The national debt: Hamilton vs. Jefferson

Alexander Hamilton and Thomas Jefferson were the first prominent American rivals in a debate that continues today. Here's a summary of Hamilton's Report on Public Credit and the debate around it.

For today's discussion, see Debt and its Discontents.

Moore (1979) The endogenous money stock

Does money supply determine inflation or does inflation determine money supply?

In The endogenous money stock, Basil Moore makes the case that the quantity of money is determined more by bank credit responding to cost and price increases than vice versa. He divides the inflation problem into two questions: (1) what is the relation between monetary growth and inflation? and (2) What is the source of change in the money stock? The data shows clear correlation between money supply and inflation, so the bigger focus is on question 2.

Moore first lays out the monetarist argument:

"The essence of monetarism can be expressed in two central propositions: a) Monetary changes are the dominant cause of changes in nominal income, swamping the temporary and minor influence of fiscal changes. b) There is no long-run, stable trade-off between inflation and unemployment; that is, the natural rate of unemployment hypothesis is valid. Changes in the rate of monetary growth cannot cause the rate of unemployment to diverge permanently from its "natural rate," except under conditions of continuously accelerating inflation."

Monetarists recommend monetary restriction to fight inflation. Their recommendation did not change when the evidence in the early 1970s (sluggish downward response of wage rates to high unemployment) proved their prescription to be painful and ineffective. Tobin has written that "Distinctively monetarist policy recommendations stem less from theoretical or even empirical findings than from distinctive value judgments. The preferences revealed consistently in those recommendations are for minimising the public sector and for paying a high cost in unemployment to stabilise prices."

One of the main sources of doubt about the monetarist argument is the question of causality.

"While the monetarists have made a case for the exogeneity of money in terms of the ability of the central bank ultimately to control the money stock, in their empirical work they unfortunately have confused the issues of causality and exogeneity. The money stock is indeed exogenous in the sense that it is ultimately under the control of the central bank. But, in econometrics, exogeneity is used in another sense: to say that a variable is exogenous is to regard it as independent of the influence of the variable whose value it seeks to explain. ... [However] the Federal Reserve and other central banks characteristically have accommodated the needs of business and the Treasury, and have operated to maintain orderly conditions in the bond markets and stabilize market interest rates."

Moore uses the relationship between prices and wage increases to show that 

"if the monetary authorities do not permit the money stock to accommodate to the rate of increase in money wages, monetary demand will not be sufficient to maintain existing employment output. Financial disorder will result if contractual obligations cannot be met, leading to downward pressure on the growth of real income and an accompanying rise in unemployment ... to the extent the authorities follow an accommodating monetary policy in order to prevent financial instability and enable real income to follow its trend path, the nominal rate of growth in the money stock will be determined by the rate of growth of money wages." 

Sort of reiterating that point, with a view of the whole economy:

"In modern economies, production costs are normally incurred and paid prior to the receipt of sales revenue. These costs represent a working-capital investment to the firm. If current production flow costs duplicate the following period, the proceeds from past sales will exactly finance current working capital costs. When wage increases raise production costs, however, even unchanged production schedules will require more working capital in money terms. Accordingly, firms must increase their borrowing from banks to finance these higher production costs for each level of output. In this manner, increases in money wage rates which exceed productivity increments and so raise unit labor costs will lead to an endogenous increase in the demand for credit, even if the aggregate production flow remains unchanged.

"Whenever the central bank accommodates this increased demand for credit, there will be a high statistical correlation between increases in the money stock and increases in prices, with the former preceding the latter."

Of course, the world is uncertain and not in equilibrium:

"The pervasive uncertainty of the real world means that decision makers seek to hold buffer stocks -- that is, inventories -- as a mechanism for absorbing unforeseen shocks ... The buffer stock par excellence is money. This suggests that individuals do not immediately adjust their money balances to a unique desired equilibrium level, but allow their holdings to fluctuate up or down, until some ceiling or floor limit is reached, before making the adjustment. To the extent that the above analysis is correct, supply-side changes (credit) largely determine short-term monetary growth. If money is supply determined in the short run, it follows that the demand for money is in short-run disequilibrium. Evidence for this is the fact that changes in real money balances [the amount of stuff a given amount of money can buy] are largely independent, and real money balances typically rise initially when the nominal money stock expands sharply. Only over the longer term is the price level determined by restoration of the equilibrium demand for money function.

In summary:

"Economists have mistakenly accepted the high-powered base approach to the determinants of monetary growth. Bank lending is the proximate and predominant source of monetary change. With lagged reserve requirements, once the deposits have been created the central bank has no choice but to make the required reserves available."

Arrow on Rawls

I'm curious about the contradictions between the utilitarian Pareto-optimal principle used by most economists and the difference principle / maximin / "veil of ignorance" principle ignored by most economists.

Vilfredo Pareto argued that a policy could only be efficient if it makes no one worse off. Cynically one could say that was a convenient theory for an Italian of noble blood to propose. John Rawls, on the other hand, argued that we should focus more on maximizing the well-being of the worst-off member of society. He called it the difference principle, economists call it maximin. To make this theory salient, Rawls proposed a "veil of ignorance": if you are about to enter the world but do not know who you will be, what kind of society do you want to enter?

Kenneth Arrow's critical review of Rawls' A Theory of Justice helped to convince me that Rawls' veil of ignorance is a useful social justice principle and that economists should bring it into decision-making. That is not the point Arrow was trying to make.

I'm no moral or political philosopher so maybe Arrow's arguments are more valid than I give them credit for, but I found them to be (1) a bit irrelevant since he immediately took things to their logical extreme instead of seriously considering the veil of ignorance as a useful decision making mechanism, and (2) a bit contradictory.

1. Logical extremes

One example of an argument employed by Arrow is that, as Pareto and Irving Fisher have argued, "there is no quantitative meaning for utility for an individual" -- it's an ordinalist position. "If the utility of an individual is not measurable, then a fortiori the comparison of utilities of different individuals is not meaningful ... Consider an individual who is incapable of deriving much pleasure from anything, whether because of psychological or physical limitations. He may well be the worst-off individual and, therefore, be the touchstone of distribution policy, even though he derives little satisfaction from the additional income." ... oversimplifying, I interpret this as: why house the homeless if one guy remains depressed? IMO Arrow is missing the point here.

2. Contradictions

Where Arrow is slightly contradictory he is at his most interesting. He was of course brilliant so there is a lot of good info even when I doubt the validity of his argument.

To take a step back, Rawls' argument that society should maximize the utility of the worst-off has two parts. First, in the original position where the quality of your entire life is at stake, it's reasonable to have high degree of risk aversion, and being concerned with worst possible outcome is an extreme form of risk aversion. Second, probabilities are in fact ill defined and should not be employed in such a calculation. Here Arrow points out:

"The second point is a version of a recurrent and unresolved controversy in the theory of behavior under uncertainty: are all uncertainties expressible by probabilities? The view that they are has a long history and has been given axiomatic justification by Ramsey and by L. J. Savage. The contrary view has been upheld by F. H. Knight and by many writers who have held to an objective view of probability; the maximin theory of rational decision-making under uncertainty was set forth by A. Wald specifically in the latter context. Among economists, G. L. S. Shackle has been a noted advocate of a more general theory which includes maximin as a special case. L. Hurwicz and I have given a set of axioms which imply that choice will be based on some function of the maximum and the minimum utility."

 And a few pages later, in defense of a utilitarian approach:

"As Ramsey and von Neumann and Morgenstern have shown, if one considers choice among risky alternatives, there is a sense in which a quantitative utility can be given meaning. Specifically, if choice among probability distributions satisfies certain apparently natural rationality conditions, then it can be shown that there is a utility function (unique up to a positive linear transformation) on the outcomes such that probability distributions of outcomes are ordered in accordance with the mathematical expectation of the utility of the outcome."

Near the end, explaining why there might not be a meaningful universal concept of justice:

"One problem is that any actual individual must necessarily have limited information about the world, and different individuals have different information."

Arrow casts doubt on Rawls' theory by saying that we can express decision making under uncertainty as a set of probabilities of futures outcomes. A few pages later he says we of course have limited information about the world, in other words it is impossible to express the future as a set of probabilities.

Maybe I'm misreading the argument, but it seems contradictory. In any event I need to read Rawls' book before I write more on this. Arrow's review is worth reading for his summary of decision making under uncertainty and his views on utilitarianism.

Inflation and Wicksell, by Leijonhufvud

The Federal Reserve does not have a working theory of inflation. That is a big deal because price stability is half its mandate.

The Phillips curve relationship -- a negative correlation between unemployment and inflation, identified by A.W. Phillips in data for the UK between 1861 and 1957 -- has been weak. Possible reasons include (i) people expect lower inflation and it's a self-fulfilling prophesy, (ii) labor unions are weaker so wage gains are weaker so corporate costs increase more slowly, (iii) the rise of e-commerce has created more competition between retailers, and (iv) shifting factories to lower-cost producers like China has kept costs down. Any/all of these factors might be keeping inflation down.

For a large part of the past 40 years, policymakers operated from a Quantity Theory of money view, summarized by Milton Friedman's "inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." This sounds legitimate but was always a bit dubious. It became openly indefensible after the huge increase in the money supply after 2008 did not result in inflation. Since the mid 1990s inflation has almost always been lower than the increase in M2. But knowing that the Quantity Theory is not right does not answer the question of what actually causes inflation.

Axel Leijonhufvud (1997) points out that Knut Wicksell made some good points on this in 1898 (as well as on "the hypothesis of intertemporal disequilibrium as the key to the understanding of business cycles"), which many economists have ignored to the detriment of macroeconomics and monetary theory as we understand it today.

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.404.5867&rep=rep1&type=pdf.

Here are three questions Leijonhfvud's article helps to answer 

1. Why is the Quantity Theory suspect?

David Ricardo's quantity theory of the price level is "completely sound and correct" for a pure "cash economy". We live however in a mostly credit economy.

"Bank money was credit money and, unlike metallic money, could not be in excess supply, Tooke maintained. An overissue by the banks would simply produce a "reflux" of notes in repayment of loans. If expansions and contractions of the banks drove the price level, rising prices should be associated with low interest rates and vice versa. But the evidence ... was just the opposite."  

2. Why not just adopt the alternative theory?

Thomas Tooke's anti-quantity theoretical conclusion is that the price level determines the stock of money. This may be true, "but it left one with no tenable theory of the price level at all."

Wicksell concluded that "the Quantity Theory cannot just be thrown overboard ... The Quantity Theory was the only monetary theory with any claim to scientific status. But it left out the influence on the price level of credit-financed demand." This omission becomes major when bank credit reduces the role of metallic money in the economy. 

"Wicksell presented a pure credit system model as "a precise antithesis to the equally imaginary case of a pure cash system, in which credit plays no part whatever ... The strategy for developing applied monetary theory, he suggested, was to regard actual monetary systems

"as combinations of these two extreme types. If we can obtain a clear picture of the causes responsible for the value of money in both of these imaginary cases, we shall, I think, have found the right key to a solution of the complications which monetary phenomena exhibit in practice."

3. What's the right combination?

There's the rub.

Wicksell's suggestion "is a stroke of genius ... But it is by the same token deeply problematic, for Wicksell has very little to tell us about how to go about fashioning a viable synthesis from his two antithetical models."

"This lack of an outline of the suggested synthesis has been unfortunate in that the Ricardian thesis and Tookean antithesis have been carried down to the present day as mutually exclusive theories with Monetarists denying the relevance of credit and Credit theorists still lacking a theory of the price level. Thus Milton Friedman turned the evolutionary argument against Credit theories: monetary theory should focus on the banking system's liabilities and not on their assets which evolution had reduced to a minor component of total credit. More recently, monetary general equilibrium theorists have generally been content simply to brush credit under the Modigliani-Miller rug. On the other side, the Tookean tradition has its most persuasive advocate today in Basil Moore."

The instability that Wicksell foresaw was postponed when in the early 20th century governments monopolized note issue and imposed reserve requirements on banks, which "gave the Quantity Theory a new lease of life." In recent decades, however, the expanded use of "smart cards" (credit cards) and the elimination of reserve requirements (which happened officially on March 15, 2020, but effectively years ago) have probably all but ended any stable relationship between aggregate demand and the "vanishingly small" monetary base.

"The newest generation of jet fighter planes ... are inherently unstable in the air and depend on extremely fast feedback-based electronic control (In fact, they cannot be flown by human pilots).

"Price level stabilization by Wicksellian bank rate policy may become similarly challenging before very long. Perhaps it is fortunate that we will be able to entrust it to a Nintendo-trained generation."

The world keeps changing and monetary policymakers need to keep adapting. 

Final note: this article is worth (re) reading, it's short and there's much in that I don't cover here.

Did the Fed save stocks?

Yes. The Federal Reserve's balance sheet expanded by $3 trillion in April and May while S&P 500 market capitalization increased by $4 trillion.

Keen on credit and aggregate demand

I had a two hour debate with a colleague today. We got to the heart of some of the disagreement when I asked "do you agree with the statement that money and credit is unimportant when thinking about economic policy." He said yes. I, on the other hand, think money and credit is important when thinking about the economy.

I watched a Steve Keen video on the debt problem and coincidentally he mentions many of the same points we discussed. But the reason I'm posting any of this is because of a point Steve makes in the video, quoted below. Really makes clear why credit is important in economic analysis. Keen explains that this is what he added to the analysis of endogenous money stock, introduced by Basil Moore in 1979.

"Nobody borrows for the sheer pleasure of being in debt. You borrow to spend. so when you borrow, that change in money becomes a change in demand, and credit therefore is an essential part of aggregate demand."

Simple and brilliant.

Biden-Sanders on budgeting

The Biden-Sanders Unity Task Force released its recommendations in July. The NY Times listed six takeaways in the areas of health care, criminal justice, climate change, the economy, education, and immigration. On a separate topic, here I quote what the report writes about the federal budgeting process, which Stephanie Kelton referenced in her August 11 interview with Dissent Magazine.

"We are committed to a budget process which eliminates biases against certain types of productive investment and provides a broad and inclusive analytical framework when assessing the economic impact of legislation. To help achieve this goal, we recommend the establishment of a commission to study shortcomings in the budget process and provide detailed recommendations. This includes examining scoring practices used by official scorekeepers, such as accounting for uncertainty in official estimates and incorporating assumptions about the extent to which public investment crowds out other economic activity.

"The budget process should also be examined to determine whether better evaluating the economic and fiscal impacts of tax expenditures can lead to more efficient, equitable, and productive tax policies. Official scorekeepers should be fully transparent in their methods, including making their forecasting models public (as does the Federal Reserve) and strive to increase the gender, racial, and academic diversity on both their staff and their Panel of Economic Advisors."

I was of course very pleased to see the mention of uncertainty and assumptions of crowding out, which today are handled unrealistically in ways that bias the legislative process against allocating resources toward things such as education, healthcare, pensions and research.

I should note that, to its credit, the Congressional Budget Office has become more transparent in recent years, for example posting a description of and code for their health insurance microsimulation model, HISIM2, in 2019.

Economics as a Moral Science

Kenneth Boulding's presidential address at the 81st meeting of the American Economic Association on December 29, 1968.

The article is here https://www.jstor.org/stable/1811088?seq=2#metadata_info_tab_contents, I've picked out a couple of topics that Boulding commented on. Examples of core, today virtually unquestioned, components of the economics curriculum.

The indifference curve

One of the most peculiar illusions of economists is a doctrine that might be called the Immaculate Conception of the Indifference Curve, that is, that tastes are simply given, and that we cannot inquire into the process by which they are formed. This doctrine is literally "for the birds," whose tastes are largely created for them by their genetic structures, and can therefore be treated as a constant in the dynamics of bird societies. In human society, however, the genetic component of tastes is very small indeed ... It was, incidentally, Veblen's principal, and still largely unrecognized, contribution to formal economic theory, to point out that we cannot assume that tastes are given in any dynamic theory, in the sense that in dynamics we cannot afford to neglect the processes by which cultures are created and by which preferences are learned.

The Heisenberg principle

The learning process of science is now running into two serious difficulties. The first might be called the generalized Heisenberg principle. When we are trying to obtain knowledge about a system by changing its inputs and outputs of information, these inputs and outputs will change the system itself, and under some circumstances they may change it radically. My favorite illustration of the Heisenberg principle is that of a man who inquires through the door of the bedroom where his friend is sick, "How are you?" whereupon the friend replies "Fine," and the effort kills him. In the social sciences of course the generalized Heisenberg principle dominates because knowledge of the social sciences is an essential part of the social system itself, hence objectivity in the sense of investigating a world which is unchanged by the investigation of it is an absurdity. 

The second difficulty is that as science develops it no longer merely investigates the world; it creates the world which it is investigating.

The definition of economics

Economics specializes in the study of that part of the total social system which is organized through exchange and which deals with exchangeables. This to my mind is a better definition of economics than those which define it as relating to scarcity or allocation, for the allocation of scarce resources is a universal problem which applies to political decisions and political structures through coercion, threat, and even to love and community, just as it does to exchange. I have elsewhere distinguished three groups of social organizers which I have called the threat system, the exchange system, and the integrative system. Economics clearly occupies the middle one of these three."

Pareto efficiency

Welfare economics attempts to ask the question "What do we mean when we say that one state of a social system is better than another in strictly economic terms?" The most celebrated answer given is the Paretian optimum ... State A is superior to State B if one or more persons prefer A and if nobody prefers B ... Many, if not most, economists accept the Paretian optimum as almost self-evident. Nevertheless, it rests on an extremely shaky foundation of ethical propositions ... it implies that there is no malevolence anywhere in the system. It implies, likewise, that there is no benevolence ... It assumes selfishness, that is, the independence of individual preference functions, such that it makes no difference to me whether I perceive you as either better off or worse off. Anything less descriptive of the human condition could hardly be imagined."

Beliefs and institutions

An interesting paper on Leigh Tesfatsion's site is Douglass North's Economics and Cognitive Science (1996). It links our internal mental models (beliefs) to the external environment (ideologies and institutions) through our attempt to reduce uncertainty or create order from disorder. As a result of evolutionary learning, personal beliefs form which are unique to each of us, ideologies form which structure our general mental environment, and institutions form which structure our external environment.

North starts by noting that the competitive markets and general equilibrium assumptions at the core of the neoclassical approach to economics are valuable in theory for understanding how a decentralized system of market forces could generate efficient resource allocation. "But valuable as this model has been for the development of an elegant body of theory it is a very imperfect tool for solving economic problems both at a moment of time but particularly over time ... In the real world of imperfectly competitive markets beliefs determine the choices of the actors." 

North first looks at how imperfect information and uncertainty complicate the neoclassical model, especially over time. He then summarizes the nature of ideologies and issues for cognitive science.

Beliefs > preferences

Neoclassical theory assumes that preferences are stable and choices are made within income and technology constraints. But significantly there are no institutional constraints: in a world of perfect information institutions are unnecessary, since"Institutions exist to structure human interaction in a world of uncertainty."

"Once we recognize this fundamental role of institutions in reducing uncertainty we must restructure the theoretical framework we use in economics and the social sciences."

Institutions provide an incentive structure at any point in time and drive the process of social change over time. They are therefore "central to the theoretical construct." Institutions comprise formal rules, informal constraints, and their enforcement characteristics.

North also notes that time "is the dimension in which human learning occurs". Over time our societies become increasingly interdependent and institutional structures become more complex.

Note- the mix between genes and cultural heritage is "in dispute" (this was written in 1995-6, I imagine there is much more research on the topic now but I'm not familiar with it). 

How do diverse belief systems arise?

"The pervasive human attempt to reduce uncertainty is the key to understanding the way belief systems evolve. In order to make uncertain situations "comprehensible" humans will develop explanations. The pervasiveness of myths, taboos and particularly religions throughout history (and prehistory, as well) suggests that humans have always felt a need to explain the unexplainable and indeed it is probably an evolutionarily superior trait to have any explanation rather than no explanation."

Humans thinking in terms of narratives has been a bit of a theme lately- most recently covered in Kay and King's Radical Uncertainty. A thought from this paper is that when thinking in terms of an economic model, the effect of inductive thinking should probably be considered not just at the individual level but at the overall system level too (if those things can be meaningfully differentiated).

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.