,

"Agents optimise, subject to defined constraints. They list possible courses of action, define the consequences of the various alternatives, and evaluate these consequences. Then they select the best available option, if necessary anticipating how others will react to their choices. People make plans for consumption across their lifetime, from education, through child rearing, through retirement. Corporations select strategies to maximise shareholder value. Governments choose policies to maximise social welfare. A moment's introspection is enough to tell us that they don't. They could not conceivably have the information required to do so ... Real households, real businesses and real governments do not optimise; they cope. They make decisions incrementally. They do not attain the highest point on the landscape, they seek only a higher place than the one they occupy now."

Essentially, we are all adaptive learners. The book contains three main propositions:

1. The world of economics, business and finance is 'non-stationary' -- it is not governed by unchanging scientific laws;
2. Individuals cannot and do not optimise; nor are they irrational, victims of 'biases' which describe the ways they deviate from 'rational' behavior; and
3. Humans are social animals and communication plays an important role in decision-making. We frame our thinking in terms of narratives.

1. Non-stationarity

Economic relationships change over time and movements in the economy reflect our expectations. Reflexivity, a term coined by Robert Merton and popularized by George Soros, essentially states that the system is influenced by our beliefs about it. As Isaac Asimov wrote in Foundation and Earth, "I knew nothing about Seldon's Plan except for the two axioms on which it is based: one, that there be involved a large enough number of human beings to allow humanity to be treated statistically as a group of individuals interacting randomly; and second, that humanity not know the results of psychohistorical conclusions before the results are achieved." Physics is in one sense easier than economics because an atom won't change it's behavior due to an anticipated federal funds rate increase.

2. Non-optimizing, non-biased behavior

Kay and King introduce two types of rationality: axiomatic rationality -- used by economists and defined based on an abstract notion of adherence to rational choice -- and evolutionary rationality -- practiced by people in the real world. They show "that the axiomatic approach to the definition of rationality comprehensively fails when applied to decisions made by businesses, governments, or households about an uncertain future. And this failure is not because these economic actors are irrational, but because they are rational, and -- mostly -- do not pretend to knowledge they do not and could not have. Frequently they do not know what is going to happen and cannot successfully describe the range of things that might happen, far less know the relative likelihood of a variety of different possible events." 

3. Narratives

"Narratives are the means by which humans ... order our thoughts and make sense of the evidence given to us." When we make a decision, whether as a juror, gambler, or insurance customer, we think in terms of narratives rather than probabilities and expected utility.

Additional thoughts

Hard, unimportant puzzles: "Economists have thrived on the difficulty of solving complex models of the economy precisely because they have been trained to tackle well-defined problems which have an answer. And (Nobel) prizes are awarded to those who solve the most difficult puzzles... Replacing complex mysteries with puzzles that have unambiguously right and wrong answers limits the interest and relevance of both problems and answers." This reminds me of Akerlof's recent article and points to a problem with how to move economics beyond its current state. Of course, an issue with economics solving hard but unimportant problems is that the models amenable to hard analysis are of course biased in some way ... "economic data and economic models are never descriptive of 'the world as it really is'. Economic interpretation is always the product of a social context or theory." [20+ neoclassical assumptions that are easier to model than other views -- from J Robinson book] Frank Knight might have put it best: "Insistence on a concretely quantitative economics means the use of statistics of physical magnitudes, whose economic meaning and significance is uncertain and dubious ... In this field, the Kelvin dictum very largely means in practice, if you cannot measure, measure anyhow!"

On a practical note: "In writing this book, we found inspiration in an anecdote from Richard Rumelt's Good Strategy/Bad Strategy, by some distance the best book on business strategy written in the last decade. Rumelt describes a conversation with a colleague at UCLA who had observed some of his case-based MBA classes: We were chatting about pedagogy ... John gave me a side-long look and said 'it looks to me as if there is really only one question you're asking in each case'. That question is 'what's going on here?' John's comment was something I've never heard said explicitly but it was instantly and obviously correct. A great deal of strategy work is trying to figure out what is going on. Not just deciding what to do, but the more fundamental problem of comprehending the situation."

Additional reading: Ramsey and Finetti vs. Keynes and Knight . Ramsey applied the math that had been used for the analysis of probabilities based on frequencies to subjective probabilities. "The winning argument which Ramsey provided to counter Keynes was that anyone who did not attach a consistent set of subjective probabilities to all uncertain events would be certain to lose money if they bet at those probabilities."

Other notes: The book clarified some things I thought I knew -- such as the issue with assuming away uncertainty in economic models. It overturned some things I thought I knew -- such as the usefulness of behavioral economics research ("biases" in the small world of experiments generally have some rational reason in the real world) and the limitations of Robert Shiller's view of narrative as simply a crisis explainer (although I haven't read his book so can't fairly comment). And it included many things I didn't know -- such as how Herb Simon's bounded rationality was "seriously misinterpreted" when it was incorporated into mainstream economics. Simon used the word 'satisficing' to describe how people approach decisions in an uncertain world by using rules of thumb to search for a 'good enough' outcome. However, "Economists have adapted the phrase 'bounded rationality' to mean something very different from Simon's description as the consequence of radical uncertainty. They have instead used it to describe the cost of processing information, which then acts as an additional constraint in an optimisation problem."

Animal spirits and business cycles

In a 1992 American Economic Review article, Peter Howitt and Preston McAfee (H&M) introduce a "stationary rational-expectations equilibrium in which an extraneous random variable, called animal spirits, causes fluctuations in unemployment."

https://ir.lib.uwo.ca/cgi/viewcontent.cgi?article=1485&context=economicsresrpt

They explain that "research in business cycle theory has been guided almost entirely by the view that fluctuations in the overall level of economic activity are the result of exogenous shocks to the fundamental conditions of a dynamically stable economic system. By this view, booms and recessions are attributable to random changes in the availability of profitable investment opportunities, the propensity to save, the stance of macroeconomic policy, population, international terms of trade, the distribution of demand, [sunspots,] etc., either contemporaneous or lagged, or to the arrival of information signalling such changes."

A competing view states that fluctuations would occur even if fundamental conditions remain unchanged. The view has two variants: (1) Fluctuations are endogenous and the economy is a nonlinear system that exhibits periodic equilibria or chaos; (2) Fluctuations occur due to random waves of optimism and pessimism -- this is Keynes' "animal spirits", can also be found in the work of Mill and Hayek.

H&M construct a model of a rational-expectations animal-spirits business cycle. They model animal spirits as an exogenous random variable that follows a two-state Markov process (high, low). When spirits are high, firms expect a high level of employment, and hence a high level of aggregate demand. High demand reduces the expected cost of contacting a potential customer, leading firms to hire more workers, and expectations are fulfilled. When spirits are low expectations are also fulfilled.

The paper has two aims. First, show that business cycles do not depend on the assumption that fluctuations in aggregate employment are driven by fluctuations in the expected rate of inflation, which induce workers to vary the amount of labor offered for sale. This is not how people think. Second, show how people could acquire the beliefs underlying an animal spirits cycle, even if they don't have rational expectations but rather form expectations through a plausible adaptive learning scheme. H&M show that Bayesian updating induces convergence to the equilibrium even if people start with no definite belief that animal spirits affect the profitability of hiring.

Their model has (strong) assumptions such as costly matching in the labor market (a lifetime contract) and a "thin-market externality that makes production more profitable when others are producing a lot". My initial thought on the paper is that it is a useful improvement on the sunspot models that rely on things such as the effect of expected inflation on labor supply. Since animal spirits are not tied to something more concrete than a Markov process, their model in this form doesn't seem that different from a sunspot model. But I think it's useful for thinking about the mechanics of how expectations can drive business investment and how to model it.

Three trends

Three trends that might have implications for how we should think about economics research in the US are the relative importance today vs. a century ago of (1) abundance vs. scarcity, (2) maintenance vs. development, and (3) production vs. finance. It may or may not be useful to think of them together, but writing down a quick note on each for future reference.

Abundance vs. scarcity

Lionel Robbins defined economics as "the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses." When he wrote this in 1935, per capita income was about an eighth of what it is today.

https://fred.stlouisfed.org/graph/?g=rZml

Robbins' statement is still true, but maybe in the opposite sense. The scarcity constraint today is less about, say, how much coal did we extract this year and how many houses will it heat, but rather how much coal can we extract without overheating the planet. Where the earlier question was "how do we incentivize sufficient extraction to heat everyone's home?" today it is "given that we have the technology and capacity to heat everyone's home in multiple ways, how will we do it in a way that leaves the planet livable in 2100?"

Calling pollution an externality made sense in 1935, but the word seems to marginalize the phenomenon in a way that doesn't make as much sense today. When scarcity was a constraint for basic material needs, economists could figure that the resulting smog has a social cost that the producer doesn't include in his calculations. That cost had useful implications for weighing the costs and benefits of various policies. Today, with an unprecedentedly productive economy facing a Pascal-ish wager on a global scale, cost-benefit analysis seems almost beside the point.

Maintenance vs. development

Consumption of fixed capital to GDP has been increasing steadily, as has (maybe more significantly for the point I'm making here) consumption of fixed capital to average annual increase in GDP.

https://fred.stlouisfed.org/graph/?g=rZlY

Decaying infrastructure -- whether in the form of leaking aqueducts or 240,000 water main breaks per year -- is usually taken as a sign of decline. Deferred costs of maintenance of infrastructure amount to over $1 trillion by the end of 2019 - $873 billion at the state level and $183 billion at the federal level. Building is easier than maintaining.

Production vs. finance

The financialization of our economy was a significant part of the narrative of how and why the financial crisis happened. The financial sector has continued to grow.

https://fred.stlouisfed.org/graph/?g=rZmB

Looking forward, when viewed together with current circumstances such as the expansion of the Fed's balance sheet, stock markets hitting records despite an unprecedentedly bad economic quarter due to an ongoing global pandemic, and increasing credit creation by nonbanks, it is a component that probably needs to be better understood and incorporated in public finance economics. What are the implications of the increased size of the financial sector not just on the sector itself (e.g., asset prices increase as more lending goes toward financial rather than productive assets) but on the broader economy?

To summarize

The increase in national wealth since 1935 enables us to set a higher floor on the standard of living without unduly minimizing the size of the private sector. To the extent that economics does not move on from researching the means of expanding the provision of basic needs to more but not all people to researching the means of most effectively structuring an economy that takes the provision of basic needs to all people as a given, it might be slowing progress.

The challenge for economics is more about sustainability and resilience rather efficiency. Today our issue isn't producing and distributing enough food and energy, it's producing it sustainably and getting it to homes in a way that accounts for the low probability exogenous (e.g., Carrington event) and endogenous (e.g., financial crisis) shocks that we tend to focus on only once they happen.

In The Wealth of Nations Adam Smith links slower population growth with a lower share of national income going to labor. "It is not the actual greatness of national wealth, but its continual increase, which occasions a rise in the wages of labour. It is not, accordingly, in the richest countries, but in the most thriving, or in those which are growing rich the fastest, that the wages of labour are highest ... The most decisive mark of the prosperity of any country is the increase of the number of its inhabitants." (p. 172-3) Labor's share of income has decreased steadily for 40 years, and for more reasons than just the ones Smith mentioned. Assuming that productivity and population growth will not start to grow at the pace they did from 1800-1970, we need to figure out how to thrive without growing. Part of this probably entails tying policy suggestions to different, more relevant metrics of economic success.

Book review: The Price of Peace

In The Price of Peace, Zach Carter writes about John Maynard Keynes' life, work, and the impact of that work through today. Keynes was "not only an economist but the preeminent anti-authoritarian thinker of the twentieth century ... a moral philosopher, political theorist, and statesman".

Keynes is best known for The General Theory of Employment, Interest and Money. This book created macroeconomics (p. 257). It "proved that the condition and organization of society were not the inevitable, dispassionate requirements of tragically insufficient resources. They were, instead, political choices that societies could not avoid." (273) The General Theory was written partly in response to societies' inability to escape the worldwide economic depression of the 1930s due to a reliance on old ideas that assumed that economies would fix themselves. This wasn't dry ivory tower economics: one reason the book is so important is that, as experience has shown, high levels of unemployment can lead pretty quickly to radicalization, militarism, and war.

Economists who repeat old doctrines simply because familiar ideas are comfortable can be dangerous, and Keynes devoted a lot of effort attempting to convert "the priesthood of academic economists to his new doctrine." (245) Keynes admired the classical economists, including Ricardo, James and John Stuart Mill, Alfred Marshall, and AC Pigou, and believed that their picture of the economy "had once been an accurate understanding of how social needs could best be met." But things change: the productive capitalist economy of the 20th century was different from the 18th and 19th century world the classical economists were describing. The General Theory was the culmination of Keynes' attempts to help the economics profession remain relevant.

The United States was the country that implemented Keynesian ideas on the biggest scale. To escape the Great Depression, FDR established more than two dozen federal agencies including the Public Works Administration, which built dams, bridges, and power plants; the Works Progress Administration, which built schools, theaters, and hospitals, and the SEC, which policed Wall Street. These policies worked: unemployment dropped from over 20 to below 10 percent, and between 1934 and 1936, the US economy grew by more than 10 percent per year. To administer the new policies, the government needed economists: public intellectuals such as John Kenneth Galbraith got their start in New Deal DC.

Galbraith explained that in 1933, things were so bad that the financial community was grateful to Roosevelt for putting things on surer footing. But there was always resistance to the implementation of Keynes' ideas, despite (and because of) their success."By 1934, things were enough better so that his efforts on behalf of farmers and the unemployed ... could be disliked and even feared. Roosevelt had become 'that man in the White House' and 'the traitor to his class.'" (287-8) This resistance extended to economics education as well. When Lorie Tarshis published The Elements of Economics in 1947, a textbook introducing students to Keynesian economics, conservatives pushed back, effectively banning book sales. Their campaign helped Paul Samuelson's Economics to become a bestseller. The difference between the books was significant. Tarshis presented markets for money and debt as "creatures of the state, an expression of democratic politics that citizens could manage and adjust." Samuelson, on the other hand, highlighted the "power of the market to order social preferences, with the help of just a little fiscal adjustment." (p. 379) The acceptance of Samuelson's ideas had widespread implications for the development of "Keynesian" economics in the US, including for the policy response to the 1970s inflation, which was seen as discrediting Keynesian ideas.

What struck me most about this book was just how damaging American Keynesians were to the project that Keynes and his Cambridge group initiated. Establishment Republicans and Democrats uniformly embraced the neoliberal project by the late 20th century. The Republicans were explicit about "starving the beast", and the Democrats to a large extent followed along. Milton Friedman said that Ronald Reagan was unsuccessful in cutting down the size of the government-- "It would take a Democrat to finish the job." (483) As the coronavirus pandemic and financial crisis made clear, we have built a system that is largely unprepared for external shocks and occasionally creates existential crises itself. In 2008, after two decades as the world's most powerful economic policymaker, Alan Greenspan admitted to being mistaken in the view that a free market could always regulate itself. He said "I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works." Keynes' work is a reminder of the danger of clinging to orthodox models that fail to provide a useful guide to circumstances. We need to adapt our economics to the world as it is, constantly changing.

The American System

In 2018 the Trump Administration criticized China for "unfair trade practices" including high tariffs, industrial subsidies, targeted investments, and intellectual property theft.

It brings to mind the American System, which included high tariffs, industrial subsidies, targeted investments, and intellectual property theft.

The American System, rooted in the ideas of the American School of economics, had its origins in Alexander Hamilton's Report on the Subject of Manufactures (1791). In this report, Hamilton argued that the US would not be fully independent until it was self-sufficient in the necessary economic products. Henry Clay named it the "American System" to distinguish it from the "British System" -- the competing theory of economics at the time, represented by Adam Smith's Wealth of Nations. 

Hamilton's Report intended to promote the growth of manufacturing and expand the applications of technology and science to agriculture. It had the following to say about unfair trade practices:

• Tariffs: "duties on those foreign articles which are the rivals of the domestic ones, intended to be encouraged."
• Subsidies: "bounties [are] one of the most efficacious means of encouraging manufactures, and ... in some views, the best."
• Investments in infrastructure: "To diversify and extend these [internal] improvements is the surest and safest method of indemnifying ourselves for any inconveniences."
• Intellectual property theft: "it is desireable in regard to improvements and secrets of extraordinary value, to be able to extend the same benefit to Introducers, as well as Authors and Inventors."

In other words, to develop a prosperous economy, erect tariff barriers, subsidize critical industries, invest in infrastructure, and get to the technological frontier, by theft if necessary.

1791 - 1970s

The American System worked very well for America from 1791 through the 1970s. Of course, not everyone was in agreement from the outset. Certain people were opposed to industrial policy on grounds of personal interests (e.g., large plantation owners) or ideology (e.g., classical economists). Hamilton explained that "There still are, nevertheless, respectable patrons of opinions, unfriendly to the encouragement of manufactures." People might be skeptical to industrial policy due to a belief in that agriculture is more productive than manufacturing, or because the private sector should handle virtually everything, or because consumers will pay more for products produced by the protected industries. In response Hamilton writes "This mode of reasoning is founded upon facts and principles, which have certainly respectable pretensions ... Most general theories, however, admit of numerous exceptions, and there are few, if any, of the political kind, which do not blend a considerable portion of error, with the truths they inculcate."

1970s - 2010s

The departure from the American System coincided with 1970s stagflation and the rapid expansion of neoliberal policies and thought, summarized nicely by Margaret Thatcher: "There is no such thing as society." But that is a topic for another post.

Today

Hamilton's report and the increased acceptance of industrial policy in the news these days brings to mind a passage from Erik Reinert in How Rich Countries Got Rich and Why Poor Countries Stay Poor:

"Since its founding fathers, the United States has always been torn between two traditions, the activist policies of Alexander Hamilton (1755-1804) and Thomas Jefferson's (1743-1826) maxim that the "government that governs least, governs best". With time and usual American pragmatism, this rivalry has been resolved by putting the Jeffersonians in charge of the rhetoric and the Hamiltonians in charge of policy."

Recent developments, such as lawmakers' push to invest billions in the semiconductor industry, are small hopeful signs that we are still open to a pragmatic approach. 

Smith and Keynes on the history of money

In The Wealth of Nations Adam Smith writes that after division of labor is established, people begin to save a bit of some commodity to trade for things they need. This could have been cattle, salt, shells, cod, tobacco, hides, nails, and so on, but "In all countries, however, men seem at last to have been determined by irresistible reasons to give the preference, for this employment, to metals above every other commodity." (Smith, p. 127) Metal was preferred because it's not perishable, can be divided into parts, and can be fused together. Eventually, people started making coins to prevent having to weigh the metal for every transaction, the public office of the mint was created to stamp money, William the Conqueror introduced the custom of paying taxes in money, avaricious and unjust princes would consistently reduce the metal in the coins, and so on. "It is in this manner that money has become in all civilized nations the universal instrument of commerce, by the intervention of which goods of all kinds are bought and sold, or exchanged for one another." (p. 131) It all sounds fine, I believed that story for about a decade. But it is so obviously wrong.

Money started when humans organized into states and those states started requiring money for taxes -- whether that money was in the form of corn, cows, or coin.

An excerpt from Carter's The Price of Peace, showing what Keynes discovered about the history of money (p. 187-8):

"Keynes had discovered an ancient history that upended some basic tenets of economics going back to Adam Smith and undermined nearly tree centuries of Enlightenment political theory. Ever since Thomas Hobbes had published Leviathan in 1651, most European philosophers had imagined government as an artificial imposition on what Hobbes called "the state of nature." For Hobbes, the state of nature was a nightmare of violent disorder where life was "nasty, brutish and short," making government--especially monarchy--a source of human salvation. Even thinkers who rejected Hobbes' politics accepted his history. In The Wealth of Nations, Smith had presented markets for trade as a primordial force that came into being long before the development of the political state. Commercial life had started with people bartering goods, trading goats for wheat or cloth for buttons. They eventually adopted money as a medium of exchange, since passing tokens to each other proved to be more convenient than toting wagonloads of cumbersome goods. All of this activity had taken place among free individuals undisturbed by the machinations of capricious, meddling sovereigns, who entered the scene much later. The market was natural, while the state was a relatively recent artifice that intervened in or distorted the independent rhythms of trade. 

"Studying Athens, Babylon, Assyria, Persia, and Rome, Keynes concluded that this history was all wrong. Capitalism itself was an ancient creation of government, dating back at least as far as the Babylonian Empire of the third millennium B.C. "Individualistic capitalism and the economic practices pertaining to that system were undoubtedly invented in Babylonia and carried to a high degree of development in epochs more distant than the archaeologists have yet explored," he wrote--one of several startling observations recorded in seventy pages of unpublished notes and fragmentary argument from his 1920s research. Money, moreover, was not a custom developed by local traders for convenience but a sophisticated tool or rulership that had emerged simultaneously with other developments of the state, including written language and standardized weights and measures. 

"Smith and other thinkers had been led astray by confusing the development of coinage with the invention of money. Coinage, according to Keynes, was "just a piece of bold vanity ... with no far-reaching importance"; money had existed in "representative" form much longer. Its real significance was as a "unit of account"--the demarcation of debt and "the legal discharge of obligations," which governments had been maintaining in ledger books, scrolls, or clay tablets for millennia. Powerful, economically sophisticated empires had developed without using coinage at all.

"States, moreover, had always maintained a policy of active monetary management as a basic condition of rulership. They created and abolished debts as reward or punishment and reformed units of measurement, depreciating or debasing their currency not merely as a trick on unsophisticated subjects but to stimulate trade and ease social tension. Inflation--viewed by orthodox economists of the 1920s as an underhanded sovereign's subversion of the natural order--had instead been a near-constant condition "throughout almost lal periods of recorded history."

"... Money, he argued, was an inherently political tool. It was the state that determined what substance--gold, paper, whatever--actually counted as money--what "thing" people and the government would accept as valid paymnt. The state thus created money and had always regulated its value. "This right is claimed by all modern states and has been so claimed for some four thousand years at least." ... The true source of monetary stability was the public legitimacy of the political authority."

Tarshis: Escape the old ideas

In The Elements of Economics (1947) Lorie Tarshis quotes Keynes when describing how adopting new ideas can be difficult when we believe things are different: "The difficulty lies, not in the new ideas, but in escaping from the old ones." Tarshis then makes the following point about the adoption and application of Keynesian theory.

"It is not easy to change our ideas about anything -- and especially about something like unemployment -- when we are so certain of the correctness of our original views. And in the social sciences it is extremely difficult, first, to be fully aware of our preconceptions, and second, to examine them objectively. If we could bring to the task the same scientific attitude that guides the student of chemistry or biology, there would be no difficulty. But, as we have already seen, it is much harder to give up the belief that "money needs a gold backing" than it is, let us say, to accept a new model of the structure of the atom ... 

"A word must be said, before we begin our analysis, about the political implications of the Keynesian theory. This is necessary because there is so much misinformation on the subject. The truth is simple. The Keynesian theory no more supports the New Deal stand or the Republican stand than do the newest data on atomic fission. This does not mean that the Keynesian theory cannot be used by supporters of either political party; for it can be, and if it is properly used, it should be. The theory of employment we are going to study is simply an attempt to account for variations in the level of employment in a capitalist economy. It is possible, as we shall see later, to frame either the Republican or the Democratic economic dogma in terms of the theory."

I think the general statement might be applicable to mainstream American economics' resistance to modern monetary theory today (p. 346-7). As a quote attributed to Mark Twain puts it, "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."

What makes money make money?

A sentence from Henry Miller's Tropic of Capricorn in the comments of Stephanie Kelton's New York Times op-ed Learn to Love Trillion-Dollar Deficits:

"To walk in money through the night crowd, protected by money, lulled by money, dulled by money, the crowd itself a money, the breath money, no least single object anywhere that is not money, money, money everywhere and still not enough, and then no money or a little money or less money or more money, but money, always money, and if you have money or you don't have money it is the money that counts and money makes money, but what makes money make money?"

Colander and Klamer 1987: The Making of an Economist

David Colander and Arjo Klamer sent a questionnaire to graduate students at top-ranking economic programs. Table 3, below, is stunning. It lends support to Robert Kuttner's (1985) statement, summarizing Leontief and Galbraith's views, that "Departments of economics are graduating a generation of idiots savants, brilliant at esoteric mathematics yet innocent of actual economic life."

A helpful description of the fed funds rate

Odd Lots interviewed Josh Younger of JPMorgan about the transition from LIBOR to SOFR.

Joe asked why the new benchmark couldn't just be a direct policy rate. Josh pointed out that the Federal Reserve's target policy rate -- the effective fed funds rate -- represents at most $75-$100bn of transactions per day. Although this is more than LIBOR, SOFR represents more than $1 trillion of underlying transactions.

Josh's description of the fed funds market was the clearest summary I've heard of it. Quoted below (slightly edited):

"The federal funds rate is actually not a direct policy rate ... it is the cost of borrowing reserves at the Fed / cash on an overnight basis from another bank. In the pre [financial] crisis days, the Fed would be the end borrower or lender to maintain a rate that was pretty consistent with their target ... in the wake of the crisis in 2008, they bought a ton of treasuries, mortgages, and agency debentures, so the balance sheet got a lot bigger which meant there was a ton of cash in the market, which meant that no one really needed to borrow cash because you would typically borrow cash to make sure that you were at your minimum reserve levels for regulatory purposes ... reserves don't earn interest in that pre crisis environment, so I want to hold as little as possible and stay as close to my minimums as possible.

"Now the Fed has done two things: they've increased the supply enormously and they pay interest. So if you're a bank and you have cash at the Fed you get a positive interest rate on that cash, so you actually are perfectly fine with holding reserves for the most part -- you don't want to minimize your exposure, a corollary to that is who would actually lend reserves when they're earning interest on them at a rate that might be below the interest they'd earn by holding them overnight.

"It turns out that the way the regulations / law was changed to allow the fed to pay interest on reserves did not include non depository institutions ... the Federal Home Loan Bank system is technically not a depository institution but they are part of the federal reserve system, so they lend out their cash at a rate below the interest on excess reserves. And the borrowers of that cash are borrowing at the IOER rate and earning the spread between the two.

"Most importantly, the effective federal funds rate is a pretty idiosyncratic thing because it really reflects where the Home Loan Bank system is going to lend out cash relative to other short term investments to foreign banks. Which doesn't strike me as the index you really want to link the rest of the economy to."

Akerlof 2020: Sins of Omission and the Practice of Economics

In a recent paper in the Journal of Economic Literature, George Akerlof describes how the reward structure of economics favors "hard" research over "soft" research. He argues that this leads to "sins of omission" as researchers ignore important topics that are difficult to approach in a "hard" way.

Akerlof pushes "for reexamination of current institutions for publication and promotion in economics" [and] greatly increased tolerance in norms for publication and promotion as one way of alleviating narrow methodological biases."

Overall I enjoyed the paper. I think it's important, especially in providing an understanding of how we got here. A couple notes are below. One important omission from the paper IMO is an examination of the role of network effects in maintaining the status quo. Without this, I find it even less likely that we'll overcome the coordination difficulties of moving to a more useful research agenda for the discipline. Also, the current mainstream benefits certain groups (such as people on the political right) who will resist a push for better questions and better methodologies, regardless of whether they provide a better understanding of our economy.

Three reasons for the bias toward hard research:

1. Place in the scientific hierarchy -- economists have physics envy
2. The evaluation process -- quantitative / hard papers are easier to judge than important ones
3. Selection into the profession -- mathematicians appreciate mathematicians

Three consequences of hardness bias:

1. Bias against new ideas -- old paradigms have tools that aid precision; also, this bias makes it harder to challenge existing paradigms
2. Overspecialization
3. The curse of the top five -- tenure committees give a lot of weight to the fop five journals

Examples of sins of omission:

1. Failure to predict the financial crisis
2. Motivations -- people act based on the stories they tell themselves rather than as rational deductive optimizers with perfect foresight
3. Four examples illustrating the unappreciated role of stories in economics:
1. The Soviet Union
2. Smoking and health
3. Global warming
4. Macroeconomics - Shiller's explanation for how the Great Depression unfolded

Additional notes

Akerlof mentions Kuhn's Scientific Revolutions (2012) which describes scientific progress as occurring when "normal science" uncovers "anomalies" within existing paradigms. Scientific revolutions that explain those contradictions lead the way to a better paradigm. But Akerlof argues that an issue with economics is that the paradigm is not just the subject matter but also the field's methodology. In other words, is a good economist someone who understands the economy or someone who understands linear algebra? The more powerful economists that think it's the latter (and I have a hunch it's a significant majority) the less chance economics has of progressing as Kuhn has described.

Lastly, Akerlof mentions that 'Colander and Klamer (1987, table 4 3, p. 100) thus found that only 3 percent of economists thought it "very important" for their success to "have a thorough knowledge of the economy"'. Three percent.

The Second Crisis of Economic Theory

An excerpt from Joan Robinson's 1971 Richard T. Ely keynote address to the American Economic Association. Somehow it seems as relevant today.

"There is no such thing as a normal period of history. Normality is a fiction of economic textbooks. An economist sets up a model which is specified in such a way as to have a normal state. He takes a lot of trouble to prove the existence of normality in his model. The fact that evidently the world does exist is claimed as a strong point for the model. But the world does not exist in a state of normality. If the world of the nineteenth century had been normal, 1914 would not have happened.

"At the time, however, in the postwar scene, normality lay in the past. As far as the economists were concerned, they did not really know very much about that world. They knew what was in their books.

"In their books, a private enterprise economy tends to equilibrium and not only to equilibrium--to an optimum position. Trouble was often caused by politicians who were shortsighted and under the sway of particular interests. If only they would establish free trade, restore the gold standard, keep budgets balanced, and leave the free play of the market forces to establish equilibrium, all would be for the best in the best of all possible worlds. Of course, there were footnotes making cautious reservations. Indeed, in the higher reaches of the profession there was something of the atmosphere of the augurs touching their noses behind the altar. Amongst themselves, they admitted it was not really like that. But their pupils took it all literally. They formed an official opinion deeply influenced by the conception of equilibrium which could be relied upon to establish itself provided that no one tried to interfere.

"The doctrine that there is a natural tendency to maintain equilibrium with full employment could not survive the experience of the complete collapse of the market economy in the thirties.

"Out of this crisis emerged what has become known as the Keynesian revolution. After the war, Keynes became orthodox in his turn. Unfortunately, the Keynesian orthodoxy, as it became established, left out the point. This is not the second crisis. This is still part of the first crisis.

"Consider what was the point of the Keynesian revolution on the plane of theory and on the plane of policy. On the plane of theory, the main point of the General Theory was to break out of the cocoon of equilibrium and consider the nature of life lived in time--the difference between yesterday and tomorrow. Here and now, the past is irrevocable and the future is unknown.

"This was too great a shock. Orthodoxy managed to wind it up in a cocoon again. Keynes had broken down the compartments of "real" and "monetary" theory. He showed that money is a necessary feature of an economy in which the future is uncertain and he showed what part monetary and financial institutions play in the functioning of the "real" economy. Now the compartments have been restored in the division between micro and macro theory."

Gopinath on dollar dominance in international trade

In Chapter 2 of the Hoover Institution's Currencies, Capital, and Central Bank Balances, edited by John Cochrane, Kyle Palermo, and John Taylor, IMF Chief Economist Gita Gopinath "shows how private international financial intermediaries tend to focus on certain currencies, with the US dollar currently the dominant currency of choice. The dollar is often used for invoicing even when trade is between two non-US entities." A couple things that stuck out to me from her chapter, Dollar Dominance in Trade and Finance, are below.

Dollar dominance in trade, finance, and central bank reserves

1. Trade

The Mundell-Fleming economic paradigm states that the importance of a country's currency in international trade is tied closely to its share in world trade. This does not actually happen because the assumption that countries export goods in their own currencies is faulty. The dollar's share as an invoicing currency is 4.7 times its share in world imports and 3.1 times its share in world exports.

Even Japan and the UK invoice only 40 and 51 percent of exports in their own currencies. US invoices 93 percent of imports and 97 percent of exports in dollars.

2. Asset markets

Dollar liabilities of non-US banks are ~$10 trillion, roughly the same magnitude as dollar liabilities of US banks.

The vast majority of syndicated cross-border loans are made in dollars -- from a low of 61% in developed countries to 97% in Emerging Americas. Euro is second with 24% and 20% in Developed Countries and Emerging Europe.

Data source: BIS locational banking statistics

3. Central bank reserves

$10 trillion in official central bank reserves (2017Q4) -- dollar share is 63 percent, followed by euro at 20 percent.

[Update for 2019Q4: $6.7 trillion of dollar reserves out of $11.8 trillion total ($11.1 trillion allocated)]

Central banks keep dollars not just for trade but also so they can be the lender of last resort to their banking system.

Data source: IMF COFER (Currency composition of Official Foreign Exchange Reserves)

What makes a currency dominant?

In short, history and network effects.

1. History: How does a currency become dominant?

First, the historical evidence described by Eichengreen (2010). How to make a dominant currency

1. Encourage its use in invoicing and settling trade;
2. Encourage its use in private financial transactions;
3. Encourage its use by central banks and governments as a form in which to hold private reserves.

This process will lead to a high demand for the currency, which will decrease the interest rates (raise the price) on safe assets in that currency.

Once you get to preferred currency status, a feedback mechanism can keep it in place: "Why do exporters invoice in dollars? Because it is cheaper to finance in dollars. Why is it cheaper to finance in dollars? Because exporters invoice in dollars."

2. Network effects: How does a currency remain dominant?

Comments made in the discussion were insightful on this point:

Adrien Auclert: "In principle, going forward, we might see the equilibrium switch again, with the euro or the renminbi becoming the new dominant currency. But what this static model misses is that existing assets and liabilities have long maturities. So in a sense, the anchor of history is likely extremely strong--it would take a really long time for all assets and liabilities to be redenominated in any new currency, and the staggered nature of contracts makes such a coordination very large to imagine."

Robert Heller: "in Silicon Valley, we talk all day long about network effects. Isn't the dollar's dominance similar to network effects? The dollar almost took over the world, and it's very difficult for a second competitor to come up and to compete with the currency once it's dominant, just simply because of network effects."

There is interaction and reinforcement between low interest rates, dollar trade invoicing, dollar liabilities in global supply chains. So we have coordination difficulties, network effects, and lock-in by historical events. Dollar dominance seems established for the foreseeable future, but beware information cascades.

Vaclav Havel: Disturbing the Peace

Vaclav Havel -- playwright, activist, last president of Czechoslovakia, first president of the Czech Republic -- published an interview book in 1986 (published in English in 1990) called Disturbing the Peace. Here is part of his answer to So you do have a more concrete notion of a better social system after all?

"I've already admitted to having one. The traditional political debate between the right and the left revolves around the ownership of the means of production, to put it in Marxist terms: that is, around the question of whether business enterprises should be privately run or made public property. Frankly, I don't see that that is the main problem. I would put it this way: The most important thing is that man should be the measure of all structures, including economic structures, and not that man be made to measure for those structures. The most important thing is not to lose sight of personal relationships--i.e., the relationships between man and his co-workers, between subordinates and their superiors, between man and his work, between this work and its consequences, and so on.

"An economy that is totally nationalized and centralized (i.e., run by the command system), such as we're familiar with in our country [Czechoslovakia], has a catastrophic effect on all such relationships. An ever-deepening chasm opens up between man and the economic system, which is why this type of economy works so badly. Having lost his personal relationship to his work, his company, to the many decisions about the substance and the purpose of his work and its consequences, he loses interest in the work itself. The company allegedly belongs to everyone, but in reality it belongs to no one ...

"... At the same time, I don't believe that we can wave a magic wand and dispose of these problems by a change of ownership, or that all we need do to remedy the situation is bring back capitalism. The point is that capitalism, albeit on another level and not in such trivial forms, is struggling with the same problems (alienation, after all, was first described under capitalism): it is well known, for instance, that enormous private multinational corporations are curiously like socialist states; with industrialization, centralization, specialization, monopolization, and finally with automation and computerization, the elements of depersonalization and the loss of meaning in work become more and more profound everywhere. Along with that goes the general manipulation of people's lives by the system (no matter how inconspicuous such manipulation may be, compared with that of the totalitarian state). IBM certainly works better than the Skoda plant, but that doesn't alter the fact that both companies have long since lost their human dimension and have turned man into a little cog in their machinery, utterly separated from what, and for whom, that machinery is working, and what the impact of its product is on the world. I would even say that, from a certain point of view, IBM is worse than Skoda. Whereas Skoda merely grinds out the occasional obsolete nuclear reactor to meet the needs of backward COMECON members, IBM is flooding the world with ever more advanced computers, while its employees have no influence over what their product does to the human soul and to human society ... the fact that IBM is capitalist, profit-oriented, and efficient while Skoda is socialist, money-losing, and inefficient, seems secondary to me.

"Perhaps it is clearer now what kind of "systemic notions" I favor. The most important thing today is for economic units to maintain--or, rather, renew--their relationship with individuals, so that the work those people perform has human substance and meaning, so that people can see into how the enterprise they work for works, have a say in that, and assume responsibility for it. Such enterprises must have--I repeat--a human dimension: people must be able to work in them as people, as beings with a soul and a sense of responsibility, not as robots, regardless of how primitive or highly intelligent they may be. It isn't easy to find an economic expression of this indicator, but I think it's more important than all the other economic indicators we've managed to isolate so far."

Kalecki 1943: Political Aspects of Full Employment

In Joan Robinson's 1971 Richard T. Ely lecture to the American Economic Association, she said that "Keynes himself was not very much interested in the theory of value and distribution. Michal Kalecki produced a more coherent version of the General Theory, which brought imperfect competition into the analysis and emphasized the influence of investment on the share of profits. Kalecki's version was in some ways more truly a general theory than Keynes'."

Here are some notes from Kalecki's 1943 paper "Political Aspects of Full Employment" -- a statement of the economic doctrine of full employment. In this paper Kalecki covers employment policy, interest rates, and inflation. He also provides reasons for why "industrial leaders" might be opposed to full employment.

Before my notes (primarily quotes from Kalecki's paper) I should also add that David Andolfatto summarized this paper in a Feb 2020 blog post http://andolfatto.blogspot.com/2020/02/kalecki-on-political-aspects-of-full.html. I like his summary: "The paper starts by taking as given what Kalecki calls the doctrine of full employment. The basic idea is that the private sector, left to its own devices, is prone to Keynesian aggregate demand failures (see here for game-theoretic interpretation). The remedy for these spontaneously-occurring "coordination failures" is a government spending program that acts, or stands ready to act, as private demand begins to falter."

Employment policy

"A solid majority of economists is now of the opinion that, even in a capitalist system, full employment may be secured by a Government spending programme, provided there is in existence adequate plant to employ all existing labour power, and provided adequate supplies of necessary foreign raw materials may be obtained in exchange for exports.

"If the Government undertakes public investment (e.g. builds schools, hospitals, and highways) or subsidises mass consumption (by family allowances, reduction of indirect taxation, or subsidies to keep down the prices of necessities), if, moreover, this expenditure is financed by borrowing and not by taxation (which could affect adversely private investment and consumption), the effective demand for goods and services may be increased up to a point where full employment is achieved."

Interest rates

Where will people get the money to lend to the government without decreasing investment and consumption?

"imagine for a moment that the Government pays its suppliers in Government securities. The suppliers will, in general, not retain these securities but put them into circulation while buying other goods and services, and so on until finally these securities will reach persons or firms which retain them as interest-yielding assets ... In reality the Government pays for the services not in securities but in cash, but it simultaneously issues securities and so drains the cash off; and this is equivalent to the imaginary process described above.

What happens if people don't want to buy all the Government securities?

"It will offer them finally to banks to get cash (notes or deposits) in exchange. If the banks accept these offers, the rate of interest will be maintained. If not, the prices of securities will fall, which means a rise in the rate of interest, and this will encourage the public to hold more securities in relation to deposits. It follows that the rate of interest depends on banking policy, in particular on that of the Central Bank. If this policy aims at maintaining the rate of interest at a certain level that may be easily achieved, however large the amount of Government borrowing. Such was and is the position in the present war. In spite of astronomical budget deficits, the rate of interest has shown no rise since the beginning of 1940."

Inflation

In response to questions about whether Government expenditure financed by borrowing will cause inflation, Kalecki explains the role of resource constraints similar to the way that MMT economists explain them:

"the effective demand created by the Government acts like any other increase in demand. If labour, plant and foreign raw materials are in ample supply, the increase in demand is met by an increase in production. But if the point of full employment of resources is reached and effective demand continues to increase, prices will rise so as to equilibrate the demand for and the supply of goods and services ... if the Government intervention aims at achieving full employment but stops short of increasing effective demand over the full employment mark, there is no need to be afraid of inflation."

Opposition

Kalecki provides three categories of reasons for the opposition of the "industrial leaders" to full employment achieved by Government spending:

1. Dislike of Government interference in the problem of employment as such;
2. Dislike of the direction of Government spending (public investment and subsidising consumption); and
3. Dislike of the social and political changes resulting from the maintenance of full employment.

For 1, Kalecki writes "Every widening of State activity is looked upon by "business" with suspicion, but the creation of employment by Government spending has a special aspect which makes the opposition particularly intense. Under a laisser-faire system the level of employment depends to a great extent on the so-called state of confidence. If this deteriorates, private investment declines, which results in a fall of output and employment (both directly and through the secondary effect of the fall in incomes upon consumption and investment). This gives to the capitalists a powerful indirect control over Government policy: everything which may shake the state of confidence must be carefully avoided because it would cause an economic crisis. But once the Government learns the trick of increasing employment by its own purchases, this powerful controlling device loses its effectiveness. Hence budget deficits necessary to carry out Government intervention must be regarded as perilous. The social function of the doctrine of "sound finance" is to make the level of employment dependent on the "state of confidence."

2 - "The fundamentals of capitalist ethics require that "You shall earn your bread in sweat"--unless you happen to have private means."

3 - "Indeed, under a regime of permanent full employment, "the sack" would cease to play its role as a disciplinary measure. The social position of the boss would be undermined and the self assurance and class consciousness of the working class would grow." Ultimately, Kalecki argues that business leaders care more about "discipline in the factories" and "political stability" than profits.

Overall Andolfatto is pretty skeptical of these points. I'm not sure where I land on this, but I'd add that today most students (future industrial leaders) are trained by economists who were trained by economists who took a lot of this as given. We have the issues of network effects, lock-in, and coordination failure locking in a generation of academics who might not be as aware of what they are doing as previous ones. But that's a broad claim and I'm not sure.

Other notes

"The fascist system starts from the overcoming of unemployment, develops into an "armament economy" of scarcity, and ends inevitably in war."

Reducing interest rates or taxes to stimulate private investment in a downturn does not guarantee full employment, even in a resulting boom.

"The rate of interest or income tax is reduced in a slump but not increased in the subsequent boom ... In the new slump it will be necessary to reduce the rate of interest or income tax again and so on. Thus in not too remote a time the rate of interest would have to be negative and income tax would have to be replaced by an income subsidy."

Why do people worry about China selling Treasuries?

Occasionally people worry about China "weaponizing" its US Treasuries by selling them.

https://www.ft.com/content/28277e4a-7c08-11e9-81d2-f785092ab560

Michael Pettis explains why it is not a concern and mentions that "the Federal Reserve could easily act to overcome any temporary volatility."

https://carnegieendowment.org/chinafinancialmarkets/79218

Based on recent Fed actions and a simple comparison of two numbers I think that it might be able to pretty easily overcome China selling its entire stash of Treasuries.

1. China's holdings as of March 2020 are below $1.1 trillion:

https://ticdata.treasury.gov/Publish/mfh.txt.

2. The Federal Reserve expanded its holdings of US Treasury securities by over $2 trillion in less than eight months (Release H.4.1). It held $2.12 trillion as of October 16, 2019 and $4.13 trillion as of June 3, 2020:

https://fred.stlouisfed.org/graph/?g=rbgV. 

Also, over that time interest rates on 10-year Treasuries have decreased from 1.75 percent to 0.77 percent:

https://fred.stlouisfed.org/graph/?g=rbhW.

Kalecki wrote "the rate of interest depends on banking policy, in particular that of the Central Bank. If this policy aims at maintaining the rate of interest at a certain level that may be easily achieved, however large the amount of Government borrowing." (Political Aspects of Full Employment, 1943).

To answer the question in the title of the post, I don't really know and we have bigger problems to worry about.

We need psychological, not mathematical, reform

It's hard to think about much beyond what's going on in America today. A national history of institutional racism and ongoing and recent grotesque, brutal events are being highlighted. I hope to God the protests are effective. The alternative seems unbearable.

As an ineffective escape I've been reading Zach Carter's The Price of Peace: Money, Democracy, and the Life of John Maynard Keynes. The following passage (p.172) seems relevant, minus the racism which only makes things much worse:

"The collective faith of the citizenry in the ability of the nation's economic system to deliver steady, predictable gains had collapsed. Millions of British workers had joined together in an attempt to shut down the entirety of the nation's commercial life. People--most people--had actively harmed their own society in order to make a political point. The unrest had extended well beyond the ranks of the unemployed; only people who had jobs could go on strike, after all. There was clearly no sense among the public that their welfare rested on secure foundations."